Anti-Equilibrium: Katharina Pistor and the Need for a Non-Market Equilibrium Framework for Understanding Financial Markets

Disequilibrium-15-1Recently a friend of mine, Rohan Grey (founder of the excellent Modern Money Network), directed me to the work of Columbia law professor Katherina Pistor. Pistor’s work seems to be getting a lot of attention, having recently won the Max Planck research award. Having looked into it a bit I can safely say that Pistor “gets it” to a far greater extent than most economists.

To get an idea of what her work is all about I suggest watching this relatively short INET presentation (Pistor’s presentation starts around the 5 minute mark);

Pistor thinks that the manner in which we are regulating financial markets — with its emphasis on reducing transaction costs and information disclosure — is entirely wrong. I totally agree and what I find so interesting about Pistor’s work is that she recognises at a very fundamental level why regulators and economists are inclined to think otherwise.

At the start of her talk Pistor presents a basic supply and demand graph and says that this is how regulators and economists think of financial markets. She is absolutely correct. Even those theories that allow for disequilibria in markets — like the noise trader theory that I discussed in this post — take as their underlying structural principle the idea that markets are basically or even “naturally” efficient and will tend toward market equilibrium.

As I argued in the above post, this bias that is inherently built into the theory blinds economists, regulators and policymakers to the actual nature of such markets which is that they are, as Pistor says, inherently crisis-prone and hierarchical. Thus having regulations that basically focus on trying to allow markets to reach their supposedly “natural” equilibrium position will likely fail spectacularly.

What economic theory needs to do is to exorcise this specter of market equilibrium altogether. I have discussed how this might be done on this blog before, but let me elaborate a little further taking as a starting point Pistor’s presentation.

There are, as alluded to above, two components to Pistor’s criticism: (i) markets are inherently crisis-prone and (ii) markets are inherently hierarchical. Let’s deal with each aspect in turn.

If we concede that markets are inherently crisis-prone we must admit that they do not tend toward efficient market equilibrium positions. Think about that for a moment. Yes, theories like the noise trader theory — and there are other lesser known but similar theories which I will not discuss here — can account for bubbles and fluctuations in markets, but they tend to conceive of these as small ripples on an otherwise calm ocean.

This is because, in contrast to Pistor, they conceive of markets as being inherently stable and any crises that arise are anomalies (likely caused by some sort of anti-market process that can be regulated away). If we take as our basic precept, however, that markets are inherently unstable then we have to drop the assumption that they tend toward an efficient equilibrium.

The problem is that economists have internalised the efficient equilibrium bias to such an extent that they tend to view it simply as a methodological tool and not an a priori assumption about the nature of markets which is what it actually is. There were a few economists who recognised how the underlying idea of efficient equilibrium is far more than simply a methodological tool, but they are few and far between. In her excellent The Accumulation of Capital Joan Robinson, for example, wrote:

[We cannot] apply the metaphor of a balance which is seeking or tending towards a position of equilibrium though prevented from actually reaching it by constant disturbances. In economic affairs the fact that disturbances are known to be liable to occur makes expectations about the future uncertain and has an important influence upon any conduct (which is, in fact, all economic conduct) directed toward future results. For instance, [financial asset] owners (and their professional advisers) are always on the look-out to buy what will rise in value. A belief that a particular share is going to rise causes people to offer to buy it and so raises the price… This element of ‘thinking makes it so’ creates the situation in which a cunning guesser who can guess what the other guessers are going to guess is able to make a fortune. There are no solid weights to give us an analogy of a pair of scales in balance. (p59).

The first step that needs to be taken if we are to reform the theory of financial markets is that we must throw out the idea of efficient market equilibrium. If we do not, it will continuously come back to haunt us. The problem is that very few economists seem to be able to understand that this idea is not merely a methodological tool but rather a normative bias about the supposed “nature” of markets that deeply affects how we conceive of them.

The second aspect of Pistor’s criticism is tied to this. What she means when she says that markets are inherently hierarchical is that there exist a network of institutions that affect the capacity of various players in financial markets. She takes as her example the Federal Reserve and claims, rightly, that we can understand the hierarchy of the financial markets by looking at its balance sheet since the 2008 crisis. Here is the balance sheet (click to enlarge):


As Pistor says in her talk, an underwater homeowner cannot hand their mortgage over to the Fed in order to ensure their solvency, but if you’re a big bank about to go under you have all sorts of options at hand.

Although at first glance this has little to do with the idea of equilibrium, I would argue that it does. What the Fed does in times of crisis is that it chooses certain asset classes and then uses its money creation abilities to pump the value of these assets up to what it considers to be an appropriate price. There is an equilibrium process underlying this process, but not a market equilibrium one.

What is happening is that private sector investment is falling for some assets and central bank investment is piling in to stabilise the price. We can represent this algebraically in a very similar manner as we might the Keynesian income-determination process. Consider that price is set by investment either by the private sector, If, or by the central bank, which we will here call the government sector, Gf. Then:


To be crystal clear, that says that price, Pft, is determined by the price in the previous time period, Pft-1, private sector investment, Ift, and government investment, Gft.

Now, let’s further say that the change in private investment is determined by expectations of future price changes. Then:

eq2Again, what that equation says is that the change in private investment is determined by the expected future change in the price. I.e. if the future price is expected to fall, private sector investment will fall and if the future price is expected to rise, private investment will rise.

I have to say that I am oversimplifying here massively. The process is actually much more complicated than this, but I’m really just interested in bringing out the basic structure of what is going on here.

Okay, that said, let’s lay out what determines the equilibrium price, Pft*.

eq3As we can see — and again, we are massively oversimplifying here — the equilibrium price is determined (a) based on the expectations among investors of future price increases/decreases and (b) government, in this case central bank, action. Here is the key point: the equilibrium outcome is not a market equilibrium outcome; rather it is a stock-flow equilibrium outcome. The equilibrium price is purely determined by investment flows into the asset; just like income is determined in the Keynesian system by investment and consumption flows.

This is what I’m working on (in a far more complex way) for my dissertation. What I think is key to expanding our understanding of financial markets is to overthrow the bias inherent in the market equilibrium view. By introducing a stock-flow equilibrium framework we can see that these markets (1) are inherently unstable and dependent on expectations and (2) determined by investment flows that have an irreducible institutional element. This, I think, is how economists can begin to integrate and talk about work like Pistor’s.


About pilkingtonphil

Philip Pilkington is a macroeconomist and investment professional. Writing about all things macro and investment. Views my own.You can follow him on Twitter at @philippilk.
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9 Responses to Anti-Equilibrium: Katharina Pistor and the Need for a Non-Market Equilibrium Framework for Understanding Financial Markets

  1. ivansml says:

    First of all, price is not a stock variable, there is no “physical” link to its past values in the same sense as e.g. current liabilities are linked to past liabilities and current flow of borrowing. Thus all I see is an equation that says: change in price today is related to expected change tomorrow and government action today. Not very insightful.

    Second, there is the usual confusion about what economist mean by equilibrium. One meaning is that equilibrium is just that in the short-run, price adjusts so that supply=demand (but how those fluctuate over time is another matter). The other meaning involves EMH, Pareto efficiency, rational expectations and all that, and is the one Pistor presumably has in mind. But the first notion of equilibrium is obviously true in many financial markets, otherwise we would observe large bid-ask spreads. Thus proclaiming that “stock flow equilibrium” should replace “market equilibrium”, as if we didn’t need to bother with supply and demand and could just rely on accounting identities (which are inapplicable here), is just silly.

    • (1) Yes, price can be thought of as a stock variable. It is due to accumulation of flow-purchases. There is no methodological reason not to use it in this way. The SF framework need not refer to “physical” quantities, just to levels of accumulated flows.

      (2) The first notion of equilibrium is irrelevant in this context. I am dealing with the second meaning.

      (3) The SF framework incorporates supply and demand. The equations I’ve laid out are demand equations. You can build supply equations quite easily. What they avoid is the idea that price is due to a downward-sloping demand curve and an upward-sloping supply curve. Such a framework cannot incorporate expectations. That’s the major problem with it.

      Also, if you’re going to discuss this, let me just highlight the following from the above piece because I get a hint of the direction you might go from your first comment:

      I have to say that I am oversimplifying here massively. The process is actually much more complicated than this, but I’m really just interested in bringing out the basic structure of what is going on here.

      • ivansml says:

        (1) At any moment, price in financial exchanges is determined by current orders placed by participants. There is no reason why those should be linked to past purchases in a mechanistic way implied by stock-flow relationship. Also, stock variables evolve, by definition, continuously, and thus cannot jump, while prices jump all the time.

        (3) Sure it can incorporate expectations. DeLong et al. paper you linked to recently does exactly that.

    • (1) I don’t get what you’re saying the first part of your answer. To the second part: a stock variable would jump from period t to period t+1 if the flows increased substantially. Oh, and in my framework the prices evolve too. It’s just a question of the time period chosen.

      (2) That paper does not use a basic supply and demand framework. Although there is one underlying it called “rational investors”.

      • ivansml says:

        (1) Let’s say that at a single moment, all market participants receive good news about a company. As a result, stock price can jump up even if there is no corresponding sudden rush of buying and selling, just because everybody is suddenly willing to buy / sell at higher price.

        In reality, there will be of course lot of activity because information doesn’t arrive instantaneously. so the above is an extreme case. Still, I think it shows that evolution of stock prices is more complicated than just summing up past financial flows. And if you want to develop this thing further, I think it’s up to you to explain properly where the equation comes from.

        (2) Yes, it does use supply and demand. In their model, demand of investors depends on current and expected future price, and then given expectations, current price is derived by requiring that market clears (the supply of security is fixed at constant amount, but that’s of no importance). Can’t get much more neoclassical than that.

      • (1) Really? Is that your example? I think this argument is over. Try again when you’re serious.

        (2) As above.

        Maybe later dude. But right now. It’s pretty sad. If you need to integrate what we’re saying into your paradigm just say it. No harm. 😉

        ** Okay, I’ll be more specific: if you want to discover your own way with the mainstream stuff: go for it. Stop arguing and picking up our arguments online. Just go for it. If its all there just put it forward. No need to talk to me or anyone else.

      • ivansml says:

        Do you understand the words “extreme case”? Do you know what a thought experiment is? Apparently not.

        So one more time, in simpler words: if asset price was stock variable driven by investment flows, that would mean that whenever I invest 1$ in the asset, the price always goes up by 1$ (or some multiple of it, but always by the same amount). That’s how a stock-flow relationship is defined, and it’s also how financial markets DO NOT work, period.

        If you will present this in an academic setting (heterodox or orthodox, doesn’t matter), it’s very likely someone will ask you the very same question, so for your own sake I hope you’ll have some answer by then.

        Finally, don’t worry about my inspiration for research. Reading heterodox blogs has been some fine procrastination, but so far almost completely useless in terms of learning anything interesting or insightful.

    • Response:

      You really should have thought this through in more detail. But now I fear you will tell me that you (and every other mainstream economist) knew this already and, just like in the case of endogenous money, nothing new is being said.

      This will then likely be followed by heroic Talmudic readings of Krugman or someone else followed by appeals to what people “really think” as opposed to what they write. Ugh, tedious rubbish.

  2. Scott Hedlin says:

    Hey Phillip, I make sense of what you illustrate here by way of a transformative modeling technique used to craft results in creative writing experiments. Consistent to these exercises are several control factors.
    They have a fixed historical timeline (once each component part has fulfilled the terms of its available options it cannot be changed or edited).
    Each linear component section has a pre established binary option of either a first thought transformation(a single spontaneous gesture) or a two stage gesture of a first thought followed by a chance to consciously maximize it. (an edited version).
    To impartially establish the binary options I take randomly selected hexagrams from the I-Ching, allowing unbroken lines to represent the first binary option and broken as the second.
    I consider the first option, more random, less receptive to governance, less predictable, more institutionally vulnerable. The second option is then more deliberate and manipulated,receives more investment and is institutionally favored.
    I generally settle on four hexagrams, four being one of the traditional numbers representing completion of a meta-cycle.
    I arrange the hexagrams linearly and consider each line connected by process with the next corresponding line in the sequence of hexagrams.
    There is now a transformational structure that functions on six semi-independent levels, semi-independent because the crafted outcome is intended to be unified as to the over all harmony of the sense or idea it conveys. I won’t go through the entire process of composing at this time, but state i generally follow the established order beginning from any six somewhat random words, one assigned to each line.
    It became apparent to me when using these models that they exhibit a function similar to diverse economies, show stock and flow relationships as they are developed and are subject to more or less governance on several different levels. That’s why I consider them a useful analogy related to this post.
    Think for example how the possibility of a single linear order of four broken lines would stand in contrast to four unbroken lines, when the former could be compared to an economic sector that is financially maximized, largely unregulated,favored by subsidy options and able to capitalize its overall influence; the latter would pale by comparison exhibiting quite limited options of economic performance yet by its very existence be essential to the developing conclusion and unity of the economy. I think it shows quite well the non-equalibrium features evident in economies and demonstrate the skewed influence of hierarchy.
    A truly provocative post. Hierarchies often marginalize with bias and only maintain an appearance of equilibrium, a symmetry that is a structure of dominant institutions and their behaviors. The fact that the central agent can only evaluate an existing hierarchy in terms of discreet stock and flow behaviors encourages trends and can easily perform contrary and often counter-intuitive to what one would think an impartial yet unifying equilibrium would be. The active capacity of each non-central agent is inherently different, each having limits of means to maximize efficiency. A central agent may for example be more likely to reward and support what appears to be more deliberate behavior by an arbitrary, insufficient standard and deprive or grant less resources to those that exhibit less predictive results which are none the less represented in the over-all composition as essential unifiers. This throws balance out the window with the bathwater. As options for the central agent to have achieved a well integrated system vanish within a measurable cycle,the defects in its judgement can be recognized as crises,small or large that have become institutionalized.
    I liked Katerina’s references to community building and multi-disciplinary exchange. I chuckled when the white-male ,administrator, problem solver comment came up, followed by cameos of two female seminarists later in the video. I wonder if they threw a greet and meet party later that day. Good video and good luck with your dissertation.

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