| Eugene Fama of the University of Chicago talks with EconTalk host Russ Roberts about the evolution of finance, the efficient market hypothesis, the current crisis, the economics of stimulus, and the role of empirical work in finance and economics. Right-click or Option-click, and select "Save Link/Target As MP3. Readings and Links related to this podcast | |
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| 0:36 | Intro. [Recording date: January 17, 2012.] Russ: Your impact on the field of finance has been immense--in a whole bunch of areas, but one that stands out is the efficient markets hypothesis (EMH). I'd like you to sketch out the evolution of that idea in the field, how it was understood initially, and how it has changed over time. Guest: How much time do we have? Russ: Well, four or five hours, but let's try to keep it to under 10 minutes for this first question, if you can. Guest: Okay. I'll go back to the beginning. The way Harry Roberts tells it, Holbrook Working in the 1930s started to become interested in whether speculative prices moved randomly. He was mostly an agricultural economist, looking at agricultural commodities, and he took a series of random numbers, simulated them, and brought them to his faculty at Stanford, faculty lounge, I guess; showed them to them and they agreed they were an agricultural series. So he thought from that that maybe a random walk kind of model would work pretty well for agricultural prices, prices of other commodities. But then there was a big gap from there to like the end of the 1950s. And what opened things up was the coming of computers, which made computations much easier. And the most readily available data was stock price data. So, basically, statisticians, econometricians took the data and started doing calculations on it, calculating autocorrelations with their estimates of how predictable returns are based on past returns. And then they stopped. Economists got into the mix and said: Okay, how would we expect prices to behave if they were set based on all available information? Which is basically the EMH, but it wasn't stated in those terms at that time. So, they said: I think they should be a random walk, an hypothesis pulled out of the air. Russ: When you say it's a random walk, explain what that means. Guest: That means that expected changes are successive changes are independent of one another. It also means they have identical distributions, but that part is not important. It's basically the independence part that's important. It basically means that you can't predict future returns based on past returns. Russ: And yesterday doesn't tell you anything about tomorrow. Guest: Right. Returns from day to day are basically independent of past returns. Now that was a very extreme hypothesis. Let me give you an example. You wouldn't say that about tomatoes, for example. Tomatoes are going to be cheaper in August than in January, for the most part, because they are seasonal. It has to do with supply and demand--mostly supply of tomatoes. There's a similar thing operating in prices of stocks, bonds, whatever. Basically, there's an expected return component, what people would require in order to hold those securities; and there's no reason that that has to be independent through time. There's no reason why that's not predictable or why it doesn't go--and there's lots of evidence that it is--higher on stocks during recessions and lower during good times. So there can be predictability in returns that is consistency with efficient markets. What people didn't understand in the beginning was that propositions about how prices should behave had to be joined to a statement about how you think they ought to behave. In other words, what you need is some statement about what we call a market equilibrium. What is the risk-return model you have in mind underlying the behavior of the prices in returns? So, for example, stocks are very risky; they require a higher expected return than bonds; and you have to take that into account in the tests. So there is this, what I call the joint hypothesis problem, which is basically what I added to the mix, but it's kind of an important part of it. It says whenever you are testing market efficiency you are jointly testing efficiency with some story about risk and return. And the two are joined at the hip. You can't separate them. So, people infer from that, it means market efficiency is not testable on its own. And that's true. But the reverse is also true. A risk-return model is untestable without market efficiency. Most risk-return models assume that markets are efficient. With very few exceptions. | | 6:18 | Russ: And so when we say markets are efficient, what do you mean by that? Guest: What you mean is that prices at any point in time reflect all available information. Russ: Now that idea--what's the distinction between the weak form and the strong form that people talk about? Guest: Two words that I used in 1970 that I came to regret. Because I was trying to categorize various tests that were done. So, I called weak form tests, tests that only used past prices and returns to predict future prices and returns. And I called semi-strong form tests, tests that used other kinds of public information to predict returns, like an earnings announcement or something like that. And then I called strong form tests, tests that look at all available information; and those are basically tests of if you look at groups of investment managers and you look at returns that they generate, you are basically looking at all the information they had to generate to [?] securities, and what's the evidence that the information they had wasn't in prices. Russ: And empirically, where do we stand today, do you believe and what has been established about those various hypotheses? Guest: Well, believe it or not, the weak form one has been the one that has been subject to the most, what people call anomalies, in finance. Things that are inconsistent with either market efficiency or some model of risk and return. The big one at the moment is what people call momentum--prices seem to move in the same direction for short periods of time. So, the winners of last year tend to be winners for a few more months, and the losers tend to be losers for a few more months. In the strong form tests, Ken French and I just published a paper called "Luck Versus Skill in Mutual Fund Performance," and basically looked at performance of the whole mutual fund industry--in the aggregate, together, and fund by fund, and try to distinguish to what extent returns are due to luck versus skill. And the evidence basically says the tests it's skill in the extreme. But you've got skill in both extremes. That's something people have trouble accepting. But it comes down to a simple proposition, which is that active management in trying to pick stocks has to be a zero sum game, because the winners have to win at the expense of losers. And that's kind of a difficult concept. But it shows up when you look at the cross section of mutual fund returns, in other words the returns for all funds over very long periods of time. What you find is, if you give them back all their costs, there are people in the left tail that look too extreme and there are people in the right tail that look too extreme, and the right tail and left tail basically offset each other. If you look at the industry as a whole; the industry basically holds a market portfolio. That's all before costs. If you look at returns to investors then there is no evidence that anybody surely has information sufficient to cover their costs. | | 10:11 | Russ: Which says that for any individual investing, certainly someone like me, that is, who doesn't spend any time or very much time at all looking--in my case no time, but let's suppose even a little time--trying to look at what would be a good investment. The implication is to go with index mutual funds because actively managed funds can't outperform. Guest: Well, no, it's more subtle than that. What's more subtle about it is, even if you spent time, you are unlikely to be able to pick the funds that will be successful because so much of what happens is due to chance. Russ: So, for me the lesson is: buy index mutual funds because the transaction costs of those are the smallest, and since very few actively managed funds can generate returns with any expectation other than chance to overcome those higher costs, I can make more money with an index fund. Guest: Right. Now, it's very counterintuitive, because we look at the whole history of every fund's returns, and sort them, and really the ones in the right tail are really extreme. Russ: Some great ones. Guest: They beat their benchmarks by 3-6% a year. Nevertheless, only 3% of them do about as well as you would expect by chance. Now what's subtle there is that by chance, with 3000-plus funds, you expect lots of them to do extremely well over their whole lifetime. So, these are the people that books get written about. Russ: Because they look smart. Guest: What this basically says is that there is a pretty good chance they are just lucky. And they had sustained periods of luck--which you expect in a big sample of funds. Russ: Of course, they don't see it that way. Guest: No, of course not. Russ: A friend of mine who is a hedge fund manager--before I made this call I asked him what he would ask you, and he said, well, his assessment is that efficient markets explain some tiny proportion of volatility of stock prices but there's still plenty of opportunity for a person to make money before markets adjust. And of course in doing so, make that adjustment actually happen and bring markets to equilibrium. Somebody has to provide the information or act on the information that is at least public and maybe only semi-public. What's your reaction to that comment? Guest: That's the standard comment from an active manager. It's not true. Merton Miller always liked to emphasize that you could have full adjustment to information without trading. If all the information were available at very low cost, prices could adjust without any trading taking place. Just bid-ask prices. So, it's not true that somebody has to do it. But the issue is--this goes back to a famous paper by Grossman and Stiglitz--the issue really is what is the cost of the information? And I have a very simple model in mind. In my mind, information is available, available at very low cost, then the cost function gets very steep. Basically goes off to infinity very quickly. Russ: And therefore? Guest: And therefore prices are very efficient because the information that's available is costless. Russ: But what's the implication of that steep incline? That information is not very-- Guest: It doesn't pay to try to take advantage of additional information. Russ: It's not very valuable. Guest: No, it's very valuable. If you were able to perfectly predict the future, of course that would be very valuable. But you can't. It becomes infinitely costly to do that. Russ: So, your assessment, that you just gave me of the state of our knowledge of this area, I would say remains what it's been for some time--that at the individual certainly there is no return to--prices reflect all publicly available information for practical purposes for an individual investor. Guest: For an individual investor? Even for an institutional investor. Russ: Correct. So, what proportion of the economics and finance areas do you think agree with that? Guest: Finance has developed quite a lot in the last 50 years that I've been in it. I would say the people who do asset pricing--portfolio theory, risk and return--those people think markets are pretty efficient. If you go to people in other areas who are not so familiar with the evidence in asset pricing, well, then there is more skepticism. I attribute that to the fact that finance, like other areas of economics, have become more specialized. And people just can't know all the stuff that's available. Russ: Sure. Guest: There's an incredible demand for market inefficiency. The whole investment management business is based on the idea that the market is not efficient. I say to my students when they take my course: If you really believe what I say and go out and recruit and tell people you think markets are efficient, you'll never get a job. Russ: Yes, it's true. And so there's a certain bias, you are saying, to how people assess the evidence. Guest: There's a bias. The bias is based, among professional money managers, the bias comes from the fact that they make more money from portraying themselves as active managers. Russ: That's true in macroeconomics as well. We'll get to that a little later in the conversation. | | 16:50 | Russ: I was going to ask you about the current crisis. Guest: I have some unusual views on that, too. Russ: I'd say that the mainstream view--and I recently saw a survey that said--it was an esteemed panel of economists; you weren't on it but it was still esteemed, both in finance and out of finance. And they asked them whether prices reflected information and there was near unanimity. Some strongly agreed; some just agreed. But there was also near unanimity that the housing market had been a bubble. Guest: The nasty b-word. Russ: Yes; and was showing some form of what we might call irrationality. Guest: Okay, so they had strong feelings about that, getting mad about the word bubble. Russ: Why? Guest: Because I think people see bubbles with 20-20 hindsight. The term has lost its meaning. It used to mean something that had a more or less predictable ending. Now people use it to mean a big swing in prices, that after the fact is wrong. But all prices changes after the fact are wrong. Because new information comes out that makes what people thought two minutes ago wrong two minutes later. Housing bubble--if you think there was a housing bubble, there might have been; if you had predicted it, that would be fine; but the reality is, all markets did the same thing at the same time. So you have to really face that fact that if you think it was a housing bubble, it was a stock price bubble, it was a corporate bond bubble, it was a commodities bubble. Are economists really willing to live with a world where there are bubbles in everything at the same time? Russ: And your explanation then of that phenomenon? Guest: My explanation is you had a big recession. I think you can explain almost everything just by saying you had a big recession. A really big recession. Russ: And why do you think we had a really big recession? Guest: I've heard some of your podcasts; I'm with you. I don't think macroeconomists have ever been good at knowing why we have recessions. We still don't understand the Great Depression. Russ: True. Although Ben Bernanke would argue, and Milton Friedman would argue and he did before he passed away, that monetary policy is a huge part of it. Guest: Let me reflect. I had this discussion with Milton, actually; and what I pointed out was from your own data, they show that there were massive free reserves throughout the Great Depression. And my point is: we can't force people to move demand deposits. Or to make love to anyone. Russ: Well, you can but it's not very productive. Guest: It's not very productive. M1 and M2--those things are basically endogenous. Russ: I have the same feeling. Guest: The only thing that's sort of exogenous is the monetary base. Russ: What did Milton say to that? Guest: All I gathered from Milton was: Interesting. Even when you won you thought you lost. Russ: Yes, I know. I had plenty of those. So, are you saying that that's analogous to our current situation? Guest: Oh, no. What I'm saying is that for example people want to blame the recession on the housing sector crashing and subprime mortgages. But if you are an economist and you are thinking about that, you have to be saying that there was some misallocation across markets, that margins weren't being equated across markets. That's pretty hard to accept because people are acting in all markets, working in all markets. That's a pretty tough one to follow. Russ: Well, a lot of people swallow it. Here's their version. They say things like there are these things called animal spirits that you can't measure, but that doesn't mean they are not real; that people get all excited about a particular asset class--in this case it was housing. And as those prices start to rise it becomes rational to speculate that it will continue to rise. And as that happens--as you would admit, people are making money along the way--and then they don't. They stop making money; the prices collapse. And this happens from time to time because of irrational exuberance; and that's just an aspect of capitalism. That's the standard counterpoint. Guest: Okay, but it wasn't just housing. That was my point when we started. The same thing was going on in all asset markets. Russ: Well, the timing isn't quite identical for all asset markets, right? The stock market--the housing market starts to collapse I think around early-mid-2006. Guest: It stops rising, right. Russ: And then begins a steady decline. Guest: That decline was nothing compared to the stock market decline. Russ: But when did that happen? Guest: I don't know the exact timing. Russ: It's not around then. It's later. Guest: The onset of the recession started with the collapse of the stock market. The recession and the collapse of the stock market, the corporate bond market, all of that basically coincides. But that also coincides with the collapse of the securitized bond market. Russ: Mortgage-backed securities. Guest: The subprime mortgages and all of that. Russ: Well, yes; that happens through 2007, 2008. I guess there is some parallel. So, you are going to reverse the causation. Guest: I'm not saying I know. What I'm saying is I can tell the whole story just based on the recession. And I don't think you can come up with evidence that contradicts that. But I'm not saying I know I'm right. I don't know. I'm just saying people read the evidence through a narrow lens. Russ: Yes, they do. Confirmation bias. Guest: And the rhetoric acquires a life of its own; so there are books written that basically all say the same thing about the crisis. Russ: And you are arguing that they have essentially cherry-picked the data. Guest: Well, they just look at pieces of the data and the fact that the housing market collapsed is taken to be the cause; but the housing market could collapse for other reasons. People don't just decide that prices aren't high any more. They have to look at supply and demand somewhere in the background. Russ: We did have people holding second and third homes who didn't have the income and capability of repaying the first one. Guest: Sure. Standards were relaxed. But then you have to look on the supply side, the lending side. The people who were lending to these people had the information. Russ: Yes, they knew it. I don't think that they were fooled. They were not overly optimistic about the value of those loans. They were willing to do that because they could sell them. Guest: The puzzle is why they were able to sell them. | | 24:17 | Russ: Correct. Now my claim is the people who bought them did it with largely borrowed money. Guest: No, that's not true. These were bought by people all over the world. Russ: Correct. Guest: No one borrowed money. Remember now: savings has to equal lending. For everyone that's short bonds, somebody is on the other side. The net amount of leverage in the world is always zero. Russ: That's true. Guest: So you can't tell a story based on leverage. Russ: So what's your story? I have to think that through. It's undeniably true, and I'm not going to argue with that point. So, what's your explanation of why people bought these things? Guest: Well, I have no explanation. Again, I'd say the market crashes because of the big recession. Even a minor depression if you like. Remember that all the people buying these subprime mortgages all over the world, they are the ones making the loans in the end, they were sophisticated investors. Institutions, big banks all over the world. They thought these things were appropriately priced. They might have been at that time, but they weren't ex post. Russ: So you are not going to allow me to make the claim that the incentives they faced to worry about how appropriately priced were distorted. Guest: The incentives to make money are always there. The question is whether the market lets you make money. So, these people that wanted to securitize all these mortgages, they could have failed at any time in the process; and they would have failed big time because in order to do these things, you have to initially finance them yourself. So when the investment bankers were bringing out the securitized mortgages and other kinds of securitized assets, they initially held them. And they held them afterwards, too. Russ: They held many of them. Guest: Well, initially they held them all, because they are bundling them together; they have to come up with the capital and then they can sell them. So, they could have failed right at that point because the market says: Forget it. We're not paying you par value for these things. Russ: But when they did fail, which they fundamentally did because, at least for them, even though the world wasn't leveraged, they were leveraged, they should have gone out of business. Guest: Right, exactly. Russ: But they did not. Guest: That's awful. That's the worst consequence of this whole episode. Russ: So, my narrative is the anticipation of that distorted their decision-making. Guest: Sure, but that doesn't satisfy what address what goes on on the demand side. Russ: Why? Guest: Because people on the demand side have to buy these things. Russ: Well, the people who were buying them, and selling them, were fundamentally the same people, right? Guest: Okay, so if greed causes me to put out securities that I know are no good, why would I hold them? Russ: Because I can hold them at a very low cost. I have uncertainty; I don't know what's going to happen. There's an upside; there's a downside. Guest: It's really a low cost if you know you are going to get bailed out. Russ: Right. My argument is it dulls your senses. Guest: It does; I agree with you there. Any probability that you are going to be bailed out is going to distort your decision. Russ: So, is your argument then that that was relatively unimportant? Guest: No, no. My argument is it can't explain why people who weren't generating these things and weren't going to be bailed out by us, investors in Norway, whatever--why were they buying? Russ: Well, I'm happy to admit that some people just made a mistake. After the fact. Ex ante they certainly didn't think they were throwing away their money. And a lot of those people making those investments around the world, we bailed them out, too. The European banks got some of the benefits. Guest: Yes, because they were mixed into the same piles that involved our own investment banks. And so they got bailed out in the process. If they were holding credit default swaps (CDSs) that were sold by AIG, they got bailed out. Russ: Although I think Goldman was the number 2 holder of those. The first was--I can't remember; it was a foreign bank, either French or German. | | 29:19 | Russ: So, you have publicly said that that was a mistake, those bailouts; we should have let them fail. Guest: It's irrelevant because there is no political regime that will let that happen. Russ: Correct. But let's suppose, let's live in a fantasy world for forty seconds. Suppose on March of 2008, Ben Bernanke and Hank Paulson and the others who got together to talk about the impending bankruptcy of Bear Stearns had just let them go. They would have opened for business Monday morning without enough cash to cover their positions; they would have had to tell their creditors: Sorry; I can't honor the promise I made to you the other day or the other money; and you won't be getting the payment you anticipated. The justification for the intervention was that if we had let that happen there would have been an enormous crisis: credit markets would have frozen up and we would have had a worldwide depression. Guest: I don't know about that last part. That's what we'll never know. The issue is: How long would it take to straighten things out? And I think it's really overrated that it would have taken a large amount of time. So, banks fail all the time, and the FDIC goes in and draws a line in the sand about who is going to get paid and who isn't; stuff is put up for sale and everything goes on. I don't know how long it would take to solve a multiple failure problem. We'll never know. Russ: Well, the Lehman Brother's bankruptcy is still in process. Which is now three years old. This was the argument made at the time--like you, I'm skeptical about it but it has some legitimacy--it's that bankruptcy is complicated enough as it is; when it's a large investment bank with international creditors like Bear, Lehman, it would take a long time. In the meanwhile everybody would be thrown into turmoil. Blah, blah, blah. Do you think there's anything to that? Guest: It's possible. What happened in the Lehman case is it's held up by multiple jurisdictions. So, you have to settle with the British shareholders. Russ: The Japanese, Korean. Guest: Who all have their own set of laws about what happens in a bankruptcy. And that's what I think they've been fighting over for three years. It's pretty clear what assets [?]. Russ: But isn't that an argument for justifying what Bernanke and Paulson did? Guest: I don't know. Because who knows what would have been done if all of them went down. The problem really is that the investment banks weren't subject to the same disposition rules that would face an ordinary commercial bank. They are not subject to the FDIC. And the FDIC can come in and arbitrarily do it. That's what you buy into when you sign up for it. Whereas for the investment banks, they are not really banks; and they are not subject to those rules. The ongoing problem is that you haven't killed their incentive to finance things the way they always have. Russ: Well, I guess my claim is that part of the problem is that we gave a regulatory advantage to triple-A rated stuff, which allowed very large and different amounts of leverage compared to other stuff. That gave an incentive to these folks to find more triple-A. The amount of triple-A is essentially, until recently, there's just not enough of it to go around, if that's the most profitable thing you can do, because that's the thing you can leverage; so they found a way to invent more of it. And that included not just the things we are talking about, but European sovereign debt. Hey, that's safe; let's leverage that, too. Guest: Right. Russ: So, once we said: this is the stuff that you can make scads of money on because you can leverage it and use other people's money. Guest: You are slipping back again, though. Russ: Because? Guest: You are saying that people will buy this stuff even though it isn't triple-A. Russ: Correct. Guest: Why? Russ: Well, that's the puzzle. Is it because they were stupid, ex ante? Guest: We are talking about the world's most sophisticated people who invest. Russ: So is the alternative argument that people just made a mistake? Guest: After the fact, definitely. Whether it was a mistake before the fact, that involves estimating the probabilities of extreme tail events, which, as you know, are very difficult. Russ: So, where does that leave us? Story-telling, of course. Guest: Which is very entertaining but it's not convincing. I don't find it convincing. | | 34:45 | Russ: Before I forget, I was going to ask you--I don't want to miss this chance to ask you this: Does your research inform your own personal portfolio decisions? And has it over time? Guest: Oh, sure, always. Russ: Has it changed over time? Guest: Well, I'm not as young as I used to be. Russ: That's part of the theory, too. Guest: Right. So, my portfolio has become somewhat more conservative. I'm also a stockholder in an investment management company, so that part of it is very unconservative. Russ: That's true. Recently--a related question to what we were just talking about before that--the government published the transcripts of the Federal Reserve deliberations in 2006. I don't know if you've looked at that. Guest: No. Russ: Well, one of the most obvious things you learn from reading those transcripts--well, first of all, this is 15 really smart people, very savvy. Their job is to try to figure out what could happen next that could be dangerous. And in 2006, we were on the edge of a collapse in the housing market. And as you argue, maybe just a general problem coming that would be unforeseeable. But what was interesting was that they made the same mistake that I made at the time; and I heard lots of other people much smarter than I am made the same mistake. They said: Well, it's true that there could be a housing price fall; it's been going up for a long time, but the subprimes are essentially only a small part of the whole housing market; housing is only a small part of the overall investment market. So, if this does occur, there's not going to be much of a consequence and we don't have to worry about it. Now, one of the things I think was mistaken, certainly for me as someone not very well versed in finance, and I think most economists are not very well versed in finance, is that we did not understand the role that leverage would play if asset prices fell by a relatively small amount. Do you think that has been a lesson that some people have learned from this crisis? And should we learn that lesson? Guest: Well, leverage will put some people out of business. Russ: Correct. Guest: So, what's the problem? Russ: Well, the problem is that if lots of people go out of business at the same time it allegedly has a multiplier effect--I hate to use that phrase--but that there is some credit market contagion, systemic risk, etc. Guest: That's a word I don't think existed 20 years ago. Russ: Which one? Guest: Systemic. Russ: But let's go back to our mutual friend, Milton. Certainly Milton would argue that the contraction of the money supply at the onset of the Great Depression precipitated by bank failures was something that the Federal Reserve should have paid attention to. Guest: What could they do? Russ: They should have injected liquidity into the system. Guest: Well, but if you have massive free reserves, what is that going to do? Russ: Well, that's a problem. Again, I wish Milton were here. I'm mystified by monetary policy generally, as anyone who has listened to these podcasts knows. Guest: Well, I am too. In the podcasts of this program that I've listened to, I've heard everybody talk about the Fed controlling the interest rates. That's always escaped me how they can do that. Russ: Yes, I'm mystified by it myself. Guest: But I'm in finance, so you've got an excuse. Russ: When I interviewed Milton in 2006 and I asked him why there had been a change in public discussion at least of what the Fed does from changing the money supply to instead manipulating interest rates, his answer was: Well, that's what they say but that's not what they do. They like to say they manipulate interest rates because it makes them feel powerful. All they really do is change the monetary base. And in fact he said, if you look at M2, that's the thing to look at. Guest: That's the thing to look at if you want to know what's happening to business activity. But it's not something you can do anything about. | | 39:28 | Russ: I'm with you there. While we're on that subject, do you have any thoughts on why the Fed is paying interest on reserves? Guest: Oh, absolutely. Because they know that if there is an opportunity cost from these massive reserves they've injected into the system, we are going to have a hyperinflation. Russ: So what's the point of injecting the reserves if you are going to keep them in the system? Guest: Exactly. Russ: So what's the answer? Guest: The answer is: this is just posturing. What's actually happened? That debt is now almost fully interest-bearing, all the liquidity that they've injected. So, they've actually made the problem of controlling inflation more difficult. Controlling inflation when they didn't pay any interest focused on the base: cash plus reserves. But now the reserves are interest-bearing, so they play no role in inflation. It all comes to cash, to currency. How do you know? Currency and reserves were completely interchangeable; that's what the Federal Reserve is all about. So I think they've lost it. Now what happened, they went and bought bonds, long-maturing bonds, and issued short-maturing bonds. It's nothing. They didn't do anything. Russ: But they are smart people. Guest: Right. Russ: Ben Bernanke is not a fool. If you could get him alone in a quiet place with nobody else listening and say: Ben, what were you thinking? What do you think he'd say? Guest: I don't know, but I wouldn't believe it. In the sense that at most he could have thought he could twist the yield curve. Lower the long-term bond rate. Now I'm looking at the long-term bond market--it's wide open. Even though they are doing big things, they are not that big relative to the size of the market. Russ: Yes, I am mystified by that as well. I don't have an explanation. Guest: Let me put it differently. So, if I look at the evolution of interest rates, is it credible that in the early 1980s the Fed wanted the short term interest rate to be 13-14%? Russ: No. You are making the argument that it's endogenous; that they can't control it. Guest: Maybe they can tweak it a bit; they can do a lot with inflationary expectations. That will affect interest rates. Turn it around--all international banks think they can control interest rates; and at the same time they agree that international bond markets are open. Inconsistent. Russ: Correct. It reminds of this CNN reporter, credible insight into economic policy. He said: Macroeconomics generally--and fiscal policy, but he could equally as well be talking about Central Bank policy--he said: Politicians who think they can control the economy are like a little kid who is playing a video game; he hasn't put the money in yet and he is watching the arcade game do all its bangs and bells and whistles and noises. Which is an advertisement for the game. And he's pushing the buttons, and he's attributing all the successes on the screen to himself even though he hasn't put the money in yet because he misunderstands the underlying process that generates what he is seeing on the screen. There is some truth to that. Guest: There's a lot of truth to it. | | 42:51 | Let's turn to fiscal policy, which you've written some interesting things on lately. You have been very skeptical, as have a few others. And by the way, I should add, before we get into this I should just mention: your view that it's an open question about whether the crisis was averted by these rather remarkable open interventions by the Fed and the Treasury Department in the last few years--it's not a mainstream view. Certainly most economists believe--and I'm with you--but most economists believe that the Fed and the Treasury and the policy makers did a good thing. Guest: That's not taking into account the long term costs. Russ: For sure. And that would be true of most of these interventions. I always find it remarkable that the auto bailout was a success, quote, "because very few people lost their jobs." As if that's the only effect we would ever want to look at. Guest: The long term effects of that are horrendous. Russ: And it's not clear that they saved very many jobs, either. Clearly they changed the incentives. Guest: Not just changed the incentives--they changed the ordering of precedence in contracts. That's something that's really dangerous. Russ: Yes, they abrogated the rule of law. It's very depressing. But on this issue of fiscal stimulus, most economists believe it's a good thing, it works. We are in the minority who suggest that maybe it isn't effective. And recently you wrote a piece suggesting, I would argue, that it's never effective--unless it's well-spent. And I would contrast it with the Keynesian view, which I heard come out of Joe Stiglitz's mouth personally--people can't be what they actually believe--I heard him actually say: It doesn't matter what you spend the money on; it's all stimulus. You are very much on the other side. So, explain why. Guest: When he says it doesn't matter what you spend the money on, I think he thinks there are multiple choices that would all be good. He doesn't think that if you just wash it down the sink, that's good. Russ: Oh, no; he said, when pressed and he was asked: If you ask people to dig ditches and fill them back in, would that stimulate the economy? And he said: Yes; but it's not as good as doing something productive. I can't explain it. It's a mystery to me. Guest: It's a mystery to me, too. Russ: But he's not on the show right now; I wish he were; I'll try to get him down the road. But in your view, talk about what you think the effect of stimulus is and why you are skeptical. Guest: This is a case where you can't be sure. If you look at the empirical evidence, it basically allows you to say anything you want, because the estimates of the effects of stimulus are subject to so much uncertainty. So, I think, though, if I interpreted Christina Romer's stuff properly, or she and her husband's stuff, what it says is that the only thing that clearly gets a pretty good statistical support is permanent [?]intervention [?]. And the other stuff is just [?]. I think that's probably--I'm an empiricist in the end, so that's probably, I don't know. I have my position that I think it's a waste of money, because it will all be wasted. Eventually, you have to finance it. You have to finance it now, which means eventually you have to pay back, future generations have to pay back, for things that are then mostly useless maybe. But the evidence doesn't, like you say. So it's possible for Stiglitz to say one thing; it's possible for you and I to say something entirely different. And neither one can point to the evidence. Russ: I don't view it as a very scientific enterprise. I view it as essentially ideology being wrapped up in scientism, scientific looking, statistical estimation. It seems to me there is too much noise. Guest: I don't agree with what you said when you started; I don't think most economists do think it works. Maybe I'm in the wrong cocoon. Russ: Yes, you need to get out more, Gene, I think. Although I'm in a different cocoon over here on the East Coast; I'm in the only cocoon, I'm at George Mason University and occasionally I'm at Stanford; so we just happen to talk about the three places where there is an overwhelming majority that is skeptical; but outside of those three, I think it's pretty much the other way. Guest: Well, Bob Barro.Russ: Lonely voice, in that enclave. Guest: I think with Barro, famous macroeconomist at Harvard, there's a younger guy. Russ: Alesina. Guest: Council of Economic Advisers. Russ: Oh, Mankiw. Guest: He's skeptical, but what he says is: Once you get into politics, you become a Keynesian. The political pressures are enormous. I think that's right. Russ: It's a terrible view of our intellectual opponents, though. It's not very nice. We don't like it when they attribute our views to being friends of business, which I find repugnant. So, it seems embarrassing to suggest that they hold their views because they like being powerful. I think there's some truth to it, but it's not very nice. You want to hold that view? Guest: Hold which view? I don't know. I don't think economists are different from other people. They all like, have their views, excepted [accepted?] by everybody else, no matter what their views are. Russ: We're prone to incentives; there's no doubt about that. Guest: I've had a tough time for a long time because I believe in efficient markets. Russ: Get a lot of flack. | | 49:13 | Russ: Let's go back to finance for a minute. I will put a link up to your recent article on stimulus where you make a theoretical argument against stimulus. Guest: There's no data, right. Russ: And I think basically--it's interesting how the Chicago school has been pushing this--you are using what I would call accounting identities. The money has got to come from somewhere. I expressed it as the resources have to come from somewhere. Guest: That's the right way to say it, actually. Russ: And so I don't understand where the free lunch comes from. Guest: There is no free lunch. Russ: But the counterpoint is that there is a free lunch because there are all these resources laying around. And then it's a question--Milton said this also--how much of the stimulus goes towards the unused, so-called-- Guest: But that's the problem of implementation, which is horrendous. The same problem in regulation: implementation, which is always the killer. Russ: But let's go back to finance. There's been a big trend in recent years towards what's called behavioral finance. What's your assessment of that? Guest: I think the behavioral people are very good at describing microeconomic behavior--the behavior of individuals--that doesn't seem quite rational. I think they are very good at that. The jump from there to markets is much more shaky. Russ: Explain. Guest: There are two types of behavioral economists. There are guys like my friend and colleague Richard Thaler, who are solidly based in psychology, reasoned economics but he's become a psychologist, basically, and he is coming from the research in psychology. Now there are other finance people who are basically what I call anomaly chasers. What they are doing is scouring the data for things that look like market inefficiency, and they classify that as behavioral finance. But to me it's just data judging [?]. Russ: They don't tell you about the times they can't find the anomaly. Guest: Exactly. In all economics research, there is a multiple comparisons problem that never gets stated. Russ: A multiple what? Guest: The fact that the data have been used by so many other people and the people using it now use it in so many different ways that they don't report, that you have no real statistical basis to evaluate and come to a conclusion. Russ: My view is you should video your keyboard so we can see your keystrokes and then we can see what didn't come out. The dishes that didn't come out of the kitchen because you didn't like the way they tasted. Guest: Right. I've had people say to me that the people who do this anomaly stuff, when they come and give a paper and I'll say, when you do this, that, or the other thing, and they'll say Yes. And I'll say, why don't you report it? And they'll say it wasn't interesting. Russ: Not publishable, either. Guest: Well, that's the problem, that there's a counting process [?] and a publication process as well. You do this, that, and the other thing and I'll say, yes, why don't you report it? And they say it wasn't interesting. Russ: It wasn't interesting. Not publishable, either. Guest: Well, that's the problem, there's a publishing process and a culling process as well. This stuff makes it through. | | 52:37 | Russ: So, we started off this conversation talking about efficient markets, and we haven't talked about a zillion other things that you've studied that are important in the field of finance. One question I'd like to hear you talk about is the issue of a non-specialist. Let's say I'm just a smart, everyday person and I want to be educated out in the world. What are the lessons for me that finance has learned that are important? There are obviously of findings that have stood up, findings that have had to be modified over the last 50 years that has become more empirical that an educated person should be able to understand and use? Guest: I'm obviously going to be biased. I think all of our stuff on efficient markets would qualify. I think there is a lot of stuff in the corporate area, corporate governance and all of that, a huge field--that has penetrated to the practical level. The Black-Scholes option pricing paper in view is the most important economics paper of the century. Russ: Why? Guest: Because every academic, every economist whether he went into finance or not, read that paper. And it created an industry. In the applied financial domain. What else can claim that? So, I think we've learned a lot about risk and return. Some of it is intuitive. But there is a lot of stuff on which stocks are more or less risky. A lot of stuff on international markets. Now, what should an ordinary, intelligent person know? That's an interesting question. Let me turn it over. What should an ordinary, intelligent person know about pricing? [More to come, 54:55] |
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