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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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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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