Efficient markets theory has lost its lustreby / February 23, 2015 / Leave a comment
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In 2013, the Nobel Prize in Economics was awarded to three men—Robert J Shiller, Eugene F Fama and Lars Peter Hansen—for their “empirical analysis of asset prices”. Where, the award committee noted, Fama’s research had led him to the conclusion that “stock price movements are impossible to predict in the short-term and that new information affects prices almost immediately, which means that the market is efficient,” for Shiller, on the other hand, “stock prices can be predicted over a longer period… In contrast to the dominant perception, stock prices fluctuated much more than corporate dividends. Shiller’s conclusion was therefore that the market is inefficient.”
In his Nobel Prize lecture, Shiller examined the effects that the “behavioural finance revolution,” which saw the insights of psychology and other social sciences imported into economics, had had on the theory of market efficiency developed by Fama and others. “Once we acknowledge that the efficient markets theory has no special claim to priority for price determination”—a conclusion Shiller had reached in his econometric work on market volatility in the 1980s—”we can look more sympathetically to other factors to understand market fluctuations,” he argued.
We can look, for instance, to what Keynes, writing in the 1920s, had called “animal spirits”—”changes that infect the thinking even of most of the so-called smart money in the market.” In 2009, Shiller and the economist George Akerlof borrowed Keynes’s phrase for the title of a book that explored the extent to which psychological factors—confidence, fear, bad faith and so on—shape financial events. That book built on the arguments of an earlier book of Shiller’s, “Irrational Exuberance”, the first edition of which was published in 2000, at the height of the boom in “dot com” stocks in the United States. In the second edition of “Irrational Exuberance,” published in 2005 (in the midst of another asset price boom, this time in house prices), Shiller offered the following definition of a speculative “bubble”: “A situation in which news of price increases spurs investor enthusiasm, which spreads by psychological contagion from person to person, in the process amplifying stories that might justify the price increases and bringing in a larger and larger class of investors, who, despite doubts about the real value of an investment, are drawn to it partly through envy of others’ successes and partly through a gambler’s excitement.”
A third, revised and expanded edition of “Irrational Exuberance” is published this week. And in it Shiller warns that, despite the near-death experience undergone by the global financial system in 2007-09, we appear not to have learned our lesson. “Evidence of bubbles has accelerated since the crisis,” he writes. “Valuations in the stock and bond markets have reached high levels in the United States and some other countries and valuations in the housing market have been increasingly rapidly in many countries.”
I spoke to Shiller on the phone last week from the US, where he is a professor of economics at Yale University. And I began by suggesting that the conclusion to draw from the latest edition of his book is that bubbles will always be with us.
RS: I think it was a mistake to regard the stock market bubble of the 1990s as in any way unique. It looked like the biggest stock market bubble in a hundred years, but it wasn’t at all unique. But part of the reason it got as big as it did was that there was a mode of thinking that had developed over the previous half century in which sociology and social psychology became marginalised. People thought markets were something entirely unrelated to those things. And that led to errors that were quite dramatic. On the other hand, it wasn’t anything fundamentally new. We weren’t necessarily chastened by the collapse after 2000. It didn’t seem chastening at all, though the efficient markets theory has lost its lustre.
JD: Do you think we’re any more chastened today, in the wake of the bursting of the bubble in 2008, than we were when the first edition of Irrational Exuberance was published?
There are some differences. The word “bubble” has undergone a surge in popularity. I do regular investor questionnaires in the US, and the word comes up a lot. I like to go back to the Dutch tulip mania [in the 17th century]. The term used to describe that in Dutch was “windhandel”, or “wind trade”. It was close to the word “bubble,” which emerged during the 1720 stock market crash, in French (“bulle”). In the second edition of the book, I included my definition of a “bubble”, which doesn’t look like the dictionary definition. After the Nobel Prize ceremony in 2013, I got into a debate with Eugene Fama (I felt sorry for Lars Peter Hansen, who was kind of [caught] in the middle). There was a problem of definition—I was defining bubbles one way, and Fama was defining it in a completely different way.
Maybe the word itself is unfortunate. The word “bubble”, the metaphor, suggests something filled with air, insubstantial, something growing and growing that’s got to burst. And when it does it’ll be catastrophic. The metaphor suggests something that’s unreal or ephemeral. Unfortunately, it brought with it the suggestion that you know when it’s over. Bang! And it’s gone.
So one of the problems with the metaphor is that it tempts us to forget that bubbles are—and this seems to me to be central to your argument—social-psychological phenomena rather than, as it were, naturally occurring phenomena?
And if bubbles are social-psychological phenomena, what implications does that have for regulators and policymakers who are in the business of trying to protect us against the worst effects of speculative manias?
What it means is that regulators and policymakers have to use their human judgement. Efficient markets theorists give a distorted version of what people are thinking. For example, Peter Garber, who used to be a professor at Brown University, wrote a book called Famous First Bubbles: The Fundamentals of Early Manias, in which he said that the Dutch tulip mania was not irrational. He said that those tulips were like works of art and people loved them. Prices were soaring. If you had a rare tulip, you could propagate it, sell it off and quite reasonably expect to make money. But I think there’s some deficiency in his argument. I can’t prove this, but I think people were enticed by the tulip mania just because it was a bubble. They weren’t really so profoundly moved by the beauty of those tulips!
The implication of what you’ve just said is that your dispute with Garber and Fama turns, in the end, on differing conceptions of human nature and human behaviour.
Right—and also different career paths! People who go the University of Chicago [where Fama is a professor] are expected to say certain things. It wouldn’t make sense, for example, to be teaching at the University of Chicago and to be a strong liberal.
You argue that in order to understand speculative bubbles, one has to use insights derived from fields other than economics—psychology, sociology, demography, history and so on. Do you think the economics profession has got any better in the 15 years since the first edition of Irrational Exuberance was published at harvesting the insights of other disciplines?
I suppose it has. We’ve had the behavioural economics revolution. There was, in the second half of the 20th century, a fashion in the economics profession for mathematical economics. I think it is a legitimate and important field. But there was maybe excessive reliance on that, though we have [now] gotten past that. There’s always going to be a problem with consilience—it’s hard to do. And we have institutional restrictions. Institutional organisation encourages people not to waste their time! You have to get tenure—it’s very competitive. You think, “Do I need to know this?”
You write in the preface to the first edition of Irrational Exuberance that “most investors seem to view the stock market as a force of nature of unto itself.” That suggests that investors are making a kind of category error, that they’re getting the ontology of stock markets wrong.
That’s right. There’s something called “physics envy”. Economists often wish they could have become physicists. A really important cultural icon today is Albert Einstein. All of us in academia have a secret mental image of ourselves as Einstein! But I don’t mean to malign the [economics] profession.
I’m President-elect of the American Economic Association and I’m looking at the meetings we had last year, as I’m going to be organising them next year. And the [subjects covered] don’t seem so impractical. The economics profession does a lot of commonsense stuff. Maybe it’s that the real mathematically-oriented people go to the Econometric Society. There’s a tendency for people to look at abstract work with a lot of Greek letters in it and imagine that that’s what the whole profession is like. But I actually think it’s a minority, though in the past it has dominated finance. Finance is a very fashionable part of economics now. But we also have labour economists, economic historians—they’re not trying to be Einstein.
Is the US in bubble territory right now?
The bond market, in the US and the UK, is behaving extremely unusually. I don’t know that it exactly fits the definition of the bubble that I added in the second edition. It has aspects of a bubble, but it’s not driven by excitement of the same sort—it’s more desperation!
“Irrational Exuberance” [revised and expanded third edition] by Robert J Shiller is published by Princeton University Press (£19.95)