Shiller Redux

Much of the thinking about the negative value of information on society in general was sparked by Robert Shiller. Not just in financial markets; but overall his 1981 paper may be the first mathematically formulated introspection on the manner in which society in general handles information. Shiller made his mark with his 1981 paper on the volatility of markets, where he determined that if a stock price is the estimated value of “something” (say the discounted cash flows from a corporation), then market prices are way too volatile in relation to tangible manifestations of that “something” (he used dividends as proxy). Prices swing more than the fundamentals they are supposed to reflect, they visibly overreact by being too high at times (when their price overshoots the good news or when they go up without any marked reason) or too low at others. The volatility differential between prices and information meant that something about “rational expectation” did not work. (Prices did not rationally reflect the long-term value of securities and were overshooting in either direction.) Markets had to be wrong. Shiller then pronounced markets to be not as efficient as established by financial theory (efficient markets meant, in a nutshell, that prices should adapt to all available information in such a way as to be totally unpredictable to us humans and prevent people from deriving profits). This conclusion set off calls by the religious orders of high finance for the destruction of the infidel who committed such apostasy.

The principal criticism against Shiller came from Robert C. Merton. The attacks were purely on methodological grounds (Shiller’s analysis was extremely rough; for instance, his using dividends in place of earnings was rather weak). Merton was also defending the official financial theory position that markets needed to be efficient and could not possibly deliver opportunities on a silver plate. Yet the same Robert C. Merton later introduced himself as the “founding partner” of a hedge fund that aimed at taking advantage of market inefficiencies. Setting aside the fact that Merton’s hedge fund blew up rather spectacularly from the black swan problem (with characteristic denial), his “founding” such a hedge fund requires, by implication, that he agrees with Shiller about the inefficiency of the market. The defender of the dogmas of modern finance and efficient markets started a fund that took advantage of market inefficiencies! It is as if the Pope converted to Islam.

Things are not getting any better these days. At the time of writing, news providers are offering all manner of updates, “breaking news” that can be delivered electronically in a wireless manner. The ratio of undistilled information to distilled is rising, saturating markets. The elder’s messages need not be delivered to you as imminent news.

This does not mean that all journalists are fooled by randomness noise providers: There are hordes of thoughtful journalists in the business (I would suggest London’s Anatole Kaletsky and New York’s Jim Grant and Alan Abelson as the underrated representatives of such a class among financial journalists; Gary Stix among scientific journalists); it is just that prominent media journalism is a thoughtless process of providing the noise that can capture people’s attention and there exists no mechanism for separating the two. As a matter of fact, smart journalists are often penalized. Like a lawyer who prioritizes arguments that will sway a jury over the truth (Chapter 11), journalism goes to what can capture our attention, with adequate sound bites. Again, my scholarly friends would wonder why I am getting emotional stating the obvious things about the journalists; the problem with my profession is that we depend on them for what information we need to obtain.