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Thursday, October 17, 2013

Transcript: Riksbank Prize, Minsky, Keen

The Nobel Prize was awarded this week.

I had no problem with Robert Shiller. He could see the bubble. Heck, he predicted the dot.com bust. And pointed out the housing bubble years in advance. As important to me, he provided the apt metaphor for the economy, or at least seconded my preference. Metaphors are essential. People understand complex issues by use of the metaphor. Once a metaphor is accepted, the rest of a person's understanding follows "intuitively." The economy is viewed by most people through the metaphor of a business or household. Everybody balances their books, goes out and earns or rents for their money. If everyone -- including the government -- plays by the same rules, then everyone is happy. The problem arises when somebody overspends or borrows imprudently.
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The apt metaphor is the family farm. For the economy to work well, everyone needs to be employed doing useful things. If the fields are too wet to plow or plant, there is fence to fix and barns to raise. There are roads to grade or drain tile to be installed. Planning is important. Anticipating the weather. Prudence is important. You don't just open the doors in the morning and let everyone out and fend for themselves. All able hands employed makes for the most vigorous enterprise. Full employment is the only route to prosperity. Shiller raised this metaphor in a couple of his New York Times pieces.

No, I had no problem with Robert Shiller.

I had a problem with Eugene Fama

So did Peter Radford

At Real World Economic Review, under the title

The Fama Quasi-Nobel: posthumous award for EMH?
from Peter Radford

They’re kidding, right?

Nope. They mean it.

What’s really weird is that he splits the award with Robert Shiller and some guy called Hansen who is an econometrician and thus unintelligible and largely irrelevant to sensible discussion of the economy.

There are a few ways to deal with this.

Take One:

Fama was the guy who created the Efficient Markets Hypothesis (EMH). ... [T]his theory tells us that there is nothing an investor can do to outfox the market. [A]ll the information that is out there is incorporated in prices. Thus all those ads telling us about past performance and about clever investment strategies are simple hoaxes. The market is what it is, and neither you nor I can outwit it unless by dumb luck.

This interpretation of EMH means it is a ... solid, relevant and good piece of work. The problem is that it is built on ... the same quicksand as its companion theories that posit rational behavior. And because it can be reduced to ... “the market is what it is,” it has little value to anyone other than obscure finance theorists. ...

In a nutshell EMH is another example of the hermetically sealed reality-resistant thinking that dominates modern economics: ... only quirks or rotten stuff sit outside the pristine and pure wondrous working of the marketplace. Which is why theorists like Fama are so ideologically hell bent against anything that appears to intrude into their precious markets. Especially governments.

Take Two:

... [Robert] Shiller [on the other hand] has devoted much of his professional career to pointing out that people are a bit less – perhaps a lot less – than rational. At least in the meaning Fama has for rational.

... Shiller achieved notoriety for his study of real estate prices and noting the rise of the bubble that so famously burst a few years back.

Bubbles would suggest that markets are somewhat less than rational and are inclined to significant overshooting, undershooting, and other total misinterpretations of information. This is hardly efficient. Indeed, a quick look at Shiller’s work seems to imply that he has debunked EMH pretty well. Don’t forget that according to EMH a house priced $100 one day and $1,000,000 the next is entirely within the realm of rational experience. The difference simply reflects different information. ...

So the quasi-Nobel prize committee is backing both sides of a very important argument. One that has huge implications for ... bank regulation. Do we regulate banks because they are likely to get swept away by Shiller-like exuberance? Or do we leave well alone because [banks] are embedded in the smooth rational workings of the financial market place a la Fama?

Take Three:

This is what I call the “Krugman cop-out”.

[Paul Krugman's] argument is that, even though Shiller seems to have undone Fama, and even though the work of the two seems to be in contradiction, the award to Fama is still worthy. After all someone had to dig the hole Shiller’s work subsequently filled up. Krugman is taking the old academic high road .... Perhaps he’s mindful that his work could also be debunked one day, and so he has closed ranks.

Take Four:

My view is that the quasi-Nobel committee was on the brink of giving Fama the prize back in the mid 2000′s, but was stopped dead in its tracks by the crisis, the bursting of the bubble, and the disarray this meant for the Fama camp. The committee had to wait for the dust to settle and for Fama’s defenders to rally 'round. They also had to allow the [audience] of anyone interested in the prize to lose sight of EMH amongst all the post-crisis confusion and exposure of economics generally. Then they had to get someone else to steal the headlines so that few outsiders would notice -- Shiller is a terrific choice.

In many ways the award is akin to posthumous recognition. It is a reward for hard work done in the service of a now debunked theory.

EMH still has its supporters, of course. They are that hardy band of rationalists who still dominate much of the economics landscape and who strenuously fight to keep reality at bay. Most of them appear to live in Chicago,

... says Peter Radford

Mark Thoma had the thought:

Are Rationality and the Efficient Markets Hypothesis Useful?

Just a quick note on the efficient markets hypothesis, rationality, and all that. [These are] important contributions not because they are accurate descriptions of the world (though they may come close in some cases), but rather because they give us an important benchmark to measure departures from an ideal world. It's somewhat like studying the effects of gravity in an idealized system with no wind, ... in a vacuum ... as a first step. If people say, "Yes, but it's always windy here," then we can account for those effects .... Same for the efficient markets hypothesis and rationality. If people say, in effect, "but it's always windy here" -- those models miss important behavioral effects ... -- then the models need to be amended appropriately (though, like dropping heavy weights short distances in the wind, some markets may act close enough to idealized conditions ...). We have not done enough to amend models to account for departures from the ideal, but that doesn't mean the ideal models aren't useful benchmarks.

Nice try. Fama's world is hypothetical. It is like studying the effects of gravity without mass. It might be an entertaining diversion, like a crossword puzzle, but it is basically meaningless.

Merign Knibbe left this, also at RWER

Inefficient financial markets and an irrational economist: example

The mortgage market has become the most important financial market. Is it efficient in the Fama sense? [That is, is it] characterized by competing, intelligent, well-educated, rational people who ... can change their assets/loans portfolio [in response to the latest information]? [Who even] know that their house and their mortgage are part of their entire assets/loans portfolio? Maybe not.

The Wall Street Journal had something interesting to say for a change

Nobel Laureates Shiller and Fama: The Oddest of Bedfellows

It’s hard to imagine an odder pair of intellectual bedfellows than Eugene Fama and Robert Shiller, who along with Lars Peter Hansen were today awarded the Nobel prize in economics.

Mr. Fama is considered by some to be the founder of modern finance for his work in developing the so-called efficient market hypothesis, the notion that prices always capture an equilibrium that incorporates all available information. In Mr. Fama’s world, where investors act rationally, there is no room for things like “momentum trading” or “chasing prices higher.” In fact, in 2010, in the wake of the devastating crisis that followed the massive run-up in real estate prices, he told the New Yorker’s John Cassidy, “I don’t even know what a bubble means.”

By contrast, the titles of behavioral economist Mr. Shiller’s popular books tell you all need to know about [how] he feels about assumptions that investors are always rational. His best-selling 2000 book “Irrational Exuberance” was ... about the forces that create market bubbles. It predicted the bursting of the tech bubble in 2001....[Its] 2005 edition identified the bubble-like behavior in U.S. real estate that would later lead to the crisis of 2008. In 2009, he published “Animal Spirits: How Human Psychology Drives the Economy, and Why It Matters for Global Capitalism,” which he wrote with George Akerlof, another Nobel laureate and the husband of Federal Reserve Chair nominee Janet Yellen. As its subtitle suggests, it’s a work that inevitably touches on how the economy is often affected by the ways in which human beings can act irrationally.

Both men have had significant influence on the formation of investment strategies and pricing models. But in the post-crisis world, it’s perhaps fair to say that Mr. Shiller is looking more in touch with our current understanding of how markets work.

That was a gentle way to end: "more in touch with our current understanding of how markets work."

The proposition that all of the information is included in the market is valid, I suppose, if you define information as views, panic, euphoria, greed, spin, and the rest of human thought and feeling and attempts to manipulate. With information so defined, Fama may have a point. But if information is defined simply as reliable data and coherent interpretations, then he is clearly wrong.

Fama's 2012 interview with the New Yorker magazine in which he denied the existence of bubbles and said flatly that the recession preceded the housing collapse offers sufficient evidence that he inhabits la-la land and is more concerned with protecting his intellectual property than coming to grips with reality. That interview is included at the end of today's transcript.

But Fama IS consistent and persistent, and so is the Riksbank. Radford called it a QUASI Nobel, as in fake. It sprang up in 1969, long after the start date of the other Nobels -- 1895, an invention of the Sveriges Riksbank. The actual name of the prize is "The Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel." If as we've said, economics science is to science what FoxNews is to news, this award comes from the staff and management of the counterpart to FoxNews. By awarding the prize to Fama, the Riksbank carries on the tradition of Black and Sholes and Friedman and Lucas and two-thirds of the other recipients with pretty theories that were wrong, some of them absurd.

I once met Douglass North who shared the prize one year long ago. I read his work. It was okay, I thought at the time. A bit trivial, perhaps. But he was an economic historian, very underrepresented among laureates. Since then I have come to appreciate Professor North. At least he was not demonstrably wrong.

Then if you think of the people who did not receive the Nobel, you see what a disgrace it is. At the top of the list: John Kenneth Galbraith. You're only eligible if you're alive, so John Maynard Keynes was never eligible, having died in 1946. Galbraith, however, lived a long and fruitful life. Served during World War II and was responsible in large part for the absence of black markets and inflation then. Later served under Kennedy. Wrote dozens of excellent books. His never receiving this prize, when it is given to the bankers' butlers, is the capstone to the proof that the prize is not relevant.

The most absurd applications of the efficient market nonsense arise when the theory strays from financial markets and tries to say something about efficient allocation of capital. The financial markets are a casino and perhaps you can't beat the house, though there are many examples of people who have. But to say markets have efficiently organized things is to ignore the welfare of billions, to accept the extravagance of trivialities and the paucity of essentials, to embrace the fever to burn through the planets environment and the indifference toward the millennia ahead and the people who could have lived here, to applaud an ambivalence about full employment and support the determination to make banks profitable. These are all market-determined. The market is controlled by, as Galbraith showed, the dominant corporations in each sector. Finance is no different. The government is the hand of the big players in most markets.

Perhaps James K. Galbraith, John Kenneth's son and intellectual heir, will someday be honored as a token to reality.

Another economist I follow closely who likely will never receive the Riksbank Prize is Australian Steve Keen, the world's most important interpreter of another non-Prize winner, Hyman Minsky.

As part of my economics activity, I have occasion to listen to accounts of Keen's personal travels. I was taken aback a couple of months ago when he announced a trip to Ecuador. Must be desperate, I thought. Completely wrong.

Ecuador under Correa, a PhD economist, has engaged the brightest young people available and set them to devising an enlightened egalitarian capitalism. A coup from the hereditary oligarchs looms over every day. The task is to neutralize them while convincing the emerging capitalists that the new way is better for everybody. Steve's accounts of the vigor and commitment of these people reminded me of the accounts of the New Deal, when Franklin Roosevelt and the motivated minds of a generation came together to solve the Great Depression.

Keen was there, working with the government and teaching through FLACSO, the Latin American School of Social Sciences. As I understood it, FLACSO operates throughout Latin America. Steve is hopeful of getting a substantial grant for the development of Minsky, his revolutionary dynamic modeling software. It's the best thing I've heard in many a moon.

A crash course Keen prepared for his FLACSO students in disequilibrium economics is linked to on the podcast.

Crash course in disequilibrium economics


Next time, maybe a bit of Minsky and Keynes.


Eugene Fama on the Housing Bubble...

Interview with Eugene Fama: The New Yorker:

John Cassidy: I met Eugene Fama in his office at the Booth School of Business. I began by pointing out that the efficient markets hypothesis, which he promulgated in the nineteen-sixties and nineteen-seventies, had come in for a lot of criticism since the financial crisis began in 1987, and I asked Fama how he thought the theory, which says prices of financial assets accurately reflect all of the available information about economic fundamentals, had fared.

Eugene Fama: I think it did quite well in this episode. Stock prices typically decline prior to and in a state of recession. This was a particularly severe recession. Prices started to decline in advance of when people recognized that it was a recession and then continued to decline. There was nothing unusual about that. That was exactly what you would expect if markets were efficient.

John Cassidy: Many people would argue that, in this case, the inefficiency was primarily in the credit markets, not the stock market—that there was a credit bubble that inflated and ultimately burst.

Eugene Fama: I don’t even know what that means. People who get credit have to get it from somewhere. Does a credit bubble mean that people save too much during that period? I don’t know what a credit bubble means. I don’t even know what a bubble means. These words have become popular. I don’t think they have any meaning.

John Cassidy: I guess most people would define a bubble as an extended period during which asset prices depart quite significantly from economic fundamentals.

Eugene Fama: That’s what I would think it is, but that means that somebody must have made a lot of money betting on that, if you could identify it. It’s easy to say prices went down, it must have been a bubble, after the fact. I think most bubbles are twenty-twenty hindsight. Now after the fact you always find people who said before the fact that prices are too high. People are always saying that prices are too high. When they turn out to be right, we anoint them. When they turn out to be wrong, we ignore them. They are typically right and wrong about half the time.

John Cassidy: Are you saying that bubbles can’t exist?

Eugene Fama: They have to be predictable phenomena. I don’t think any of this was particularly predictable.

John Cassidy: Is it not true that in the credit markets people were getting loans, especially home loans, which they shouldn’t have been getting?

Eugene Fama: That was government policy; that was not a failure of the market. The government decided that it wanted to expand home ownership. Fannie Mae and Freddie Mac were instructed to buy lower grade mortgages.

John Cassidy: But Fannie and Freddie’s purchases of subprime mortgages were pretty small compared to the market as a whole, perhaps twenty or thirty per cent.

Eugene Fama: (Laughs) Well, what does it take?

John Cassidy: Wasn’t the subprime mortgage bond business overwhelmingly a private sector phenomenon involving Wall Street firms, other U.S. financial firms, and European banks?

Eugene Fama: Well, (it’s easy) to say after the fact that things were wrong. But at the time those buying them didn’t think they were wrong. It isn’t as if they were na├»ve investors, or anything. They were all the big institutions—not just in the United States, but around the world. What they got wrong, and I don’t know how they could have got it right, was that there was a decline in house prices around the world, not just in the U.S. You can blame subprime mortgages, but if you want to explain the decline in real estate prices you have to explain why they declined in places that didn’t have subprime mortgages. It was a global phenomenon. Now, it took subprime down with it, but it took a lot of stuff down with it.

John Cassidy: So what is your explanation of what happened?

Eugene Fama: What happened is we went through a big recession, people couldn’t make their mortgage payments, and, of course, the ones with the riskiest mortgages were the most likely not to be able to do it. As a consequence, we had a so-called credit crisis. It wasn’t really a credit crisis. It was an economic crisis.

John Cassidy: But surely the start of the credit crisis predated the recession?

Eugene Fama: I don’t think so. How could it? People don’t walk away from their homes unless they can’t make the payments. That’s an indication that we are in a recession.

John Cassidy: So you are saying the recession predated August 2007, when the subprime bond market froze up?

Eugene Fama: Yeah. It had to, to be showing up among people who had mortgages. Nobody who’s doing mortgage research—we have lots of them here—disagrees with that.

John Cassidy: So what caused the recession if it wasn’t the financial crisis?

Eugene Fama: (Laughs) That’s where economics has always broken down. We don’t know what causes recessions. Now, I’m not a macroeconomist so I don’t feel bad about that. (Laughs again.) We’ve never known. Debates go on to this day about what caused the Great Depression. Economics is not very good at explaining swings in economic activity.

John Cassidy: Let me get this straight, because I don’t want to misrepresent you. Your view is that in 2007 there was an economic recession coming on, for whatever reason, which was then reflected in the financial system in the form of lower asset prices?

Eugene Fama: Yeah. What was really unusual was the worldwide fall in real estate prices.

John Cassidy: So, you get a recession, for whatever reason, that leads to a worldwide fall in house prices, and that leads to a financial collapse...

Eugene Fama: Of the mortgage market… What’s the reality now? Everybody talks about a credit crisis. The variance of stock returns for the market as a whole went up to, like, sixty per cent a year—the Vix measure of volatility was running at about sixty per cent. What that implies is not a credit market crisis. It would be stupid for anybody to give credit in those circumstances, because the probability that any borrower is going to be gone within a year is pretty high. In an efficient market, you would expect that debt would shorten up. Any new debt would be very short-term until that volatility went down.

John Cassidy: But what is driving that volatility?

Eugene Fama: (Laughs) Again, its economic activity—the part we don’t understand. So the fact we don’t understand it means there’s a lot of uncertainty about how bad it really is. That creates all kinds of volatility in financial prices, and bonds are no longer a viable form of financing.

John Cassidy: And all that is consistent with market efficiency?

Eugene Fama: Yes. It is exactly how you would expect the market to work.

John Cassidy: Taking a somewhat broader view, the usual defense of financial markets is that they facilitate investment, facilitate growth, help to allocate resources to their most productive uses, and so on. In this instance, it appears that the market produced an enormous amount of investment in real estate, much of which wasn’t warranted...

Eugene Fama: After the fact...There was enormous investment across the board: it wasn’t just housing. Corporate investment was very high. All forms of investment were very high. What you are really saying is that somewhere in the world people were saving a lot—the Chinese, for example. They were providing capital to the rest of the world. The U.S. was consuming capital like it was going out of sight.

John Cassidy: Sure, but the traditional Chicago view has been that the financial markets do a good job of allocating that capital. In this case it, they didn’t—or so it appears.

Eugene Fama: (Pauses) A lot of mortgages went bad. A lot of corporate debt went bad. A lot of debt of all sorts went bad. I don’t see how this is a special case. This is a problem created by a general decline in asset prices. Whenever you get a recession, it turns out that you invested too much before that. But that was unpredictable at the time.

John Cassidy: There were some people out there saying this was an unsustainable bubble…

Eugene Fama: Right. For example, (Robert) Shiller was saying that since 1996.

John Cassidy: Yes, but he also said in 2004 and 2005 that this was a housing bubble.

Eugene Fama: O.K., right. Here’s a question to turn it around. Can you have a bubble in all asset markets at the same time? Does that make any sense at all? Maybe it does in somebody’s view of the world, but I have a real problem with that. Maybe you can convince me there can be bubbles in individual securities. It’s a tougher story to tell me there’s a bubble in a whole sector of the market, if there isn’t something artificial going on. When you start telling me there’s a bubble in all markets, I don’t even know what that means. Now we are talking about saving equals investment. You are basically telling me people are saving too much, and I don’t know what to make of that.

John Cassidy: In the past, I think you have been quoted as saying that you don’t even believe in the possibility of bubbles.

Eugene Fama: I never said that. I want people to use the term in a consistent way. For example, I didn’t renew my subscription to The Economist because they use the world bubble three times on every page. Any time prices went up and down—I guess that is what they call a bubble. People have become entirely sloppy. People have jumped on the bandwagon of blaming financial markets. I can tell a story very easily in which the financial markets were a casualty of the recession, not a cause of it.

John Cassidy: That’s your view, correct?

Eugene Fama: Yeah.

1 comment:

  1. Lot of frustration over the awarding of these Sveriges Riksbank Prizes. Proponents of three baseless concepts: rational expectations, real business cycle theory and now efficient market hypothesis will ensure that ivory tower orthodoxy remains irrelevant when it comes to the economy. A nice RWER post (hat tip to Ramanan) http://www.paecon.net/PAEReview/issue56/GuerrienGun56.pdf that critiques Fama's EMH.