I have long had an interest in what the financial crisis means for the future of the fields of economics and finance (see Future of Financial Economics and Future of Financial Economics Part Deux). So I was incredibly pleased to come across Krugman’s abbreviated history and thoughtful criticisms of the field of economics in the New York Times Magazine (see How Did Economists Get It So Wrong).

A bit of a teaser:

Last year, everything came apart.

Few economists saw our current crisis coming, but this predictive failure was the least of the field’s problems. More important was the profession’s blindness to the very possibility of catastrophic failures in a market economy. During the golden years, financial economists came to believe that markets were inherently stable — indeed, that stocks and other assets were always priced just right. There was nothing in the prevailing models suggesting the possibility of the kind of collapse that happened last year. Meanwhile, macroeconomists were divided in their views. But the main division was between those who insisted that free-market economies never go astray and those who believed that economies may stray now and then but that any major deviations from the path of prosperity could and would be corrected by the all-powerful Fed. Neither side was prepared to cope with an economy that went off the rails despite the Fed’s best efforts.

What happened to the economics profession? And where does it go from here?

As I see it, the economics profession went astray because economists, as a group, mistook beauty, clad in impressive-looking mathematics, for truth…the central cause of the profession’s failure was the desire for an all-encompassing, intellectually elegant approach that also gave economists a chance to show off their mathematical prowess.

Unfortunately, this romanticized and sanitized vision of the economy led most economists to ignore all the things that can go wrong. They turned a blind eye to the limitations of human rationality that often lead to bubbles and busts; to the problems of institutions that run amok; to the imperfections of markets — especially financial markets — that can cause the economy’s operating system to undergo sudden, unpredictable crashes; and to the dangers created when regulators don’t believe in regulation.

Krugman follows that introduction with a fascinating, and well-informed, account of the history and development of the field of economics, with a focus on macroeconomics/finance and the longstanding debate between so-called freshwater (Free-Market) economists and saltwater (Keynseyian) economists. Although Krugman and I are in different academic fields (Krugman is an international macro scholar and I am an international business strategy scholar), our conclusions with respect to the future of financial economics are more or less aligned. Krugman suggests:

If the profession is to redeem itself, it will have to reconcile itself to a less alluring vision — that of a market economy that has many virtues but that is also shot through with flaws and frictions. The good news is that we don’t have to start from scratch. Even during the heyday of perfect-market economics, there was a lot of work done on the ways in which the real economy deviated from the theoretical ideal. What’s probably going to happen now — in fact, it’s already happening — is that flaws-and-frictions economics will move from the periphery of economic analysis to its center.

There’s already a fairly well developed example of the kind of economics I have in mind: the school of thought known as behavioral finance [economics].

Krugman’s article is a fairly long (hence its placement in the magazine), but well worth your time to read. So carve out a bit of time, visit the NY Times Magazine website, pour yourself a drink, and enjoy the read.

Back in March I suggested that an open discussion about the future of financial economics seemed warranted (see Future of Financial Economics). I wrote:

Are the fundamental assumptions about human behavior associated with the dominant paradigm in financial economics appropriate?

The first assumption that I took issue with was that of complete markets. In fact, as I suggested:

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.

Markets break down largely because humans do not behave as “rational” actors typically assumed in our most celebrated models.

In addition to the view of markets as complete, I took issue with some of the other assumptions underlying the efficient market hypothesis.

…associated with the [efficient market hypothesis] 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.

I concluded by calling for greater inclusion, and an openness to contributions from behavioral economics and other social science disciplines.

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.

With that as background, I was pleased to come across a fascinating set of articles from this week’s issue of the Economist entitled “Economics: What went Wrong?” This collection of articles asked fundamentally important questions about the future of the field of economics (see Economics: What went Wrong?, Other-worldy Philosophers, and Efficiency and Beyond).

On the field of economics:

Barry Eichengreen, a prominent American economic historian, says the crisis has “cast into doubt much of what we thought we knew about economics.”

…two central parts of the discipline—macroeconomics and financial economics—are now, rightly, being severely re-examined. There are three main critiques: that macro and financial economists helped cause the crisis, that they failed to spot it, and that they have no idea how to fix it.

On financial economics:

In 1978 Michael Jensen, an American economist, boldly declared that “there is no other proposition in economics which has more solid empirical evidence supporting it than the efficient-markets hypothesis” (EMH). That was quite a claim. The theory’s origins went back to the beginning of the century, but it had come to prominence only a decade or so before. Eugene Fama, of the University of Chicago, defined its essence: that the price of a financial asset reflects all available information that is relevant to its value.

From that idea powerful conclusions were drawn, not least on Wall Street. If the EMH held, then markets would price financial assets broadly correctly. Deviations from equilibrium values could not last for long. If the price of a share, say, was too low, well-informed investors would buy it and make a killing. If it looked too dear, they could sell or short it and make money that way. It also followed that bubbles could not form—or, at any rate, could not last: some wise investor would spot them and pop them.

That is why many people view the financial crisis that began in 2007 as a devastating blow to the credibility not only of banks but also of the entire academic discipline of financial economics.

On macroeconomics:

In many macroeconomic models…insolvencies cannot occur. Financial intermediaries, like banks, often don’t exist. And whether firms finance themselves with equity or debt is a matter of indifference. The Bank of England’s DSGE model, for example, does not even try to incorporate financial middlemen, such as banks. “The model is not, therefore, directly useful for issues where financial intermediation is of first-order importance,” its designers admit. The present crisis is, unfortunately, one of those issues.

…Economists can become seduced by their models, fooling themselves that what the model leaves out does not matter. It is, for example, often convenient to assume that markets are “complete”—that a price exists today, for every good, at every date, in every contingency. In this world, you can always borrow as much as you want at the going rate, and you can always sell as much as you want at the going rate.

The benchmark macroeconomic model…suffers from some obvious flaws, such as the assumption of complete markets or frictionless finance…nuanced theories are often less versatile. They shed light on whatever they were designed to explain, but little beyond.

On behavioral economics:

…[a] branch of financial economics is far more sceptical about markets’ inherent rationality. Behavioural economics, which applies the insights of psychology to finance, has boomed in the past decade. In particular, behavioural economists have argued that human beings tend to be too confident of their own abilities and tend to extrapolate recent trends into the future, a combination that may contribute to bubbles. There is also evidence that losses can make investors extremely, irrationally risk-averse—exaggerating price falls when a bubble bursts.

“In some ways, we behavioural economists have won by default, because we have been less arrogant,” says Richard Thaler of the University of Chicago, one of the pioneers of behavioural finance. Those who denied that prices could get out of line, or ever have bubbles, “look foolish”.

The Economist concludes:

Add these criticisms together and there is a clear case for reinvention…Economists need to reach out from their specialised silos…

I could not agree more.

However you may feel about the future of financial economics, I encourage you to read the articles in full:

• Economics: What went Wrong?
• Other-worldy Philosophers
• Efficiency and Beyond

I’ve been tied up with end of year meetings, graduation, and conference travel lately. This has kept me from posting as regularly as I might like. But I did get to see Hillary Clinton speak at NYU’s commencement last week (see Clinton Gives NYU Commencement Speech).

I quite liked Hillary’s speech, but then again, I’m a sucker for idealistic, inspirational graduation messages. Between you and me, I also enjoy the pomp and circumstance, and the pageantry of the day. And as much as we academics like to complain that graduation ceremonies are long, boring, and suck up otherwise productive hours from a day, a good speaker or two can go a long way toward making the experience worthwhile.

A good set of commencement speeches never fail to remind me why I got into the education business in the first place – to learn, to discover, to share, to teach, and to inspire. Needless to say, I came away from the NYU commencement ceremony feeling reinvigorated and reassured about our academic mission (despite the economic challenges).

So now that I’ve had all the inspiration I can take for one week, let’s switch gears to something not quite as uplifting – the impending bankruptcy of GM (see GM Doesn’t See Deal Before Deadline). According to the NY Times:

With a week remaining before the expiration of a tender offer to its bondholders, General Motors said Tuesday that it did not expect to reach an agreement with the United Automobile Workers and others before bondholders decide.

G.M. is trying to persuade the holders of $27 billion in unsecured notes to exchange them for about 41 cents on the dollar. It must receive tenders for 90 percent of its bonds in order for the offer to be successful and avoid a bankruptcy filing.

Many analysts believe that the offer, which expires May 26, will fail and that G.M. will seek Chapter 11 protection.

But we knew that already.

And we wait…

The big story today is the Obama administration’s decisions regarding GM and Chrysler aid (see US Lays Down Terms for Bailout). I won’t spend time re-hashing the specifics; instead, I will provide commentary on the plan as it has been advanced, assuming you already know the specifics.

Overall, I think this plan represents a sensible approach. It recognizes that there is substantial heterogeneity across GM and Chrysler. Their importance to the broader economy differs. GM is obviously the more systemically important firm of the two. Moreover, the two are not on equal footing with respect to future prospects. GM’s product portfolio moving forward is far superior. For these reasons, I have been an advocate of treating GM and Chrysler differently (see Pre-Packaged Bankruptcy, Preventing Moral Hazard, and Aid for Chrysler? Just say No! for details).

Kudos to the auto task force for recognizing this and responding accordingly. As a result, the Obama administration has committed to seeing GM through this crisis. Chrysler, by contrast, is on its own.

The Obama administration will provide additional aid for GM, and has committed to an out-of-court restructuring, provided GM receives substantial concessions from its creditors and its union. In the absence of a meaningful agreement with the UAW and bondholders, at the very least, the US government has pre-committed to act as GM’s DIP financier in bankruptcy, and guarantee its existence through the restructuring process (see Could GM Survive Bankruptcy?). The threat of bankruptcy for GM (hopefully a credible one) should be enough to elicit cooperation from the bondholders and the UAW.

With respect to Chrysler, this is the beginning of the end. The administration has told Chrysler that it has 30 days to strike a deal with Fiat or else it will not receive any additional public funds. This creates a dilemma for Chrysler. It needs Fiat to survive, but Fiat needs the US government to commit a significant amount of capital before it agrees to any deal. After all, Fiat does not intend to inject capital into Chrysler (see Fiasco for Fiat and Chrysler and Fiat Revisited). What is clear is that Chrysler would require significantly more to survive than the $6 Billion that the government has promised in the event that they strike a deal with Fiat (see GM, Chrysler Need More Aid than Requested). Fiat knows that. Moreover, the likelihood that the US government will continue to throw money at Chrysler (in excess of the $6 Billion promised), even if they strike a deal with Fiat, is remote. Fiat knows that too.

So the writing is on the wall. Chrysler is likely finished.

What is unclear to me from the plan as it has thus far been outlined, is whether the US government acts as the DIP financier when Chrysler goes bankrupt, or whether it allows Chrysler to be liquidated. Obama seems to be hinting (as I listen in real time) that the government will act as DIP financier to Chrysler, …but I am skeptical.

Irrespective of whether the US government acts as Chrysler’s DIP financier, Chrysler will serve as a lesson to GM, its creditors, and its bondholders union. Allowing Chrysler to go bankrupt should be enough to wake up GM’s creditors and bondholders union to the reality that US taxpayers will not support them indefinitely.

As a first shot over the bow, the Obama administration began by ousting Rick Wagoner.

UPDATE @ 11:30am

One last point, some have been asking why not just impose bankruptcy now (at the very least for Chrysler) if that will be the endgame anyway. I think the answer to this question lies in the shock that would have reverberated throughout the market. A sudden bankruptcy would have caused panic among stakeholders of all sorts. At this point, bankruptcy for Chrysler is all but assured. Bankruptcy for GM is a real possibility (perhaps 50/50). So the point of today’s action (stopping just short of imposing bankruptcy) is to forewarn market participants. Given this information, it would be prudent for those who have a stake in this outcome to get their affairs in order.

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.