Home > The Economics Profession > Economics’ odd couple highlights a Nobel folly

Economics’ odd couple highlights a Nobel folly

from Steve Keen

I would love to be in the audience watching the body language at this year’s “Nobel” ceremony for economics. Robert Shiller, who is far too polite a person to make it obvious, will nonetheless at least fidget as he listens to Eugene Fama’s speech, since Fama continues to dispute that bubbles in asset prices can even be defined. Shiller, in contrast, first came to public prominence with his warnings in the early 2000s that the stock and housing markets in the States were displaying signs of “irrational exuberance”.

Fama came to prominence within economics – though not in the wider body politic – in the 1970s with his PhD research that argued that asset markets were “efficient” not just a first order (getting the actual values right) but even to a second order (picking the turning points in valuation as well).

How can two such diametrically opposed views receive the Nobel Prize in one year? The equivalent in physics would be to award the prize to one research team that proved that the Higgs Boson existed, and another that proved it didn’t. 

The answer, of course, is that economics is not a science. Nor is the Nobel Prize in Economics a true Nobel Prize. Both facts have been obvious for decades to insiders and some astute observers, but this year’s award throws that reality into such sharp relief, especially since it coincides with the never-ending aftermath to the global financial crisis. That it was announced in the same week of the US farce over public debt and healthcare showed just how juvenile our appreciation of economics still is.

The basic background to the real Nobel Prizes themselves is that they were devised by the inventor of dynamite, Alfred Nobel, who endowed a fund to award annual prizes in Physics, Chemistry, Medicine, Literature and Peace. There was no prize for economics,  nor was there one for mathematics, for example.

Mathematicians lived with this situation, accepting logically that there couldn’t be a Nobel Prize for everything – or that if there were, then despite Nobel’s enormous bequest, the prizes themselves would be infinitesimal. Instead, the Canadian mathematician Jack Fields campaigned for an award to encourage young mathematicians.

He died before his idea was implemented, and he left $47,000 towards its funding in his will, compared to the half-billion dollar fund that grew out of Nobel’s will and backstops the Nobel Prizes today. The Fields Medal is awarded every 4 years to up to 4 mathematicians under 40, who each receive the princely sum of $15,000 Canadian dollars.

The Nobel Prizes, in contrast, carry an award of 8 million Swedish Krona each today, which is well over $US1 million. Mathematicians now have a couple of other better endowed awards, including the Abel Prize that grants 6 million Norwegian Kroner (less than the Nobel, but still roughly $1 million). But unlike the Nobels, which can be spent at the recipients’ discretion, the Abel funds have to be used for mathematical research.

Something as discreet as this wasn’t good enough for economists it seems. Instead, when the “Sveriges Riksbank” (the Swedish Central Bank), considered how to celebrate its 300th anniversary, it proposed the establishment of a “Prize in Economic Science dedicated to the memory of Alfred Nobel”. Its proposal – which included it providing the sum for both the prize and its administration – was accepted by the Nobel Foundation. So now we have the “Nobel Prize in Economics”.

To give the Riksbank its due, it is the oldest Central Bank in the world – the US Fed is still a baby at a mere century old, for example. There was good reason to celebrate its 300th anniversary, and a prize in economics makes some sense as part of that.

But a “Prize in Economic Science dedicated to the memory of Alfred Nobel”? What? Firstly, the Swedish Central Bank had nothing to do with Alfred Nobel. Secondly, Alfred Nobel had nothing to do with economics. Associating their prize with Alfred Nobel was and remains one of the most outrageous and most successful examples of false advertising in the history of capitalism.

However, there is one thing that makes this deception palatable: the Nobel Prizes themselves were an even more outrageous and successful example of false advertising (or perhaps false eulogising), since the reason that Alfred Nobel instituted them was that eight years before his own death, he got the chance to read his own obituary. And he wasn’t happy.

Nobel was an outstanding intellect, who had over 350 patents in his own name – the most famous of which was for dynamite, which was a much safer alternative (for the user) to both gunpowder and nitroglycerin. He was also a highly successful businessman, with a specialisation in both explosives and armaments, though he regarded himself as a pacifist. But one glance at the obituaries published after his brother’s death was falsely attributed to him made it obvious that his belief that he was a pacifist would die with him: a French newspaper carried the headline “The merchant of death is dead.”

His clever response was to create the Nobel Prizes in his will. So now we associate the name Nobel with peace, with literature, and with advances in fundamental sciences. And, by a subterfuge built upon a subterfuge, we associate economics with the real sciences as well.

Some science, when two individuals with diametrically opposed views can receive it in the same year, and for research in the same field! But that said, what are the merits of the two? (yes I know there is a third recipient, but I’d barely heard of him before this year’s award, and to give the prize the respect it deserves, I’m going to ignore him here too)

Shiller is a worthy recipient for a number of reasons. First and foremost, he has emphasised the need for long term empirical data in economics, and he has provided it as well. He developed a long-term database of house prices in America, using data on repeat sales of the same property (see Figure 1). It remains the gold standard of house price indices around the world.

Figure 1

Graph for Economics' odd couple highlights a Nobel folly

He also maintains (though he didn’t originate) a stock market index which compares the price of stocks now to their accumulated earnings over the previous decade (see Figure 2).

Figure 2: Shiller’s long-term share PE ratio data (available here).

Graph for Economics' odd couple highlights a Nobel folly

These two contributions in effect make him the Tycho Brahe of economics, and for those alone, I support the award to him. Economics generally behaves as a pre-Galilean discipline in which observation comes a very poor second to theoretical beliefs. Shiller has instead always emphasized that the data must be considered—especially when it contradicts beliefs, which is so often the case in economics.

The clincher for me, however, comes from Shiller’s third contribution: his personal courage in speaking out against the economic mainstream in the lead-up to the bursting of the DotCom bubble in 2000, and during the Subprime bubble. I’ve spent 40 years as a rebel in economics, so it’s no problem for me to lambast conventional thinkers, as I did during a session of the American Economic Association’s annual conference in Denver in 2011. But at that same session I saw how much personal intimidation shapes the “debate” within American economics.

The session, called “Adding A Bit More Creativity to the Graduate Economics Core”, was organized by David Colander, a respected textbook writer who is more open than most to including non-orthodox thought in the curriculum. David’s intention was to consider how the staunchly neoclassical core of the graduate curriculum might be expanded to allow in some alternative viewpoints. Not a bad idea, you might think, especially since this was 4 years after an economic crisis that Neoclassical economics completely failed to anticipate. But instead, John Cochrane (and others on the panel) hijacked the discussion by interpreting the topic as “how can we get more innovative students to undertake economics PhDs”? The body language against even discussing alternative thought was a prime lesson in primate behavior.

Somehow, Schiller has managed to speak out over decades about and against bubbles in asset markets, despite the primal peer pressure against him. For that reason, were I in the audience on December 10, I would join the standing ovation to him.

And Fama? Curiously, he has also done some empirical work that I find extremely valuable. Two papers of his in 1999 provide empirical support for my own work modeling the change in corporate debt as being driven by the difference between retained earnings and desired investment:

The leverage and debt regressions (Table 4) then confirm that, for dividend payers, debt is indeed the residual variable in financing decisions.

My favorite Fama paper is one where he empirically disproves the “Capital Assets Pricing Model”, which is the Siamese twin of the “Efficient Markets Hypothesis”:

“The attraction of the CAPM is that it offers powerful and intuitively pleasing predictions about how to measure risk and the relation between expected return and risk. Unfortunately, the empirical record of the model is poor—poor enough to invalidate the way it is used in applications… whether the model’s problems reflect weaknesses in the theory or in its empirical implementation, the failure of the CAPM in empirical tests implies that most applications of the model are invalid.”

But Fama has received the award for proving “that stock prices are extremely difficult to predict in the short run, and that new information is very quickly incorporated into prices”.

Poppycock. Years before Fama promoted the “Efficient Markets Hypothesis” as an equilibrium-fixated explanation for the obvious fact that it’s “extremely difficult to predict in the short run”, Benoit Mandelbrot had developed the concept of fractals which gave a far-from-equilibrium explanation for precisely the same phenomenon. Economics ignored Mandelbrot’s work completely – so much so that he gave up on economics and moved across to geometry and geography, where his perceptive ideas were rapidly accepted. Today, his vision has returned to economics and finance in the “fractal markets hypothesis”, and its explanation for the behaviour of stock prices is the utter opposite of Fama’s thesis. If anyone deserves a Nobel for asset pricing models, it’s the now deceased Mandelbrot (whose work was ignored by Fama as well, despite the fact that Mandelbrot was one of his PhD supervisors).

On the intimidation front, Fama’s outspoken championing of an equilibrium approach to modeling asset markets was the exact opposite of Shiller’s brave resistance to the groupthink of American economics. He has been an enforcer of conformity to mainstream thought who has stuck with his equilibrium beliefs despite evidence to the contrary.

Shiller, on the other hand, has been willing to accept that the messiness of the real world is indeed reality, even if it conflicts with the mainstream economics preference for believing that everything happens in equilibrium.

The Odd Couple indeed. Give me Robert Shiller’s messy Oscar over Fama’s anally retentive Felix any day.

  1. October 28, 2013 at 9:12 am

    Economics IS a science, but what currently passes for mainstream economics is mostly not. These people are (mostly unwitting) charlatans.

    • October 28, 2013 at 11:38 am

      I think what you mean is: economics CAN be a science, but it IS NOT. The reason is mainstream economics is not a science, but pretends to be the most scientific of all schools of economics.

  2. paul davidson
    October 28, 2013 at 1:29 pm

    The function of a science is to explain phenomena we observe, — Prediction is icing on the Science cake.

    there are recognized sciences that can not predict. For example, Darwin’s theory of evolution explains he development of more complex living things from earlier primitive forms — but it can not predict what will be the next evolutionary form after humans.

    As I have explained here, to be a predictive science , the process must be an ergodic stochastic process where probability distributions are imdependent of the time they are calculated.

    Keynes’s economic general theory does explain financial crisis, unemployment, the use of money contracts to organize all market production and exchange processes — something classical and mainstream economics — including Fama’s theory — does not.

    • October 28, 2013 at 7:56 pm

      Paul, you are quite wrong. There are many types of predictions in science which do not involve the ergodic axiom. For example, chemists predicted and found many previously unknown elements. Geneticists predicted and found certain laws of inheritance. The most recent Nobel Prize in physics was given for the theoretical prediction and empirical discovery of the Higgs boson. Even Darwin’s theory has been used to predict the existence of certain previously unknown species, which were later discovered. It is not beyond economics to make this type of prediction.

      Keynes’.general theory is a great economic treatise, full of insightful observations and quotable quotes, but it does NOT explain financial crisis, unemployment etc. Much of his macroeconomics has been debunked many times already, if one cares to look, even casually. There were several decades when Keynesian macroeconomics was the orthodoxy. Its failure in practice was what had allowed the neoclassical revival, with condemnations such as:

      “For policy, the central fact is that Keynesian policy recommendations have no sounder basis, in a scientific sense, than recommendations of non-Keynesian economists or, for that matter, non-economists”.

      The sad fact is: this statement is still true today, even when the word “Keynesian” is supplemented by “or any other”. There is no better time, as now, to build a new foundation for economics, free from mistakes of the past.

  3. Ivan Sutoris
    October 28, 2013 at 4:12 pm

    * It’s not true that CAPM is “the Siamese twin” of EMH. One thing that Fama and others have repeatedly emphasized is that any test of EMH must be a test of “joint hypothesis”, where one needs to assume an asset pricing model – of which CAPM is just one particular possibility.

    * Fama didn’t ignore Mandelbrot, but in fact wrote a paper which referenced him directly (“Mandelbrot and the Stable Paretian Hypothesis”, The Journal of Business, vol. 36 no. 4 (Oct. 1963)). If economists later focused their attention elsewhere, it wasn’t because they were ignorant of Mandelbrot’s work.

    * And by the way, that Mandelbrot (1963) paper has nothing to do with equilibrium or efficiency, it’s just a purely probabilistic/statistical model proposed for modeling log-prices with nongaussian, but still independent (unpredictable) increments.

    * The prize citation and research summary makes it perfectly clear that recipients got it for *empirical* work on asset prices. It’s entirely possible that two people who have in mind different theoretical explanations both make valuable empirical contributions.

    Why oh why can’t we have better critics of mainstream economics?

    • Jeff Z.
      October 29, 2013 at 3:54 pm

      One observation:

      By Fama’s own admission, and Ivan’s: “It’s not true that CAPM is “the Siamese twin” of EMH. One thing that Fama and others have repeatedly emphasized is that any test of EMH must be a test of “joint hypothesis”, where one needs to assume an asset pricing model – of which CAPM is just one particular possibility.”

      This is the Duhem-Quine thesis in operation in modern finance. Basically you can’t test a scientific hypothesis in isolation since it depends on one or more background assumptions or hypothesis. Fama in some ways built it in to his model, if we take him at his word. If the EMH needs to be tested, it needs to be tested with an asset pricing model, not in isolation as Ivan points out. There are then a bunch of other assumptions lying in the background, such as those used in setting up the asset pricing model. This is a problem for nearly all sciences, though it is a larger one for for some fields than others. If the joint EMH – asset price model fails to predict asset returns accurately, then the question is which of the joint hypotheses is at fault -EMH or the asset pricing model? How is the joint model modified? Suppose neither of these is at fault? Which of the myriad background assumptions do you look at, and on what basis do you make that judgment?

      Strictly speaking, market efficiency depends on the assumption that ALL ACTORS in the economy have perfect information – every single one. It does not mean that as a collective entity, all market actors possess bits and pieces of the whole. The EMH seems to me to rest on the idea that the (asset) market(s) AS A WHOLE posses the information, but each actor possesses different parts of the information. Even this presents a Duhem-Quine problem, because market inefficiency could rest on the idea that humans are not rational in the way traditionally supposed by large parts of the economics profession. Which is the problem – incomplete information, or irrational exuberance? Both? In any event, the implication is that the EMH remains unrefuted, while “market efficiency” is destroyed.

      As a result, it seems that there is no conceivable test that could either definitively refute the EMH (in whatever form), nor confirm it. It becomes strictly tautological.

      In all honesty, I am perfectly comfortable with the idea of market inefficiency on grounds of incomplete information and human irrationality. That means I get around the so called “joint hypothesis problem’ by accepting market inefficiency. I believe Amartya Sen has done good work on the subject of the narrowness of the rationality assumption in economics, and Akerlof and Stiglitz won ‘Nobel’ prizes for their work on imperfect information.

  4. Norman L. Roth
    October 29, 2013 at 12:52 am

    Oct.28, 2013
    Re:The author of #4’s quite wrong-headed & ‘scientistic’ [Hayek’s term] dismissal of Paul Davidson’s clear understanding in # 3, of the limits to predictability & the nature of explanation in economics, as compared to the physical sciences. In order to understand what follows, I strongly suggest that readers review the following threads by Norman L. Roth.
    [1] THE KEYNES SOLUTION, July 23,2013, # 10 & #12
    [2] IT’S THE MATH AGAIN, Aug.24, 2013, # 18
    [3] PENG CHEN’S CHALLENGE TO THE RWER, Sept. 12, 2013, #3

    In lecturing to Paul Davidson about predictability in the physical sciences, “lyonwiss” should recall that the eminent M. Davidson was a chemist before he was an economist, . Mr. Davidson probably understands only too well,how the misguided quest for the “scientific” respectability that only “quantification” can bestow, gutted the neoclassical economists pseudo-scientific mimesis [Philip Mirowski’s term] of mid-19th century energy physics. Not to mention their misadventures in the land of general equilibrium, when they became infatuated with the concept of equilibrium “constants” from physical chemistry & clumsily misapplied it to economics…The land where no constants need apply. The late Paul Samuelson’s bizarre “application” of Le Chatelier’s “law” to neoclassical economics, turned him into a laughing stock among the scientists & mathematicians [e.g. the great Norbert Weiner] on M.I.T.’s premises. And even caused John Von Neumann to remark about Samuelson’s “murky ideas about stability”.
    Keynes himself, a mathematical prodigy in his youth, clearly understood the disaster that awaited those who assumed that “prediction” in Economics was as attainable as in the physical sciences. He never missed a chance to turn his devastating wit on economists who thought that the methods of control engineering & classical mechanics could be applied to economics: In particular, Irving Fisher’s subliminal mimicry of Boyle’s Law of Gases, which he “applied” to the Quantity theory of money. Fisher is reputed to have designed & built a mechanical-hydraulic ‘model’ of the monetary “flows” inherent in the Quantity theory, which may still survive among the thousands of unexhibited artifacts in the storehouses of the SMITHSONIAN .Keynes despised the quantity theory of money. Almost as much as he despised Marxist anti-“economics”. “Lyonwiss” should also ponder the words of Roger Penrose at the very beginning of TELOS & TECHNOS. “Consciousness cannot be computable”. Why are so many still determined to follow that same “primrose path” ?
    Norman L. Roth, Toronto Canada. Please GOOGLE: [1] Origins of Markets, Norman Roth
    [2] Economics of Technology, Norman Roth [3] Telos & Technos, Roth

  5. October 30, 2013 at 3:17 am

    The whole of modern finance, both EMH and CAPM (or other asset models), is nonsense from a scientific point of view. Theoretically the theoretical foundation suffers from the ergodic fallacy (among other fallacies). Empirically no one in practice believes in those theories, as evident by their decisions and their actions and also by the broad macroeoconomic outcome of markets.

    From working in investment management and consulting for twenty years, I see modern finance theory from academics as mostly just a scam. No working professional can, or want to, disprove it, because there are strong incentives not to disprove it, since false beliefs and misinformation can be exploited by those who understand it for their own personal gain.

    They play along with the concept of inherent efficiency to avoid regulation, as they are doing “God’s work” to exploit market inefficiencies so that the markets become efficient, in a convoluted logic. The implication is that without the extraction of billions of dollars from the markets by mega investment banks such as Goldman Sachs, the financial markets would be even more volatile and inefficient.

    In truth, the financial markets act as a giant wealth transfer mechanism for those working in them to take ordinary people’s wealth through their ignorant or corrupt intermediaries (e.g. pension fund managers), who take no real responsibility for losses. For example, some professional investment managers pay lip service to modern portfolio theory to win the business of ignorant clients such as the pension funds and hedge funds.

  6. October 30, 2013 at 5:44 am

    There you have it, the latest from Fama: what the US Federal Reserve does is “kind of nothing activity”:


    Doesn’t this let the Fed off the hook if the economy continues to deteriorate, since they are really doing nothing and therefore blameless? But of course, if the economy improves then they must be doing good Keynesian stmulus! Either way, the Fed wins or does not lose in the media.

  7. Norman L. Roth
    October 30, 2013 at 1:30 pm

    Oct. 30, 2013

    Refer to #8 above & # 7.

    The author of thread #8 has left out an adjective at the beginning of his first sentence. It should read “finance capital” not just ‘modern finance’. Why doesn’t he just condense his invective into one short line. ‘The entire banking system is just one great web of conspiracy conducted by certain chosen puppeteers for their own benefit” . Wonder if lyonwiss cares to inform us who the “certain chosen” & “their” are ?
    Please GOOGLE (1) Origins of Markets, Norman Roth
    [2] TELOS & TECHNOS, Roth [3] Economics of Technology, Roth

    • October 31, 2013 at 10:27 am

      “Modern finance” really means “modern Finance theory” which is not “finance capital”. Modern finance theory has underpinned much of economic policy for the past few decades.

      I never used the term “certain chosen”, so I don’t know what you mean. I have never implied any “great web of conspiracy”, even though others may rightly have suspected such. It is quite clear that those who have found a situation to exploit (false beliefs) are not eager to abandon the opportunity or to enlighten the misguided.

      You need to be more accurate with your reading and extrapolations.

  8. John Durham
    March 27, 2014 at 3:17 pm

    I watched a UTube of Steve in Ireland recently. An issue came up about the fact that Ireland no longer has a national currency. (UK still does-what’s with that?) Someone had suggested to Steve, that a national currency, used only within Ireland might be an answer and that idea rang some bell in Steve’s mind.

    It might be interesting for Steve to know that this is exactly the system that Helmut Schmdt/Giscard D’Estang’s ECU suggested. The ECU never intended for any of the Nation States entering the Union to give up their own currency, ie, their economic sovereignty. The Dollar when used in poorer nations always becomes an international looting mechanism to that poorer nation. Schmidt/Giscard, not intending to kill poorer nations thusly, in any Union of Europe, devised the ECU to facilitate equatable Union trade. The ECU, would be based on a basket of European currencies, plus gold, plus the Dollar and not used except between the nations, ie, every citizen would use two currencies, not just one.

    If the Government accepts their own currency for payment of taxes and validates their own national currency, there is no problem within the boundaries of each nation of using toilet paper squares and money. Only between nations are made would the ECU have come into effect, providing the mechanisms that would prevent wealth gravitating to the nation with the highest living standards at the “start of the game”, which nation eventually would end up with more and more of “the chips”.

    I always assumed that the EURO was installed deliberately in order for Germany to loot the rest of the EU understanding since 1980 how the ECO functioned and how it would be applied from extensive coverage in EIR in the early ’80’s. Else why would there have been a huge effort to kill Schmidt and Giscard’s offices, one after the other?

    • davetaylor1
      March 28, 2014 at 11:18 am

      I’d worked out the logic of this for myself, and agree with it (actally I would also have local and world-level [Keynes’s bancor?] currencies too) but here in Britain we never heard much about this Schmidt/Giscard schema for a European Currency Union. I’d much appreciate your spelling it out a bit and pointing to some sources.

  9. John Durham
    March 27, 2014 at 3:21 pm

    If the Government accepts their own currency for payment of taxes and validates their own national currency, there is no problem within the boundaries of each nation of using toilet paper squares FOR money. (change that)

  10. March 29, 2014 at 5:34 pm

    Fama wrote: “The attraction of the CAPM is that it offers powerful and intuitively pleasing predictions about how to measure risk and the relation between expected return and risk. Unfortunately, the empirical record of the model is poor—poor enough to invalidate the way it is used in applications… whether the model’s problems reflect weaknesses in the theory or in its empirical implementation, the failure of the CAPM in empirical tests implies that most applications of the model are invalid.”

    An explanation as to why the data is poor is due to the nature of the attractor(s) of the dynamic process. As hyperbolic attractors are not observed in nature, per force, the attractor of the economic process is non-hyperbolic. Non-hyperbolic attractors of complex dynamic systems are extremely sensitive to noise and noise causes observables to be spurious. The problem with economics is that spuriousness is inevitable as long as information sets of agents are incomplete.

    P.S. I tend to agree with Paul (#3) on non-ergodicity. I think that is what Jacob Bernoulli alluded to in the Ars Conjectanti. Paraphrasing, in game of chance, one can determine the probability of an outcome a priori. But only in rare cases does life replicate games of chance. In most instances we have to estimate probabilities a posteriori. However, an estimate of probabilities a posteriori is impossible unless we assume that the past is a reliable guide to the furure. In other words, if information is incomplete, we can not use the rules of probability to predict outcomes.

  1. No trackbacks yet.

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out /  Change )

Google photo

You are commenting using your Google account. Log Out /  Change )

Twitter picture

You are commenting using your Twitter account. Log Out /  Change )

Facebook photo

You are commenting using your Facebook account. Log Out /  Change )

Connecting to %s

This site uses Akismet to reduce spam. Learn how your comment data is processed.