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F.A.Z.-Column by Emanuel Derman : Is Economics a Science?

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Die Gewinner des Wirtschaftsnobelpreises 2013: Eugene Fama und Lars Peter Hansen Bild: AP

Is Economics a Science? Certainly it is. But it has less to do with Natural Science than with Philosophy and Social Sciences. Protoscience would be a good term.

          5 Min.

          The Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel for 2013 was awarded to Eugene Fama, Robert Shiller, and Lars Hansen “for their empirical analysis of asset prices.” To understand their contributions, I recently reread some of their papers.
          Fama, a professor of finance (a subfield of economics) is famous for proposing the Efficient Market Hypothesis (EMH) in the 1960s. The EMH proclaims that it is impossible to predict whether a stock price will go up or down in the next instant. Fama’s 1965 publication on the topic was a careful examination of historical data and an analysis of what it takes to claim that stock prices are unpredictable. Stock prices, he argued, move such that “the future path of the price level of a security is no more predictable than the path of a series of cumulated random numbers,” that is a so-called random walk. The EMH was a kind of cunning jiu-jitsu response on the part of economists to turn weakness into strength:  I have no success at prediction, so I’ll make that a principle.”

          There is little doubt that it is incredibly hard to predict whether a stock price will go up or down from moment to moment, and so in that sense, markets do efficiently destroy your short-term ability to forecast them. You could compare Fama’s hypothesis to the Theory of Evolution by Natural Selection, since it’s a statement of principle. Or you could compare it to Kepler’s laws of planetary motion, since it’s an attempt to discover patterns of motion. These would be comparisons too flattering, since experiments like Mendel’s on breeding as well as the discovery of the role of DNA as genetic material provide broad sorts of confirmation and mechanisms, and Kepler’s precise mathematical description of planetary orbits have been observed to hold far more rigorously than any of Fama’s regularities.

          Shiller, Fama’s co-winner, is a professor of Economics who also specializes in finance. His contribution was to poke an empirical  hole in Fama’s EMH about fifteen years after it was formulated.  For Fama, efficient meant guaranteeing the unpredictability of stock price movements. Shiller’s 1980s publications showed that markets are inefficient in a different sense. He demonstrated that, though stock prices may fluctuate unpredictably, they fluctuate up or down much more dramatically than the future dividends they ultimately pay to the owner of the stock. That is strange, because, in a rational world, it is precisely the future dividends that are the reward for buying the stock. You could say that stock prices are prima donnas, while dividends, to mix metaphors, are merely corps de ballet. Stock prices are bipolar compared to dividends, and when they are too high they are observed to eventually come down, and when they are too low they are observed to eventually rise. There is little doubt that Shiller noticed a correct pattern too.

          Some commentators have compared Fama and Shiller to Newton and Einstein but that isn’t justified. Newton’s laws of motion and gravitation actually explained Kepler’s patterns, and Einstein later refined Newton’s notions of time, space, motion and gravitation to work even better, with consequences like nuclear bombs and iPhones that depend on them being correct.  In contrast, no one in finance, not even Fama and Shiller, has yet produced any model that successfully provides a genuine explanation of the behavior of stock price movements. None of this is meant to denigrate the accomplishments of Fama and Shiller. It is simply a fact that finance is much much harder than physics.

          Some other commentators have mocked this Nobel prize because it seems to honor two conflicting descriptions, and have argued that since this could not happen in the natural sciences, it proves that economics is not a science. But this isn’t true. Fama and Shiller are attempting to describe the empirical behavior of markets, and both of them can have discovered very approximate regularities.

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