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Zombies versus irrationality: dissecting the economics Nobel

Dynamite king Alfred Nobel never designated a Nobel for economics, possibly because in the late 19th century (or any time really) it was hard to envision the wannabe science ever meeting his test of providing "the greatest benefit" to mankind. Sweden's central bank decided to remedy this oversight on the occasion of its 300th birthday in 1969, funding an annual Prize in Economic Sciences in Memory of Alfred Nobel.

The Nobel family has never warmed to this unsolicited expansion of the philanthropist's agenda. And it's a safe bet that the latest trio of winners, University of Chicago professors Eugene Fama and Lars Peter Hansen and Yale University's Robert Shiller, won't improve their mood.

"The economics prize … is awarded as if it were a Nobel Prize. But it's a PR coup by economists to improve their reputation," great-grandnephew Peter Nobel huffed in 2005. Mr. Nobel, a noted human rights advocate, pointedly added that two-thirds of the prizes had been handed out to "U.S. economists of the Chicago School who create mathematical models to speculate in stock markets and options – the very opposite of the purposes of Alfred Nobel to improve the human condition."

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The model-loving selection committee outdid itself this year, giving prizes to both Prof. Fama, an architect and leading proponent of the efficient market hypothesis, and Prof. Shiller, his harshest academic critic. The third winner, Prof. Hansen, is renowned for his work in statistical modelling. Combined, their efforts "laid the foundation for the current understanding of asset prices," declared the Royal Swedish Academy of Sciences, which hands out the prizes.

In essence, Prof. Fama's theory holds that prices of equities, bonds and other assets reflect all available information and that the markets as a whole are smarter than any individuals, who can't possibly hope to outperform them. Since the 1970s, the theory has underpinned a host of modern investing and risk-management methods, including the rise of index funds, that transformed the industry. It also provided the intellectual underpinning for the wholehearted embrace of deregulation that enabled Wall Street to eventually blow itself up in an orgy of excess.

As far back as 1984, Prof. Shiller famously labelled his rival's cherished hypothesis "one of the most remarkable errors in the history of economic thought." He argued that it ignored the role of often irrational human behaviour. "Mass psychology may well be the dominant cause of movements in the price of the aggregate stock market." And subsequent financial events have largely proved him right.

In 2009, I wrote that the efficient markets theory had finally been buried under an avalanche of uncontrolled greed, bizarre asset valuations, spectacularly burst bubbles (which should not exist in an efficient market), an historic worldwide financial collapse and other seemingly irrational behaviours for which the hypothesis simply couldn't account. But its devoted adherents found new explanations to justify its continuing value. After all, Prof. Fama declared, high market volatility in difficult times is "precisely what you expect in an efficient market."

So although the behavioural economists are gaining more influence – and even winning Nobels – the rational market hypothesis lives on.

Indeed, the idea is so resilient that prominent Australian economist and blogger John Quiggin put it at the top of his list in his 2010 book, Zombie Economics: How Dead Ideas Still Walk Among Us. "The theory is hard to kill because proponents can shift between strong versions, which form the basis of their policy recommendations but aren't consistent with the evidence, and weak versions, which are impossible to refute, but don't imply anything much about policy," Prof. Quiggin told me.

And now they can point to a Nobel Prize of a sort as further affirmation for the person behind the whole concept.

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About the Author
Senior Economics Writer and Global Markets Columnist

Brian Milner is a senior economics writer and global markets columnist. In a long career at The Globe and Mail, he has covered diverse business beats, including international trade, the automotive industry, media, debt markets, banking and the business side of sports. More


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