From efficient markets to 'animal spirits'

From efficient markets to 'animal spirits'

Ten years ago, Eugene Fama and Robert J Shiller were awarded the Nobel Prize in Economics (together with Lars Peter Hansen) "for their empirical analysis of asset prices".

Profs Fama and Shiller, however, hold diametrically opposing views on asset-price movements. Fifteen years after the global economic crisis, it is a disagreement worth revisiting.

Prof Fama is a member of the Chicago school of economics, both literally -- he is a professor at the Booth School of Business -- and intellectually. The Chicago school holds that economic actors are rational utility-maximising agents, able to deploy infinite cognitive capacity and complete information at all times. With his highly influential "efficient market hypothesis", Prof Fama takes this further, positing that prices almost immediately incorporate all available information about future values and thus accurately reflect economic fundamentals.

Prof Shiller, a Yale-based behavioural economist, could not disagree more. Taking a Keynesian view of markets, he argues that, in markets shaped by "animal spirits", individual actors have irrational tendencies, which can be amplified by the collective mood of the market.

The Nobel committee justified the joint award by differentiating the time horizons to which the theories of Profs Fama and Shiller apply. Prof Fama's scholarship suggests that asset prices are extremely difficult to forecast in the short run (making financial markets difficult to game), because they incorporate new information very quickly, whereas Prof Shiller's work establishes that they are more predictable in the long run (making finance amenable to human manipulation).

So are markets endowed with some divine power that guarantees efficient outcomes? Or do mere mortals have to do the hard work of ensuring the proper functioning of their economic systems and institutions? To answer these questions, we must venture into the "twilight zone of economics", the as-yet ill-defined realm of economics at the interface of micro and macro.

The orthodox Chicago school view adheres to methodological individualism: economic actors make their utility-maximising decisions entirely independently of one another and of social forces, though the collective result serves the public interest. While the pooling of individual information contributes to more accurate pricing and, thus, better resource allocation decisions, the mechanism that transforms countless isolated, self-interested micro-level decisions into broadly shared benefits is as clearly defined as alchemy.

Prof Shiller, by contrast, offers a real analysis of the relationship between micro decisions and macro outcomes. According to his research, asset pricing typically resembles a kind of Keynesian beauty contest in which participants are asked to select the six prettiest faces from a hundred headshots, knowing that the person whose selections best align with the most popular picks will win a prize. In this context, it's rational for participants to ignore personal preference and choose the faces they believe others will select. Similar psychological forces, Prof Shiller explains, shape the prices of assets, from tech stocks to real estate. In 2005, a few years before a housing-price crash in the US triggered the 2008 global financial crisis, Prof Shiller warned that "irrational exuberance" was fuelling a housing bubble -- and it was destined to end badly. (Compare this with Prof Fama's explanation of that crisis: "Economics is not very good at explaining swings in economic activity.")

As Prof Shiller explains in his recent work, narratives are the key factor. Stories can cause humans to behave in all manner of ways, and if believed widely enough, they can shape economic outcomes. That is why it is essential to consider individual economic actors' cognitive and emotional qualities and the ways these actors interact with one another. Group psychology is analytically distinct from individual decision-making, and in modern economies, nobody decides anything in a vacuum.

While Prof Fama says humans can't beat markets, Prof Shiller insists humans make markets, which means humans can strive to improve their functioning. Which claim you believe has important implications for economic theory and financial regulation. If the Chicago school's market-shaping divinity does not exist, we should treat the economy as a socially constructed institution created by and for humans, with all our biases, limitations, morals, and values. In his Nobel address, Prof Shiller said the overarching theme of his work is that we need to "democratise and humanise finance". To do it well, we must not be afraid to enter the economic twilight zone. Understanding markets requires understanding human social dynamics. ©2023 Project Syndicate


Antara Haldar, Associate Professor of Empirical Legal Studies at the University of Cambridge, is a visiting faculty member at Harvard University.

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