I recently reread a 2010 interview with Eugene Fama, who has just been awarded the Nobel Prize for his work on the Efficient Markets Hypothesis (EMH). In the interview Fama tries to defend the position that the EMH held up “quite well” in the financial crisis of 2008. The interview is worth reading in the original as it is quite bizarre.
Here, however, I want to deal with two points. One appears to me to be a willed contradiction on Fama’s part. The other surrounds his highly contradictory statements on asset price bubbles.
Now, some may tell me that I am being unfair to Fama. They might say that in interviews we often say things in a more careless and sloppy manner as we might in writing. I accept that this is true but nevertheless the oversights and contradictions in Fama’s arguments appear to me to paint a picture of a deeply confused man.
Let’s start with the second point; namely, that of how we define asset price bubbles. Fama starts by saying that he “doesn’t know what the term credit bubble means”. The interviewer then posits the following meaning,
I guess most people would define a bubble as an extended period during which asset prices depart quite significantly from economic fundamentals.
Although I don’t fully agree with that I think its a fairly robust definition. And Fama seems to agree in that he says “That’s what I would think it is”. Now here’s where the whole thing gets a bit weird. First of all he says the following,
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. (My emphasis)
Okay, that’s pretty clear, right? Fama is saying that people who make calls on asset bubbles are right about half the time and wrong about half the time. Well, I’m not sure if that’s true but I certainly agree that asset bubbles can be predicted. Indeed, Fama this year shared the Nobel with Robert Shiller and Shiller called both the tech bubble and the housing bubble. But Fama then goes on in literally the next breath to assert that asset bubbles are not predictable phenomena. When asked whether he is saying that bubbles do not exist he says,
They have to be predictable phenomena. I don’t think any of this was particularly predictable.
Now, Fama just said that those making predictions about asset bubbles were right about half the time. That seems to me to imply that there is some predictability to these phenomena. So, why does Fama go on to say that they are not predictable? I have no idea. Frankly I think that he is talking rubbish.
Fama then goes on to further tie himself in knots. With regards to recession he says that,
That’s where economics has always broken down. We don’t know what causes recessions.
Well by Fama’s own criteria that would surely mean that recessions do not exist, right? If in order for economics to recognise a phenomena it must be predictable then the discipline cannot, by Fama’s own criteria, recognise recessions. But in the second part of the interview Fama seeks to blame the financial collapse of 2008 on — you guessed it — a recession. The reason he posits that we cannot talk about asset bubbles is because they are, according to him, not predictable but then he goes on to discuss recessions which, again according to him, are also not predictable. This is very strange stuff altogether.
The next oversight/contradiction in the interview is slightly more difficult to detect but when recognised it seems to imply that Fama is probably not being honest with himself and is probably defending his theory based on a desire to do so rather than any real thinking through of the evidence. When asked whether people were getting loans in credit markets that they shouldn’t be getting Fama wheels out the shaky old right-wing argument that this was due to government policy. He says,
That was government policy; that was not a failure of the market. The government decided that it wanted to expand home ownership. Fannie Mae and Freddie Mac were instructed to buy lower grade mortgages.
The interviewer then points out that this was only a small slice of the market. But we will ignore that and focus on the coherence of Fama’s own narrative. Because when pressed on this question he quickly points out, quite correctly, that you cannot blame subprime mortgages because many countries saw housing bubbles (of course, Fama would not call them bubbles…) even though they didn’t have subprime markets.
You can blame subprime mortgages, but if you want to explain the decline in real estate prices you have to explain why they declined in places that didn’t have subprime mortgages. It was a global phenomenon. Now, it took subprime down with it, but it took a lot of stuff down with it.
Fair enough. I actually agree with this. Ireland had the biggest housing bubble in the world and subprimes were nowhere to be seen. But here’s the kicker: neither were Fannie Mae and Freddie Mac.
You see Fama is picking and choosing arguments to suit his own purposes here. When it suits his argument he will pin the US housing bubble on Fannie Mae and Freddie Mac but then when he is pressed on this he will also highlight that rising house prices in other countries were not due to the same factors as were operating in the US. So, why not follow this through to its logical conclusion: this implies that Fannie Mae and Freddie Mac were not the real cause of the US housing bubble any more than subprimes were? Because, frankly, I don’t think Fama’s argument is in any way serious. I think that he is willing to basically say anything to defend his theory against criticism.
As I said though, the interview is worth reading in the original. It is a truly bizarre document which I’m sure will appear in many history books in the future. What the historians will have trouble explaining, I think, is why the person in the interview was given a Nobel Prize in Economics only three years later.