The names of this year’s Nobel Prize winners have been released over the past few weeks. This is the real celebrity news, naming people that you either have never hear of, or have heard of without being quite clear what it is they have done (like Higgs). To my shame, I had never heard of the magnificent Organisation for the Prohibition of Chemical Weapons, winners of this year’s Peace Prize.
As a former economics teacher I should really be giving you guidance on the winners of the Economics Prize. It says something for the state of modern economics that the prize is being shared by three people who propose opposing theories. As John Kay said in the Financial Times, “it is like awarding the physics prize jointly to Ptolemy for his theory that the Earth is the centre of the universe, and to Copernicus for showing it is not”.
Eugene Fama is known for the Efficient Markets Hypothesis, which tells us that free markets accurately price assets by incorporating all public knowledge. This suggests that, when investing in the Stock Market, you are best to invest in a tracker fund that simply replicates the market, rather than an actively managed fund where investment managers choose promising stocks (and try to second guess the real value of assets). In fact, this turns out to be pretty accurate – actively managed funds usually do worse than the stock market average, and charge you extra for the service. As an outsider, however, you may think feel the idea that market prices are always right a curious theory to hold : if it were true, no-one would ever (non-corruptly) make money out of stock market speculation, and commodity bubbles would never happen. In fact, Fama denies that bubbles happen, telling his interviewer in the New Yorker that the word is meaningless .
On the other hand, one of the other winners, Robert J. Shiller (so near to being Bob Shilling – what a great name that would be for an economist) not only says bubbles can happen, he predicted the US housing crash. Where should we go in all this ? I’m not sure. I respect people who say that the EMH may not be great, but it is useful and the best we have got. I remain with deep suspicions about the enthusiasm shown towards a theory that says markets are just great, and (by implication) governments should leave them alone. I remember that Joan Robinson, herself no mean economist, said that economics has two functions. One is to explain the behaviour of the economy, the other was to supply an ideology for the ruling class.
The best explanation for laymen I have found – and that, now, includes me, I’m afraid, is to be found in a blog by John Kay. It’s a bit of a long haul, but you may be amused by his discussion of the use of evidence in economics, and his revelation of the number of assumptions that have to be made to find that the EMH (and a lot else in market economics) is true.