By Kara Odum '15Economics Columnist
Recently, the Nobel Prize for Economics was awarded to Eugene Fama, Lars Hansen, and Robert Shiller. All three are Americans; Fama and Hansen are from the University of Chicago and Shiller from Yale. Their work and research has focused on the pricing of assets such as stock, bonds, and houses. Fama is best known for his research supporting the “efficient markets hypothesis,” which states that markets are good at incorporating all known information about the valuation of an asset. Shiller, on the other hand, is a proponent of applying human psychology to explain pricing from a behavioral economics angle. The award represents the joining of these two opposing theories to better explain market movements. The debate between rational and irrational economic models is a very pertinent debate in the fallout of the 2008 recession and market crash, especially because neither seems to have the answer for everything. I think there is a lot of room for growth in the syndication of these two fields of study, drawing on the strengths of each to better model world markets. For example, in the book “The Big Short” by Michael Lewis, he looks at the causes of the financial crisis in 2008 from both sides of the mortgage backed bonds market. This particular point in economic history is interesting because it deals with many people who were behaving rationally, people who thought they were behaving rationally, and people who were acting completely irrationally. Those who were behaving rationally noticed that the market was behaving outside the norm and that there were as opportunity to make a lot of money by betting against the market. These people were using classic economic and financial techniques to identify trends in the market, such as fundamental analysis, quantitative analysis, and valuation modeling. The people who thought they were behaving rationally but weren’t were the people who created, packaged, and sold the worthless bond packages without really looking at them. They were trying to use quantitative methods but defaulted to emotions when the models weren’t working. A good example of this is the Black Scholes equation, which is used to price assets and quantify risk, because it was used incorrectly. During the period before the crisis, the market was behaving outside the bounds and not following the assumptions so when the equation was applied, it was applied incorrectly. However, the equation has been popular for about 30 to 40 years, so while it may have been rooted in quantitative methods, it still has to be evaluated and not taken on blind faith. Trouble happens when people think they are behaving rationally but are in fact just acting on emotions. This mix of people is why a balance of rational and irrational economics is called for with current economic issues.