The Nobel Memorial Prize in Economic Sciences is to be announced next Monday, and currently — according to the New Zealand-based prediction website iPredict at least — Richard Thaler of the Chicago Booth faculty is seen as the most likely economist to win:
(H/T Carpe Diem)
A win by Richard Thaler, though, could prove exceedingly timely for anyone wondering about just what the heck is going on in the world of pricing, market structure and auctions at the moment.
Thaler is, of course, best known for his theories in behavioral finance and above all the concept of a ‘winner’s curse‘.
In a recent FT opinion piece, for example, he argued that prices may not always be right at all. An argument which also happens to be echoed by another prospective Nobel prize winner Robert Shiller (currently No.3 in the betting stakes).
Efficient markets theory, it seems, could be coming up against some very serious limitations if both are to be believed. Especially on the back of the crisis — which seems to have made everyone a little bit less rational of late.
Very interestingly, Thaler himself noted the following in the FT (our emphasis):
Tests of this component of EMH are made difficult by what Mr Fama calls the “joint hypothesis problem”. Simply put, it is hard to reject the claim that prices are right unless you have a theory of how prices are supposed to behave.
However, the joint hypothesis problem can be avoided in a few special cases. For example, stock market observers – as early as Benjamin Graham in the 1930s – noted the odd fact that the prices of closed-end mutual funds (whose funds are traded on stock exchanges rather than redeemed for cash) are often different from the value of the shares they own.
This violates the basic building block of finance – the law of one price – and does not depend on any pricing model. During the technology bubble other violations of this law were observed. When 3Com, the technology company, spun off its Palm unit, only 5 per cent of the Palm shares were sold; the rest went to 3Com shareholders. Each shareholder got 1.5 shares of Palm.
It does not take an economist to see that in a rational world the price of 3Com would have to be greater than 1.5 times the share of Palm, but for months this simple bit of arithmetic was violated. The stock market put a negative value on the shares of 3Com, less its interest in Palm. Really.
Which obviously does make you wonder about current stock-market valuations, including the impact of index funds as well as correlation effects.
Overall he concluded that:
The bad news for EMH lovers is that the price is right component is in more trouble than ever. Fischer Black (of Black-Scholes fame) once defined a market as efficient if its prices were “within a factor of two of value” and he opined that by this (rather loose) definition “almost all markets are efficient almost all the time”. Sadly Black died in 1996 but had he lived to see the technology bubble and the bubbles in housing and mortgages he might have amended his standard to a factor of three. Of course, no one can prove that any of these markets were bubbles. But the price of real estate in places such as Phoenix and Las Vegas seemed like bubbles at the time. This does not mean it was possible to make money from this insight. Lunches are still not free. Shorting internet stocks or Las Vegas real estate two years before the peak was a good recipe for bankruptcy, and no one has yet found a way to predict the end of a bubble.
As regards the winner’s curse, his original paper made some equally interesting observations about what might happen to ‘price’ once the conditions of the game or auction have changed — due in part to the suboptimal behaviour of the participants involved, the result of possibly informed advantage, and/or the breakdown of common value.
Namely, he noted:
The possibility of suboptimal behavior by other participants in an auction raises an issue rarely discussed in economic theory, namely what to do when you realize that your competitors are making mistakes.
Theoretical treatments of bidding typically assume that bidders are rational and that the rationality of other bidders is common knowledge.
Suppose you are Capen and his colleagues and you have figured out the winner’s curse. You now have an advantage over other oil firms. How can you exploit your new competitive advantage? If you react by optimally reducing your bids, then you will avoid paying too much for leases, but you will also win very few auctions.
In fact, you may decide not to bid at all! Unless you want to switch businesses, this solution is obviously unsatisfactory. You could let your competitors win all the auctions and try to make money by selling their shares short, but this strategy can be risky.
In the oil drilling case, for instance, the price of oil skyrocketed, and the price of oil stocks went up too. A better solution may be to share your new knowledge with your competitors, urging them to reduce their bids as well.” If they believe your analysis, then the game can be profitable for the bidders. This, of course, is exactly what Capen, Clapp and Campbell did. More generally, the study of optimal strategy for games in which one’s opponents are less than fully rational deserves greater attention from economists.
But would a Nobel win for Thaler actually raise attention about some of these issues?
Depends, we guess, whether he suffers a winner’s curse.
Recipes for Ruin, in the Gulf or on Wall Street – New York Times
Pregaming the Economics Nobel: Don’t Bet On It – WSJ
Irish government debt needs you – FT Alphaville
A loser’s nightmare in Europe’s debt auctions? – FT Alphaville