The King is dead. Long live the King
from Juan Pablo Pardo-Guerra
The financial crisis has the makings of a Kuhnian revolution. In competition for a reconstituted sense of legitimacy are at least two houses of economic thought. The established regime of neoclassical economics provided the theoretical, normative and rhetoric scaffolds of financial regulation since at least the late 1960s. Behavioral economics, in contrast, emerged more recently as a reaction to the apparent illusion of rationality, uncovering the anomalies and biases that are unintelligible to the theoretical instruments of the previous regime. And today, whilst regulators scramble to rescue the institutions of the past and secure the markets of the future, economists wrestle – perhaps not nearly as explicitly as one would think – to redefine the nature and scope of their discipline in relation to the state and its regulatory practices. The contest between two royal households is on, between the extended neoclassical family and the smaller though by no means less robust house of behavioral economics.
The contest for legitimacy began some months ago when, in the midst of the crisis, the King of the neoclassical house was declared. Then, numerous commentators and analysts identified the failure of the extant paradigm of financial regulation to control systemic risks in the market. Neoclassical economics, read the epitaph, failed to provide the required insurance against catastrophe, the veracity of its representations fractured by the irrational mobs of the market. In July 2009, a series of articles in The Economist highlighted the tensions between efficient-market believers and behavioral economists. A few months later, in November 2009, the economics editor for the BBC, Stephanie Flanders, anticipated disciplinary transformations as a result of the crisis. And, in a different tone, paradigmatic change reached the ears and pens of financial regulators. In its relatively recent Turner Review, the Financial Services Authority provided the outlines of a new royal household, substituting the names of yore – from Fischer Black and Eugene Fama to Merton Miller, Robert Merton and William Sharpe – with a new and peculiar legion – from John Maynard Keynes and Benoit Mandelbrot to Hyman Minsky and Robert Shiller. As an offspring of the neoclassical tradition, modern financial economics seemed to have become a thing of the past.
Recently, however, the King’s household has shown signs of strength. Perhaps the King and his court were merely secluded in the country, awaiting the revolution in the city to subside. Chicago, the seat of the aristocracy, seems relatively untouched by the crisis. The soul-searching, noted David Ruccio, seems to be returning to the practices of the past. Rather than blaming the tools, some organizations are emphasizing an apparent ‘lack of information’ as the cause of crisis. In effect, as the pragmatism of reconstruction kicks in, the novelty of revolution has lost its luster.
The survival of the King and his followers may well be a reflection of the durability of the institutions and instruments of the neoclassical canon. There exists no substitute, be it in rhetoric scope, organizational weight or instrumental specificity, to the dominant traditions of neoclassical economics. Behavioral economics and behavioral finance, however strong they may seem, remain at the margins of the mainstream. And despite valiant attempts to give them a regulatory form, the instruments of policy and control deployed by the old regime still outnumber the tools of the behavioral house economics. Indeed, the fragility of behavioral approaches to the market may well reside in the fact that they have yet to coalesce into the type of institutional forms adopted by financial economics almost three decades ago – from business schools to masters programs, from forms of representation to forms of overt intervention and design. Alas, behavioral economics seems confined to the detection of discrepancies in the market, to constructing arbitrage opportunities, and, in this sense, to proving that markets are efficient after all.
There remain key battles to be fought, however, and in the contest for legitimacy, ‘novel’ approaches to systemic risk are likely to become central to the re-distribution of authority within economics. The theorization of leverage is once again in debate, as are incentive structures within the financial services industry. The organizational investments of fund managers and traders, along with the capital structure of banks is, once again, a matter of debate. Nevertheless, a critical task that has yet to be approached is unpacking the risks of interconnectivity, from the legal networks that bound and structure complex synthetic instruments to the systemic behaviors of markets that are increasingly driven by algorithmic trading. Perhaps neither royal house possesses the requisite instruments for examining economic life in the realm of millisecond trading. Perhaps the aggregative approach of traditional time series analyses is no longer helpful for basing our descriptions and theorizations of the market. Indeed, it may be time for the division of labor between economics and its neighbouring disciplines to be revised altogether, for the editorial boards across the field to forgo their preference for the axiomatic formalization of economic relations and embrace a broader set of analytical approaches.
The future is uncertain, but perhaps this very uncertainty is the best catalyst of all. Maybe (just maybe) regulators will deliver; if not a robust framework of control and surveillance for the markets of the future, at the very least an incentive on which to construct a new (perhaps less regal) tradition.