Bob Lucas and his papers

My first post described a few anecdotes about what a warm person Bob Lucas was, and such a great colleague. Here I describe a little bit of his intellectual influence, in a form that is I hope accessible to average people.

The “rational expectations” revolution that brought down Keynesianism in the 1970s was really much larger than that. It was really the “general equilibrium” revolution. 

Macroeconomics until 1970 was sharply different from regular microeconomics. Economics is all about “models,” complete toy economies that we construct via equations and in computer programs. You can’t keep track of everything in even the most beautiful prose. Microeconomic models, and “general equilibrium” as that term was used at the time, wrote down how people behave — how they decide what to buy, how hard to work, whether to save, etc.. Then it similarly described how companies behave and how government behaves. Set this in motion and see where it all settles down; what prices and quantities result. 

Nobels and financial crises

 (At National Review)

What This Year’s Nobel Economists Can Teach Us about Financial Crises

This week, economists are celebrating the Nobel Prize given to Ben Bernanke, Doug Diamond and Phil Dybvig for their work on banking.

Bernanke pointed out that banks matter. In the Great Depression, banks failed, and there was nobody left who knew how to make new loans. The economy contracted, not just for lack of money or for animal spirits of investors, but for lack of credit. Diamond and Dybvig wrote the classic economic model of bank runs, which shows how banks can fail even when they are “illiquid” rather than “insolvent.” The logic works like this: The bank has invested our money in illiquid projects, so if I suspect others are going to run to get their money out, I run to get mine out first before it’s all gone. 

But it is no insult to say that these are not eternal verities. The papers were written about 40 years ago. Each was the launching pad for a vast and important investigation. Indeed, Nobel Prizes largely recognize that sort of lasting influence on subsequent work. But that subsequent investigation opens new possibilities. Newton is no less profound for having been followed by Einstein. Each also sought to understand the world as it was, which is how one should start. But there are other possibilities for how the world might be — and how it might be better. 

Sowell Nobel Redux

Nobel Prize season is around the corner. Last year, I blogged in favor of Tom Sowell. I update, with some edits. 

Dear Nobel Committee: How can you not give the prize to Tom Sowell this year? 

Tom's work evidently merits a Nobel purely as a contribution to economics, covering many issues. But we can't ignore what year it is. Race is a forefront issue of our time. How can you not give the prize to the living economist who has written the most penetrating economic analysis of race? 

Yes, he's a free-market economist, and thus characterized as conservative. His deeply fact-based research is  uncomfortable to The Narrative. For example, groups that white people cannot tell apart have profoundly different outcomes in the US. Nigerian immigrants are among the highest achieving ethnic groups in the US. West Indians do well. Asians of different waves of immigration and different countries -- Chinese, Laotians, Vietnamese -- show profound differences. Tom has thousands of such facts, impeccably documented. 

But you're the Nobel Committee. You care about Science, about facts, about logic, not about cheers from the Davos crowd. You care about issues that are important, as you should, but you do not care about embracing one or the other political narrative's answers to those questions. You care about the reputation of your Prize, for courageously recognizing great research, even if its surprising conclusions upset established orders. And, to your credit, you have given the prize to economists of widely different political enthusiasms through the years.  

Sowell Nobel?

There is less than a week to go before the Economics Nobel Prize. 

Dear Nobel Committee: How can you not give the prize to Tom Sowell this year? 

Tom's work evidently merits a Nobel purely as a contribution to economics, covering many issues. But we can't ignore what year it is, and what's going on in the world. Indeed, in the Physics and Chemistry prizes this year, as well as Nordhaus' climate-economics Nobel, the Prize committees show they care about research that applies to hot-button problems. Race is a screaming issue of our time. How can you not give the prize to the living economist who has written the most penetrating economic analysis of race? 

Oh, yes, he's free-market, and thus characterized as conservative. His deeply fact-based research is  uncomfortable to The Narrative. For example, groups that white people cannot tell apart have profoundly different outcomes in the US. Nigerian immigrants are among the highest achieving ethnic groups in the US. West Indians do well. Asians of different waves of immigration and different countries -- Chinese, Laotians, Vietnamese -- show profound differences. Tom has thousands of such facts, impeccably documented. 

But you're the Nobel Committee. You care about Science, not about cheers from the Davos crowd. You care about issues that are important, as you should, but you do not care about embracing one or the other political narrative's answers to those questions. You care about the reputation of your Prize, for courageously recognizing great research, even if its surprising conclusions upset established orders. And, to your credit, you have given the prize to economists of widely different political enthusiasms through the years.  

You're not, say, the American Economics Association, whose  statement from the American Economic Association Executive Committee, still up on its website, and referenced in mandatory DEI training, reads 

We encourage all economists to seek out existing scholarship on race, stratification economics, and related topics. To get us started, our AEASP and CSMGEP colleagues and students are compiling a reading list on racism and the experience of Black Americans. Members of the AEA Executive Committee have pledged to continue to educate themselves in part by reading works from the list and to seek to integrate work by diverse authors in course syllabi, and we ask all economists to make the same pledge.

The officially-endorsed reading list, though updated, to this day brazenly omits Sowell. Or Walter Williams. Or Glenn Loury. Or Roland Fryer. (Committee, if you're looking for others to share the prize, here are some suggestions!) If  you must, as you sometimes do, you may shrink from controversy by pairing the prize, Hayek and Myrdal; Fama and Shiller. But give Tom the prize. 

Yes, Tom's work is empirical, neither full of equations of theory or econometrics. (Though Knowledge and Decisions is an excellent pice of theory.)  Tom writes books. Well, maybe it's time to celebrate persuasive fact-based books as well as the more standard approaches, as you also have done in the past. 

While Tom is hardy, he is 91. None of us last forever. Nor does your opportunity to recognize one of the most important economists of our time. This is the year. 

********

Update: If you don't know Tom, and don't want to face an overwhelming volume of primary sources, his Wikipedia page is not bad. Twitter commenters complain that he appears on Fox News. Well, Paul Krugman appears in the New York Times. Within a respectable range, really, we need to start keeping political commentary separate from scientific contribution, like other hobbies. 

Sowell on grand movements

A correspondent sends me this gem from Tom Sowell: 

This was written in 1995. So no, he was not talking about any of the great causes that inundate us today. He was writing about causes in the 20th century going back to eugenics. But it seems both prescient and timeless. 

Source The Vision of the Anointed, link takes you to Google books where you can read a lot of it. 

Nobel guess

Covid has really hurt the annual Nobel Prize gossip in economics circles. Here's my guess: Claudia Goldin and Tom Sowell. 

The last several decades have been amazingly productive in economics. There are dozens of economists who have made Nobel-worthy contributions, and the committee has a hard job sorting through just who should get it and when. 

Among these, who has superb, scholarly, innovative research, on issues that everyone cares about at the moment  (as well as on other important issues), demonstrating the power of economics to address important problems, and happens to embody some of the diversity everyone recognizes is missing in our profession? Claudia Goldin and Tom Sowell. 

Sure, their research comes up with uncomfortable answers. That's what good research should do. 

I will surely be wrong. I have yet to correctly predict a Nobel!    

Update:

Sowell review

Coleman Hughes writes a wonderful review of Thomas Sowell's life and work in City Journal. Savor it.

My first Sowell book was Knowledge and Decisions, and I am heartened to see Hughes put that foremost as well. Sowell takes up where Hayek left off, how the price system is the network like our neurons communicating information across a complex economy. This remains a verbal part of the economics tradition, resisting formal modeling so far, and is thereby too often glossed over in graduate training. Read it. 

Sowell of course has written masterpieces on race, a collection of impeccably documented uncomfortable truths to the progressive left. My first, The Economics and Politics of Race is just one of nearly a dozen meticulous books, from Black Education: Myths and Tragedies (1972) to Discrimination and Disparities, second edition (2019). Hughes reviews important points in Conquests and Cultures, Migrations and Cultures, and Race and Culture.

Lessons of the ELB

I gave a short presentation on monetary policy at the Nobel Symposium run by the Swedish House of Finance. It was an amazing conference, and I'll post a blog review as soon as they get the slides up of the other talks. Offered 15 minutes to summarize what I know about the zero bound, as well as to comment on presentations by Mike Woodford and Stephanie Schmitt-Grohé, here is what I had to say. There is a pdf version here and slides here. Novelty disclaimer: Obviously, this involves a lot of recycling and digesting older material. But simplifying and digesting is a lot of what we do.

Update: video of the presentation here. Or hopefully the following embed works:

Lessons of the long quiet ELB
(effective lower bound) 

We just observed a dramatic monetary experiment. In the US, the short-term interest rate rate was stuck at zero for 8 years. Reserves rose from 10 billion to 3,000 billion. Yet inflation behaved in this recession and expansion almost exactly as it did in the previous one. The 10 year bond rate continued its gentle downward trend unperturbed by QE or much of anything else.

Europe's bound is ongoing with the same result.

Asness and Liew on Efficiency

Source: Institutional Investor

Cliff Asness and John Liew -- Chicago PhD's and now founding principals of AQR -- have a nice piece in Institutional Investor on Fama, Shiller, Nobel Prizes and efficiency.

They do a good job on the joint hypothesis theorem -- maybe a more important part of Fama's 1970 paper than efficiency itself -- and value and momentum strategies.

They point out one big difficulty for the inefficiency view (p.5). If value stocks are just overlooked and growth stocks irrationally overpriced, why do value stocks all subsequently rise or fall together, and growth stocks go the other way? "Cheap stocks would get cheaper across the board at the same time. It didn't matter if the stock was an automaker or an insurance company. When value was losing it was losing everywhere."

A second very important theorem: the average investor must hold the market portfolio, so alpha is a zero sum game. If you're going to profit, it helps a lot to identify just who the morons are whose money you are taking and why they're willing to give it to you. Everyone thinks the other guy is "behavioral." Are you sure it's not you?

A Brief History of the Efficient Markets Hypothesis

Back in 2008, Gene Fama made a nice video for the American Finance Association on the history of the efficient markets hypothesis. The video is finally out on the new AFA youtube channel here. You may have to drag the cursor back to see the introduction, on which I did a pretty good job if I do say so myself.

Three Nobel Lectures, and the Rhetoric of Finance

It was my great pleasure -- and honor -- to attend this year's Nobel prize ceremonies. It started with the Nobel prize lectures, which I found very thought provoking.

Shiller 

I'll work backwards, as it was thinking about Bob Shiller's talk that taught me the biggest lesson. Preview: this will start pretty negative, but I learn a big lesson by the end. Hang in there, Shiller fans.

Hansen Nobel Spanish Translation

Spanish translation of my blog post on Lars Hansen's Nobel Prize

El premio Nobel de Lars Hansen (traducción al español de Pedro Cervera)

Lars ha realizado tal cantidad de investigación pionera y profunda, que ni siquiera puedo comenzar a enumerar la lista completa sin comentar que sólo entiendo una parte de ella.

Escribí capítulos enteros de mi libro de texto “Valoración de activos” basándome tan sólo en uno de los documentos de Hansen. Lars escribe para el futuro y normalmente tardamos diez años o más en entender lo que ha hecho y su verdadera importancia....

(para el resto, haga clic aquí (pdf))

Unintentionally hilarious Nobel coverage

Shawn Tully at Fortune wrote a very thoughtful piece describing Gene Fama's research and views on efficient markets.

The version I saw on  CNN money magazine is unintentionally both hilarious, and ends up making a far deeper point than I think Shawn intended.  It is chock full of little links trying to draw you off to other articles on the magazine. These were undoubtedly not put in or even reviewed by Shawn, but they tell you an enormous amount about the world of finance and finance journalism.

For example, here we are in the middle of an article describing Gene and efficient markets.

...Understanding Fama's evolving view of the market is one of the most valuable, practical guides for today's investors. 

MORE: 20 top picks from 20 star investors 

Fama's ideas may have received the ultimate validation, but they're still highly controversial.... 

Well, they haven't received the ultimate validation from the bots that run CNN money, that's for sure!

Fama Nobel En Espanol

Pedro Cervera kindly translated my short piece on Gene Fama's Nobel prize, which will appear in "Estrategia Financiera" next month:

Eugene Fama: Mercados eficientes, primas de riesgo y el premio Nobel.

En 1970, Gene Fama definió que un mercado era “informacionalmente eficiente” si los precios incorporaban en cada momento la información disponible relativa a los valores futuros.

“Un mercado en el que los precios reflejan la totalidad de la información existente es denominado eficiente “[Fama, 1970]. 

....

para el resto, haga clic aquí para un pdf

For the rest go here for a pdf (I don't speak Spanish and gave up trying to get accents right in blogger!)

The Work Behind the Prize: Video and Text

This is a link to the "Work Behind the Prize" event from Monday Nov 4. Our charge was, explain to the community of scholars at the University of Chicago, what Lars Hansen and Gene Fama's research was that won them Nobel Prizes. Jim Heckman and John Heaton talk about Lars Hansen's work, Toby Moskowitz and I talk about Gene Fama. 10 minutes each. I start at 33:50.

Here is the text of my remarks. (Faithful blog readers will note some recycling. Let's call it "refining.") A pdf with embedded pictures is here. The video on youtube is here

Eugene Fama: Efficient markets, risk premiums, and the Nobel Prize

In 1970, Gene Fama defined a market to be “informationally efficient” if prices at each moment incorporate available information about future values.

A market in which prices always `fully reflect’ available information is called `efficient.’” - Fama (1970)

If there is a signal that future values will be high, competitive traders will try to buy. They bid prices up, until prices reflect the new information, as I have indicated in the little picture. “Efficient markets” just says that prices in a competitive asset market should not be predictable.


“Efficient markets” is not a complex theory. Think Darwin, not Einstein. Efficiency is a simple principle, like evolution by natural selection, which organizes and gives purpose to a vast empirical project.

The Work Behind the Prize

This afternoon (Monday November 4) a panel of four will try to explain the research that Gene Fama and Lars Hansen did to win the Nobel Prize for the University of Chicago community.

This is classic University of Chicago, community of scholars stuff: Yes, we've congratulated you.  Now, let's talk seriously about the ideas and the research.

My job: Explain efficiency, long run returns and volatility in 10 minutes flat. Wish me luck. John Heaton and Jim Heckman will describe Lars Hansen's work, and Toby Moskowitz will join me on the Fama panel.  Gary Becker will moderate

The announcement is here; RSVP if you want to attend as seating is limited. The event will be web-cast here

Bob Shiller's Nobel

As with Lars Hansen and Gene Fama, Bob Shiller has also produced a span of interesting innovative work, that I can't possibly cover here. Again, don't let a Nobel Prize for one contribution overshadow the rest. In addition to volatility, Bob did (with Grossman and Melino) some of the best and earliest work on the consumption model, and his work on real estate and innovative markets is justly famous.  But, space is limited so again I'll just focus on volatility and predictability of returns which is at the core of the Nobel.

Source: American Economic Review

The graph on the left comes from Bob's June 1981  American Economic Review paper. Here Bob contrasts the actual stock price p with the "ex-post rational" price p*, which is the discounted sum of actual dividends. If price is the expected discounted value of dividends, then price should vary less than the actual discounted value of ex-post dividends.  Yet the actual price varies tremendously more than this ex-post discounted value.

This was a bombshell. It said to those of us watching at the time (I was just starting graduate school) that you Chicago guys are missing the boat. Sure, you can't forecast stock returns. But look at the wild fluctuations in prices! That can't possibly be efficient. It looks like a whole new category of test, an elephant in the room that the Fama crew somehow overlooked running little regressions.  It looks like prices are incorporating information -- and then a whole lot more!  Shiller interpreted it as psychological and social dynamics, waves of optimisim and pessimism.

Lars Hansen's Nobel

Lars has done so much  deep and pathbreaking research, that I can't begin to even list it, to say nothing of explain the small part of it that I understand.  I wrote whole chapters of my textbook "Asset Pricing" devoted to just one Hansen paper. Lars writes for the ages, and it often takes 10 years or more for the rest of us to understand what he has done and how important it is.

So I will just try to explain GMM and the consumption estimates, the work most prominently featured in the Nobel citation. Like all of Lars' work, it looks complex at the outset, but once you see what he did, it is actually brilliant in its simplicity.

The GMM approach basically says, anything you want to do in statistical analysis or econometrics can be written as taking an average.

Understanding Asset Prices

The Nobel Committee's "Understanding Asset Prices" "scientific background" paper for the Fama, Hansen, Shiller award is excellent. It is pretty much a self-contained graduate course in empirical finance.

Gene Fama's Nobel

(For a pdf version click here.)

Photo: Elizabeth Fama

Gene Fama’s Nobel Prize

Efficient Markets

Gene’s first really famous contributions came in the late 1960s and early 1970s under the general theme of “efficient markets.” “Efficient Capital Markets: a Review of Theory and Empirical Work’’ [15] is often cited as the central paper. (Numbers refer to Gene’s CV.)

“Efficiency” is not a pleasant adjective or a buzzword. Gene gave it a precise, testable meaning. Gene realized that financial markets are, at heart, markets for information. Markets are “informationally efficient” if market prices today summarize all available information about future values. Informational efficiency is a natural consequence of competition, relatively free entry, and low costs of information in financial markets. If there is a signal, not now incorporated in market prices, that future values will be high, competitive traders will buy on that signal. In doing so, they bid the price up, until the price fully reflects the available information.

Like all good theories, this idea sounds simple in such an overly simplified form. The greatness of Fama’s contribution does not lie in a complex “theory” (though the theory is, in fact, quite subtle and in itself a remarkable achievement.) Rather “efficient markets” became the organizing principle for 30 years of empirical work in financial economics. That empirical work taught us much about the world, and in turn affected the world deeply.

For example, a natural implication of market efficiency is that simple trading rules should not work, e.g. “buy when the market went up yesterday.” This is a testable proposition, and an army of financial economists (including Gene, [4], [5],[ 6]) checked it. The interesting empirical result is that trading rules, technical systems, market newsletters and so on have essentially no power beyond that of luck to forecast stock prices. It’s not a theorem, an axiom, or a philosophy, it’s an empirical prediction that could easily have come out the other way, and sometimes did.