Advancing Imperfect Knowledge Economics

Instability is an inherent feature of financial markets, and more broadly of capitalist economies. Long before the financial crisis that began in 2007, leading economists acknowledged that contemporary models are of little help in understanding this instability. In two recent books and related research, Roman Frydman and Michael Goldberg have traced this failure to the core assumption of the macroeconomic and finance theory: markets can be adequately portrayed as machines, and their participants as robots. By assuming away the importance of change that cannot be pre-programmed by economists, contemporary models assume away financial markets’ very raison d’être – to help society cope with change that no one can fully predict and allocate capital to projects whose prospects can be known only imperfectly at best.

Aiming to restore the connection between contemporary models and modern economies, Frydman and Goldberg developed Imperfect Knowledge Economics (IKE). By opening macroeconomic and finance models to non-routine change and the imperfect knowledge that it engenders, IKE provides an appropriate framework for analyzing asset-price swings and risk and their interdependence with fluctuations in consumption, investment, and employment.

In order to advance IKE as a new approach to modeling outcomes in asset markets, this project will incorporate behavioral insights. To this end, the project will focus on the relative roles that macroeconomic fundamentals and psychological factors, such as market sentiment, play in driving price movements and risk in currency and equity markets. The aim is to show that the importance of psychological factors in driving asset prices and risk arises from imperfect knowledge of the processes driving these outcomes and thus should not be interpreted, as contemporary behavioral-finance models do, as a symptom of irrationality.

Beyond incorporating behavioral insights into IKE, the project will develop and empirically test one of IKE’s key claims: price swings are integral to the way financial markets allocate capital among projects and companies. If substantiated, this claim would have important implications for financial reform, and, more broadly, it would suggest a new way to think about the market-state balance in modern economies.