Lars Peter Hansen understands why he is being asked, but he isn’t comfortable with the question. “Are financial markets efficient or irrational?” repeats Professor Hansen, a University of Chicago economist. “I don’t really know how to answer that.”
Yet since being named last month as one of three recipients of the Nobel Memorial Prize in Economic Science, he has been saddled with this question repeatedly.
It’s an odd one for him because he has spent decades working with complex mathematical models of financial markets and the overall economy, and he isn’t sure that it is important to label the behavior he is modeling rational or irrational.
But he shares the Nobel with Eugene F. Fama, a fellow economist at Chicago, and with Robert J. Shiller, an economist at Yale, and their dispute over this terminology has commanded attention.
He puts the matter positively: “A common theme in our work is that we’ve all characterized the puzzling implications that emerge from financial market data. But we take different approaches.”
That’s an understatement. In fact, the other two laureates don’t see eye to eye on some basic issues and have engaged in an unusual public debate — recently, in interviews and in a column in these pages.
Professor Shiller, a frequent contributor to Sunday Business, stresses the irreducibly human, irrational elements found in asset bubbles and busts. Professor Fama, known as the father of the “efficient markets hypothesis,” says market behavior can be explained quite well without any need to call it irrational.
Professor Hansen, 61, doesn’t want to become embroiled in this. “Shiller and Fama can speak for themselves,” he says.
But in a long telephone conversation this month, he was happy to speak about his own, rather different perspective. It was formed, in part, at the University of Minnesota in the 1970s with the help of two economists there. They were Thomas J. Sargent, now at New York University, and Christopher A. Sims, now at Princeton — the recipients of the Nobel two years ago.
The committee that awarded the Nobel to Professors Sargent and Sims also cited Professor Hansen’s contributions, and he continues to collaborate with Professor Sargent. In a symposium on the current prizes held this month at the University of Chicago, James J. Heckman, also a Nobel laureate, said that this year’s Nobel was, in a sense, “Lars’s second Nobel prize.”
The Nobel committee recognized Professor Hansen this year for developing a statistical technique, the generalized method of moments. He described it as “a method that allows you to do something without having to do everything.” For example, it’s still impossible to come up with a complete and entirely coherent model of either the overall economy or financial markets, to say nothing of combining the two. But his methods help make it possible to study some of the elements and connections in a statistically valid way. “The idea is to make progress,” he said, “even if you can’t do it all now.” And his approach is in wide use in other areas of social science.
Earlier in his career, along with Professor Sims and especially with Professor Sargent, he provided some of the mathematical underpinnings for what is known as the rational expectations theory — the notion that people use all available information in making economic decisions. It suggests that people may not “be fooled by policy makers” into making decisions against their own self-interest, he said — for example, by spending all the proceeds of a one-time tax cut if they understand that the windfall is only temporary.
With Professor Sargent, Professor Hansen says, he later “pushed back” on that theory “because it implied way too much precision on the part of individuals that we just didn’t think was very plausible.”
The science of economic model-building is very much a work in progress, he said. “The thing to remember about models is they’re always approximations and they will always turn out to be wrong,” he said. That shouldn’t be a surprise, he said, and it doesn’t mean that the models are useless. “You need to ask, are the models wrong in ways that are central to the questions you want to ask, or are they wrong in ways that aren’t so central?” The important thing is to make them better and to come up with interesting answers, he said.
He returns to the Shiller-Fama controversy, and suggests that he can see both sides of it. Collectively, the Nobel committee said, all three men have made major contributions to our understanding of asset pricing. And while he has generally worked with models of economic behavior containing “rational agents who are struggling to cope with uncertainty,” he said, human behavior in financial markets can certainly be called irrational.
But, he cautioned: “If you simply announce that things are irrational, then that alone doesn’t get you very far. You have to replace rational agents with some concrete notion of what it means to be irrational.” You need to test that notion in a formal, mathematical model, he said. Some of his students have been working at this. “As long as they’re doing this in formal and rigorous ways, I’m all in favor of it.”
In his own recent research, he has used econometrics to try to understand a crucial subject for this era: the precise linkages and interactions between financial markets and the overall economy. “There are enormous gaps in our knowledge,” he said.
Prevailing economic models do not adequately explain the financial crisis, the severe recession or the weak global recovery, he said.“Systemic risk” is a buzzword for politicians and financial regulators, he said, but “the truth is, we really don’t know how to measure it or what exactly it is.”
This issue is critical, he said, because financial regulators are having to improvise solutions to dilemmas they don’t entirely understand.