Yoda and Jedi Knight

The words “analysis and rigorous debate” boomed out of interim dean Dean Douglas Skinner at the luncheon at the Chicago Booth annual Management Conference on Friday.  After reading about the riots at Berkeley, the assaults on Charles Murray at Middlebury and the disruption of Heather MacDonald at Claremont, the renaming of buildings, the demand for “safe spaces” and “trigger warnings, it was a breath of fresh air.  The University of Chicago may be one of the last redoubts of intellectual integrity, and its business school and economics department is at its epicenter.  This weekend, I had an opportunity to hear two of its finest finance minds—Eugene Fama and Amir Sufi.  Fama won a Nobel Prize in economics in 2013 for his work in portfolio theory and asset prices.  Sufi won the 2017 Fischer Black Prize, awarded to the top finance scholar under 40 for his work on household debt.

Wry, blunt and at times self-deprecating, Fama is a true scientist.  In many ways he stands as an icon for what The University of Chicago represents.  He analyzes data and has a history of upending his own hypotheses when he discovers data that do not conform to his models. He began with a 3 factor model for determining asset prices and has expanded it to a 5 factor model, but says he is “suspicious about profitability” as a factor. 

In his pithy and droll delivery, Fama offered these policy nuggets:

• ·         Banks need more equity.  Shadow banks should be allowed to fail.  Too Big To Fail is the biggest blunder in capitalism and it’s getting worse.
• ·         [On proposed Trump tax cuts]  Corporate taxes are irrational.  System is all messed up.  How many times do you want to tax a dollar of value creation?
• ·         A trade war and protectionism are insane.  There is lots of evidence that the Smoot Hawley tariff worsened the Great Depression.  The world is intertwined.  An airplane gets built with parts from all over the world.
• ·         A single currency for Europe is a good idea.  But Europe is drowning in its own entitlements. It  can’t pay for them.  It will either have to renege or suffer out migration.
• ·         More government equals less growth.
• ·         I don’t know about China.  How soon can you trust any of the data you get from them?
• ·         The word “bubble” is a swear word.
• ·         Our debt is a problem.  There are only two ways to pay off the debt—taxes and inflation.

Fama remains fairly humble about his Nobel Prize.  When asked how it has changed his life, he flatly responded, “The room is full, isn’t it? People treat you with more respect."

But he recounted the day after he won the Nobel when a TV camera man followed him across campus.  When they got back to his office the camera guy said, “I noticed that none of the students looked up from their studies in the Quads when you walked by.”  Fama answered, “If they looked up every time a Nobel winner walked by here, they wouldn’t get anything done.”

If Fama is Yoda, Amir Sufi is the young Jedi Knight.  Sufi won the Fischer Black Prize in 2017.  The Fischer Black Prize is given for original research in finance by someone under 40.  Sufi’s book, House of Debt: How They (and You) Caused the Great Recession and How We Can Prevent It from Happening Again, published in 2014 was one of the top 10 business and finance books chosen by the Financial Times. 

Sufi’s thesis is that credit supply shocks are an important driver of economic fluctuation.  They work through the household sector more than the business sector.  They amplify the cycle- fueling a boom and making the bust harder.   Sufi’s says that a credit supply shock is a variation in  the risk premium which he believes is more important than expected future cash flows. 

Sufi contends that sudden increases in household debt systematically predict a decline in growth.  It happened in the Great Depression and in the Great Recession.  Increases in household debt occur in low interest rate environments. These increases in debt are associated with consumption booms and increases in imports of consumer goods. 

Sufi asserts that the most important factor in the housing meltdown was not deregulation but a boom fueled by huge inflow of cash from Asia that was looking for yield and ended up in mortgages.   When a boom happens, you should be careful to ask why.   For instance, if housing prices are rising in Englewood, you need to ask whether something is fundamentally changing in Englewood or whether it is someone just looking for yield.  If it is the latter, that is a dangerous condition.

As for macro trends, Sufi offered these observations:

• ·         The student loan default rate spike is largely limited to the for-profit colleges, not places like Michigan.
• ·         The biggest problem in the world economy is too much capital chasing too few good investments.
• ·         The biggest problem with wealth inequality is that it could create a credit supply shock—again, capital chasing yield.
• ·         Changes in the discount rate are more important than cash flow. 
• ·         There appears to be a credit problem in the subprime auto but that could be distorted because of Uber.
• ·         Sufi has great worries that our economy looks a lot like Japan’s after their housing bust.

I intentionally chose these two presenters from the menu of faculty that were presenting on Friday back to back because both of these great minds brought new knowledge and new ways of thinking about our world with a rigor that is the hallmark of Chicago finance and economics.  I found it fascinating that Fama said he did not travel much after his Nobel, although he certainly could have.  No one in that department rests on laurels and neither does the school.  There is a nearly 40 year age difference between these two fine scholars.   Chicago has a deep bench and an unwavering commitment to rigor and debate.  After hearing about recent events on campuses across the country, Chicago continues to be a beacon of light.