After the press conferences, the television interviews, the parties and champagne, the University of Chicago celebrates Nobel Prizes Chicago-style: we examine, illuminate, and maybe even debate the prize-winning ideas.
“The Work Behind the Prize” gathered the campus community Nov. 4 to applaud the latest laureates, Eugene Fama and Lars Peter Hansen, recipients of the 2013 Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel.
As President Robert J. Zimmer told the crowd of nearly 450, it is fitting to celebrate by examining their accomplishments and the decades of work that led up to the prize. Four of Fama and Hansen’s close colleagues did exactly that, with institute chair Gary S. Becker moderating.
Unifying Theory, Data, and Statistics
James J. Heckman, the 2000 Nobel laureate, kicked things off: “Lars Hansen is a model economic scientist. His work tackles a fundamental problem: In a changing world, how can we predict the future, make plans, or devise effective policies?”
Heckman placed Hansen in the context of a line of pioneering Chicago economists and statisticians who have struggled to understand economic dynamics and incorporate uncertainty into economic models. Among them were Frank Knight, a strong influence in Hansen’s work; several economists with the Cowles Commission, including the recently deceased Lawrence Klein; and the late Leonard Jimmie Savage of the statistics faculty. “Their motto is Lars’s motto: science is measurement,” Heckman said. “His work embodies this vision of econometrics as the unification of theory, and data and statistics.”
Hansen’s key contribution was finding statistical methods to simplify complex economic models. The conclusion Hansen’s Generalize Method of Moments (GMM) is that the discrepancy between predicted and actual values must be uncorrelated to any data observed by the decision making agent at the investment date.
“Lars took this … as a way to understand observed phenomenon, and applied it with profound results,” Heckman noted.
With coauthor Thomas J. Sargent, Hansen worked out the new econometrics of rational expectations models pioneered in part by Robert Lucas Jr., who won the 1995 Nobel Prize for that work.
By recognizing that many people don’t fully understand the world around them when making economic choices, Heckman said that Hansen relaxed the rational expectations model, incorporating uncertainty more effectively into economic models.
“He has integrated modern decision theory into what’s called robust controls, risk sensitive controls,” said Heckman. “This is model science. He applies and adopts the scientific method to learn from data, to understand the world and make it a better place.”
Doing Something Without Doing Everything
John Heaton, PhD’89 (Econ), Deputy Dean for Faculty at the University of Chicago Booth School of Business is Hansen’s coauthor and former student. He used Hansen’s own words to describe GMM: “You can do something without having to do everything.”
Heaton explained Hansen’s work with a few simple charts. In a series of papers with Kenneth Singleton, Hansen examined the relationship between aggregate consumption and risk in financial market movements. They showed that when the stock market dips, as in the recent financial crisis, consumption wobbles.
“The relationship of these two things … is a measure of risk. Investors looking at these two data series are asking, ‘Should I be in the market, given that risk?’” said Heaton, the Joseph L. Gidwitz Professor of Finance.
Consumption, asset returns, and covariance are all factors that are easily measurable. “What’s missing is the risk preference parameter—how risk-averse people are,” Heaton said. “What Hansen and Singleton showed us is that without having to understand the whole dynamics, when given that [data] series, we can identify that parameter, using historical moments.”
The risk parameter is important in many practical applications, Heaton said. For example, when the Federal Reserve changes interest rates, we expect investors and consumers to respond. “That’s really what’s behind this rational expectations business—it’s investors trying to solve a dynamic estimation problem.”
Heaton said Hansen’s work has important implications for macroeconomists, particularly those at the Fed, who are trying to build complex economic models incorporating many dynamic factors. It helps simplify and isolate the key factors.
Marked by a measure of seriousness and modesty, Hansen’s work is rooted in his deep understanding of the implications that can be drawn from the data, Heaton concluded. “His analysis says that measurements of these linkages and risk are difficult, not just for individuals but for economists as well. Some of the recent things I’ve heard Lars say are just absolutely right and worth listening to, especially with regard to the implications for policymakers overseeing markets. Simple rules and regulation may be the best way to go.”
Continuing the theme of simplicity, John Cochrane explained Fama’s most famous contribution in a nutshell: “In 1970, Gene defined markets to be informationally efficient – that prices at any given moment reflect all information about future.”
“It’s not a complex theory. Think Darwin, not Einstein,” said Cochrane, the AQR Capital Management Distinguished Service Professor of Finance at Chicago Booth. “It simply says what prices in competitive market should look like. They should not be predictable.”
But the efficient markets hypothesis has subtle and surprising implications. One is that trading rules, technical systems, or market newsletters—all the methods deployed to beat the market—have essentially no power, beyond luck, to forecast stock prices. “That’s not a theory, an axiom, not a philosophy, or a religion,” said Cochrane. “It’s an empirical observation that easily could have come out the other way —and sometimes it does.”
Today, 43 years after Fama put forth the efficient markets hypothesis, it remains contentious—mostly because people confuse a few anecdotal examples of beating the market with solid long-term evidence, or they misunderstand what economists mean by efficiency.
“The main prediction of efficient markets is that prices should be unpredictable. But starting in the mid-1970s, Gene started looking at long-run returns,” said Cochrane. “Lo and behold, he found that you can predict prices at long horizons.”
In recent periods, people should have responded rationally to low stock prices after a sharp market decline, but didn’t buy because they felt the market was too risky. “Efficiency is still there, but the facts require huge revision of our world view. The business cycle variation in risk premiums—not variation in expected cash flows—accounts entirely for the volatility in stock valuation,” Cochrane explained.
There are vastly different theories to explain observed facts in financial markets. “We need models of market equilibrium that tie these price fluctuations to more facts. These facts set the set the agenda that my generation is working on,” Cochrane concluded.
And Cochrane said there are many more important questions to answer: “Is the finance industry too large or small? Why do we pay fund managers so much? What accounts for the monstrous amount of trading in markets? How prevalent are runs? Are banks regulated correctly?”
“Gene always has the bottom line for it: Look at the facts. Collect the data. Analyze them carefully. Every time we do, the world surprises us. And it will again.”
Why Asset Prices Matter
The final speaker, Tobias Moscowitz, touched briefly on how Fama’s work improved upon the capital asset pricing model (CAPM). With the Fama-French model, Fama added two additional factors that produced expected return estimates that aligned much more closely with actual returns.
“With all this work trying to explain asset price movements, why do we care?” asked Moskowitz, the Fama Family Professor of Finance at Chicago Booth.
“We need to know how prices are set because they determine resource allocation. They determine the cost of capital, because different risks face different prices when borrowing,” said Moskowitz. “We can also use these models to evaluate money managers.”
Moskowitz noted that the idea of market efficiency has spawned the whole index fund industry, leading to a huge savings on management fees for investors.
The efficient markets hypothesis led to event studies—analysis of how asset prices behaved leading up to a major announcement such as a merger, and how quickly information is incorporated into the price. Academics and finance practitioners alike have found success in the area.
“Asset pricing research helps understand what risks people care about and how are they priced. That has been a theme in Lars’s work and Gene’s as well,” he concluded.
Chicago Booth Dean Sunil Kumar wrapped up the event by thanking panelists “and the winners for winning the prize.” Kumar said that since he came to UChicago, he has wondered what happens when someone wins a Nobel Prize here.
“Now I know,” he said. “We launch an inquiry.”