What the Great Fama-Shiller Debate Has Taught Us

It’s a little hard to imagine a Nobel Prize in physics being shared by (1) a guy famous for advancing a particular hypothesis and (2) a guy famous for relentlessly attacking that hypothesis. This of course is what the Nobel committee has done with this year’s economics award, with the added Hegelian twist of giving another third of the prize to a guy who came out somewhere in between. Thesis (Gene Fama)! Antithesis (Bob Shiller)! Synthesis (Lars Peter Hansen)!

This is, to a certain extent, further evidence that economics isn’t a science like physics is a science (and yeah, yeah, the economics Nobel isn’t a real Nobel prize). But that’s not because economists are all frauds — it’s at least partly because economics is harder than physics. And the interaction over the decades between the differing ideas of Fama and Shiller, while maybe not exactly scientific, has certainly been enlightening, and had a huge impact on the world.

Like a lot of people, I know much more about Fama and Shiller than about Hansen. That’s partly because Fama and Shiller have been willing (downright eager, in Shiller’s case) to explain their work to the public, while Hansen apparently prefers to sit in his office and do math. It’s also because Fama and Shiller are the obvious poles of the debate, while Hansen is one of a number of people who have been plowing the extensive acreage between them. I think he got the Nobel nod (instead of somebody like Andy Lo, or Mordechai Kurz, or Roman Frydman) because he was (1) very early to the game, (2) a macroeconomist (the Nobel people generally seem more comfortable with macro than with finance), and (3) most suited to being shoehorned into a narrative of steady scientific progress. It’s also possible that Hansen just got the prize because his work is so great and/or has spawned lots of productive further research, but I’m really in not in a position to judge that — his stuff is really dense. So I’m not going to pretend that I know much about his contributions; you need to go elsewhere for that.

Fama and Shiller, though, are people I spent years thinking about, reading about, and talking to for a book I wrote a few years ago. I could go on about them forever, but here’s the very short version of why they’re important:

Fama studied finance at the University of Chicago’s business school in the early 1960s, then started teaching it there. This was a time of great ferment in financial research at Chicago and a few other campuses, occasioned by the arrival of a few new ideas and a few more big computers. At the annual meeting of the American Finance Association in 1969, Fama presented a paper (published the next year in the Journal of Finance) summing up what he and others had learned about stock market behavior over the previous decade and sketching out a way forward. “Efficient Capital Markets: A Review of Theory and Empirical Work” laid out the evidence that stock market prices were hard to predict using past price behavior (that is, they followed a “random walk”) and even information about corporate performance, and that professional investors generally failed to beat the market. He suggested taking things a step further, and testing whether the stock market was actually “efficient” in the sense that it “provide[d] accurate signals for resource allocation.”

The way to test this, Fama said, was in conjunction with a theory of “market equilibrium under uncertainty.” The main model available at the time was the Capital Asset Pricing Model, which says that a stock’s returns over time should be commensurate with its riskiness in relation to the overall market. Early tests of CAPM came out reasonably well, and by the end of the 1970s Fama’s former student Michael Jensen was (in)famously declaring that “I believe there is no other proposition in economics which has more solid empirical evidence supporting it than the Efficient Market Hypothesis.”

Research into stock market prices had also been popular at MIT in the 1960s, and MIT’s Paul Samuelson even authored the first paper mathematically demonstrating that a rational stock market would be a random, unpredictable one. But Samuelson never believed that real-world markets approached this ideal, and MITers were critical of the hardening Chicago conviction that they did. Shiller, who got his Ph.D. from MIT in 1972, devised his own test of market efficiency, asking in a paper published in the American Economic Review in 1981, “Do Stock Prices Move Too Much to be Justified by Subsequent Changes in Dividends?” His answer: Why yes they do!

Shiller’s paper was hugely controversial at the time, and if you bring it up with old-guard finance professors they still tend to grumble about it. Perhaps his claim that the Efficient Market Hypothesis was “one of the most remarkable errors in the history of economic thought” had something to do with that. But within a few years — especially after the market crash of 1987 — it was widely accepted that yes, stock prices did appear to be much more volatile than the economic and corporate fundamentals that they were supposedly reflecting and predicting. For a time most finance scholars still argued that it was impossible to say until after the fact when exactly market prices were out of line, but the tech stock bubble of the late 1990s and early 2000s changed a lot of minds about that.

It didn’t change Fama’s mind. He still contends that those who speak of market “bubbles” are being intellectually sloppy. But his students have with his encouragement documented lots of apparent market inefficiencies, and his own empirical work has done as much damage to the EMH as he proposed it in 1969 as Shiller’s has. In a study published in the Journal of Finance in 1992, Fama and co-author Kenneth French found that, contrary to earlier evidence, the Capital Asset Pricing Model didn’t do a very good job at all of explaining stock market returns in the U.S. from 1941 through 1990. Fama and French chose to try to save EMH by jettisoning CAPM and replacing it with their own multi-factor risk model in which the small-stock effect and the value stock effect are said to “explain” price behavior (others have since added other factors). But it’s just as valid to hold on to CAPM and label these effects market inefficiencies. As CAPM loyalist Fischer Black of complained of Fama and French in 1993: “They don’t want to hear about theory, especially theories suggesting certain factors or securities are mispriced.” But Fama had framed his hypothesis in a way that it could be tested, and has been pretty relentless about testing it. You can applaud that without embracing his conclusions.

Meanwhile, Shiller, for all his criticisms of the Efficient Market Hypothesis, still seems to endorse a very loose version of it. He has shown that asset prices have a tendency to overshoot, but he’s nonetheless generally a big believer in financial markets, frequently arguing that what we need are more markets and more ways to hedge our risks. His extracurricular activities, from his books to the Case-Shiller real estate price indices he co-created, are best seen as attempts to educate market participants and get them to do a better job of setting prices.

Fama’s main work outside of academia has involved advising the big small-stock index-investing firm Dimensional Fund Advisors, founded by his former students David Booth — after whom the Chicago business school was renamed in 2008 after he gave it $300 million — and Rex Sinquefield. His research also played a big role in the creation and rise of the index investing industry in general. And his most important and consistent message through the years, that it’s really hard to beat the market, remains really good advice.

So I’ll admit that it’s an odd combination of Nobel Prize recipients. But it’s not necessarily an incorrect one.

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