Can future systemic financial risks be quantified?: ergodic vs nonergodic stochastic processes

Paul Davidson

doi:10.1590/s0101-31572009000400001

Abstract

Different axioms underlie efficient market theory and Keynes's liquidity preference theory. Efficient market theory assumes the ergodic axiom. Consequently, today's decision makers can calculate with actuarial precision the future value of all possible outcomes resulting from today's decisions. Since in an efficient market world decision makers "know" their intertemporal budget constraints, decision makers never default on a loan, i.e., systemic defaults, insolvencies, and bankruptcies are impossible. Keynes liquidity preference theory rejects the ergodic axiom. The future is ontologically uncertain. Accordingly systemic defaults and insolvencies can occur but can never be predicted in advance.

Highlights

Different axioms underlie efficient market theory and Keynes’s liquidity preference theory
What is rarely noted is that what is significant about this current economic crisis is that it origin, like the origin of the Great Depression, lies in the operations of free financial markets
As I pointed out in two recent articles (Davidson, 2008a, 2008b), it is the deregulation of the financial system that began in the 1970s in the United States that is the basic cause of our current financial market distress

Summary

Paul Davidson*

Different axioms underlie efficient market theory and Keynes’s liquidity preference theory. What is rarely noted is that what is significant about this current economic crisis is that it origin, like the origin of the Great Depression, lies in the operations of free (deregulated) financial markets. In an amazing “mea culpa” testimony before Congress on October 23, 2008, Alan Greenspan admitted that he had overestimated the ability of free financial markets to self‐correct and he had entirely missed the possibility that deregulation could unleash such a destructive force on the economy. A Nobel Prize [in economics] was awarded for the discovery of the [free market] pricing model that underpins much of the advance in [financial] derivatives markets. This modern risk management paradigm held sway for decades. The purpose of this paper is to explain the fundamental problem confronting anyone attempting to quantify systemic financial risks regarding future outcomes in a money using capitalist economy

THEORIES EXPLAINING THE OPERATION OF A CAPITALIST ECONOMY

What is required to quantify future systemic financial risks?

Policy Implications