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     Oct 29, '13

Shiller's reckoning
By Martin Hutchinson

Eugene Fama and Robert Shiller, who together with Lars Peter Hansen received economics Nobel prizes this month, had differing views about bubbles. Fama thought they were rare and impossible to spot, whereas Shiller made his name spotting them.

The difference in their approach may however simply reflect a difference in the monetary policies pursued during their rise to fame, the generally cautious approach of Federal Reserve chairman William McChesney Martin in the 1960s versus the crazed expansionism under Fed chairman Alan Greenspan from the middle 1990s and by Ben Bernanke since. To any neutral observer it must be clear: modern monetary policies have a

tendency to produce asset bubbles. It is perhaps their most important disadvantage.

Fama's Efficient Market Hypothesis was published in the May 1970 edition of the Journal of Finance. It stated the hypothesis that markets are efficient, in other words a stock's market price contained all available information about the stock's value. It fitted with Fama's own previous work on random walks in stock market prices and was well timed, as the stock market had just fallen off a cliff after a burst of irrationality.

As the market meandered around the same level for the following decade, losing ground steadily to inflation, it was easy to believe Fama's thesis, and to regard fluctuations in stock prices as driven by fluctuations in interest rates and corporate and economic prospects.

Certainly the 1970s' gradual stock price decline in real terms seemed to reflect a rational adaptation to the deterioration in US prospects as political crisis, inflation and the 1973 Arab oil embargo appeared to darken America’s political/economic position after the optimistic 1960s. The stock price recovery after 1982 also appeared driven by the renaissance in US prospects under Ronald Reagan, while the further rise in prices after 1990 appeared to owe much to the removal of uncertainties over the global economy through the collapse of the Soviet Union. Only after 1995 did stock prices come to seem irrational.

Fama on the whole still holds to his interpretation of market behavior. He believes bubbles are only visible in 20-20 hindsight and the 2007-8 housing crash was caused by an oncoming recession, not a bursting bubble. "Can you have a bubble in all asset markets at the same time? Does that make any sense at all? Maybe it does in somebody’s view of the world, but I have a real problem with that," he said in a recent interview. My response: Yes, you can, when Ben Bernanke is running monetary policy. But more on that later.

Shiller's view is in many ways the contrary of Fama's. But that's not surprising; his best-known book, Irrational Exuberance, predicting a sharp stock market downturn, was published in 2000, the height of the dot-com bubble. Subsequent to that, Shiller predicted the housing downturn in 2005 and a major general economic downturn in 2006. Shiller believes bubbles are common, and that the US stock market is currently thoroughly overvalued, based on long-term earnings trends.

Long-term readers will know that in the past I have been scathing about efficient-market theory, and tend to share Shiller's view of bubbles, seeing them as fairly frequent and very damaging when they occur. But then that's not very surprising; I am approximately a contemporary of Shiller's, and although I am only 11 years younger than Fama, I was not economically active when he propounded his Efficient Market Hypothesis. With the experience of market movements since 1995, it is difficult to imagine that the market is either rational or efficient, or that stocks and other assets are rationally priced, except occasionally in passing.

Speaking personally, the latter months of 2002 and the spring of 2009 are the only occasions in the last two decades when I have not believed the stock market to be fundamentally overvalued. Equally, I claim no great prescience for having believed, in my first years as owner of investible capital, 1979-82, that the stock market at the time represented a screaming bargain.

The correlation between lax monetary policy and bubble creation is far too obvious to ignore. Excess monetary creation pushes interest rates down toward or below the level of inflation, rewarding those who have access to leverage. This not only pushes up the prices of all assets, but by its nature results in asset-price overshooting - the creation of bubbles - because the "hot money" leveraged capital seeks quick returns in temporarily fashionable sectors, hence pushing their prices up beyond all reason.

At first, the bubbles are concentrated in the more obvious assets, such as stocks and housing, which rise to irrational peaks and then crash. However, if lax monetary policy continues after the crash, the original bubble sectors are less likely to attract capital because of their recent unhappy history, and bubbles spread ever more widely throughout the more obscure asset classes. Eventually the situation Fama derided occurs - a bubble in all asset markets at the same time. That is the stage we have reached now; it doesn't take much imagination to envisage the miserable denouement that awaits us.

Having said that Shiller's model of asset prices is more plausible than Fama's, at least at present, we have not however finished the argument. For just as it is clear that Shiller currently represents market reality, it is even more clear that a market that at least approximately follows Fama is economically not only more "efficient" than a market following Shiller but more likely to lead to fairer outcomes and a greater sum total of human happiness. There are a number of reasons for this:

A Fama market, since it remains approximately centered around the rationally calculated value of the assets concerned, is less volatile than a Shiller market; hence it imposes smaller losses on the investing public attempting to plan its retirement, and is less risky.

A Fama market's rational pricing of stocks implies that resources in that market are more or less optimally allocated. In a Shiller market, when a bubble is in progress, investments at excessive prices in the favored asset class may be far above the optimal. Bubbles are very wasteful because of the malinvestment they cause. In stocks, liquidation and redeployment of the malinvestment are fairly easy. In other assets such as real estate, for example, the excessive investment may remain in place, blighting the market for a decade or more.

Irrational exuberance is very costly because it causes wasteful investment in favored assets. However, so is its corollary, irrational pessimism, which generally follows irrational exuberance after the bubble bursts. The best example of this occurred in the deep property and stock market depression that followed the British bubble of 1972-73, which caused the Financial Times share index to decline by 70% from its high, or more than 80% in inflation-adjusted terms. As a result, the most entrepreneurial houses in the London market, which of their nature were more leveraged than stodgier names, went bankrupt, wiping out not only assets, but the City careers of Jim Slater and Oliver Jessel, who would otherwise have been available to fight off the global behemoth invasion after the 1986 Big Bang deregulation of the London market.

Similarly in 2008, the Lehman Brothers bankruptcy, of a house in business since 1847, might not have happened had not the prices of subprime mortgages fallen as far below their correct level as they had previously been above it.

A Shiller market, if accompanied by rapid money creation and the encouragement of leverage, results in the creation of unattractive fortunes by "quick buck" artists. It also appears to demonstrate to the public the irrationality of the price mechanism. As the 1930s and recent years have demonstrated, this produces a political momentum for socialism, wealth redistribution and other schemes of cuckoo economics and government aggrandizement. These schemes impoverish the country concerned and are extremely difficult to eradicate once they have been put in place.

As Wall Street demonstrated in the years before 2008 and JP Morgan demonstrated again with its 2012 "Whale" disaster, assuming that the market follows the axioms of Fama and other efficient-market theorists is both unsound and potentially very expensive, since it causes you to underestimate risk. Needless to say, assuming that the market follows Fama is especially damaging and expensive if, as since 1995, it is essentially following Shiller.

Nevertheless, a Fama market is the ideal at which policymakers should aim, even while discouraging bankers from assuming its existence. Monetary policy should be conducted so as to quell bubbles when they appear, which would reduce both asset misallocation and financial misbehavior because the overleveraged fast-buck artists responsible for so much financial fraud would be forced out of business by market rationality and a high cost of borrowing. Needless to say, other policies should be aligned so as to facilitate optimal asset allocation, avoiding subsidies such as the mortgage-interest tax deduction and making taxation as light as possible, without discriminating unduly between different forms of income (thus dividends should be encouraged by making them deductible at the corporate level, for example).

Once he had propounded the Efficient Market Hypothesis, Fama and his colleagues demonstrated that there were a number of exceptions to it, such as the "small company effect" by which small, poorly researched companies have higher returns than the market. Moreover, efficient-market theory offers no room for superior intelligence, which while rare is not entirely unknown even among the financial community. Still, the smaller these exceptions are, the better the market works for all of us. It should be the objective of policymakers to prove Robert Shiller wrong.

Martin Hutchinson is the author of Great Conservatives (Academica Press, 2005) - details can be found on the website www.greatconservatives.com - and co-author with Professor Kevin Dowd of Alchemists of Loss (Wiley, 2010). Both are now available on Amazon.com, Great Conservatives only in a Kindle edition, Alchemists of Loss in both Kindle and print editions.

(Republished with permission from PrudentBear.com. Copyright 2005-13 David W Tice & Associates.)




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