There used to be time when a belief in the eternally optimal market outcomes was the article of truth. Paper after economic paper was littered with stylized models depicting these desirable outcomes, jingoisitically referred to as “Pareto efficient” or “Pareto-optimal equilibria”.
Few lone voices, like Hyman Minsky, argued that no such “equilibria” existed and that markets are, after a bout with exuberance, prone to self crashing.
Minsky gained in notoriety after the great 2008 crash, but behind his financial instability hypothesis was left a “modeling” void – an absence of a stylized set of circumstances onto which economists can apply equations, do some calculus on them, and “show” that, indeed, markets are crazy.
“Although individuals in our model are rational; markets are not,” says the latest paper by Roger E.A. Farmer, Carine Nourry, Alain Venditti.
This triplet of economists says that markets are not rational because had it been rational no trader would be able to profit. The fact that some, in the financial world, make money by trading on the account of informational discrepancy, is indicator enough that there is no such thing as rational markets.
As a result, financial markets do no produce “Pareto efficient outcomes, except by chance,” say the authors.
They are critical of the existing literature which starts from the premise that all is logical in the financial markets and the screw-ups are caused by various types of “frictions” – sort of road blocks that srew up the intrinsic bliss of the free-flow of financial information and trading skills.
“We do not rely on frictions, market incompleteness or transactions costs of any kind. Instead, we modify a simple stochastic representative agent model by allowing for birth and death and by allowing for heterogeneity in agents’ discount factors,” say the author cryptically.
The “birth and death” problem assumes that a financial contract made in the past is incongruent with the financial realities that predominate right now. As a result, some traders are “unable to participate in markets that open before they are born” therefore they have inadequate means to hedge against that.
“The first welfare theorem fails because participation in financial markets is necessarily incomplete as a consequence of the fact that agents cannot trade risk in financial markets that open before they are born. For this reason, financial markets do not work well in the real world,” conclude authors.
We see such outcomes in the wage and wealth numbers of cohorts.
“When agents have realistic death probabilities and discount factors ranging from 2% to 10%, we find that the human wealth of new-born agents can differ by a factor of 25% depending on whether they are born into a boom or into a recession,” note the authors.
With full intricacies of their stylized model and pages of equations dabble, the paper is available here.