Will Financial economics post crisis be more Keynesian in spirit??

What an amazing paper by Carlo Zappia of University of Siena. It connects so many dots in such few pages that one is just amazed.

It looks at history of financial economics and how it has changed/expected to change post the financial crisis. The history bit is a really abridged version of Capital Ideas book by Bernstein.  It covers the works of Markowitz, Sharpe, Merton/Scholes/Black, Fama etc.

He starts by pointing how the crisis has led to rethinking on much of these finance theories. He then reflects on how all this theory around finance developed and was later questioned by behavioral theories.

The crux of this crisis from fin eco perspective is that basic assumptions laid by Markowitz (and followed by others) was not true. Much of it is based on Bayesian thinking which is flawed:

indeed, among the recent explanations of the failure of financial economics those hinging on the behavioural element are  paramount, as both the theoretical literature (Akerlof and Shiller 2009) and the middlebrow one (Tett 2009) show. But when examining in retrospect the efforts of Markowitz and his followers it is obvious that the issue is not simply that of introducing more accurate behavioural assumptions in the model. What is at stake here is the very normative content of the theory: the violations of the maxims of behaviour implicit in mainstream decision theory are so pervasive that Markowitz’s (1991: 285) reference to expected utility theory as “theoretically correct” becomes highly questionable, at least as much as the empirically oriented financial literature his work originated.

The search for models capable to account for actual behaviour cannot be limited to the amending of the models devised to explain financial phenomena, since the bias inserted by “noisy” behaviour in the market is persistent and  noise traders would not regret making their decisions even when made aware of “fundamental” values. So it may well be that this search should start from the more foundational theoretical work of analysing alternatives, if any, to Bayesian decision theory.

This brings to the second part of his terrific paper- Decision theory.  Fin eco and decision theory are connected because both require making decisions under risky/uncertain times. And much of decision theory is based on Bayesian thinking which is faulty as it does not really represent uncertainty:

Savage’s Bayesian approach is deemed faulty because it is not rich enough to describe one’s degree of confidence in her assessment, while a paradigm of rational belief should allow a distinction between assessments that are well-founded and those that are arbitrary. As a result, “the Bayesian approach could be viewed as an elegant but imperfect method for representation of uncertainty, one among many to be used depending on the application. Indeed, this is the way that it is viewed by many in diverse fields such as statistics, philosophy and computer science. However, within economic theory the Bayesian approach is the sole claimant to the throne of rationality”

He points to an alternate version of decision theory discused by Itzhak Gilboa of Tel Aviv University. As per Zappia, Gilboa and Schmeidler should be considered  for Nobel Eco for their work on decision theory. They have developed much iof the thinking on Decision Theory based on behavioral theories. Need to read much more on this.

Two broad points from his paper:

It is widely agreed that the failure of financial economics to account for market phenomena like the ones that originated the recent global crisis makes a reconsideration of the whole approach necessary. But this critical appraisal cannot be limited to what the mainstream explanation of the workings of financial markets regards as empirical “anomalies”. As seen above, the pioneering papers by Markowitz and others are an application of a specific theory of decision under uncertainty, one that denies any relevance to the distinction between risk and uncertainty. The normative content of this theory is now questioned and the search for an alternative foundational theory is seen by many as an urgent task. The new decision theories under uncertainty recently devised by Gilboa and others aim to replace the mainstream theory by generalising it.

The second point is of relevance to the history of economics. The tradition of thought putting emphasis on the distinction between risk and uncertainty – neglected after the acceptance of Savage’s axioms – has produced a series of heterodox contributions that are worth re-considering. 

This second issue on uncertainity is something Keynes was interested in. But Keynesians believed it is impossible to  formalise. Well they are wrong:

In particular, some Keynesian authors have long referred to “true uncertainty”, and the decline of interest in it has been considered as a major cause of the economics profession’s inability to anticipate the current crisis and its catastrophic effects (Skidelski 2009). However, these Keynesians’ insistence on the impossibility of providing a formal representation of true uncertainty appears misplaced. As briefly shown, Gilboa’s “behavioral theories” try to address exactly the same issues Keynes was interested in, namely that the degree of confidence in a probabilistic assessment of uncertain events is of crucial importance in decision making.

Even Giboa is wrong not acknowledging that his work is mainly Keynesian in nature:

The point is that when Gilboa (2009: 132-136) refers to a cognitive unease motivating the critical approach to decision theory he fails to acknowledge that this is very much in the tradition of Keynes, and on Ellsberg’s elaboration of Keynes’s viewpoint. It should be kept in mind thus that if and when a new theory of decision under uncertainty is proposed – one that gives a new normative content to decision theory and at the same time accounts for those “irrational” choices that put financial markets in disarray – it will be Keynesian in spirit.

Well again, I have hardly read anything  on decision theory.. But its linkage to fin eco is pretty much there and fascinating.  How fin eco boils down to decision in risk and uncertainty  is ignored but really important…It is all flowing from DT..

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