Reality Check From Nobel Winners
The winners of this year's Nobel prize in economics made the study of real data critical to their theories.
The Great Recession was caused by the collapse of an impossibly over-valued housing market, fueled by an oversupply of cheap credit.
One person who pointed out the dangerous asset bubble developing in 2005 was economist Robert Shiller, whose composite Case-Shiller index, created in the 1990s, studies real estate prices nationally and in key urban areas.
Shiller, a professor at Yale University, was one of three U.S. recipients of the Nobel Memorial Prize in Economic Science for 2013. The other two winners, Eugene F. Fama and Lars Peter Hansen, are professors at the University of Chicago and are known for their research on asset markets, the predictability of markets, and for the creation of formulas that can help craft more effective economic policy. The awards were announced on Monday.
"Shiller is on the opposite side of Fama and Hansen, who are efficient market hypothesis guys," says John Dunham, president of economic consultancy Dunham and Associates in New York.
Markets, according to Shiller, are driven by psychology, and hence they can create irrational bubbles, Dunham says.
Efficient market theorists, by contrast, tend to look at markets a little bit like machines that rattle and vibrate in the short run, Dunham says, but are essentially stable in the long run.
This year's winners incorporated the advent of the information age and developed models of how markets can also respond to day-to-day and minute-by-minute information, such as the minutiae involved in the current budget battle and debt-ceiling talks in Congress.
Fama, for example, helped create formulas that can look deeply at vertical markets, such as retail or technology, and how they too respond to new information.
Hansen's seminal work essentially updated an important theory of statistical modeling from the late 1800s, called the Method of Moments, allowing it to be used more accurately for things like setting monetary policy. His theory is called the Generalized Method of Moments.
"What these men have done is focus the attention of economists away from pure theory and look toward data, and finance is the ideal area for this purpose, because we have lots of data," says Hrishikesh D. Vinod, a professor of Economics and director of the Institute for Ethics and Economic Policy, at Fordham University.
All three men have worked on their evolving theories for the past 50 years, so the prize is something of a life-time achievement award. Taken together, the winners' work is also a kind of composite view of the behavior of markets and assets over time, experts say.
"Such thought is prevalent throughout the financial industry, and all models on Wall Street, so it is influential," Dunham says.
Practically speaking, entrepreneurs won't get a lot from their theories on a day-to-day level, though they are affected by the monetary policy set by current Federal Reserve Chairman Ben Bernanke, who almost certainly used modeling developed by Hansen, Vinod said. The exception is, of course, Shiller, whose index plotting house values is useful to many entrepreneurs, many of whom use the value of their houses to fund their businesses.
For those entrepreneurs, Shiller's data may not be perfect at predicting trends, but it's proven it deserves careful watching.
"Shiller essentially said housing prices don’t always go up like [they did during the bubble], so he was taking a contrasting approach," Dunham says.