Finance

How Do We Know What We Know? Three Nobel-Winning Approaches

The Royal Swedish Academy of Sciences announces the winners of the 2013 Nobel Memorial Prize in Economic Sciences in Stockholm Monday. The prize went to U.S. professors Eugene Fama, Lars Peter Hansen and Robert Shiller.

hide captionThe Royal Swedish Academy of Sciences announces the winners of the 2013 Nobel Memorial Prize in Economic Sciences in Stockholm Monday. The prize went to U.S. professors Eugene Fama, Lars Peter Hansen and Robert Shiller.

Claudio Bresciani/AP

Eugene Fama, Lars Peter Hansen, and Robert Shiller were awarded the Nobel Prize in economics today for their efforts to answer to a key question: How do the prices of assets like stocks and real estate behave over time?

They came to rather different answers to that question. The markets are rational and efficient, Fama has argued; not so much, has been Shiller's reply. This difference has been widely discussed today.

But it's also worth pointing out how differently these three economists study the world, which points to a much bigger question: How do we know what we know in economics, or indeed in any social science? The three winners of today's Nobel Prize in economics differ not only in their conclusions, but also in their ways of knowing.

Fama is an empiricist, and studies the world of asset prices from his computer screen. For nearly 50 years he has been examining price movements, minute by minute year by year. Perusing the 105 research papers on Fama's CV makes clear his way of knowing: Millions of "observations" that is, price data points — examined with exactitude. From these millions of data points – consistently observed — Fama has discerned what is. In this way of knowing, one need not venture out. The beauty of staying inside is the consistency of the weather: it is possible, in empirical testing, to control for much of the messiness outside. A "clean" empirical test a good one.

Shiller, on the other hand, is nothing if not out. Though his early methods were similar to Fama's, Shiller's recent work begins with the premise that the world cannot be understood through data points alone. His work pioneered the use of psychology in understanding market behavior, inviting the messiness of the human mind into the conversation. While Fama watched price behavior, Shiller watched human behavior, and then developed ideas about the mechanisms by which one influenced the other.

Hansen is a scientist's scientist, the quantitative heavyweight of the three. Unlike Fama or Shiller, he has no position to defend. Instead he has made his mark designing ways to statistically ask and answer questions about how prices behave. His contribution is in accurate and creative measurement. Advances in measurement advance our ability to incorporate the messiness of the world into clean empirical tests, in fact, to bring Shiller and Fama into one another's orbit.

How do we know what we know? We examine data, we study people, and then we measure everything as best we can. We need all three.

Pietra Rivoli is Professor at the McDonough School of Business at Georgetown University.

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