The Financial Crisis as a Symbol of the Failure of Academic Finance?
Abstract (Via SSRN)
The failure of academic finance can be considered one of the symbols of the financial crisis. Two important underlying reasons why academic finance models systematically fail to account for real-world phenomena follow directly from two conventions: (a) treating economics not as a ‘true’ social science (but as a branch of applied mathematics inspired by the methodology of classical physics); and (b) using economic models as if the empirical content of economic theories is not very low. Failure to understand and appreciate the inherent weaknesses of these ‘conventions’ had fatal consequences for the use and interpretation of key academic finance concepts and models by market practitioners and policymakers. Theoretical constructs such as the efficient markets hypothesis, rational expectations, and market completeness were too often treated as intellectual dogmas instead of (parts of) falsifiable hypotheses. The situation of capture via dominant intellectual dogmas of policymakers, investors, and business managers was made worse by sins of omission – the failure of academics to communicate the limitations of their models and to warn against (potential) misuses of their research – and sins of commission – introducing (often implicitly) ideological or biased features in research programs Hence, the deeper problem with finance concepts such as the ‘efficient markets hypothesis’ and ‘ratex theory’ is not that they are based on assumptions that are considered as not being ‘realistic’. The real issue at stake with academic finance is not a quarrel about the validity of the assumption of rational behavior but the inherent semantical insufficiency of economic theories that implies a low empirical content (and a high degree of specification uncertainty). This perspective makes the scientific approach advocated by Friedman and others less straightforward. In addition, there is wide-spread failure to incorporate the key implications of economics as a social science. As response to these ‘weaknesses’ and challenges, five suggested principles or guidelines for future research programmes are outlined.
Introduction (Via SSRN)
Can the financial crisis also be considered a symbol for the failure of academic finance2? An affirmative answer can in my view be based on the reasoning that most research programs in academic finance, and economics more in general, have systematically neglected the implications of the nature and limitations of economics as a social science for the development of our theories and related empirical models. And this has had adverse, perhaps even fatal, consequences for the use or interpretation of these models, in particular heavily quantified ones, by practitioners.
This situation has, in turn, been an important reason why academic economic models systematically fail to account for real-world phenomena. One manifestation of this state-of-affairs is the quite common situation where the empirical results of different studies of a similar topic have often a very wide range of outcomes and values for structural parameters (and without a convincing or clear explanation why this is the case). Clearly, in the physical sciences such a situation would be unthinkable and unacceptable. For example, if physicists would obtain different outcomes when addressing a similar problem, then this would be a key reason for an urgent scientific debate until the discrepancy in measurement results has been resolved.
A similar debate in economics is rare. More often than not, we are happily ignoring this situation while we turn our attention to prepare the next study….