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Alan Kirman, GREQAM, Universit é Paul Cézanne, EHESS, IUF

Problems and progress in Financial Economics: The General Equilibrium Model, the Efficient Market Hypothesis and a new equilibrium concept. Alan Kirman, GREQAM, Universit é Paul Cézanne, EHESS, IUF Presentation at the Econofis’ 10 Meeting Sao Paolo, Brazil March 25th 2010.

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Alan Kirman, GREQAM, Universit é Paul Cézanne, EHESS, IUF

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  1. Problems and progress in Financial Economics: The General Equilibrium Model, the Efficient MarketHypothesis and a new equilibrium concept Alan Kirman, GREQAM, Université Paul Cézanne, EHESS, IUF Presentation at the Econofis’ 10 Meeting Sao Paolo, Brazil March 25th 2010

  2. Two important questions • To what extent should the economic crisis cause us to rethink economic theory? • Do economists and their theories bear any responsibility for the crisis? Presentation at the Econofis' 10 meeting Sao Paolo, Brazil, March 25th 2010

  3. A Remark • We spent the twentieth century perfecting a model based on nineteenth century physics • Maybe in the twenty first century we can make more use of twentieth century physics Presentation at the Econofis' 10 meeting Sao Paolo, Brazil, March 25th 2010

  4. Paul De Grauwe: The crushing responsibility of economists • « Clearly the financial crisis is not only due to the delusions of macroeconomists. The delusions were quite widespread among bankers, supervisors, media and policymakers. Yet society expects the community of scientists to be less prone to delusions than the rest. In that sense the responsibility of the economics profession is crushing ». Financial Times 2009 Presentation at the Econofis' 10 meeting Sao Paolo, Brazil, March 25th 2010

  5. Blameless Economists • Economics should bear no more blame for predicting any economic meltdown than a meteorologist for failing to call for snow. Both fields of modeling are as complex and vast when done correctly. Now it is possible that someday meteorologist will get really good at predicting the weather, and it seems they do improve with time, but I doubt they will ever get it exactly right all the time. Economics will always be the same. They will never get it exactly right, particularly since whatever they predict actually influences the prediction. So, since predicting the weather is a worthwhile exercise even though it is inexact, so to is economic prediction. in both cases, the fields are getting less wrong with time, but will never always be right. • Brian Jones FT Blog Presentation at the Econofis' 10 meeting Sao Paolo, Brazil, March 25th 2010

  6. The responsibility of scientists • This is a longstanding debate with which physicists are familiar • It was brought into particular prominence by the development of nuclear weapons. • But what about economists? Presentation at the Econofis' 10 meeting Sao Paolo, Brazil, March 25th 2010

  7. Which side should we come down on? • My basic claim is that we have been building unsound models which were the basis for many policies and practices. • This was not simply harmless academic research • Too many people developed and acted according to a world view which was unjustified • What are now referred to as « excesses » are an intrinsic part of the economic system. • We were not guilty of not forecasting the onset of the crisis but we were guilty of building models in which it could not happen. Presentation at the Econofis' 10 meeting Sao Paolo, Brazil, March 25th 2010

  8. Today’s Crisis • We are faced with a virtual collapse of the world’s financial system which has had dire consequences for the real economy. • The explanations given involve networksof banks, trustand contagionat all levels • These are not features of, nor characteristic of, economic models • They are typical of complex systems Presentation at the Econofis' 10 meeting Sao Paolo, Brazil, March 25th 2010

  9. Confidence in our theory The “central problem of depression-prevention has been solved,” , Robert Lucas 2003 presidential address to the American Economic Association. In 2004, Ben Bernanke, chairman of the Federal Reserve Board, celebrated the « Great Moderation » in economic performance over the previous two decades, which he attributed in part to improved economic policy making. Presentation at the Econofis' 10 meeting Sao Paolo, Brazil, March 25th 2010

  10. Economists live in a different world • Chicago’s Cochrane, outraged at the idea that government spending could mitigate the latest recession, declared: “It’s not part of what anybody has taught graduate students since the 1960s. They [Keynesian ideas] are fairy tales that have been proved false. It is very comforting in times of stress to go back to the fairy tales we heard as children, but it doesn’t make them less false.” … Cochrane doesn’t believe that “anybody” teaches ideas that are, in fact, taught in places like Princeton, M.I.T. and Harvard. • Paul Krugman (2009) NYT Presentation at the Econofis' 10 meeting Sao Paolo, Brazil, March 25th 2010

  11. Explaining economic phenomena • Everyone wants to know how the economy can suddenly go into a downturn like the current crisis. • Do economists build models which can explain this or do they offer ad hoc explanations without really questioning their models, (DSGE for example)? • In my view, we start with the wrong basis, we start from the isolated individual and build up to the aggregate without looking at the most important feature: the economy as a system of interacting agents. • I believe, that we should view the economy as a « complex adaptive system » Presentation at the Econofis' 10 meeting Sao Paolo, Brazil, March 25th 2010

  12. Our Basic Aims as Economists? • We wish to explain economic phenomena • We would like to construct models based on reasonable assumptions that lead to testable conclusions • When confronted with empirical data it should be possible to reject the model • But the very basis of our approach is not conducive to these aims. Presentation at the Econofis' 10 meeting Sao Paolo, Brazil, March 25th 2010

  13. An economic model is not scientific if it does not have“Sound Micro-foundations” • By this we mean that we have a model based on the rational optimising behaviour of the individuals in the market or economy.This has been widely criticised from Simon onwards. • In standard market models and in particular in macro models we characterise aggregate behaviour as resulting from such an individual model. • This is at the heart of the General Equibrium Model • Yet much structure is lost under aggregation so this is not legitimate theory. Presentation at the Econofis' 10 meeting Sao Paolo, Brazil, March 25th 2010

  14. The scientific approach « There is something fascinating about science. One gets such wholesale returns of conjecture out of such a trifling investment of fact » Mark Twain, Life on the Mississippi (1883) Presentation at the Econofis' 10 meeting Sao Paolo, Brazil, March 25th 2010

  15. Rationality • Why are we economists so attached to our rational individuals? • Mathematical convenience or economic plausibility? • The assumptions are not testable they come from introspection. (Pareto, Koopmans, Hicks…..) • They do not allow for development of preferences over time • They do not allow for the influence of others Presentation at the Econofis' 10 meeting Sao Paolo, Brazil, March 25th 2010

  16. What do our assumptions on rationality allow us to show? • Think, for the moment of an exchange economy, one without production. • Individuals have preferences over bundles of the l goods and an initial endowment of goods, e(a) • We make strong assumptions about these preferences, complete pre-orders, continuity, monotonicity,convexity • Individuals optimise their choice at given prices within their budget constraint Presentation at the Econofis' 10 meeting Sao Paolo, Brazil, March 25th 2010

  17. Demand and Aggregate Demand. • Each individual thus has a demand function for each price system p • We can aggregate over agents a • This gives • Now finally we can consider aggregate excess demand given by Presentation at the Econofis' 10 meeting Sao Paolo, Brazil, March 25th 2010

  18. Equilibrium, existence, uniqueness and stability • An equilibrium is then simply defined as p is an equilibrium price vectorif Z(p) = 0. • What we can show is the existence of an equilibrium • What we cannot show, (results of Sonnenschein, Mantel and Debreu) are the uniqueness or stability of equilibrium • Yet these two are primordial. Why? Presentation at the Econofis' 10 meeting Sao Paolo, Brazil, March 25th 2010

  19. Warnings • This should have alerted us to the difficulties of our model • No uniqueness, no comparative statics • For an economy to converge to an equilibrium from arbitrary starting prices would need an infinite amount of information, (result of Saari and Simon) Presentation at the Econofis' 10 meeting Sao Paolo, Brazil, March 25th 2010

  20. The Easy Way Out • Macroeconomists make the assumption that the aggregate economy or market acts like an individual. • They use the « representative agent » • This removes the problems raised by SMD since an economy with one agent has a unique and stable equilibrium • But is this legitimate? Presentation at the Econofis' 10 meeting Sao Paolo, Brazil, March 25th 2010

  21. Correspondence with Bob Solow April 1988 • « My view of the way economists actually do behave coincides with yours , and most especially about macroeconomists. I have become a sort of common scold on this subject. • I wholeheartedly agree with the point that economics self-destructs in part because we insist on supposing that everywhere and always individuals maximize purely individualistic preferences subject only to technological, legal, and budget constraints. Presentation at the Econofis' 10 meeting Sao Paolo, Brazil, March 25th 2010

  22. Correspondence continued • It is a transparently false assumption, and the brotherhood expends vast ingenuity trying to account for facts within that silly framework. • There are at least two of us. » Robert M Solow Presentation at the Econofis' 10 meeting Sao Paolo, Brazil, March 25th 2010

  23. The result of the insistence on « scientific » foundations • Modern macro-economists have built more and more abstract and mathematically sophisticated models (Dynamic Stochastic General Equilibrium Models). • These models do not contain the possibility of a crisis • They bear no perceptible relation to reality. Presentation at the Econofis' 10 meeting Sao Paolo, Brazil, March 25th 2010

  24. Bob Solow’s View today • Maybe there is in human nature a deep-seated perverse pleasure in adopting and defending a wholly counterintuitive doctrine that leaves the uninitiated peasant wondering what planet he or she is on.—Robert M Solow 2009 Presentation at the Econofis' 10 meeting Sao Paolo, Brazil, March 25th 2010

  25. Is Rationality Intrinsic or Learned? "In general we view, or model, an individual as a collection of decision rules (rules that dictate the action to be taken in given situations) and a set of preferences used to evaluate the outcomes arising from particular situation-action combinations. These decision rules are continuously under review and revision: new decisions are tried and tested against experience, and rules that produce desirable outcomes supplant those that do not. I use the term "adaptive" to refer to this trial-and-error process through which our modes of behaviour are determined." Lucas (1988) Presentation at the Econofis' 10 meeting Sao Paolo, Brazil, March 25th 2010

  26. Yes But! So Lucas argues that we can safely assume that individuals act as if they were optimising But, if the environment consists of other individuals who are also learning what guarantee do we have that the system will converge to « as if «  optimising behaviour? Presentation at the Econofis' 10 meeting Sao Paolo, Brazil, March 25th 2010

  27. Who is learning in the economy? • People learn but they learn about other people who are also learning! • So it is not clear who is really learning! Presentation at the Econofis' 10 meeting Sao Paolo, Brazil, March 25th 2010

  28. Herb Simon • “Roughly by a complex system I mean one made up of a large number of parts that interact in a nonsimple way. In such systems, the whole is more than the sum of the parts, not in an ultimate metaphysical sense, but in the important pragmatic sense that, given the properties of the parts and the laws of their interaction, it is not a trivial matter to infer the properties of the whole. In the face of complexity, an in-principle reductionist may be at the same time a pragmatic holist.”Herbert Simon (1962, p. 267) Presentation at the Econofis' 10 meeting Sao Paolo, Brazil, March 25th 2010

  29. Is complexity just a fad in economics? • Complex systems are characterised by the following features: • They are composed of interacting “agents” • These agents may have simple behavioural rules • The interaction among the agents means that aggregate phenomena are intrinsically different from individual behaviour. • The network which governs the interaction is crucial • Some comments on the current financial situation Presentation at the Econofis' 10 meeting Sao Paolo, Brazil, March 25th 2010

  30. Coordination v. Efficiency • Efficiency is the major concern of economists • We focus on efficient mechanisms, such as auctions (an example). • Yet perhaps the problem of coordination is the most important • How do collective outcomes emerge from the interaction between individuals each of whom has only a local vision of the situation? Presentation at the Econofis' 10 meeting Sao Paolo, Brazil, March 25th 2010

  31. Why are Aggregates Different from Individuals? Revolutions and Crowds

  32. Who is responsible? • « In a an avalanche no single snowflake feels itself responsible » Voltaire Presentation at the Econofis' 10 meeting Sao Paolo, Brazil, March 25th 2010

  33. Isaac Newton « I can calculate the motion of heavenly bodies, but not the madness of people » Presentation at the Econofis' 10 meeting Sao Paolo, Brazil, March 25th 2010

  34. Why not treat the aggregate like an individual??

  35. Back to basics: Our first aim in theory Our analysis is based on the idea of equilibrium. Thus we have, as I have said, first to prove the existence of equilibrium Presentation at the Econofis' 10 meeting Sao Paolo, Brazil, March 25th 2010

  36. For this we want CONTINUITY of aggregate behaviour • This we try to obtain by constructing continuous individuals. • Adding these will guarantee continuity at the aggregate level • But when individuals are heterogeneous and not continuous we may still get continuous behaviour at the aggregate level. Presentation at the Econofis' 10 meeting Sao Paolo, Brazil, March 25th 2010

  37. An Example: Bees The example of bees. Notice the difference between the “representative bee” and reality. Presentation at the Econofis' 10 meeting Sao Paolo, Brazil, March 25th 2010

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  39. Where does the difficulty with the standard economic model come from? • The economy is made up of individuals who interact directly. • Such systems do not have aggregate behaviour which can be characterised as the average behaviour of the individuals Presentation at the Econofis' 10 meeting Sao Paolo, Brazil, March 25th 2010

  40. Direct interaction • Economic agents interact with each other • They exchange information • They influence each other by modifying each others’ expectations for example • They mimic each other • They trade Presentation at the Econofis' 10 meeting Sao Paolo, Brazil, March 25th 2010

  41. Trade and its organisation • None of the following questions is answered within the standard model • Who trades with whom? • How is this organised? • Who sets prices and how? • What are the prices at each stage? • These questions are not, in general, meaningful without direct interaction. Presentation at the Econofis' 10 meeting Sao Paolo, Brazil, March 25th 2010

  42. Game Theory • This is one approach which does take account of direct interaction • The problems with this approach • The rationality attributed to individuals is of a different order from that of the General Equilibrium model. • We increase the calculating capacity of agents. • Coordination, the choice of roads. Presentation at the Econofis' 10 meeting Sao Paolo, Brazil, March 25th 2010

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