The Value of Bottom-Up Analysis

I think we can agree (...or I hope we can...) that institutional investors were poorly served by conventional finance theory over the past few years, especially in the area of risk management. As such, I’m of the mind that we need more academics challenging the ontology (dare I say ideology) of finance and economics in this domain — not because I’m some revolutionary trying to replace top-down approaches with a new intellectual toolkit, but because I think the people using the quantitative tools need to understand their limitations and, better still, supplement these top-down tools with bottom-up approaches.

Enter Dan Awrey of Oxford University: He recently posted a (now very popular) paper to SSRN entitled “Complexity, Innovation and the Regulation of Modern Financial Markets.” It’s a neat article that looks to “establish a more stable and constructive equilibrium between financial theory and financial regulation”. More specifically, Awrey shows the complexity of global financial markets and, in turn, demonstrates why attempts to “generalize” and “abstract” through mathematical models is so difficult. Here are some blurbs I thought were particularly insightful:

“As American essayist H.L. Mencken once observed: ‘for every complex problem there is an answer which is clear, simple and wrong’.”

“The intellectual origins of the global financial crisis of 2007-2009 (GFC) can be traced back to shortcomings – blind spots – emanating from within conventional financial theory. These blind spots are distorted reflections of the perfect market assumptions underpinning the canonical theories of financial economics.”

“These theories share a common and highly stylized view of financial markets, one characterized by, inter alia, perfect information, the absence of transaction costs and rational market participants. Yet in reality financial markets – and market participants – rarely (if ever) strictly conform to these assumptions.”

“...the empirically (con)testable assumptions of conventional financial theory have been transformed into the central articles of faith of the ideology of modern finance: the foundations of a widely held belief in the self-correcting nature of markets and their consequent optimality as mechanisms for the allocation of society’s resources.”

“This market fundamentalism was grounded in the conviction that rational and fully informed market participants – utilizing sophisticated quantitative methods and the innovative financial instruments these methods made possible – had effectively mastered risk.”

“The GFC has revealed the folly of market fundamentalism as a driver of public policy. It has also exposed conventional financial theory as fundamentally incomplete. Perhaps most glaringly, conventional financial theory failed to adequately account for both the complexity of modern financial markets and the nature and pace of financial innovation.”

I can’t really speak to the paper’s claims about regulation (not my forte), but I can repeat the fact that I’m sympathetic to the author’s views about finance theory. In fact, I think they are awesome. Why? Because I’ve been frustrated with these same issues for over a decade.

Some background on me: After doing a BA and MA in economics with a concentration in finance, I bailed and left academia altogether. I was only convinced to return to the academy when I got an opportunity to join a program (Oxford University’s program in economic geography) that afforded researchers methodological freedom. In economic geography, I found a discipline that encouraged researchers to understand and appreciate the immense complexity and idiosyncrasies of the economic world around us rather than constantly trying to generalize through models. I chose research topics based on their relevance and importance rather than on the availability of quantifiable data. It was fantastic.

But there were consequences: my old colleagues had disdain and contempt for my decision to leave the ‘church of economics’ in search of truth elsewhere. I recall presenting some qualitative research to a group of young economists in Washington DC (...we’d all been awarded the same research grant...) to curious and skeptical views. At the end, I didn’t get a single question. It was painful.

My frustration that economists simply didn’t “get the value of what I was doing” boiled over in 2006 near the end of my PhD. I convinced my wife (who was also a PhD candidate — but in economics) to write a paper with me specifically for the Oxford economics department (via a student run journal). The objective: To make economists aware of the value of a ‘bottom up’ approach to understanding economic issues.

Anyway, the paper generated some interesting and gratifying discussions. But the real change ultimately came with the financial crisis: people started to understand the value of field work — of local appreciation. I still think the discipline of economics has a long way to go. (For example, when was the last time you read an economics paper based on a series of case studies? Maybe Ronald Coase in developing his theory of the firm? Or Adam Smith’s pin factory for division of labor?) Nonetheless, multi-method approaches are becoming more popular (and accepted)...and that’s a good thing. True appreciation of the economic landscape requires both top-down and bottom-up approaches.