The award of the Economics Nobel Prize to three scholars for their contributions to “empirical analysis of asset prices” underlines the importance that finance has come to occupy in the modern economy. Traditionally, much of the world of economics was carved up between the macro (issues of growth, inflation, unemployment, savings and investment) and the micro (subjects such as consumer and firm behaviour; the supply, demand and prices of goods and services; the functioning of their markets under conditions ranging from perfect competition to monopolistic). Finance occupied a lowly place in the pecking order; in fact, it seemed to exist in the fringes much like, for example, farm management studies — interesting only to those already converted. Finance was also treated not so much like an independent engine of growth but a lubricant — something that greased the wheels of commerce and kept the ‘real’ economy going.

It is with deregulation and the development of markets for assets — as opposed to goods sold and bought purely for consumption — that finance came into its own. Finance became important not just from the narrow perspective of company accountancy, but also for its ramifications on the wider economy. Economists could no longer ignore the happenings in the equity and bond markets, or even markets that turned ‘real’ commodities and property into securitised assets. As the turnover in these financial products (including derivatives) grew to several times their underlying physical value, so did the stature of economists studying the behaviour of asset prices. And these prices impacted the real economy to the extent they influenced consumer and investor sentiment or the ability of companies to raise capital. This was demonstrated in the 2008 global economic meltdown, caused mainly by the collapse of the mortgage-backed securities market in the US.

Curiously, two of this year’s Nobel winners — Eugene F. Fama and Robert J. Shiller — represent divergent views within the field of finance. Fama founded the so-called “efficient market” school of thought, which holds that prices of stocks and other traded assets reflect all publicly available information on them. Also, since any new information is impounded in the price instantly, there are hardly any opportunities for arbitrage. Shiller, in contrast, held financial markets to be naturally prone to bubbles and maintained that price changes occur for reasons other than asset-specific information. The resultant mispricing he attributed to “animal spirits”, which led investors to oscillate from irrational exuberance to deep mistrust and loss of confidence. This position is the antithesis of the efficient-market theory or the “rational expectations” models. The last time two people with such contradictory opinions shared the Economics Nobel was in 1974, when it was awarded to the pro-free market Friedrich August von Hayek and the socialist Gunnar Myrdal. It is a reminder that economics, which is about human behaviour, is not an exact science and hence not governed by immutable laws.

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