The Future of Finance
The consequence of financial innovation and de-regulation has quite clearly not been the achievement of the full general equilibrium ideal posited in Arrow (1953). Indeed, the global financial crisis of 2007-09 has brought with it widespread questioning of both the DSGE model (in economics) and the EMH (in finance).
Arrow himself was prescient about the limitations of both, insisting repeatedly in print that the problems of risk and time are not really addressed within the intertemporal general equilibrium model (Arrow 1978: 159; see also Arrow 1981). Indeed, as Frank Hahn, among others, has repeatedly emphasized, the model has no place in it for money (Hahn 1965).That is the fundamental reason that academic economics and finance had so little to say when the crisis struck. The crisis was essentially about money and liquidity, matters from which both economics and finance had resolutely abstracted (Mehrling 2011). Before the crisis, most people thought that efficient markets would be liquid markets, because there would always be a buyer willing to step forward when price fell even a little bit below fundamental value. “Not so”, is the verdict of history, and “Why not so?” is the question now confronting the field of financial economics.
This reading of history suggests that the road forward, both for finance and for economics, and hence a fortiori for financial economics, will involve a shift of focus to matters of money and liquidity. The crisis has made clear that the modern real world is in important ways not like the ideal world posited long ago by intertemporal general equilibrium theory. As a consequence, public finance and monetary economics that are orientated around that ideal world are simply not finance enough for modern economics. During the crisis, states were called upon to act and they did so, but without much help from economics. Public entities, just as much as private entities, confronted the problem
of managing their affairs in the face of the “dark forces of time and ignorance”. As in the past, we can expect the future fertility of financial economics to arise from attempts to respond to practical problems, both public and private, in the real world.
Perry Mehrling