The twilight zone of economics

CAMBRIDGE — 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”. Fama and Shiller, however, hold diametrically opposing views on asset-price movements, from what drives the decisions of economic actors to whether markets are inherently efficient. Fifteen years after the global economic crisis, it is a disagreement worth revisiting.

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, in order to make decisions that will best serve their material interests. With his highly influential “efficient market hypothesis”, Fama takes this further, positing that prices almost immediately incorporate all available information about future values, and thus accurately reflect economic fundamentals.

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. This sometimes results in irrational and suboptimal outcomes, such as speculative asset bubbles.

The Nobel committee justified the joint award by differentiating the time horizons to which the theories of Fama and Shiller apply. 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 Shiller’s work establishes that they are more predictable in the long run (making finance amenable to human manipulation).

Shiller, for one, was not convinced. In his view, even Fama’s own research shows that markets are not efficient. But Fama’s loyalties to the laissez-faire Chicago School run deep. As Shiller put it, “It’s like being a Catholic priest and then discovering that God doesn’t exist or something you can’t deal with so you’ve got to somehow rationalize it.”

So, does God exist? 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 what I call 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 so-called 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. But how? 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. Beyond Adam Smith’s “invisible hand”, an account of how the rationality of markets exceeds that of its individual actors remains out of view.

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 overall will win a prize. In this context, it is rational for participants to ignore personal preference and choose the faces they believe others will select.

Similar psychological forces, Shiller explains, shape the prices of assets, from tech stocks to real estate. Back in 2005, just a couple of years before a housing-price crash in the United States triggered the 2008 global financial crisis, Shiller warned that “irrational exuberance” was fueling a housing bubble, and that it was destined to end badly. (Compare this with Fama’s explanation of that crisis: “Economics is not very good at explaining swings in economic activity.”)

As Shiller explains in his more 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 Fama says that humans can’t beat markets, Shiller insists that it’s humans who make markets, which means that humans can strive to improve their functioning. Which claim you believe has important implications for economic theory and for financial regulation, from how much is appropriate to whether central banks should attempt to identify and pop price bubbles. If the Chicago School’s market-shaping God does not exist, we should be treating the economy as a socially constructed institution, created by and for humans, with all our biases, limitations, morals and values.

In his Nobel address, Shiller explained that the overarching theme of his work is that we need to “democratise and humanize finance”. If we are to avoid a repeat of the 2008 global economic crisis, with all the suffering it wrought, that is exactly what we must do. To do it well, we must not be afraid to enter the economic twilight zone. Understanding markets requires understanding human social dynamics.

Antara Haldar, associate professor of Empirical Legal Studies at the University of Cambridge, is a visiting faculty member at Harvard University and the principal investigator on a European Research Council grant on law and cognition. Copyright: Project Syndicate, 2023. www.project-syndicate.org