Sat, 27 December 2014
This episode of Economics Detective Radio features George Bragues, professor of business at the University of Guelph-Humber, discussing his work developing a distinctly Austrian theory of finance. While there have been forays into finance by Austrians such as Mark Skousen and Peter Boettke, Austrians have not yet fully developed a complete and distinctly Austrian theory of finance.
George names five pillars of modern finance theory: (1) The capital asset pricing model (CAPM), (2) the Black-Scholes option pricing model, (3) the efficient markets hypothesis (EMH), (4) behavioural finance, and (5) the Modigliani-Miller theorem.
CAPM is a model that derives the value of assets based on the risk-free rate and market risk, that is, risk that cannot be diversified away. The Austrian response to this model is that there is no such thing as a risk-free asset, as risk is inherent to human action. An Austrian alternative to CAPM would incorporate the Austrian theory of a natural interest rate derived from time preference.
Black-Scholes, a model for pricing options—opportunities to buy or sell at a given price at some point in the future—assumes that price movements are normally distributed. Nassim Taleb has been forceful in his critique of this assumption; in his book, The Black Swan, he argues that returns are subject to so-called Black Swan events. Statistically, this implies a fat lower tail in the distribution of returns. George holds that, given Austrians’ skepticism about mathematics, there is little hope for an Austrian option pricing model. However, pricing assets was never the role of theorists, but of entrepreneurs.
The efficient markets hypothesis, developed by Eugene Fama, holds that the market price reflects all available information. This view holds economic equilibrium to be a normal state of affairs. The Austrian view is that equilibrium is an abnormal state of affairs; the market is always tending towards equilibrium, but it rarely reaches equilibrium. Austrian theory holds that identifying misequilibriums and arbitraging them away is the role of entrepreneurs. Identifying such opportunities isn’t easy; it requires prudence, or what Mises called “understanding.” If you believe the EMH, then Warren Buffet is not an example of someone with great insight and prudence; rather, he is someone who has repeatedly won a stock-market lottery.
Behavioural finance, developed by Robert Schiller, is a theory that argues that, contra the EMH, market prices reflect psychological factors rather than the real underlying values of the assets being traded. Behavioural finance has identified so many biases that it is essentially irrefutable. For instance, the gambler’s fallacy and the clustering illusion, yield opposite predictions. If a stock price has risen repeatedly, the gambler’s fallacy would hold that it is “due” for a correction downwards, while the clustering illusion would hold that the trend must continue upwards. Behavioural economists could thus explain a movement in either direction according to their theory, making the theory untestable in principle. Austrian theory avoids such psychological theorizing. Austrians hold that you can derive sound theory from the axiom that humans act, that they use means to achieve ends. Austrians have no particular qualm with bringing psychological factors into the analysis of economic history, but they don’t see them as part of economic theory.
Modigliani-Miller is a theory of corporate finance that says that the way a firm is financed, with more debt or equity, is irrelevant to its value. M&M holds that the value of the firm is uniquely determined by its discounted stream of revenues. Austrians might contend, in contrast, that firms financed through debt are exposed to greater risk in the case that they make entrepreneurial errors.
George is working towards an “Austrian markets hypothesis,” which would hold that markets are constantly endeavoring to achieve equilibrium, but never actually succeeding. Austrians can bring a greater appreciation of understanding, prudence, practical experience, and local knowledge to finance theory. These ideas have been wrongly impugned by modern quantitative finance, which has elevated theoreticians above entrepreneurs.