The Virtues and Vices of Equilibrium and the Future of Financial Economics
John Geanakoplos and Doyne Farber
In this working paper from the Cowles Foundation at Yale University, economist John Geanakoplos and physicist Doyne Farber provide a very insightful discussion of the state of financial economics and its future using insights from other sciences such as physics and biology.
Both authors have experiences in academia and hedge funds and their professional careers have led them to think about financial economics as it stands today.
Financial economics is fundamentally a branch of economics and shares its intellectual roots in equilibrium theory and market efficiency. Given a set of restrictive assumptions, markets clear and are efficient in equilibrium. Agents maximize their utility functions and follow rational expectations. This approach has been very successful in constructing rigorous and theory-based financial economics especially as it emphasizes rationality, succinctness and a standardized approach to tackle economics problems.
The main weaknesses are that the assumptions are likely to be too strong in terms of rationality and perfect information and that there are very few models of out-of-equilibrium dynamics contrary to the fields of physics for instance. Many market situations involve disequilibrium. As an example, the authors discuss the subprime mortgage crisis of 2007 with its dynamics from lax financial regulation to overly tight financial constraints that caused the crisis.
The authors have interesting discussion on when a physics-like perspective can be more useful than an agent-based modeling, for instance, a crowd can be seen as a fluid instead of a discrete group of interacting and calculating economic agents. The power-law is an example of a physical pattern frequently observed (such as in the distribution of the size of cities of the income of wealthy individuals) that does not require a micro-based modeling.
In their last section, the authors discuss several promising paths for the future of financial economics: behavioral and experimental finance, zero-intelligence models, bounded rationality models, biological models (evolution and ecology) and the importance of having a taxonomy of investment strategies.