Compliments to the Complements: Why the 2013 Nobel is not a Contradiction
2013 Nobel Laureates Eugene Fama (left) and Robert Shiller
As all reading this are surely aware, the Nobel Prize in Economics (btw, technically not a true Nobel) was awarded last week to Eugene Fama and Robert Shiller for their work on financial asset pricing. Lars Hansen also earned a share of this year's award for his creation of the model estimation technique known as General Method of Moments. My co-author tells me a piece on Hansen is forthcoming. What might surprise some not steeped in economics is that Fama and Shiller were not colleagues; quite the contrary, Shiller's contribution was in pointing out the shortcomings of Fama's framework.
The work for which Fama is being recognized has its roots in the 1960s. At that time, Fama was a pioneer in the theory of efficient markets and in fact developed the Efficient Market Hypothesis (EMH) in his doctoral thesis. By factoring in all public information about assets, Fama reasoned, market agents collapse on a single price for any asset that reflects its expected value as a stream of payments discounted by time and interest rate.
Before behavioral finance was even a field however, there were some glaring weaknesses in the hypothesis. For example, one of Fama's assumptions was that firms were already pricing assets this way, even though he had just proposed the theory, which would really be a neat trick (read: not too likely). Perhaps even more obviously, speculative bubbles and consequent bursts should be effectively ruled out by efficient markets since they represent gross inefficiencies in agents' ability to price assets. Taking critique in to account, Fama would respond in 1970 by proposing three versions of his EMH: strong, semi-strong, and weak. Each progressively weaker form assumes increasingly imperfect information, and thus increasing ability of firms to profit in the short run.
It wasn't for another few decades that the strict rationality of markets would become truly game for intellectual inquiry. And it was here that Robert Shiller made his Nobel-worthy contributions: by discovering that market movements couldn't be explained on the basis of fundamental analysis alone, Shiller suggested that behavioral biases must be interplaying with rationality, thus inventing the field of Behavioral Finance. While published well after his formal academic work on the subject landed, Shiller's book "Irrational Exuberance" laid out his case to the public at-large. And his timing could not have been more perfect: that same month (March 2000), the tech bubble burst! Cue the oracular acclamations.
To be fair: the EMH has held up remarkably well. Even Shiller largely buys it; after all, he needed EMH to build his own work off of. Noah Smith makes a typically apt analogy by calling Shiller the Einstein to Fama's Newton, in that EMH, like Newtonian physics, does a damn good job explaining the broad contours of market behavior, while Shiller's codification of market failures fills in the gaps where EMH breaks down.
So then, rather than contradiction, this year's Nobel represents complementary ideas from two brilliant economics that revolutionized and re-revolutionized the ways the economics field explores market behavior. Dubious contemporary macro-policy commentary notwithstanding, these men have made monumental contributions to our understanding of the financial world and have emphatically earned this grandest of distinctions.