2. The crisis is at least partly due to shortcomings a certain theory of economics
"Those of us who have looked to the self-interest of lending institutions to protect shareholder's equity (myself especially) are in a state of shocked disbelief. … It was the failure to properly price such risky assets that precipitated the crisis. In recent decades, a vast risk management and pricing system has evolved, combining the best insights of mathematicians and finance experts supported by major advances in computer and communications technology. A Nobel Prize was awarded for the discovery of the pricing model that underpins much of the advance in derivatives markets. This modern risk management paradigm held sway for decades. The whole intellectual edifice, however, collapsed in the summer of last year because the data inputted into the risk management models generally covered only the past two decades, a period of euphoria."
— Testimony of Dr. Alan Greenspan, US House of Representatives Committee on Government Oversight and Reform, October 23, 2008
When economists and other scientists study a complex system they begin by asking about what assumptions have been used previously in understanding it, and how well they have done compared to data. So if we approach the crisis in this way, we have to begin by asking about the principles and assumptions that have been used to construct and justify the complex financial instruments whose use contributed to the present instability. We want to know how these theoretical ideas have been tested, and whether or not the present crisis is evidence that the ideas that the financial system have been built on may need to be improved.
In fact, there is an economic theory that shapes much of our thinking, as well as the practices of investment banks and the decisions of economic policy makers. This is called neoclassical economics. It is based on the following assumptions:
i. Most of the time markets are in or close to stable equilibrium.
ii. Participants in markets act rationally to maximize fixed and known preferences described by definite and time independent utility functions.
iii. Participants in markets have perfect knowledge of the information driving the markets as well as all other participants.
iv. Prices are set by a deterministic process of joint maximization of the preferences of all involved in a trade.
v. Fluctuations in prices are small, random and uncorrelated.
vi. There is perfect liquidity so all prices are well defined, and all markets clear.
vii. There is no important difference between markets comprising a few individuals and those comprising millions, so simple models suffice to elucidate the principles that govern markets.
The neoclassical paradigm based on these ideas has had some undisputed successes. At the same time, it appears to have led to the adoption of practices and recommendations, which are at least partly at the root of the present crisis. These included the ideas that,
i. Regulation is limited or unnecessary because markets find and stay close to stable equilibrium where they operate most efficiently, leading to maximally stable economic growth, whereas regulation only leads to slower growth. But we face a potentially precipitous decline in economic growth and prosperity in the wake of some deregulation.
ii. Everything has a value or price, at all times, that can be uniquely determined by some definite objective process. This includes contracts that refer to prices of fluctuating variables at future times. There is experience with futures contracts, which have prices which are set daily by their being actively traded. But we are now seeing these values evaporate.
iii. This trading experience may be generalized to a claim that complex financial instruments which oblige actions to be taken at future times based on conditions not known till then, still have definite values and prices even if they are never or rarely traded. But part of the crisis is due to the fact that the balance sheets of banks and companies holding these contracts cannot be computed because they include instruments whose prices have been revealed as simply hypothetical and are now proving to be indeterminate [1].
iv. Stability can be increased by inventing and trading abstract complex financial instruments rather than principal contracts like stocks and mortgages. Examples are derivatives. Although these predate the birth of Christ and have been a factor in every economy of scale since, our markets have recently been flooded with a host of new ones which cleverly combine functions of different prices at different times into financial instruments whose values are purported to fluctuate less than the values of stocks making them up. The theory behind the possibility of combining fluctuating variables into variables that fluctuate less is critically dependent on the above assumptions, especially that the fluctuations are small, random and uncorrelated. But these assumptions have been shown to be false.
v. It has been argued that these innovative instruments should not be regulated even as much as stock trading because they function as insurance to increase stability. This was based on another false assumption that any mathematical function of the values of stocks at different times has a fixed and determinate value at any time.
vi. Because price determination is a definite process of maximization of known preferences in an environment of perfect knowledge, and because all values are definite, it can be in some instances automated and carried out by computers programmed to trade under specified conditions. But some markets thus operated have failed to function or clear trades.
Before we look more deeply into possible difficulties with the neoclassical paradigm, we have to also emphasize that it has been so influential because it does give important insight into how markets work in some circumstances. Nor has it ignored the possibility that markets can have instabilities. For example, there is a long list of well known market failures (principal agent problems, moral hazard, public goods, menu costs, lemon markets, adverse selection, rent-seeking behavior, incomplete knowledge, incomplete markets, multiple equilibria etc. …) So we do not want to ignore the successes of this paradigm or overlook the role that these well known understandings may play in understanding the current crisis. But we also want to ask if there are alternative ideas, principles and methods of modeling economic systems which might also provide the basis for wise advice and policy.
As a result, in part, at least of belief in the neoclassical paradigm, a very technical approach to trading has come to dominate markets based on complex financial instruments and strategies that require mathematical scientists and computers to carry out. Beginning as small speculative efforts, these now dominate markets. In most markets including equities and credit, the value of derivative contracts now exceeds by an order of magnitude the total value of underlying contracts, which must be traded to fulfill those derived from them.
When physicists made the atomic bomb they realized what they had conceived and immediately felt a sober responsibility to help make the world safe from their invention. At this time there is a responsibility for those with the knowledge and skills to understand the financial instruments involved in this crisis to help first to resolve this crisis and to next turn their attention to the design and regulation of a stable market system. This will involve economists, mathematicians, physicists, biologists, computer scientists and others working together to make a more stable economic system.
In our view, the current crisis does suggest there are weakness in the paradigm of neoclassical economics. In particular:
i. The big markets in the economy appear not to be in equilibrium. Not now, and perhaps also not normally. The fluctuations in the values of stocks, currencies, and commodities are often not random and uncorrelated and, as we have seen recently, they need not be small. Some other paradigm is needed to describe the workings of real markets.
ii. More generally, the theory of competitive general equilibrium is based on assumptions that appear to be too idealized. These include the assumption that at equilibrium prices are set so that all markets will clear no matter how the future unfolds and the assumption that each agent has a view on the value of all possible dated contingent goods [2].
iii. Participants in markets do not have fixed preferences, but the theory of competitive general equilibrium assumes that they do. Preferences change in time unpredictably due to changing tastes and circumstances as well as in response to innovations which introduce new products and eliminate the needs for old products, and we should acknowledge this. The unforeseeable aspects of innovations renders risk assessments problematic.
iv. There has been an unjustified extrapolation from simple models of markets with two participants and two goods (or something similar) to real markets with millions of participants and thousands of goods, a mistake we should not repeat.
v. Participants in markets do not have perfect knowledge, indeed their knowledge and beliefs about the market conditions are sometimes false or unreliable and different participants have different knowledge and beliefs. We should acknowledge this freedom because it is not the case, as sometimes assumed, that the lack of perfect knowledge by traders averages out as noise.
vi. This has the effect that swings in belief can crash markets and hurt people even when much of the machinery of the goods and services economy is healthy and prepared to function well with an orderly availability of capital.
vii. Increasing returns can lead to path dependence in the economy so that the evolution of an economy will depend on historical contingencies. This makes prediction and risk assessment difficult.
viii. There appears to be a basic lack of appreciation of the importance of relative scales. This is because of the misapplication of the neoclassical paradigm that the markets operate near equilibrium. Financial instruments such as derivatives indeed can do little harm except to those who use them, so long as they represent only a fraction of a market. However, an extremely dangerous situation emerges when their use grows to the point where so much equity is pledged in the resulting contracts that a movement in the markets in a non-random direction can introduce an instability in which the contracts are called but cannot possibly be fulfilled. Any meaningful discussion about whether a novel financial instrument requires regulation must involve the scale of its use.
