I’ve had a series of interesting conversations with thoughtful, articulate, and intelligent academics who span disciplinary boundaries (finance, economics, sociology, and psychology) about what the future of the field of financial economics should/will/might look like. In light of the financial crisis, this has been a popular topic of conversation.

There have been two recurring themes:

1. Are the fundamental assumptions about human behavior associated with the dominant paradigm in financial economics appropriate?
2. Is shareholder wealth maximization the appropriate objective function?

With respect to the former, I have been engaged in conversations with folks who echo some of Willem Buiter’s concerns. In a brilliant blog post (see State of the Art Uselessness) Buiter contends:

The most influential…theorists all worked in what economists call a ‘complete markets paradigm’. In a world where there are markets for contingent claims trading that span all possible states of nature (all possible contingencies and outcomes), and in which intertemporal budget constraints are always satisfied by assumption, default, bankruptcy and insolvency are impossible. As a result, illiquidity – both funding illiquidity and market illiquidity – are also impossible…

[The] complete markets…theories not only did not allow questions about insolvency and illiquidity to be answered.  They did not allow such questions to be asked.

It is clear that, when searching for an appropriate simplification to address the intractable mess of modern market economies, the starting point of ‘no markets’…is a much better one than that of ‘complete markets’.

My Comment: 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. But back to Buiter:

In…approaches to monetary theory…the strongest version of the efficient markets hypothesis (EMH) was maintained.  This is the hypothesis that asset prices aggregate and fully reflect all relevant fundamental information, and thus provide the proper signals for resource allocation.

My Comment: I would go one step further and suggest that associated with the 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. Buiter alludes to that as well, although he does not come right out and say it:

The efficient markets hypothesis assumes that there is a friendly auctioneer at the end of time – a God-like father figure – who makes sure that nothing untoward happens with long-term price expectations or (in a complete markets model) with the present discounted value of terminal asset stocks or financial wealth.

What this shows, not for the first time, is that models of the economy that incorporate the EMH…are not models of decentralised market economies, but models of a centrally planned economy.

My Comment: Interesting, so in treating human behavior as governed by the tenets of homo economicus, our agentic models actually obviate agency.

In one of the conversations that I had with a prominent game theorist and a well-regarded entrepreneurship scholar, some of these issues came up. For example, we discussed the importance of incorporating the varying belief-structures of the participants in a market into the value equation. The participants themselves may have such varying beliefs about the market that, in effect, they might actually be playing different games governed by different rules. In such a circumstance it might be better to analytically treat assets as not having an intrinsic (fundamental) value, but rather, to treat the “value” of the assets as contingent upon participants’ subjective beliefs – i.e., the value of the asset is only worth what the next guy is willing to pay for it.

With respect to the second issue (shareholder wealth maximization), I have had more than a few conversations with prominent economists and sociologists about the social implications of a dogmatic adherence to models of shareholder wealth maximization. Unfortunately, if incentives are structured such that they exclusively reward shareholders (and in some cases, managers) at the expense of other constituents (stakeholders), this could lead to suboptimal social outcomes.

As an alternative, a group of scholars in strategy have offered a Stakeholder view of the firm. Stakeholder Theory, most closely associated with Edward Freeman (see wikipedia for a brief overview), suggests that firms ought to incorporate the interests of various stakeholders into their decision calculus, and not simply what’s best for shareholders. They argue that this would result in a firm that generates value not just for shareholders, but also for stakeholders (suppliers, customers, employees, communities, etc.). It shifts the maximization problem from one of individual utility maximization (in the interest of shareholders) toward one of joint utility maximization (balancing the disparate concerns of various interested parties).

Shareholder maximization vs. Stakeholder maximization has been a topic of considerable debate in the strategy literature over the past 15-20 years. And given the social costs of this financial crisis, I would not be surprised to see the Stakeholder view gain more traction in the years to come.

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.

This entry was posted on Wednesday, March 18th, 2009 at 9:38 pm and is filed under Business Schools, Economy, Philisophy. You can follow any responses to this entry through the RSS 2.0 feed. You can skip to the end and leave a response. Pinging is currently not allowed.