In a recent interview in the New Yorker, Eugene Fama, Chicago School economist and father of the efficient-markets hypothesis (EMH), defended his theory in light of the housing boom and crash. Fama's views on asset bubbles and business cycles stand in sharp contrast to the standard Austrian position. Although Chicago and Austrian economists are on the same side on many policy questions — particularly in their opposition to Keynesian solutions — Fama's interview reveals the large differences in their theoretical toolboxes.
What's a Bubble?
The EMH has many different formulations, depending on how formal the presentation. For casual discussion with the public, defenders of the EMH will often say that market prices quickly react to news, so that at any given time prices reflect all publicly available information.
Another popular implication of the EMH is that an investor can't systematically "beat the market," at least not using theories or data that other investors can access. Although the EMH is an economic theory, it obviously tends to be associated with economists who favor laissez-faire policies.
In the wake of the massive boom and bust in the housing and financial sectors, many interventionists have pounced on the apparent absurdity of the EMH and its proponents. The following exchange shows the interviewer John Cassidy's sniping and Fama's attempts to defend the EMH:
JOHN CASSIDY: Many people would argue that, in this case, the inefficiency was primarily in the credit markets, not the stock market — that there was a credit bubble that inflated and ultimately burst.
EUGENE FAMA: I don't even know what that means. People who get credit have to get it from somewhere. Does a credit bubble mean that people save too much during that period? I don't know what a credit bubble means. I don't even know what a bubble means. These words have become popular. I don't think they have any meaning.
CASSIDY: I guess most people would define a bubble as an extended period during which asset prices depart quite significantly from economic fundamentals.
FAMA: That's what I would think it is, but that means that somebody must have made a lot of money betting on that, if you could identify it. 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.
CASSIDY: Are you saying that bubbles can't exist?
FAMA: They have to be predictable phenomena. I don't think any of this was particularly predictable.…
Well, (it's easy) to say after the fact that things were wrong. But at the time those buying them [subprime-mortgage-backed securities] didn't think they were wrong. It isn't as if they were naïve investors, or anything.
I agree with John Cassidy's definition of a bubble. Note that all prices are driven by supply and demand. But when we say that an asset is in a bubble, what that means is that the demanders (i.e., new buyers) aren't buying because of "fundamental" reasons, but rather for speculative reasons. In other words, they are only buying because they think the price will go up.
This isn't purely a psychological guessing game. There are empirical implications of an asset or commodity price being driven by speculation rather than an increase in "fundamental" demand. For example, if the price of oil is being pushed higher because speculators anticipate a war with Iran, then we would expect to see crude inventories rising, as the rising market price draws forth greater current production than industrial consumers and refiners want to use.
Hence, in the short run, the speculative increase in oil prices would cause more oil to be pumped daily than was consumed daily, leading to more barrels accumulating in inventory. Note that this is exactly what we want the market economy to do — when people forecast a looming war with Iran, we want to economize on oil right now and stockpile for the future.
In housing, there were different indicators that prices were being driven by speculative demand rather than a fundamental shift in the demand for housing. For one thing, house prices compared to rental prices increased more than would have been justified even if we accounted for things such as mortgage rates and the Clinton-era change in the capital-gains treatment of house sales.
For another example, the proportion of owner-occupied homes fell as the housing boom intensified, which is consistent with the theory that people were buying homes intending to "flip" them in a year or two after gaining the price appreciation.
Now of course, Fama is aware of these simple observations. He is saying that perfectly intelligent investors — many of them millionaires — were aware of these simple facts as well. However, there were other things going on during the boom years, which allowed "experts" to argue away the obvious indicators that housing prices were being driven by speculative demand.
Fama seems to think he has just defused the critics of the EMH, but I don't see how. All Fama has demonstrated is that the people who bought overvalued assets didn't realize they were buying overvalued assets at the time, or at the very least thought they could unload them before the crash. Well, nobody denies that. It doesn't take any empirical evidence to "test" such a proposition, either. All you need to do is assume that investors don't like losing money, and you can easily prove that nobody buys an asset that he thinks will collapse in price soon after he buys it.
This is a crucial point, so let me say it differently. Critics of the EMH argue that markets are capable of periods of mass delusion as it were, in which asset prices get pushed far above any "rational" level justified by the underlying fundamentals. Some critics blame Bush's alleged deregulation for this, while others (such as Austrian economists) blame the Fed for flooding the credit market with absurdly cheap money.
In this context, it doesn't do much good for Fama to say that the investors at the time weren't aware of their delusions. We could just as easily "prove" that religious cults or other fanatical organizations don't exist.
The Issue of Predictability
It's true, some investment advisors and pundits may have "called" the housing bubble through sheer luck, either because they are permanently bearish or because they used an illegitimate technique that just so happened to spit out the right analysis on this occasion.
"It doesn't do much good for Fama to say that the investors at the time weren't aware of their delusions."Yet, as I asked in my previous critique of the EMH, what could people have done to prove to someone like Fama that they had called the bubble? Fama says he doesn't see how any of the investors could have predicted the sudden collapse in housing prices. But what if they were familiar with Austrian business-cycle theory, and had read Mark Thornton's 2004 prediction that the boom in housing was too good to be true?
Fama would presumably say that Thornton got lucky, and that his general macro forecasting (using Austrian theory) would "beat the market" half the time and be beaten by the market the other half.
Yet this standard defense of the EMH has two problems. First, Fama obviously has not reviewed the forecasting record of Mark Thornton (or of the other investors who made significant amounts of money when they "got out" in time before the crash). Second, Austrian economic theory is not a model that spits out stock picks. But if it occasionally flashes warnings saying, "The current monetary policies will lead to a huge boom and bust!" who's to say that these warnings must necessarily balance out in the long run?
In the grand scheme, I think Fama argues in a circle: in his view, investors can't be blamed for pushing up housing and stock prices, since the market (a.k.a. investors) was pushing up housing and stock prices. Now, the EMH has been defended with econometric tests in the academic journals, but that's not what I mean here. I'm talking about economists applying the EMH to real-world events, as Fama has done in this interview.
Before moving on, I want to congratulate Matt Yglesias for pointing out another troubling part of Fama's epistemology. Here's Yglesias:
The really strange thing … is [Fama's] metaphysical claim that something can't be real unless it's predictable. Fama says that most bubbles are 20/20 hindsight. But 20/20 vision is good vision. The point about 20/20 hindsight is that you can see things clearly, once they've already happened. But those things really did happen. Whether or not you believe there was a methodologically reliable way to tell that there was a real estate bubble in 2006, there's clearly such a way to tell today — it's called hindsight.…
Consider earthquakes. We can't predict when earthquakes are coming. But earthquakes are still very real — they topple buildings and kill people. And even though nobody can predict earthquakes, we can still say things of some predictive value about earthquakes.…
If you had a guy standing around saying "there's no such thing as earthquakes" when what he actually meant was "earthquakes are unpredictable," then you'd wind up with very bad public policy.
Now, Matt Yglesias is a self-described progressive who thinks "very bad public policy" in the case of financial markets is deregulation. But even though Yglesias and I see things very differently in terms of how to prevent future bubbles, we both agree that the US economy just went through one.
Fama, in contrast, has adopted what could be described as a postmodernist approach to asset prices, in which bubbles don't exist unless the consensus view at the time was that a bubble was in progress.
I reject Fama's view and side with Yglesias. Using the definition of fundamental versus speculative demand, we can objectively define in principle what a bubble is. (There is a subtlety in situations where speculators are anticipating a future increase in the fundamental price, such as our thought experiment of a war with Iran.) Under that definition, the United States obviously just experienced a huge bubble in the housing and financial markets. The fact that a lot of people missed it at the time doesn't eliminate its existence — on the contrary, it explains how the bubble got so big.
Let's switch back to the earthquake analogy to see the point: Suppose some seismologists are reading their instruments and tell the mayor, "We need to evacuate the city! The big one's coming!" But other seismologists dismiss the warnings, explaining that "this time, it's different." After the quake, Fama points to the massive death toll and says, "There was no earthquake here. People don't like dying, after all. I'm not really sure what 'earthquake' means — maybe shaking buildings or something — but that shaking would have to be predictable to have operational meaning."
Fama on Causality
In addition to his postmodern view of bubbles, Fama gives an explanation for the recession that reverses the cause-and-effect timing that most analysts have adopted:
FAMA: What happened is we went through a big recession, people couldn't make their mortgage payments, and, of course, the ones with the riskiest mortgages were the most likely not to be able to do it.…
CASSIDY: But surely the start of the credit crisis predated the recession?
FAMA: I don't think so. How could it? People don't walk away from their homes unless they can't make the payments. That's an indication that we are in a recession.
CASSIDY: So you are saying the recession predated August 2007, when the subprime bond market froze up?
FAMA: Yeah. It had to, to be showing up among people who had mortgages.
Fama's views here — despite his claim to being an empirical economist — are really flowing from his theory, not from the data. Fama simply can't imagine how the financial crisis could've caused the recession, rather than the other way around.
The odd thing here is that the standard explanation — not just the one given by the Austrians, but the one given by just about everyone who opines on what happened — shows the flaw in Fama's reasoning. It was precisely because of the hanky-panky with "liar loans," teaser adjustable-rate mortgages, zero-down or even negative amortization mortgages, and so forth that the bursting of the housing-price bubble caused such a crisis.
As house prices appreciated at incredible rates, it didn't matter whether a buyer had the income to afford "so much house." The strategy was to get the guy into a house so that the loan could be sold off to Wall Street, who would slice and dice it and sell its pieces again in the form of mortgage-backed securities.
"Market prices can get screwed up when the Fed tinkers with interest rates. Because of the distorted price signals, the actual real resources are invested improperly."It didn't matter if the borrower's income was insufficient to meet the mortgage payments once the adjustable-rate mortgage reset, because the borrower could refinance into a conventional mortgage, or, failing that, could simply sell the house. In a market rising at double-digit rates in some cities, who cares about the creditworthiness of the borrower?
But once the housing market plateaued, the recklessness of this mindset became apparent. People who had bought "too much house" couldn't unload it to break even, let alone for a quick profit. As the housing price bubble popped, there were many speculative buyers — house flippers — who had very little equity invested in their properties. Why would they continue to make mortgage payments (which might be resetting to much higher levels) on a vacant house that was now many thousands of dollars underwater, when they could just walk away?
I have discussed these matters with Doug French, a former Las Vegas banker, who confirms that this is indeed what happened. But the problem with Fama isn't so much whether the story above is valid or not, it's that Fama doesn't even concede its theoretical possibility. Instead, Fama simply assumes that if people began walking away from their mortgages, it must be because their paychecks had taken a hit due to a recession. It is his lack of imagination that leads him to ignore the obvious timing of various events in the recent financial crisis.
Of Credit Bubbles and Saving
Before closing, let's address one final mistake that I believe Fama makes in his glib dismissals of a systemic failure in asset pricing.
FAMA: When you start telling me there's a bubble in all markets, I don't even know what that means. Now we are talking about saving equals investment. You are basically telling me people are saving too much, and I don't know what to make of that.
On the one hand, I sympathize with Fama's frustration here. He is presumably alluding to the popular theory that blames the housing bubble on the low interest rates fueled by Asian saving. Like Fama, I reject that theory as silly, as I explain here.
However, Fama's more general point is quite mistaken. There can certainly be a bubble in all (or most) markets, even though savings necessarily equals investment in terms of real resources.
Not just Austrians but even mainstream economists are coming around to the conclusion that Alan Greenspan kept interest rates too low for too long following the dot-com crash. Fama seems not to think about the implications of the Federal Reserve creating new money out of thin air and injecting it into the credit markets. Is he really so sure that this couldn't set in motion several broad bubbles?
Fama's invocation of the macro accounting tautology of Savings = Investment seems to have in mind the idea that if, say, $100 billion flows into housing, then $100 billion must not be available for some other sector where prices therefore must fall.
Yet this confuses flows with stocks. Suppose XYZ's stock is currently selling for $10, and then a bullish investor buys 1,000 shares for $11 each. If there are a total of a million shares of XYZ outstanding, then the $11,000 expenditure by the investor has created an increase of $1 million in the portfolio values of the investors holding XYZ. There's no reason that the investor's use of the $11,000 must translate into a $1 million fall in asset values elsewhere.
Fama is correct that the physical or "real" resources in an economy do not multiply because of the printing press — Bernanke can't conjure up more tractors and factories by writing checks. But the Austrian point is that the corresponding market prices can get screwed up when the Fed tinkers with interest rates by flooding the credit markets with new fiat money. Because of the distorted price signals, the actual real resources — made available by genuine saving — are invested improperly. The Austrian story is not one of "overinvestment" but one of malinvestment.
Conclusion
Eugene Fama is a clever economist, and his efficient-markets hypothesis certainly deserves study. However, as his recent interview with the New Yorker demonstrates, Fama doesn't seem aware of the limits of his theory. He glibly dismisses the very possibility of what actually caused our current economic crisis.
