Amidst the all the discussion of President Obama’s Nobel Prize, the Royal Swedish Academy of Sciences quietly made another political statement by giving the Nobel Prize in Economics to to Elinor Ostrom and Oliver Williamson for their analysis of “economic governance.” The choice of Ostrom and Williamson is notable not only because Ostrom is the first woman to receive the award, but also because she is a professor of political science, and both Ostrom and Williamson are more widely read by political scientists than by economists.
Ostrom and Williamson were long shots to win the prize. The heavy favorite to win was Eugene Fama, who came up with the “efficient-market hypothesis.” According to this hypothesis, market prices always reflect the best information available, so that it is impossible to consistently beat the market without inside information. The problem with this idea—which became the dominant view in economics—is that it can’t explain why bubbles develop or why they burst. The fact is that markets don’t behave as rationally as the efficient market hypothesis supposes.
The current recession may finally be the end of the idea that real markets are priced efficiently. Indeed, as Jeremy Grantham argues, the idea that markets are efficient may even have contributed the current crisis by blinding us to the possibility—by effectively assuming it away—that asset prices might be unrealistic.
By giving the Nobel Prize to Ostrom and Williamson, the prize committee is coming out against the orthodox view that markets operate efficiently by themselves. Because the central insight of Ostrom and Williamson’s work is that it matters how markets are governed—that the structure of our institutions matters. It’s an insight that’s fundamental to the field of political science, but that's still outside the mainstream in academic economics. Indeed, Paul Krugman—who won the Nobel Prize last year—freely admits that he doesn’t really know Ostrom’s work. But the Nobel Prize Committee is right that we need to think more the role institutions play in governing economic behavior, especially as we try to avoid economic crises in the future.