It is a supreme irony that a man whose ideas could have helped us avoid the most recent financial crisis now shares a Nobel with one whose work went a long way toward making it possible.
The two economists -- Robert Shiller of Yale University and Eugene Fama of the University of Chicago, winners of the 2013 memorial prize in economics -- are both admirers of the power of financial markets. As Shiller rightly argues, finance is a technology that can be just as beneficial as any other, from electric power to the Internet. Without finance, how would we pool our collective resources to fund the vast undertakings required for medical research, oil exploration or even education? How would we insure ourselves against the staggering costs of earthquakes and other natural catastrophes? How many of us would ever own a house?
Yet Shiller’s enthusiasm is balanced by an understanding that markets frequently generate perverse social outcomes. In his 2000 book “Irrational Exuberance,” Shiller warned loudly of the impending collapse of the dot-com bubble. In the years prior to the recent financial crisis, he spoke about distortions in the housing market and the dangers of subprime mortgages. For Shiller, the technology of finance, while immensely useful, also carries a host of dangers, with no guarantee of proper functioning without constant supervision.
If Shiller’s were the standard view in financial economics, the world almost certainly would have avoided the worst consequences of the crisis. Unfortunately, his realism hasn’t been shared by others, most notably Fama. Perhaps no one over the past 40 years has done more than Fama to push the notion that finance is a technology that we don’t need to worry about - - a claim that involves an impressive contortion of language.
Usually in economics, the word “efficient” refers to some theoretical assessment of a market’s ability to allocate resources to their best use. The meaning comes from equilibrium models that Kenneth Arrow and Gerard Debreu pioneered in the 1950s. Those models are so divorced from reality that nobody really knows what implications they have for the world we live in. That said, their notion of efficiency at least makes sense: The ideal market gives an outcome that is better than the alternatives.
Fama’s work injected a considerable dose of confusion by using the word “efficient” in a very different sense. He talked about “information efficiency,” and defined it as a situation in which market prices “reflect all available information.” Over the years, he and others played with a variety of versions -- strong, semi-strong and weak -- that differ in what information (private or public) they require real-world market prices to reflect (see my blog for further detail).
Ultimately, real-world data have supported only the weak version, in which efficiency signifies that market movements are almost impossible to predict, meaning it’s very difficult for an investor to beat the market consistently. This comes as a surprise to almost no one, and has nothing to do with how any normal person understands the word “efficient.” A market driven up and down by monkeys hitting the keys of typewriters would also be efficient in this very peculiar sense.
The amount of ink spilled over the efficient markets idea in the past 40 years is truly stupendous. On the bright side, it inspired the creation of index funds, on the assumption that investors can do better by passively holding a wide variety of assets than they can by trying to beat the market.
Unfortunately, the damage done is far greater. The view of prices as being in a perpetual equilibrium helped to discourage the development of more realistic theories of markets as ecologies of interacting strategies which never reach any benign resting point. These only received serious exploration beginning in the 1990s, and remain unknown to many economists even today.
Worst of all, easy acceptance of the phrase “markets are efficient” has for several decades helped to feed a complacency surrounding the global financial system. Fama and others showed that markets are “efficient” in a weird technical sense, and then used the familiarity of this word to convince us that markets do their job really well and therefore should be left alone.
It’s hard to say whether this was intentional deception or merely self-delusion. Either way, it has done humanity a great disservice.
(Mark Buchanan, a theoretical physicist and the author of “Forecast: What Physics, Meteorology and the Natural Sciences Can Teach Us About Economics,” is a Bloomberg View columnist.)
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