Ro­bust Fi­nance

Ro­bust Fi­nance:

Strate­gic Power, Knight­ian Un­cer­tainty, and the Foun­da­tions of Eco­nomic Pol­icy Ad­vice

March - July 2015

The the­ory of fi­nan­cial mar­kets is one of the most suc­cess­ful the­o­ries so­cial sci­en­tists, ap­plied math­e­mati­cians and physi­cists have ever de­vel­oped. Its suc­cess, how­ever, has also con­tributed to its im­mense mis­use and fail­ure in prac­tice. The on­go­ing cri­sis has been ac­com­pa­nied by huge losses in­curred by in­vest­ment banks that had to be cov­ered by so­ci­eties as a whole.

Eco­nomic pol­icy ad­vi­sors failed to pre­dict, let alone un­der­stand, the causes and con­se­quences for the real side of the econ­omy. The usual macro­eco­nomic mod­els used to es­ti­mate the course of the econ­omy and to ad­vise pol­icy mak­ers did not in­clude fi­nan­cial mar­kets and thus were un­able to an­tic­i­pate the ef­fects of the fall­out from the storm that was build­ing up in fi­nan­cial mar­kets.

On the sci­en­tific side, some con­sen­sus has emerged re­gard­ing cer­tain un­for­tu­nate de­vel­op­ments that con­tributed to the cri­sis. One pri­mary fac­tor was the in­creas­ing splin­ter­ing of fi­nance, fi­nan­cial math­e­mat­ics and eco­nom­ics into dis­joint sub­jects. In re­cent years, fi­nan­cial math­e­mat­ics has de­vel­oped into more and more se­cluded re­gions of fi­nan­cial en­gi­neer­ing with­out uni­ver­sal sound eco­nomic foun­da­tions. Mi­cro­eco­nomic the­ory, al­though es­sen­tial for un­der­stand­ing the so­cial and wel­fare ef­fects of fi­nan­cial de­ci­sions, has not been in­te­grated into fi­nan­cial math­e­mat­ics.

Our re­search group aims to over­come this un­for­tu­nate sep­a­ra­tion into what one might call "fi­nan­cial en­gi­neer­ing with­out judg­ment" and "eco­nomic pol­icy with­out math­e­mat­i­cal so­phis­ti­ca­tion" by cre­at­ing a the­ory of fi­nance that achieves the heroic aim of using the math­e­mat­i­cal tools of sto­chas­tic cal­cu­lus in com­bi­na­tion with the sound eco­nomic judge­ment pro­vided by game the­ory, mech­a­nism de­sign, and de­ci­sion the­ory. .

We also take the fail­ure of macro­eco­nomic pol­icy mod­els as an in­cen­tive and a new chance to study the po­ten­tial of eco­nom­ics as a so­cial sci­ence: can we pre­dict the course of com­plex eco­nomic sys­tems, or are there nat­ural bound­aries for a so­cial sci­ence that pre­vent any se­ri­ous pre­dic­tion? If this is so, what are the con­se­quences for the sci­en­tific con­sul­tancy of eco­nomic pol­icy? .