Barry Ritholtz: Fama Has Shiller to Thank for his Nobel Prize: Noted
Barry Ritholtz: Fama Has Shiller to Thank for his Nobel Prize:
At the University of Chicago, there are two professors of economics named Eugene Fama…. Fama the Younger… developed a profound insight about the markets…. The Efficient Market Hypothesis, as Fama called it, meant that stock-picking was a futile exercise…. The relevance to finance was soon obvious: Most investors are better off owning the entire market, rather than guessing which stocks might do better or worse. We can quibble with some of Fama’s reasoning. It turns out that prices are not all that rational and frequently deviate from known data--but Fama got the big concept right…. For this, Fama is thought of as the intellectual father of… passive investing…. His work became hugely influential, and remains so to this day…. Had he stopped there, Fama the Younger probably would have flown to Sweden to pick up his Nobel Prize money decades ago.
But… the Nobel committee was confronted with the problem of Fama the Elder… [who claimed] the rules and regulations related to securities were unnecessary… counterproductive because they interfered with the price discovery process. Insider trading rules? We don’t need them! Why would we, when even nonpublic information known to insiders is reflected magically in stock prices! Indeed, we can eliminate nearly all of the rules that have been developed since the Great Depression to regulate investing and trading….
Fama the Elder… shaped financial theory… influenced generations of economics and business students… swayed senators, Federal Reserve chairmen, even presidents. This created a bit of problem for the Nobel committee…. The second Fama is in many ways the intellectual father of the financial crisis. His thinking laid the groundwork for deregulations that had a terrible impact…. Consider the grand experiment just before the financial crisis: The Commodity Futures Modernization Act of 2000 turned derivatives into a unique category of financial instruments. They did not mandate any disclosure, they were not obligated to be traded on any exchange, and underwriters were not required to hold reserves against potential losses. The theory was that the risks would be reflected, somehow, in the price. The repeal of Glass-Steagall was another deregulation that could be traced to Fama….
Even then-Federal Reserve Chairman Alan Greenspan fell prey to the errors of Fama’s hypothesis. Fed Gov. Ed Gramlich had brought the subprime mortgage lenders and securitizers to the Fed chief’s attention as predatory lenders with the power to destabilize the mortgage markets. Greenspan called them “financial innovators” who should not be burdened with regulation. As detailed by the Mortgage Lender Implode-o-meter, 388 of these firms went down in flames, ravaging the credit markets. Despite all of this, Fama the Elder went so far as to say, “I don’t know what a credit bubble means.”
You can see the quandary this created for the Nobel committee…. Fama the Younger’s work was insightful and created an immense benefit for investors. But Fama the Elder’s work was almost as bad as the earlier work was good…. The Nobel committee resolved this problem quite elegantly…. Fama the Elder… had an adversary…. After the 1987 crash, Shiller remarked, “The efficient-markets hypothesis is the most remarkable error in the history of economic theory.”… So the Nobel committee could recognize Fama the Younger, awarding him the prize for his work on unpredictability. But it could distance itself from the silliness of Fama the Elder, by having the Younger share the award with Shiller. And that is how the most astute critic of the efficient-market hypothesis helped its creator win a Nobel Prize in economics.
