What Economic Modelling Hypotheses Should Underlie Regulation & Policy Advice? Towards a Probabilistic Approach

Abstract

The recurrence of financial crises in the last fifty years reveals a market coordination failure that regulation and economic policy were unable to prevent. While several explanations exist for the emergence of financial and economic crises, none seems to be fully satisfactory or conclusive. This text develops the idea that the theoretical assumptions that underlie policy and regulation are inadequate to fully map economic reality and that this explains the observed policy and regulatory failures. The paper suggests to assess the adherence of standard economic assumptions to reality from a probability viewpoint. It notes in particular that the no-arbitrage condition is the key assumption retained by modern finance for the pricing of financial assets. It is supported by the same set of logical premises that are associated to competitive markets in general equilibrium theory. Still today, this group of normative requirements remains central in policy advice and regulation, be it through Modern Finance or other applied fields such as Public Choice. Based on simple probabilistic arguments, the paper reminds that the domain of relevance of the above standard normative conditions is necessarily very limited. The inadequacy of the assumptions retained by regulators and policy makers to map actual economic reality can thus explain the regulatory and policy failures that allowed financial crises to develop. Public action should use more wisely normative conditions. A closer look at the adherence of the relevant assumptions to reality may be a way for improving policy and regulation effectiveness in the future.