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Fama’s markets

14 October 2013 By Olaf Storbeck, Viktoria Dendrinou

Economics is the only field in which two people can share a Nobel prize for saying opposing things. This old joke, provoked by the 1974 prize that went to ideological antagonists Friedrich August von Hayek and Gunnar Myrdal, is proving relevant again. Eugene Fama, Lars Peter Hansen and Robert Shiller all worked on financial markets’ efficiency and drew separate, if not opposing, conclusions. This is a welcome reminder that the dismal science has few absolute truths to offer – mostly questions to explore.

Hansen’s merits are methodological. His key innovation, the Generalized Method of Moments (GMM), is a popular econometric technique with applications in micro- and macro-economics, used to uncover relationships between variables in uncertain, complex economic environments – such as asset markets. 

Unlike Hansen, Fama and Shiller are mostly known for the conclusions they – or often, others – draw from their academic work. Fama is one of the founding fathers of the “efficient market hypothesis”, which roughly holds that financial markets always send the right price signals. Shiller, on the other hand, seems to have spent decades debunking the EMH, collecting empirical evidence that markets are prone to bubbles and irrational exuberance.

An important practical insight of Fama’s research is that it is difficult – if not impossible – to beat the wider stock market over a sustained period of time. Empirical research supports this finding, and triggered the rise of passive investment funds that track stock market indices.

Overall, however, Fama’s influence on practical policy has been stronger than it should have. EMH nurtured an excessive faith in the wonders of unregulated financial markets, which led economists to ignore speculative excesses. That partly explains the general passivity during the dot.com hype, and later the housing bubble, which triggered the biggest financial and economic crisis since the Great Depression.

Robert Shiller is one of the few economists who warned against those bubbles. His was at times a lonely voice, which explained stock market movements by “animal spirits”. More recently, especially after the crisis, his approach has become more mainstream.

Rewarding both Shiller and Fama the same year shows that economics remains a healthy chorus of loud, conflicting voices. But Hansen’s work in particular shows that a technical framework remains key to better understanding of complex questions, or at least framing the debate.


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