Fama, Shiller and Billy Beane – A Nobel Prize in Baseball

A couple of days ago it was announced that Eugene Fama, Lars Peter Hansen and Robert Shiller had been awarded the Nobel Prize in economic for their contribution to the understanding of asset prices.

The interesting thing of course is that Fama’s main contribution is the Efficient Market Hypothesis (EMH), while Shiller’s main contribution has been to try to empirically prove that EMH is wrong.

I think most of my readers know that I am mostly in the EMH camp, but also that I in my day-job is in the business of trying to beat the market. So I am a bit split – even though I after years of trying to beat the markets and having obsermtved others trying to do the same thing has come to the conclusion that people do get lucky – sometimes more than once (just look at Shiller!) – but that it is very hard to find anybody who consistently beat the markets. That in my view is the real-world version of EMH. Or said in another way it might be possible to find indicators that will make it possible for you to beat the market in shorter or longer periods, but these indicators eventually breaks down.

Anyway, the Nobel Prize news reminded me of an old post I did on the Oakland A’s. So let me quote a bit from that post. I think it shows why both Fama and Shiller are right.

I have been watching Moneyball. It is a great movie… economics play a huge role in this movie. So that surely made me interested. It is of course very different from Michael Lewis’ excellent book Moneyball, but it is close enough to be an interesting movie even to nerdy economists like myself.

… why bring Moneyball into a discussion about money and markets? Well, because the story of the Oakland A’s is a pretty good illustration that Scott Sumner is right about the Efficient Market Hypothesis (EMH) – even when it comes to the market of baseball players. So bare with me…

And here I should of course also have said that Fama is right.

Back to my old post:

The story about the Oakland A’s is the story about the A’s’ general manager Billy Beane who had the view that the market was under-pricing certain skills among baseball players. By investing in players with these under-priced skills he could get a team, which would be more “productivity” than if he had not acknowledged this under-pricing. Furthermore as other teams did not acknowledge this he would increase his chances of winning even against teams with more resources. It’s a beautiful story – especially because theory worked. At least that is how it looked. In the early 2000s the Oakland A’s had much better results than should have been expected given the fact that the A’s was one the teams in the with the lowest budgets in the league. The thesis in Moneyball is that that was possible exactly because Billy Beane consistently used of Sabermetrics – the economics of Baseball.

Whether Lewis’ thesis correct or not is of course debatable, but it is a fact that the Oakland A’s clearly outperformed in this period. However, after Moneyball was published in 2003 the fortune of the Oakland A’s has changed. The A’s has not since then been a consistent “outperformer”. So what happened? Well, Billy Beane was been beaten by his own success and EMH!

So Billy Beane was the Robert Shiller of baseball. He found a way to beat the market! But success was, however, not forever – again back to my old post:

Basically Billy Beane was a speculator. He saw a mis-pricing in the market and he speculated by selling overvalued players and buying undervalued players. However, as his success became known – among other things through Lewis’ book – other teams realised that they also could increase their winning chances by applying similar methods. That pushed up the price of undervalued players and the price of overvalued player was pushed down. The market for baseball players simply became (more?) efficient. At least that is the empirical result demonstrated in a 2005-paper An Economic Evaluation of the Moneyball Hypothesis“ by Jahn K. Hakes and Raymond D. Sauer. Here is the abstract:

Michael Lewis’s book, Moneyball, is the story of an innovative manager who exploits an inefficiency in baseball’s labor market over a prolonged period of time. We evaluate this claim by applying standard econometric procedures to data on player productivity and compensation from 1999 to 2004. These methods support Lewis’s argument that the valuation of different skills was inefficient in the early part of this period, and that this was profitably exploited by managers with the ability to generate and interpret statistical knowledge. This knowledge became increasingly dispersed across baseball teams during this period. Consistent with Lewis’s story and economic reasoning, the spread of this knowledge is associated with the market correcting the original mis-pricing.”

Isn’t it beautiful? The market is not efficient to beginning with, but a speculator comes in and via the price system ensures that the market becomes efficient. This is EMH applied to the baseball market. Hence, if a market like the baseball market, which surely is about a lot more than making money can be described just remotely as efficient why should we not think that the financial markets are efficient? In the financial markets there is not one Billy Beane, but millions of Billy Beanes.

Every bank, every hedgefund and every pension fund in the world employ Billy Beane-types – I am one of them myself – to try to find mis-pricing in the financial markets. We (all the Billy Beanes in the financial markets) are using all kind of different methods – some of them very colourful like technical analysis – but the aggregated result is that the markets are becoming more efficient.

Like Billy Bean the speculators in the financial markets are constantly scanning the markets for mis-priced assets and they are constantly looking for new methods to forecast the market prices. So why should the financial markets be less efficient than the baseball market? I think Scott is right – EMH is a pretty good description of the financial markets or rather I haven’t seen any other general theory that works better across asset classes.

So yes Fama and Shiller both deserve the Nobel Prize (as do Lars Peter Hansen), but I don’t believe that Robert Shiller is better at forecasting than the markets in general and I would certainly not think that regulators are better at forecasting than the market!

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Guest post: GDP-Linked Bonds (by David Eagle)

Guest post: GDP-Linked Bonds, Another Whole Literature to Synthesize into Market Monetarism

by David Eagle

As Dale Domian and I have been frustrated at our continuous attempts to publish our quasi-real indexing research, I have kept reminding myself of one thing and that is that we were the first to design quasi-real indexing (Eagle and Domian, 1995. “Quasi-Real Bonds–Inflation-Indexing that Retains the Government’s Hedge Against Aggregate-Supply Shocks,” Applied Economic Letters).  However, I have recently encountered some good news and some bad news concerning quasi-real indexing.

First, the bad news: It turns out that Dale and I were not the first to come up with the notion of quasi-real indexing.  Somebody actually beat us by two years.  The reference is is Robert Shiller’s Macro Markets: Creating Institutions for Managing Society’s Largest Economic Risks”.

Actually, Shiller did not use the term “quasi-real indexing.”  Instead, he used “GDP-linked bonds.”  Shiller shares the same origins for these bonds as Dale and I do.  We all started thinking about government bonds.  At the time of our 1995 paper, the U.S. government was considering inflation-indexed bonds.  Instead, we proposed an alternative bond that would be safer for the government.  Unfortunately, the U.S. government decided to issue TIPS, an inflation-indexed bond, rather than either Shiller’s proposal or Dale’s and my proposal.

Now the good news: A significant literature has evolved concerning GDP-linked bonds.  The existence of this literature provides the market monetarists another literature to bring into the Market Monetarism literature.  In particular, I have come to recognize that quasi-real indexing basically provides insurance against the central bank not meeting its nominal GDP target even if the central bank is not targeting GDP.  If those in the GDP-linked-bond literature can recognize that that is what their GDP-linked bonds do, they will then realize that George Selgin was right in Less than Zero about how risk on loans should be shared between borrowers and lenders.  Also, they should realize that nominal bonds will achieve the same effect as GDP-linked bonds as long as the central bank successfully targets nominal GDP.

You can find GDP-linked bonds in Wikipedia; unfortunately, you cannot find “quasi-real indexing” there (yet).  More recently Professor Shiller joined Mark Kamstra in a paper proposing “Trills,” which are a GDP-linked bond.  Other literature concerning GDP-linked bonds include:

Mark Kamstra and Robert J. Shiller: “The Case for Trills: Giving Canadians and their Pension Funds a Stake in the Wealth of the Nation.”

Kruse, Susanne, Matthias Meitner and Michael Schroder, “On the pricing of GDP-linked financial products.” Applied Financial Economics 15: 1125-1133, 2005.

Griffith-Jones, Stephany, and Krishnan Sharma, “GDP-Indexed Bonds: Making It Happen.” DESA Working Paper No. 21, 2006.

Schröder, Michael; Heinemann, Friedrich; Kruse, Susanne; Meitner, Matthias; “GDP-linked Bonds as a Financing Tool for Developing Countries and Emerging Markets”

Travota, Alexandra “On the Feasibility and Desirability of GDP-Indexed Concessional Lending,”

Also, some blog posts exist on GDP-linked bonds:

Jonathan Ford: The Case for GDP Bonds

: GDP-Linked Securities

Also, a very recent blog post in the WSJ.com just covered Robert Shiller’s proposal of these GDP-linked bonds:

“Worried About U.S. Debt? Shiller Pushes GDP-Linked Bonds”

I myself am still reading these other papers, books, and blog posts.

The reality is that if not only the U.S. government issued quasi-real bonds or GDP-linked bonds, but also European governments issued them as well, then the European sovereign debt crisis would not be at all as serious a problem as it is today.  Also, as most market monetarists know, if the European Central Banks had been targeting nominal GDP successfully, then the European sovereign debt crisis would be of a much smaller magnitude than it has become.  Paul Krugman has noted how the increase in European sovereign debt coincided with the beginning of the last recession.  I hope that Professor Krugman will look into the GDP-linked-bond and quasi-real-indexing literatures to learn how these types of bonds would have prevented this increase to happen.

Actually, Argentina has recently issued some GDP-linked bonds as one of the above blogs points out.

In economics, we have a lot of unconnected literatures that needs to be brought together. Obviously, Dale and my “quasi-real indexing” needs to be synthesized into the GDP-linked bond literature.  However, synthesizing both of these literatures along with the wage-indexation literature and the nominal GDP targeting literature leads to the incredible conclusions: (1) Much of the Pareto-efficiency associated with complete markets can be achieved either through quasi-real indexing of all contracts or by the central bank (successfully) targeting nominal GDP, (2) Most of the negative economic effects of the business cycle would be eliminated either through quasi-real indexing  or nominal GPD targeting.

I hope this post encourages those involved in the GDP-linked bond literature, wage indexation literature, and the literature on NGDP targeting to work on synthesizing all of their literatures together.

© Copyright (2012) by David Eagle

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