By Toni Shears
Photo by Robert Kozloff
“ This is model science. It is work that doesn’t dismiss economics, it extends it. It confronts data, doesn’t avoid it. ”
—Prof. James Heckman
Nobel laureate, speaking about the work of Prof. Lars Peter Hansen
What happens when not one but two faculty members win a Nobel? At the University of Chicago, the campus-wide celebration on Nov. 4 had a distinct Chicago style, with thoughtful praise and even debate of the prize-winning ideas.
“The Work Behind the Prize” gathered the campus community to applaud the latest laureates, Eugene Fama and Lars Peter Hansen, recipients of the 2013 Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel. As President Robert J. Zimmer told the crowd of more than 400 gathered at the Logan Center, it was a fitting to celebrate by examining the laureates’ accomplishments and the decades of work that led up to the prize.
“Don’t you love the University of Chicago?” asked University of Chicago Booth School of Business Professor John Cochrane. “We spend our entire professional lives with these guys, so what are we going to do? Funny stories, anecdotes, ‘How do you feel?’ Nope, let's talk about the research.” Cochrane and three more of Fama’s and Hansen’s close colleagues did exactly that.
The participants included John Heaton, the Joseph L. Gidwitz Professor of Finance and deputy dean for faculty at Chicago Booth; James Heckman, the Henry Schultz Distinguished Service Professor of Economics and winner of the 2000 Nobel in Economic Sciences; and Tobias Moskowitz, the Fama Family Professor of Finance at Chicago Booth. Gary S. Becker, University Professor of Economics and Sociology and recipient of the 1992 Nobel in Economic Sciences, moderated the session.
They were there to honor Fama, the Robert R. McCormick Distinguished Service Professor at Chicago Booth, and Hansen, the David Rockefeller Distinguished Service Professor in Economics, Statistics, and the College, and research director of the Becker Friedman Institute for Research in Economics. Fama and Hansen took the stage near the end of the event to respond to the panelists’ points.
Strengthening the scientific method in economics
Heckman kicked off the conversation: “Lars Hansen is a model economic scientist. His work embodies this vision of econometrics as the unification of theory, and data and statistics,” Heckman said. “He applies and adopts the scientific method to learn from data, to understand the world, and make it a better place.”
Hansen’s work tackles a fundamental problem: In a changing world, how can we predict the future, make plans, or devise effective policies? Heckman placed Hansen in a line of pioneering Chicago economists who have struggled to understand economic dynamics and incorporate uncertainty into economic models. “Their motto is Lars’s motto: 'Science is measurement,'” Heckman said.
Hansen’s key contribution was finding statistical methods to simplify complex economic models. His approach, called Hansen’s Generalized Method of Moments (GMM) concludes that the discrepancy between predicted and actual values must be uncorrelated to any data observed by the decision-making agent at the investment date.
Part of the method’s power is its ability to isolate well-defined problems in economics—as Hansen has put it: “You can study something without having to study everything.” That's a fundamental contribution in a field with so many unknowns.
“Lars took this…as a way to understand observed phenomenon, and applied it with profound results,” Heckman noted.
With coauthor Thomas J. Sargent, Hansen worked out the new econometrics of rational expectations models pioneered in part by Robert Lucas Jr., who won the 1995 Nobel Prize for that work.
“His final contribution was relaxing rational expectations,” Heckman said. Recognizing that many people don’t fully understand the world around them when making economic choices, Hansen worked to incorporate that uncertainty more effectively into economic models.
“This is model science,” Heckman said. “It is work that doesn’t dismiss economics, it extends it. It confronts data, doesn’t avoid it.”
The business of calculating risk
Heaton, PhD’89, has co-authored papers with Hansen and said he still considers himself a student of Hansen’s.
Heaton took the audience on a tour of Hansen’s work with a few simple graphs. In a series of papers with Kenneth Singleton, Hansen examined the links between aggregate consumption and risk in financial market movements. When the stock market dips, as in the recent financial crisis, consumption wobbles, Hansen and Singleton showed. The relationship between consumption and stock prices at any given time is a measure of risk.
“Investors looking at these two data series are asking, ‘Should I be in the market, given that risk,’” Heaton said.
“What’s missing is the risk preference parameter—how risk-averse people are,” Heaton said. “What Hansen and Singleton showed us is that without having to understand the whole dynamics, given that [data] series we can identify that parameter, using historical moments.”
Heaton said Hansen’s work has important implications for macroeconomists, particularly those at the Fed, who are trying to build complex economic models incorporating many dynamic factors.
The key hallmark of Hansen’s work is a level of seriousness and modesty, rooted in his deep understanding of implications that can be drawn from the data, Heaton concluded. “His analysis says that measurements of these linkages and risk are difficult, not just for individuals but for economists as well.”
Continuing the theme of simplicity, Cochrane explained Fama’s most famous contribution in a nutshell: “In 1970, Gene defined markets to be informationally efficient—that prices at any given moment reflect all information about future.”
“It’s not a complex theory. Think Darwin, not Einstein. It simply says what prices in competitive market should look like. They should not be predictable,” explained Cochrane, the AQR Capital Management Distinguished Service Professor of Finance.
But the efficient markets hypothesis has subtle and surprising implication. One is that trading rules, technical systems, market newsletters—all the methods deployed to beat the market—have essentially no power, beyond luck, to forecast stock prices. “That’s not a theory, an axiom, not a philosophy, or a religion. It's an empirical observation that easily could have come out the other way—and sometimes it does,” Cochrane said.
In recent periods, people rationally should have responded to low stock prices after a sharp market decline, but didn’t buy because they felt the market was too risky. “Efficiency still there, but the facts require huge revision of our world view,” Cochrane said. He pointed out that Fama's work has continued to exert a transformative influence on the study and practice of finance. "Not many people were central to both the first and second revolutions in their fields," Cochrane said. "Gene was.”
Why asset prices matter
The final speaker, Tobias Moskowitz, touched briefly on how Fama’s work improved upon the capital asset pricing model (CAPM). With the Fama-French model, he added two additional factors that produced expected return estimates that aligned more closely with actual returns.
“With all this work trying to explain asset price movements, why do we care?” asked Moskowitz, the Fama Family Professor of Finance at Chicago Booth.
“We need to know how prices are set because they determine resource allocation,” Moskowitz said. “They determine the cost of capital, because different risks face different prices when borrowing. We can also use these models to evaluate money managers.”
Moskowitz noted that the idea of market efficiency has spawned the whole index fund industry, leading to a huge savings on management fees for investors.
The efficient markets hypothesis led to event studies—analysis of how asset prices behaved leading up to a major announcement such as a merger, and how quickly information is incorporated into the price. This has been an area of success for academics and finance practitioners.
“Asset pricing research helps [us] understand what risks people care about and how are they priced. That has been a theme in Lars’s work and Gene's as well,” he concluded.
Chicago Booth Dean Sunil Kumar wrapped up the event by thanking panelists “and the winners for winning the prize.” Kumar said that since he came to UChicago, he has wondered what happens when someone wins a Nobel Prize here.
“Now I know,” he said. “We launch an inquiry.”
Originally published on November 6, 2013.