Eugene Fama – The business of central banks is like pornography

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This new interview with Eugene Fama  – has been published on the website of Finanz und Wirtschaft, Switzerland’s leading business newspaper. Below are excerpts (re-posted with permission) – The full interview between Finanz und Wirtschaft editor Christoph Gisiger and Herro can be found here ->

But isn’t there a risk that central banks are distorting asset prices with negative interest rates and other unconventional policy tools?

Everyday we read headlines on what the central banks are doing. But their policies don’t have any effect. They are just like treading water. All the central banks are doing is substituting one form of debt with another form of debt. They’re issuing short term debt and using it to buy long term debt. In finance, we tend to think that’s a neutral activity, even though those stimulus programs are huge. So basically, I think it means the business of central banks is like pornography: It’s not the real thing.

But in the past, every time the Federal Reserve launched a new bond buying program the financial markets rallied.

You can’t make a case based on a few individual events. That’s not evidence. Evidence is the accumulation of lots of events.

So what would be a better way to get the economy going?

Everybody wants the world to be a better place and some think that government actions can bring that about. But they don’t take into consideration that government actions can often do more harm than good. My view is that the world is just too regulated. There is regulation of everything these days. For instance, it’s too difficult to start a business. The rate of business formation in the US has gone way down and listed companies have declined by 30%. So with less regulation I think you would see growth come back. Of course, there are situations where you need regulation. Antitrust regulation for example is a good idea because you want competition. But beyond that it gets very difficult.

Then again, history shows that free markets can lead to irrational exuberance and even speculative bubbles.

I don’t think there is any concrete evidence of bubbles. A bubble to me means something that has a predictable ending. But nobody has ever been able to identify any predictability in financial markets. For example, if I take a series of totally random numbers and accumulate them it will generate patterns that look like bubbles. But what we see are just variation in prices. They’re totally unpredictable because I generated the series with random numbers. I think that’s what people see in hindsight. They say: “Oh, there was a bubble”. But there wasn’t anything predictable about it at that time. That’s why I don’t use the word bubble.

Does that mean that markets never make mistakes? How about the staggering high equity valuations  during the dotcom hype?

Efficiency doesn’t mean the market doesn’t make mistakes. It just means they’re unpredictable. Actually, there are lot’s of mistakes but you can only identify them after the fact. The problem is identifying mistakes forward looking since prices can only reflects what’s knowable. They can’t make predictions of what’s unknowable. In the late nineties, people thought the internet was going to create lots of big important profitable companies. Today, we find that the internet really did revolutionize business. So that prediction was right. The problem was that there wasn’t a lot of money to be made because competition was intense and market entry easy. But we did get a couple of big players out of it. It was just that they didn’t come around at that time. Google for example became a huge company eventually. I’m sure the market value of Google now is way bigger than the combined value of all these dotcom companies in 2000. So there was a big winner to come out of the internet, it just wasn’t at that time.

But what about emotions like fear and greed? Aren’t they the ever driving forces of financial markets?

Tastes and behavior are important in economics. Nobody denies that. But the question is: How much of behavior is irrational and how much of the irrational behavior really affects prices? It turns out that’s very difficult to answer. You can talk about these things all you want. But it’s very difficult to find the effects of irrational behavior in the change of stock prices or any asset prices. Also, it’s hard to tell the difference between emotions and attitudes towards risk. As you go trough time, people are more risk averse sometimes and less risk averse in other times. For example, when recessions come along people get more risk averse because times are bad. On the other hand, when times are good people get less risk averse. That seems to be totally rational for me.

Yet, if greed takes over in the financial markets the consequences for the real world can be catastrophic. The best example is the financial crisis of 2008/09. 

It’s typical to tell the story that the financial crisis caused the recession. But I don’t think that’s something you can conclude with any degree of certainty. You can’t tell whether the financial markets caused the recession or it went the other way around. People just didn’t wake up one morning and said: “I’m walking away from my house.” They defaulted on their mortgages because they lost their jobs and that was recession related. That caused the financial crisis because these subprime mortgages were everywhere in the banking system. So I don’t think you can tell me concretely that the financial crisis wasn’t caused by the recession rather than the other way around.

The crash of housing prices in the US was also called a “Black Swan”. How do you explain such a very rare event, that was unthinkable to happen?

I wrote my Ph.D. thesis on that 55 years ago. It was clear then that there are more extreme returns, both positive and negative, than you can explain with a normal distribution of probabilities. Black Swans are just a rediscovering of that. I had lots exposure to Benoit Mandelbrot. He spent his life kind of pushing the idea that there are too many extreme outcomes that you can expect under a normal distribution. So I wrote my thesis on this idea with respect to stock returns. It was the first big study of that kind in the stock market.

See the full article here

Eugene Fama  - The business of central banks is like pornography
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