Imperfect Knowledge

Every banking crisis has its own overarching narratives and coincidental streams of various sub-narratives that course through the marketplace day to day.

In a new book, How Novelty and Narratives Drive the Stock Market, economist Nicholas Mangee examines the influence of stories on stock market outcomes in an uncertain world.

A formal argument that Kahneman and Tversky’s compelling empirical findings, and those of other behavioral economists, do not provide a basis for a general approach to specifying participants’ “predictable errors.”

A new view of stock market instability under Knightian uncertainty

A tractable formalization of the Knightian uncertainty faced by an economist and market participants in an intertemporal asset-price model.

Stock-Price Volatility During the Pandemic

Stock-Price Volatility During the Pandemic

INET’s President introduces a new research program that challenges orthodox assumptions about the limits of economic knowledge

This paper introduces the Knightian Uncertainty Hypothesis (KUH), a new approach to macroeconomics and finance theory.

Asset markets are indispensable in harnessing society’s diverse views and insights about future business performance. But those views are shaped as much by emotion and crowd mentality as by rational expectations.

Asset markets are indispensable in harnessing society’s diverse views and insights about future business performance. But those views are shaped as much by emotion and crowd mentality as by rational expectations.

In the face of  laissez-faire capitalism at home and resurgent nationalism across the globe, INET offers an innovative look at the causes of—and solutions for—the problems that ail a fissuring world economy.

The World Economic Roundtable seeks to help the business, investment, and policy communities understand ongoing changes in the world economy and to promote a discussion of ideas that can advance the goal of a widely shared global prosperity.

After re-iterating five well-known theorems about the properties of conditional expectations in stationary settings—such as providing unbiased minimum mean square error predictions despite in- complete information, and the law of iterated expectations—we clarify unpredictability and illustrate its prevalence empirically.

In the paper that we present this afternoon, Soren Johansen, Anders Rahbek, Morten Tabor, and I introduce the Qualitative Expectations Hypothesis (QEH) as a new approach to modeling macroeconomic and financial outcomes.

How we can create useful economic theory that recognizes that the future is radically uncertain?

If standard economic theory can’t explain a traffic jam, how can it cope with crises?

Model Ambiguity, Consistent Representations of Market Forecasts, and Sentiment

“The humility to accept that economic propositions cannot be universal would save us from self-defeating arrogance.” Economist Amit Bhaduri adds his perspective to our Experts on Trial discussion.

As part of an International Economy symposium, INET Research Director Tom Ferguson assessed the challenge facing central bankers through the lens of the missing virtues of Dorothy’s travel companions in the Wizard of Oz

Notes from the Institute’s Director of Research on some significant papers and contributions produced in 2016 under the INET rubric 

In the 40th anniversary year of John Kenneth Galbraith’s Age of Uncertainty, the 1970s look remarkably stable in comparison with today’s turbulent world 

The Volcker Alliance has launched a series of new papers with important proposals for reforming financial regulations to guard against future crises 

Past failures, present uncertainty, and a challenging political environment have vastly complicated the central bank’s task, says Institute President Rob Johnson

Like any family reunion, the Jackson Hole Economic Symposium may have been as significant for what was said as it was for what was not discussed

Neither the Rational Expectations Hypothesis nor behavioral finance approaches alone provides an adequate predictor of investor behavior, argues Roman Frydman

Behavioral finance views stock-market investors’ expectations as largely unrelated to fundamental factors. Relying on survey data, this paper presents econometric evidence that fundamentals are a major driver of investors’ expectations.

This paper analyzes what assumptions on formation of expectations are consistent with Minsky’s Financial Instability Hypothesis (FIH) and its corollaries.

A gap between theory and reality has haunted economists.

This essay critically evaluates the benefits and costs of the dominant methodology in macroeconomics, the DSGE approach. Although the approach has led to great progress in some areas, it has also created biases and blind spots in the profession that hold back our understanding and our ability to govern the macroeconomy. There is great scope for progress in macroeconomics by judiciously pushing the boundaries of some of the methodological restrictions imposed by the DSGE approach.

US Military needs during the Cold War induced a mathematical modeling of rational allocation and control processes while simultaneously binding that rationality with computational reality. Modeling strategies to map the optimal to the operational ensued and eventually became a driving force in the development of macroeconomic dynamics.

Tania Singer on the key importance of understanding preferences and behavioral change.

The financial crisis of 2008 was unforeseen to a significant extent. One reason is that the dominant academic theories influencing political decision makers ignore recent advances and instead rely largely on models and decision science dating back to the Second World War.

We discuss recent work on bounded rationality and learning in relation to Soros’ principle of reflexivity and stress the empirical importance of non-rational, almost self-fulfilling equilibria in positive feedback systems.

We call attention to the class of models that serve as the foundation for the rational expectations hypothesis (REH). Models in this class rule out completely any structural change that cannot be fully anticipated with a probabilistic or other quantitative rule. REH models are abstractions of rational decision-making, but only in a hypothetical world in which participants can fully anticipate when and how they might revise their understanding of the process driving outcomes.

This chapter surveys experimental research on networks in economics.

Private data is leaked more and more in our society. Wikileaks, Facebook, and identity theft are just three examples. Network defenses are constantly under attack from cyber criminals, organized hacktivists, and even disgruntled ex-employees.

Economists discussing the problem of radical uncertainty commonly invoke Frank Knight’s classic definition in Risk, Uncertainty and Profit, but only rarely venture to explore the broader contours of his argument.

Does it matter if the Rational Expectations Hypothesis is unrealistic?

The main goal of the macroeconomist is to understand the sources behind business cycles and the behavior of financial markets in the modern economy.

The destruction of trust is not an accident.

In the aftermath of the 2008 financial crisis, distrust in the financial sector was widespread. Even after the mess appeared to be cleaned up, the uncertainty over whether the worst was over remained real.

Finance is built on trust. It is based on promises about tomorrow, often paper promises backed by nothing other than words on a page. When trust in those promises breaks down, so too does the financial system. That is the lesson of thousands of years of history.

“You are now leaving the world as you know it.”

Sadly, it is questionable whether the economy has really improved.

what would measures of systematic risk have indicated to Treasury Secretary Paulsen if they had been available at that time?

Five years after the collapse of the U.S. investment bank Lehman Brothers, the world has still not addressed the fundamental cause of the subsequent financial crisis – an excess of debt. And that is why economic recovery has progressed much more slowly than anyone expected (in some countries, it has not come at all).

What happens when professionals lose touch with the people they’re supposed to serve?

These are extraordinary times for central banks. Near zero interest rates and massive liquidity injections are still failing to bring life back to so many economies in the developed world.

Innovation. The word is evocative of ideas, products and processes which have somehow made the world a better place. Prior to the global financial crisis, many viewed financial innovation as unequivocally falling into this category.

The exteriors of major central banks may be solid marble and doric columns, but, inside, monetary policy remains a work in progress.

A core puzzle in Önancial economics is the inability of standard risk-premium models to account for excess returns in currency and other asset markets.

There is much anecdotal evidence in the popular media, backed up by survey research, that participants in currency markets pay close attention to fundamental economic variables in forming their forecasts of future exchange rates.

For macroeconomists, an individual is rational if she uses her understanding of the way the economy works in making decisions that do not conflict with her objectives.

The present-value model of stock prices is a workhorse in financial economics. The model relates today’s price of a stock (or a basket of stocks) to the market’s forecasts of next-period’s price and dividend, appropriately discounted.

In this paper, we examine one of the core puzzles in International Macroeconomics, the so-called “forward-discount anomaly.”

A core premise of contemporary economic models is that researchers can adequately specify in probabilistic terms how individuals alter the way they make decisions and how the processes underpinning market outcomes unfold over time.

The first part of this text comes back on the standard economic viewpoint on expectational coordination, a viewpoint that the recent events have challenged.

Uncertainty is an unavoidable feature of economic life, although we may cope with it sometimes by ignoring it. Institutions, conventions and behaviour are all conditioned by uncertainty, and they in turn condition uncertainty in a reflexive manner.

My remarks today will be focused primarily on features of the developed world’s financial system which led to the crisis of 2008 and to the Great Recession that followed, from which we are only slowly and painfully emerging.

In his recent lecture at the Cass Business School, Lord Turner noted that even mentioning the possibility of overt monetary financing was akin to breaking a taboo.

Paper revised for the Institute’s Plenary Conference in Berlin

Financial stability, or the lack thereof.

Albeit the majority of the profession either ignores Minskyís Financial Instability Hypothesis (FIH) or considers it plainly wrong, at least since the mid-80’s a few influential economists —who have certainly not embraced any unorthodoxcredo —have grown more receptive to this idea and eager to incorporate it in their models, even if diluted and sometimes disguised in order to make it more palatable to the conventional “representative” macroeconomist

Elephant seals have got too big for their beaches. A large specimen might weigh over 8000 lbs (3700 kg).Their size has a simple evolutionary explanation. Large males fight for the right to mate with a whole beach full of females. For elephant seals it is, quite literally, winner-takes-all. And the key to winning is simple – size.

We have grown accustomed to regulating financial markets based on imagined, not real markets. Real markets are shaped by and co-evolve with institutional arrangements within two fundamental constraints: Imperfect knowledge and the threat of illiquidity.

The financial sector can support growth but it can also cause crisis. The present crisis has exposedgaps in economists’ understanding of this dual potential.

In the seemingly never-ending aftermath to the economic crisis that began in 2007, there is little disagreement that financial markets are characterized by instability rather than stability.

Many feel that due to its size and scale the financial system has become a burden on society rather than a servant to it. What are the key elements of a productive financial sector?

Taking a long‐run view from economic history, I make three points about instability in financial markets. First, I argue that economic historians have a relatively good understanding of the proximate causes of financial crises.

What creates instability in financial markets? How does the weight of debt, the structure of expectations, or radical uncertainty contribute to instability?

In modern economies, individuals and companies engage in innovative activities, discovering new ways to use existing physical and human capital, and new technologies in which to invest. The institutional and broader social context within which these activities take place also changes in novel ways.

The economics profession stands on the fragile foundation of presuppositions adopted by professional agreement rather than as a result of empirical observation.

The human brain relies on three devices for its decisions: emotion controls; addictive learning; and intellectual processing. Understanding the conditions under which the three devices are engaged is essential for conscious decision-making.

George Soros, Axel Leijonhufvud and Perry Mehrling in Berlin, Germany (2012).