On the Future of Financial Economics: Part II

by: Alpha Author

Back in March I suggested that an open discussion about the future of financial economics seemed warranted (see Future of Financial Economics). I wrote:

Are the fundamental assumptions about human behavior associated with the dominant paradigm in financial economics appropriate?

The first assumption that I took issue with was that of complete markets. In fact, as I suggested:

One of the things that drew me to the field of strategy in the first place (versus finance or economics) is that we start with a baseline assumption that markets are incomplete, and markets break down.

Markets break down largely because humans do not behave as “rational” actors typically assumed in our most celebrated models.

In addition to the view of markets as complete, I took issue with some of the other assumptions underlying the efficient market hypothesis.

…associated with the [efficient market hypothesis] EMH-dominated financial economics view is an assumption that there is a true, objective, underlying fundamental price for an asset. We might deviate from that price in the short run; but in the long run, the fundamental price will prevail.

I concluded by calling for greater inclusion, and an openness to contributions from behavioral economics and other social science disciplines.

All told, I think the field of financial economics would be well served to be more inclusive when it comes to behavioral approaches to human behavior (whether from economics or psychology) and behavioral views of the firm (whether informed by psychology, sociology, or economics). Thankfully, not only are both processes well underway, but in some quarters, they have been for some time.

With that as background, I was pleased to come across a fascinating set of articles from this week’s issue of the Economist entitled “Economics: What went Wrong?” This collection of articles asked fundamentally important questions about the future of the field of economics (see Economics: What went Wrong?, Other-worldy Philosophers, and Efficiency and Beyond).

On the field of economics:

Barry Eichengreen, a prominent American economic historian, says the crisis has “cast into doubt much of what we thought we knew about economics.”

…two central parts of the discipline—macroeconomics and financial economics—are now, rightly, being severely re-examined. There are three main critiques: that macro and financial economists helped cause the crisis, that they failed to spot it, and that they have no idea how to fix it.

On financial economics:

In 1978 Michael Jensen, an American economist, boldly declared that “there is no other proposition in economics which has more solid empirical evidence supporting it than the efficient-markets hypothesis” (EMH). That was quite a claim. The theory’s origins went back to the beginning of the century, but it had come to prominence only a decade or so before. Eugene Fama, of the University of Chicago, defined its essence: that the price of a financial asset reflects all available information that is relevant to its value.

From that idea powerful conclusions were drawn, not least on Wall Street. If the EMH held, then markets would price financial assets broadly correctly. Deviations from equilibrium values could not last for long. If the price of a share, say, was too low, well-informed investors would buy it and make a killing. If it looked too dear, they could sell or short it and make money that way. It also followed that bubbles could not form—or, at any rate, could not last: some wise investor would spot them and pop them.

That is why many people view the financial crisis that began in 2007 as a devastating blow to the credibility not only of banks but also of the entire academic discipline of financial economics.

On macroeconomics:

In many macroeconomic models…insolvencies cannot occur. Financial intermediaries, like banks, often don’t exist. And whether firms finance themselves with equity or debt is a matter of indifference. The Bank of England’s DSGE model, for example, does not even try to incorporate financial middlemen, such as banks. “The model is not, therefore, directly useful for issues where financial intermediation is of first-order importance,” its designers admit. The present crisis is, unfortunately, one of those issues.

…Economists can become seduced by their models, fooling themselves that what the model leaves out does not matter. It is, for example, often convenient to assume that markets are “complete”—that a price exists today, for every good, at every date, in every contingency. In this world, you can always borrow as much as you want at the going rate, and you can always sell as much as you want at the going rate.

The benchmark macroeconomic model…suffers from some obvious flaws, such as the assumption of complete markets or frictionless finance…nuanced theories are often less versatile. They shed light on whatever they were designed to explain, but little beyond.

On behavioral economics:

…[a] branch of financial economics is far more sceptical about markets’ inherent rationality. Behavioural economics, which applies the insights of psychology to finance, has boomed in the past decade. In particular, behavioural economists have argued that human beings tend to be too confident of their own abilities and tend to extrapolate recent trends into the future, a combination that may contribute to bubbles. There is also evidence that losses can make investors extremely, irrationally risk-averse—exaggerating price falls when a bubble bursts.

“In some ways, we behavioural economists have won by default, because we have been less arrogant,” says Richard Thaler of the University of Chicago, one of the pioneers of behavioural finance. Those who denied that prices could get out of line, or ever have bubbles, “look foolish”.

The Economist concludes:

Add these criticisms together and there is a clear case for reinvention…Economists need to reach out from their specialised silos…

I could not agree more.

However you may feel about the future of financial economics, I encourage you to read the articles in full:

Disclosure: No positions