WS MoreOrLess: Nobel Prize puzzle

Summary

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More or Less – "Nobel Prize Puzzle"

Host: Tim Harford (BBC Radio 4)
Date: October 19, 2013
Episode Theme:
An exploration of the apparent contradiction at the heart of the 2013 Nobel Memorial Prize in Economics, awarded jointly to Eugene Fama, Robert Shiller, and Lars Peter Hansen for work that seems to support mutually exclusive views about market efficiency.

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Main Theme Overview

This episode investigates the economics Nobel Prize awarded to Eugene Fama and Robert Shiller, two scholars with sharply conflicting views on how financial markets operate. Tim Harford introduces listeners to the history of "random walks," the efficient markets hypothesis (EMH), and the concept of irrational exuberance, revealing not only scientific debates but also their real-world implications for investors and regulators.

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Key Discussion Points & Insights

1. Louis Bachelier and the Origins of Market Theory

• The story opens with Louis Bachelier, who in 1900 theorized that bond prices move in a 'random walk,' their fluctuations unpredictable and driven by new information.
  • "His remarkable idea is that the price of government bonds follows a random walk, meaning that each new movement in the price will be unpredictable, up or down." (Tim Harford, 00:45)
• Why prices are unpredictable: If future gains were obvious, prices would immediately adjust, leaving only uncertainty.

2. Eugene Fama and the Efficient Markets Hypothesis (EMH)

• Eugene Fama advanced Bachelier’s thinking at the University of Chicago in the 1960s, developing the EMH: prices reflect all available information, making consistent outperformance impossible.
  • “Prices reflect all available information. Prices are a random walk.” (Eugene Fama, 01:55)
  • Fama notes EMH is not enough without an underlying model – introduces the "joint hypothesis problem," meaning market efficiency cannot be tested independently of assumptions about how prices should behave.
    • “Market efficiency can only be tested along with some assumptions about what would prices look like if they were correct.” (Fama, 02:44)
• Practical outcome: It's extremely difficult for investors or managers to reliably beat the market.
  • "For practical investment purposes, people might as well behave as if markets are efficient because if they are inefficient, it's very difficult to tell how, when and where." (Fama, 03:24)

3. Robert Shiller and Market Inefficiency

• Shiller’s work in the 1980s and 1990s challenged EMH, showing markets move more than can be justified by fundamentals, suggesting the presence of "bubbles".
  • “The market moves too much, the volatility is too high to be explained by these fundamentals. I had some statistical evidence...I'm just saying something that's common sense and obvious. These markets aren’t perfect.” (Robert Shiller, 04:15)
• Memorable moment: Shiller suggests to Federal Reserve Chairman Alan Greenspan that he publicly discuss market overvaluation. Greenspan’s later "irrational exuberance" speech pushes the term into public currency.
  • “Maybe you ought to consider making a statement about the overpricing of the market.” (Shiller, 04:47)
  • “How do we know when irrational exuberance has unduly escalated asset values?” (Greenspan, quoted by Fama, 05:21)
• Shiller's approach: Comparing stock prices to long-term average company earnings to reveal excessive valuation.
• Skepticism about recognizing bubbles in real-time: Shiller notes, "a lot of people benefit by seeing the boom continue...no one should shout fire in a crowded theater."
  • (Shiller, 06:31)

4. Sharp Differences in Perspective

• Shiller believes in identifying (and warning about) bubbles; Fama is highly skeptical of the concept.
  • Fama: "The notion that regulators should somehow go in and burst bubbles is, to me, a joke. I don't think anybody really recognizes bubbles. I mean, I don't even like the word except on 2020 hindsight." (06:59)
• Fama argues that boom and bust cycles reflect rational shifts in expectations, not market irrationality.

5. Reconciling the Contradiction

• The Nobel committee recognized both camps, leaving the listener with intriguing ambiguity.
  • Shiller: "A history of economic thought in the future, we'll mention both our works as contributing… it's a little bit like religion... maybe there's some wisdom about living that comes out of all of them." (08:01)
• Despite the apparent conflict, both laureates express respect for one another's contributions.
  • Fama: "I think all points of view, all interpretations of the evidence should get a full earring. All of that makes the world a much more interesting place, and I was thrilled that Bob got it." (08:32)

6. Lars Peter Hansen's Role

• The episode briefly mentions Lars Peter Hansen, who developed statistical tools essential for analyzing markets, providing methodological advances rather than taking sides in the debate.

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Notable Quotes & Memorable Moments

• On the Efficient Market Hypothesis:
  • "For practical investment purposes, people might as well behave as if markets are efficient because if they are inefficient, it’s very difficult to tell how, when and where."
    — Eugene Fama, 03:24
• On Market Volatility:
  • “These markets aren’t perfect.”
    — Robert Shiller, 04:15
• On the Dilemma of Identifying Bubbles:
  • "The notion that regulators should somehow go in and burst bubbles is, to me, a joke..."
    — Eugene Fama, 06:59
  • "Let’s not create a stampede, but let’s gradually get people out of here."
    — Robert Shiller, 06:45
• On Scholarly Disagreement:
  • "It’s a little bit like religion, you know. There’s all these different sects… But maybe there’s some wisdom about living that comes out of all of them."
    — Robert Shiller, 08:01
  • "All points of view… should get a full earring. All of that makes the world a much more interesting place, and I was thrilled that Bob got it."
    — Eugene Fama, 08:32

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Timestamps for Major Segments

• 00:45: Louis Bachelier and the origins of 'random walk'
• 01:55 - 03:53: Eugene Fama explains efficient markets, joint hypothesis problem, and practical investment implications
• 04:15 - 06:51: Robert Shiller argues markets are excessively volatile; recounts Greenspan episode, and discusses the difficulty of recognizing bubbles
• 06:59 - 07:14: Fama's skepticism about the concept of bubbles and regulatory intervention
• 08:01 - 08:48: Reconciling the Nobel: mutual respect and the value of disagreement

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Summary

This episode deftly unpacks the intellectual tension between two Nobel laureates—Fama and Shiller—who represent opposing views on how well markets process information. While Fama’s work underpins today’s index investing and skepticism about active management, Shiller’s insights foreshadowed the tech and housing bubbles, highlighting irrational swings in asset prices. Ultimately, the shared Nobel is positioned not as a contradiction, but as a testament to economics’ capacity for nuanced, sometimes contradictory truths.

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Transcript

[A]

Thank you for downloading from the BBC. For details of our complete range of podcasts and our terms of use, go to bbcworldserveys.com podcasts this is the short edition of More or Less, first broadcast on the BBC World Service. Hello and welcome to More or Less on the BBC World Service. I'm Tim Harford. This week, the story of how two economists who disagree with each other have been jointly awarded the Nobel Memorial Prize for a economics the story begins at the start of the 20th century in Paris. Louis Bachelier, aspiring physicist, lives a life filled with misfortune. Both parents die, leaving him holding his baby brother, drafted into the army, misses the window to study at the Grande Ecole, studies physics at night school, and trades bonds by day to pay the bills. Produces one of Einstein's famous results before Einstein does, and yet is all but laughed out of academia. But in 1900, Bachelier publishes work that long after his death will be recognized as ground breaking. His remarkable idea is that the price of government bonds follows a random walk, meaning that each new movement in the price will be unpredictable, up or down. That might seem odd. Why would the performance of a financial asset be random? But Bachelier understands that if it was obvious that a share or a bond would be worth more next week, then the price should already have risen in anticipation of that. Predictable moves have already happened because the market is efficient, and all that is left are the unpredictable surprises of the random walk. In the economics department of the University of Chicago in the 1960s, student Eugene Farmer knew Louis Bachelier's theory well.

[B]

But at the end of the 60s, it dawned on me that that statement wasn't enough. So the statement of prices reflect all available information. Prices are a random walk, but there's no economic model behind that. So you've basically made a statement about what prices should look like, and it's not really based on anything. So what I did in the late 60s and early 70s was to say, look, you really need a model that tells you what the market is trying to do in setting prices in order to test whether prices are in fact conforming to that prescription. And that's what was then became known as the joint hypothesis problem, that market efficiency can only be tested along with some assumptions about what would prices look like if they were correct.

[A]

The joint hypothesis problem is that before you test the hypothesis that a financial market is efficient, you first have to take some view about what investors in that market are actually trying to achieve. For example, how they feel about risks. Still, the basic implication of an Efficient market is quite simple. There's no point trying to make a killing. The market will always be one step ahead of you. Better to invest broadly rather than believing in some get rich quick scheme. Farmer himself has found some ways to beat the market, at least investment strategies that would have beaten the market in the past. But he concludes, I think the evidence

[B]

is very clear that for practical investment purposes, people might as well behave as if markets are efficient because if they are inefficient, it's very difficult to tell how, when and where. So people spend lots of money, for example, trying to hire managers that can pick stocks, although the evidence says quite conclusively that that is probably impossible to do.

[A]

So the market is always right. Or is it? A decade later, a challenger to the efficient markets hypothesis arrives on the scene. Robert Shiller, now at Yale, then at mit, both in the United States. His idea was that markets overreact to news or react to non news.

[C]

I wrote a paper arguing that the market moves too much, the volatility is too high to be explained by these fundamentals. I had some statistical evidence got me into a huge controversy. Then I was wondering, why are people so emotional on this? I'm just saying something that's common sense and obvious. These markets aren't perfect.

[A]

And this argument made it into the real world. In 1996, Robert Shiller was invited to lunch with the chairman of the US Federal Reserve, Alan Greenspan.

[C]

I asked the table, when was the last time a Fed chairman had said he thought the stock market was overpriced? Greenspan didn't answer because one of the staff persons answered for him. I think he said it was 30 years ago. And so I said to Greenspan, maybe you ought to consider making a statement about the overpricing of the market. And then three days later he gave this famous speech in December of 96 in which he said as a How

[B]

do we know when irrational exuberance has unduly escalated asset values which then become subject to unexpected and prolonged contractions as they have in Japan over the past decade?

[A]

Shiller went on to write a best selling book called Irrational Exuberance. And he's famous for saying in the late 1990s that shares were hugely overvalued and they did crash not long after. And in 2005 for saying that US house prices were overvalued and they crashed too, was he just lucky? What were his reasons for pointing to a bubble? Well, stock analysts commonly look at how company profits or earnings compare to their share price. This is called the price Earnings ratio. Shiller and his colleague John Campbell decided to take a longer term view, comparing the share price to the average earnings for the past 1010 years. This long term price earnings ratio showed a sharp peak in 1929, just before the Great Wall street crash. But the peak in the late 1990s was far bigger yet. So why do so few people see these booms as irrational at the time?

[C]

I think it's because a lot of people benefit by seeing the boom continue. And there's a sense that no one should shout fire in a crowded theater. Everything is going great, right?

[A]

Unless of course, there is a fire in the theatre, in which case it's

[C]

like the pressure is building. Let's not create a stampede, but let's gradually get people out of here.

[A]

But Eugene Farmer, Schiller's fellow laureate, isn't convinced that it's quite so easy to spot trouble in financial markets.

[B]

The notion that regulators should somehow go in and burst bubbles is, to me, a joke. I don't think anybody really recognizes bubbles. I mean, I don't even like the word except on 2020 hindsight.

[A]

In gene Farmer's view, when technology stocks boomed in the late 1990s and then crashed, that reflected people's views about the prospects of highly successful companies emerging from the melee. Not quite enough of them did in the end. But that didn't make the market irrational, it just made it wrong. With hindsight, we shouldn't overlook the fact that there was a third Nobel Prize winner in economics this year. His name is Lars Peter Hansen, and he developed statistical tools that are now ubiquitous in the study of financial markets. But we wouldn't be human if we weren't curious about the apparent contradiction in awarding shares of the Nobel Prize to Eugene Fama for showing that the market is efficient and Robert Shiller for showing that it isn't. Is the committee just hedging its bets?

[C]

The way I would put it? Is that a history of economic thought? In the future, we'll mention both of our works as contributing towards some. It's a little bit like religion, you know. I mean, there's all these different sects and when you look at them in the whole, it doesn't seem to make any sense. They contradict each other so fundamentally. But maybe there's some wisdom about living that comes out of all of them.

[A]

But come on, was it not a little irritating to share the Nobel Memorial Prize with someone who seems to contradict you?

[B]

Oh, well, I think there is room for substantial disagreement and I think all points of view, all interpretations of the evidence should get a full earring. All of that makes the world a much more interesting place, and I was thrilled that Bob got it.

[A]

Eugene Farmer and before him, Robert Schiller. Congratulations to both of them, and to Lars Peter Hansen for being awarded this year's Nobel Memorial Prize in Economics. If there are any numbers you'd like us to investigate or to explain, do please email us. Our address is more or [e-mail] and you can also sign up for a free download of this program at our website, bbcworldservice.com moreorless there are dozens of different podcasts now available from the BBC, including news, documentaries, science, business, arts and sports. For details of them all go to bbcworld service.com podcasts.