Eugene Fama has recently cancelled his subscription of the Economist magazine. The Economist has recently published a several articles on financial market bubbles. Fama did not like this tendency and decided not to by the magazine again. But why? Of course, I have to give some information about Fama for those who does not know him. I also have to mention why the said news took place on the media. Otherwise, this subscription cancelling incident would not have any meaning.
A couple of days ago, one staff writer of the New Yorker magazine have visited Chicago University and interviewed with many academics. Chicago University is one of the cornerstones of mainstream economic theory. It is true that we cannot put every academic there in the same pot; but there exists unshakable faith in the markets there. The university has a substantial number of academics with a Nobel Prize. They have raised a number of bright minds and studies. Even if you do not like the economic policy recommendations based on these studies, or even if studies conducted by other bright minds question the studies from the Chicago University, you have to give the devil his due.
Fama is an academic from Chicago University. He is seventy years old and he has four kids and ten grandkids. Of course his cancelling the subscription to the Economist has nothing to do with his age or the number of his kids or grandkids.
The issue is: he is known as the founder of modern theory of finance. For Fama, financial markets and bubbles are two concepts that cannot be mentioned together. He is an economist who has made big contributions to the idea of the efficiency of financial markets. What does an efficient market mean? In an efficient financial market, current prices (for instance stock prices) reflect the fundamentals in financial markets. Considering financial markets, 'fundamentals' and 'bubble' are two inconsistent concepts. If the price is the 'fundamentals' price, those fundamentals should have changed to change the price. Here fundamentals for instance for a stock does not only refer to the current condition o the firm issuing the stocks. It at the same time refers to the sector, economy, external conditions, and political developments. For instance, if expectations for early elections are strong, price of the stock changes as the fundamentals change. Of course it is not necessary that everybody's expectations will be in the same direction. The important thing is that sufficient number of individuals and institutions to influence the prices through purchase and sale activities develop such expectations. As an extension to this, if the decision for early elections is actually taken as expected, the prices will not change. It is kind of a 'this news was already purchased' situation.
However, prices set by 'bubbles' can change at any time based on anything. As per the definition, bubble will burst eventually; but it is not possible to estimate when. In a market where no bubbles exist, they will not be too much volatility either. The global financial crisis has hit hard to the 'efficient financial markets hypothesis.' It was frequently discussed that bubbles in the housing and subprime mortgage prices, which inflated for a long time and then burst, had a major impact on the emergence of the crisis. The interesting part is, in the interview with the New Yorker staff writer, Fama does accept that a bubble inflated in housing prices or subprime mortgage prices before the crisis. According to him, the rapid rise and then the fall in the mentioned indicators result solely from economic foundations.
You cannot just say 'stubborn old man' and skip the issue. After all, we are talking about a man two left his mark with his studies on financial economics. I should also say; even in undergraduate textbooks, efficient markets hypothesis is explained first and then observations that support or contradict with this hypothesis are addressed. Of course everyone does not have a blind confidence in the efficiency of financial markets. However, the problem is that shadow banking sector, which constitutes an important part of US's financial markets, was not regulated, or supervised relying substantially on the efficient financial markets hypothesis. And this was exactly when the crisis emerged.
This commentary was published in Radikal daily on 24.01.2010
