Future Research in Finance

Please read Mark Thoma’s piece on Capital Market Theory after the Efficient Market Hypothesis. It’s an interesting paper and Thoma’s own observations add to it well.

Dimitri Vayanos and Paul Woolley argue that we do not need to abandon the assumption of rational expectations in order to better understand how asset markets function, but we do need to incorporate principal agent problems into asset market models.

Setting aside whether agents are rational, I am fully sold on the idea that we need to do a better job of incorporating principal agent problems into these models…

The story below is one where asset price “momentum” is generated from principal agent issues driven by incomplete information on the quality of investment fund managers…

I’m very interested in the study of capital markets post-crash. I need to do a mind dump on this topic, so I’ll add some wide-ranging thoughts, that will increase in zaniness until I fall asleep on the publish button.

Economics

– We’ve had credible rational agent theories explaining momentum going back at least 20 years with DeLong, Shleifer, Summers, and Waldmann (1990), “Positive-Feedback Investment Strategies and Destabilizing Rational Speculation.”

– Principal-agent modeling is going to get weird quickly. Take hedge funds: They are highly secretive, use opaque strategies, have no legal disclosure requirements, and have giant windows in how you can withdraw your money from the fund. Yet people line up around the block to get their money into them. Is that a principle-agent problem? What is the deal with those who want to invest – are they suckers? Or brilliant? Would Lakonishok’s work with window-dressing and mutual funds hold up?

– The lowest hanging fruit for the information crowd is uncertainty over the risk-free asset, which certainly caused many problems in the previous crisis. See the Lucas quote here.

– I hope people can bridge the gap between macro and finance. The Business College-Liberal Arts College gap doesn’t help. I’m sure there are money differences too. I remember how shocked I was when I heard a macro person sneer that finance theory, Black-Scholes, etc. was “a partial equilibrium thing” (as if it was the market for pizza!) – I thought we’d get along like PB&J. So naive back then….

Also macro people are the prima donnas of every department, in case you weren’t getting that sense from the internet discussions (how could you not?). Which makes finance people want to deal with them even less.

Efficient Markets

– I think the liability for formal economics to tackle the capital markets problem is that they assume that profit-maximizing transactions leads toward an equilibrium. Particularly an equilibrium that has some fairly beneficial properties to them. This is almost certainly true for “the market for pizza”, but it’s an assumption that may have to be weakened at least during initial investigations. Notice some quotes from Summers getting it in the New Yorker profile:

Summers told me that, as a graduate student, he first studied claims, made famous by economists at the University of Chicago, that financial markets are always rational and self-correcting. He said, “I encountered a sentence that was much quoted: ‘The efficient-market hypothesis is the best established fact in social sciences.’ Any sentence like that is a red flag to an ambitious academic.”….

Since his days tearing apart the E.M.H., Summers had had a healthy academic understanding that markets under severe stress could be thrown so out of whack that their self-correcting mechanisms broke down and required outside intervention….

Summers returned to his attacks on the efficient-market hypothesis. While it is true that the market is often self-correcting…at other times…the shocks to the financial system are so pronounced that the market does not self-correct, and eventually tips the economy into recession. Summers explained that although the relationship between supply and demand is the cornerstone of a self-correcting market, in some financial crises that relationship breaks down. “If you think about a security that is bought on margin,” Summers explained during a speech early last year, “when its price goes down there are margin calls which force liquidations, and more of it is sold. So a falling price is not a stabilizing mechanism, but it is potentially a destabilizing mechanism.”

Getting a theoretical and empirical handle on that would be a great start.

– Methods wise modeling the way things fall apart would best be done, as far as I can see, by getting one’s hands dirty with stochastic calculus instead of models with dynamic programming (which, as smart people have pointed out, is really a one-period model disguising itself as an infinite period model.) Maybe not, but probably so.

– The best theoretical tool still standing is something like Andrew Lo’s Adaptive Market Hypthoesis. So much of what constitutes meaning and form in financial markets changes the moment it’s observed. It almost has quantum properties that way – observing it changes the nature of it. Beta worked really well, until everyone modeled their risk on it. There was a January effect, until everyone learned about it. Etc. Financial markets are always cannibalizing the very terms that are trying to describe it.

Other Fields

– Economists should be willing sit back and let the sociologists, ethnographers and anthropologists get a solid crack at this. It’s telling that the two new books I find the most informative about the crisis are Fool’s Gold, written by someone with a PhD in social anthropology, and The Myth of the Rational Market, a history of ideas which I read as very similar to the sociologist MacKenzie’s An Engine Not a Camera, but without as much performance theory (and focused on asset markets as opposed to derivative markets).

– I think this is true because there’s a big performativity component to financial markets that Lo’s Model hints at, but also because I think the mathematical formalism may be too strangling in the first passes. For instance, if you held Minsky’s (who is doing a lot of work for a lot of people during this crisis) fantastic Financial Instability Hypothesis, the actual paper, next to, say, Polyani and/or a systems theorist, and then held it against Duffie’s Dynamic Asset Pricing Theory financial economics textbook, it would obviously go into the first pile. Could Minsky get tenure nowadays? Math-ing up Minsky’s ideas is a very good goal, but first we need the ideas fleshed out. And that requires getting the ideas.

– Speaking of ideas: let’s imagine an economist asks a feminist why women have so much more control over their sexual and economic lives nowadays. You can imagine the feminist discussing glass ceilings, “The Second Sex”, Judith Butler, and the economist cutting her off saying: “aww, you’re sweet. But really the technology process gave you The Pill, and there was a move from manufacturing to service industries, and that’s it. All your consciousness raising has done nothing.” I think that’s a fair stereotype. Given that, why are we sitting around listening to economists navel-gaze about their methods so much? I feel like so much of the debate around macro has been completely cut-off from the evolving nature of capital markets. You’d think economists would be the first to see a debate over whether or not Euler equations belong in a paper as being the kind of academic fashion that distracts us from the technology processes that are really determining things.

Now feminist theory obviously doesn’t set the interest rate (insert stimulus joke here). And I do believe ideas matter. Especially economic ones in a neoliberal age. But they matter because they help us construe a world that is simultaneously construing us. Why aren’t we forcing economists to look at the actual institutions and capital market structures and see whether or not their ideas are matching up to them anymore? Krugman’s big article on Dark Age macro made no references to anything outside academia.

Here I really like Perry Mehrling’s short 2005 The Development of Macroeconomics and the Revolution in Finance (“In fact, as I shall argue, neoKeynesian macroeconomics circa 1965 was destabilized not by the various internal theoretical problems that standard pedagogy emphasizes, but rather by fundamental changes in the institutional structure of the world that neoKeynesian macroeconomics had been developed to explain. We see this fundamental institutional change most clearly when we focus our attention on the financial sector”), and it comes with the highest recommendation. It’s all about placing the debates in macroeconomics against the actual capital markets, and in particular the question of who is setting the risk-free rate: the market or the government? I would love to see more work done in this vein.

Financialization

– A good starting place, but I am not sure if economics has the tools to tackle it right now, is what does “the financialization of the economy” mean? This is what I’m dedicating my study to, and I’m willing to go to just about any source, and so far the answers have been weak. What does it mean that the share of business profits going to the finance sector has more than doubled from 15% to 35%?

The knee-jerk economics answer is “that’s no different than if the pizza sector was 35% of the economy and what are you going to do go around telling people how much pizza to eat?” The sophisticated economics answer is that it must be the result of consumption smoothing and business cycle smoothing and that this sector is growing because consumers are enjoying their services. Maybe that’s unfair, but I don’t see much else.

Is it the sign that an economy has matured, and the finance sector is just trying to eek out some extra growth? Does it have implications for IO or labor contacts? Is this a new form of global hegemony? Is it a byproduct of The Great Moderation? Is it just rent-seeking on the productive sectors? And most importantly, does this sector being this big increase the chances of financial disasters? I do not know, and I’m hoping to learn more in the future.