Richard Thaler on the EMH and Trust

This is a wide-ranging interview. I focus on just two of the topics covered: the Efficient Market Hypothesis (EMH) and the role of trust in a market economy.

The office of behavioural economist Richard Thaler (born 1945) is close to that of the 2013 Nobel laureate Eugene Fama, widely regarded as father of the EMH. The two Chicago professors are close friends, but Thaler, like Yale economist Robert Shiller (also a 2013 Nobel laureate), is a critic of the EMH. Thaler stresses that the Efficient Markets Hypothesis has two parts: 1) There is no free lunch. 2) The price is always right. Although the first component is broadly true, the second is not, Thaler argues.

Regarding trust, Thaler believes that this is essential for economic growth. Free markets alone will not do the job.

Region: What are your thoughts about the EMH today, given the recent financial crisis?

Thaler: Well, I think it’s very hard to argue that real estate prices in Phoenix, Las Vegas and south Florida were rational at the peak. Now, Gene [Fama] will say, correctly, that neither I nor anyone else was able to say when that bubble would break. (I’m not allowed to use the word “bubble” when I’m with Gene.) ….

So when Gene and I have these arguments, he’ll say the fact that you can’t predict when they will end means you can’t say anything about them. I say, no, that’s not the case. And that’s why I separate these two aspects of the efficient markets argument: Whether you can get rich (the “no-free-lunch” part) and whether the “price is right.”

It’s hard to get rich because even though I thought Scottsdale real estate was overpriced, there was no way to short it. Even if there were a way … you might have gone broke before you were right.  ….

But, … most active managers underperform the market. So, I think Gene and I would give similar advice to people, which would be to buy index funds. ….

I think it’s hard to beat the market. Nobody thinks it’s easy, and so that part of the hypothesis is truer, but if we look at what happened to Nasdaq in 2000 [when it fell from 5,000 to 1,400], and then the recent crash [from 2,800 to 1,300 in 2009], well, of course, we’ve never gotten back to 5,000. So it’s very hard to accept that markets always get prices right. ….

Region: One thing we haven’t talked about yet is your work on reciprocity and cooperation. ….

Thaler: ….  It’s very fortunate that we don’t live in a society where everybody is out to take advantage of us. For instance, if you have work done in your house or on your car, there’s absolutely no way for you to monitor what they’re doing, unless you’re willing to spend the time watching them and you happen to know a lot about the work, materials and methods being used.

So it has to involve trust. Trust is really important in society, and anything we can do to increase trust is worthwhile. There’s probably nothing you could do to help an economy grow faster than to increase the amount of trust in society.

Douglas Clement, “Interview with Richard Thaler“, The Region (Federal Reserve Bank of Minneapolis), September 2013.

There is much more in the full interview, including a discussion of Nudge: Improving Decisions about Health, Wealth and Happiness (Yale University Press, 2008), a best-selling book that Thaler wrote with US legal scholar Cass R. Sunstein (born 1954).

Douglas Clement, editor of The Region, interviewed Professor Thaler on 17 July 2013, before the 2013 Nobel laureates in economics were announced.

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