argues that competitive market equilibrium with imperfect information is not necessarily described by market conditions where demand equals supply. The assumption that the pricing system ensuring market-clearing conditions is linear may not be tenable in light of price discounts relative to purchased quantities. The incomplete set of markets can also be explained by prohibitive information costs and transactions costs, which render difficult the inception of markets for risk allocation under all contingencies and all future delivery dates. Furthermore, Stiglitz (2011) notes that the recent literature on general equilibrium indicates that even under rational expectations, markets are not necessarily (constrained) Pareto efficient. This degree of market efficiency is never achieved under imperfect and asymmetric information and incomplete markets for risk allocation. It is the failure of modern macroeconomic models to account for market inefficiencies that limits their relevance for prediction, policy, or explanation purposes.
Rethinking Conventional Economics and Finance
Thus, the scope and limits of Arrow-Debreu equilibrium analysis are subject to continuous scrutiny. But this general equilibrium model provides a theoretical framework for optimal risk sharing. In an ideal conventional financial system, financial markets and financial intermediaries provide opportunities for intertemporal consumption smoothing by households and capital expenditure smoothing by firms. Savings represent a trade-off between current and future consumption, and real investments represent present expenditures with expectations of future economic output. It is natural that attitudes toward risk, including income risk and consumption risk, differ across market participants. The Arrow-Debreu framework allows for the distribution of risk in the economy among economic agents according to their respective degrees of risk tolerance, as noted by Hellwig (1998). In addition, the significant advances in general equilibrium models and finance theory have, nevertheless, provided a rigorous analytical framework for the examination of an ideal financial system for optimal allocation of risks in the society. They provide also clear evidence about the existence of a trade-off between risk and return and about the concept of no-arbitrage asset pricing, which underlie the capital asset pricing model and the arbitrage pricing theory.
However, the recurrence of financial crises has exposed the inherent instability of the conventional financial system. Reinhart and Rogoff (2009) provide evidence from the history of debt crises about the universality of serial defaults. The procyclicality of the financial system reflects the propensity of the banking system to expand credit during economic booms and restrict it in response to economic downturns. This procyclicality is, as noted by Rochet (2008), intrinsic to the financial system, but it is associated with financial fragility, which as defined by Allen and Gale (2009) reflects the potential for small shocks to generate significant effects on the financial system. As argued by Stiglitz (2011), there is a general recognition of the failure of standard macroeconomic models to predict the U.S. financial crisis or to understand the extent of its implications. It is further argued that the pursuit of self-interest “did not lead, as if by an invisible hand, to the well-being of all.” Indeed, Mirakhor and Krichene (2009) argue that the Arrow-Debreu conceptualization of an exchange economy based on risk sharing was transformed in steps into an economy based on risk transfer and eventually on risk shifting to taxpayers through government bailouts. As argued by Reinhart (2012), elevated levels of government indebtedness are conducive to a resurgence of financial repression, as reflected by tightly regulated financial environment. Since financial repression involves a distortion of resources allocation, as noted by Cottarelli (2012), this process is not consistent with the ideal conventional financial system and the Arrow-Debreu competitive economy with optimal allocation through risk sharing.
In light of the properties of the conventional financial architecture, there is an ongoing debate about rethinking the foundations of macroeconomics and financial economics, and reconsidering the implications of behavioral economics and behavioral finance for policymaking, regulatory, and academic purposes. In this regard, Stiglitz argues that “New Macroeconomics will need to incorporate an analysis of risk, information, and institutions set in a context of inequality, globalization, and structural transformation, with greater sensitivity to assumptions (including mathematical assumptions) that effectively assume what was to be proved (for example, with respect of risk diversification, effects of redistributions). Agency problems and macroeconomic externalities will be central” (2011, 636–637). The misalignment of incentives, moral hazards, information asymmetry problems, and regulator's capture stemming from risk transfer activities indeed contribute to the complexity of an interconnected financial system and to the complexity of prudential regulation. It is for these reasons that Bean (2009) also argues for the need to reconsider the role of financial intermediation in the development of macroeconomic models, in consideration of the peculiar properties of the balance sheets of financial intermediaries.
The renewed argument is thus made also for abolishing fractional reserve banking with the aim of dissociating the credit and monetary functions of commercial banks. As argued earlier by Fisher (1936), the merits of the Chicago Plan for monetary reform, created by some Chicago economists during the Great Depression based on the requirement for hundred percent reserves against demand deposits, include the attenuation of business cycle fluctuations, elimination of bank runs, and reduction of the levels of public and private debt. The revisit of the Chicago Plan by Benes and Kumhof (2012) using a dynamic stochastic general equilibrium model provide analytical evidence that the implications of the monetary reform program are strongly validated. It was also found that altering the banks' attitudes toward credit risk resulted in additional benefits, including significant steady-output gains due to the reduction or elimination of distortions such as interest-rate risk spreads, and costs of monitoring credit risks. There is also a potential for steady-state inflation as the focus of banks is directed towards the financing of investment projects as the government's ability to control broad monetary aggregates is increased. These analytical results are also consistent with the proposal for limited-purpose banking advanced by Kotlikoff (2010), which argues for confining banks to their core and legitimate function of channeling savings toward real investment. It is further argued that financial intermediation through limited purpose banking is less prone to breakdowns and that trust in the financial system would be restored.
In the aftermath of the U.S. financial crisis, there has also been a renewed focus on the role of morality and the relation between finance and good society, which is examined by Robert Shiller (2012), among others.6 Shiller notes that not everyone is “good” in the good society, but the issue is whether it is possible to redefine the role of institutions to contribute toward a system “that encourages all the complex basic patterns of actual human behavior into an effective and congenial whole.” (2013a, 402) This process involves the democratizing and humanizing of finance. As argued by Shiller (2011), democratizing finance entails the development of technology and human arrangements such as financial education and financial advice to facilitate greater participation into the financial system. The humanizing of finance involves the organization of financial institutions under effective incentives to take into account the reality of human nature and human psychology. It is about the development of institutions that are cognizant of behavioral patterns and attitudes toward risk that are conducive to the formation of asset bubbles and financial crises.
There is indeed a growing awareness about an insufficient representation, if not neglect, of human psychology and economic history in economics teaching. Whereas the role of mathematical models in understanding the complexity of economic systems, properties of general equilibrium, and effects of financial crises is widely recognized, the relevance of abstract theory to the discipline is not. There are indeed concerns that economics has developed as a mathematical science in pursuit of minute exactness, with insufficient relevance to economic experience and public policy. As noted by Boulding, the failure is apparent, for instance, in the economists' attempts to “develop mechanical models of the business cycle, somewhat along the lines of celestial mechanics” (1970, 8). For similar reasons, the relation between moral philosophy and economics is also revisited. For instance, Zingales argues for an active role for finance academics in elevating moral standards, stating:
[o]ur standard defense is that we are scientists, not moral philosophers. Just like physicists do not teach how atoms should behave, but how they do behave, so should we. Yet, physicists do not teach to atoms and atoms do not have free will.