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"Falahati, Kazem"
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Time, Arbitrage, and the Law of One Price: The Case for a Paradigm Shift
Consider a Competitive, Efficient, and Frictionless Economy (CEFE) where resources are scarce at any date, and hence money as a valid claim against scarce resources is also scarce. In this economy, there is always price competition, which can at any date generate an unlimited number of arbitrage opportunities. For example, at any date, opportunities can exist to buy and sell each one of the contracts for delivery of the same good or asset at multiple prices currently as well as on an infinite number of future dates. I prove all arbitrage transactions, including \"spot\" transactions, tie up arbitrageurs' capital representing money, good or asset such that this capital cannot be used for any other purpose for a non-zero quantity of time. This makes it impossible to exploit all arbitrage opportunities with the scarce capital available at any date and leads to an infinite number of unexploited opportunities and a non-negligible opportunity cost of the capital tied-up in arbitrage transactions, represented by each arbitrageur's best missed arbitrage opportunity, if no better opportunity exits, hence the breakdown of the law of one price in its standard sense. This helps construct a new paradigm of CEFE which resolves long-standing theoretical, empirical, and experimental puzzles.
Journal Article
Systemic Characteristics of Financial Instability
I describe how in the new paradigm of a Competitive, Efficient, and Frictionless Economy (CEFE), introduced in Falahati (2019), macroeconomic imbalances with fluctuating levels of liquidity emerge endogenously. This provides a solid foundation for studying Minsky's views on financial instability in an economy with a banking and risk-underwriting system. I identify an inverse relationship between liquidity premia and risk premia, which leads to endogenous risk-premium rating cycles, including credit-risk-premium rating cycles, and macroeconomic swings. Ceteris paribus, lower liquidity increases the prices of contracts covering risks (e.g., credit default swaps), whist it decreases prices of all other assets. The opposite occurs with higher liquidity. I analyze operations of banks, risk-underwriters, and the State/Central Bank, and present a new theory of banking which improves current understandings. This theory explains how a banking system uses the floating capital of the economy more efficiently, while it also generates greater systemic risks, compared to an economy without banks. I show how the banking system can induce macroeconomic booms and busts and generate endogenous asset price bubbles and bursts. I highlight other systemic problems of the economy and derive their implications for improving the financial management of the economy and its institutions.
Journal Article
The standard model of rational risky decision-making
Expected utility theory (EUT) is currently the standard framework which formally defines rational decision-making under risky conditions. EUT uses a theoretical device called von Neumann-Morgenstern utility function, where concepts of function and random variable are employed in their pre-set-theoretic senses. Any von Neumann-Morgenstern utility function thus derived is claimed to transform a non-degenerate random variable into its certainty equivalent. However, there can be no certainty equivalent for a non-degenerate random variable by the set-theoretic definition of a random variable, whilst the continuity axiom of EUT implies the existence of such a certainty equivalent. This paper also demonstrates that rational behaviour under utility theory is incompatible with scarcity of resources, making behaviour consistent with EUT irrational and justifying persistent external inconsistencies of EUT. A brief description of a new paradigm which can resolve the problems of the standard paradigm is presented. These include resolutions of such anomalies as instant endowment effect, asymmetric valuation of gains and losses, intransitivity of preferences, profit puzzle as well as the St. Petersburg paradox.
Journal Article
EXAMINING THE APPLICATION OF MATHEMATICS IN ECONOMICS
In most scientific disciplines, mathematical models work well empirically and experimentally. However, it is widely recognized that in standard (i.e. neoclassical) economics, mathematical models do not work quite as well, not even at the theoretical level. The question is why. This diagnostic study, which is one of the first in its kind, addresses this question and reveals that mathematics is non-rigorously applied in economics by focusing on the case of ordinal utility theory (which rests at the foundation of neoclassical economics), and identifying three mathematical oversights there. For these reasons, this paper calls for a reconstruction of economic theory with a much more solid foundation than that of the currently dominant paradigm, and with a much more rigorous application of logic and mathematics.
Journal Article
New Paradigms in Financial Economics
The recent global financial crisis has made the inadequacies of the scientific state of economics and finance glaringly obvious, as these disciplines gave the false reassurance that such a self-destructive phenomenon could not happen. A similar phenomenon arose in the 1930's, when the pitfalls of the dominant economic theories were sharply exposed. Since then, the same analytical framework, in its new versions, has revealed a huge number of other empirical and experimental failures.
On the other hand, the founders of the currently dominant theories in economics and finance (i.e. the standard paradigm) such as Walras (1834-1910), Modigliani (1918-2003) and Miller (1923-2000) have identified mathematical contradictions within their own foundational models, the root cause of which no one has yet discovered. The standard paradigm has thus lost the reason for its existence in the light of experience, experiments and logical rigour. This book identifies the heuristic cause of these external and internal contradictions of the standard paradigm and remedies these problems by offering a new paradigm which can explain and predict observed economic behaviour, and resolve the extant behavioural, empirical and experimental puzzles.
The new paradigm offers a dramatically improved understanding of economic behaviour at the micro as well as macro level of the economy within an over-arching framework comprising the real and the financial sectors. It does so in a rigorous but simple and clear way, using an axiomatic approach. It also offers policy recommendations on how the economy should be managed to avoid severe swings. It therefore is of great interest to scholars and practitioners in economics and finance.
eBook
New paradigms in financial economics : how would Keynes reconstruct economics?
1. Introduction -- 2. Irrational foundations of \"rational\" behaviour in the standard paradigm -- 3. Contradictions of the Marxian paradigm -- 4. The new paradigm -- 5. Resolution of puzzles in microeconomics -- 6. Resolution of puzzles in finance -- 7. Resolution of puzzles in macroeconomics -- 8. Economic role of the state -- 9. The recent global financial crisis -- 10. Conclusion, policy and research recommendations.
Book
Resolution of Puzzles in Finance
The theory of finance studies how a free market economy operates by means of different types of financial contracts which bind market participants' behaviour over time. Hence, its study must reveal how the financial system comprising the nexus of such contracts works at the micro as well as macro level of the economy, and how it helps or hinders the 'real', i.e. non-financial, economy where production and consumption of non-financial goods and services take place. If so, we should be able to understand how endogenous swings in the economy emerge. However, this understanding has so far eluded economists, as Greenspan (Financial Times
2009: 11) notes:
We can model the euphoria and the fear stages of the business cycle. Their parameters are quite different. We have never successfully modelled the transition from euphoria to fear.
Book Chapter
The new paradigm
In this chapter we set out our common ground with the existing literature, and present our assumptions. We shed light on old concepts such as liquidity, economic friction and opportunity cost; and introduce new concepts such as risk-caring behaviour. These form the foundations for the new paradigm from which we derive our results. The intuition behind the new paradigm comes from the following insight:
Book Chapter