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Guest post: Reflections on Fama (By Otto Brøns-Petersen)

If I ever had a real mentor I would have to say it was Otto Brøns-Petersen. Otto was my boss when I started working at the Danish Ministry of Economic Affairs in the Mid-1990s. Otto taught me a lot about economics, but he particularly taught me to understand the politics of economic policy making. Something that made me tremendously skeptical about the ability of policy makers to do the “right thing”.

While I left government work long-time ago Otto kept working for the Danish government until recently. However, he is now Head of Research at the Danish free market think tank CEPOS.

Recently Otto wrote a piece for the Danish business Daily Børsen on some policy implications to draw from Nobel Prize winner Eugene Fama’s work. I asked Otto whether he would be interested in writing a similar piece for my blog . I am happy he accepted the challenge.

– Lars Christensen

PS After knowing Otto for nearly 25 years I just realized I would describe his economic thinking as Coasian more than anything else.

Reflections on Fama

– By Otto Brøns-Petersen

This year marks the 50th anniversary of Eugene Fama’s demonstration of “random walk” in stock prices. The price today does not predict the price tomorrow. Rather, stock prices absorb the information available to the market at any given time. As financial markets do not systematically omit information, there are no systematic price movements. The market is “efficient”.

In the longer term, however, patterns in price movements do emerge. Fama has been leading the research into how such patterns can be explained and what they mean. A couple of weeks ago, he and two other American economists, Lars Peter Hansen and Robert Shiller, were awarded the Nobel Prize in Economics for their empirical work on pricing in financial markets.

Does this mean that we have now cracked the code of what drives prices in the long term? Far from it! Fama’s research continues, and his colleague, John Cochrane, even believes that he has his best work ahead of him. Futhermore, with its choice of laureates, the Nobel Committee choose to highlight that there are two very different and competing approaches to understanding financial markets. Fama’s approach is to look for rational investor motives. In particular, it appears that changes in investors’ risk aversion can explain movements in prices over time. Shiller’s approach, on the other hand, is based on behavioral economics, which looks for psychological motives that are not necessarily rational.

Can we learn something from this research, something about good policy? In my opinion, we can indeed.

Firstly, bubbles in the financial markets are very difficult to predict. Disagreement about how empirical price movements should be interpreted theoretically is in itself an element of unpredictability. But although consensus on the interpretation of historical data might increase, predictability about the future will not necessarily do so too. Researchers are watchingers are not alone in looking over their shoulders for/at investors, but investors are also watching also looking over their shoulders for/at scientists and their research.. There is money to be made from learning how to avoid historical errors in the future. In particular, theories of systematic errors will tend to undercut themselves because of learning by agents. So, we should not expect to be able to predict bubbles.

Secondly, cognitive and psychological limitations on rationality not only apply to investors but also to politicians and officials. If investors have exaggerated beliefs about being able to get out of a market before it falls, one should be concerned about a similarly exaggerated belief of authorities that they can trace an unsustainable market development before it is too late.

Thirdly, it is crucial to realize whether incentives support appropriate behavior in financial markets. Basically, there are very strong incentives to avoid errors for investors who have their fortunes at stake. And the financial markets even support rational behavior by selecting good investors at the expense of bad ones. Markets, so to speak, entail what we could call “systemic rationality”. If incentives, on the other hand, reward inappropriate behavior – eg. in the form of moral hazard, where the bill for mistakes ends up with someone else than the decision-makers – one should indeed expect more inappropriate behavior. Finally, it is important to be clear about the incentives not just for agents in the financial markets, but also for political and bureaucrat decision-makers.

In my opinion, there is reason to worry whether policy makers are drawing the wrong lessons from the financial crisis in their policy response. Financial Supervisory Authorities, central banks and central government officials have been asked to step up surveillance of the macro economy, financial markets and financial institutions. Regulation is on the rise. Actual improvements in incentives are, however, still missing.

One might ask: Doesn’t increased monitoring just add extra security and isn’t it in the worst case harmless? Unfortunately, it also has costs.

Firstly, it may give the agents in financial markets and customers in financial firms a false sense of security, giving authorities greater moral responsibility for financial crises and thus increase the likelihood of government bailouts. Thus, it increases the moral hazard problem and distorts incentives.

Secondly, the increased monitoring to avoid one type of error increases the frequency of another type of error. We may (but not very likely) discover more bubbles early on, but at the expense of more false alarms and misguided political interventions. At the same time, the incentive structure of authorities seems unsound. It will attract attention if a crisis is overlooked, whereas it is harder to tell if an intervention was based on a wrong diagnosis. There is thus a built-in propensity for political action, and the ever-changing political winds add a further element of instability in regulation and legislation.

Interestingly enough, the recent Danish Government Committee on the Financial Crisis noted that liberalization of financial markets has been a net economic advantage, both advantages and disadvantages taken into account. There is a need for a similar assessment of financial regulation and supervision in general.

It is perhaps understandable that many after the financial crisis instinctively conclude that “someone ought to watch out and make sure we will not see another crisis.” But it may well be a little like hoping for someone to come up with a “sure thing” stock advice. Neither is founded in reality. The effective tools in the toolbox of economists are called: Incentives, incentives and incentives.

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