Why the Nobel Prize matters
- 14 October 2013
- From the section Business
The Nobel Prize in Economics has been awarded to three academics who have transformed our understanding of stock and house prices.
The official announcement stated that the prize was awarded to Eugene F Fama, Lars Peter Hansen and Robert J Shiller "for their empirical analysis of asset prices".
Fama and Hansen of the University of Chicago will be less known in popular circles than Yale's Robert Shiller - who is one of the people behind the Case-Shiller US house price index.
Fama's 1970 paper is associated with the "efficient market hypothesis", which says that information is quickly incorporated into stock prices so that markets are "efficient".
This meant it was hard to have an advantage over all of those in the market already, so investors might as well consider buying an index fund that tracked a particular stock market, since any information that anyone might have was already factored into the stock price.
All three of these economists are within the field of what's called behavioural finance. Fama as more of a critic.
This field questions just how rational investors and others are, which radically changed the premise that all actors in the economy are perfectly rational.
Sounds strange, I know, but a lot of economic models are written on the basis that everyone is rational. Just take a look at an undergraduate microeconomics textbook sometime.
Of the three, Hansen's contribution is the hardest to explain. He is the pioneer of an econometric method that helps us to improve the understanding of how a variable, say a stock market or housing index, is affected by another, e.g. credit availability.
For those who are truly keen, it's known as the Generalised Method of Moments or GMM.
Finally, Shiller is probably better known because he has not only warned about the US housing bubble, but has written several popular books. His work analyses what determines asset prices and he also created an index that tracked US house prices over a long period of time.
He explained to me that when he started looking at house prices, he was astounded that such a long-term index didn't exist. Thus, the Case-Shiller index was born.
The Nobel Prize carries with it a hefty prize of eight million kronas or about $1.2m. But it's the prestige that matters.
Like a Hollywood film, the award brings greater attention to the work of the recipients.
For many of us seeking to understand how the last financial crisis happened and are worried about the next housing bubble or dotcom boom and bust, their research is certainly worth taking a look at.