The Enduring Mystery of Financial Markets

Economists need to move beyond the insights of three prizewinners

The Enduring Mystery of Financial Markets
Economists need to move beyond the insights of three prizewinners (Illustration by Bloomberg View)
Illustration by Bloomberg View

The recipients of this year’s Nobel prize in economic sciences—Eugene Fama and Lars Peter Hansen of the University of Chicago and Robert Shiller of Yale University—have all made important contributions to the understanding of financial markets. Fama demonstrated that markets are very good at processing new information quickly. Shiller showed that despite this, prices can get out of whack and stay that way for long periods. Hansen provided tools to help figure out whether markets’ often odd behavior can happen in a world where investors are rational or must be explained by human bias or some other malfunction.

Unfortunately, decades after the three economists had their groundbreaking insights, the crucial question remains unanswered: Can policymakers know with any certainty when markets are dangerously out of line, and is there anything they can do about it?

Central bankers still debate whether it’s possible to recognize asset bubbles when they occur and whether they can or should be deflated. Regulators and bankers remain at odds over new financial products such as credit derivatives: Do they simply improve the market’s ability to process and reflect information, or do they also present new dangers of their own?

This failure left the world unprepared for the most recent financial crisis, and the economics profession has been far too complacent about it. Economists can’t be expected to predict the future. But they should be able to identify threatening trends and to better understand the conditions that can turn a change in prices into a financial tsunami.

What’s amazing is that the largest and most prestigious universities aren’t placing more emphasis on such paradigm-shifting work. For young researchers trying to get published and land good jobs in academia, challenging the conventional wisdom—and questioning the workings of a financial industry that provides lucrative backing to business schools—can be perilous. The commanding heights are often occupied by tenured professors heavily invested in the status quo.

This year’s Nobel shows the economics discipline in all its frustrating, admirable splendor. With apologies to Harry Truman’s jaundiced view of economists, it’s only a matter of time before the joke starts making the rounds: Did you hear about the two economists who couldn’t agree on how markets work? Yeah, they won a Nobel for it.

Yet if better understanding of that question is possible, it will come only through trial and error, the positing and refuting of theories. This is exactly the kind of creative thinking and intellectual risk taking that Fama, Hansen, and Shiller engaged in. It’s also what the economics profession needs more of as it continues to try to understand financial markets and how they can go awry.

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