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The Twilight Zone of Economics

While Chicago School orthodoxy says that humans can’t beat markets, behavioral economists insist that it’s humans who make markets, which means that humans can strive to improve their functioning. Which claim you believe has important implications for both economic theory and financial regulation.

CAMBRIDGE – Ten years ago, Eugene Fama and Robert J. Shiller were awarded the Nobel Prize in Economics (together with Lars Peter Hansen) “for their empirical analysis of asset prices.” Fama and Shiller, however, hold diametrically opposing views on asset-price movements, from what drives the decisions of economic actors to whether markets are inherently efficient. Fifteen years after the global economic crisis, it is a disagreement worth revisiting.

Fama is a member of the Chicago School of economics, both literally – he is a professor at the Booth School of Business – and intellectually. The Chicago School holds that economic actors are rational utility-maximizing agents, able to deploy infinite cognitive capacity and complete information at all times, in order to make decisions that will best serve their material interests. With his highly influential “efficient market hypothesis,” Fama takes this further, positing that prices almost immediately incorporate all available information about future values, and thus accurately reflect economic fundamentals.

Shiller, a Yale-based behavioral economist, could not disagree more. Taking a Keynesian view of markets, he argues that, in markets shaped by “animal spirits,” individual actors have irrational tendencies, which can be amplified by the collective mood of the market. This sometimes results in irrational and suboptimal outcomes, such as speculative asset bubbles.