Bursting Nobel laureate Fama's Bubble

7/27/2019 Bursting Nobel laureate Fama's Bubble

http://slidepdf.com/reader/full/bursting-nobel-laureate-famas-bubble 1/6

Bursting Eugene Fama's Bubble

Mises Daily: Monday, February 15, 2010 by Robert P. Murphy (http://mises.org/daily/author/380/Robert-P-Murphy)

Tweet 5 2 12

In a recent interview

(http://www.newyorker.com/online/blogs/johncassidy/2010/01/interview-with-

eugene-fama.html) in the New Yorker , Eugene Fama, Chicago

School economist and father of the efficient-markets

hypothesis (EMH), defended his theory in light of the

housing boom and crash. Fama's views on asset bubbles

and business cycles stand in sharp contrast to the

standard Austrian position. Although Chicago and Austrian

economists are on the same side on many policy

questions — particularly in their opposition to Keynesian solutions — Fama's interview reveals the

large differences in their theoretical toolboxes.

What's a Bubble?

The EMH has many different formulations, depending on how formal the presentation. For casual

discussion with the public, defenders of the EMH will often say that market prices quickly react to

news, so that at any given time prices reflect all publicly available information.

Another popular implication of the EMH is that an investor can't systematically "beat the market," at

least not using theories or data that other investors can access. Although the EMH is an economic

theory, it obviously tends to be associated with economists who favor laissez-faire policies.

In the wake of the massive boom and bust in the housing and financial sectors, many

interventionists have pounced on the apparent absurdity of the EMH and its proponents. The

following exchange shows the interviewer John Cassidy (http://mises.org/daily/3946) 's sniping and Fama'sattempts to defend the EMH:

Recommend Send 45 people recommend this. Be the first of your friends.

Like 45



JOHN CASSIDY: Many people would argue that, in this case, the inefficiency was primarily

in the credit markets, not the stock market — that there was a credit bubble that inflated

and ultimately burst.

EUGENE FAMA: I don't even know what that means. People who get credit have to get it

from somewhere. Does a credit bubble mean that people save too much during that

period? I don't know what a credit bubble means. I don't even know what a bubble means.

These words have become popular. I don't think they have any meaning.

CASSIDY: I guess most people would define a bubble as an extended period during which

asset prices depart quite significantly from economic fundamentals.

FAMA: That's what I would think it is, but that means that somebody must have made a lot

of money betting on that, if you could identify it. It's easy to say prices went down, it

must have been a bubble, after the fact. I think most bubbles are twenty-twenty hindsight.

Now after the fact you always find people who said before the fact that prices are too

high. People are always saying that prices are too high. When they turn out to be right,

we anoint them. When they turn out to be wrong, we ignore them. They are typically

right and wrong about half the time.

CASSIDY: Are you saying that bubbles can't exist?

FAMA: They have to be predictable phenomena. I don't think any of this was particularly

predictable.…

Well, (it's easy) to say after the fact that things were wrong. But at the time those buying

them [subprime-mortgage-backed securities] didn't think they were wrong. It isn't as if they

were naïve investors, or anything.

I agree with John Cassidy's definition of a bubble. Note that all prices are driven by supply and

demand. But when we say that an asset is in a bubble, what that means is that the demanders (i.e.,

new buyers) aren't buying because of "fundamental" reasons, but rather for speculative reasons. In

other words, they are only buying because they think the price will go up.

This isn't purely a psychological guessing game. There are empirical implications of an asset or

commodity price being driven by speculation rather than an increase in "fundamental" demand. For

example, if the price of oil is being pushed higher because speculators anticipate a war with Iran,

then we would expect to see crude inventories rising, as the rising market price draws forth greater

current production than industrial consumers and refiners want to use.

Hence, in the short run, the speculative increase in oil prices would cause more oil to be pumped

daily than was consumed daily, leading to more barrels accumulating in inventory. Note that this is

exactly what we want the market economy to do (http://mises.org/daily/2399) — when people forecast a

looming war with Iran, we want to economize on oil right now and stockpile for the future.

In housing, there were different indicators that prices were being driven by speculative demand

rather than a fundamental shift in the demand for housing. For one thing, house prices compared

to rental prices increased more than would have been justified even if we accounted for things

such as mortgage rates and the Clinton-era change in the capital-gains treatment of house sales.

For another example, the proportion of owner-occupied homes fell as the housing boom

intensified, which is consistent with the theory that people were buying homes intending to "flip"

them in a year or two after gaining the price appreciation.

Now of course, Fama is aware of these simple observations. He is saying that perfectly intelligent

investors — many of them millionaires — were aware of these simple facts as well. However, therewere other things going on during the boom years, which allowed "experts" to argue away the

obvious indicators that housing prices were being driven by speculative demand.

Fama seems to think he has just defused the critics of the EMH, but I don't see how. All Fama has

demonstrated is that the people who bought overvalued assets didn't realize they were buying

overvalued assets at the time, or at the very least thought they could unload them before the



"It doesn't do much good for

Fama to say that theinvestors at the time

weren't aware of their

delusions."

crash. Well, nobody denies that. It doesn't take any empirical evidence to "test" such a proposition,

either. All you need to do is assume that investors don't like losing money, and you can easily

prove that nobody buys an asset that he thinks will collapse in price soon after he buys it.

This is a crucial point, so let me say it differently. Critics of the EMH argue that markets are

capable of periods of mass delusion as it were, in which asset prices get pushed far above any

"rational" level justified by the underlying fundamentals. Some critics blame Bush's alleged

deregulation for this, while others (such as Austrian economists) blame the Fed (http://mises.org/daily/2936)

for flooding the credit market with absurdly cheap money.

In this context, it doesn't do much good for Fama to say that the investors at the time weren't

aware of their delusions. We could just as easily "prove" that religious cults or other fanatical

organizations don't exist.

The Issue of Predictability

It's true, some investment advisors and pundits may have "called" the housing bubble through sheer

luck, either because they are permanently bearish or because they used an illegitimate technique

that just so happened to spit out the right analysis on this occasion.

Yet, as I asked in my previous critique (http://mises.org/daily/3835) of the

EMH, what could people have done to prove to someone like Famathat they had called the bubble? Fama says he doesn't see how any

of the investors could have predicted the sudden collapse in

housing prices. But what if they were familiar with Austrian

business-cycle theory, and had read Mark Thornton's 2004

prediction (http://mises.org/daily/1533) that the boom in housing was too good to be true?

Fama would presumably say that Thornton got lucky, and that his general macro forecasting (using

Austrian theory) would "beat the market" half the time and be beaten by the market the other half.

Yet this standard defense of the EMH has two problems. First, Fama obviously has not reviewed the

forecasting record of Mark Thornton (or of the other investors who made significant amounts of

money when they "got out" in time before the crash). Second, Austrian economic theory is not a

model that spits out stock picks. But if it occasionally flashes warnings saying, "The current

monetary policies will lead to a huge boom and bust!" who's to say that these warnings must

necessarily balance out in the long run?

In the grand scheme, I think Fama argues in a circle: in his view, investors can't be blamed for

pushing up housing and stock prices, since the market (a.k.a. investors) was pushing up housing and

stock prices. Now, the EMH has been defended with econometric tests in the academic journals,

but that's not what I mean here. I'm talking about economists applying the EMH to real-world

events, as Fama has done in this interview.

Before moving on, I want to congratulate Matt Yglesias for pointing out another troubling part of

Fama's epistemology. Here's Yglesias (http://yglesias.thinkprogress.org/archives/2010/01/2020-vision-is-accurate.php) :

The really strange thing … is [Fama's] metaphysical claim that something can't be real

unless it's predictable. Fama says that most bubbles are 20/20 hindsight. But 20/20 vision is

good vision. The point about 20/20 hindsight is that you can see things clearly, once

they've already happened. But those things really did happen. Whether or not you believe

there was a methodologically reliable way to tell that there was a real estate bubble in

2006, there's clearly such a way to tell today — it's called hindsight.…

Consider earthquakes. We can't predict when earthquakes are coming. But earthquakes are

still very real — they topple buildings and kill people. And even though nobody can predict

earthquakes, we can still say things of some predictive value about earthquakes.…

If you had a guy standing around saying "there's no such thing as earthquakes" when what

he actually meant was "earthquakes are unpredictable," then you'd wind up with very bad

public policy.



"Market prices can get

screwed up when the Fed

tinkers with interest rates.

Because of the distorted

price signals, the actual real

resources are invested

Now, Matt Yglesias is a self-described progressive who thinks "very bad public policy" in the case of

financial markets is deregulation. But even though Yglesias and I see things very differently in terms

of how to prevent future bubbles, we both agree that the US economy just went through one.

Fama, in contrast, has adopted what could be described as a postmodernist approach to asset

prices, in which bubbles don't exist unless the consensus view at the time was that a bubble was in

progress.

I reject Fama's view and side with Yglesias. Using the definition of fundamental versus speculative

demand, we can objectively define in principle what a bubble is. (There is a subtlety in situations

where speculators are anticipating a future increase in the fundamental price, such as our thought

experiment of a war with Iran.) Under that definition, the United States obviously just experienced

a huge bubble in the housing and financial markets. The fact that a lot of people missed it at the

time doesn't eliminate its existence — on the contrary, it explains how the bubble got so big.

Let's switch back to the earthquake analogy to see the point: Suppose some seismologists are

reading their instruments and tell the mayor, "We need to evacuate the city! The big one's coming!"

But other seismologists dismiss the warnings, explaining that "this time, it's different." After the

quake, Fama points to the massive death toll and says, "There was no earthquake here. People don't

like dying, after all. I'm not really sure what 'earthquake' means — maybe shaking buildings or

something — but that shaking would have to be predictable to have operational meaning."

Fama on Causality

In addition to his postmodern view of bubbles, Fama gives an explanation for the recession that

reverses the cause-and-effect timing that most analysts have adopted:

FAMA: What happened is we went through a big recession, people couldn't make their

mortgage payments, and, of course, the ones with the riskiest mortgages were the most

likely not to be able to do it.…

CASSIDY: But surely the start of the credit crisis predated the recession?

FAMA: I don't think so. How could it? People don't walk away from their homes unless they

can't make the payments. That's an indication that we are in a recession.

CASSIDY: So you are saying the recession predated August 2007, when the subprime bond

market froze up?

FAMA: Yeah. It had to, to be showing up among people who had mortgages.

Fama's views here — despite his claim to being an empirical economist — are really flowing from his

theory, not from the data. Fama simply can't imagine how the financial crisis could've caused the

recession, rather than the other way around.

The odd thing here is that the standard explanation — not just the one given by the Austrians, but

the one given by just about everyone who opines on what happened — shows the flaw in Fama's

reasoning. It was precisely because of the hanky-panky with "liar loans," teaser adjustable-rate

mortgages, zero-down or even negative amortization mortgages, and so forth that the bursting of

the housing-price bubble caused such a crisis.

As house prices appreciated at incredible rates, it didn't matter whether a buyer had the income to

afford "so much house." The strategy was to get the guy into a house so that the loan could be sold

off to Wall Street, who would slice and dice it and sell its pieces again in the form of mortgage-

backed securities.

It didn't matter if the borrower's income was insufficient to meet

the mortgage payments once the adjustable-rate mortgage reset,

because the borrower could refinance into a conventional

mortgage, or, failing that, could simply sell the house. In a market

rising at double-digit rates in some cities, who cares about the

creditworthiness of the borrower?



improperly."

(http://mises.org/store/Politically-

Incorrect-Guide-to-the-Great-Depression-and-the-New-Deal-P580.aspx?

utm_source=Mises_Daily&utm_medium=Graphic&utm_campaign=Item_in_Daily)

But once the housing market plateaued, the recklessness of this

mindset became apparent. People who had bought "too much

house" couldn't unload it to break even, let alone for a quick profit. As the housing price bubble

popped, there were many speculative buyers — house flippers — who had very little equity invested

in their properties. Why would they continue to make mortgage payments (which might be resetting

to much higher levels) on a vacant house that was now many thousands of dollars underwater, when

they could just walk away?

I have discussed these matters with Doug French (http://mises.org/articles.aspx?AuthorId=627) , a former Las Vegas

banker, who confirms that this is indeed what happened. But the problem with Fama isn't so much

whether the story above is valid or not, it's that Fama doesn't even concede its theoretical

possibility . Instead, Fama simply assumes that if people began walking away from their mortgages,

it must be because their paychecks had taken a hit due to a recession. It is his lack of imagination

that leads him to ignore the obvious timing of various events in the recent financial crisis.

Of Credit Bubbles and Saving

Before closing, let's address one final mistake that I believe Fama makes in his glib dismissals of a

systemic failure in asset pricing.

FAMA: When you start telling me there's a bubble in all markets, I don't even know whatthat means. Now we are talking about saving equals investment. You are basically telling

me people are saving too much, and I don't know what to make of that.

On the one hand, I sympathize with Fama's frustration here. He is presumably alluding to the

popular theory that blames the housing bubble on the low interest rates fueled by Asian saving.

Like Fama, I reject that theory as silly, as I explain here (http://mises.org/daily/3203) .

However, Fama's more general point is quite mistaken. There can certainly be a bubble in all (or

most) markets, even though savings necessarily equals investment in terms of real resources.

Not just Austrians but even mainstream economists are coming around to the conclusion that AlanGreenspan kept interest rates too low for too long following the dot-com crash. Fama seems not to

think about the implications of the Federal Reserve creating new money out of thin air and

injecting it into the credit markets. Is he really so sure that this couldn't set in motion several

broad bubbles?

Fama's invocation of the macro accounting tautology of Savings = Investment seems to have in mind

the idea that if, say, $100 billion flows into housing, then $100 billion must not be available for

some other sector where prices therefore must fall.

Yet this confuses flows with stocks. Suppose XYZ's stock is currently selling for $10, and then a

bullish investor buys 1,000 shares for $11 each. If there are a total of a million shares of XYZ

outstanding, then the $11,000 expenditure by the investor has created an increase of $1 million in

the portfolio values of the investors holding XYZ. There's no reason that the investor's use of the

$11,000 must translate into a $1 million fall in asset values elsewhere.

Fama is correct that the physical or "real" resources in an economy

do not multiply because of the printing press — Bernanke can't

conjure up more tractors and factories by writing checks. But the

Austrian point is that the corresponding market prices can get

screwed up when the Fed tinkers with interest rates by flooding

the credit markets with new fiat money. Because of the distorted

price signals, the actual real resources — made available by

genuine saving — are invested improperly. The Austrian story

(http://mises.org/daily/2728) is not one of "overinvestment" but one of

malinvestment.

Conclusion



Eugene Fama is a clever economist, and his efficient-markets hypothesis certainly deserves study.

However, as his recent interview with the New Yorker demonstrates, Fama doesn't seem aware of

the limits of his theory. He glibly dismisses the very possibility of what actually caused our current

economic crisis.

Robert Murphy is an adjunct scholar of the Mises Institute, where he teaches at the Mises Academy.

(http://academy.mises.org/) He runs the blog Free Advice (http://consultingbyrpm.com/blog/) and is the author of The

Politically Incorrect Guide to Capitalism (http://mises.org/store/Politically-Incorrect-Guide-to-Capitalism-The-P360C0.aspx) ,

the Study Guide to "Man, Economy, and State with Power and Market," (http://mises.org/resources/3318/Study-

Guide-to-Man-Economy-and-State) the "Human Action" Study Guide (http://mises.org/resources/3810/Study-Guide-to-Human-Action)

, The Politically Incorrect Guide to the Great Depression and the New Deal (http://mises.org/store/Politically-

Incorrect-Guide-to-the-Great-Depression-and-the-New-Deal-P580.aspx) , and his newest book, Lessons for the Young

Economist (http://mises.org/resources/5706/Lessons-for-the-Young-Economist) . Send him mail

(mailto:[email protected]) . See Robert P. Murphy's article archives (http://mises.org/daily/author/380/Robert-P-

Murphy) .

Comment on the blog. (http://blog.mises.org/archives/011671.asp)

You can subscribe to future articles by Robert P. Murphy via this RSS feed

(http://mises.org/Feeds/articles.ashx?AuthorId=380) .

Bursting Nobel laureate Fama's Bubble

Documents

Transcript of Bursting Nobel laureate Fama's Bubble