The Limits of Economics

On August 1, 2011, in economic theory, by Jon Lewis

Beyond Mechanical Markets: Asset Price Swings, Risk, and the Role of the State. Roman Frydman and Michael D. Goldberg. Princeton University Press 2011, pp.285, $35.00. In assessing the financial crisis of 2007-2008, it is important to have a conceptual framework to understand not only what went wrong, but also why it went wrong. Was the [...]

Beyond Mechanical Markets: Asset Price Swings, Risk, and the Role of the State. Roman Frydman and Michael D. Goldberg. Princeton University Press 2011, pp.285, $35.00.

In assessing the financial crisis of 2007-2008, it is important to have a conceptual framework to understand not only what went wrong, but also why it went wrong. Was the crisis a result of a liquidity shock, a herd mentality by investors and speculators overly optimistic about ever rising housing values, or the deregulation of the financial services industry? One’s policy and regulatory recommendations will depend to a large extent on how one views the causes of the crisis. If the crisis was the inevitable result of deregulation, more and better regulation is the logical response. If government intervention, however, prolonged and worsened the crisis, then the rational response is for the federal government to do less when the next, similar crisis comes around.

But what if, instead, economists have been thinking about the financial crisis from the wrong perspective? Indeed, what if the very assumptions underlying contemporary macroeconomics have made it difficult to properly understand what went wrong? In Beyond Mechanical Markets, Roman Frydman (New York University) and Michael D. Goldberg (University of New Hampshire) make the case that “the conceptual framework underpinning the debate triggered by the global financial crisis is grossly inadequate for understanding what went wrong with our economies and what should be done to reform them. The reason is simple: contemporary macroeconomic and finance theory attempts to account for risk and swings in asset prices with models that suppose nonroutine change is irrelevant, as if nothing genuinely new can ever happen.”

Frydman and Goldberg argue that, “by ruling out novelty, contemporary macroeconomic and finance models assume away financial markets’ raison d’être—namely, to help allocate society’s capital in the face of nonroutine change and the imperfect knowledge that it engenders in modern economics.” The authors want to place the concept of imperfect knowledge back at the conceptual foundation of macroeconomics. Indeed, they write approvingly of not only John Maynard Keynes and Frank Knight, but also of Friedrich A. Hayek for understanding the limits of knowledge and predetermination when it comes to market prices and risk. The authors, in their Acknowledgements, maintain that they “have likewise been stimulated and sustained over the years by George Soros’s ideas about the role of imperfect knowledge and reflexivity in the workings of financial markets and historical change.” It should be noted that earlier this year Soros wrote an op-ed in which he praised Hayek for the Nobel Prize winner’s belief that imperfect knowledge leads to unintended consequences.

With the premise that economic knowledge is imperfect, the authors propose a different macroeconomic framework – Imperfect Knowledge Economics (IKE). In their view, IKE both incorporates the notion of imperfect knowledge and rejects the notion that knowledge of the (economic and market) future can be fully captured and predicted by rigid mechanistic rules. Their approach should be contrasted with variations of the widely accepted Rational Expectations Hypothesis (REH) framework. Frydman and Goldberg contend that “[r]egardless of their informational assumptions, Rational Expectations models assume away the importance of nonroutine change and the imperfect knowledge that it engenders.”

Given the authors’ emphasis on imperfect information and nonroutine change, it is not surprising that their policy prescriptions would be somewhat different from that of other economists. While they are very critical of the Soviet experiment in central planning and make the case that “the ultimate reason that central planning was impossible is that it supposed that a group of individuals – the planners – could predict and shape the future,” Frydman and Goldberg do not accept a purely laissez-faire approach to the economy either.

Their primary concern is with excessive upswings in asset prices that are followed by prolonged downturns and provide an alternative approach for state intervention. “Because price swings are inherent to how markets help society search for worthy investments, IKE-inspired policy reform suggests that so long as swings in broader market indexes or in key sectors remain within a guidance range of reasonable values, the state should limit its involvement to setting and enforcing the basic institutional framework for market transactions.” They propose that central banks could announce a range of non-excessive values in certain markets as “[a] first step in dampening excessive asset-prince swings.”

Frydman and Goldberg’s contention is that “[t]he need for state intervention in key asset markets arises not because policy officials have superior knowledge about asset values, but because the profit-seeking market participants do not internalize the huge social costs associated with excessive upswings and downswings in these markets.” This certainly merits further consideration. They are certainly correct that policy makers do not have, in their words, “superior knowledge.” Indeed, the assumption that a centralized government agency can have such knowledge belies the conceit of central planning that they criticize earlier in their book. With regard to their view that market participants do not internalize the social costs associated with upswings and downswings, one must question whether it is the appropriate role of the state to protect the wider public from these costs.

While on the one hand, the bidding up of stock prices and the subsequent downswing in a market will have a great social cost to the American public (i.e., the unemployment that followed the dot-com boom and bust), the question of how far (and for some readers, if) the state should go to protect the public from market participants is not easily answered. That said, those concerned that Frydman and Goldberg are merely seeking excessively intrusive state intervention into the financial markets would be heartened to know that their “policy measures based on Imperfect Knowledge Economics are not designed to prevent excessive price swings in key asset markets but to reduce their frequency and dampen their magnitude.”

Although Beyond Mechanical Markets is not an easily accessible work for the non-specialist, the authors utilize a clear writing style. This makes it possible for readers to better understand the complex philosophical notions about the role of (imperfect) knowledge underlying contemporary macroeconomic thought. For policy makers and those concerned with the recent dismal news about lagging growth, Frydman and Goldberg’s approach provides a different way of thinking about not only asset prices and markets, but the role of the state in the economy. Even if one does not necessarily subscribe to the authors’ thesis or their policy recommendations, their argument should remind us that there is a different way to look at markets than from the prevailing REH approach.

In conclusion, Beyond Mechanical Markets is a thought-provoking philosophical critique of much of contemporary macroeconomic thought. Those readers interested not only in economics, but also in the history of economic thought will find much of interest in the work.

Jon Lewis (c) 2011

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