The (Admittedly Beautiful) Conservation Laws of Financial Economics

January 11, 2013

Book Review
James Case


Finance and the Good Society.
By Robert J. Shiller, Princeton University Press, Princeton, New Jersey, 2012, 304 pages, $24.95.

Robert J. Shiller is the Arthur M. Okun Professor of Economics at the Cowles Foundation for Research in Economics, and a professor of finance at the International Center for Finance at Yale. He is, in the opinions of many, the most deserving economist still without a Nobel Prize.

In this, his most recent book, Shiller both concedes the need for financial reform and expresses doubt that the good society, however defined, can exist without a prosperous financial sector. His warning to the growing number who would nationalize the banks, bomb Wall Street, and/or impose an inordinate regulatory burden on financial activity, is simple: Don't throw the baby out with the bath water.

Shiller's basic message is not new. At most times, he says, there is both a supply of money available for investment and a demand for such money from would-be entrepreneurs. The purpose of the financial sector is twofold: identify the worthiest projects and steer the available funds to them. The phrase "picking winners," which came into vogue during the Reagan administration, is still heard on late-night TV. Shiller seeks to flesh out his message by explaining how the various financial actors contribute to the well-being of society.

To that end, he devotes the first part (18 chapters/130 pages) of his book to explaining what various participants in the financial process actually do, from CEOs, investment managers, and bankers of various descriptions, to policy makers in charge of stabilizing the economy, trustees, and philanthropists. Most of this material, although familiar to those already involved in the financial process, will be enlightening to some.

The second part of the book (12 chapters, 100 pages) is more diverse and eclectic. The first chapter thereof, Finance, Mathematics, and Beauty, may be the most interesting to the SIAM community. In it Shiller concedes that the hypocrisy and manipulation that pervade financial capitalism may sometimes obscure the beauty both of the system itself and of theories explaining it. Yet he insists that the beauty is real, and seeks to describe some of it.

In so doing, he quotes mathematician Hermann Weyl to the effect that "beauty is bound up with symmetry," and physicist Leon Lederman to the effect that "comprehending the universe means understanding its symmetries." Symmetries in nature find their most obvious expression in the conservation laws that govern---in appropriate circumstances---mass, energy, linear and angular momentum, and so forth. The same can be said of symmetries in economics, and specifically in financial economics. The Black–Scholes formula for the price of a European option, asserting that the values of certain portfolios are unchanged by (suitably random) fluctuations in the prices of the component assets, is one example of a conservation law in finance.

The so-called Modigliani–Miller theorems of corporate finance, which assert that it often makes no difference whether a firm borrows or issues additional shares of stock to raise funds needed for expansion, are another example of value conservation in economics. There again, certain values and returns on investment turn out to be transformed by financial activity in such a way that their total value is exactly conserved.

A somewhat more controversial principle, dubbed "Ricardian equivalence" by Harvard economist Robert Barro, holds that government spending to stimulate the economy is little more than a trick, as savvy taxpayers will know that any such expenditure must be followed by increased taxes to discharge the debt, thereby shifting the pain of an economic slowdown onto future generations. This too is a conservation law---it asserts that society can choose to endure the pain of an economic downturn immediately or can postpone it at least temporarily, but cannot alter the magnitude (severity) of the pain.

Shiller chides his professional colleagues for being too easily seduced by (perceived) beauty, and insists that truth need not always be beautiful. In particular, the (admittedly beautiful) conservation laws of financial economics are only as valid as their underlying assumptions, and their relevance to the real world remains debatable. This is particularly true of the appealing efficient markets hypothesis, which asserts that the prices generated by financial markets furnish, at any given time, the best possible estimate of the present value of any potential investment. The EMH has been disproven many times over---never more convincingly than by Shiller himself in his best-selling Irrational Exuberance---yet refuses to die.

In Shiller's opinion, the survival of this and other "beautiful" but easily disproven generalizations makes it easier for still other unsubstantiated beliefs to influence public policy. In expressing that opinion, he reminds his audience that the marketplace of (scientific) ideas---perhaps more than any other market---is ruled by "the law of the jungle," often described as "survival of the fittest." As facts come to light, explanatory hypotheses are proposed and tested. A hypothesis that fails even one test must be either modified or discarded, no matter how many previous tests it may have passed. Thus, any undiscarded hypothesis is necessarily a survivor. One that has survived extensive testing becomes a potential "law of nature." Over time, potential laws of nature gain acceptance as actual laws of nature, though such acceptance is ultimately provisional. No science can adhere to so lofty a standard at all times, but---in Shiller's carefully considered opinion---economic science falls unacceptably short.

Shiller maintains that, despite its many shortcomings, regulated financial capitalism serves the common good better than any known alternative, and is capable of further improvement via---among other things---democratization. The public, he suggests, needs to participate more widely in financial activity, and to become more conversant with the fundamentals of risk and reward. For only when they understand the financial system well enough to participate in it with confidence born of sustained success will the middle and working classes cease to suspect that the economy is run by and for a power elite.

James Case writes from Baltimore, Maryland.


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