Fama on Finance

0:36

Intro. [Recording date: January 17, 2012.] Russ: Your impact on the field
of finance has been immense--in a whole bunch of areas, but one that
stands out is the efficient markets hypothesis (EMH). I'd like you to sketch
out the evolution of that idea in the field, how it was understood initially,
and how it has changed over time. Guest: How much time do we
have? Russ: Well, four or five hours, but let's try to keep it to under 10
minutes for this first question, if you can. Guest: Okay. I'll go back to the
beginning. The way Harry Roberts tells it, Holbrook Working in the 1930s
started to become interested in whether speculative prices moved
randomly. He was mostly an agricultural economist, looking at agricultural
commodities, and he took a series of random numbers, simulated them,
and brought them to his faculty at Stanford, faculty lounge, I guess;
showed them to them and they agreed they were an agricultural series. So
he thought from that that maybe a random walk kind of model would work
pretty well for agricultural prices, prices of other commodities. But then
there was a big gap from there to like the end of the 1950s. And what
opened things up was the coming of computers, which made computations
much easier. And the most readily available data was stock price data. So,
basically, statisticians, econometricians took the data and started doing
calculations on it, calculating autocorrelations with their estimates of how
predictable returns are based on past returns. And then they stopped.
Economists got into the mix and said: Okay, how would we expect prices to
behave if they were set based on all available information? Which is
basically the EMH, but it wasn't stated in those terms at that time. So, they
said: I think they should be a random walk, an hypothesis pulled out of the
air. Russ: When you say it's a random walk, explain what that
means. Guest: That means that expected changes are successive changes
are independent of one another. It also means they have identical
distributions, but that part is not important. It's basically the independence
part that's important. It basically means that you can't predict future
returns based on past returns. Russ: And yesterday doesn't tell you
anything about tomorrow. Guest: Right. Returns from day to day are
basically independent of past returns. Now that was a very extreme
hypothesis. Let me give you an example. You wouldn't say that about
tomatoes, for example. Tomatoes are going to be cheaper in August than in
January, for the most part, because they are seasonal. It has to do with
supply and demand--mostly supply of tomatoes. There's a similar thing
operating in prices of stocks, bonds, whatever. Basically, there's an
expected return component, what people would require in order to hold
those securities; and there's no reason that that has to be independent
through time. There's no reason why that's not predictable or why it
doesn't go--and there's lots of evidence that it is--higher on stocks during
recessions and lower during good times. So there can be predictability in
returns that is consistency with efficient markets. What people didn't

Fama on Finance
understand in the beginning was that propositions about how prices should
behave had to be joined to a statement about how you think they ought to
behave. In other words, what you need is some statement about what we
call a market equilibrium. What is the risk-return model you have in mind
underlying the behavior of the prices in returns? So, for example, stocks
are very risky; they require a higher expected return than bonds; and you
have to take that into account in the tests. So there is this, what I call the
joint hypothesis problem, which is basically what I added to the mix, but
it's kind of an important part of it. It says whenever you are testing market
efficiency you are jointly testing efficiency with some story about risk and
return. And the two are joined at the hip. You can't separate them. So,
people infer from that, it means market efficiency is not testable on its
own. And that's true. But the reverse is also true. A risk-return model is
untestable without market efficiency. Most risk-return models assume that
markets are efficient. With very few exceptions.

6:18

Russ: And so when we say markets are efficient, what do you mean by
that? Guest: What you mean is that prices at any point in time reflect all
available information. Russ: Now that idea--what's the distinction between
the weak form and the strong form that people talk about? Guest: Two
words that I used in 1970 that I came to regret. Because I was trying to
categorize various tests that were done. So, I called weak form tests, tests
that only used past prices and returns to predict future prices and returns.
And I called semi-strong form tests, tests that used other kinds of public
information to predict returns, like an earnings announcement or
something like that. And then I called strong form tests, tests that look at
all available information; and those are basically tests of if you look at
groups of investment managers and you look at returns that they generate,
you are basically looking at all the information they had to generate to [?]
securities, and what's the evidence that the information they had wasn't in
prices. Russ: And empirically, where do we stand today, do you believe and
what has been established about those various hypotheses? Guest: Well,
believe it or not, the weak form one has been the one that has been
subject to the most, what people call anomalies, in finance. Things that are
inconsistent with either market efficiency or some model of risk and return.
The big one at the moment is what people call momentum--prices seem to
move in the same direction for short periods of time. So, the winners of
last year tend to be winners for a few more months, and the losers tend to
be losers for a few more months. In the strong form tests, Ken French and
I just published a paper called "Luck Versus Skill in Mutual Fund
Performance," and basically looked at performance of the whole mutual
fund industry--in the aggregate, together, and fund by fund, and try to
distinguish to what extent returns are due to luck versus skill. And the

Fama on Finance
evidence basically says the tests it's skill in the extreme. But you've got
skill in both extremes. That's something people have trouble accepting. But
it comes down to a simple proposition, which is that active management in
trying to pick stocks has to be a zero sum game, because the winners have
to win at the expense of losers. And that's kind of a difficult concept. But it
shows up when you look at the cross section of mutual fund returns, in
other words the returns for all funds over very long periods of time. What
you find is, if you give them back all their costs, there are people in the left
tail that look too extreme and there are people in the right tail that look too
extreme, and the right tail and left tail basically offset each other. If you
look at the industry as a whole; the industry basically holds a market
portfolio. That's all before costs. If you look at returns to investors then
there is no evidence that anybody surely has information sufficient to cover
their costs.

10:1

Russ: Which says that for any individual investing, certainly someone like

me, that is, who doesn't spend any time or very much time at all looking-in my case no time, but let's suppose even a little time--trying to look at
what would be a good investment. The implication is to go with index
mutual funds because actively managed funds can't
outperform. Guest: Well, no, it's more subtle than that. What's more subtle
about it is, even if you spent time, you are unlikely to be able to pick the
funds that will be successful because so much of what happens is due to
chance. Russ: So, for me the lesson is: buy index mutual funds because
the transaction costs of those are the smallest, and since very few actively
managed funds can generate returns with any expectation other than
chance to overcome those higher costs, I can make more money with an
index fund. Guest: Right. Now, it's very counterintuitive, because we look
at the whole history of every fund's returns, and sort them, and really the
ones in the right tail are really extreme. Russ: Some great
ones. Guest: They beat their benchmarks by 3-6% a year. Nevertheless,
only 3% of them do about as well as you would expect by chance. Now
what's subtle there is that by chance, with 3000-plus funds, you expect lots
of them to do extremely well over their whole lifetime. So, these are the
people that books get written about. Russ:Because they look
smart. Guest: What this basically says is that there is a pretty good chance
they are just lucky. And they had sustained periods of luck--which you
expect in a big sample of funds. Russ: Of course, they don't see it that
way. Guest: No, of course not. Russ: A friend of mine who is a hedge fund
manager--before I made this call I asked him what he would ask you, and
he said, well, his assessment is that efficient markets explain some tiny
proportion of volatility of stock prices but there's still plenty of opportunity
for a person to make money before markets adjust. And of course in doing

Fama on Finance
so, make that adjustment actually happen and bring markets to
equilibrium. Somebody has to provide the information or act on the
information that is at least public and maybe only semi-public. What's your
reaction to that comment? Guest: That's the standard comment from an
active manager. It's not true. Merton Miller always liked to emphasize that
you could have full adjustment to information without trading. If all the
information were available at very low cost, prices could adjust without any
trading taking place. Just bid-ask prices. So, it's not true that somebody
has to do it. But the issue is--this goes back to a famous paper by
Grossman and Stiglitz--the issue really is what is the cost of the
information? And I have a very simple model in mind. In my mind,
information is available, available at very low cost, then the cost function
gets very steep. Basically goes off to infinity very quickly. Russ: And
therefore? Guest: And therefore prices are very efficient because the
information that's available is costless. Russ: But what's the implication of
that steep incline? That information is not very-- Guest: It doesn't pay to
try to take advantage of additional information. Russ: It's not very
valuable. Guest: No, it's very valuable. If you were able to perfectly predict
the future, of course that would be very valuable. But you can't. It
becomes infinitely costly to do that. Russ: So, your assessment, that you
just gave me of the state of our knowledge of this area, I would say
remains what it's been for some time--that at the individual certainly there
is no return to--prices reflect all publicly available information for practical
purposes for an individual investor. Guest: For an individual investor? Even
for an institutional investor. Russ: Correct. So, what proportion of the
economics and finance areas do you think agree with that? Guest: Finance
has developed quite a lot in the last 50 years that I've been in it. I would
say the people who do asset pricing--portfolio theory, risk and return-those people think markets are pretty efficient. If you go to people in other
areas who are not so familiar with the evidence in asset pricing, well, then
there is more skepticism. I attribute that to the fact that finance, like other
areas of economics, have become more specialized. And people just can't
know all the stuff that's available. Russ: Sure. Guest: There's an incredible
demand for market inefficiency. The whole investment management
business is based on the idea that the market is not efficient. I say to my
students when they take my course: If you really believe what I say and go
out and recruit and tell people you think markets are efficient, you'll never
get a job. Russ: Yes, it's true. And so there's a certain bias, you are
saying, to how people assess the evidence. Guest: There's a bias. The bias
is based, among professional money managers, the bias comes from the
fact that they make more money from portraying themselves as active
managers. Russ: That's true in macroeconomics as well. We'll get to that a
little later in the conversation.

Fama on Finance
16:5

Russ: I was going to ask you about the current crisis. Guest: I have some

unusual views on that, too. Russ: I'd say that the mainstream view--and I
recently saw a survey that said--it was an esteemed panel of economists;
you weren't on it but it was still esteemed, both in finance and out of
finance. And they asked them whether prices reflected information and
there was near unanimity. Some strongly agreed; some just agreed. But
there was also near unanimity that the housing market had been a
bubble.Guest: The nasty b-word. Russ: Yes; and was showing some form
of what we might call irrationality. Guest: Okay, so they had strong
feelings about that, getting mad about the word
bubble. Russ: Why? Guest: Because I think people see bubbles with 20-20
hindsight. The term has lost its meaning. It used to mean something that
had a more or less predictable ending. Now people use it to mean a big
swing in prices, that after the fact is wrong. But all prices changes after the
fact are wrong. Because new information comes out that makes what
people thought two minutes ago wrong two minutes later. Housing bubble-if you think there was a housing bubble, there might have been; if you had
predicted it, that would be fine; but the reality is, all markets did the same
thing at the same time. So you have to really face that fact that if you think
it was a housing bubble, it was a stock price bubble, it was a corporate
bond bubble, it was a commodities bubble. Are economists really willing to
live with a world where there are bubbles in everything at the same
time? Russ: And your explanation then of that phenomenon? Guest: My
explanation is you had a big recession. I think you can explain almost
everything just by saying you had a big recession. A really big
recession. Russ: And why do you think we had a really big
recession? Guest: I've heard some of your podcasts; I'm with you. I don't
think macroeconomists have ever been good at knowing why we have
recessions. We still don't understand the Great Depression. Russ:True.
Although Ben Bernanke would argue, and Milton Friedman would argue and
he did before he passed away, that monetary policy is a huge part of
it. Guest: Let me reflect. I had this discussion with Milton, actually; and
what I pointed out was from your own data, they show that there were
massive free reserves throughout the Great Depression. And my point is:
we can't force people to move demand deposits. Or to make love to
anyone. Russ: Well, you can but it's not very productive. Guest: It's not
very productive. M1 and M2--those things are basically
endogenous. Russ:I have the same feeling. Guest: The only thing that's
sort of exogenous is the monetary base. Russ: What did Milton say to
that? Guest: All I gathered from Milton was: Interesting. Even when you
won you thought you lost. Russ: Yes, I know. I had plenty of those. So, are
you saying that that's analogous to our current situation? Guest: Oh, no.
What I'm saying is that for example people want to blame the recession on
the housing sector crashing and subprime mortgages. But if you are an

Fama on Finance
economist and you are thinking about that, you have to be saying that
there was some misallocation across markets, that margins weren't being
equated across markets. That's pretty hard to accept because people are
acting in all markets, working in all markets. That's a pretty tough one to
follow. Russ:Well, a lot of people swallow it. Here's their version. They say
things like there are these things called animal spirits that you can't
measure, but that doesn't mean they are not real; that people get all
excited about a particular asset class--in this case it was housing. And as
those prices start to rise it becomes rational to speculate that it will
continue to rise. And as that happens--as you would admit, people are
making money along the way--and then they don't. They stop making
money; the prices collapse. And this happens from time to time because of
irrational exuberance; and that's just an aspect of capitalism. That's the
standard counterpoint.Guest: Okay, but it wasn't just housing. That was
my point when we started. The same thing was going on in all asset
markets. Russ: Well, the timing isn't quite identical for all asset markets,
right? The stock market--the housing market starts to collapse I think
around early-mid-2006.Guest: It stops rising, right. Russ: And then begins
a steady decline.Guest: That decline was nothing compared to the stock
market decline.Russ: But when did that happen? Guest: I don't know the
exact timing.Russ: It's not around then. It's later. Guest: The onset of the
recession started with the collapse of the stock market. The recession and
the collapse of the stock market, the corporate bond market, all of that
basically coincides. But that also coincides with the collapse of the
securitized bond market. Russ: Mortgage-backed securities. Guest: The
subprime mortgages and all of that. Russ: Well, yes; that happens through
2007, 2008. I guess there is some parallel. So, you are going to reverse
the causation. Guest: I'm not saying I know. What I'm saying is I can tell
the whole story just based on the recession. And I don't think you can
come up with evidence that contradicts that. But I'm not saying I know I'm
right. I don't know. I'm just saying people read the evidence through a
narrow lens. Russ: Yes, they do. Confirmation bias. Guest: And the
rhetoric acquires a life of its own; so there are books written that basically
all say the same thing about the crisis. Russ: And you are arguing that
they have essentially cherry-picked the data. Guest: Well, they just look at
pieces of the data and the fact that the housing market collapsed is taken
to be the cause; but the housing market could collapse for other reasons.
People don't just decide that prices aren't high any more. They have to look
at supply and demand somewhere in the background. Russ: We did have
people holding second and third homes who didn't have the income and
capability of repaying the first one. Guest: Sure. Standards were relaxed.
But then you have to look on the supply side, the lending side. The people
who were lending to these people had the information. Russ: Yes, they
knew it. I don't think that they were fooled. They were not overly optimistic

Fama on Finance
about the value of those loans. They were willing to do that because they
could sell them. Guest: The puzzle is why they were able to sell them.

24:1

Russ: Correct. Now my claim is the people who bought them did it with

largely borrowed money. Guest: No, that's not true. These were bought by
people all over the world. Russ: Correct. Guest: No one borrowed money.
Remember now: savings has to equal lending. For everyone that's short
bonds, somebody is on the other side. The net amount of leverage in the
world is always zero. Russ: That's true. Guest: So you can't tell a story
based on leverage. Russ: So what's your story? I have to think that
through. It's undeniably true, and I'm not going to argue with that point.
So, what's your explanation of why people bought these
things? Guest:Well, I have no explanation. Again, I'd say the market
crashes because of the big recession. Even a minor depression if you like.
Remember that all the people buying these subprime mortgages all over
the world, they are the ones making the loans in the end, they were
sophisticated investors. Institutions, big banks all over the world. They
thought these things were appropriately priced. They might have been at
that time, but they weren't ex post. Russ: So you are not going to allow
me to make the claim that the incentives they faced to worry about how
appropriately priced were distorted. Guest: The incentives to make money
are always there. The question is whether the market lets you make
money. So, these people that wanted to securitize all these mortgages,
they could have failed at any time in the process; and they would have
failed big time because in order to do these things, you have to initially
finance them yourself. So when the investment bankers were bringing out
the securitized mortgages and other kinds of securitized assets, they
initially held them. And they held them afterwards, too. Russ: They held
many of them. Guest: Well, initially they held them all, because they are
bundling them together; they have to come up with the capital and then
they can sell them. So, they could have failed right at that point because
the market says: Forget it. We're not paying you par value for these
things. Russ: But when they did fail, which they fundamentally did
because, at least for them, even though the world wasn't leveraged, they
were leveraged, they should have gone out of business. Guest: Right,
exactly. Russ: But they did not. Guest: That's awful. That's the worst
consequence of this whole episode. Russ: So, my narrative is the
anticipation of that distorted their decision-making. Guest:Sure, but that
doesn't satisfy what address what goes on on the demand
side. Russ: Why? Guest: Because people on the demand side have to buy
these things. Russ: Well, the people who were buying them, and selling
them, were fundamentally the same people, right? Guest: Okay, so if
greed causes me to put out securities that I know are no good, why would I

Fama on Finance
hold them? Russ: Because I can hold them at a very low cost. I have
uncertainty; I don't know what's going to happen. There's an upside;
there's a downside. Guest: It's really a low cost if you know you are going
to get bailed out. Russ: Right. My argument is it dulls your
senses. Guest:It does; I agree with you there. Any probability that you are
going to be bailed out is going to distort your decision. Russ: So, is your
argument then that that was relatively unimportant? Guest: No, no. My
argument is it can't explain why people who weren't generating these
things and weren't going to be bailed out by us, investors in Norway,
whatever--why were they buying? Russ: Well, I'm happy to admit that
some people just made a mistake. After the fact. Ex ante they certainly
didn't think they were throwing away their money. And a lot of those
people making those investments around the world, we bailed them out,
too. The European banks got some of the benefits. Guest: Yes, because
they were mixed into the same piles that involved our own investment
banks. And so they got bailed out in the process. If they were holding
credit default swaps (CDSs) that were sold by AIG, they got bailed
out. Russ: Although I think Goldman was the number 2 holder of those.
The first was--I can't remember; it was a foreign bank, either French or
German.

29:1

Russ: So, you have publicly said that that was a mistake, those bailouts;

we should have let them fail. Guest: It's irrelevant because there is no
political regime that will let that happen. Russ: Correct. But let's suppose,
let's live in a fantasy world for forty seconds. Suppose on March of 2008,
Ben Bernanke and Hank Paulson and the others who got together to talk
about the impending bankruptcy of Bear Stearns had just let them go. They
would have opened for business Monday morning without enough cash to
cover their positions; they would have had to tell their creditors: Sorry; I
can't honor the promise I made to you the other day or the other money;
and you won't be getting the payment you anticipated. The justification for
the intervention was that if we had let that happen there would have been
an enormous crisis: credit markets would have frozen up and we would
have had a worldwide depression. Guest: I don't know about that last part.
That's what we'll never know. The issue is: How long would it take to
straighten things out? And I think it's really overrated that it would have
taken a large amount of time. So, banks fail all the time, and the FDIC
goes in and draws a line in the sand about who is going to get paid and
who isn't; stuff is put up for sale and everything goes on. I don't know how
long it would take to solve a multiple failure problem. We'll never
know. Russ:Well, the Lehman Brother's bankruptcy is still in process.
Which is now three years old. This was the argument made at the time-like you, I'm skeptical about it but it has some legitimacy--it's that

Fama on Finance
bankruptcy is complicated enough as it is; when it's a large investment
bank with international creditors like Bear, Lehman, it would take a long
time. In the meanwhile everybody would be thrown into turmoil. Blah,
blah, blah. Do you think there's anything to that? Guest: It's possible.
What happened in the Lehman case is it's held up by multiple jurisdictions.
So, you have to settle with the British shareholders. Russ: The Japanese,
Korean. Guest:Who all have their own set of laws about what happens in a
bankruptcy. And that's what I think they've been fighting over for three
years. It's pretty clear what assets [?]. Russ: But isn't that an argument
for justifying what Bernanke and Paulson did? Guest: I don't know.
Because who knows what would have been done if all of them went down.
The problem really is that the investment banks weren't subject to the
same disposition rules that would face an ordinary commercial bank. They
are not subject to the FDIC. And the FDIC can come in and arbitrarily do it.
That's what you buy into when you sign up for it. Whereas for the
investment banks, they are not really banks; and they are not subject to
those rules. The ongoing problem is that you haven't killed their incentive
to finance things the way they always have. Russ: Well, I guess my claim
is that part of the problem is that we gave a regulatory advantage to tripleA rated stuff, which allowed very large and different amounts of leverage
compared to other stuff. That gave an incentive to these folks to find more
triple-A. The amount of triple-A is essentially, until recently, there's just not
enough of it to go around, if that's the most profitable thing you can do,
because that's the thing you can leverage; so they found a way to invent
more of it. And that included not just the things we are talking about, but
European sovereign debt. Hey, that's safe; let's leverage that,
too. Guest: Right.Russ: So, once we said: this is the stuff that you can
make scads of money on because you can leverage it and use other
people's money. Guest: You are slipping back again,
though. Russ: Because? Guest: You are saying that people will buy this
stuff even though it isn't triple-A. Russ: Correct.Guest: Why? Russ: Well,
that's the puzzle. Is it because they were stupid, ex ante? Guest: We are
talking about the world's most sophisticated people who invest. Russ: So is
the alternative argument that people just made a mistake? Guest: After
the fact, definitely. Whether it was a mistake before the fact, that involves
estimating the probabilities of extreme tail events, which, as you know, are
very difficult. Russ: So, where does that leave us? Story-telling, of
course. Guest: Which is very entertaining but it's not convincing. I don't
find it convincing.

34:4

Russ: Before I forget, I was going to ask you--I don't want to miss this

chance to ask you this: Does your research inform your own personal
portfolio decisions? And has it over time? Guest: Oh, sure,

Fama on Finance
always. Russ:Has it changed over time? Guest: Well, I'm not as young as I
used to be.Russ: That's part of the theory, too. Guest: Right. So, my
portfolio has become somewhat more conservative. I'm also a stockholder
in an investment management company, so that part of it is very
unconservative.Russ: That's true. Recently--a related question to what we
were just talking about before that--the government published the
transcripts of the Federal Reserve deliberations in 2006. I don't know if
you've looked at that. Guest: No. Russ: Well, one of the most obvious
things you learn from reading those transcripts--well, first of all, this is 15
really smart people, very savvy. Their job is to try to figure out what could
happen next that could be dangerous. And in 2006, we were on the edge of
a collapse in the housing market. And as you argue, maybe just a general
problem coming that would be unforeseeable. But what was interesting was
that they made the same mistake that I made at the time; and I heard lots
of other people much smarter than I am made the same mistake. They
said: Well, it's true that there could be a housing price fall; it's been going
up for a long time, but the subprimes are essentially only a small part of
the whole housing market; housing is only a small part of the overall
investment market. So, if this does occur, there's not going to be much of a
consequence and we don't have to worry about it. Now, one of the things I
think was mistaken, certainly for me as someone not very well versed in
finance, and I think most economists are not very well versed in finance, is
that we did not understand the role that leverage would play if asset prices
fell by a relatively small amount. Do you think that has been a lesson that
some people have learned from this crisis? And should we learn that
lesson? Guest: Well, leverage will put some people out of
business. Russ:Correct. Guest: So, what's the problem? Russ: Well, the
problem is that if lots of people go out of business at the same time it
allegedly has a multiplier effect--I hate to use that phrase--but that there is
some credit market contagion, systemic risk, etc. Guest: That's a word I
don't think existed 20 years ago. Russ: Which
one? Guest: Systemic. Russ: But let's go back to our mutual friend,
Milton. Certainly Milton would argue that the contraction of the money
supply at the onset of the Great Depression precipitated by bank failures
was something that the Federal Reserve should have paid attention
to. Guest: What could they do? Russ: They should have injected liquidity
into the system. Guest: Well, but if you have massive free reserves, what
is that going to do? Russ: Well, that's a problem. Again, I wish Milton were
here. I'm mystified by monetary policy generally, as anyone who has
listened to these podcasts knows. Guest:Well, I am too. In the podcasts of
this program that I've listened to, I've heard everybody talk about the Fed
controlling the interest rates. That's always escaped me how they can do
that. Russ: Yes, I'm mystified by it myself. Guest: But I'm in finance, so
you've got an excuse. Russ: When I interviewed Milton in 2006 and I

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asked him why there had been a change in public discussion at least of
what the Fed does from changing the money supply to instead
manipulating interest rates, his answer was: Well, that's what they say but
that's not what they do. They like to say they manipulate interest rates
because it makes them feel powerful. All they really do is change the
monetary base. And in fact he said, if you look at M2, that's the thing to
look at. Guest: That's the thing to look at if you want to know what's
happening to business activity. But it's not something you can do anything
about.

39:2

Russ: I'm with you there. While we're on that subject, do you have any

thoughts on why the Fed is paying interest on reserves? Guest: Oh,

absolutely. Because they know that if there is an opportunity cost from
these massive reserves they've injected into the system, we are going to
have a hyperinflation. Russ: So what's the point of injecting the reserves if
you are going to keep them in the system? Guest: Exactly. Russ: So
what's the answer? Guest: The answer is: this is just posturing. What's
actually happened? That debt is now almost fully interest-bearing, all the
liquidity that they've injected. So, they've actually made the problem of
controlling inflation more difficult. Controlling inflation when they didn't pay
any interest focused on the base: cash plus reserves. But now the reserves
are interest-bearing, so they play no role in inflation. It all comes to cash,
to currency. How do you know? Currency and reserves were completely
interchangeable; that's what the Federal Reserve is all about. So I think
they've lost it. Now what happened, they went and bought bonds, longmaturing bonds, and issued short-maturing bonds. It's nothing. They didn't
do anything. Russ: But they are smart people. Guest: Right. Russ: Ben
Bernanke is not a fool. If you could get him alone in a quiet place with
nobody else listening and say: Ben, what were you thinking? What do you
think he'd say? Guest: I don't know, but I wouldn't believe it. In the sense
that at most he could have thought he could twist the yield curve. Lower
the long-term bond rate. Now I'm looking at the long-term bond market-it's wide open. Even though they are doing big things, they are not that big
relative to the size of the market. Russ: Yes, I am mystified by that as
well. I don't have an explanation. Guest: Let me put it differently. So, if I
look at the evolution of interest rates, is it credible that in the early 1980s
the Fed wanted the short term interest rate to be 13-14%? Russ: No. You
are making the argument that it's endogenous; that they can't control
it.Guest: Maybe they can tweak it a bit; they can do a lot with inflationary
expectations. That will affect interest rates. Turn it around--all international
banks think they can control interest rates; and at the same time they
agree that international bond markets are open.
Inconsistent. Russ:Correct. It reminds of this CNN reporter, credible insight

Fama on Finance
into economic policy. He said: Macroeconomics generally--and fiscal policy,
but he could equally as well be talking about Central Bank policy--he said:
Politicians who think they can control the economy are like a little kid who
is playing a video game; he hasn't put the money in yet and he is watching
the arcade game do all its bangs and bells and whistles and noises. Which
is an advertisement for the game. And he's pushing the buttons, and he's
attributing all the successes on the screen to himself even though he hasn't
put the money in yet because he misunderstands the underlying process
that generates what he is seeing on the screen. There is some truth to
that. Guest: There's a lot of truth to it.

42:5

Let's turn to fiscal policy, which you've written some interesting things on

lately. You have been very skeptical, as have a few others. And by the way,
I should add, before we get into this I should just mention: your view that
it's an open question about whether the crisis was averted by these rather
remarkable open interventions by the Fed and the Treasury Department in
the last few years--it's not a mainstream view. Certainly most economists
believe--and I'm with you--but most economists believe that the Fed and
the Treasury and the policy makers did a good thing. Guest: That's not
taking into account the long term costs. Russ: For sure. And that would be
true of most of these interventions. I always find it remarkable that the
auto bailout was a success, quote, "because very few people lost their
jobs." As if that's the only effect we would ever want to look at. Guest: The
long term effects of that are horrendous. Russ: And it's not clear that they
saved very many jobs, either. Clearly they changed the
incentives. Guest:Not just changed the incentives--they changed the
ordering of precedence in contracts. That's something that's really
dangerous. Russ: Yes, they abrogated the rule of law. It's very depressing.
But on this issue of fiscal stimulus, most economists believe it's a good
thing, it works. We are in the minority who suggest that maybe it isn't
effective. And recently you wrote a piece suggesting, I would argue, that
it's never effective--unless it's well-spent. And I would contrast it with the
Keynesian view, which I heard come out of Joe Stiglitz's mouth personally-people can't be what they actually believe--I heard him actually say: It
doesn't matter what you spend the money on; it's all stimulus. You are
very much on the other side. So, explain why. Guest: When he says it
doesn't matter what you spend the money on, I think he thinks there are
multiple choices that would all be good. He doesn't think that if you just
wash it down the sink, that's good. Russ: Oh, no; he said, when pressed
and he was asked: If you ask people to dig ditches and fill them back in,
would that stimulate the economy? And he said: Yes; but it's not as good
as doing something productive. I can't explain it. It's a mystery to
me. Guest: It's a mystery to me, too. Russ: But he's not on the show right

Fama on Finance
now; I wish he were; I'll try to get him down the road. But in your view,
talk about what you think the effect of stimulus is and why you are
skeptical. Guest: This is a case where you can't be sure. If you look at the
empirical evidence, it basically allows you to say anything you want,
because the estimates of the effects of stimulus are subject to so much
uncertainty. So, I think, though, if I interpreted Christina Romer's stuff
properly, or she and her husband's stuff, what it says is that the only thing
that clearly gets a pretty good statistical support is permanent
[?]intervention [?]. And the other stuff is just [?]. I think that's probably-I'm an empiricist in the end, so that's probably, I don't know. I have my
position that I think it's a waste of money, because it will all be wasted.
Eventually, you have to finance it. You have to finance it now, which means
eventually you have to pay back, future generations have to pay back, for
things that are then mostly useless maybe. But the evidence doesn't, like
you say. So it's possible for Stiglitz to say one thing; it's possible for you
and I to say something entirely different. And neither one can point to the
evidence. Russ: I don't view it as a very scientific enterprise. I view it as
essentially ideology being wrapped up in scientism, scientific looking,
statistical estimation. It seems to me there is too much noise. Guest: I
don't agree with what you said when you started; I don't think most
economists do think it works. Maybe I'm in the wrong cocoon. Russ: Yes,
you need to get out more, Gene, I think. Although I'm in a different cocoon
over here on the East Coast; I'm in the only cocoon, I'm at George Mason
University and occasionally I'm at Stanford; so we just happen to talk
about the three places where there is an overwhelming majority that is
skeptical; but outside of those three, I think it's pretty much the other
way.Guest: Well, Bob Barro.Russ: Lonely voice, in that enclave. Guest: I
think with Barro, famous macroeconomist at Harvard, there's a younger
guy.Russ: Alesina. Guest: Council of Economic Advisers. Russ: Oh,
Mankiw.Guest: He's skeptical, but what he says is: Once you get into
politics, you become a Keynesian. The political pressures are enormous. I
think that's right. Russ: It's a terrible view of our intellectual opponents,
though. It's not very nice. We don't like it when they attribute our views to
being friends of business, which I find repugnant. So, it seems
embarrassing to suggest that they hold their views because they like being
powerful. I think there's some truth to it, but it's not very nice. You want to
hold that view?Guest: Hold which view? I don't know. I don't think
economists are different from other people. They all like, have their views,
excepted [accepted?] by everybody else, no matter what their views
are. Russ:We're prone to incentives; there's no doubt about
that. Guest: I've had a tough time for a long time because I believe in
efficient markets. Russ: Get a lot of flack.

Fama on Finance
49:1

Russ: Let's go back to finance for a minute. I will put a link up to your

recent article on stimulus where you make a theoretical argument against

stimulus. Guest: There's no data, right. Russ: And I think basically--it's
interesting how the Chicago school has been pushing this--you are using
what I would call accounting identities. The money has got to come from
somewhere. I expressed it as the resources have to come from
somewhere. Guest: That's the right way to say it, actually. Russ: And so I
don't understand where the free lunch comes from. Guest: There is no free
lunch. Russ: But the counterpoint is that there is a free lunch because
there are all these resources laying around. And then it's a question--Milton
said this also--how much of the stimulus goes towards the unused, socalled-- Guest: But that's the problem of implementation, which is
horrendous. The same problem in regulation: implementation, which is
always the killer. Russ: But let's go back to finance. There's been a big
trend in recent years towards what's called behavioral finance. What's your
assessment of that? Guest: I think the behavioral people are very good at
describing microeconomic behavior--the behavior of individuals--that
doesn't seem quite rational. I think they are very good at that. The jump
from there to markets is much more shaky. Russ: Explain. Guest: There
are two types of behavioral economists. There are guys like my friend and
colleague Richard Thaler, who are solidly based in psychology, reasoned
economics but he's become a psychologist, basically, and he is coming from
the research in psychology. Now there are other finance people who are
basically what I call anomaly chasers. What they are doing is scouring the
data for things that look like market inefficiency, and they classify that as
behavioral finance. But to me it's just data judging [?]. Russ: They don't
tell you about the times they can't find the anomaly. Guest: Exactly. In all
economics research, there is a multiple comparisons problem that never
gets stated. Russ: A multiple what? Guest: The fact that the data have
been used by so many other people and the people using it now use it in so
many different ways that they don't report, that you have no real statistical
basis to evaluate and come to a conclusion. Russ: My view is you should
video your keyboard so we can see your keystrokes and then we can see
what didn't come out. The dishes that didn't come out of the kitchen
because you didn't like the way they tasted. Guest: Right. I've had people
say to me that the people who do this anomaly stuff, when they come and
give a paper and I'll say, when you do this, that, or the other thing, and
they'll say Yes. And I'll say, why don't you report it? And they'll say it
wasn't interesting. Russ: Not publishable, either. Guest: Well, that's the
problem, that there's a counting process [?] and a publication process as
well. You do this, that, and the other thing and I'll say, yes, why don't you
report it? And they say it wasn't interesting. Russ: It wasn't interesting.
Not publishable, either. Guest: Well, that's the problem, there's a
publishing process and a culling process as well. This stuff makes it

Fama on Finance
through.

52:3

Russ: So, we started off this conversation talking about efficient markets,

and we haven't talked about a zillion other things that you've studied that
are important in the field of finance. One question I'd like to hear you talk
about is the issue of a non-specialist. Let's say I'm just a smart, everyday
person and I want to be educated out in the world. What are the lessons
for me that finance has learned that are important? There are obviously of
findings that have stood up, findings that have had to be modified over the
last 50 years that has become more empirical that an educated person
should be able to understand and use? Guest: I'm obviously going to be
biased. I think all of our stuff on efficient markets would qualify. I think
there is a lot of stuff in the corporate area, corporate governance and all of
that, a huge field--that has penetrated to the practical level. The BlackScholes option pricing paper in view is the most important economics paper
of the century. Russ: Why? Guest: Because every academic, every
economist whether he went into finance or not, read that paper. And it
created an industry. In the applied financial domain. What else can claim
that? So, I think we've learned a lot about risk and return. Some of it is
intuitive. But there is a lot of stuff on which stocks are more or less risky. A
lot of stuff on international markets. Now, what should an ordinary,
intelligent person know? That's an interesting question. Let me turn it over.
What should an ordinary, intelligent person know about pricing? Russ:Well,
I have some thoughts on that. You probably do, too. Guest: Yes. It's
difficult. I know lots of very intelligent business people who need some
knowledge of what's going on in finance. But not an awful lot. Because
that's not a big part of their business. Russ: Correct. I would worry about
what people think they know that isn't so and the things they should
know. Guest: That happens to me all the time. I'll be playing golf with
somebody and they ask me what I do, and I tell them I teach finance and
they say, oh my goodness, they don't know anything about finance. And
then they give me a lesson in finance. Russ: What do they usually say?
Guest: They tell me all about their smart investments. Russ: Do you smile
and just take another strike at the ball? Guest: I do. Russ: Do you say
anything back? Guest: No, I don't; but I avoid them in the
future. Russ:One of the fascinating things about our profession--it must be
true for other professions as well--but everybody's an expert. So, your 50
years of empirical, in-the-trenches work is meaningless because that guy
had a good month. Guest: Right. Russ: He doesn't think he has much to
learn from you. Guest: Indeed. He's making a lot of money. Russ: He is,
sure. He's doing great. He knows. I was really thinking more of
practitioners than experts, not of lay-people, so I assume there are some
things we know in finance that may not turn out to be so. Guest: Oh,

Fama on Finance
absolutely. Russ: I guess I'm thinking about macro, which I know a little
bit more about when thinking about the Great Moderation and the comfort
that people had that we had mastered the business cycle; and that turned
out not to be true. So, I assume there are some aspects of finance that
may turn out not to be true. Guest: Oh, absolutely. What I say to my
students is: I'm showing you the stuff that people have done in the last 30
years, but in 20 years, it may all be irrelevant; so the best I can do is to
train you about how to think about these things, so you can absorb stuff
that comes along in the future that may overturn what's there now. That's
what makes this profession fun, I think--the fact that stuff can get
overturned. Russ: Of course, if we only have the illusion of understanding,
or what Hayek called the pretense of knowledge, we could be doing some
dangerous and stupid things under the guise of thinking we are making
progress. Guest: Right. Russ: So, you do have to be careful. Where do
you think in the near future finance is going? Guest: Oh, gee, I don't know.
That's part of the fun of it. You just don't know. I wouldn't have been able
to predict 30 years ago the stuff that evolved during those intervening 30
years. No way. Russ: It's kind of a random walk. Guest: I don't think it
pays to think about it very much. There's so much serendipity in what
happens in research. My best stuff has always been--I didn't start thinking
about writing a great paper. I started thinking about a little problem; it just
kept working in circles into a bigger problem. Or had offshoots that were
related. I've beaten many topics to death, with the consequence I've got a
lot of recognition; what started as a little thing developed into something
much bigger. That's not a predictable process. Lots of little things end up as
nothing. Russ: And?Guest: A student comes to me, a Ph.D. student, and
says: I want to write a great paper. You can't start out to do that. You have
to pick a problem and hope it works out into something that will get you a
job, and hopefully a good one. But if you start saying: I want to come up
with a great topic, you won't come up with anything. Russ: You recently
wrote a very nice essay, "My Life in Finance," that gives an overview of
some of your contributions and some of your thinking along the way and all
those little problems. You started out by talking about your thesis topic,
where you had five ideas and Merton Miller said four of them weren't very
good. Guest: Right. Russ:Did you ever go back to any of those
four? Guest: No, actually. Merton was incredible. He had a great eye for
stuff that would work and wouldn't work. I went to Belgium for two years
to teach, and I came back and showed him the stuff I'd been working on,
and I think he discarded like 8 out of 10 things. He was right on all of
them. Russ: Such is life. Guest: It taught me that nobody can work in a
vacuum. You really need colleagues around you to enrich your work. You
get credit for it in the end, but there are a lot of inputs from other people
that go into it in the meantime.

Fama on Finance