Uncertainty, Expectations, and Financial Instability

Uncertainty, Expectations, and Financial Instability: Reviving Allais's Lost Theory of Psychological Time

Eric Barthalon
Copyright Date: 2014
DOI: 10.7312/bart16628
Pages: 448
https://www.jstor.org/stable/10.7312/bart16628
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  • Book Info
    Uncertainty, Expectations, and Financial Instability
    Book Description:

    Eric Barthalon applies the neglected theory of psychological time and memory decay of Nobel Prize--winning economist Maurice Allais (1911--2010) to model investors' psychology in the present context of recurrent financial crises. Shaped by the behavior of the demand for money during episodes of hyperinflation, Allais's theory proves economic agents perceive the flow of clocks' time and forget the past at a context-dependent pace: rapidly in the presence of persistent and accelerating inflation and slowly in the event of the opposite situation. Barthalon recasts Allais's work as a general theory of "expectations" under uncertainty, closing the gap between economic theory and investors' behavior.

    Barthalon extends Allais's theory to the field of financial instability, demonstrating its relevance to nominal interest rates in a variety of empirical scenarios and the positive nonlinear feedback that exists between asset price inflation and the demand for risky assets. Reviewing the works of the leading protagonists in the expectations controversy, Barthalon exposes the limitations of adaptive and rational expectations models and, by means of the perceived risk of loss, calls attention to the speculative bubbles that lacked the positive displacement discussed in Kindleberger's model of financial crises. He ultimately extrapolates Allaisian theory into a pragmatic approach to investor behavior and the natural instability of financial markets. He concludes with the policy implications for governments and regulators. Balanced and coherent, this book will be invaluable to researchers working in macreconomics, financial economics, behavioral finance, decision theory, and the history of economic thought.

    eISBN: 978-0-231-53830-5
    Subjects: Economics, Finance, Business

Table of Contents

  1. Front Matter
    (pp. i-vi)
  2. Table of Contents
    (pp. vii-x)
  3. List of Tables
    (pp. xi-xiv)
  4. List of Figures
    (pp. xv-xviii)
  5. Preface
    (pp. xix-xxii)
  6. Acknowledgments
    (pp. xxiii-xxx)
  7. Introduction
    (pp. xxxi-xl)

    MORE THAN any of the previous crises, through its sheer size, intensity, and costs, the global financial crisis that seemingly started in 2007 has challenged economists and their analytical tools. In a way, it is fair to say that this crisis has been and still is, first and foremost, a crisis in economic theory. Some accepted theories or paradigms, such as rational expectations and efficient markets, seem to have been radically wrong-footed by unnerving facts and pervasive uncertainty.¹

    This is somewhat of a paradox that we should be disappointed by the rational expectations hypothesis (REH), limited as its ambition ever...

  8. Glossary of Mathematical Symbols in Order of Appearance
    (pp. xli-xlviii)
  9. PART ONE The Progressive Emergence of Expectations in Economic Theory

    • CHAPTER ONE Expectations Before the Rational Expectations Revolution
      (pp. 3-16)

      HINTS OR even statements about time, uncertainty, and expectations are present in the writings of early economists. In 1755, Cantillon, for example, defined the farmer as “an undertaker who promises to pay to the Landowner . . . a fixed sum of money . . . without assurance of the profit he will derive from this enterprise.”¹

      He reinforced his point by saying that “the price of the Farmer’s produce depends naturally upon . . . unforeseen circumstances, and consequently he conducts the enterprise of his farm at an uncertainty.”

      In the same vein, Cantillon defined merchants as “undertakers [who]...

    • CHAPTER TWO Rational Expectations Are Endogenous to and Abide by “the” Model
      (pp. 17-42)

      THErational expectations hypothesis(REH) is a much more ambitious, comprehensive, and complex theory than any of the expectations theories that we have just reviewed. It is a pillar of the neo-Walrasian approach to general equilibrium, a mathematically demanding theory purporting to show how the interaction between rational agents engaged in constrained maximization of consumption, production, profits, etc., over time, generates a unique and stable intertemporal equilibrium. The explicit consideration of time in this general equilibrium approach calls either for future markets in all goods or, failing such markets, for an expectations theory of future prices, so as to account...

  10. PART TWO Allais’s Theory of “Expectations” Under Uncertainty

    • [PART TWO Introduction]
      (pp. 43-46)

      THE HRL FORMULATION we are going to present in part II of this book, and to transpose in Part III to financial behavior, is originally one element of Allais’s theory of monetary dynamics. To fully appreciate what the HRL formulation is liable to bring to the modeling of financial behavior, it is necessary to give an overview of Allais’s theory of monetary dynamics. This is not a minor challenge since it implies summarizing 50 years of research and a 1300-page book in a few pages.¹ Since this exercise is meant to be an overview, it will be limited to presenting...

    • CHAPTER THREE Macrofoundations of Monetary Dynamics
      (pp. 47-66)

      IT IS MOST MEANINGFUL that Allais’s first foray in monetary macroeconomics¹ consisted in laying its foundations on a set of comprehensive accounting identities that link exchanges of goods and services, securities transactions, and, last but not least, bank credit (and therefore money creation).² How he did that is even more telling. In contrast to Kalecki and Keynes, Allais’s methodology is a “bottomup” one, in which macroaggregates are derived from the summation of microdata, namely, of what corporate finance knows as the cash flow statement (or the statement of sources and applications of funds) of a given business. His methodology is...

    • CHAPTER FOUR Microfoundations of Monetary Dynamics: The HRL Formulation of the Demand for Money
      (pp. 67-94)

      ALLAIS PRESENTED THE HRL formulation of the demand for money in 1965.¹ As said in the Introduction, although this HRL formulation can be interpreted as a general theory of expectations under uncertainty, Allais always refrained from calling it a theory of expectations, concerned as he was to stress that our “expectations” are in fact rooted in memory. Therefore, to be consistent with Allais’s thinking, we must agree on the following semantic convention. We shall refer to the variables produced by the HRL formulation as being perceived as opposed to being “expected.” We shall talk of perceived inflation (or return) instead...

    • CHAPTER FIVE The Fundamental Equation of Monetary Dynamics
      (pp. 95-112)

      IN SECTION 3.2, we have observed that money creation was absent from relationship 3.43, which shows the impact of hoarding (respectively dishoarding) on the fluctuations in aggregate nominal spending. The fundamental equation of monetary dynamics, which Allais presented in 1968, not only corrects this omission, but it also explains the fluctuations in money velocity.¹

      The major contribution of the fundamental equation of monetary dynamics is indeed to introduce the relative difference between effective and desired money in the differential expression of the Newcomb-Fisher equation of exchange, thereby showing that this is the factor that causes money velocity to fluctuate. Alongside...

    • CHAPTER SIX Joint Testing of the HRL Formulation of the Demand for Money and of the Fundamental Equation of Monetary Dynamics
      (pp. 113-128)

      AS WE HAVE PRESENTED Allais’s fundamental equation of monetary dynamics (FEMD) in chapter 5, we have insisted on the fact that this equation is logically independent of Allais’s HRL formulation of the demand for money. Any formulation of the demand for money is indeed liable to be compatible with the fundamental equation of monetary dynamics.

      Nevertheless, the HRL formulation of the demand for money and the fundamental equation of monetary dynamics complement each other and are in practice interdependent. Through the coefficient of psychological expansionZ, the HRL formulation of the demand for money establishes a link between the sequence...

  11. PART THREE Transposing the HRL Formulation to Financial Markets:: Preliminary Steps

    • CHAPTER SEVEN Allais’s HRL Formulation: Illustration of Its Dynamic Properties by an Example of Hyperinflation (Zimbabwe 2000–2008)
      (pp. 131-152)

      THREE FUNDAMENTAL NOTIONS underpin Allais’s HRL formulation: memory, psychological time, and satiety.¹ Every one of us has at least an intuition of these three concepts. Their expression in mathematical terms is what makes the HRL formulation difficult to command. In their comments on the HRL formulation, Cagan, Darby, and Scadding all invoked Milton Friedman’s authority.²

      Yet, there is little doubt that Cagan, Darby, and Scadding did not fully understand how the HRL formulation really works.

      Allais replied to their comments in great detail, but his answers remained mostly theoretical. This is not to say that Allais did not accept the...

    • CHAPTER EIGHT The HRL Formulation and Nominal Interest Rates
      (pp. 153-180)

      ALLAIS’S THEORY of psychological time and memory decay plays a central role in his formulation of the demand for money. However, this theory purports to describe the operation of memory in general, not just in the context of monetary dynamics. It is, in fact, independent of monetary dynamics. It can be interpreted as a general theory of “expectations” under uncertainty. Can it, therefore, explain other phenomena?

      With his theory of the psychological rate of interest, Allais suggests that the theory of psychological time and memory decay is indeed liable to shed light on the determination of nominal interest rates.

      Allais...

  12. PART FOUR The HRL Formulation and Financial Instability

    • CHAPTER NINE Perceived Returns and the Modeling of Financial Behavior
      (pp. 183-200)

      ARGUABLY, ALLAIS did not have financial markets in mind when he conceived the HRL formulation of the demand for money. But following a path pointed out by Allais himself, chapter 8 of this book has confirmed, with the example of nominal interest rates, that the HRL formulation is relevant beyond the field of monetary dynamics. Financial market practitioners will probably not be surprised by this extension, for Allais’s psychological assumptions are indeed very general and describe behavior they can observe on trading floors, in investment and risk committees, or during pitches to clients, at least from time to time.

      Therefore,...

    • CHAPTER TEN Downside Potential Under Risk: The Allais Paradox and Its Conflicting Interpretations
      (pp. 201-240)

      IN THE PRECEDING CHAPTERS, we have seen that the HRL formulation can be used to model how people form return “expectations” under uncertainty. Were it not for its approximate semantics, the next question would be, And what about risk “expectations” under uncertainty? Bearing in mind Knight’s critical distinction between risk and uncertainty, the more rigorously formulated question we want to address now is the following: can we use the HRL formulation to model how financial market participants form “expectations” of the dispersion of returns under uncertainty?

      Investing in long-term financial assets can indeed be analyzed as a repetitive game in...

    • CHAPTER ELEVEN Downside Potential Under Uncertainty: The Perceived Risk of Loss
      (pp. 241-264)

      FROM OUR DISCUSSION of the Allais paradox and cardinal utility in chapter 10, there are two insights to take away: first, the dispersion of outcomes matters; second, losses loom larger than gains. While the second insight is independent of any consideration of time, the first one is closely connected with the flow of time.

      As a matter of fact, if—even in the universe of risk—the distribution of potential outcomes matters alongside their mathematical expectation, it is precisely because insightful individuals understand that the latter is a concept that implicitly assumes that all potential outcomes happen at once in...

    • CHAPTER TWELVE Conclusion
      (pp. 265-270)

      THIS BOOK being nothing but an invitation to add Allais’s HRL formulation to the tool kit of any scholar, economist or not, interested in “expectations” formation, it seems appropriate to conclude our inquiry by summarizing in a comparative way and with the rational expectations terminology what makes Allais’s contribution original, important, and modern.

      To start with, many of the rational expectations theorists’ criticisms of standard adaptive expectations do not apply to the HRL formulation. Allais’s algorithm is not a constant-gain one; it is a time-varying algorithm. As a consequence, the sum of the weights on the lagged variable is not...

  13. APPENDIX A How to Compute Zn and zn
    (pp. 271-274)
  14. APPENDIX B Nominal Interest Rates and the Perceived Rate of Nominal Growth
    (pp. 275-276)
  15. APPENDIX C Proofs
    (pp. 277-326)
  16. APPENDIX D Comparison Between the Kalman Filter and Allais’s HRL Algorithm
    (pp. 327-330)
  17. APPENDIX E A Note on the Theory of Intertemporal Choice
    (pp. 331-342)
  18. APPENDIX F Allais’s Cardinal Utility Function
    (pp. 343-346)
  19. Notes
    (pp. 347-366)
  20. Bibliography
    (pp. 367-374)
  21. Index
    (pp. 375-396)