Are Asset Markets Rational? The Economics Nobel

Eugene Fama, Lars Peter Hansen and Robert Shiller are this year's Nobel Prize winners in economics [insert here the snark about how economics Nobels are not real Nobels].  From The New York Times:  

Three American professors — Eugene F. Fama, Lars Peter Hansen and Robert J. Shiller — were awarded the Nobel Memorial Prize in Economic Science on Monday for competing theories about the movements of asset prices. The three men, who worked independently, were described as having collectively illuminated the financial markets by showing that stock and bond prices moved unpredictably in the short term but with greater predictability over longer periods. The prize committee said these findings showed that markets were moved by a mix of rational calculus and human behavior.

None of these folks is a surprise but the fact that Fama and Shiller have shared the prize is a surprise becuase in many ways Fama and Shiller are polar opposites. Fama is a died in the wool Chicago efficient markets type (aka freshwater - where markets are rational, forward looking and where bubbles don't exist, Shiller is a real saltwater type that challenges the idea that markets are always rational and efficient.

 That said the two are not contradictory. In large part Fama is correct about markets quickly incorporating information so that if you try to trade on what is on today's Wall Street Journal front page you are a sucker. Shiller's research could be described as challenging the notion that markets are operating with full information not that they process it badly.  For example the speculation on housing prices was part and parcel of a lack of a true understanding of the junky mortgages that were being written and the financial vehicles that were created with them.  In this sense traders might be boundedly rational: doing the best they can with the information available to them but having to make imperfectly informed decisions.

So in many ways it could be said that this Nobel prize is both a recognition of the seminal work of Fama that taught us that markets are incredible efficient at incorporating new information and Shiller's work that taught us to appreciate the lacuna in the informational environment in which markets operate.

Oh and what about Hansen? His contribution is more on the empirical side, allowing us to study asset price movements in data.  But almost all students of economics will have heard of his major contribution: the Generalized Method of Moments (GMM).

Kudos to all.