Lessons for US politicians in Nobel winners' efficient markets theories

Congressmen would do well to study Nobel trio's work on efficient markets and grasp how their own actions make them inefficient

PUBLISHED : Sunday, 20 October, 2013, 5:26am
UPDATED : Sunday, 20 October, 2013, 5:26am

The irony could not have been more jarring.

As the world waited with bated breath while American politicians decided whether to tip the United States into debt default, three American economists were jointly awarded the 2013 Nobel Prize in Economics.

Eugene Fama and Lars Peter Hansen of the University of Chicago and Robert Shiller of Yale University "laid the foundation for the current understanding of asset prices", the Royal Swedish Academy of Sciences said. Their achievements were in developing new methods for studying how assets such as stocks and bonds are priced and how financial markets work.

While the new US laureates were being lauded for their research on asset price fluctuations, the US government was in serious danger of defaulting, potentially destabilising the entire global financial system.

Irony aside, however, the political conflict in Washington reflects in a way the competing theories of two of the Nobel winners. Fama and Shiller painted two diametrically opposing pictures of the financial markets, just as the struggle in Congress illustrates polarities in the functioning of government: is it based on the ideal of institutional processes with checks and balances managed by rational individuals, or is it subject to real-world chaos with those individuals acting irrationally at times?

Fama is best known for his investigation into and description of how the financial markets would work in a world of perfect efficiency. Using highly complex mathematics, his seminal work focuses on his hypothesis that there is an efficient market and the behaviour of stock prices in such a market. In an efficient market, all participants act rationally, with access to all the available information. Any activity or information that affects a company will be immediately digested by the market, resulting in an adjustment of its stock price. Hence the stock price reflects the true intrinsic value of the company, and its movements are merely random fluctuations around this intrinsic value. By analysing extensive historical stock price data, he concluded that price movements in the past and the present - the fundamentals - do not provide any guidance to a company's stock price in the short term.

This has immense implications for investors like you and me. Fama's theory means that it is futile for investors to examine past patterns in stock price movements in making near-term investment decisions. There is no need to watch the financial news, closely monitor stock prices or consult your investment adviser. You cannot do any better than ride the efficient market, for example by putting your money in market-index funds which track the movement of the market.

In reality, of course, the financial market is not perennially perfect and efficient, and people are not always rational. According to Shiller, human psychology is the main cause of market inefficiencies, with the occasional large and sustained mispricing of asset values based on mistaken optimism ("irrational exuberance" was his famous term) or extreme pessimism.

To use an old analogy, we can divide economists into "poets" who articulate radical new visions in the study of economics, and "plumbers" who install the infrastructure needed to implement those visions. Fama is the plumber who through mathematical insight constructed the efficient market model, while Shiller is the poet, interpreting the world as it is, complete with human foibles, rather than one that is most amenable to sophisticated mathematical analysis.

Of the three laureates, Hansen is the one who dug the deepest into econometrics, the mathematics of economics, in analysing data and asset prices. He created a rigorous framework through which to draw meaningful conclusions from imperfect data such as deficits, debt, interest rates, inflation, and employment. While Fama and Shiller occupy two ends of the spectrum between those who believe financial markets are efficient and those who think that they are influenced by irrational human behaviour, Hansen sits in the middle doing the mathematics.

Before the next crisis of debt brinkmanship, US politicians should acquaint themselves with the work of all three to better understand how efficient markets function and how their own irrational behaviour contributes to its occasional, alarming inefficiency.

Tom Yam is a Hong Kong-based management consultant with a doctorate in electrical engineering and an MBA from Wharton School. He has worked at AT&T, Ernst & Young and IBM