Book Review: Uncertainty, Expectations, And Financial Instability

by: CFA Institute Contributors

Reviewed by Mark S. Rzepczynski

Maurice Allais is the Nobel Prize-winning economist who nobody in macro finance has read or even remembers. He was not directly part of the declared wars between the Keynesian, monetarist, and rational expectations schools of thought. He was neither a microeconomic expert nor a leading figure in finance nor a creator of pricing formulas. Allais was a polymath who wrote mostly in French and greatly advanced our knowledge on a broad range of problems, including monetary economics, expectations, and uncertainty. He had wide-ranging research interests, with a special focus on how expectations are formed. At best, some will recognize him for the Allais paradox in utility theory (i.e., the inconsistency between actual choices and what expected utility theory predicts).

Allais seems to have been relegated to the history of economists past. Theory and thought have moved forward. Nevertheless, in Uncertainty, Expectations, and Financial Instability: Reviving Allais's Lost Theory of Psychological Time, Eric Barthalon, the global head of capital markets and tactical asset allocation at Allianz Investment Management, rekindles Allais's theories on expectations as insightful thinking that has something important to say about today's market complexities.

This book is not, however, merely a review of Allais's work. Barthalon uses some key aspects of Allais's thoughts to address the problems of the global financial crisis. He shows how a nonmainstream perspective may break through current problems of expectation formation, which is timely in light of the failure of rational expectations to explain potential financial crises. Barthalon's focus is on Allais's concept of the psychology of time and its impact on expectations. Because expectations are not rational in the sense of always being correct, the market can make mistakes that have to be corrected as investors gain more information and additional time to assess it. The intensity of events affects the elasticity of behavior as investors adapt and adjust.

Uncertainty, Expectations, and Financial Instability is broken into four parts: a history of the development of expectations in economics, an explanation of Allais's theory of expectations, the application of the Allais framework for analyzing financial markets, and the use of the Allais formulation and theories in explaining financial instability. There is also an extensive appendix explaining, for the interested reader, the math presented in the book.

The first section is a short review of how expectations are formed. It offers a cogent history of expectation formation and demonstrates the limitations of the current rational expectations paradigm. Barthalon's critique of rational expectations allows for a fresh presentation of the Allais model - referred to as the hereditary, relativist, and logistic (HRL) framework of economic expectations - as a reasonable alternative.

Allais developed the HRL framework more than 50 years ago to explain the changing behavior of money demand, especially in periods of hyperinflation. Barthalon lays out Allais's theory of money demand to set the stage for using the HRL framework as a more general approach to expectation development. The Allais framework is a richer, more nuanced approach than static adaptive expectation. Although rejected by the rational expectations framework, the adaptive expectations concept has seen some resurgence as an approach that can account for behavioral biases and the slow adjustment of expectations. What makes the HRL framework useful is that it offers a foundation for describing how adaptive expectations change over time on the basis of prevailing conditions.

The hereditary element is a foundation for expectations because our market views are all based on our experiences and memories. Our collection of memories determines how we adjust and form future expectations. Sticking with this simple concept, however, is not novel. The innovation of Allais's expectation structure is the notion of psychological time, which states that memory decay changes with the phenomena faced. Our memory adapts with the strength of signals received, giving rise to the relativist portion of expectation formation. Expectations are context driven. In the monetary area, higher-than-normal inflation is associated with shorter-than-usual memory life. Big events focus our attention and shorten our response time. The psychological time scale is compacted when there are strong "signals." The logistic portion of expectations suggests that our behavioral response is not different from a logistic function. Our expectation behavior changes according to the intensity of signals, constituting a nonlinear response. Do not think in terms of clock time but, rather, in terms of event intensity; our responses to these changes are bounded in behavioral terms.

This approach is presented through the macro and micro foundations of monetary dynamics. Uncertainty, Expectations, and Financial Instability is not merely a discussion of expectations; it offers a complete framework of monetary dynamics that uses the HRL framework as the expectation driver. After detailing this framework, Barthalon tackles some real-world problems using the Allais HRL monetary framework. He examines the hyperinflation in Zimbabwe and adapts the model to fit nominal interest rates of the last decade. This "old" framework does a good, practical job of explaining the dynamic events faced by investors.

The book ends with the policy implications of a dynamic expectation structure that can lead to market instability. Barthalon looks at financial behavior using Allais's expectation modeling and his work on utility to discuss the market's downside potential through risk and uncertainty. This section examines the core problem of inherent instability when expectations dynamically adapt to growing uncertainty.

Barthalon is a careful writer who focuses on the deep details of Allais's theories and the math associated with the concepts. He provides a strong framework for reaching his conclusions on financial instability, doing justice to the ambition of reviving the Allais theory of expectations. The story could have been improved significantly, however, by placing the framework in the context of the macro foundations of other monetary theories and the micro foundations of the behavioral finance revolution. Behavioral biases affect expectation formation, and the Allais framework provides a workable model of how expectations can adapt to the environment. Linking these ideas more closely would have been very useful and made the work more accessible to readers.

This is not an easy book, as it moves between conceptual discussions, theory, math, and empirical analysis. Although it commendably resurrects the forgotten theories of Allais, the analysis is not always approachable. The reader must carefully sift through concepts whose market applications are not immediately clear, easily deployable, or placed in the context of the behavioral finance revolution. The author jumps between a very useful synthesis on expectations, on the one hand, and a modeling of monetary supply and demand that has generally not been presented in the classroom for decades, on the other. The Allais framework describes current market behavior, but this important context should have been more fully developed.

Nevertheless, Barthalon shows how a great thinker used simple pragmatism to address a complex problem effectively. Those who incorporate the HRL framework into their thinking will emerge with an improved framework for expectation formulation. Barthalon's book provides novel insights and a market perspective and shows brilliance at presenting complex ideas in a historical context. Uncertainty, Expectations, and Financial Instability will be an intellectual stretch for most charterholders, but the few who take the time to work through its complexities will be rewarded by seeing something that is considered old and tired as actually fresh and insightful.

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