John Cassidy: I met Eugene Fama in his office at the Booth School of Business. I began by pointing out that the efficient markets hypothesis, which he promulgated in the nineteen-sixties and nineteen-seventies, had come in for a lot of criticism since the financial crisis began in 1987, and I asked Fama how he thought the theory, which says prices of financial assets accurately reflect all of the available information about economic fundamentals, had fared.
Eugene Fama: I think it did quite well in this episode. Stock prices typically decline prior to and in a state of recession. This was a particularly severe recession. Prices started to decline in advance of when people recognized that it was a recession and then continued to decline. There was nothing unusual about that. That was exactly what you would expect if markets were efficient.
John Cassidy: Many people would argue that, in this case, the inefficiency was primarily in the credit markets, not the stock market—that there was a credit bubble that inflated and ultimately burst.
Eugene Fama: I don’t even know what that means. People who get credit have to get it from somewhere. Does a credit bubble mean that people save too much during that period? I don’t know what a credit bubble means. I don’t even know what a bubble means. These words have become popular. I don’t think they have any meaning.
John Cassidy: I guess most people would define a bubble as an extended period during which asset prices depart quite significantly from economic fundamentals.
Eugene Fama: That’s what I would think it is, but that means that somebody must have made a lot of money betting on that, if you could identify it. It’s easy to say prices went down, it must have been a bubble, after the fact. I think most bubbles are twenty-twenty hindsight. Now after the fact you always find people who said before the fact that prices are too high. People are always saying that prices are too high. When they turn out to be right, we anoint them. When they turn out to be wrong, we ignore them. They are typically right and wrong about half the time.
John Cassidy: Are you saying that bubbles can’t exist?
Eugene Fama: They have to be predictable phenomena. I don’t think any of this was particularly predictable.
John Cassidy: Is it not true that in the credit markets people were getting loans, especially home loans, which they shouldn’t have been getting?
Eugene Fama: That was government policy; that was not a failure of the market. The government decided that it wanted to expand home ownership. Fannie Mae and Freddie Mac were instructed to buy lower grade mortgages.
John Cassidy: But Fannie and Freddie’s purchases of subprime mortgages were pretty small compared to the market as a whole, perhaps twenty or thirty per cent.
Eugene Fama: (Laughs) Well, what does it take?
John Cassidy: Wasn’t the subprime mortgage bond business overwhelmingly a private sector phenomenon involving Wall Street firms, other U.S. financial firms, and European banks?
Eugene Fama: Well, (it’s easy) to say after the fact that things were wrong. But at the time those buying them didn’t think they were wrong. It isn’t as if they were naïve investors, or anything. They were all the big institutions—not just in the United States, but around the world. What they got wrong, and I don’t know how they could have got it right, was that there was a decline in house prices around the world, not just in the U.S. You can blame subprime mortgages, but if you want to explain the decline in real estate prices you have to explain why they declined in places that didn’t have subprime mortgages. It was a global phenomenon. Now, it took subprime down with it, but it took a lot of stuff down with it.
John Cassidy: So what is your explanation of what happened?
Eugene Fama: What happened is we went through a big recession, people couldn’t make their mortgage payments, and, of course, the ones with the riskiest mortgages were the most likely not to be able to do it. As a consequence, we had a so-called credit crisis. It wasn’t really a credit crisis. It was an economic crisis.
John Cassidy: But surely the start of the credit crisis predated the recession?
Eugene Fama: I don’t think so. How could it? People don’t walk away from their homes unless they can’t make the payments. That’s an indication that we are in a recession.
John Cassidy: So you are saying the recession predated August 2007, when the subprime bond market froze up?
Eugene Fama: Yeah. It had to, to be showing up among people who had mortgages. Nobody who’s doing mortgage research—we have lots of them here—disagrees with that.
John Cassidy: So what caused the recession if it wasn’t the financial crisis?
Eugene Fama: (Laughs) That’s where economics has always broken down. We don’t know what causes recessions. Now, I’m not a macroeconomist so I don’t feel bad about that. (Laughs again.) We’ve never known. Debates go on to this day about what caused the Great Depression. Economics is not very good at explaining swings in economic activity.
John Cassidy: Let me get this straight, because I don’t want to misrepresent you. Your view is that in 2007 there was an economic recession coming on, for whatever reason, which was then reflected in the financial system in the form of lower asset prices?
Eugene Fama: Yeah. What was really unusual was the worldwide fall in real estate prices.
John Cassidy: So, you get a recession, for whatever reason, that leads to a worldwide fall in house prices, and that leads to a financial collapse...
Eugene Fama: Of the mortgage market… What’s the reality now? Everybody talks about a credit crisis. The variance of stock returns for the market as a whole went up to, like, sixty per cent a year—the Vix measure of volatility was running at about sixty per cent. What that implies is not a credit market crisis. It would be stupid for anybody to give credit in those circumstances, because the probability that any borrower is going to be gone within a year is pretty high. In an efficient market, you would expect that debt would shorten up. Any new debt would be very short-term until that volatility went down.
John Cassidy: But what is driving that volatility?
Eugene Fama: (Laughs) Again, its economic activity—the part we don’t understand. So the fact we don’t understand it means there’s a lot of uncertainty about how bad it really is. That creates all kinds of volatility in financial prices, and bonds are no longer a viable form of financing.
John Cassidy: And all that is consistent with market efficiency?
Eugene Fama: Yes. It is exactly how you would expect the market to work.
John Cassidy: Taking a somewhat broader view, the usual defense of financial markets is that they facilitate investment, facilitate growth, help to allocate resources to their most productive uses, and so on. In this instance, it appears that the market produced an enormous amount of investment in real estate, much of which wasn’t warranted...
Eugene Fama: After the fact...There was enormous investment across the board: it wasn’t just housing. Corporate investment was very high. All forms of investment were very high. What you are really saying is that somewhere in the world people were saving a lot—the Chinese, for example. They were providing capital to the rest of the world. The U.S. was consuming capital like it was going out of sight.
John Cassidy: Sure, but the traditional Chicago view has been that the financial markets do a good job of allocating that capital. In this case it, they didn’t—or so it appears.
Eugene Fama: (Pauses) A lot of mortgages went bad. A lot of corporate debt went bad. A lot of debt of all sorts went bad. I don’t see how this is a special case. This is a problem created by a general decline in asset prices. Whenever you get a recession, it turns out that you invested too much before that. But that was unpredictable at the time.
John Cassidy: There were some people out there saying this was an unsustainable bubble…
Eugene Fama: Right. For example, (Robert) Shiller was saying that since 1996.
John Cassidy: Yes, but he also said in 2004 and 2005 that this was a housing bubble.
Eugene Fama: O.K., right. Here’s a question to turn it around. Can you have a bubble in all asset markets at the same time? Does that make any sense at all? Maybe it does in somebody’s view of the world, but I have a real problem with that. Maybe you can convince me there can be bubbles in individual securities. It’s a tougher story to tell me there’s a bubble in a whole sector of the market, if there isn’t something artificial going on. When you start telling me there’s a bubble in all markets, I don’t even know what that means. Now we are talking about saving equals investment. You are basically telling me people are saving too much, and I don’t know what to make of that.
John Cassidy: In the past, I think you have been quoted as saying that you don’t even believe in the possibility of bubbles.
Eugene Fama: I never said that. I want people to use the term in a consistent way. For example, I didn’t renew my subscription to The Economist because they use the world bubble three times on every page. Any time prices went up and down—I guess that is what they call a bubble. People have become entirely sloppy. People have jumped on the bandwagon of blaming financial markets. I can tell a story very easily in which the financial markets were a casualty of the recession, not a cause of it.
John Cassidy: That’s your view, correct?
Eugene Fama: Yeah.