[ print ]

Father of Behavioral Economics; Director, Center for Decision Research, University of Chicago Graduate School of Business; Co-Author, Nudge
[Questioning the Question:] Don't Give Wrong Theories Funerals. Just Stop Treating Them as True.

I have a problem with this question, so I will answer a somewhat different one. I suppose the intent of the question is to point to some ideas have been definitively shown to be either wrong or unhelpful, and so should be dropped from our scientific lexicon. In economics there are certainly many theories, hypotheses and models that are badly flawed descriptions of the behavior of economic agents, so one might think that I would have many nominations for ideas that should be given funerals. But I don't. That is because most of these theories, while demonstrably poor descriptions of reality, are extremely useful as theoretical baselines. As such, it would be a mistake to declare these theories dead.

Before getting to a couple specific examples, it is important to stress that in economics theories usually serve dual purposes. The first purpose is "normative" in the sense that it defines what a rational agent should do. The second purpose of the theory is "descriptive"; that is, it is meant to be an accurate description of how firms actually behave. Economists use the same theory for both purposes, and this leads to problems.

For example, consider the efficient market hypothesis (EMH) first elaborated by my colleague Eugene Fama of the University of Chicago, who recently won the Nobel Prize in economics. The theory has two components. The first is that prices are unpredictable and that you can't beat the market. I call this the No Free Lunch part of the EMH. The second is that asset prices are equal to fundamental value. I call this the Price is Right component. Ever since the EMH was formulated it has been used as a baseline, null hypothesis in financial economics research. In a world consisting of just rational investors both components of the theory would be descriptively accurate, but of course we do not live in such a world. How does the theory stand up in the real world?

If I were fact checking the No Free Lunch part of the theory I would score it "mostly true". It is hard to beat the market, and most people who try fail, including professionally managed mutual funds. It is just "mostly true" because it does seem possible to beat the market, for example by buying "value stocks" whose prices seem low relative to earnings or assets. Still, a strategy of buying cheap index funds that track the market is a sensible one for investors to follow, so believing this part of the theory does little damage.

The other component of the theory, The Price is Right, is both more important and more problematic. Two recent experiences, the tech stock bubble in the late 1990s and the real estate bubble in the early 2000s reveal that prices can diverge to a significant degree from their intrinsic value. The late financial economist Fischer Black, co-inventor of the famous Black-Scholes option pricing formula, once conjectured that asset prices can diverge from their true values by a factor of two. Fischer, who died in 1996, might have revised that estimate to a factor of three had he lived to see the NASDAQ fall from 5000 to 1400 when the tech bubble burst. More than a decade later the NASDAQ is only now reaching the level of 4000 with no adjustment for inflation.

With the two components of the EMH graded partly wrong and badly wrong should we abandon the theory? Hardly. None of the research done by behavioral finance researchers, including my fellow traveller Robert Shiller who shared the Nobel Prize with Fama this year along with Lars Hansen, would have been possible without the EMH benchmark. Shiller's early research showed that prices were too variable, compared to what would be expected in a rational model.

So, if we should not banish the EMH, what should change? The change I would advocate is abolishing the presumption that it is true. Part of Alan Greenspan's reasoning for the Fed not taking any action after hearing a talk from Shiller in 1996 warning of an overheated market was that bubbles were impossible in an efficient market. Even the Supreme Court, in the 1988 case Basic vs. Levinson, ruled that plaintiffs could rely on the efficient market hypothesis in bringing cases alleging misconduct by firms.

The problem here is that users of this concept are neglecting the last word in the phrase "efficient market hypothesis." The same mistake is made in the use of another theory that contributed to a Nobel Prize, Franco Modigliani's life cycle hypothesis. Here the hypothesis is that people figure out how much they are going to make over the course of their lifetime, how much they will earn on their investments, how long they will live, and then solve for the optimal amount to save each year while they are accumulating money, and similarly how to draw down their assets once they retire. Once again this is a useful benchmark, and can be helpful in offering advice to people regarding how much they should be saving for retirement.

It would be a mistake to discard this theory, but it would be a much bigger mistake to presume that it is true. The hypothesis counterfactually assumes that people are capable of solving a very difficult mathematical problem, and are also able to implement such a plan without falling victim to spending temptations along the way. Presuming the theory to be true induced many economists to confidently but wrongly predict that offering people retirement savings plans such as 401(k)s would have no effect on savings since people were already saving the right amount, and would merely shift their saving into the new tax favored plans, costing the government money but producing no new saving. A similar presumption makes the false prediction that small changes such as automatically enrolling participants will have no effect on behavior.

Let's keep these and many other wrong theories and hypotheses alive, but remember they are just hypotheses, not facts.