The Great Debate

How the Nobel economists changed investing forever

The 2013 Nobel Prize for economics celebrates that financial markets work, but cautions how little we know. One theme unifies the work of all three winners: Eugene Fama, Robert Shiller and Lars Hansen — risk. (A disclosure: until August I worked at Dimensional Fund Advisors, where Fama is a director and consultant.) Risk is unpredictable, but can be very profitable. That sounds simple enough, but it has profound implications — not only for the lords of high finance, but households, too. Risk teaches humility, to overconfident investors and also policymakers. That humility was notably absent at the IMF/World Bank meetings last week. Policymakers should take special note of the prize this year; it reveals how little we really understand about financial markets.

Fama’s work showed that prices incorporate all available information; this is known as the efficient market hypothesis. The implication is that you cannot systematically outperform the market, unless you have information other people don’t or can access part of the market others can’t. But that doesn’t mean you can’t make money. Over time you can expect, but are not guaranteed, that riskier assets generate higher returns. Stocks, on average, return more than bonds because they are riskier. The stock of smaller companies is riskier than larger ones, so they typically generate more returns. It’s a straightforward concept, but often poorly understood. Even many sophisticated investors get it wrong.

The implications of this theory changed markets, even for the average investor. The concept of efficient markets helped create demand for index funds. Index funds are a type of mutual fund, which is a collection of many different stocks. Active funds profess to know which stocks will outperform the market. Index funds don’t make that promise; stocks are weighted by their size relative to the rest of the market or use a weighting based on identifiable price or size characteristics. Because there’s no magic formula or talent presumed in constructing these funds, they are cheap; if no one can beat the market, why pay 1 or 2 percent of your assets to someone who claims they can? If you believe in efficient markets you’d only hold index funds. This has been revolutionary for the average investor. Through the 1960s few Americans owned stock at all, and if they did they only held a handful of individual stocks, which was very risky. Now about 50 percent of the population owns stock, mostly through mutual funds and increasingly with allocations based on indexing. The average household can invest as well as many hedge funds, for a fraction of the price. The existence of index funds shows that the best innovations (in finance or any industry) are often the simplest.

Fama’s later work, and the work of the other new Nobelists, further refined our understanding of risk. Fama’s more recent work helped us understand what kinds of risk investors are compensated for and how the return from risk varies over time and with economic conditions. Shiller’s work showed that asset prices are more volatile than models would predict, but there may be some predictability to returns over long horizons. Shiller may be skeptical that asset prices accurately reflect all information, but he still believes markets work. He advocates more financial innovation, based on his ideas, including products that hedge housing price risk and swings in economic activity.

Hansen’s work provided a way to measure how variables interact without presuming a perfect knowledge of how risky they are. His methods have been used in finance and macroeconomics. As the last five years have shown, financial risk has profound effects on the real economy. But how and through what channels is not well understood; macroeconomists often make unrealistic assumptions about risk or ignore it altogether. But even though Hansen pioneered new ways of using data to understand macro models of the economy and finance, he stresses we should not overestimate what we know.

Saving Defense dollars: From BRAC to ORAC

While the government shutdown continues because of the Democrats’ and Republicans’ profound disagreement, the real issue facing the nation is something that both parties agree on, in principle: the need to reduce the size of the federal deficit.

The Budget Control Act of 2011 and sequestration have made some steps in this direction, though aiming indiscriminately at certain parts of government far more than others. Half of all cuts, for example, come from the Defense Department.

There are a wide range of options for domestic spending reduction. But military spending cuts are more narrow and difficult. They can be done responsibly, however. Sequestration’s reductions are severe, perhaps excessive (especially early on), with $500 billion in 10-year cuts, on top of the $500 billion already accepted back in 2011. That said, tens of billions can undoubtedly be saved through smart economies and business practices — without cutting muscle or breaking faith with the men and women in uniform.

Looking to diplomacy with Iran

President Barack Obama has decided to test whether Iranian President Hassan Rouhani’s “charm offensive” is a legitimate effort to reach an agreement on a more constricted and transparent Iranian nuclear program. With this decision, he embarks on the most transformative and important diplomatic initiative of his presidency.

The closest historical analogy is President Richard M. Nixon’s opening to China in 1971. Nixon had recognized a major adversary’s new willingness to change course and he seized the opportunity to further vital U.S. national security interests.

This China analogy, however, has some flaws. Most important, Nixon and his national security adviser Henry A. Kissinger began their quest in secrecy to avoid a divisive public debate that could have scuttled the initiative. Obama’s public commitment to test an opening to Iran, though, will be subjected to fierce scrutiny by domestic and foreign opponents.

from David Rohde:

A new Paul Ryan?

This week, Representative Paul D. Ryan (R-Wi.) may have made himself a leading Republican presidential contender in 2016. By proposing an end to the budget impasse that did not include one word -- Obamacare -- Ryan may have outmaneuvered Senators Rand Paul (R- Ky.) and Ted Cruz (R- Texas).

Multiple proposals are under consideration in Washington. If Ryan's plan becomes the basis for a bipartisan budget agreement, it will boost his standing and be a body blow to the Tea Party.

Ryan is clearly trying to position himself as a fiscal conservative who is serious about addressing the country’s deficit problem -- without destroying the U.S. economy in the process. He is trying to win the support of the moderate Republicans and mainstream business leaders increasingly exasperated by the Tea Party’s flirtation with default.

Helping the victims of American sex trafficking

Friday marks the International Day of the Girl. The United Nations has set aside October 11 to focus on the discrimination and abuse that women and girls suffer throughout the world.

One brutal crime that demands a far more intensive worldwide response is commercial sexual exploitation. This problem is of crisis proportion, and each time it happens it amounts to selling the rape of a child for profit.

This illicit global industry has begun to receive some of the attention its victims desperately require. But a blind spot remains: American girls on American soil.

For Syrians, a no-fly zone of their own


For two years, the rebels in Al Qusayr held out against the forces of Syrian President Bashar al-Assad. Then in April the regime, supported by fresh fighters from the Lebanese militant group Hezbollah, renewed its attack on the mountain town overlooking the Lebanon border.

But it wasn’t Hezbollah that made the difference. It was the relentless bombardment by Assad’s air force that shattered the rebel defenses — killing 80 opposition fighters and sending the survivors into retreat. Assad’s jets and helicopters, unleashed against rebels and civilians alike in mid-2012, have proved a decisive force in the now 30-month Syrian civil war.

Because of this aerial onslaught, the rebels have begged the United States and its allies in the North American Treaty Organization to enforce a no-fly zone over rebel-held areas concentrated in Syria’s mountainous north. Barring that, opposition leaders have an alternative proposal: Washington and its allies supply rebel fighters with the weapons they need to defend a no-fly zone on their own.

The budget is its own ‘debt ceiling’

It could be that President Barack Obama and the Republican House of Representatives will again be able to avert fiscal and financial chaos through a short-term, ad hoc agreement on government funding and the “debt ceiling” limit. This would be good news for the world and its markets.

Going forward, however, we should repeal the 1917 Liberty Bond Act — the source of the “debt ceiling” regime that everyone’s talking about. This was effectively superseded by today’s budget regime, enacted under the Congressional Budget and Impoundment Control Act of 1974. Making this explicit by repealing the 1917 “debt limit” regime is preferable to leaving things merely implicit as they are now.

In what sense does the 1974 regime “implicitly” repeal the 1917 regime? To answer, begin with this apocryphal early 20th century statute familiar to some lawyers: This law supposedly imposed a strange, impossible requirement on two train conductors when their trains approach from opposite directions. The conductor of each train was to stop, await the other train’s passage and then continue the journey. If read literally, of course, this statute would leave trains idling indefinitely on the prairies, shutting down the railway. So the law cannot require what the “plain” language seems to suggest — nor would any court rule this way.

Antisocial genesis of the social cost of carbon

The day after his 2009 inauguration, President Barack Obama committed to “creating an unprecedented level of openness in government.”

He vowed to build on “transparency [that] promotes accountability by providing the public with information about what the government is doing,” “participation [that] allows members of the public to contribute ideas and expertise,” and “collaboration [that] actively engages Americans in the work of their government.”

Despite these promises, and despite longstanding requirements of administrative law, the Obama administration is making significant regulatory decisions behind closed doors — without transparency or public involvement. Yet these new regulations could have enormous impact on Americans for generations to come.

A 14th Amendment for all centuries

During the 1980s, a colorful Washington figure used to stand in Lafayette Square near the White House holding a sign: “Arrest Me. I Question the Validity of the Public Debt. Repeal Section 4, Fourteenth Amendment to the U.S. Constitution.” That section reads: “The validity of the public debt of the United States, authorized by law, including debts incurred for payment of pensions and bounties for services in suppressing insurrection or rebellion, shall not be questioned.” As far as I know, the whimsical “protester” was never arrested; he wasn’t breaking any law. Congressional Republicans, if they force the United States into default on its debt, will be.

Even most journalists and policy wonks hadn’t heard of Section 4 until recently. But with a default on “the public debt” increasingly possible, many now find the subject gripping. What if the House Republican majority decides that they are just too angry to authorize repayment of the debt? They’d be violating the Constitution — but what would happen to the country, and to them?

During the debt-ceiling crisis of 2011, a number of scholars, including me, suggested that President Obama could end the standoff by proclaiming that Section 4 required him, as part of his duty to “take care that the laws be faithfully executed,” to set aside the debt ceiling and borrow enough money to fund payments on the debt. Obama later said his lawyers told him that was “not a winning argument.” This time around, White House Press Secretary Jay Carney has already said that “this administration does not believe that the 14th Amendment gives the power to the president to ignore the debt ceiling.”

Why airline mergers are inevitable

The American Airlines/US Airways merger talks are on hold due to the ongoing antitrust trial led by the Department of Justice. The D.O.J. is concerned, from the perspective of protecting consumers’ interests, that the resulting airline would have too much market power in many of its locations. Though this is true (assuming nothing about the airlines’ business was changed and no assets were divested), the underlying issues are broader than that.

This is an inevitable story of consolidation and creative destruction and the cyclicality of the two. This proposed merger — or one like it – will happen. It’s just a matter of time. But let’s compare an American Airlines/US Airways pairing with two, comparable, big-headline mergers.

Back in 2012, the music industry consolidated from four big players to three as EMI was split up. Its music business went to Vivendi’s Universal Music Group and its publishing business to Sony/ATV. In this deal, similar concerns of market power led the European Commission to stipulate that Universal had to sell a third of EMI’s assets. And that deal went through.