“Behavioral” finance approaches are mainstream in macro

Noah Smith, a finance professor, has written a piece arguing that the finance approach to “behavioral” economics/finance has been very successful, whereas it has been largely rejected by the macroeconomics profession. The piece is confusing, however: even though Smith explains that the term “behaviorial economics” refers to a much narrower field of study than the term “behavioral finance,” he does not explore fully the implications of these two different definitions.

Smith explains the different terms:

To most economists, behavioral economics means using findings from psychology to modify models of individual behavior. But behavioral finance has come to have a much more expansive meaning, basically encompassing anything that doesn’t conform to the Efficient Markets Hypothesis (which says that you can only earn market-beating returns by taking on extra risk).

What is left out of Smith’s piece is that many of the approaches that are categorized as “behavioral” in finance, are categorized as mainstream in macroeconomics. There’s no division between saltwater and freshwater macroeconomists on whether macro needs to study frictions using the whole of the microeconomic toolbox including contract theory, mechanism design, etc. The study of the many ways in which Arrow-Debreu (and more generally the efficient markets hypothesis) fails has been fundamental to the macroeconomic research agenda for at least three decades.

By contrast, when the finance profession categorizes mainstream economic theory as “behavioral,” this has the effect of defining as mainstream finance that which is consistent with the efficient markets hypothesis. As a result finance is probably the only economics-related field that has not yet integrated the mid-20th century critiques of the competitive model into its “mainstream” body of theory. For this reason, the fact that “behavioral finance” is alive and well is hardly surprising: if this were not the case, the field of finance theory would be decades behind the theory that is used throughout the economics profession.

The real question then is why the finance profession has not dropped the “behavioral” moniker from behavioral finance, and renamed non-behavioral finance “frictionless finance.”


Note: It is clear that Paul Romer finds that macroeconomists have a lot of work to do when it comes to incorporating decades-old critiques of the competitive model into the their work. As I understand his argument, he objects to the way the critiques have been incorporated in macro, because this constitutes a pluralistic “views about the shape of the earth differ” approach, rather than an effort to  fully acknowledge and integrate the logical implications of these critiques into what constitutes mainstream theory.  I suspect that Romer would agree, however, that macro theory is several steps ahead of efficient-markets-based finance theory — if only because mainstream macro at least includes theory that is not price-taking and frictionless.


4 thoughts on ““Behavioral” finance approaches are mainstream in macro”

  1. Paul Romer here. The comment thread may not be the place to respond, but I’ll give it a try.

    My suggestion is that in these discussions, we distinguish any substantive question (such as whether allowing for agents that have different preferences or motivations) from process questions (such as how we communicate with each other and work toward a scientific consensus.)

    There are some questions where reasonable economists/finance people may disagree and it is fine to have these “differences of opinion” and some attempts at trying to persuade others about which is the right opinion.

    There are other questions where statements are not opinions, but rather are implications that are based on assumptions and which, conditional on the assumptions, have an objective truth value.

    What I am calling mathiness is the presentation of statements as correct logical implications based on explicitly stated assumptions, but which are in fact precise and false, or are too ambiguous to be logical implications. Presenting ambiguous statements as if they are implications is inadmissible conduct wrong no matter what the intent. If the math that is supposed to provide the logical foundation for the statements is opaque, this too is inadmissible. If opaque math is combined with ambiguous statements in a way that seems to be intentionally misleading, it is a much more harmful type of conduct.

    No matter what the substantive question or which side of any question a scientist is on, the following principles of good scientific discourse should apply:

    1. Distinguish opinions/advocacy from
    — a) statements of fact, or
    — b) claims based in logic.

    2. A theory–that is, a collection of statements linked by logic–can be stated in words alone or a mixture of words and mathematical symbols. The second type of theory, mathematical theory, should use:
    — a) math that is as clear and understandable as possible, and
    — b) words with sufficient precision and tight enough links to the math to make it possible for a reader to confirm whether the verbal statements are true or false.

    1. I, along with most other economists I think, share your frustration with theory papers that appear interesting, but after two or more hours of delving into them are exposed as arguments that, if clearly presented, would also be recognized as clearly not-so-interesting. From my point of view, however, the line between “intentionally misleading” and “I was just trying to write the most convincing paper I could” is one that I’m not that comfortable exploring.

      While your goal of improving the discourse in economics is admirable, I think that you may run into a problem similar to the one that Russell and Whitehead ran into in exploring the foundations of mathematics: the set of assumptions upon which every mathematical conversation is based is either incomplete or inconsistent.

      See for example this response to your latest post, http://rjwaldmann.blogspot.com/2015/06/thoughts-on-eulers-theorem-denialism.html . Your argument is premised on the assumption that we all agree that firms maximize profits. So in some sense, the first thing that you need to define is: what are the parameters of the discussion. But, while you will probably find agreement that working with a profit maximizing framework is an acceptable parameter, I suspect (without having expended the energy to delve deep into the issue) that there will be a legitimate debate over the appropriateness of the parameters you are assuming when you draw your conclusions about the role of increasing returns to scale.

      That said, you, being familiar with the literature, are most likely correct that the implications of increasing returns for growth are often not addressed in the literature with as much care as they should be. And that this is having an adverse effect on the quality of macro-economic analysis.

      How do we go from a pluralistic approach to economic theory to one that more effectively rejects theory that is internally inconsistent and illogical is a real challenge for economics. In no small part because the foundational model — i.e. price-taking — is internally inconsistent unless one makes the reality-divorced assumption that every member of the economy is infinitesimal in size.

      Your endeavor is worthwhile, but the more I learn of the history of economic thought, the more it seems that very similar battles were being fought a century ago. Careful theories that challenge price-taking have a long history of foundering on the shoals. I don’t know whether there is a path to success.

  2. Thanks.

    1. I understand that “misleading” is a judgment call and that different people have to set their own threshold. When a statement crosses over into being “misleading” might be an interesting example of something on which different scientists can have different opinions. But eventually, we have to make a call. After all, LaCour seems to be arguing that he did not mislead about anything important. People who are knowledgable about what he did seem unanimous in their conclusion that he is guilty of a very serious violation of scientific conduct. But do we have evidence from a randomized experiment and statistical tests that reject the null of honesty at the 1% significance level? No.

    2. I should probably try to respond to the post you reference concerning the issue of profit maximization. Once again, I’m going to invoke the distinction between substance and process. If someone wants to assert that as a SUBSTANTIVE claim that firms do not maximize profits and then proceed to work out the consequences of this assumption, I have absolutely no problem with this. As a matter of process, the economists I criticize as “Euler Theorem Deniers” are making the assumption that behavior in a model is characterized by a competitive equilibrium and this includes by definition the assumption that firms maximize profits. All I’m asking as a matter of PROCESS is that they be transparent about what their assumptions are and what their conclusions are and that they make at least a minimal effort to show that their conclusions follow according to the rules of logic. If they want to assume some form of competition without profit maximization, they should say so. I see zero evidence that this was what they were trying to do and if it was, it was their job to say so. I do not see the point of an ex post exercise of the form, “let’s see if we can come up with some unstated assumption that might rationalize what they said.”

    3. Re returns to scale, there are many substantive questions that are unresolved. Reasonable people can differ about how best to use models to investigate these questions. I have certainly do not think that anything I have written has resolved all these questions and who knows, I may even have made an error and if I have I’ll admit it. What I am insisting on is that when someone presents a theoretical argument, they have to do so clearly, precisely, making best efforts to help the reader understand. The economists I criticize for opaque mathiness have failed on at least one of these three counts. The economists I’ve criticized for saying things that are false have done precisely that. They were precise enough about their assumptions and conclusions that one can check via logic that they say things that are false. This brazen mathiness.

    1. I’m going to tread on some dangerous ground here, because I haven’t read Boldrin-Levine. But this was my thought: most likely the results are correct under very restrictive assumptions. (Levine was on my dissertation committee. He’s good at math.)

      In particular, a comment on Nick Rowe’s blog, http://worthwhile.typepad.com/worthwhile_canadian_initi/2015/06/mathiness-and-growth-theory.html , helps me think about what might be going on:
      “A monopolist is in the same situation as a perfect competitor if: a) the utility of his product is not subjected to decreasing marginal utility (or if the only decrease is from “have utility” to “no utility”); AND b) the product has the same utility (or the same reserve price) to all potential customers.”

      Thus, my guess was that Boldrin-Levine was probably correct, given a situation where diminishing marginal returns may have been neutralized by assumption, and that the difference between your critique and their point may be whether it is proper to draw significant conclusions from such an environment.

      As I said, I didn’t read the paper, so this analysis may be wrong. But my guess is that the dispute boils down to: what are the proper assumptions to make when doing macroeconomic analysis?

      If I am underestimating your critique, I apologize. But I really don’t have time to look into it closely enough. (Your post on Lucas 2009 was very valuable because it really clarified what the issue was.)

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