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Headline News — 28 October 2013

By John Rogers

Upon his death in 1896, the will of the wealthy inventor Alfred Nobel established the Nobel Prizes in Physics, Chemistry, Physiology & Medicine, Literature and Peace. He created the prizes after reading a premature obituary of himself that described him as “the merchant of death,” which made him apprehensive of how he would be remembered.

The prizes were Nobel’s attempt at atonement for destructive power of some of the inventions that had amassed him so much wealth, the most famous of which is dynamite. Nobel left almost all of his extensive estate for the endowment of these prizes that were to go to “…those who, during the preceding year, shall have conferred the greatest benefit on mankind.”

Economics is conspicuously absent from the original five prizes, and maybe for good reason. The research being awarded this year certainly has not met the lofty intentions of the original five prizes.

Eugene Fama and Robert Schiller, two out of three of this year’s laureates, were recognized, “for their empirical analysis of asset prices. “ Their research in to asset prices both provided confounding evidence as to whether or not to trust asset markets as stewards of our economy and the foundation for the financial chaos that led to the Great Recession and succeeding stagnant economy.

Fama and Schiller are the primary intellectuals at the forefront of the debate over whether asset markets, such as those for stocks and bonds, can be trusted to efficiently price them; Fama advocating market efficiency and Schiller arguing the opposite. Their conflicting research had served as dogmatic scripture for economists and policymakers on both side of the debate over financial regulation and policy and ultimately overconfidence in our understanding of the economy.

The overconfidence stemming from their research can be understood with two significant events in the last 15 years. Efficient asset markets should allocate risk to those who can bare it best. Obviously markets were not very efficient in 2008 with the collapse of the mortgage lending industry.

Large institutions that supposedly had expertise in dealing with these types of investments either failed or would have failed without government backing. The risks taken out-weighted the returns earned, and a financial crisis ensued that spread throughout the economy. We are still stuck with the aftermath of high unemployment and low growth five years later.

This wasn’t the case during the tech bubble of the early 2000’s however. In 2001 there was a massive run-up in the stock prices of tech companies that weren’t justified by those companies’ earnings. Once this was realized, it led to a precipitous decline in those companies’ stocks and in the market in general. But the 2001 bubble didn’t spread to the economy as a whole like that of the most recent crisis. Yes, it was tough for workers and firms in the tech sector, but it was a small blip in the macroeconomic data.

So why was 2001 only a blip and 2008 a disaster? Because while there were many big losers in both crashes, but in 2001 markets allocated risk efficiently to those who could best bare it and in 2008 risk was allocated inefficiently to those who could not.

So does these two episodes lead us to believe Fama or Schiller? For myself, I’m not sure and I am happy to admit it. But a lot of economists on both sides of the debate claim to know, and their overconfidence in their understanding of markets has created a false sense of security.

Economists have unintentionally led us down a road where we believe we can trust their intricate math models of extreme complex systems. If the last 15 years or so is any indication, we can’t tell when their models are right or wrong a priori.

In 2001 and 2008 you had just as good of a chance of tell whether there was something wrong in asset markets by flipping a coin as you did if you relied on either Fama or Schiller.

I don’t want to impinge the character, academic integrity, or genuine beliefs of Fama, Schiller, or any other economists that base their worldview on the research of either laureate. I want to point out that maybe we don’t know as much as we claim, and recognizing our limited knowledge will help us make better decisions in the future.

Identifying the limits of our knowledge allows us to assess uncertainty and better plan for it. Ultimately uncertainty is risk and not recognized it leads to risk being allocated inefficiently. I fear that if we don’t admit the limits of what we know economics will become just as destructive as Alfred Nobel’s dynamite or dismissed altogether.

Photo courtesy of helix84, Wikimedia Commons

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About Author

John is a senior from Rochester Hills, MI. He is majoring in economics and is interested in economics and how it can help everyone get the m.ost out of life. Twitter: @John_RogersJr

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