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.