SOME people still remember their university exam questions; I can still vaguely recall a few if I really put my mind to it. But I vividly remember a mock exam we were given in an undergraduate financial economics course at the London School of Economics in the late 1990s. It went something like this: if financial markets are efficient, how come Warren Buffett exists?
If that sounds mad, that must mean you are not acquainted with the works of Eugene Fama, who yesterday was one of three economists to be awarded the Nobel Prize. He was a pioneer of the efficient markets hypothesis, which comes in a weak, semi-strong or strong form. Despite the hypothesis’ name, it has little to do with whether privatisations work, or whether capitalism is better at generating growth than socialism; rather, it is about whether or not assets traded on markets (including equities) reflect all available information (and the extreme variant, even insider information). If they do, then it becomes impossible to beat the market: investors, over time, won’t be able to generate higher risk-adjusted returns.
There are lots of complications; Fama himself spent ages explaining or rationalising various instances of apparent excess returns, together with his co-author Kenneth French – though as far as I can tell, he never “explained” the existence of the tiny number of market-beating geniuses such as Warren Buffett or Anthony Bolton. But for ordinary investors, a variant of the efficient market hypothesis holds in practice, which is why so many people now invest in tracker funds and exchange traded funds.
Fama made many other contributions, trying to understand and reduce the costs caused by the division between the ownership and the management of listed firms. His take on the banking crisis – that bust banks should have been allowed to fail and that this would have worked better than the bailouts and the years of nonsense that followed – is refreshing. Much of the criticism directed against his work is due to a lack of understanding of what he actually said – but that doesn’t mean that he was right about everything, far from it.
My biggest problem with his worldview has less to do with his mainstream assumptions about rationality and more that it didn’t include a realistic, monetary-based theory of macroeconomic fluctuations. If you pump the economy full of liquidity, you get a bubble and a bust. Any approach that rejects this is faulty, regardless of the accuracy of its other predictions.
One man who did see the importance of bubbles is Robert Shiller, another of yesterday’s winners. He made his name with Irrational Exuberance, published in 2000 – and for warning of the dot.com bubble and then the property bubble – but many of his breakthroughs came earlier. In some ways, his insight is the exact opposite of Fama’s: if bubbles exist (and they certainly do), then it ought to be possible for those who spot them and agree that asset prices are mean-reverting to systematically make money. Timing is an issue, however.
Another of Shiller’s fascinating ideas is that it is possible to extend financial markets and derivatives in ways that would help the general public by allowing them to diversify risk. It ought to be possible for futures markets in GDP to be developed, and for individuals to use these to insure against unemployment or falling real wages. It ought also to be much easier to hedge against falling house prices, or even for entire economies to insure themselves against a localised recession. Anybody interested in ways of moving on from our present, crumbling and inefficient welfare state should read his classic book Macro Markets. Both men disagreed on much and were wrong on much – but together with the third winner, econometrician Lars Peter Hansen – thoroughly deserve their prize.