Fixing financial theories….

José De Gregorio, Governor Central bank of  Chile ususally has something interesting to say. 

He has been a leading proponent of this idea- Easy  monetary conditions did not lead to crisis. The crisis originated because of financial markets and that is where the problems lie. 

In his recent speech he spaeks on macro models and the need to fix finance theories. 

On macro models he says there is a need to bring models closer to reality and useful for policymakers. Most econs instead make papers and models to meet publish or perish deadline. There is a trade-off :  sophisticated model which are complex vs closer to reality model which are simpler and more apt for policies. This needs to be balanced:

 Macroeconomics has increasingly moved towards models more rigorously specified, with sound micro-foundations, with all general equilibrium interactions, and explicit informational constraints. However, there will always be tensions between rigor, realism and flexibility. There are many tradeoffs.

 

The costs of these tradeoffs are often subtle. The tendency to base models on ever more rigorous grounds, although a logical trend, has undesired effects. The incentives for younger academics—the very ones who are supposed to push the borders of knowledge, and who must publish or perish—limit their capabilities for innovation. The required rigor ends up necessarily threatening realism. Nobody expects a model to explain all the complexities of the real world, but the problem is that it can overlook elements that are crucial to understanding and preventing economic disasters like the one we faced some years ago. It may be more rewarding from an academic standpoint to write an equilibrium model explaining some particular phenomenon, than trying to formulate a model that properly represents all the distortions of said phenomenon. It is harder and less rewarding for an academic to formulate distortions—of which the real world has plenty—than to use elegant general equilibrium competitive models to explain important stylized facts with a minimum number of new ingredients. Only a handful of academics are able to think rigorously out of the box, and Kouri was one of them.

 

He explains it is for this simplicity reason IS-LM and Solow’s growth model were used for many years.

 

He then looks at theory of finance:

Indeed, the current crisis has revealed that models have a limited ability to deal with all the complexities of the real world. Even current state-of-the-art DSGE models, used in many central banks, have been unable to consider in a manageable and explicit way all the intricacies associated with financial markets’ distortions and imperfect arbitrage, let alone the existence of default and credit losses.

This brings me to the theory of finance. If there ever was one discipline that should have anticipated the vulnerabilities that were building up in financial markets, it was finance. Had the origin of the problem been inflationary, then the problem would have been macroeconomics, but the origin was financial The origin of the crisis was closely related to financial innovation and the creation of instruments that should have diversified risks. ……

It is paradoxical that while asset price theories, and their application to the real world, are based on the existence of full arbitrage (consider, for example, the CAPM), corporate finance theories are essentially dominated by information asymmetries and are plagued by frictions from principal-agent problems. This dichotomy will have to be corrected over time to ensure that more realistic models of how financial markets work become available, models which will shed more light on economic policy recommendations.

This is very well put. It summarises in nut shell the problem of theory of finance. …

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