Nobel Laureate Eugene Fama: Markets are efficient, regulation is the problem

Eugene Fama is a living legend of modern finance theory. He has been teaching at the University of Chicago Booth School of Business for over 50 years, having earned tenure at the age of 26. He has worked alongside celebrity professors such as Friedrich von Hayek, Milton Friedman, Ronald Coase, and Gary Becker.

                                  --Translated from the original Slovak by Sonia Ostatnikova

 

April 7, 2017 | Ján Záborský | TREND Magazine   

He was one of the first finance researchers who understood the value of computers. Before anyone talked about Big Data, he used his own database of stock prices to ensure that his research is based on real data. When the university founded the Center for Research in Security Prices, the most comprehensive database used in stock market research, Fama became one of its strongest supporters and users. Today, he is the Center’s Chairman of the Board. Being the eighth most cited economist in the world, he received the Nobel Prize in 2013 for his theory of efficient markets. He says that he has fully exploited every one of his research ideas. For example, if you hear about passive index funds as the best investment option because no investment manager can continuously beat the market, it is a half-a-century old idea thoroughly examined by Fama. For this and other reasons, many refer to him as “the father of modern finance.”         

 

What is your perception of modern finance as a system?

With regards to current financial institutions, “too big to fail” is a problem created by government regulations. It will be hard to fix. But markets are completely fine. Just look at the billion people worldwide who have escaped poverty because they accepted the market economy. It is a great success. But it would not be possible without finance. Without it, you cannot achieve anything. If you are unable to take people’s savings and turn them into productive investments, you cannot get far. Finance is also thriving in terms of research. Perhaps even too much, as it has become impossible to keep track of all new research. Finance is unique when compared to other areas of economics. All financial research has practical implications. Many economic theories outside finance are not practical; they are interesting only to academics who research similar topics. When I accepted the Nobel Prize, I said the same thing: finance is applicable to daily life.

The University of Chicago is known for its support of free markets, from Hayek to Friedman, Gary Becker, and you. Why?

Once the train gets going, it keeps going. I would not look for a deeper meaning. People tend to hire people who look like them. That explains a lot. But I think most economists support free markets. A Marxist economist is not really an economist. He is more of a politician.

Why did you choose Chicago?

It was a long time ago. I wanted to teach at a business school and my advisors at Tufts University singled out Chicago as the most academically focused business school. I liked that.

An academic business school is a peculiar combination. One would expect more of a practical focus.

At that time, it meant that you spent time on fundamental disciplines such as statistics and economics rather than on case studies.

Why do you still teach?

I like it. Teaching forces you to re-think and re-evaluate everything. It also helps your research. Moreover, when you look around, all these buildings were paid for by students. David Booth, whose name the school bears since his gift to the school, was my student. I see relatively few students, less than five percent, as my lectures are quite rigorous. But it also means that the students I see are the most successful ones.

Who attends your lectures? ‘Theory of Financial Decisions’ does not sound terribly enticing.

It is a required subject for doctoral students. But there are more MBA students in my class as well as students from other university departments. In the past, I used to have even more students in my class but my lectures have become harder.

You received the Nobel Prize for the theory of efficient markets. How do you perceive the current global pressure for their increased regulation? The rhetoric is roughly that markets are not efficient and that’s why we need regulation.

They regulate financial institutions rather than markets. I do not think there was ever anything wrong with markets. What you want to have in markets is equal opportunity, a level playing field. No advantage for a subset of players. If you need anything at all, it’s less market regulation. The whole regulation idea started because a few large players were too big to fail. New rules have been designed to prevent that, but I doubt they will work. Markets worked perfectly even in 2008 and 2009; individual financial institutions did not.

New rules are incentivizing banks to become even bigger. The Basel Accords are easier to satisfy by big players.

Compliance costs have risen sharply so cost savings are bigger for big institutions. So, yes, the effect is the opposite of what regulators had in mind. It would be easier just to say that banks that are too big and should have sufficient capital so they cannot fail. But that number would be much higher than the current 10 to 12 percent. And that is already double compared to what it was before the financial crisis.

Speaking of the crisis, aren’t such market crashes a sign that markets are inefficient?

No. When things get worse, people become more cautious and prices fall. It happens almost always before a recession. I know that this is used as an argument against market efficiency. But if that were the case, recessions would be predictable.

Could current regulations cause another crisis? The public is led to believe that central banks and regulators have full control and nothing bad can happen.

Going back to 2008, there were a number of rules and regulations. Regulators from the Securities and Exchange Commission had a seat in every big investment or commercial bank. But they did not notice anything bad. Why should they do a better job next time? Their numbers have tripled, but I think they would miss a looming crisis again.

How do you combine research and teaching? In addition, you are chairman of the board at the Center for Research in Security Prices, you are in business…

I am the official chairman but I do not do anything there. I think research is a natural part of teaching. As for business, I am only active in Dimensional Fund Advisors, but I do not do anything specific for them. They only use parts of our research for their clients. We help them implement it but it does not take much time.

How do you choose your research co-authors?

That’s simple. I have been working with the same person for the past 30 years. As for students, if they work on something interesting, I work with them, that is natural.

How do you keep yourself “in the picture” in your field?

I have never traveled too much. But when we invite people from other universities or business to our school, they always come. We have a great system of workshops here. You could spend your whole life in workshops. People from other universities present their research here. Another way is my own research. You have to examine the work of others so you do not repeat what has already been done. It used to be easier when I started. There was less competition. It was like catching fish in a barrel. There were fewer researchers in finance and economics. Today you have no chance of grasping everything. You can only follow what is directly relevant to your area. When I started, there were no journals in finance worth reading. Now there are at least five. I am active in some of them. Fifty years ago, finance research was done only at Chicago and MIT.  Today every good-size university has a good-quality finance group. They attract a lot of talent.

Why is there still so much interest in finance? In the 1990s, it made sense. But today it is more about following rules which would better fit lawyers.

For a long time, it used to be about asset pricing—how to factor in risk, how asset prices respond to new information. Corporate finance, which studies how companies make investment decisions and how they finance them, was way behind. Nowadays, this area is growing enormously. Add to it venture capital, private equity, and corporate governance. Twenty years ago, nobody predicted that corporate finance would become important because it was considered a dead area. One never knows what is going to happen. It helps to have a flexible schedule and be able to adapt.

How long do you plan to teach and do your research?

For as long as I breathe. Gary Becker taught here until his death.

Gary Becker started a new field of economics that had not existed before.

He opened a giant door. He said that economics is everything: family, society… Microeconomics back then had no empirical research. Today it’s huge.

How do people at Chicago choose a research topic? Students in Slovakia tend to look for something simple, not too demanding.

American universities are very competitive. In Europe, universities are run by governments. That means that eventually, they begin to resemble governments. They are no longer effective at achieving their goals. In the U.S., few professions are more competitive than academia. We have both public and private universities, but the private ones keep the public ones on their toes. Competition among universities pushes the research bar high. In addition, universities attract people from all over the world. A million foreign students attend American universities. You do not see that in Europe.

What brings them here? Chicago Booth has the image of a demanding school.

I think they believe that a degree from an American university will help them succeed, that they will learn more here than elsewhere. Why else would they be willing to pay $100,000 in tuition?

When you began working with Dimensional Fund Advisors, did you ever fear that your theories might not work in practice?

Of course, you can never be 100 percent sure. The efficient markets theory has been around a long time and it has been working well.  What has changed is the relationship between risk and uncertainty. We always try to implement things that are robust, well supported by data. After we conduct initial tests, we extend them to other time periods and ranges. Despite that, you can never be completely sure. We always try to balance empirical work and theory.

How do you formulate a new theory? You first have an idea and then search for data to support it?

Nobody ever starts with theory. You always start with data. Looking back 50 years, the efficient markets theory started with the introduction of computers. People were suddenly able to do calculations that had been infeasible. Stock price data became readily available and so people started exploring them. Gradually, economists became involved and they asked: What stock price patterns can we expect if markets work correctly? And that’s how the efficient markets theory was born.

How did computers change and affect your research area?

I was the first one using computers on a large scale. We had no computers in high school. I worked with a professor who only had a mechanical calculator. They never gave you a correct answer. You could have easily made a mistake plugging in numbers and not notice it. Then computers were introduced. They were laughable when compared to present computers. But they allowed us to do things that had been unthinkable. We were gradually able to study huge amounts of empirical data, which would have taken us too long before.

Have computers changed how markets work?

I do not think so. They often ask me how technology has changed markets. There is no visible effect in the data. Perhaps it is because data contain a lot of noise; naturally, there is a lot of volatility. But you cannot find any clear effect of technology. For example, technology has diminished transaction costs to nearly zero. One could say that has made markets more efficient, but that is not the case. They had been efficient before. Decades ago, I predicted that trading would be done by computers, which would reduce transaction costs. It took a long time but it has become a reality.

Isn’t it surprising that there are still people involved in trading?

You mean brokers? There are fewer and fewer of them. Nobody wants to be a stock broker these days. It used to be a popular and well-paid job, but not anymore. Even large investment banks are pulling back from this business.

Read the original article in Trend Magazine.