«The business of central banks is like pornography»

Eugene Fama, professor of finance and Nobel laureate thinks that negative interest rates won’t help to bring back growth and warns that big banks are still posing a high risk to the financial system.

Christoph Gisiger

From Europe to Japan central bankers are taking more and more extreme measures to stimulate growth. However, their actions don’t have any impact on the real economy, says Eugene Fama. Often referred to as the “Father of Modern Finance”, the Nobel laureate developed the efficient market hypothesis. He explains why stock market crashes aren’t that unusual and calls for less regulation, especially when it comes to the founding of new businesses. The professor at the renowned Chicago Booth School of Business also thinks that in twenty years the whole western world is going to be screaming for immigrants.

Professor Fama, negative interest rates are turning the credit process upside down. What’s their impact on the efficiency of financial markets?

Interest rates have been low for a long time now and it doesn’t look like they’re going up soon. But that’s the way the market is these days. The world is very risk averse and everybody wants these short term riskless securities. So if you want low risk you have to pay for it instead of getting paid. That’s why you get negative yields. The efficient market hypothesis doesn’t say anything about what interest rates should look like. It just says that prices reflect all available information.

But isn’t there a risk that central banks are distorting asset prices with negative interest rates and other unconventional policy tools?

Everyday we read headlines on what the central banks are doing. But their policies don’t have any effect. They are just like treading water. All the central banks are doing is substituting one form of debt with another form of debt. They’re issuing short term debt and using it to buy long term debt. In finance, we tend to think that’s a neutral activity, even though those stimulus programs are huge. So basically, I think it means the business of central banks is like pornography: It’s not the real thing.

But in the past, every time the Federal Reserve launched a new bond buying program the financial markets rallied.

You can’t make a case based on a few individual events. That’s not evidence. Evidence is the accumulation of lots of events.

So what would be a better way to get the economy going?

Everybody wants the world to be a better place and some think that government actions can bring that about. But they don’t take into consideration that government actions can often do more harm than good. My view is that the world is just too regulated. There is regulation of everything these days. For instance, it’s too difficult to start a business. The rate of business formation in the US has gone way down and listed companies have declined by 30%. So with less regulation I think you would see growth come back. Of course, there are situations where you need regulation. Antitrust regulation for example is a good idea because you want competition. But beyond that it gets very difficult.

Then again, history shows that free markets can lead to irrational exuberance and even speculative bubbles.

I don’t think there is any concrete evidence of bubbles. A bubble to me means something that has a predictable ending. But nobody has ever been able to identify any predictability in financial markets. For example, if I take a series of totally random numbers and accumulate them it will generate patterns that look like bubbles. But what we see are just variation in prices. They’re totally unpredictable because I generated the series with random numbers. I think that’s what people see in hindsight. They say: “Oh, there was a bubble”. But there wasn’t anything predictable about it at that time. That’s why I don’t use the word bubble.

Does that mean that markets never make mistakes? How about the staggering high equity valuations  during the dotcom hype?

Efficiency doesn’t mean the market doesn’t make mistakes. It just means they’re unpredictable. Actually, there are lot’s of mistakes but you can only identify them after the fact. The problem is identifying mistakes forward looking since prices can only reflects what’s knowable. They can’t make predictions of what’s unknowable. In the late nineties, people thought the internet was going to create lots of big important profitable companies. Today, we find that the internet really did revolutionize business. So that prediction was right. The problem was that there wasn’t a lot of money to be made because competition was intense and market entry easy. But we did get a couple of big players out of it. It was just that they didn’t come around at that time. Google for example became a huge company eventually. I’m sure the market value of Google now is way bigger than the combined value of all these dotcom companies in 2000. So there was a big winner to come out of the internet, it just wasn’t at that time.

But what about emotions like fear and greed? Aren’t they the ever driving forces of financial markets?

Tastes and behavior are important in economics. Nobody denies that. But the question is: How much of behavior is irrational and how much of the irrational behavior really affects prices? It turns out that’s very difficult to answer. You can talk about these things all you want. But it’s very difficult to find the effects of irrational behavior in the change of stock prices or any asset prices. Also, it’s hard to tell the difference between emotions and attitudes towards risk. As you go trough time, people are more risk averse sometimes and less risk averse in other times. For example, when recessions come along people get more risk averse because times are bad. On the other hand, when times are good people get less risk averse. That seems to be totally rational for me.

Yet, if greed takes over in the financial markets the consequences for the real world can be catastrophic. The best example is the financial crisis of 2008/09. 

It’s typical to tell the story that the financial crisis caused the recession. But I don’t think that’s something you can conclude with any degree of certainty. You can’t tell whether the financial markets caused the recession or it went the other way around. People just didn’t wake up one morning and said: “I’m walking away from my house.” They defaulted on their mortgages because they lost their jobs and that was recession related. That caused the financial crisis because these subprime mortgages were everywhere in the banking system. So I don’t think you can tell me concretely that the financial crisis wasn’t caused by the recession rather than the other way around.

The crash of housing prices in the US was also called a “Black Swan”. How do you explain such a very rare event, that was unthinkable to happen?

I wrote my Ph.D. thesis on that 55 years ago. It was clear then that there are more extreme returns, both positive and negative, than you can explain with a normal distribution of probabilities. Black Swans are just a rediscovering of that. I had lots exposure to Benoit Mandelbrot. He spent his life kind of pushing the idea that there are too many extreme outcomes that you can expect under a normal distribution. So I wrote my thesis on this idea with respect to stock returns. It was the first big study of that kind in the stock market.

What does that mean for investors?

The stock market crash during the financial crisis wasn’t that unusual. In the thirties it got much worse and after that it has happened a couple of times. With a normal distribution of probabilities that’s way too many times. It should never happen. And we have seen extreme positive price movements too. You get them both ways but it’s just that over longer periods of time they are less important because those things tend to even out more.

Your research plays also an important role with respect to the investment firm Dimensional Fund Advisors, which focuses on passive investment strategies. Why should passive strategies provide investors with a better chance of returns than an active equity selection?

If prices reflect all available information it implies about investing that it is very difficult to beat the market. All the evidence of studying investment performance say that’s definitely true. The industry that has been studied most detailed is mutual funds. What you find is that when you try to identify those funds that have done well versus those which have done poorly then you can’t tell the difference whether luck or skill is involved. There are extremely good outcomes and extremely bad outcomes but you just can’t tell which are because of luck and which are because of skill. And then, if you think that investors don’t get returns before fees and expenses, the whole industry looks awful. And that’s why it’s better to just buy a low fee, well diversified mutual fund.

But what about a highly successful investor like Warren Buffett? Is he just a lucky guy?

You can’t tell because there’s a statistical problem. Think about the process: If I flip a coin one time I get a 50/50 chance of getting heads. If I flip the same coin ten times I have almost a zero probability that I will get ten times heads. Now, suppose I take ten million coins and flip them ten times. Then I’m going to get a lot of cases with ten times heads. Likewise, there are millions of businessmen. So you can’t just take the one who’s been most successful and say he was a genius. You have to take into account what to expect if you take all the businessmen and ask how the best one would look like if he was just lucky. In this case, he doesn’t look very good.

Let’s go back to the financial crisis one more time. What’s the big lesson of 2008/09 in your view?

None of what happened after the financial crisis is going to solve the problem of Too Big to Fail. Dodd-Frank is not going to solve it. It would have been better if they had nationalized the big banks and then brought them back to the market afterward. People would have understood that they are not going to get bailed out when the next crisis happens. The way to think about it is this: If you’re too big to fail, basically the government is guaranteeing your debt. That’s like a subsidy. So these big banks have an advantage over the small banks which are allowed to fail. That’s why I think Too Big to Fail is awful. It’s a big perversion of capitalism.

What should be done to solve Too Big to Fail?

The only way to solve Too Big to Fail is to make sure that the big banks don’t fail. That means they have to have so much equity that they can absorb whatever happens to their assets. But we haven’t raised the equity requirements sufficiently to do that. Taking them from 5 to 10% is not going to do it. The banks are kicking and screaming against higher equity requirements. They say it will restrict lending and it will do this and that. But higher equity requirements don’t have any of those effects. According to the Modigliani-Miller theorem it doesn’t matter how you finance what you are doing. If I have a given pile of assets, they have a given value. It doesn’t matter if you finance them with debt or equity. Now, the banks say they have problems raising so much equity. But at the same time, they are paying dividends. So they could just retain the dividends and that automatically pushes up their equity. That’s why they shouldn’t have to be allowed to pay dividends until their equity got up to 25%.

What else is worrying you?

In the whole western world people are not reproducing enough to replace themselves. Especially Europe faces a big challenge because people are not having enough children. So given this decline in population you have to ask how the entitlements of the current generation are going to be paid for. All the pension systems are underfunded. People who retire don’t have pre-funded benefits that the government is supposed to give them. They’re counting on the next generation to work and to pay for those benefits. But that’s not going to work if the population is dying.

What will be the consequences of these demographic changes?

What we’re seeing now in terms of immigration is nothing. In a generation from now, all the western world is going to be screaming for immigrants. That’s the only prediction I make: Every country is going to want to import people. Immigration is a good thing if you can assimilate the immigrants. In the US, we’ve always had immigration but now there’s a backlash against it. We act totally crazy here. We educate so many people in our university systems and then we send them back. They are very productive people and they are going to create lots of jobs. So why would you send them back? In twenty years, the whole western world is going to be competing for immigrants and everybody is going to want the good ones. So if you’re being born now in some country where you can end up getting a good education you’re going to be in high demand. Everybody is going to want you.