Those Confusing Nobelists

October 24th, 2013 at 4:58 pm

I’m late to this, but a number of people, as in non-economists, have been asking me about the confusing Nobel prizes given out this year to economists with seemingly fundamentally different views of how the economy works, particularly from the perspective of asset pricing.  One winner (Fama) is associated with a theory of highly informed, rational economic agents interacting through markets to set the efficient price.  The other winner (Shiller) argues that bubbles happen: pricing is often far less rational and efficient.

Fama famously said “I don’t even know what a bubble means.”  Shiller was among the few who called the housing bubble.

These economists are surely both very smart people, but onlookers can be forgiven for wondering not just how to square these two theories, but what it says about the “science” of economics that such a high honor went to two people with such disparate views.  Economist Nancy Folbre found this quote from John Kay at the FT arguing that it was a bit like “awarding the physics prize jointly to Ptolemy for his theory that the Earth is the center of the universe and to Copernicus for showing it is not.”

I found Folbre’s take on this conundrum particularly interesting.  She argues that the difference between these two Nobelists “…are smaller than they have been portrayed, especially compared with a darker theory of financial crisis based on the work of John Maynard Keynes and Hyman Minsky.”

As she sees it, both Nobelists view markets as generally efficient information centers; it’s just that in Shiller’s world, people make mistakes.  They get swept up in “Irrational Exuberance” (the title of one of his books) and ignore the persistent and systemic departure of prices from their fundamentals thus inflating a bubble.

Over to Nancy:

Theories based on the Keynes/Minsky view of the business cycle focus not on the imperfect rationality of individual investors, but on the institutional dynamics of financial profit maximization under conditions of uncertainty. Banks face temptations to overextend and overleverage themselves during booms and to develop inherently opaque securities like derivatives that offer them enormous profits.

In the absence of effective regulation, they are able to hold other economic actors hostage to bail out on the grounds that they are too big to fail.

From this perspective the assertion that markets are efficient [Fama] serves as an ideological justification for deregulation, while the acknowledgement that individuals sometimes act irrationally [Shiller] merely distracts attention from the larger problem.

This is an institutional critique: even if most individual participants are effectively processing economic information, as the business cycle progresses lenders will become less risk averse, leverage up, and introduce “innovations” that use that leverage to make outsized profits.  Both the leveraging and the opaqueness of the innovations amplify and underprice the risk.

The financial system, in Minsky’s view, is thus inherently unstable.  More transparent pricing of this derivative over that one, for example, might help a bit, but it is risk itself, as noted, that becomes underpriced.  That might not have been too damaging at an earlier point in time, but given the global connectedness of today’s financial and credit markets, it has the potential to do lasting harm, a potential that’s been consistently realized in recent decades.

The solution, as Folbre notes, is stricter regulation.  Simply requiring much higher capital reserves (i.e., less leveraging) and more closely monitoring underwriting would be steps in the right direction.  Unfortunately, you won’t get a big prize for pushing those ideas.  You’ll just get less frequent and less deep recessions, a tradeoff most of us would gladly embrace.

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3 comments in reply to "Those Confusing Nobelists"

  1. Kevin Rica says:

    This is hardly the first time something like this has happened. Remember the Swedes love to compromise, so if one side gets something, so does the other.

    In summer of 1973, the great Swedish author Wilhelm Moberg was walking ashore from a swim and dropped dead of a heart attack. He should have gotten the Literature prize, but the committee waited to long. So the following year, the awarded the Literature Prize to two obscure Swedes who haven’t been heard from since.

    The Riksbank also wanted to do the same for another Swede, Gunnar Myrdal. But Bertil Ohlin insisted that they had to balance the prize, so they gave it to Von Hayek too. Just as weird as this year’s prize.

    Politics is politics the world over, just the rules on contact vary.

  2. wkj says:

    The Economics Nobel is midway between the Physics Nobel and a Grammy.

  3. David Ciscel says:

    Thanks, I really liked this explanation. As the recession progressed over the past 5 years, I became more and more a old fashioned Keynesian. It is nice to have someone like Fobre remind me of the insights that the institutionalists regularly bring to economic analysis. While Galbraith made many errors in his analysis of modern capitalism, he always insisted that Keynesian analysis needed to be informed by the current institutional structure of the capitalist ‘enterprise’.