The three most recent Nobel Laureates may be famous for their work in understanding finance markets but they have fundamentally affected the way people think about housing markets.
Eugene Fama is most famous for his work showing that finance markets are “information efficient” in the sense that it is really hard for an individual to know more than the collective intelligence of the market. (It is still possible to earn excess profits using insider trading but that is illegal.)
Robert Shiller’s work notes that, even if a stock price can be right on average, crowds can be wrong for depressingly long periods of time. He may be best known outside the academic community for the Case- Shiller house price indices whose practical importance is noted below.
Lars Peter Hansen’s work is useful and intimidates many.
Often, people think that the Nobel Laureates do not deserve their awards because the “Great Discovery” is obvious or obviously wrong. (See the comments on the NYT’s article.) Their ideas were not obvious at the time that the research was being conducted. I wish to focus on how their research led to practical innovations.
For example, Fama’s work on efficient markets implies that, at best, it is a waste of time for most investors to try to beat the market. Luck (e.g. having small children pick stocks or a friend’s “hot tip”) may reveal a stock which beats the market with some probability. Especially in financial markets, it is easy to say that the current price is wrong. When competing against everybody else, even a little bit of carelessness in the financial analysis can be very costly: there are two sides to the market and lots of people on the other side of the market willing to sell you the rope to hang yourself. Fama’s research opened the door to the success of passive “index funds” and helps to understand why REITs create value for investors.
Shiller’s practical implication started from the idea that the efficient markets theory requires complete markets (i.e. that people can buy or sell any asset at the market price). Some important markets were missing. Most famously, people are scared by the huge investment risk when buying their first house. So, why not create a market in which homeowners could sell (at a price) this risk or in which, if house prices are obviously too high, an investor could profit from the stupidity of others?
The US has the Case- Shiller House Price Indices and markets in which some Americans buy or sell contracts. Canada has a house price index constructed in the same way but Canadian cannot trade it. Without such markets, price bubbles tend to crash suddenly as opposed to deflating slowly: even if 99 percent of people know that the price will fall (sometime soon), price trends continue because there are few ways to profit from this knowledge. The few that are available are rarely mentioned by people who claim that the Canadian property market is in a bubble: in other words, commentators are not willing to put their money where their mouths are.
Congratulations to this year’s Nobel Prize Laureates. Their ideas have changed the world.