The theory that caused the financial crisis gets a Nobel prize

alfred nobelVivek Kaul

Do financial markets have bubbles? Like most things in economics, the answer to what seems like a rather straightforward question, is yes and no. It depends on which economist you are talking to.
Eugene Fama and Robert Shiller are two of the three economists(the third being Peter Hansen) who have won the Nobel Prize in Economics this year.
When it comes to the bubble question Fama feels there are no bubbles. Shiller, on the other hand, has done some of his best work in economics around financial market bubbles. In fact, he was one of the few economists, who predicted both the dotcom bubble as well as the real estate bubble. Ironically enough, both of them have won the Nobel Prize in the same year.
Eugene Fama, who teaches at the University of Chicago, came up with the efficient market hypothesis(EMH), sometime in the 1960s. A lot of financial theory that followed was built around EMH.
Benoit Mandelbrot, a mathematician who did some pioneering work in economics, was Fama’s thesis advisor. As Mandelbrot (along with Richard Hudson) writes in The (Mis) Behavior of Markets – A Fractal View of Risk, Ruin and Reward “It (i.e. EMH) became the intellectual bedrock on which orthodox financial theory sits.”
So what is the EMH? As Mandelbrot and Hudson write “At its heart: In an ideal market, security prices fully reflect all relevant information…Given that, the price at any particular moment must be the “right” one.”
And how is that possible? How can the price of a financial security( lets say a stock or a bond) at any point of time incorporate all the information?
Mark Buchanan explains this through a small thought experiment in his book Forecast – What Physics, Meteorology and Natural Sciences Can Teach Us About Economics “Let’s do a thought experiment, which I’ll call the 5 percent problem. Suppose that on Tuesday morning everyone knew for sure that the markets would recover, stocks gaining 5 percent(on average) in a big rally in the final half hour at the end of the day. Everyone in the market would expect this rise, and lots of people on that morning would be eager to pay up to 5 percent more than current values to buy stock, as they would profit by selling at the day’s very end. Knowledge of the coming afternoon rise would make the market rise immediately in the morning, violating the assumption we made to start this thought experiment; the prediction of a late rally would be totally wrong.” Hence, information about the market rising by 5% towards its close, would be incorporated into the price of the stocks immediately.
Mandelbrot and Hudson give another similar example to explain EMH. “Suppose a clever chart-reader thinks he has spotted a pattern in old price records – say, every January, stocks prices tend to rise. Can he get rich on that information by buying in December and selling in January? Answer: No. If the market is big and efficient then others will spot the trend, too, or at least spot his trading on it. Soon, as more traders anticipate the January rally, more people are buying in December – and then, to beat the trend for a December rally, in November. Eventually, the whole phenomenon is spread out over so many months that it ceases to be noticeable. The trend has vanished, killed by its very discovery,” write Mandelbrot and Hudson.
And this happens primarily because the market is made up of many investors, who are all working towards spotting a trend and trading on it. As Buchanan explains in 
Forecast “In this view, a market is a vast crowd of investors with diverse interests and skills all working hard to gather information on every kind of manufacturing company, bank, nation, technology, raw material, and so on. They use that information to make best investments they can, jumping on any new information that might affect prices as it comes along, and using that information to profit. They sell currently valued stocks, bonds, or other instruments, and buy undervalued ones. These very actions act to drive the prices back toward their proper, realistic, or “intrinsic” values.”
Given this financial markets are correctly priced all the time. Robert Shiller summarises this argument best in 
Irrational Exuberance. As he writes “The efficient markets theory asserts that all financial prices accurately reflect all public information at all times. In other words, financial assets are always priced correctly, given what is publicly known, at all times.”
And if financial assets are correctly priced, there is no question of any speculative bubbles occurring. As John Cassidy writes in 
How Markets Fail – The Logic of Economic Calamities “During the 1960s and ’70s, a group of economists, many of them associated with the University of Chicago, promoted the counter-intuitive idea…that speculative bubbles don’t exist. The efficient market hypothesis…states that financial markets always generate the correct prices, taking into account all of the available information…In short financial prices are tied to economic fundamentals: they don’t reflect any undue pessimism..If markets rise above the levels justified by fundamentals, well informed speculators step in and sell until prices return to their correct levels. If prices fall below their true values, speculators step in buy.”
This ensures that all the available information is priced in. Hence, at any point of time, the market price is the correct price. And given that where is the question of any bubbles popping up? As Fama put it in a 2010 interview, “I don’t even know what a bubble means. These words have become popular. I don’t think they have any meaning.”
Robert Lucas, another University of Chicago economist who won the Nobel prize in 1995, reflected Fama’s sentiment when he said “The main lesson we should take away from the EMH for policy-making purposes is the futility of trying to deal with crises and recessions by finding central bankers and regulators who can identify and puncture bubbles. If these people exist, we will not be able to afford them.”
And this is the view that came to dominate much of the prevailing economic establishment since the 1960s. It is surprising that economists have had so much confidence in a theory for which the evidence is at best sketchy. Raj Patel makes this point in 
The Value of Nothing “The problem with efficient market hypothesis is that it doesn’t work. If it were true, there’d be no incentive to invest in research because the market would, by magic, have beaten you to it. Economists Sanford Grossman and Joseph Stiglitz demonstrated this in 1980, and hundreds of subsequent studies have pointed out quite how unrealistic the hypothesis is, some of the most influential were written by Eugene Fama himself.”
Also, if EMH were true, prices of financial assets would be right all the time, which is clearly not the case. As Buchanan writes “In November 2010, the 
New York Times reported on a dozen “mini flash crashes” in which individual stocks plunged in value over a few seconds recovering shortly thereafter. In one episode, for example, stock of Progress Energy – a company with eleven thousand employees – dropped 90 percent in few seconds. There was no news released about the business prospects of Progress Energy either before or after the event…On May 13(2011), Enstar, an insurer, fell from roughly $100 a share to $0 a share, then zoomed back to $100 in just a few seconds.”
Shiller gives the example of eToys and Toys “R” Us, two companies which were into selling toys. As he writes “Consider, for example, eToys a firm established in 1997 to sell toys over the Internet. Shortly after its initial public offering in 1999, eToys’ stock value was $8 billion, exceeding the $6 billion value of the long established “brick and mortar” retailer Toys “R” Us. And yet in fiscal 1999 eToys’ sales were $30 million, while the sales of Toys “R” Us were $11.2 billion, almost 400 times larger. And eToys’ profits were a negative $28.6 million, while the profits of Toys “R” Us were a positive $376 million.”
So a company with no profits had a greater market capitalization in comparison to a company making substantial profits. Now as per the EMH this should have never happened. Investors would have sold the eToys’ stock and driven down its price. But that did not happen, at least for a few years. And the stock price of eToys went from strength to strength.
But despite the weak evidence in support of EMH, the prevailing economic thinking since the 1960s has been that market prices of financial assets reflect the fundamentals, and hence, there was no chance of bubbles popping up. And even if bubbles did pop up, now and then, there was no chance of identifying them in advance. Alan Greenspan, the Chairman of the Federal Reserve of United States between 1987 and 2006, believed that a central bank could not spot a bubble, but could hope to mitigate its fallout, once it burst.
This led to him letting the dotcom bubble run. A few years later he let the real estate bubble run as well. He was just following the economic theory that has dominated over the last few decades. As Patel writes “ Despite ample economic evidence to suggest it was false, the idea of efficient markets ran riot through governments. Alan Greenspan was not the only person to find the hypothesis a convenient untruth. By pushing regulators to behave as if the hypothesis were true, traders could make their titanic bets…Governments enabled the finance sector’s binge by promising to be there to pick up the pieces, and they were as good as their word.”
In the end, Greenspan did find out that the model did not work and that bubbles did occur, now and then. As he admitted to before a committee of the House of Representatives in October 2008, “I found a flaw in the model that I perceived is the critical functioning structure that defines how the world works, so to speak…I had been going for 40 years or more with very considerable evidence that it was working exceptionally well.”
So Eugene Fama’s EMH doesn’t really work and has caused the world a lot of harm.
Now compare this to Robert Shiller who in the first edition of 
Irrational Exuberance, which released some time before the dotcom bubble burst, compared the stock market to a Ponzi scheme. As he wrote “Ponzi schemes do arise from time to time without the contrivance of a fraudulent manager. Even if there is no manipulator fabricating false stories and deliberately deceiving investors in the aggregate stock market, tales about the market are everywhere. When prices go up a number of times, investors are rewarded sequentially by price movements in these markets just as they are in Ponzi schemes. There are still many people (indeed, the stock brokerage and mutual fund industries as a whole) who benefit from telling stories that suggest that the markets will go up further. There is no reason for these stories to be fraudulent; they need to only emphasise the positive news and give less emphasis to the negative.”
Hence, financial markets at times degenerate into Ponzi schemes, where prices are going up simply because prices are going up. These bubbles can keep running for a while, just as the dotcom bubble in the US and the real estate bubble all over the developed world, did. When these bubbles burst, they caused huge economic problems, as we have seen over the last few years.
The trouble is that the dazzle of efficient market hypothesis has blinded economists so much that they cannot spot bubbles anymore. Hence, it is important that economists junk the efficient market hypothesis, and start looking at a world where bubbles are possible and keep popping up all the time. Else, we will have more trouble ahead.

The article originally appeared on on October 15, 2013
(Vivek Kaul is a writer. He tweets @kaul_vivek) 


About vivekkaul
Vivek Kaul is a writer who has worked at senior positions with the Daily News and Analysis(DNA) and The Economic Times, in the past. He is the author of the Easy Money trilogy. Easy Money: The Greatest Ponzi Scheme Ever and How It Is Set to Destroy the Global Financial System , the latest book in the trilogy has just been published. The first two books in the trilogy were published in November 2013 and July 2014 respectively. Both the books were bestsellers on and Currently he works as an economic commentator and writes regular columns for He is also the India editor of The Daily Reckoning newsletter published by His writing has appeared across various other publications in India. These include The Times of India, Business Standard,Business Today, Business World, The Hindu, The Hindu Business Line, Indian Management, The Asian Age, Deccan Chronicle, Forbes India, Mutual Fund Insight, The Free Press Journal,,, Business World, Huffington Post and Wealth Insight. In the past he has also been a regular columnist for He has lectured at IIM Bangalore, IIM Indore, TA PAI Institute of Management and the Alliance University (Bangalore). He has also taught a course titled Indian Economy to the PGPMX batch of IIM Indore. His areas of interest are the intersection between politics and economics, the international financial crisis, personal finance, marketing and branding, and anything to do with cinema and music. He can be reached at

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