New Paradigms in Financial Economics

How Would Keynes Reconstruct Economics?

Kazem Falahati

• Publisher: Routledge
• Year: 2012
• eBook ISBN: 9781136221538
• Topic: Business
• Subtopic: Business General
• Index: Business

The recent global financial crisis has made the inadequacies of the scientific state of economics and finance glaringly obvious, as these disciplines gave the false reassurance that such a self-destructive phenomenon could not happen. A similar phenomenon arose in the 1930's, when the pitfalls of the dominant economic theories were sharply exposed. Since then, the same analytical framework, in its new versions, has revealed a huge number of other empirical and experimental failures.

On the other hand, the founders of the currently dominant theories in economics and finance (i.e. the standard paradigm) such as Walras (1834-1910), Modigliani (1918-2003) and Miller (1923-2000) have identified mathematical contradictions within their own foundational models, the root cause of which no one has yet discovered. The standard paradigm has thus lost the reason for its existence in the light of experience, experiments and logical rigour. This book identifies the heuristic cause of these external and internal contradictions of the standard paradigm and remedies these problems by offering a new paradigm which can explain and predict observed economic behaviour, and resolve the extant behavioural, empirical and experimental puzzles.

The new paradigm offers a dramatically improved understanding of economic behaviour at the micro as well as macro level of the economy within an over-arching framework comprising the real and the financial sectors. It does so in a rigorous but simple and clear way, using an axiomatic approach. It also offers policy recommendations on how the economy should be managed to avoid severe swings. It therefore is of great interest to scholars and practitioners in economics and finance.

1 Introduction

In one of his mid-career works in economics, Keynes (1923:107) uses the cost free theory of arbitrage in what we now call frictionless competitive markets to derive the currently well-known ‘interest rate parity theorem’. However, he qualifies this, and refers to ‘the floating capital’ needed for engaging in arbitrage and observes:

It must be remembered that the floating capital… for…taking advantage of…arbitrage profits… is by no means unlimited…

(Our emphasis)

Alas, Keynes does not follow up the consequences of this pithy insight, perhaps because he senses that it may clash with the prevailing views of his day on market equilibrium. We do so in this book, where we recognize that this capital constraint arises from scarcity of resources, in contrast to the standard paradigm which overlooks it. This helps define what liquidity means, and devise a new paradigm which resolves long-standing puzzles on economic behaviour of individuals, firms, banks, insurers and the generation of endogenous economic cycles (Kirman 2009). Perhaps, given a second life, Keynes would do likewise, hence the title of this book.

We identify the rationale underlying recognized inconsistencies relating to general equilibrium (Geanakoplos 1987: 119) and equilibrium asset pricing (Dybvig and Ingersoll 1982). We also resolve the puzzles discovered in experimental economics, e.g. the instant endowment effect (Kahneman et al. 1990) and asymmetric valuation of gains and losses (Benzion et al. 1989). Other puzzles we resolve include: empirical observations on financial policies of firms, including banks, following the 1958–61 Modigliani and Miller papers, excess volatility of share prices compared to dividends (Shiller 1981, 2003), reasons for the existence of corporate control premium and discount to net full asset value for closed-end mutual funds (Dimson and Minio-Paluello 2002) in efficient markets. The facts are not in dispute, what is missing is an overarching theory explaining these apparently disconnected points.

Our review of the existing literature challenges the foundational theories underlying so-called ‘rational’ economic behaviour and ‘rational’ expectations. We disprove the existence of utility functions by the standards of rigour in modern mathematics. We also contest claims on the existence of equilibrium, or the existence of single prices for goods, in efficient, frictionless and competitive markets. We deduce from our review of the existing literature that whilst existing paradigms provide pioneering, ad hoc and speculative contributions to our understanding, they do not offer a logically or mathematically rigorous and unified framework for resolving these puzzles. We fill this gap by a new overarching theoretical framework, which we call the new paradigm of frictionless competitive economies as a first proxy to the real world. The new paradigm forces us to think more precisely than hitherto about concepts such as opportunity cost, friction, liquidity, and the law of one price, and thereby offers new perceptions. It also provides a unified view of the real as well as the financial economy incorporating microeconomics and macroeconomics, contrary to the currently fragmented theories.

Table 1.1 gives an overview of assumptions and results in the new and old paradigms. The new paradigm resolves many long-standing puzzles such as the profit puzzle in microeconomics. It also provides logical explanations for many behavioural puzzles arising from experience and experiments. It proves that there are inherent swings in the economic reproduction cycle, and that the market has a natural tendency to price risk pro-cyclically, a well-known documented case of which is seen in the underwriting cycle of the general (property/casualty) insurance industry.

Table 1.2 compares our theory of the firm and model of corporate finance with that of the standard (neoclassical) paradigm in efficient frictionless competitive economies. It shows that the new paradigm can incorporate financial intermediaries, e.g. the banking system, unlike the standard paradigm. It also illustrates that our results do not contradict observed economic behaviour, and indeed they explain and predict it, contrary to those of the standard paradigm. The new paradigm can accommodate imperfect competition and frictions without much change to the insights it provides.

The structure of this book is as follows: In Chapters 2 and 3, we explain the key conceptual oversights in the most influential frameworks of economic analysis over the past 100 years, i.e. the Neoclassical and the Marxian paradigms. Our main aim here is to illustrate the internal contradictions of these paradigms in the simplest and most rigorous language, and explain that this is the reason for their empirical failure.

In Chapter 4, we introduce the new paradigm by setting out our common ground with the existing literature, clarifying and refining key concepts on economic behaviour and market characteristics, and presenting the assumptions of the new paradigm. We also derive our key theorem. In Chapter 5, we explain how the new paradigm resolves long-standing theoretical puzzles on economic behaviour, and those arising from experimental economics.

In Chapter 6, we describe the characteristics of the model of corporate finance and investment in the new paradigm, where firms can include financial institutions, including banks. In Sections 6.1 and 6.2 we study corporate policy assuming investor unanimity, whilst in Section 6.3 we relax this assumption. In Section 6.1, we prove that the firm has a maximum debt-capacity, which helps explain how credit booms turn into busts endogenously. In Section 6.2, we find that shareholder preferences on corporate dividend policy matter, and we obtain a new dividend valuation model, which explains the excess volatility of share prices compared with dividends. In Section 6.3, we focus on publicly listed firms with no investor ...

Table of contents

• Front Cover
• Half Title
• Routledge International Studies in Money and Banking
• Title Page
• Copyright
• Dedication
• Contents
• List of figures
• List of tables
• Preface
• List of abbreviations and acronyms
• 1 Introduction
• 2 Irrational foundations of ‘rational’ behaviour in the standard paradigm
• 3 Contradictions of the Marxian paradigm
• 4 The new paradigm
• 5 Resolution of puzzles in microeconomics
• 6 Resolution of puzzles in finance
• 7 Resolution of puzzles in macroeconomics
• 8 Economic role of the State
• 9 The recent global financial crisis
• 10 Conclusion, policy and research recommendations
• Appendix 1 A review of some of the academically more popular paradigms
• Appendix 2 A review of some of the academically less popular paradigms
• Appendix 3 Existing literature on resolution of puzzles in corporate finance
• List of commentators
• List of institutions
• Bibliography
• Index