Myths of financial markets being essentially well-functioning and efficient die hard. We need to radically change the way finance is taught.
It was a French mathematician, Louis Bachelier, who pioneered mathematical finance in the early 20th century. Today, it is another French professor of quantitative finance at the University of Zurich, Marc Chesney, who seriously questions modern financial theories.
His main concern is about finance education, which is where future bankers, traders, managers and investors draw their working assumptions from. «The academic world didn’t sufficiently learn the lessons from the 2007-2008 financial crisis, remaining very low key in front of repeated financial scandals. Yet responsibility rests on academia to analyze these issues with objectivity, if academic freedom is to have any meaning».
On skimming numerous course programs, he is amazed at the inertia of mainstream finance: more often than not, university programs contain no mention of the 2008 financial crisis, or it is referred to, but only succinctly. In most Masters in Finance programs, ethics and sustainability are not covered. How about the unprecedented attempts by Western central banks to control interest rate markets and asset prices? It is largely absent from the textbooks.
«We need to put into question classical economic and financial concepts», says Marc Chesney, «and ask ourselves to what extent they are realistic». For example, students are still taught the general equilibrium theory, but «today, there is no such a thing as a general equilibrium. A theory of disequilibrium would be relevant».
The outspoken specialist and author of several books is one of the main promoters of the microtax popular initiative, which is in the process of collecting the 100’000 signatures required for a national vote. It aims at a complete reset of the Swiss tax system by replacing the VAT, the direct federal tax and the stamp duty, by one simple tax with a very small rate, around 0,1%, on electronic transactions, be it retail consumption, commercial payments, banking transfers or high frequency trading.
As an academic, Marc Chesney, together with other prominent professors – like Beat Burgenmeier, former dean of the economics faculty at Geneva University – has made a clear case for changing the way finance is taught. The Chicago school of thought still reigns unchallenged in classrooms and in academic reviews, the Zurich-based professor says.
Yet theories like Markowitz’s modern portfolio theory, which earned the Chicago professor a so-called* Nobel Prize in economics in 1990, proved to be inoperative, especially in times of market turmoil. Classic asset valuation theory assumes perfectly rational and informed investors, and this too is but academic folklore. The Black-Scholes formula for option pricing assumes an absence of arbitrage opportunities «when in real life, arbitrage is a key profit factor in financial markets», adds Marc Chesney.
French-American mathematician Benoit Mandelbrot (1924-2010) also challenged the Chicago school of economics (Markowitz, Black, Scholes and Merton). As he noted in his 60s to 90s research, stock prices are all about discontinuity, «wild chance» and risk concentration over time. Mandelbrot’s main criticism of the Neoclassics was that these theories strongly underestimate unlikely events and fail to take into account extreme variations. In other terms, they got probabilities wrong.
Even worse, adds Marc Chesney, is that it’s often impossible to accurately compute such probabilities. «In November 2019, what was the probability of a coronavirus pandemic occurring in early 2020 and of the resulting financial crashes?». Furthermore, adds Marc Chesney, what is needed are mandatory courses on the history of financial crises.
«Strangely enough, these courses are not mandatory today, though they are essential». But only a minority in the academic world seems interested in these critical issues, he observes. Today, Marc Chesney would like faculties to make a clean sweep and start teaching reality.
Finance shouldn’t be learned as a single discipline, he adds, recalling how the social and economic sciences faculties were split, in Switzerland in particular, into two distinct fields. An unfortunate choice, he feels, that killed the necessary debate between economic and social scientists. «These debates are deemed inconvenient for the unmovable dogmas of academic finance».
This split explains why finance papers and teachings are so often disconnected from relevant economic and social issues of our time. Finance professors used to interact with economic historians, now often moved to social science departments.
«To understand finance, we need cross-disciplinary teachings. Assessing the dangers of a pandemic and its possible consequences means you need to associate physics, biology and political science with economics and finance», claims Marc Chesney.
Acknowledging the interrelation between financial flows and global warming, the loss of biodiversity, deforestation, pollution, and how growth and the environment couldn’t be studied separately, he co-created a cross-disciplinary Competence Center for Sustainable Finance at the University of Zurich.
Economic science is mistaking itself for a hard science, though there are no fundamental laws in economics and finance. Unlike physics, financial data are dependent on human beings, human emotions, context, epoch, location, habits and culture, just like sociology and history. Therefore, finance doesn’t obey immutable norms. It belongs to the historical sciences family.
In this quality, it is time for finance to be taught for what it is: a human activity which can serve very different purposes, based on society’s deliberate choices, policies and concepts conveyed by education. It is long overdue for universities to live up to their responsibility to society and organize a complete and in-depth rethink of the theories they need to teach, in order to ensure that a new responsible financial generation takes over.
*) What we commonly call the “Nobel Prize in economics” is not one of the prizes that Alfred Nobel established in 1895. Therefore it is not a Nobel Prize. It was created by the Bank of Sweden in 1968 and is administered by the Nobel Foundation, and referred to along with the Nobel Prizes.