The Royal Swedish Academy of Sciences continues to astonish the public when awarding the Nobel Memorial Prize in Economics. In 2011 it celebrated the success of recent research in promoting macroeconomic stability. This year it pays tribute to the capacity of economists to predict the long-run movement of asset prices.
People with knowledge of financial economics may be further surprised that this year Eugene Fama and Robert Shiller are both recipients . Prof Fama made his name by developing the efficient market hypothesis, long the cornerstone of finance theory. Prof Shiller is the most prominent critic of that hypothesis. It is like awarding the physics prize jointly to Ptolemy for his theory that the Earth is the centre of the universe, and to Copernicus for showing it is not.
Actually, it is not as bad as that analogy suggests. Although the efficient market hypothesis is not true, the basic idea – that there is a tendency for publicly available information to be reflected in market prices – is an essential tool for anyone involved in securities markets. And while the claim that economists are good at predicting long-run asset prices is a stretch, Prof Shiller’s research supports strong evidence of long-run mean reversion, as prices return to the fundamental values established by the earning capacity of the underlying assets.