Why ‘sunspots’ matter12 January, 2017 at 23:42 | Posted in Economics | 1 Comment
My recent research with Carine Nourry and Alain Venditti argues that while there are strong reasons for believing there are no free lunches left uneaten by bonus-hungry market participants, there are really no reasons for believing that this will lead to Pareto efficiency, except, perhaps, by chance …
In our model environment, booms and crashes occur simply as a consequence of the animal spirits of market participants. Why should we care if there are big movements in the asset markets? After all, the borrowers and lenders are rational and they have made bets with each other in full knowledge that these large asset movements might occur.
•The problem is that the next generation is unable to insure against swings in wealth that have a big influence on their lives.
Steve Davis and Till von Wachter (2011) have shown that the present value of lifetime income of new entrants to the labour market can differ substantially depending on whether their first job occurs in a boom or a recession. In our model, the lifetime income of the young can differ by as much as 20% across booms and slumps.
Given the choice, the young agents in our model would prefer to avoid the risk of a 20% variation in lifetime wealth. There is a feasible way of allocating resources that would insure them against this risk, but financial markets cannot achieve this allocation, except by chance. The inability of our children to trade in prenatal financial markets is sufficient to invalidate the first welfare theorem of economics.
In short, sunspots matter. And they matter in a big way.
Yes indeed. David Cass’ and Karl Shell’s ‘sunspots’ show that financial markets are far from Pareto efficient. And the day Roger Farmer is prepared to drop his residual mainstream infatuation with models building on assumptions of ‘complete financial markets,’ rational expectations, and households planning for infinite futures, his thought-provoking critique of mainstream economics will be even more forceful …