June 20, 2011 - David Buckham CEO of Monocle
In his will Alfred Nobel made provision for exactly five prizes to be awarded annually. These would recognise an outstanding contribution in the fields of physics, chemistry, physiology or medicine, literature, and peace. He had built a substantial fortune, initially through his invention of dynamite in 1866, and then later ownership of Swedish arms manufacturer Bofors. He made provision for the awards after the unpleasant experience of reading his own obituary eight years before his own death (it was in fact his brother who had died). The obituary was entitled “The merchant of death is dead”.
In 1968 the Sveriges Riksbank decided to mark its tercentenary by establishing the “Bank of Sweden Prize in Economics in Memory of Alfred Nobel”. The Riksbank reinforced the prestige of the prize, and even the credibility of economics as a science, by enlisting the Nobel Foundation and the Royal Swedish Academy of Sciences to administer the prize. It would be similar to the Nobel in every respect, except that it would be funded by the Riksbank. Popular science and the media at large regard the prize as equivalent to a Nobel, an outcome which was clearly intentional on the part of the Riksbank. On the whole, economists themselves have done nothing to dispel this notion.
Peter Nobel, great grandnephew of Alfred, has vigorously crusaded against the notion that the prize in economics should be regarded as a ‘real’ Nobel. He has campaigned for the prize to be abolished, or at least the title changed, so that the link to Alfred Nobel is severed. His sentiments are shared by the economist Gunnar Myrdal, the mathematician Nassim Taleb, and the chaos theorist Ralph Abraham, among many others. When the namesake of the prize itself is trying to remove the association of economics with the Nobel, it represents a low point in the prestige of this pseudo-science, which has been extremely heavily criticised over the past few years.
The first memorial prize was awarded to Jan Tinbergen and Ragnar Frisch in 1969 for their work in developing dynamic models to analyse economic processes. Tinbergen is known as the father of econometrics, a field of study which proposes to predict future economic movements. Robert Engle and Clive Granger in 2003 also received a joint prize for their work in econometrics. Practitioners of econometrics themselves are the first to concede, that in spite of econometrics being the de facto honours degree course in economics, it is very rarely able to offer anything more than a variance prediction, as opposed to an actual value prediction.
Perhaps the most recognisable names to have won the prize are Robert Merton and Myron Scholes, who did so for their contribution in developing the Black-Scholes model. Black-Scholes is a closed-form mathematical description of option pricing taught to all finance students. Over the past few years, the theories of financial mathematics haven’t exactly showered themselves in glory. With respect to Black-Scholes, it is widely recognised that the assumption of normality in the first difference distribution is untenable. According to the normal distribution, the probability of a negative four standard deviation event on the S&P 500 daily return, which is a daily return worse than -4.7 percent, is one in a hundred years. In actual fact, this has occurred more than 40 times over the past hundred years.
MBA students everywhere will have learnt the Modigliani-Miller theorem. Franco Modigliani and Merton Miller, who were recognised separately, formulated this theorem of the irrelevance of the capital structure of a firm. Whilst an interesting insight, it has no real value, because the capital structure of a firm is often what brings it to its knees.
Eugene Fama, widely respected within and outside of academia, was a candidate for the 2003 prize, in recognition of his efficient markets hypothesis (EMH). The EMH is premised on the massive assumption that there are no information asymmetries in the market, in other words that markets are informationally efficient. The consequence of this is that it should be impossible to consistently achieve excess returns on a risk-adjusted basis.
The complete lack of an objective basis upon which to assess the merit of the memorial prize is abundantly clear, when one considers that just the previous year (2002) the prize was awarded to Daniel Kahnemann, a psychologist whose work on cognitive biases has completely discredited the EMH. A macroeconomics professor I know was shocked at the time to learn that the prize had been awarded to a lowly psychologist. Shocked.
I wouldn’t like to paint myself in a corner by chorusing the cacophony of shrill voices condemning the economics profession out of hand. There have certainly been powerful thinkers in the discipline whose legacy to us today is a simple, but elegant body of knowledge. However, it is particularly in the areas of financial economics and financial mathematics that theory has been abused.
It is therefore perhaps not surprising that the field of economics is regarded by many as the dynamite responsible for imploding the world’s economy. The question remains, in spite of the ‘Nobel’ efforts of the founder’s nephew Peter, has society achieved any lasting value through these awards? Peter Nobel’s attempt to remove economics from the roll-call of prizes has to be seen as a return to the penance to humanity intended by Alfred Nobel for his invention of dynamite.
David Buckham, CEO of Monocle