I have always been of the view that there’s no real point in getting too outraged about the Nobel Prize for Economics. For one thing – economics is an important subject which is bound to have an important prize, and it’s a good thing that this prize isn’t wholly in the control of the American Economic Association[1], because if it was it would be a whole lot worse. For another, on an objective look at the quality of the company which the Economics Nobel is keeping, I don’t think anyone can really claim it’s bringing the average down. The Peace Prize is a notorious joke, of course, but the Literature prize is also wildly eccentric, and even the Physics and Chemistry prizes are occasionally awarded to people who believe in ESP[2]. So let’s stipulate that the Balzan Prize and the Fields Medal are both really really good prizes, and that winning one of them is probably even better than having dinner with the King of Sweden[3].
So, the Fama/Shiller/Hansen prize, or as the vast majority of comment has it, the prize for “Fama, Shiller and that other guy”. What does it say about the state of economics? I think it encapsulates everything good and bad about the subject. First, the good.
People have really misinterpreted what this prize is about – in particular, anyone who thinks there’s anything at all paradoxical about it being shared between Fama and Shiller is really getting the wrong end of the stick. It’s a prize that’s been awarded for decades of empirical work on the statistical properties of securities prices. Allow me a potted history …
Securities markets are big and important economic things, so it would be a good idea to understand as much as we can about them, even if there wasn’t the tantalizing possibility of making a load of money out of predicting their movements, which there is. They also have the attractive property that definitionally, all securities transactions have to be recorded[4] and are denominated in cash, so there aren’t the same measurement issues as there are with a lot of other economic phenomena. We also had (via Paul Samuelson, among others) a very intriguing piece of theory, which suggests that, in the title of his 1965 paper “Properly Anticipated Prices Fluctuate Randomly“. There is a hell of a lot of intellectual debate (and because this is economics, an awful lot of ideological bullshit) related to what conclusions might follow from the fact that market prices properly discount all available information, which I will get onto later. But on the face of it, and bearing in mind that “Properly Anticipated Prices Fluctuate Randomly” does not mean the same as “Randomly Fluctuating Prices Are Properly Anticipated”, the stochastic properties of securities prices, and specifically the question of whether they fluctuate randomly or not, would seem to be quite an important thing to know about.
This is where Eugene Fama came in, round one. Unfortunately, at this point, a piece of misnomenclature occurred, and the “Random Walk Hypothesis” (ie, the hypothesis that securities prices[5] are a random walk process) got renamed the “Efficient Markets Hypothesis”. At least at this point, it was still called a “Hypothesis”, which gave at least a clue that it was an empirical claim about the statistical properties of securities returns rather than a necessary truth about underlying reality – the “Efficient Markets Theory” (and, god help us, “Theorem”[6]) was yet to come.
Although he was one of the parties to the mis-re-naming, Eugene Fama did a lot of really fundamental work in sharpening up the concept of what it might mean for securities prices to fluctuate “randomly” [7]. In particular, his weak, semi-strong and strong forms of the Efficient Markets Hypothesis started the ball rolling with respect to thinking about what sort of information one should be conditioning on, when carrying out the statistical tests for a random walk. On the basis of his own research – which was very good at the time, albeit that as time and science moved on, it became apparent that the standard statistical tests of the day were pretty low in power and tended not to be very good at rejecting the hypothesis of a random walk[8] – Fama concluded that the basic answer to the question was that as far as anyone could tell, and certainly to the extent of being able to profit from them, securities prices were random and anyone charging money for the service of being able to predict them was probably lying. This was described, rather embarrassingly, as “the best established proposition in social sciences”, in 1978 by Michael Jensen, who was one of a large crew of mainly American academics who kind of picked up this ball and ran with it, as we will get into discussing later.
At the start of the 1980s, though, Shiller kind of put a bomb under the EMH, by attacking it from the other side. Although as I noted above, “”Properly Anticipated Prices Fluctuate Randomly” does not imply “Randomly Fluctuating Prices Are Properly Anticipated”, the reverse implication is valid – if prices could be demonstrated to not properly anticipate the changes in the underlying cash flows they represent claims on, then it could be demonstrated that they weren’t wholly random, as well as blowing up the larger intellectual project of “market efficiency” that had been built on the foundations of the Random Walk Hypothesis.
Shiller’s 1981 paper is pretty conceptually simple[9]. Given that securities prices (particularly share prices) are meant to be based on the present value of a stream of future dividends, and given that dividend streams are not really all that volatile, why is it that share prices go up and down so much? Shiller showed that in order to believe that prices properly anticipated the risk-adjusted discounted value of future cash flows, you would have to believe something pretty implausible about the unobserved parameters (the rate of risk aversion and/or time preference) and that it was considerably more appealing to believe that the market simply and constantly got it wrong.
I like to think that, as the majority of CT readers stroke themselves with pleasure at the thought of “Markets are not efficient after all! I was right to do that humanities degree!”[10] and mark down Robert Shiller as A Good Thing to be counterposed to Eugene Fama who was A Bad Thing [11], a small minority of like-minded souls will be thinking “hang on, tell me about that ‘stock prices not random’ thing?”.
Indeed my friends. If stock prices have “too much” randomness, then they overreact in both directions. Specifically, if the Shiller Cyclically Adjusted Price Earnings ratio (or price-dividends, or whatever) is historically high, then it will tend to fall and vice versa if it is low. This one works. It’s by now a really quite well-established fact about securities prices.
In fairness to Fama, his “round two” contribution to this debate showed that he is a good empiricist at heart[12], as he spent most of the 80s and early 90s doing work with Kenneth French on testing what kinds of “anomalies” or sources of predictability could be explained away as artifacts of the data or statistical quirks, and which were real and persistent effects that had to be taken into account. In the end, he concluded that before saying that stock prices fluctuated randomly, one had to condition on factors which might include company size, “value” (book to market ratio) and even “momentum” (shares which have performed strongly in recent periods do seem to have a tendency to continue to outperform which can’t fully be chalked up to statistical noise). For reasons I don’t fully understand [13], Fama still thinks that a theory which allows for these factors is still worth calling a theory of “efficient markets”, but fair do’s to the guy – he won the prize for empirical work and he has not been scared to go where the data took him[14].
Meanwhile, in another part of the forest, Hansen’s work goes to one of the points that I kind of skated over in the discussion of Shiller above. I noted that, given the variability of dividends and the variability of share prices, one would have to have an absolutely implausible amount of variability in risk aversion to conclude that share prices were “Properly Anticipating” the future. But how can you know what amount of variability is or isn’t implausible? The state of the art in econometrics when Shiller (1981) came out was the “maximum likelihood” method, by which you specify a probability distribution for the error process and then calculate how far out of the tail (or how close to the centre) of this distribution the errors (“residuals”) would have to be in order to give the actual data, if the model you were considering was the correct model.[18]
Which is not very satisfactory, given that we are dealing with securities prices here and that one of the things we have known about securities prices since Mandelbrot (Fama’s dissertation supervisor) is that when you are making assumptions about their probability distribution, you are on really very shaky ground. Which is why Hansen is getting a share of the prize, despite not appearing on television as much as the other two. The General Method of Moments is much weaker in its assumptions than MLE … what you do is …
Rather than maximizing the likelihood function of the residuals, what you do is take advantage of the fact that your model will usually define some function of the residuals of which you want the expectation to be zero. You find out what you have to do to the parameters to make this function equal zero, and you have your estimate, in the simple case, without having to make any of the simplifying assumptions of the linear regression model. In the difficult case (for example with difficult time series structures, where you would want some function of the correlation of the errors to also be zero), there will be more such functions than you have parameters, so you choose the set of parameters which minimize the value of these “identifying restrictions”. Then, Hansen’s methodology tells you how to transform the distance from zero of the minimized functions to get a variable that is chi-square distributed, allowing you to test your model after all [19].
In the context of securities prices, this allows you to build a full model of investment and consumption behaviour and compare the “excessive” variability found in Shiller to the amount of variation in risk appetite which it might actually be reasonable to presume (given that risk aversion is driven by diminishing marginal utility of consumption, and given the actual variability of consumption). And you find that quite a lot, but not all, of the excess variability could plausibly be chalked up to people correctly anticipating the fluctuations in their real consumption, and being more or less willing to bear investment risk as a result.
And so that’s my tour d’horizon of the empirical securities returns research – it’s basically a quite important and very interesting project which (by the end, in the Hansen estimates of generalized consumption-driven asset pricing models) has taken us to some quite deep and interesting places in understanding fundamental things about risk attitudes and utility. Along the way, a lot of very useful techniques were invented – particularly the General Method of Moments – which have been useful in all sorts of other fields. Stripped of all the ideological bullshit, this is a thoroughly deserved Nobel for all concerned.
But …. well, “stripped of all the ideological bullshit”, the Nuremberg Rallies were a folk festival. This is economics, and the ideology is not something that can be yaddaed away. As I’ve noted on this blog a load of times, there is, hiding somewhere inside the bloated corpus of economics, a nice and intellectually respectable branch of science struggling to get out. It’s just that, somewhere in the nineteenth century, this lean and useful engineering discipline fell into disreputable company, acquired a huge amount of psychological and philosophical baggage, leaving it in very poor shape to resist the further intellectual depredations of the Cold War. So yeah, “Efficient Markets Theory” … it’s bad.
We’ve discussed its Zombie qualities on a number of occasions (and in the relevant chapter of John’s book), but my favourite trip round this particular mulberry bush was in 2004, where John set out the numerous and important policy debates in which fairly massive and substantial conclusions were deduced from a hypothesis (and after 1981, a largely falsified hypothesis) about the stochastic properties of prices on the New York Stock Exchange. I said right at the top of the piece that “Properly Anticipated Prices Fluctuate Randomly” can’t be taken to mean “Prices Which Fluctuate Randomly Are Properly Anticipated”, but actually where this horse and cart was driven to, it looked more like “Because Some Prices Seem To Fluctuate Randomly, No Non-Market-Based Policy Can Be Optimal”. And even beyond that, to various theories of the confidence fairy under which the main job of government is to act as an investor relations officer for the local treasury bonds, which aren’t even consistent with the original thesis about securities predictability. The disastrous metastasis of “random walk” into “efficient markets” is a perfect example of how difficult it is to take the ideology out of economics.
So should we get rid of the prize for the economists “until they can show they are a proper science”? Well, I don’t think so. If you’re going to have economics at all, you’re going to have politicized economics; that’s the nature of the beast. All the sciences have disagreements, and (ugly little secret) in all the sciences, those disagreements are resolved by social processes and things which very much resemble politics of some sort or other – this is a difference of degree, not of kind. Economics has the problem to a much greater degree than other sciences, for the fairly obvious reason that it’s the branch of science which has most to do with the distribution of finite resources in society, so an incorrect view in economics can still be worth pushing in a way in which an incorrect theory of fundamental physics can’t. But this problem isn’t fundamentally one of economics as a science – it’s due to the fact that economics is carried out in the context of society. And really, if someone makes the argument that “third world countries ought to deregulate their capital accounts because most American mutual funds don’t justify their fees”, and society believes them, surely whose fault is that?
[1] Of course the idea would be for the premier global prize in economics to be awarded by the Econometric Society, not least because John is a member of it.
[2] Brian Josephson (Physics, 1973) and Kary Mullis (Chemistry, 1993)
[3] He gives academics the popular culture recognition that they’ve been need’n
[4] Although not necessarily recorded in a consistent, comparable or machine-readable way. One of the big unsung achievements of empirical finance has been the creation of consolidated and “clean” securities returns datasets.
[5] Log returns, yes yes. Give me a break here, I’m writing for a general audience.
[6] Where this solecism is used in print, it appears to mean Samuelson’s result about 40% of the time, the Modigliani-Miller theorem about 30%, some version of the Markowitz portfolio theorem 20% and that the author does not have a clue what he is talking about roughly 100% of the time.
[7] As Samuelson’s concluding paragraphs have it … “I have not here discussed where the basic probability distributions are supposed to come from. In whose minds are they ex ante? Is there any ex post validation of them? Are they supposed to belong to the market as a whole? And what does that mean? Are they supposed to belong to the “representative individual”, and who is he? Are they some defensible or necessitous compromise of divergent expectation patterns? Do price quotations somehow produce a Pareto-optimal configuration of ex ante subjective probabilities? This paper has not attempted to pronounce on these interesting questions”.
[8] Nearly all this work was done by economists and econometricians, by the way. One area in which economics really can hold its head up high with any “hard” science you care to name is in the invention of useful pieces of statistical toolkit to deal with random variables.
[9] It’s also technically a beauty, although I’m oversimplifying it mightily here. Wait until I get onto Hansen, then the real intellectual vandalism will start.
[10] Kidding! Love you guys really.
[11] Shiller, by the way, is a guy who believes not only that there should be derivatives markets in absolutely everything from GDP to unemployment to average wages, but that everyone, in the sense of the normal middle class, should actively trade on these markets, in the belief that this would allow people to “hedge” their macroeconomic risk exposures. Personally I think this is a world-beater of a Terrible Idea (and take comfort in the fact that no such contract has ever even looked like taking off, with the possible and qualified exception of the Case-Shiller housing index futures). In the context of Shiller’s results on stock market volatility, it really looks to me like a case of “This food is terrible! And everyone needs to eat it in larger portions!”.
[12] On the other hand, I am not going to cosign stuff like this, of course, but I think this has to be counted as personal and ideological peccadilloes which shouldn’t be taken as detracting from the underlying quality of the work. As I discuss later in this essay, there are admittedly a hell of a lot of such peccadilloes to yaddayadda around, but hey – Kary Mullis had glowing raccoons from outer space.
[13] For the longest time, the view from Chicago was that the size, value and momentum effects might be proxies for as yet unknown sources of risk, for which the associated excess returns were fair compensation. This was never disproved, but as far as I can tell the Chicago guys just got tired of getting laughed at and kind of gave up on this theory. Nowadays as I understand it, the view when pressed is that the “anomalies” are genuine features of the dataset which have to be taken into accounting when testing theories on historical data, but not really part of the underlying model, and maybe they will disappear when we have ten thousand years of equity returns to deal with. At least it’s an ethos.
[14] So hang on, does this mean that you can beat the market? Basically yup. An awful lot of people writing on this Nobel appear to have learned the 1970s version of Efficient Markets when they were at university or at business school and never kept up with the rest of the literature. If you hold a value, size and momentum-loaded portfolio (and load up on a couple of other factors outside the Fama-French ones, most particularly on stocks with low volatility), and if you rebalance it between stocks and cash when the Shiller dividend and earnings ratios are a long way from long term values, then the current state of science is that you will have constructed a portfolio which on the basis of historical evidence is likely to outperform[15]. And all you need is good enough data to calculate these ratios, trading costs low enough to execute the strategy and enough self-discipline and strength of will to stick to the plan when it looks like it is going wrong (as Shiller’s results demonstrate it will, a lot of the time). Easier to say than do, but there are some people who manage it.[16]
[15] Does not constitute investment advice, not least because it is couched in such absurdly general terms as to hardly constitute advice at all.
[16] I once gave advice[17] on a mailing list that
“As far as active investment goes, I always put it this way – are you prepared to put as much time and effort into managing your investments as you would into running a small business? If you are then go for it – playing the market is not a bad hobby, about as interesting as birdwatching or something. And most people on this list actually do have enough intelligence to beat the market and therefore to beat most active-managed funds, in my opinion. The trouble is of course that beating the market doesn’t just require intelligence, it requires self-discipline, hard work and the ability to control your emotions. But in many ways so does success in bird-watching.”
[17] Not in any regulatory or fiduciary sense.
[18] Plenty of fast skating over technical material there, but frankly, as a description of the method of maximum likelihood which can be squeezed into two tweets, I think that is pretty bloody good actually.
[19] Not so good, that one. Five and a half tweets and considerably less clear. Any suggestions for improvement gratefully received. On Twitter itself, I managed
“The expectation of model errors ought to be 0. Their correlation ought to be 0. The extent to which it isn’t is a measure of model fit”
Which is pretty barbaric (quite apart from anything, the residual covariance matrix gives you a measure of significance, not fit), but kind of gives the flavour of it in 140 characters
{ 78 comments }
bexley 10.15.13 at 6:17 pm
For another, on an objective look at the quality of the company which the Economics Nobel is keeping, I don’t think anyone can really claim it’s bringing the average down. The Peace Prize is a notorious joke, of course, but the Literature prize is also wildly eccentric, and even the Physics and Chemistry prizes are occasionally awarded to people who believe in ESP[2].
One question I have for those who know better – how often is the Economics Nobel awarded to people whose theories have never been even remotely tested and verified? Awarding the prize to somebody who does some important research and is also an ideological hack may be annoying for his/her opponents but isn’t necessarily embarrassing for the prize. Awarding the prize to a hack whose theories have no evidence to even back them would be embarrassing though. How often does this happen?
Josephson may believe in ESP but he was awarded his Nobel for some genuinely important work. IMO to be truly embarrassing the Nobel would have had to be awarded for his research into ESP!.
Barry 10.15.13 at 6:40 pm
Thanks, Daniel. This helped me understand it better.
dsquared 10.15.13 at 6:46 pm
FTR: I am getting some pushback on Twitter over whether Mandelbrot was in the strict administrative sense Fama’s supervisor. But he was definitely an academic mentor and Fama’s first papers were based on his work.
Substance McGravitas 10.15.13 at 6:54 pm
I’m just surprised at the existence of an Italian set of judges that is apparently better than others, given previous writings here. And what the heck, let’s throw in the 15th page of the OECD’s latest pot-stirring epic just for fun.
John Emerson 10.15.13 at 7:30 pm
There’s a God in Heaven after all! Eugene Fama DID win the quasi-Nobel-Prize! (I didn’t know that yesterday).
Now everyone will know that economics is a discourse within which ideologically pleasing, technically brilliant theories are held in regard even if they are completely WRONG.
Fama is famous for saying “I don’t even know what a bubble IS”. I believe that he’s also one of the many who believe that there’s no such thing as unemployment — it’s just that about 5 years ago about 5% of the work force suddenly decided all at once to choose leisure over work.
Science!
(Usually I don’t come around, but I’m just so happy today!)
John Emerson 10.15.13 at 8:11 pm
Jesus, people, don’t be afraid. I’ve paid my debt to society and am a new man.
William Timberman 10.15.13 at 8:14 pm
With everyone’s toes crimped over the edge of the abyss — okay, that’s a matter of some dispute, I admit — I prefer the brilliantly dour Bruce Wilder to the brilliantly, wittily d-squared Daniel Davies. In a more perfect world, it might not be so, but in ours…?
Brett 10.15.13 at 8:16 pm
Well, what is a bubble? Fama was right to ask that, and he’s not the only one. You get the term “bubble” thrown around every time there’s a boom in the market.
John Emerson 10.15.13 at 8:31 pm
Well, anyway, if no one else wants to talk.
I’m one of those liberal arts types who’s been gloating. I’ve never understood the technical criticisms of economics very well, though by reading the writings of competent critical economists I have come to believe that there are a lot of them, above all when you consider economics to be a way of understanding social reality rather than an entirely autonomous construction which relates only to the aspects of social reality that it has decided are important.
The main reasons for my antipathy aren’t technically sophisticated. Mostly it’s because I think economists tend to be corrupt and self-serving ideologues. Even the liberal good guys among mainstream economists (Samuelson when I was young) seem that way, complacent, excessively well fed, and supremely sure of their benevolence and of the transcendent power of their science. But then, I’m an envious humanities type.
As far as scientificity goes, I think that that criticism is valid in the following way: there are really enormous areas of chemistry, physics, and biology which are standard and unquestioned and can be relied upon by engineers. There’s always a frontier of research, and there are often differences in terminology, etc., but the amount of agreed on fact is enormous. I don’t think that that’s true of economics, and I think that when economists claim to be True Scientists (Lazear) they are claiming for economics exactly what it doesn’t have. (This has nothing to do with the question of reductionism, or whether economics should be expected to be similar to physics in this wya or that. It’s about the way economists are, in effect, fraudulently trying to hitchhike on the prestige of more powerful, more complete science when they talk about their own scientificity.
Nonetheless, there’s something there. There are times when you need an economist the same way that there are times that you need a lawyer. In both cases the thing you have to know at the beginning is that the guy is actually working for you and not for someone else (for example, himself alone). Lawyers and economists do know something, they’re just not scientists.
And finally, if some of the wisest and most brilliant representatives of a profession say things like “I don’t even know what a bubble is” or “There’s no such thing as unemployment; some people just choose leisure instead of income”, that’s a really crappy profession regardless of anything else. If that kind of person is most highly honored by his fellow professionals, that’s a shitty profession, even if most members know better. This isn’t like a Nazi physicist or a Stalinist biologist; unemployment and bubbles are part of the subject matter of economics (besides being painfully important to pretty much everyone in the world).
John Emerson 10.15.13 at 8:36 pm
Was Fama right to say that because he can’t say what a bubble is, no such thing exists? That strikes me as too solipsistic.
Jerry Vinokurov 10.15.13 at 8:40 pm
Operationally, you could define a bubble as “growth so fast it doesn’t look right.” Just because you can’t tell where the gas leak is doesn’t mean it’s safe to strike a match.
John Emerson 10.15.13 at 8:51 pm
The historian J H Hexter said a long time ago that the things that social scientists can’t predict are far too often to be the very things we most need to have predicted.
Ingrid Robeyns 10.15.13 at 9:06 pm
Thanks Daniel, that was enlightening. And fun to read.
Two comments, if I may…
“If you’re going to have economics at all, you’re going to have politicized economics; that’s the nature of the beast”
I guess my main problem with economics (as I know it) is the lack of willingness in the profession (exceptions notwithstanding) to admit this. If economists were just straightforward about whenever they make a normative claim or a political claim, it would be so much easier to have a constructive conversation with them. In my experience, economists often don’t even see the normativity (and hence moral and political nature) of what they are saying/doing, and also don’t have the right attitude of epistemic humility of wondering whether, once in a while, they could learn something from someone who’s profession it is to analyze the normative and political nature of ideas, claims, institutions, etc. Too many of them are so bloody arrogant. I blame that on the discipline who produces economists, not on the individual people.
And really, if someone makes the argument that “third world countries ought to deregulate their capital accounts because most American mutual funds don’t justify their feesâ€, and society believes them, surely whose fault is that?
I take it you don’t think economists should be blamed for saying stupid things that are believed and then implemented by society [If I misunderstood this, ignore what follows]. But I think that’s too easy. Surely if as a profession you don’t organize self-criticism in a healthy way, or if you basically rigidly impose requirements on your disciples implying that radical internal criticism becomes very hard, and if you react aggressively to any outside criticism, and if you do not train your students with virtues such as epistemic humility, and if you work hard on getting power in society — then I don’t think they are free from blame if societies follow their stupid advice. There’s something about asymmetric power relations leading to asymmetric levels of responsibility, don’t you think?
Haftime 10.15.13 at 9:39 pm
Not sure that your comparison to Physics and Chemistry is fair – Brian Josephson and Kary Mullis may have wacko ideas (Kary Mullis has the best bio I think I’ve ever read: http://www.nobelprize.org/nobel_prizes/chemistry/laureates/1993/mullis-bio.html – highlight for me is the para beginning ‘We tortured the cows.’) but it’s not clear that their ideas really reflect on the work at all. That interview with Eugene Fama seemed to be pretty intimately tied up with his work and theoretical outlook on economics.
The complaints about Chemistry Nobels seem to be more for unawarded or prematurely awarded prizes. Or about pesky biologists. In the end though, it’s some random Swedes with a pot of cash.
Akshay 10.15.13 at 10:15 pm
Thanks, interesting piece!
dsquared 10.15.13 at 10:59 pm
Ingrid – I think my view is that society basically gets the economists it deserves. I absolutely don’t think that epistemic humility is much of a virtue in any social science; this debate was all about very important issues relating to the organisation of production in society and I think it’s entirely appropriate that people with strong and well-informed views on something that important state them forcefully and publicly. That’s what democracy is all about. The whole problem with much of that period was exactly that so many people on the other side refused to make normative claims or to state their case as strongly, and that in turn was because it was the Cold War followed by the fall of Communism and the global left was a bit short of compelling arguments. The neoliberal period shaped the economists, not vice versa. But as I say, I think this is not only the right way but probably the only way to have a democracy; I’m not a fan of the only-my-opinion way of doing things because it seems to deny that these are always deeply political questions. I must say I find political scientists equally frustrating because they too often seem to be all bloody science and no bloody politics.
Your other point, though, on the professional monoculture and inward lookingness of modern academic economics is spot on though. It’s a real problem and the profession seems to be still in total denial about it.
Daniel 10.15.13 at 11:37 pm
Actually reading that back, it seems more like a defence of Actually Existing Economics than I meant it to be. What I want to say is that the science of economics is a different thing from the profession, and that you can defend one (and indeed award prizes for it) without having to defend the other, even in cases where the actual individual scientists involved were also ideologues of the highest water (I mean, some of the things Fama said in links above are just unbelievably dumb). But – ideologues exist for a reason, and that reason is that we’ve organised society in the way we have. I’d far rather have a Fama or Cochrane where the ideology is out in the open and relatively easy to detach from the science (and where you can set up a Krugman or Quiggin against him), than some slippery customer like Giddens, who is in my opinion altogether too good at hiding his political agenda in little sleight of hand moves.
In other words, the genuinely radical critique of economics is to hold it to its own standards as a science. Social sciences which don’t have those pretensions find it a lot easier to slip away from any sort of fundamental critique at all, at the expense of being rather ineffectual.
Nine 10.16.13 at 12:19 am
Daniel@17 – “’than some slippery customer like Giddens, who is in my opinion altogether too good at hiding his political agenda in little sleight of hand moves.”
Assuming this is Anthony Giddens, I’m curious, just what is his “hidden agenda” ? I can’t make out head or tail from reading his Guardian page – a quick browse suggests a pretty bland third wayer or whatever they call themselves – and in any case don’t know enough about politics in the UK to decipher the politicified prose in his op-ed’s.
Ronan(rf) 10.16.13 at 12:47 am
On beating the markets (#14) – (this might be a stupid question) – but why do only *some* people manage it? (partiularly given the advice at #16) Is it primarily a matter of resources?
Also, and this might be an even more foolish question, but could someone design a computer program (or whatever, I assume a program) which could run your investments on the basis of the general criteria listed at #14, and beat the market that way?
bxg 10.16.13 at 1:08 am
> The state of the art in econometrics when Shiller (1981) came out was the “maximum likelihood†method, by which you specify a probability distribution for the error process and then calculate how far out of the tail (or how close to the centre) of this distribution the errors (“residualsâ€) would have to be in order to give the actual data, if the model you were considering was the correct model.[18]
> [18] Plenty of fast skating over technical material there, but frankly, as a description of the method of maximum likelihood which can be squeezed into two tweets, I think that is pretty bloody good actually.
I’d like to imagine I understand maximum likelihood pretty well, but I don’t recognize it in the slightest here. There sounds like classical hypothesis testing: i.e. stipulate a distribution for the error process, and draw conclusions based on how well (or not) the actual data fit this. Maximum likelihood is, among other things, a _maximization_ process (choose the distribution/parameters that maximize…) rather than stipulating (“specifying” ?) a distribution and running with that. It’s an estimation procedure, not a testing procedure. Not a fan of classical hypothesis testing or ML estimation as a generic tools (albeit both having strengths when carefully applied) but … being as generous as I can be to the “two tweets” constraint, I think you are adding negative information.
Though I somewhat expect someone to explain to me “maximum likelihood” doesn’t meant to an economist at all what it means to a statistician.
ezra abrams 10.16.13 at 1:25 am
If CT had a post about the Nobel in physics or chemistry or biology, I bet there would be way fewer comments, as 99.9% of us know we are not qualified to say anything about quantum field theorys, algorithms for transition state theory, or role of Clathrin adaptor proteins in Golgi to ER trafficking…yet somehow, everyone is an expert on EMH.
go figure
LFC 10.16.13 at 1:52 am
dsquared @16
I must say I find political scientists equally frustrating because they too often seem to be all bloody science and no bloody politics.
There is a not-too-obscure (so someone around here should be able to supply it), rather old, semi-serious, snarky quote to the effect that political science is a way of avoiding “that difficult subject, politics” — except I can’t recall the *exact* quote or its source, which is annoying me. (And google seems to be no help.)
Colin Danby 10.16.13 at 1:59 am
I’m still stuck on the luminous raccoons. Will they abduct Eugene Fama?
Welcome back, John!
stubydoo 10.16.13 at 2:28 am
Re the politicization of economics:
The world (or at least the world that I inhabit) is full of people who incessantly decry the influence of economics on politics, and diligently try to minimize said influence.
Those people have it backwards. Their efforts would be socially beneficial if instead they were decrying the influence of politics on economics, and diligently trying to minimize that.
They act as if the fact that the confluence of economics and politics produces some toxic effects constitutes sufficient proof that changing the mixture in their preferred direction necessarily constitutes an improvement.
Bruce Wilder 10.16.13 at 2:59 am
I thought dsquared made an admirable effort. But, maybe, it could have been more dour.
Ronan(rf) @ 19: On beating the markets . . . why do only *some* people manage it? . . . could someone design a computer program . . . beat the market that way?
You’re not “beating the market”, you’re beating someone else in the market; so, for some hedgie to win big, generally requires someone, somewhere to lose. In a growing economy, realizing investments with a positive net present value, it doesn’t have to be exactly a zero-sum game, but it also doesn’t have to be a growing economy, realizing investments with a positive net present value — it might be a shrinking economy, burdened by parasitic greed spreading like a cancer, realizing the negative net present value of toxic assets and an eroding rule of law.
Lots of people go to Las Vegas to exercise their death instinct in miniature, and its good business for the casinos. Ditto, I expect, for Wall Street. Homo superior doesn’t have to be all that superior, if he is playing with the advantage of house odds.
Program trading has a Wikipedia article. http://en.wikipedia.org/wiki/Program_trading
Arguing about whether markets are efficient, and just how efficient, is a way to train one’s mind to ignore the possibility that someone, in casino capitalism, might be cheating. Imagine gambling without card sharks and pool hustlers and weighted dice and . . . well, you get some idea of the imaginary world of finance conjured up by the mind of Eugene Fama.
I particularly liked dsquared’s view of the entanglement of politics and political ideology with the science of economics. I admire the work of Fama and Schiller, as economic science. The problem, as I explained on another thread, is that I think their work, with the politics & political ideology in the mix, becomes an example to agnotology — an exercise in making people more ignorant and politically feeble.
The institutions, by which prices and property rights are formed and regulated, are critically important, and it should not be so easy to give honors to people, who have dedicated themselves to blowing so much smoke in front of the efforts to undermine the integrity of those institutions.
Nine 10.16.13 at 3:16 am
ezra abrams@21 – “yet somehow, everyone is an expert on EMH.go figure”
IIRC, it was Martin Wolf who said that the Higg’s boson doesn’t care one way ot the other if physicist’s get it wrong but human beings will most certainly have strong opinions regarding economic policies that affect their lives. So yes, a good many people will have things to say about economics, I suggest you learn to deal with it in a hurry.
Manoel 10.16.13 at 3:27 am
Re #20: I didn’t like the explanation about maximum likelihood either.
About bubbles. On one hand, it’s silly to say that we don’t know what a bubble is. People experience it and it is a social object, so economics need to theorize and explain it. On the other hand, it’s necessary to properly define ex-ante what a bubble is. And Fama is right on asking this question. What are the properties of a bubble? Is it possible to identify a bubble? Or, at least, to say that it is non-observeable, but its effects are, and if so, which are these effects? In this way, we can at least test our theories about bubbles. So, mixed feelings here.
Robert 10.16.13 at 3:38 am
“how often is the Economics Nobel awarded to people whose theories have never been even remotely tested and verified?”
I think the Kydland and Prescott prize qualifies. They have lots of citations. You could write a long post about the technical substance of their supposed contributions. Prescott is also famous for saying stupid, right-wing nonsense.
John Quiggin 10.16.13 at 5:34 am
I was in a rush, as usual, so I only wrote one sentence on finance in my post, inevitably overstating the point. I agree with pretty much everything DD has said, though I’m obviously a bit more concerned about the claim that it’s a prize in economic sciences, perhaps because I still want the field to be a science, and am therefore upset that it falls so obviously short.
One point that hasn’t been made is that most of what remains valid in Fama was pointed out, around the same time, by Samuelson, who avoided most of Fama’s errors. That’s not unusual: if they were playing by the stated rule of prizes for individual discoveries rather than lifetime achievement, Samuelson would have shared in three or four of the prizes.
AJ 10.16.13 at 5:50 am
Permit me to post a few thoughts on this forum regarding a larger philosophical question – is the awarding of the Prize to Fama and the Chicago School a Good thing or a Bad thing? To the extent that it rewards good research, it is Good. But the real problem is that it fundamentally distorts incentives in the economics profession. Basically, all economics departments want to talk about how many Nobel Laureates they have. And this Nobel means one thing – it means that there will inevitably an incentive to have more people try to do this sort of research : coming up with good quality answers while denying even basic premises of the field (‘is there such a thing as a bubble?’ ‘what IS the proper role of government?’ ‘is defaulting on the debt really SO bad? Let us take a gamble and see. Can’t hardly wait.’)
One cannot do reearch in many of these economics departments without running into a bunch of these crazy reality distorters. With the awarding of this prize, the reality distorters will be further incentivized. Students and professors employing common sense will be the losers.
As Daniel Davies has argued, Fama has made some contributions to our understanding of security prices. So the Ends are good ones. But what about the Means? Were they good ones as well? To see this, let us see why Fama says “I don’t even know what a bubble IS”. First, the question is asked “Can stock prices be wrong for an extended period of time?” To this, Fama’s response is “Stock prices simply reflect available information”. The implication is that there is no right or wrong, but that isn’t really true. As Shiller has shown- of course, stock prices may be wrong. Then the question is asked of Fama – “If you think that, then what do you think of bubbles? We suffered a massive collapse during the dot com period. Wasn’t that a mispricing?” To that, the answer is the classic “I don’t even know what a bubble IS.” Because that is the only response he has left. So, the means of ‘constant reality denialism’ are not justifiable at all. I can’t see how anyone can justify the Means at all.
There is a distinction between Nobel Prize winners in the sciences talking about ESP and Nobel Prize winners in economics talking about free market fundamentalism – there are clear demarcations/boundaries in the sciences so it is easy to tell the theories apart. Also, the incentives are not distorted because departments don’t rush off to fund ESP research as a result of these sorts of statements. Furthermore, there is no ‘reality denialism’ intended here of the kind you see in the Chicago School. (These guys hotly contested any need to put limits on what financial firms can do. So, we had the Long Term Capital Management disaster. Then, these guys conteste any need to regulate the financial markets. And then we got Bear Stearns, Lehmann Brothers and the Great Recession of 2008.) It is this that is really worrying. Will this Nobel be taken as a vindication of the Chicago School of thought?
In the end, oddly, it is not the guy talking ESP who is truly distorting reality here and causing me to worry and shake. It is the crazy market fundamentalists whose cry of ‘free markets in everything’ that shake me to the bones.
Daniel 10.16.13 at 6:04 am
Also, and this might be an even more foolish question, but could someone design a computer program (or whatever, I assume a program) which could run your investments on the basis of the general criteria listed at #14, and beat the market that way?
The answer is yes you can – this is the basis of Cliff Asness’s hedge fund AQR and I basically cribbed the list of anomalies from Asness’ work. But it is not easy …
It’s an estimation procedure, not a testing procedure.
Someone give the engineer a biscuit. Yes Beavis, maximum likelihood is an estimation procedure, as I described. “Negative information”, do me one, and also “I am not a fan of classical hypothesis testing”, also jog on. If you mention the word “Bayesian” on this thread, be aware that I have powers of deletion and if you link to that god damned xkcd cartoon I may consider sterner remedies.
AJ 10.16.13 at 6:09 am
Fama’s interview in the New Yorker went like this : ‘Q. But surely the start of the credit crisis predated the recession? Ans. I don’t think so.[..]. Q. So you are saying the recession predated August 2007, when the subprime bond market froze up? Ans. Yeah.[..]. Q. Let me get this straight, because I don’t want to misrepresent you. Your view is that in 2007 there was an economic recession coming on, for whatever reason, which was then reflected in the financial system in the form of lower asset prices? Ans. Yeah. [..].’
http://www.newyorker.com/online/blogs/johncassidy/2010/01/interview-with-eugene-fama.html
I know that whole bit about Fama in my comment above sounds a bit like I am putting words in his mouth, but trust me, it is less weird than what Fama actually said, which is quite in the realm of fantasy. This is basically the way I am rationalizing his opinions. I don’t know what else I can do other than to “interpret” his words.
Peter T 10.16.13 at 9:19 am
The post is very enlightening. It does point to what I see as a major gap in economics – the focus on markets and the neglect of the other ways the economy is organised and run. The rules of informal cooperation and gift exchange that generate and maintain the labour force, for instance, or the internal workings of corporations and governments. The latter is often passed over as a simple affair of command and sanction when it is nothing of the sort.
Someone mentioned above than an economist could analyse the Roman economy; I’ve read a few attempts and they are rubbish, because the Roman economy ran on very different lines to any modern one, and is not usefully analysable in the same terms (even if we had the numbers, which we do not). There are large areas where economists need to sit back and listen to sociologists and anthropologists before they can begin to explain even a modern economy.
Luis Enrique 10.16.13 at 9:47 am
v nice post D2
Phil 10.16.13 at 10:02 am
Kary Mullis had glowing raccoons from outer space.
“Look at all my work in UV-sensitive plastics, but do they call me Photo-Sensitive Mullis? I pioneered polymerase chain reaction techniques, do they call me PCR Mullis? But you meet one luminous extra-terrestrial raccoon…”
I was initially inclined to cut the guy a bit of slack (maybe it had been a long day) but it turns out he’s also Aids Denialist Astrologer Mullis, so sod that. Googling Brian Josephson is a bit less gruesome, but not much fun.
On Fama and bubbles, incidentally, isn’t he quite literally saying that there can’t be a tenner on the ground because if there were somebody would have picked it up? There should be a name for that fallacy. Or maybe it’s not a fallacy if the numbers are big enough, I dunno (sums are hard, says humanities graduate).
Ben 10.16.13 at 10:31 am
Man not only was this a great lil’ primer but I’m enjoying invective about statistical methods way too much.
I would like to see this explicated, though: “Social sciences which don’t have those pretensions find it a lot easier to slip away from any sort of fundamental critique at all.”
What are you thinking of? Political science, ok, but the Perestroika thing, alone. Psychology? Not a whole lot of fundamental critique, but it’s there. Sociology / anthropology is nothing but methodological critique. So, what, then?
And to push back against the “we get the economists we deserve” / “it was the Cold War’s fault and lack of coherent response” frame a little bit: that ignores all the Road from Mont Pelerin / Corey Robin stuff about the institutional building of right-wing economics and political economy, which certainly took advantage of the Cold War atmosphere but wasn’t necessitated by it.
And though I don’t have all of their argument under my fingers yet, the Panitch and Gindin Making of Global Capitalism epic seems to leave little room for that kind of frame.
Ebenezer Scrooge 10.16.13 at 10:57 am
I grew up a chemist in New York City, where they said that the Nobel prize in chemistry was invented to give the goyim a chance. (Fat chance this year!) Of course, they were only talking about the three real Nobel prizes.
Was the Nobel prize in economics invented to give the grifters a chance?
dsquared 10.16.13 at 11:35 am
And to push back against the “we get the economists we deserve†/ “it was the Cold War’s fault and lack of coherent response†frame a little bit: that ignores all the Road from Mont Pelerin / Corey Robin stuff about the institutional building of right-wing economics and political economy, which certainly took advantage of the Cold War atmosphere but wasn’t necessitated by it.
I have the greatest respect for Corey (and a real soft spot for this kind of intellectual history, which I always buy whether it’s him or Phil Mirowski writing it), but always find explanations of “why it is that capitalist ideas grew so strongly after 1968” which don’t involve a heavy role for the slow-motion intellectual collapse of Marxism after the Prague Spring, to be a bit like those explanations your uncle gives you for his permanent hacking cough which don’t mention the forty Bensons he smokes every day.
bexley 10.16.13 at 12:29 pm
@ 28 thanks.
@ 32. Wow some painfully daft things from Fama there. My favourite may be:
Phil 10.16.13 at 1:23 pm
slow-motion intellectual collapse of Marxism after the Prague Spring
Ouch – and we can’t say we weren’t warned. At the time, I was convinced Solidarnosc was in some sense a socialist movement, or that there were at least socialist currents within it (I mean, come on, a wildcat union occupying workplaces?). I was greatly disappointed to read a first-hand account which demonstrated that, within Solidarnosc, ‘socialism’ just meant ‘a totally discredited set of ideas that even Jaruzelski only pays lip-service to’. (I mean, it did mean that, obviously, but… It was as if they’d never heard of Raymond Williams or Guy Debord. Which in fact they probably hadn’t.)
Even in 1991 Western Marxists didn’t really know what had hit them (us) – and by then it had been hitting us for some time, did we but know it. After the end of the USSR I wrote an article saying, in effect, “you know what? this actually does affect us, and not in a good way”; there weren’t many people saying that, though. We had, after all, built our self-image around not being Stalinists, not being pro-Soviet, not being on the side of Jaruzelski against Walesa or Husak against Dubcek. Unfortunately, so had all our enemies.
Thinking back now, the smart move would have been to claim the franchise of sister party to the Swedish Social Democrats – at least they’re still there. Nothing succeeds (in terms of political credibility) like success (in actually governing somewhere).
Newy stats 10.16.13 at 3:07 pm
Re #31 yes+++++
I agree that in the OP you are missing the point that with likelihood, you’re considering a function of the parameter, but I love the threats about the B word and xkcd. There is so much partially informed Bayes cheerleading around.
Pseudomymous McGee 10.16.13 at 3:37 pm
To unpack notions like (A) “it is a bad thing that economics impacts politics” or (B) “its is a bad thing that politics impacts economics”…
I read (A) as “it is a bad thing that private interests lobbies use the technocratic bona fides of academic economics to push policies that aggravate looting and rent-extraction.”
and read (B) as “it is a bad thing that private interest lobbies buy bona fides in academic economics (and in so doing discredit the discipline and distort research incentives)”.
To be charitable to academic econ (I’m feeling soft-hearted this morning), bona fides are “bought” by funding a broad environment of nudges towards some ways of thinking over others, rather than outright shill-hiring. Though there are plenty of paid shills at the lower tiers of the discipline, just as in e.g. medicine.
To be uncharitable to academic econ, it often boils down to statisticians meddling with data sources that they are unqualified to parse. Perhaps there are less perversion-prone ways to discover statistical tools, albeit less likely to attract patrons of science.
notsneaky 10.16.13 at 4:29 pm
At the time, I was convinced Solidarnosc was in some sense a socialist movement, or that there were at least socialist currents within it (I mean, come on, a wildcat union occupying workplaces?). I was greatly disappointed to read a first-hand account which demonstrated that, within Solidarnosc, ‘socialism’ just meant ‘a totally discredited set of ideas that even Jaruzelski only pays lip-service to’.
You’re not talking Prague Spring here right? If yes, then which Solidarnosc are you talking about, the 1980 version, the 1989 version, the 1995 version or the present day version?
At least for the 1980’s version there certainly were socialist, even Socialist, currents, though they were in a minority. Keep in mind that at its peak it had 10 million members, or more than 1/4 of *total* (not just adult) population. So you had find all kinds of currents in it. Syndicalists, greens, liberterians, etc. Even members of the communist party itself. Of course these were rather small, with the dominant role held by ex-Trotskite western style Social Democrats in an uneasy alliance with western style Christian Democrats, with a good bit of nasty infighting, coordinating activities with plain vanilla style Trade Unionists. And even as late as 1987 the “official” rhetoric of the movement was that it was trying to “fix” socialism not overthrow it. In 1982 a splinter organization, the “Fighting Solidarity” emerged which was explicit about its desire to overthrow socialism. For this reason it was considered quite radical by the other Solidarity.
Anyway, off topic (and hi to John here too)
Jonathan 10.16.13 at 5:11 pm
I liked this post; my biggest problem with d^2 posts is that there aren’t enough of them.
But (naturally) I take issue with this:
“I think my view is that society basically gets the economists it deserves. I absolutely don’t think that epistemic humility is much of a virtue in any social science; this debate was all about very important issues relating to the organisation of production in society and I think it’s entirely appropriate that people with strong and well-informed views on something that important state them forcefully and publicly. ”
In our present situation those propounding certain views will get a megaphone, courtesy of the wealthy and powerful who have an interest in seeing those views accepted. I object to calling those wealthy “society.” Do the rest of us deserve the plutocrats? If so, what are our sins and how to we expiate them?
And to the extent that the views propounded are not well-informed (or even bat-shit crazy) they are not entitled to a free ride on the prestige derived from genuine contributions. This isn’t science; it’s propaganda masquerading as science. Broadcasting such stuff should at least have a cost in terms of professional reputation and acceptance; the fact that is doesn’t (at least as far as I can tell) is to the discredit of the Economics profession.
Herman 10.16.13 at 5:59 pm
Nice post, but I do have one quibble:
” … “Random Walk Hypothesis†(ie, the hypothesis that securities prices[5] are a random walk process) got renamed the “Efficient Markets Hypothesis†“
Is this even correct?
Strictly speaking a RWH assumption says nothing about why securities prices follow a random walk. But the EMH is about the why.: New information and/or changes in risk preferences and nothing else.
dsquared 10.16.13 at 6:37 pm
Yes you’re right, which is why I say it was such an intellectual disaster when the one research programme segued into the other, seemingly without anyone realising that anything had changed.
Kanchhedia Chamaar 10.16.13 at 6:39 pm
I entirely agree that “there’s no real point in getting too outraged about the Nobel Prize for Economics.” In fact the same thing can be said about the Nobel Prize for Peace and about Nobel Prize for Literature.
Both a serial killer and a mass murderer kill a lot of people: while the serial killer kills them one at a time, or in series, the mass murderer kills them all at once. Combining the two, we get a serial mass murderer, and the most successful of these, Henry Kissinger, was given the Nobel Prize for Peace. Winston Churchill killed millions of Bengali peasants and was given the Nobel Prize for Literature.
I understand that the Nobel foundation is in financial trouble. Perhaps one day a hedge fund manager will manage to kill the Nobel foundation, for which even the joint bestowal of both the Nobel Prize for Peace and Nobel Prize for Literature will not be reward enough.
Phil 10.16.13 at 6:43 pm
You’re not talking Prague Spring here right?
No, I was unclear – “At the time” was meant as “At the time of Solidarnosc”. I was thinking in particular of the 1980 (pre-crackdown) Solidarnosc, as documented by John Taylor’s 1981 book Five months with Solidarity. Taylor commented that, despite being in the midst of a grassroots trade union taking wildcat action, he’d only heard the word ‘socialism’ used twice – both times derisively.
John Emerson 10.16.13 at 7:26 pm
“Everyone is an expert on EMH. Go figure”
I also think critically about medicine, even though I’m not a doctor. Like everyone else in the work, I am a subject of economic masters, and I take an interest in my fate.
This is on top of the fact that, precisely because econmics is highly consequential in policy formation and very relevant to everyday life, corruption and ideological bias are an ever-present possibility, and in fact an actuality.
So now the economists are whining about how they are victims and everyone should just sit quietly and submit. Jesus.
John Emerson 10.16.13 at 7:33 pm
“I always find explanations of “why it is that capitalist ideas grew so strongly after 1968″ which don’t involve a heavy role for the slow-motion intellectual collapse of Marxism after the Prague Spring, to be a bit like those explanations your uncle gives you for his permanent hacking cough which don’t mention the forty Bensons he smokes every day.”
In the US it was the realization that the labor-management harmony imposed during WWII (and the resulting Great Compression) were no longer required after the South left the Democratic coalition. I see it explained as an intellectual victory of the Chicago School over the Keynesians because of stagflation, but that strikes me as a fairly classic ideological mask.
John Emerson 10.16.13 at 7:43 pm
One of the reasons for the resentment of the quasi-pseudo Econ Nobel Prize is that it takes as valid the economists’ claim that economics was, at last, a TRUE REAL science, and that all other attempts at social science are just “social work and butterfly collecting”. That claim was usually justified by econ’s use of mathematics that most critics (and many old-school economists) didn’t understand. This ignores the GIGO principle, even though Friedman’s justification of “counterfactual assumptions” (= false assumption) guaranteed that there would be abundant GIGO results.
The actual profession of economics never treated the efficient markets hypothesis as givingus ” an important benchmark to measure departures from an ideal world”. They treated it as a description of reality and many advocated that it serve as a guide to policy. Then when it turned out to be a disastrous error, they did their famous methodological two-step and claimed that they never took it literally at all. Fingers crossed, you see.
LFC 10.16.13 at 8:03 pm
@50
I see it explained as an intellectual victory of the Chicago School over the Keynesians because of stagflation, but that strikes me as a fairly classic ideological mask.
Steady ec. growth, relatively low unemployment, and manageable inflation were preconditions (and/or accomplishments) of ‘the Keynesian accommodation’. When those conditions ceased to exist (c.1970-73 onward), the accommodation broke down. In the U.S., the rise of the ‘new right’ then clicked in, furnishing a a double whammy.
LFC 10.16.13 at 8:04 pm
correction:
only one “a”
godoggo 10.16.13 at 8:06 pm
OK, I have a question: how come you can’t buy a mutual fund that beats the market? Or am I wrong about this?
Trader Joe 10.16.13 at 8:24 pm
@54
Its certainly possible to buy a mutual fund that “beats the market” in any given year. The percentage that manage to do so varies by year – some years it is very low and some years its as high as about 25% of funds that do so.
Assuming a fund isn’t using leverage and isn’t using higher risk investments to ‘juice’ returns (i.e. is truly just trying to beat the market through stock selection) – the biggest constraint is fees. Actively managed funds usually have fees in the 1% to 2% range – some of that pays for distribution of the funds (i..e commissions) and some pays for the managers and trading costs + profits….whatever the use fo the fee, what it means is for a fund to actually “beat” the market, it has to actually beat it by enough to pay the expneses.
Said differently if the “market” earns 12%, and the fund has to make +13% in order for the investor to earn 12%. Getting that level of outperformance is possible, but it is very difficult to achieve for multiple consecutive periods. A few fund managers, such as Bill Miller at Legg Mason Value have managed to achieve outstanding long-term records of “beating” the market – in his case its via taking concentrated large positions on investments he has strong conviction about AND being right….that said, if portfolio management skill is distributed on a bell curve, he’d be a 99% example.
So to you question – its possible, just not probable, if a mutual fund purchaser buys and holds a single fund for a long stretch of time. If the purchaser trades funds each year, it puts the burden of success on the him to find a new outperformer each year – which is also highly unlikely. That’s why your premise that you can’t buy a fund that beats the market is largely correct in the long run, but perhaps wrong in the short run.
John Emerson 10.16.13 at 8:34 pm
“That’s why your premise that you can’t buy a fund that beats the market is largely correct in the long run, but perhaps wrong in the short run.”
Not totally relevant here, but it is one of my theories that one of the reasons that the Democrats perform so sluggishly is that their leaders are too often old-style social scientists who think entirely in normalizing, administrative, long-run, general rule terms, whereas the Republican leaders are greedy, semi-criminal opportunists always looking for momentary windows of opportunity where they can grab something quickly. This is no way to run a government, of course, but this approach has the advantage that sometimes these seemingly brief windows of opportunity are just the entering wedge of permanent changes.
godoggo 10.16.13 at 8:36 pm
Thank you.
adam.smith 10.16.13 at 8:41 pm
@54 – several reasons:
The main reason is that mutual funds’ admin costs are too high. D^2’s “beat the market” solution won’t dramatically beat the market and so it’s not worth it.
The other thing is that every reasonable ETF portfolio already does a crude version of what he suggests. If you go, say, to Schwab and have them put you together an ETF portfolio, they’ll suggest to you a distribution of stocks and bonds, depending on your investment horizon. You should regularly rebalance such a portfolio (and a good online broker should have tools that make this super-easy, but even 30mins with a calculator will do) so that the shares don’t get out of whack. That’s a reasonable (though not perfect) proxy for the Shiller P/E ratio, so your laypersons ETF portfolio will already beat the market in much the same way he suggests. There are companies that will do that for you, but they charge a surprisingly large fee, which gets you back to 1.
John Emerson 10.16.13 at 8:43 pm
Well, it’s time for me to leave. I’ll finish by saying that, while I like and admire Dsquared, I feel that in this case his contrarianism caused him to seem to be saying that what the economics profession most needs, prior to its political disestablishment, is to have as many people as possible flicking shit at it, preferably in a well-informed way, but otherwise too.
John Emerson 10.16.13 at 8:46 pm
Well, it’s time for me to leave. I’ll finish by saying that, while I like and admire Dsquared, I feel that in this case his contrarianism caused him to to FAIL TO POINT OUT that what the economics profession most needs, prior to its political disestablishment, is to have as many people as possible flicking shit at it, preferably in a well-informed way, but otherwise too.
The most embarrassing kind of editing error, the “not not” error.
ezra abrams 10.16.13 at 10:42 pm
@51
http://xkcd.com/435/
@26 – just because i want to learn EMH doesn’t mean that i can or will
I agree with youabout why econ is more discussed (and have argued same in past), but if I may say so, you r ignoring my main point: just becaue people want to discuse EMH, doesn’t mean that they can (or should)
godoggo 10.16.13 at 11:44 pm
http://www.hark.com/clips/bhfkqjgjvd/homepage_embed?width=480&autoplay=true
godoggo 10.16.13 at 11:46 pm
OK, I guess I do do it occasionally.
ralph 10.17.13 at 12:05 am
I’m with d^2 a bit here on the intellectual history. If you were to discuss the persuasiveness — as I believe d^2 did when he said, first:
It’s the cultural context that is the staging for the actors; the socio-economic moment in which the increasing conservative institutional foundations can drive home some sense of importance, a sense of, “hey…. that might be right…” with people who previously might have been more resistant. Had Western European socialism been more able to drive out of eastern european “socialism”, the context for these economic arguments — well funded or no — would have been far less conducive to creating some degree of social agreement.
Saying this doesn’t deny the force of the conservative retrenchment and focus — without that, these arguments might also have been failures. But the two coming in the same period? Nice. I find this persuasive.
CartRight 10.17.13 at 8:19 am
to AJ @32, 30
AJ, sometimes it does one an awful lot of good, to abandon ALL tenants of mainstream thought for a while, and see the world – ie the economy – from a totally different perspective – try http://www.elliottwave.com No-one these days denies that herding plays an important role in human behaviour, few have dared to try and determine how big that part is; why not try to see it as the fundamental driver? Separately, Fama may not be the only one who thinks the recession started before the credit crises – try http://www.businesscycle.com
AJ 10.17.13 at 2:29 pm
I am reluctant, unlike dsquared, to simply sweep everything Chicago under the term ‘ideological’.
> Wow some painfully daft things from Fama there. My favourite may be:
> An experience like we’ve had rehabilitates the remnants of the old socialist
> gang. (Laughs) Unfortunately, they seem to be in control of the government, at
> this point.
Daft, right? You would think daft, right? I know. But how do we know it is daftness? It is better to go with the hypothesis that this is what falls out naturally from Fama’s assumptions.
Intellectually, it is a situation akin to Einstein claiming that Newton’s laws are actually not quite right. That is way many in the Chicago School see the world – based on their assumptions, things in the real world don’t seem to quite gel but who cares? It is just a theory. Would you or I then revisit the assumptions to fit reality? Yes, we would. But not the Chicago boys. It is weird. It is odd. Given the many times this happens, it is plain disgusting.
Lest I should be supposed to have any ideological bias. I should add that I find that the Democratic economists such as Paul Krugman are equally disgusting sometimes. In between these ideological camps, common sense dies a lonely death.
chris auld 10.17.13 at 7:13 pm
If I could briefly interrupt the economist-bashing: Daniel, the EMH and the Random Walk hypothesis are not the same hypothesis. Forty years ago, LeRoy (1973) showed that an informationally efficient market does not necessarily generate prices which even follow a martingale, and a random walk is a highly restrictive special case of a martingale. More generally, the hypotheses are neither necessary nor sufficient for each other: the EMH could hold and yet prices do not follow random walks, or prices could follow random walks yet the EMH does not hold.
I also have a hard time making sense of your explanation of GMM. Linear regression and maximum likelihood are special cases of GMM. “Error” and “residual” are not synonyms. It is not generally true that the correlation of model errors should be zero. “Minimize the value of the `identifying restrictions'” is misleading: the identifying restrictions are imposed a priori, not something minimized during estimation.
I am not a finance guy, so consider an example from microeconometrics. We want to estimate the causal effect of schooling on wages. A toy model of might look like,
wage = b(schooling) + noise,
where “noise” represents causes of wages other than schooling. Since we have no reason to suppose that such causes are uncorrelated with schooling, simple linear regression doesn’t help me estimate b, the causal effect of schooling on wages. But maybe schooling is affected by two policies Policy1 and Policy2 which don’t directly affect wages,
schooling = c(Policy1) + d(Policy2) + noise.
GMM can be used to estimate the effect of schooling on wages in this model. The “identifying restrictions” here are that the coefficients on P1 and P2 in the wage equation are zero. These restrictions were imposed by me, the person who wrote down the equations above. I can use the moments implied by those restrictions to derive estimates; they are Cov(P1, wages | schooling)=0 and Cov(P2, wages | schooling) = 0. I only have one parameter, b, and two equations, so I choose b to make some weighted average of those moment conditions as small as possible, where “small” is measured in terms of squared deviations. GMM tells me what weights I should use to make my estimates as precise as possible, although I will still hone in on the right answer as my sample size grows even if I don’t use weighting at all.
godoggo 10.17.13 at 7:28 pm
Anyways, good post, more please, thanks, bye.
Peter K. 10.17.13 at 9:17 pm
“But …. well, “stripped of all the ideological bullshitâ€, the Nuremberg Rallies were a folk festival. ”
Ha ha.
Herman 10.17.13 at 10:23 pm
Hope a bit of levity isn’t out of place.
Excellent though DSquared’s presentation is, I am afraid he fails to “fully reflect” the EMH, since he focuses — quite understandably, like the Swedes — on the “Random Walk” aspect rather than on the “Efficient Market” theology. My humble attempt at explaining the EMH follows:
Empirical work in the 1950’s suggested that equity prices moved arbitrarily. This was initially thought to suggest that prices were always wrong. Fama, however claimed otherwise, and the economics profession heaved a sigh of relief. Thus spake Fama:
Prices are always ‘right’, and they move in response to exactly two factors:
1. God’s Will
2. Satan’s wiles
Prices at all times “fully reflect” God’s Will.
God moves in mysterious ways.
Ergo, prices move in mysterious ways.
Now, prices sometimes move in ways that are a bit too mysterious and irreconcilable with any conceivable interpretation of God’s Will. Such changes, decreed Fama, must by definition, be ascribed to Satan’s wiles.
Shiller’s work in the 1980’s showed that price movements are too mysterious even allowing for Satan’s wiles. This is the issue of “excess volatility” in Satan’s wiles. Exploring Satanic mood swings has since become a growth industry.
The EMH also represents the greatest advance in epistemology in centuries, perhaps even millennia, as it is simultaneously a hypothesis and a tautology. The EMH is both , and true by definition. The EMH both, tells us that financial markets are informationally efficient, and has no implications whatsoever and so cannot be wrong.
Here ends the lesson.
bxg 10.18.13 at 2:43 am
@chris auld
I don’t know you, just read your comment but … Could you perhaps help me out here, or confirm DD in his rebuttal. I suggested that his description of ML:
‘ “maximum likelihood†method, by which you specify a probability distribution for the error process and then calculate how far out of the tail (or how close to the centre) of this distribution the errors (“residualsâ€) would have to be in order to give the actual data, if the model you were considering was the correct model.[18]’
which he is rather proud of (see [18]) provided “negative information”. That sounds more snarky than I meant (at least in my initial comment; my attitude a bit different now); I was just trying to avoid saying “true” or “false” which seem inappropriate judgements for an intentionally short accessible summary of a complex subject. I could have phrased this better for sure (maybe, “unhelpful”?).
But it still seems to me his description, even making fully allowance for the brevity and accessibility constraints, is so far away from anything remotely like ML (while looking very much like hypothesis testing) as to be actively damaging to anyone-who-care’s understanding, and as close to plain “wrong” as makes sense to attribute to a quick summarization.
DD kind of called me out of this, among other thinks insisting that his description does an estimation procedure (whereas I just don’t see this anywhere; said it seemed to be a testing procedure.) I will double down on my concern: to write this description of ML, then boast about it, then snark at comment (“give the engineer a biscuit”) makes me think DD doesn’t really know what ML is. Everyone makes errors, but to boast about how “bloody good” his quick summary is – !?! [18].
No chance I could get you to chime in?
N.b. I would never have commented but for his boast [18]. But now I want to know, am I crazy or not?
adam.smith 10.18.13 at 4:21 am
FWIW bxg, I think the distinction you’re drawing is too strict, but I also think D^2 might not be correctly understanding MLE (especially since he seems to conflate it with Bayesian statistics in his later comment?). The one thing that I think is definitely wrong that he writes is that you specify a probability distribution for the error – which you just don’t. You specify a distribution for the data generating process (be it uniform, logit, poisson, etc.) and then estimate the parameter(s) that maximize the likelihood that that distribution produced the observed data.
Where you’re wrong, in my opinion, is in your claim that in standard MLE you don’t specify a distribution. You do. How else would you estimate a parameter?
Where I think you’re too strict is in the distinction on MLE and classical hypothesis testing, because you can (and certainly in econ in 1980 you almost always did) estimate the precision of your ML estimates using standard hypothesis tests based on the likelihood ratio.
chris auld 10.18.13 at 6:41 pm
bxg: I agree with you that the description of ML provided in the original post is at best unclear. ML means exactly the same thing in econometrics as it does in stats: choose parameters to maximize the likelihood of the sample, given enough structure to calculate that likelihood. Conventionally that means specifying the distributions of the errors, but there are also semiparametric ML estimators which allow some flexibility over such assumptions.
James Wimberley 10.18.13 at 9:56 pm
The OP is impressive on the economics but an F on basic HTML. Linking to a footnote is on page 2 of Dave Raggett’s old two-page guide to HTML for dummies. Some of these old tags are “deprecated” in modern issues, but since they still work on the browser you’ve got, we might as well keep using them.
Tim Wilkinson 10.19.13 at 6:01 pm
Great post!
robotslave 10.20.13 at 12:31 am
@74
You have to admire the sheer chutzpah of first mistaking an issue of style for a technical issue, and then immediately failing not only to link to an appropriate anchor within a document, but to link to the page cited at all.
Well done, master Wimberley!
AJ 10.20.13 at 11:58 pm
I haven’t taken a look at the responses to my ‘disgusting’ comments. I wasn’t meaning to say it quite so bluntly. I suppose I just got a bit angry and said something that, out of sheer politeness, I have simply not said in the past.
What we are seeing in many ways playing out in the United States are ‘vestigeal organizational behavior’. They are vestigeal in the same sense that the appendix is a vestigeal organ. No use for it, but it continues to exist because it played a certain function at a different time.
The response of the American right in the past 2 months (and in the context of the Chicago School, for the past few decades) is reminiscent of the early Christian Church. In Asia Minor, the early Christians would spook their fellow citizens any time there was an earthquake and a pagan church fell down. ‘The End Times are here’, they would say. This was an attempt to spook the poor pagans into believing that their time was up and so they had better subscribe to the Christian faith, and this was a deadline-driven marketing effort (‘Offer valid for limited time only’) that seemed to have paid off rich dividends for them in ages past. So, this successful organizational behavior was preserved down the centuries as a so-called “Article of Faith” – “End Times” be true ‘cuz it says so in our Holy Book. The end result has been that, on the hand, the world is scared about the debt ceiling and, on the other hand, the American right talks about “End Times”. Asia Minor’s organizational practices of the 1st century rumbling down the decades only to bite us in the ass in the 21st century.
So much for the Republicans. What about the American left? Their organizational behavior are reminiscent of those of simians. Yes, monkeys. Specifically, tree monkeys sitting secure in their trees throwing random things at the creatures below just to annoy them and because they have the power to do so. As Niall Ferguson has clearly demonstrated, Paul Krugman is not always right. But Krugman is secure in his tree. To be clear, a tenured position is even more secure than a tree, but within the timespan of a fight betweem the monkeys and the ground dwellers, the chances that a monkey would be shaken off the tree were minimal and so professors do seem a lot like monkeys in secure positions. Said monkeys do seem throw a lot of stuff on hapless ground-dwelling creatures even today. To be clear- this is not only what they do on the Internet. It is also what they do in their own classes. If you have never seen the simian behavior of Dennis Yao, you have probably not seen a Democrat in action. The use of the terms “idiot”, derping”, et cetera, from a professor who himself gets things wrong are indicative of a mind gone ape.
I reserve the right to republish this stuff. I think this bit is pretty clever even if I say so myself – and it is funny because it hits the mark.
ogmb 10.21.13 at 6:54 pm
It seems worth pointing out that Nobels (including the Rjksbank) are not awarded for the advancement of science, but for work that benefits mankind [sic]. (It also stipulates that the work must have been done in the preceding year, a restriction widely ignored.) So while I’m generally in accord with the claim that Fama advanced economic science, I find the notion that humankind benefited from it harder to swallow.
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