Finance and General Equilibrium

To understand better the resistance of economics to modern finance, it is necessary to appreciate the role played by general equilibrium theory in orienting economists’ sense of their intellectual project in the years after World War II, and to appreciate the place of finance in that theory.

Famously, the canonical Arrow-Debreu model (Arrow and Debreu 1954) extended general equilibrium from one period to many, and from the case of certainty to the case of risk, by imagining markets in state-contingent commodities, each with its own price. In the real world, of course, such markets are noticeably absent, except in a very few cases of generic raw commodity inputs such as wheat, cotton, and oil. However, crucially, Arrow (1953) also showed how financial instruments that promise state­contingent payoffs (so-called Arrow-Debreu securities) could substitute for those missing commodity markets, and how the price of those financial instruments could substitute for state-contingent commodity prices. In effect, he argued that a world of complete financial markets would be equivalent to the idealized Arrow-Debreu world

of complete state-contingent commodity markets, and either world would provide the institutional basis for full general economic equilibrium.

In this way of thinking, the role for policy intervention, both fiscal and monetary, arises from institutional imperfections of one kind or another that prevent the economy from achieving full general economic equilibrium. If the institutions were perfect, the economy would already be at that equilibrium, and there would be no need for policy intervention. However, the institutions are not perfect, so policy intervention is needed to push the economy closer to the ideal. Finance enters the picture because proper cali­bration of policy intervention requires an understanding of how any particular interven­tion is transmitted through financial markets into the broader economy.

For both men, the key link between the ideal world of Arrow-Debreu and the large- scale econometric modelling project they were conducting was the theory of “monetary Walrasianism”. Also, the key figure who set the agenda for monetary Walrasianism was Jacob Marschak, initially in his pre-war “Money and the theory of assets” (1938). The story of intellectual transmission from these origins has only recently begun to surface, but a central chapter clearly involves Marschak’s role, during 1943-48, as Research Director of the Cowles Commission. (See Mehrling 2010; also Hagemann 2006; Cherrier 2010.)

Crucially, it was Marschak, before anyone else, who took the pre-World War II work of Irving Fisher as his starting point, especially Fisher’s 1930 The Theory of Interest as Determined by Impatience to Spend Income and Opportunity to Invest It. Subsequently, post-war macroeconomics became a project of bringing the sensibility of Irving Fisher to bear on post-war problems, using updated analytical tools that had been developed in the meanwhile, many of them under the pressure of war. James Tobin, himself Research Director of the reconfigured Cowles Foundation from 1955 to 1961 and 1964 to 1965, can be viewed as the standard bearer of this neo-Fisherian American-style Keynesianism (Tobin 1985; Dimand 1997).

Marschak-Tobin was the first road leading from Irving Fisher, but CAPM and modern finance was the next, and this second road led in a much more radical direction. The Marschak-Tobin monetary Walrasian project was about providing a scientific basis for government policy intervention to steer the economy closer to the full general equi­librium ideal.

This second road leading from Irving Fisher to modern finance is clearest in the life and work of Fischer Black, who from the first interpreted CAPM as the broader macro­economic construct that arises when we retrace the steps of Irving Fisher but with risk, time, and equilibrium built in from the beginning. (See Mehrling 2005: 93-8.) Black’s particular view has not (so far) prevailed, but the larger transformative finance project that he anticipated certainly has. In my view, future historians will see developments after about 1970 in these more fundamental terms as a struggle between old economics versus new finance, and the contemporary quarrelling between Keynesianism and mon­etarism within economics will come to seem much less important. To the generation of Tobin and Modigliani, and also Milton Friedman, “financial economics” meant applica­tions of economics to financial topics. To the generation of today, it means applications of modern finance to economic topics.