Predicting the future like an economist! Nobel Prize in Economy

It’s awards season again!  

What's that you say?   The Grammys aren’t for another 90 or so days and the Oscars aren’t until March? That they haven’t actually announced the winners for the National Book Awards yet?  And the MTV Music Awards have already gone down in infamy for the year?  I say that you aren’t thinking big enough.  It’s Nobel Prize season!  Winners have been announced and the big fancy ceremony isn’t until December, so we still have time to prepare for our Nobel Prize Parties.  

Photo: Graffiti about the Nobel Prize by Quinn DombrowskiFirst awarded in 1901, there were prizes for Peace, Physics, Chemistry, Medicine, Literature.  Added to the list in 1968 was The Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel which is a bit more of a mouthful. All in all there have been 561 prizes given out to 875 people.  Which seems like a lot until you remember that there are over 7 billion people on the planet right now.

This year’s Economics prize went to three American economists: Eugene Fama, Lars Peter Hansen and Robert Shiller "for their empirical analysis of asset prices”.  My first two thoughts reading this were “Congrats!” and “Huh?”  I had this vision of scientist working side by side wearing matching lab coats.  As it turns out, it’s all about how markets price things, like stocks and bonds.  And that the scariest thing an economics will probably spill on themselves is coffee, so no lab coats.

Stocks which are explained by a nice video from Investopedia are basically little parts of a company that you buy into. The Stock Market are where people (traders), and computers (big ones!!) buy and sell stocks.   There’s actually a bunch of markets. Wall Street in New York is the one most people hear about, but the idea of everyone getting together and trading actually started in London coffee houses.  The stock market lets you buy little pieces of a company, which gives the company the money to grow their business. This sounds like a really great plan: They get your money, so the company get bigger which means your piece of the company is worth more!  But...   What company?  And what if something goes wrong?  Markets crash when prices people think something is worth gets too far off from reality. What if you pick a company and they don’t make more money?  When to buy? Sell?  Yeah.  I don’t have any answers here.  But Fama, Hansen, and Shiller do!  Sort of, well… Of course, it might have been nice if the answers were the same.

Fama says that you can’t use the past to predict the future.  What happened to a stock last week will not tell you what the price will be next week and that the markets take in and react to new information so quickly it doesn’t really change much for very long.  This isn’t a bad thing and when markets are working well, they look really random because everything is swept along so fast prices bounce around.    And then Shiller came along to say that you can predict the future: but only from a distance.  Because people aren’t as cool and reasonable as economists want us to be it takes a while for things to work out. If you look at what a stock is doing- the price vs. the dividend (the payout you get on the stock), you can tell where it is heading 3 to 5 years from now.  

Photo Ticker board by Frank GruberAnd where does Hansen fit in? He created a model (as in a math not fashion) called the Generalized Method of Moments that actually make both Fama and Shiller make sense at the same time.  

So why is this such a big deal?  Because it changed how people think about economics and markets.  It opened new ways to research and gave real human emotions and actions a place.  It changed how people actually buy and sell things in the stock market.  They changed how we see the world.  And that, sooner or later, will change your life.

Do you want to more than we covered here?  Contact a librarian!

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