Years come and years go, and every year someone wins the Nobel prize for economics and, honestly, the rest of the world simply yawns and says, “Please pass the butter.” And most people are right — economic theories come and go, like polka dots and the Farrah Fawcett hairstyle. In fact, apart from weather forecasters, there probably isn’t an occupation where regular failure is so predictable as that of economist.
And yet, like weathermen, we look to economists to give us answers. Governments look to the ranks of the economists to guide their economic policies. And, among all challenges facing the Chief Executive of the world’s largest nation, which one is the most important? As ex-President Bill Clinton sloganed in his campaign to unseat an incumbent President, “It’s the economy, stupid.”
As we look at the history of economic policy, though, it’s hard not to conclude that, unlike weather science, there seems to be no agreement among economists about what happened, is happening, or should happen.
Economics is the only field where two people can share a Nobel prize for saying opposing things, as someone once said. And few things bear this out as eloquently as this year’s crop of Nobel prize winners: two of the three laureates believe the exact opposite of each other. That’s the same as awarding the Nobel prize for weather forecasting (if there were such a thing) to two weather anchors, one of whom forecasts snow, and the other sunshine… for the same day.
That’s how different the two gentlemen in the top row of the composite picture above are:
Robert Shiller (top right) warned in 2005 that the nation is facing a housing bubble of epic proportions. Unless something is done, he warned, the meltdown ensuing when the bubble burst will be devastating.
Eugene Fama (top left), however, maintains, even after the bubble burst, that there was no bubble, is no bubble and never will there ever be a bubble, not too unlike the famous three monkeys we all know.
Fama: There Is No Bubble
Eugene Fama caused quite the stir with his Ph.D. dissertation in the mid sixties which, when published as a book, became one of the cornerstones for understanding stock prices. It adopted the notion of “random walk” to economics, specifically the way information pertaining to an asset, such as a stock (or home) becomes disseminated among everyone looking at that asset. Perhaps the best way to understand how a stock price is determined through a random walk process is to view the picture to the right: that was the result of a random walk algorithm attempting to describe the form of a man.
Fama’s views became the basis for what has became known as the Efficient Market Hypothesis, or the EMH. According to this view, all known information about an asset (a stock or your home) gets disseminated quickly. Even though the asset’s price may fluctuate, it quickly resembles its “true price” just as the random pieces of steel in the Gormley statue form the picture of a man, only quicker.
This view holds that the market is efficient and the economy needs to be deregulated and left free to perform its rational, efficient magic.
Every price on every house, therefore, is a accurate reflection of all possible information. That, then precludes anything resembling a bubble or “irrational exuberance,” the title of Shiller’s seminal book.
Shiller: Beware the Bubble
Robert Shiller, top right, warned in 2005 that the United States is facing a housing bubble which, if not nipped in the bud, could lead to economic disaster: “…further rises in the [stock and housing] markets could lead, eventually, to even more significant declines… A long-run consequence could be a decline in consumer and business confidence, and another, possibly worldwide, recession. This extreme outcome … is a much more serious risk than is widely acknowledged.” Among respected economists, his was the only voice advocating caution. It was ignored by all governments we had during the past twenty years.
He started his career in the early eighties with a challenge to the Efficient Market Hypothesis, claiming that there is way more movement in the prices of stocks and houses than can be explained by the EMH, or any other theory, for that matter. His work coincided with that of psychologists Amos Tversky and Daniel Kahneman, and is credited with forming a new view, called Behavioral Economics.
In 2000, Mr. Shiller published Irrational Exuberance, focused on the stock market bubble which we know today as the dot-com bubble. Needless to say, his views and predictions gained immense credibility when the stock market crashed, right as he predicted. Proving that he was not a one-trick pony, he reissued Irrational Exuberance in 2005, this time focused on the developing real estate bubble.
It’s as easy to poke fun at economists who get it wrong as it is to disparage the local weather anchor on last night’s news. There is one difference, though: the nation’s wellbeing doesn’t depend on whether they got it right on the six o’clock news last night. A nation’s leaders make decisions that affect our personal wellbeing, and to do that, they have nobody to rely on except those who call themselves economists. And so it was, for instance, than in the early 2000’s, those of Mr. Fama’s persuasion guided the country’s economic policy of deregulation. Those who used common sense, backed with good data, like Mr. Shiller, were dismissed as “story-tellers” (Mr. Fama’s dismissive description).
We all know the outcome. In the early 1900’s, classical economists proudly proclaimed that the market is efficient and needs to be left alone. When the government did that, the Great Depression ensued. It was almost a hundred years later when they did the same thing… with the same result.
Paul Krugman (himself an economics Nobel laureate) wrote an insightful “state of the union” type of review of economics in 2009, entitled How Did Economists Get I Wrong? The key mistake of the classical economists is mistaking beauty for truth: elegant mathematical models are not necessarily accurate reflections of reality. They seem to understand the good times, but they ignore the bad times because it interferes with those models. This leads to statements like recessions happen because people simply feel like they need to take a little time off. (I am not making that up.)
However, while it’s easy to poke fun at economists and chuckle over their silliness, the fact is they’re the best we have. And, as with weathermen, a bad one is better than no one at all. And so we have to listen to what they say, but use our own common sense to avoid the mistakes blind adherence to their predictions bring. Carry an umbrella and a rain storm will never catch you by surprise. Stay out of debt and no recession will destroy you.
There is one area, though, where you have nothing to fear from economists: your insurance. All you need to do for total peace of mind is give Grant a call once a year to review your needs. That call could save you big money. And isn’t that the kind of economics you really want to have?