• Towards an Austrian Theory of Finance

    pdficon2George Bragues
    University of Guelph-Humber
    Email: george.bragues@guelphhumber.ca

     

     

    If there is one area of economics in which the Austrian school has been demonstrably lacking, it is the theory of finance. While their Keynesian and Chicago rivals have produced no less than seven Nobel prize winners for their contributions to finance, the Austrians have been relegated to making their biggest dent outside academia among a relatively small cadre of hard money and gold advocates playing their trade in the capital markets. Other than brief discussions of the equity market and joint stock companies, one finds little that directly bears on the main topics of financial theory in the two leading treatises of modern Austrian economics, whether it be Ludwig von Mises’ (1963 [1949]) Human Action or Murray Rothbard’s (2009 [1962]) Man, Economy, and State . This is not to deny that there have been extensive scholarly treatments. The most thorough in the Austrian tradition is that of Fritz Machlup (2007 [1940]) in his book, The Stock Market, Credit, and Capital Formation. Yet that was actually written more than seventy years ago before Machlup shifted his allegiance to more orthodox streams of economics. Since then, Austrian minded scholars have published a not trivial number of articles on finance, including Mark Skousen (1994), Peter Boettke (2010), and Gregory Dempster (2011), that strive to apply the school’s ideas about entrepreneurship, prices, forecasting, and the business cycle to particular debates surrounding the capital markets. Still missing, however, is a cohesive and systematic exploration of the entire subject-matter of finance culled from Austrian teachings.

    What follows are some initial steps in this direction. Adopting the method of Socrates and Aristotle of launching the search for understanding by first surveying and evaluating the prevalent views on the subject at hand, I will run through four pillars of contemporary financial theory: (i) Modern portfolio theory; (ii) the Capital Assets Pricing Model; (iii) the Efficient Markets Hypothesis; and (iv) the Black-Scholes Model[1]. By questioning this canon, we can begin to discern the outlines of an Austrian theory of finance.

    Four Pillars

    (I)Modern Portfolio Theory

    Finance may be defined as the various means of deploying money to manage the time discrepancies between receipts and expenses that arise in the pursuit of one’s ends. As an area of study, finance has a long history. We can go as far back as Ancient Greece when Xenophon (1925 [354 BCE]) wrote a work on public finance entitled Ways and Means focusing on the city-state of Athens. But to the academic establishment today, finance really started little more than sixty years ago – or, to be more exact, 1952 (Miller, 1999). That was when the so-called big bang of modern finance occurred with the publication in the Journal of Finance of an article by Harry Markowitz (1952). Entitled “Portfolio Selection”, Markowitz mathematically demonstrated the benefits of diversification, showing that risk can be reduced by investing in a portfolio of securities without sacrificing expected returns[2]. This free lunch, as Markowitz came to call it, arises out of the fact that the price movements of securities are not perfectly correlated with one another. With this free lunch, however, came the recognition that not every kind of risk is compensated in the financial markets. After all, investors only get paid to bear risk that is otherwise unavoidable. Nobody will compensate another person to take on a burden that they can readily eliminate on their own. But to the extent that the risks associated with holding an individual security can be diversified away, investors will only be rewarded for the hazards assumed in holding a diverse group of financial instruments. Not the risk peculiar to a security, but rather a more general kind of exposure must be what explains the returns that investors earn. To maximize returns at a desired level of risk, therefore, Modern Portfolio Theory (MPT) summons investors to focus on the portfolio, rather than the individual security, as the fundamental unit of analysis.

    Mises never directly confronted MPT, but his discussion of probability and risk is germane towards the development of an Austrian alternative. Defining probability as those situations where we know something, but not everything, in gauging the truth or falsity of a given proposition, Mises (1963 [1949], pp. 106-117) held that such judgments come in two varieties.  Class probability is where we know everything about what will transpire in a class of phenomena, but are unsure about the impending behavior of any particular member of that class. Nicely exemplifying this are throws of a six faced die. We know that in the class of events consisting of all throws of this die that each side will end up having an equal 1/6 share of all instances. Still, we are uncertain about which number will come up on any given roll of the die. We may say that there is a 1/6 probability of any specific number getting thrown, though all we are really doing is stipulating its distribution within the entire set of dice rolls. By contrast, case probability is where we are unable to place a prospective outcome within a class of events, yet still grasp some of the factors influencing its occurrence. To illustrate this, Mises cites the prediction of U.S. Presidential elections. While it may appear that there is a class of previous elections to which we can appeal in calculating the odds of a particular candidate winning, the truth is that every campaign is irreducibly different with respect to the variables that determine the outcome. Not only are there distinct personalities at play, but the social, political, and economic circumstances impinging on the electorate fundamentally vary from one election to the next, as do the valuations that voters bring in assessing their choices. “The case”, Mises observes, “is characterized by its unique merits, it is a class by itself” (p.111).  Here, quantitatively derived estimates of probability make no real sense. If one happens to go beyond a qualitative sense of expectation to arrive at a number, it will always reflect what Mises calls understanding – that is, an assessment based on experience of a series of unique events applicable to the situation at hand (pp. 51-58).

    Given its quantitative pretensions, MPT is best seen as a claim to render investment into a matter of class probability. Furthering this interpretation is that MPT can be likened to insurance, a business whose essential practices Mises identifies with class probability (pp. 108-109). Properly speaking, a firm is engaged in providing insurance when it offers coverage to all parties exposed to a given adverse event, such as premature death. Where the mortality tables indicate that 1 in 100 of all forty year-old men die per year in Canada, the company can safely make money by offering life insurance at a premium reflecting that ratio so long as it does so to a lot of forty year old Canadian men. Anything less than that and it is no longer engaged in insurance, but gambling. However, there is no equivalent of the mortality table in financial markets. Every previous historical incident one might look to shed light on, say, the future direction of the Dow Jones Industrial Average, was driven by a concatenation of singular causes that is not going to be exactly repeated. An Austrian perspective is not thereby compelled to reject diversification as a viable strategy to manage the risk-return trade-off in finance. It only questions the idea that the prospective benefits of diversification can be mathematically delineated; it sees all the calculations of expected returns and covariances that go into MPT as so many metaphors numbering the case probabilities otherwise qualitatively apprehended in people’s historical understanding of the markets.

    As even the exponents of MPT acknowledge, it is not as if the world was ignorant of the value of diversification before MPT along. In The Merchant of Venice, Shakespeare (2000 [1596-1598]) depicts the character of Antonio as not being anxious about his sea trading ventures because his investments were spread amongst many ships (Act 1, Scene 1). Shakespeare gained this insight about diversification by attending to the specifics of human affairs, not by running equations. And it was because of this understanding that he recognized what a quantitative approach cannot with its assumption that the past repeats itself in the future – namely, that diversification is not guaranteed. All of Antonio’s ships wind up being sunk. Or, as market professionals nowadays are wont to say: in a financial crisis, the correlations between securities go to 1.

    (II) Capital Asset Pricing Model

    Left hanging in MPT is the nature of the more general risk that investors are rewarded for assuming in well-diversified portfolios. The Capital Asset Pricing Model (CAPM), associated most closely with William Sharpe (1964), is an attempt to specify that recompense. It maintains that the return on a security is essentially a function of two variables. The first is the risk free rate of interest representing the time value of money; the second is a premium for the degree of market risk assumed, measured by the sensitivity of a security to the general tides of asset prices. That sensitivity, in turn, is denoted by beta, from the Greek symbol β in the linear regression equation from which it is calculated. The beta of a security is 1 if its movements perfectly correlate with the swings of the over-all market; a beta of 2 means that the security is twice as volatile as the market, whereas 0.5 indicates that it is only half as volatile. In theory, the market refers to the portfolio of every capital asset in the world, but as the value of all the constituents would be very difficult to collect and aggregate, a proxy is usually adopted, usually in the form of a broadly representative stock index like the S&P 500. So other than being remunerated for sacrificing present consumption, CAPM says that investors are paid an extra amount for shouldering the exposure to such adversities as war, revolutions, depressions, recessions, and natural disasters to which the economic system is subject.

    An Austrian view would not deny this risk premium. Yet it would go further in rejecting CAPM’s assumption that a corner of the financial universe can be located which is risk free. For that rate, users of CAPM typically input the yield on a highly rated government bond, such as that of the U.S. or Germany, but even the debt securities of the most trustworthy state carry some risk that the latter will be tempted to inflate away its obligations by printing money. Thus included in their yields is a component in addition to the time value of money. “There are in this world”, Mises (1963 [1949]) well observes, “no such things as stability and security and no human endeavors are powerful enough to bring them about” (p.226). Governments are no exception to this brute reality. In this way, the Austrian tradition offer something more definite than the abstract notion of beta to explain the systemic market risk that investors are compelled to assume in agreeing to give up their funds in the here and now for some future set of cash flows. As Mises notes:

    Over all species of deferred payments hangs, like the sword of Damocles, the danger of government interference. Public opinion has always been biased against creditors. It identifies creditors with the idle rich and debtors with the industrious poor. It abhors the former as ruthless exploiters and pities the latter as innocent victims of oppression. It considers government action designed to curtail the claims of the creditors as measures extremely beneficial to the immense majority at the expense of a small minority of hardboiled usurers (p.540).

    Market risks consist not in beta, or any of the other measures that financial economists have subsequently proposed to overcome the now widely acknowledged flaws of CAPM[3]. Market risk equals political risk.

    (III) Efficient Markets Hypothesis

    The centerpiece of contemporary financial economics is the Efficient Markets Hypothesis (EMH). Resuscitating a forgotten doctoral thesis on speculation written by Louis Bachelier (2006 [1900]), EMH came to the fore in the 1960’s and 1970’s with the contention that security prices immediately assimilate all available information (Fama, 1970). As there is no discernible pattern by which new information enters the market, EMH further maintains that security prices follow a random walk. The practical upshot is that it is impossible for any investor to consistently beat the market by predicting the direction of prices better than otherwise dictated by the even odds of success. Starting in the 1980’s, though, EMH was challenged by Behavioral Finance, a more psychologically based approach stating that investors are systematically vulnerable to numerous cognitive biases that cause financial asset prices to deviate from their informationally correct values for sustained periods of time. A succession of events that seemingly belied the idea that markets are completely rational  – the 1987 crash, the 1990’s dotcom mania, the 2000’s housing boom — lent credence to Behavioral Finance, such that its foremost proponent, Robert Shiller (2000) ended up sharing the 2013 Nobel Prize in Economics with Eugene Fama, the godfather of EMH. Though no longer supreme, EMH remains the default position in academic finance.

    What an Austrian perspective would have to contest in EMH is the underlying assumption that equilibrium is the normal condition in markets.  EMH does not negate that there are moments when gains from trading are available from exploiting mismatches between prices and the economic realities those are supposed to reflect. But such moments are so short, according to EMH, that for all practical purposes security prices are always in equilibrium. From an Austrian standpoint, this would only hold in an evenly rotating economy where future conditions are entirely known, hardly the situation in financial markets. Rather than being in equilibrium, markets are a continual process towards equilibrium, never (or rarely) ever getting there amid the entrepreneurial search for undiscovered opportunities. As such, Austrian economics does not discount the idea that markets can be beat by astute investors able to predict the future better than others. Warren Buffet and Peter Lynch are not accidents. But it is not easy; it is just as difficult as it is to succeed as an entrepreneur in the larger economy. And like an entrepreneur, an investor’s success will depend on an understanding of historical contingencies, even if expressible in quantitative terms, as opposed to a theory positing invariant laws of human behavior. As for behavioral finance, Austrians can potentially make use of its psychological insights when endeavoring to give a concrete account of why investors pursued the goals that they did in the way that they did. Yet, strictly speaking, that would be to engage in the task of economic history. The only psychology, if one wants to call it that, economics needs to logically deduce its conclusions is the axiom that human beings act by choosing among various means to realize their subjective ends (Rothbard, 2009 [1962],pp. 72-74). 

    (IV) Black-Scholes Model

    Nowhere is the mathematical character of present-day financial theory more complex and forbidding than it is among the myriad of equations formulated to price derivative securities. Primary among these is the Black-Scholes Model (BSM), which is meant to value an option — the right to buy or sell an underlying security at a pre-established price (known as the strike price) within a specified time frame (Black & Scholes, 1973). BSM prices this right by considering the current price of the underlying security in relation to the strike price of the option, the time left before the right expires, the prevailing risk free interest rate, along with the expected volatility of the underlying security[4]. Entering the financial scene in the mid-1970’s, BSM is widely assigned a decisive role in spawning the phenomenal growth that derivative markets have since undergone. Though there are now a much greater variety of derivatives than the options that BSM originally appraised, the conceptual underpinnings of the model continue to influence theoretical valuations of more recent instruments, including those that figured prominently in the 2007-2009 financial crisis, such as collateralized mortgage obligations (CMO) and collateralized debt obligations (CDO). Most significant in this legacy is the assumption of BSM that, in valuing a derivative, the future path of the underlying security’s prices can be envisioned as a normally distributed range of periodic returns. To critics, this deludes major players in the financial system into underestimating the chances of extreme negative price shocks affecting their derivative portfolios, thus bringing about a cluster of forecasting errors that are apt to trigger crises (Taleb, 2010).

    An Austrian view would be sympathetic to this critique. Insisting that there are no regularities in human affairs for which statistical methods can be used to frame social-scientific laws, Austrians are not in the least surprised that financial markets occasionally exhibit price declines of the kind that a normal distribution of returns says should only happen once every two million years. Not only that, the absence of constant relations in the human condition implies that the entire project of mathematically deducing precise estimates of derivative prices is fundamentally mistaken. As with diversification and capital asset pricing, the valuation of derivatives is properly left to the prudential methods of historical understanding.

    Conclusion

    Obviously, much more can be said before exhausting everything that the Austrian corpus potentially has to say about finance. Nonetheless, based on the critical survey presented here of four key ideas in contemporary financial economics, one might tentatively conclude that an Austrian theory of finance would, at a minimum, encompass the following propositions:

    • Diversification is a useful risk management technique, though not perfect, and any benefit it promises is best gauged prudentially and historically.
    • In place of CAPM, an Austrian Capital Asset Pricing Model holds that the expected return of a security equals the time discount rate plus the political risk associated with that security.
    • Instead of EMH, the Austrian Markets Hypothesis is that financial market prices are constantly endeavoring, but never actually succeeding, to assimilate all available information. Investors can beat the market (i.e. achieve better than risk adjusted returns), but it is very difficult to do so consistently.
    • It is hopeless to mathematically demonstrate any empirically valid equation for the pricing of derivatives.

     

     

    References

    Bachelier, Louis (2006 [1900]) The Theory of Speculation: The Origins of Modern Finance. Mark Davis & Alison Etheridge, trans. Princeton: Princeton University Press.

    Black, Fischer and Scholes, Myron (1973) “The Pricing of Options and Corporate Liabilities”, Journal of Political Economy 81, 637-654.

    Boettke, Peter (2010) “What Happened to Efficient Markets?”, The Independent Review, 14 (3), 363-375.

    Dempster, Gregory M. (2011) “Austrian Foundations for the Theory and Practice of Finance”, Journal of Economics and Finance Education, 10 (2), 70-81.

    Fama, Eugene F. (1970) “Efficient Capital Markets: A Review of Theory and Empirical Work”, The Journal of Finance, 25 (2), 383-417.

    Fama, Eugene F. (1991) “Efficient Capital Markets: II”, The Journal of Finance, 46(5), 1575-1617.

    Fama, Eugene F. and French, Kenneth R. (1993) “Common Risk Factors in the Returns on Stocks and Bonds”, Journal of Financial Economics, 33(1), 3-56.

    Machlup, Fritz (2007 [1940]) The Stock Market, Credit, and Capital Creation. Auburn, Ala: Ludwig von Mises Institute.

    Malkiel, Burton. (2007) A Random Walk Down Wall Street. New York: W.W. Norton & Company.

    Markowitz, Harry (1952). “Portfolio Selection” The Journal of Finance, 7(1), 77-91.

    Miller, Merton H. (1999) “The History of Finance”, The Journal of Portfolio Management, 25 (4), 95-101.

    Mises, Ludwig von (1963 [1949]) Human Action: A Treatise on Economics. San Francisco: Fox & Wilkes.

    Rothbard, Murray (2009 [1962]) Man, Economy, and State with Power and Market. Auburn, Ala: Ludwig von Mises Institute.

    Shakespeare, William (2000 [1596-1598]) The Merchant of Venice. Hertfordshire, UK: Wordsworth Editions.

    Sharpe, William. F. (1964). “Capital Asset Prices: A Theory of Market Equilibrium under Conditions of Risk”, The Journal of Finance, 19(3), 425-442.

    Shiller, Robert J. (2000) Irrational Exuberance. Princeton: Princeton University Press.

    Skousen, Mark (1994) “Financial Economics” in Peter J. Boettke ed. The Elgar Companion to Austrian Economics. Aldershot, UK: Edward Elgar Publishing Limited.

    Taleb, Nassim N. (2010) The Black Swan, 2nd ed. New York: Random House.

    Xenophon, “Ways and Means” in E.C. Marchant and G.W. Bowersock, trans. Xenophon, Vol. 7. Cambridge, MA: Harvard University Press.

     

     


    [1] There is arguably a fifth pillar, the Modigliani-Miller debt/equity equivalence theorem. But I have decided not to treat it in this short discussion, as it is not as directly related to the financial markets as the other four pillars.

    [2] For an accessible elaboration of this risk-return dynamic, see Malkiel (2007, pp. 186-190).

    [3] On those flaws, see Fama (1992). Since the demise of beta, the Fama-French model of asset pricing has emerged as the leading substitute for CAPM. This model asserts that the returns on stocks can be explained by the price-to-book value ratio and market capitalization, with lower values of these correlating with higher returns. See Fama & French (1993)

    [4] Readers unfamiliar with the equations can consult any derivatives textbook to learn the exact specifications.