Opinion

The Great Debate

Does it matter whether or not economics is a ‘science’?

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.

That conversation demonstrates the understandable frustration people have with the economics profession. That frustration deepened with the financial crisis, which few predicted, and the anemic recovery that followed it, where economic policies failed to revive growth. It leads many to ask: “What use are economists and their theories?”

It’s important to understand that economics isn’t fortune-telling. If you judge a single economic model by its ability to predict the future, inevitably it will fail you. Economics merely aims to determine the best use of scarce resources. That requires some understanding of how different factors in the economy interact. For example, if you have limited means to boost the economy and increase government spending, what happens to income?

To answer that question, economists design models that describe how the economy functions. These models are abstractions of the real world, which is complicated and contains an uncountable number of factors. It’s similar to drawing a map: to construct a tractable map, you must make choices about what to include. If you included every tree, hill, and country road the map would be too confusing to be useful. The purpose is to understand how different, relevant factors relate to each other. That serves an important role, but it makes no guarantees. You might take a highway featured in a road atlas and a truck could slam into you on that road. But that doesn’t negate the validity of the map. Driving on a highway poses some risk and, as financial economics cautions, so do markets.

What is included or left out in an economic model is where things get contentious, but economic models are still valuable. Many maps exist of New York State that don’t resemble each other, but all are useful. For a hike in the Hudson Valley you’d use a trail map that contains every path and hill. But if you were driving from New York City to Albany, a trail map wouldn’t get you too far — you’d use a road map. Or if you wanted to understand the size and location of New York relative to Ohio, you’d look at a coarser map of the states. Each map is accurate in the right context, but often useless for other purposes.

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.

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