Eugene Fama, Lars Peter Hansen and Robert Shiller shared the 2013 Nobel Prize in Economics, each for his individual contribution. The shared prize, presented Tuesday in Stockholm, Sweden, was awarded in recognition of their theoretical and empirical work on financial markets: how they function; how predictable they are; and how they determine asset valuation.
The conclusions that they derived from their research were far from identical, but there is no doubt that the three together know a lot about financial markets. In his presentation speech the chairman of the economic sciences prize committee, Per Krusell, said that “…their discoveries constitute the pillars of our current understanding of asset markets.”
When one of these three Nobel laureates says he is concerned about a stock market bubble and another says that the government debt picture may cause a global recession next year, then, we should listen. Intently.
Robert Shiller has earned a special credibility when it comes to markets, for he is one of the very few economists who foresaw the gathering financial storm that precipitated the 2008 recession and its lasting effects.
Price-earnings ratios have been rising globally, but currently he is most concerned about the booming U.S. stock market as well as rapidly rising housing prices and their potential for serious damage to our still weakened economy.
Eugene Fama’s concern is that the large and growing government debt levels in the U.S. and Europe could trigger a global recession in 2014. In an interview with Reuters news service he said that the debt could reach a point “…where the financial markets say none of their debt is credible anymore and they can’t finance themselves.”
Much has been made of the different conclusions that Fama and Shiller drew from their research into financial markets, and they are certainly different enough to remind us of a question raised by John F. Kennedy after a briefing on Vietnam in the early 1960s.
He had dispatched two emissaries, one military and one diplomatic, to assess the situation there, and when they returned they presented their views to the president in the Oval Office.
The two briefings were well-prepared and thorough but so radically different that after listening to them Kennedy paused for a moment and said, “You both went to the same country?”
We might ask the same kind of question of professors Fama and Shiller. “You both were looking at the same market?”
Without minimizing the differences, which are significant from both a theoretical and a practical standpoint, there is a connection between the two views, a connection that is especially relevant to our markets and our economy today.
The connection is government debt itself. It provides a known, predictable element that is absorbed rationally into Fama’s efficient market pricing theory. At the same time, its size and policy-dependent character provide a speculative, spontaneously irrational element that supports Shiller’s theory that financial markets cannot be predicted reliably with asset-pricing models.
A major contributor to the stock market boom has been the scarcity of investment opportunities in government bonds. This is an artificial scarcity, of course, caused by the central banks in the U.S. and Europe forcing interest rates down to near zero. With a zero or negative rate of return available in that market, investors are driven to buy stocks and even riskier propositions.
The goal of zero short-run interest rates is to encourage borrowing and investment, support the housing market, and dampen the inflationary effect of increasing government debt. The effectiveness of zero-rates on commercial borrowing and investment is questionable, but the flow of funds into the stock market it caused has pushed prices there to the point where they seem driven more by momentum than rationality. Certainly it is difficult to justify the current market’s overall price-earnings ratio by any reasonable expectation of profits or dividends.
Looking at the structure of his work, it is interesting that Professor Fama chose a semi-irrational variable, credibility, as the foundation of his recession worries. He is absolutely right to do so, of course, for experience tells us that market credibility is not a totally rational thing.
In its rational form debt is evaluated and priced marginally, according to risk. As an organization takes on more debt, the market price declines. Market credibility, though, sometimes evaporates suddenly and entirely. When market participants lose confidence in an organization and its management, the price doesn’t just go down gradually. No one wants its bonds at any price.
Shiller’s “bubble” in the housing market and “boom” in the stock market have a lot in common with Fama’s “market credibility” of government debt. They are all pointing to a financial market instability which we can and should deal with … while we can.
James McCusker is a Bothell economist, educator and consultant. He also writes a monthly column for the Herald Business Journal.
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