A Brief Word on the 2013 Nobel

The 2013 Economics Nobel was awarded this morning to Fama, Shiller and Hansen, the first two major figures in finance and the third a somewhat odd choice who, I would think, is much more associated with econometrics and general macro via his introduction of GMM; indeed, the Nobel press conference seemed to be straining on how to include Hansen in the trio. Even stranger, Hansen was a natural fit only a couple years ago when the price went to Sargent and Sims. In any case, he is fully deserving.

Finance is well outside my area of expertise, but I do recommend Shiller’s 2003 article in the Journal of Economic Perspectives, which nicely summarizes persistent anomalies in financial world. Note that, as Shiller also points out, irrationality or behavioral quirks on the part of investors is not sufficient to generate deviations from the standard efficient markets model. We must also have some reason that rational traders do not simply take advantage of investors with these deviations. There is sufficient reason to believe that Malkiel’s prescription from the 1970s – that you as an individual investor are wasting your time trying to predict stocks – is correct (though Jeff Ely pointed out in an offhand comment that if you are risk-neutral and transaction costs are small enough to ignore, efficient markets also imply that whatever crazy trading strategy you want to use will generate identical returns in expectation!).

So why is it that the market doesn’t just knock out the idiots, in Larry Summers’ diplomatic phrasing? One pretty compelling reason, due to Summers and three coauthors, is roughly that noise traders behave unpredictably, hence it is risky to bet against them, hence you need to be compensated for doing so if you are rational, hence prices can deviate from fundamentals. Alp Simsek has a very nice recent paper on when optimists will be able to get loans to continue bidding up the bubble; consider the housing crisis, where clearly “irrational exuberance” required the exuberant to somehow get loans from supposedly staid bankers. There is also a literature about how limits on the ability to short assets restrict the rational from betting the other way, but I have not followed the extent to which these limits are empirically important.

(Even more fundamental than puzzles about why trades deviate from random walk conditions is the puzzle of why trades in an efficient market happen at all. Take any common-value good like a stock. If I, given my information, believe the future dividend payments mean the stock is worth 5 bucks, and you offer it at 4, then I should infer that you know something I don’t; this is the fundamental principle from Aumann and Milgrom/Stokey. There are many solutions, but I’m partial to the adverse selection models begun with Gloster and Milgrom, which generate bid-ask spreads in perfectly competitive broker markets.)


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