Thursday, October 17, 2013

Nobel for Economics

FT has two interesting articles on this year's Nobel for Economics, one by John  Kay and the other by Tim Harford (of Undercover Economist fame). They make a point that many others have made, that two of Nobel Laureates, Eugene Fama and Robert Shiller, got the award for holding rather contradictory views. Fama propounded the theory that markets are efficient, that is, securities prices reflect all available information. Shiller contended that markets are prone to bubbles and that volatility in stock prices exceeds what can be ascribed to new information.

Who is right? Well, in a way, I suppose both are. Markets tend towards efficiency; the fact that they deviate from efficiency often or even for long periods does not refute Fama's basic postulate. As Harford points out, one big outcome has to been to discredit stock analysts and stock pickers in general. It's far better in terms of returns and far more cost effective simply to invest in a basket that mimics the market.

The popular view is that the sub-prime crisis arose from the belief in market efficiency and that this belief underlies the crisis. Harford makes an interesting point: true believers in market efficiency would have wondered how safe (AAA securities) could yield such high returns and would have stayed away from these.

I guess the point about the crisis is that the banks ventured into activities that are more the preserve the capital markets; poor regulation allowed them to do so. Capital markets may not be efficient at all times but that does not diminish their role. Banks too have their traditional role but they must be careful not to stray away from it and involve themselves heavily in capital markets.

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