Recently, at the House of Sweden, there was a feisty exchange among the newest Nobel laureates. First, one of the economics winners, Robert Shiller, questioned the validity of the efficient markets hypothesis, the prize-wining idea of co-laureate Gene Fama. This prompted chemistry winner, Martin Karplus, to say “What understanding of the stock market do you really have?” He reckoned economics can’t explain the market and questioned if “the dismal science” is even a science.
The Great Debate
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.