Pragmatic Pluralism 5: Finance

This chapter provides a map through the complex jungle of economic theories. There are many different theoretical approaches, and each aspect of the economy has been analysed by a number of different ones. However, it is neither feasible nor productive for students to engage with every possible angle for every topic. Hence, the chapters on different topics, together with Building Block 8: Economic Theories, sets out an alternative approach: pragmatic pluralism. Rather than pursuing the extreme of either only focusing on one approach, or including every possible strand of thought for every topic, we propose a pragmatic middle ground: teaching a select number of approaches for each topic. In this way, it is possible to introduce students to the variety and diversity of economic thinking, whilst still having enough time and space to properly discuss each of the insights in detail with them.

Topics:

Main opposing perspectives

■ Post-Keynesian economics: Animal spirits shape market movements

■ Neoclassical economics: Banks are rational intermediators

Main complementary perspective

□ Complexity economics: Systemic risk

Additional perspectives and insights

+ Behavioural economics: Systematic irrationality

+ Cultural economics: Analytical constructs shape the market

There are two long-standing strands of thinking about the role of finance within the economy. The first strand, deductive in nature, is often referred to as equilibrium models. It originates from the physiocrats in the 18^th century and is a central part of modern day neoclassical economics. The second, more inductive approach, is known as accounting or stock-flow consistent models. This strand of thought was born in the ideas of Jean-Baptiste Say and can today be found in modern day post-Keynesian economists. 

The former sees the non-financial economy and rational individual behavior as key, arguing that money is merely a unit of account and that finance can be excluded from macroeconomic models. The latter in contrast emphasizes the importance of the monetary flows in modern economies and dynamics at the system, rather than individual, level. The strands derive their names from the fact that accounting models strive for completeness in capturing all flows (transactions) and stocks (balance sheets) in an economy, while equilibrium models only include variables that are theoretically deemed to be important in an economy defined by optimal outcomes (equilibria).

These differences might seem abstract and irrelevant, but they have enormous consequences for the world we live in. It is, for example, often said that no one saw the financial crisis of 2008 coming. This is, however, only true for those who used neoclassical equilibrium models (perhaps with the exception of Rajan, 2005). Various post-Keynesian economists did see it coming with the use of their accounting models, as Dirk Bezemer describes in more detail in his paper “No one saw this coming” (2009).

Neoclassical economics assumes the financial sector acts as an intermediary between savers and investors in order to ensure efficient capital allocation. This role of finance can be understood as pure intermediation in which they simply connect savings to investment opportunities. Within this theoretical strand we can also find the theory of the money multiplier. This theory refers to the situation in which commercial banks should only hold a certain ratio of reserves, that in turn determines the maximum amount of money they can create. In both cases, the financial sector, however, has a passive role as it simply facilitates the real economy. Based on this understanding of the financial sector, many models have been built in order to explain the level of interest rates and asset prices. One of the most famous theories is the efficient-market hypothesis which sees investors as making rational trade-offs between risk and return based on all available information and thus argues that only new information should cause change. 

In contrast to the neoclassical idea that the financial sector plays a passive role in the real economy, post-Keynesian economists argue instead that finance has an active and innovative role which has enormous consequences for the rest of the economy. They argue that financial decisions depend on animal spirits, instead of rationality, as decisions are influenced by instincts, emotions and proclivities. 

The reason why post-Keynesian economists argue that financial decisions cannot be merely rational decisions made upon calculations of the probabilities of future events, is due to the existence of fundamental, or Knightian, uncertainty. When something is characterized by fundamental uncertainty it is inherently unpredictable and impossible not only to assign any form of probability but sometimes impossible to even imagine, in other words ‘unknown unknowns’. Investors facing this type of uncertainty have no choice but to base their decisions upon knowledge of the past or on instincts. Furthermore, they point out that banks do not just intermediate, they create new money by granting credit. This is also linked to the idea that the credit cycle, which describes the expansion and contraction of access to credit over time, drives the business cycle. In opposition to the efficient market hypothesis, some post-Keynesian economists have therefore proposed the financial instability hypothesis. Prosperous periods cause speculative borrowing and bubbles to arise, which in turn end in a Minsky moment and credit crunch, which hurts the rest of the economy. 

Complexity economics overlaps to a certain extent with post-Keynesian approaches to finance as it focuses on system dynamics. Financial booms and busts are understood as self-reinforcing asset-price changes, which are prevalent but unpredictable as the decisions and forecasts of many individual agents in complex networks go through phases because of their interactions and feedback effects. An important topic is therefore systemic risk, which is the risk associated with the financial system as a whole, as opposed to individual banks, companies or firms, and thus is concerned with interlinkages and interdependencies. Systemic risk also explains why the failure of one individual entity can trigger a crisis for the entire system. Countering earlier popular ideas that diversification and deregulation are generally desirable, this line of research focuses on the risks associated with interconnectedness and ever more sophisticated financial instruments.

Finally, behavioural and cultural economics provide additional insights into how finance works by focusing on psychological, cognitive and social processes.

Behavioural economics: While largely staying within the neoclassical framework, behavioural finance assumes that people are boundedly, instead of fully or hyper, rational. People make errors because of their limited cognitive capabilities, lack of self-control, biases, loss aversion, time-inconsistent preferences, and emotions. Because of this, behavioural finance argues that people make systematic errors which create market inefficiencies, but also allow other participants to take advantage of this.

Cultural approach: Over the last decades, an increasing number of scholars has been applying the cultural approach to understand the world of finance. Economic anthropologists, for example, have used ethnographic methods to better understand everyday workplace culture and norms shape how the financial system works. Economic sociologists, on the other hand, have been mainly focusing on cognitive processes and the role of economic ideas in the workings of finance. An important insight is that economic ideas can be performative in the sense that they can shape the phenomena they describe and thereby bring reality closer to their theory. One example of this, is how the neoclassical Black-Scholes-Merton model of option pricing initially poorly described pricing patterns, but later on became empirically successful as market participants began to use the model to trade.

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