If Fama were Newton, would Shiller be Einstein?

OK OK, another quick break from my blogging break. An Econ Nobel for behavioral finance is just too juicy to resist commenting on.

Before the prize was announced, I said that it would be funny if Fama and Shiller shared the prize. But I also think it's perfectly appropriate and right that they did. Many people have called this prize self-contradictory, but I don't think that's the case at all. If Newton and Einstein had lived at the same time, and received prizes in the same year, would people say that was a contradiction? I hope not! And although it's probably true that no economist is on the same intellectual plane as those legendary physicists, Fama's Efficient Markets Hypothesis (which was actually conceived earlier, in different forms, by Bachelier and Samuelson and probably others) seems to me to be the closest thing finance has to Newton's laws, and behavioral finance - of which Shiller is one of the main inventors - seems like an update to the basic EMH theory, sort of like relativity and quantum mechanics were updates to Newton.

People criticize the Efficient Markets Hypothesis a lot, because it fails to account for a lot of the things we see in real financial markets - momentum, mean reversion, etc. But that's like criticizing Newton's laws of motion because they fail to explain atoms. Atoms are obviously important. But the fact is, Newton's laws explain a heck of a lot of stuff really well, from cannonballs to moon rockets. And the EMH explains a heck of a lot of real-world stuff really well, including:

* Why most mutual funds can't consistently beat the market without taking a lot of risk.

* Why almost all of you should invest in an index fund instead of trying to pick stocks.

* Why "technical analysis", or chartism, doesn't work (except perhaps in the highest-frequency domains).

* Why many measures of risk are correlated with high average returns.

These are important empirical, real-world victories for the EMH. Just like Newton's Laws will help you land on the moon, the EMH will help you make more money with less effort. I don't know what more you could ask of a scientific theory. If macroeconomics had a baseline theory as good as the EMH, it would be in much better shape than it is! (And if you think I'm being contentious by saying that, see what Gene Fama has to say about our understanding of recessions...)

Update: EMH-haters should also realize that the EMH implies that there are large market failures in the finance industry, because of the continued popularity of active management. So informational efficiency implies economic inefficiency in finance.

Anyway, sticking with the physics analogy, Shiller is really more like Michelson & Morley than Einstein. He found an anomaly - mean reversion in stock prices - that provoked a paradigm shift. In other words, Shiller really discovered behavioral finance rather than inventing it (actually, Fama, whose work is mainly empirical, isn't really like Newton either). The theorizers who came up with the reasons why markets couldn't be completely efficient were people like Joseph Stiglitz, Sanford Grossman, Paul Milgrom, and Nancy Stokey. I hope those people win Econ Nobels as well (Stiglitz, of course, already has one). But that paradigm shift built on the EMH, it didn't knock it down.

I think Mark Thoma puts it very well. The EMH is a simple model that works well in some cases, not so well in others. It's a great guide for most investors. It's not a great guide for policy, because bubbles are real, and they hurt the economy even if you can't reliably predict when they'll pop. And it's not a great guide for executive compensation, because stock prices fluctuate more than the value of firms.

But that's how science should work. You find a useful model, and then you take it as far as you can. When you hit the limits of its usefulness, you look for new stuff to add. And, by and large, that is what finance theory has done over the last half-century.

Anyway, for more info and opinions on this year's Econ Nobelists, check out Mark Thoma's link roundup. I especially like this one by Daniel of Crooked Timber. Also, see the various posts by my co-bloggers. Now back to work for yours truly...