Three U.S. economists will share the Nobel Prize for economics for work that’s altered the way assets are priced and portfolios are managed. Given poor pricing information and other problems that led to the financial crisis, the award seems well deserved, especially if it can prevent another stumble.
Here’s the story from the Wall Street Journal:
Three American scholars won the Nobel Prize in economics for pioneering work in financial markets that has transformed portfolio management and asset pricing and launched the study of how emotions affect investment decisions.
The Royal Swedish Academy of Sciences on Monday honored Eugene Fama and Lars Peter Hansen of the University of Chicago and Robert Shiller of Yale University, citing their complementary but independent breakthroughs on “empirical analysis of asset prices.”
The laureates focused on how prices are set for stocks and bonds, but their findings have implications far beyond financial markets. Every corner of the macroeconomy is affected by the risk tolerance—as well as rational and irrational acts—that spur individuals and corporations to invest or save.
The Reuters story focused on Robert Shiller and his comments about the current state of the U.S. housing market:
One of three American economists who won the 2013 economics Nobel prize on Monday for research into market prices and asset bubbles expressed alarm at the rapid rise in global housing prices.
Robert Shiller, who shared the 8 million Swedish crown ($1.25 million) prize with fellow laureates Eugene Fama and Lars Peter Hansen, said the U.S. Federal Reserve’s economic stimulus and growing market speculation were creating a “bubbly” property boom.
The Royal Swedish Academy of Sciences lauded the economists’ research on the prices of stocks, bonds and other assets, saying “mispricing of assets may contribute to financial crises and, as the recent global recession illustrates, such crises can damage the overall economy.”
This was the case in the collapse of the U.S. housing market, which helped trigger the 2008-2009 global financial crisis. Markets are at risk of committing the same error now, Shiller told Reuters after learning he had won the Nobel prize.
“This financial crisis that we’ve been going through in the last five years has been one that seems to reveal the failure to understand price movements,” Shiller said.
Bubbles are created when investors fail to recognize when rising asset prices become detached from underlying fundamentals.
Shiller and other economists warn that prices in some markets have risen too far, too fast due to the Fed’s ultra-easy monetary policy. The benchmark U.S. Standard & Poor’s 500 index hit a record in September, though it is generally not considered overvalued based on expectations for corporate earnings results or economic growth.
The Associated Press story focused on the differences in the researchers’ work and the insights they gleaned. Excerpts are below:
Fama’s research revealed the efficiency of financial markets: They absorb information so fast that individual investors can’t outperform the markets as a whole. His work helped popularize index funds, which reflect an entire market of assets, such as the Standard & Poor’s 500 stock index.
Shiller’s research examined asset prices from a contrasting angle. He showed that in the long run, stock and bond markets can behave irrationally, reaching prices that are out of whack with economic fundamentals.
Shiller, 67, predicted the dot-com crash of the early 2000s and the implosion of home prices in 2007. He has also been a pioneer in the field of behavioral economics, or how human emotions, biases and preferences can collectively influence financial markets.
Using mathematical tools like the well-known Case-Shiller index of home prices, Shiller has expanded the available information on asset prices.
Hansen has focused on statistical models, creating ways to test competing theories of why asset prices move as they do.
Fama and Shiller “provide the ends of the spectrum” between those who believe financial markets are efficient and those who think them deeply flawed, with Hansen “in the middle doing the math,” said Allen Sanderson, a University of Chicago lecturer in economics.
The lead of the New York Times story focused on the conflict between Fama and Shiller’s theories:
The economist Robert J. Shiller in 2005 described the rapid rise of housing prices as a bubble and warned that prices could fall by 40 percent.
Five years later, with home prices well on the way to fulfilling Mr. Shiller’s prediction, the economist Eugene F. Fama said he still did not believe there had been a bubble.
“I don’t even know what a bubble means,” said Mr. Fama, the author of the theory that asset prices perfectly reflect all available information. “These words have become popular. I don’t think they have any meaning.”
The two men, leading proponents of opposing views about the rationality of financial markets — a dispute with important implications for investment strategy, financial regulation and economic policy — were joined in unlikely union Monday as winners of the Nobel Memorial Prize in Economic Science.
Mr. Fama’s seminal theory of rational, efficient markets inspired the rise of index funds and contributed to the decline of financial regulation. Mr. Shiller, perhaps his most influential critic, carefully assembled evidence of irrational, inefficient behavior and gained a measure of fame by predicting the fall of stock prices in 2000 as well as the housing crash that began in 2006.
They will share the award with a third American economist, Lars Peter Hansen, who developed a method of statistical analysis to evaluate theories about price movements that is now widely used by other social scientists.
The three economists, who worked independently, were described as collectively illuminating the workings of financial markets by showing that stock and bond prices move unpredictably in the short term but with greater predictability over longer periods. The prize committee said these findings showed that markets were moved by a mix of rational calculus and irrational behavior.
No matter if they agree with each other or not, collectively the work is being used across the globe for better risk management, market predictions and insight into price movements. It’s easy to see why these three deserve the prize given recent history. Here’s hoping that bankers, portfolio managers and traders are able to use the information to create a more stable system.