Markowitz portfolio theory explicitly observes that portfolio managers are not (expected) utility maximisers, as they diversify, and offers the hypothesis that a desire for reward is tempered by a fear of uncertainty. This model concludes that all investors should hold the same portfolio, their individual risk-reward objectives are satisfied by the weighting of this ‘index portfolio’ in comparison to riskless cash in the bank, a point on the capital market line. The slope of the Capital Market Line is the market price of risk, which is an important parameter in arbitrage arguments.
Merton had initially attempted to provide an alternative to Markowitz based on utility maximisation employing stochastic calculus. He was only able to resolve the problem by employing the hedging arguments of Black and Scholes, and in doing so built a model that was based on the absence of arbitrage, free of turpe-lucrum. That the prescriptive statement “it should not be possible to make sure profits”, is a statement explicit in the Efficient Markets Hypothesis and in employing an Arrow security in the context of the Law of One Price. Based on these observations, we conject that the whole paradigm for financial economics is built on the principle of balanced reciprocity. In order to explore this conjecture we shall examine the relationship between commerce and themes in Pragmatic philosophy. Specifically, we highlight Robert Brandom’s (Making It Explicit Reasoning, Representing, and Discursive Commitment) position that there is a pragmatist conception of norms – a notion of primitive correctnesses of performance implicit in practice that precludes and are presupposed by their explicit formulation in rules and principles.
The ‘primitive correctnesses’ of commercial practices was recognised by Aristotle when he investigated the nature of Justice in the context of commerce and then by Olivi when he looked favourably on merchants. It is exhibited in the doux-commerce thesis, compare Fourcade and Healey’s contemporary description of the thesis Commerce teaches ethics mainly through its communicative dimension, that is, by promoting conversations among equals and exchange between strangers, with Putnam’s description of Habermas’ communicative action based on the norm of sincerity, the norm of truth-telling, and the norm of asserting only what is rationally warranted …[and] is contrasted with manipulation (Hilary Putnam The Collapse of the Fact Value Dichotomy and Other Essays)
There are practices (that should be) implicit in commerce that make it an exemplar of communicative action. A further expression of markets as centres of communication is manifested in the Asian description of a market brings to mind Donald Davidson’s (Subjective, Intersubjective, Objective) argument that knowledge is not the product of a bipartite conversations but a tripartite relationship between two speakers and their shared environment. Replacing the negotiation between market agents with an algorithm that delivers a theoretical price replaces ‘knowledge’, generated through communication, with dogma. The problem with the performativity that Donald MacKenzie (An Engine, Not a Camera_ How Financial Models Shape Markets) is concerned with is one of monism. In employing pricing algorithms, the markets cannot perform to something that comes close to ‘true belief’, which can only be identified through communication between sapient humans. This is an almost trivial observation to (successful) market participants, but difficult to appreciate by spectators who seek to attain ‘objective’ knowledge of markets from a distance. To appreciate the relevance to financial crises of the position that ‘true belief’ is about establishing coherence through myriad triangulations centred on an asset rather than relying on a theoretical model.
Shifting gears now, unless the martingale measure is a by-product of a hedging approach, the price given by such martingale measures is not related to the cost of a hedging strategy therefore the meaning of such ‘prices’ is not clear. If the hedging argument cannot be employed, as in the markets studied by Cont and Tankov (Financial Modelling with Jump Processes), there is no conceptual framework supporting the prices obtained from the Fundamental Theorem of Asset Pricing. This lack of meaning can be interpreted as a consequence of the strict fact/value dichotomy in contemporary mathematics that came with the eclipse of Poincaré’s Intuitionism by Hilbert’s Formalism and Bourbaki’s Rationalism. The practical problem of supporting the social norms of market exchange has been replaced by a theoretical problem of developing formal models of markets. These models then legitimate the actions of agents in the market without having to make reference to explicitly normative values.
The Efficient Market Hypothesis is based on the axiom that the market price is determined by the balance between supply and demand, and so an increase in trading facilitates the convergence to equilibrium. If this axiom is replaced by the axiom of reciprocity, the justification for speculative activity in support of efficient markets disappears. In fact, the axiom of reciprocity would de-legitimise ‘true’ arbitrage opportunities, as being unfair. This would not necessarily make the activities of actual market arbitrageurs illicit, since there are rarely strategies that are without the risk of a loss, however, it would place more emphasis on the risks of speculation and inhibit the hubris that has been associated with the prelude to the recent Crisis. These points raise the question of the legitimacy of speculation in the markets. In an attempt to understand this issue Gabrielle and Reuven Brenner identify the three types of market participant. ‘Investors’ are preoccupied with future scarcity and so defer income. Because uncertainty exposes the investor to the risk of loss, investors wish to minimise uncertainty at the cost of potential profits, this is the basis of classical investment theory. ‘Gamblers’ will bet on an outcome taking odds that have been agreed on by society, such as with a sporting bet or in a casino, and relates to de Moivre’s and Montmort’s ‘taming of chance’. ‘Speculators’ bet on a mis-calculation of the odds quoted by society and the reason why speculators are regarded as socially questionable is that they have opinions that are explicitly at odds with the consensus: they are practitioners who rebel against a theoretical ‘Truth’. This is captured in Arjun Appadurai’s argument that the leading agents in modern finance believe in their capacity to channel the workings of chance to win in the games dominated by cultures of control . . . [they] are not those who wish to “tame chance” but those who wish to use chance to animate the otherwise deterministic play of risk [quantifiable uncertainty]”.
In the context of Pragmatism, financial speculators embody pluralism, a concept essential to Pragmatic thinking and an antidote to the problem of radical uncertainty. Appadurai was motivated to study finance by Marcel Mauss’ essay Le Don (The Gift), exploring the moral force behind reciprocity in primitive and archaic societies and goes on to say that the contemporary financial speculator is “betting on the obligation of return”, and this is the fundamental axiom of contemporary finance. David Graeber (Debt The First 5,000 Years) also recognises the fundamental position reciprocity has in finance, but where as Appadurai recognises the importance of reciprocity in the presence of uncertainty, Graeber essentially ignores uncertainty in his analysis that ends with the conclusion that “we don’t ‘all’ have to pay our debts”. In advocating that reciprocity need not be honoured, Graeber is not just challenging contemporary capitalism but also the foundations of the civitas, based on equality and reciprocity. The origins of Graeber’s argument are in the first half of the nineteenth century. In 1836 John Stuart Mill defined political economy as being concerned with [man] solely as a being who desires to possess wealth, and who is capable of judging of the comparative efficacy of means for obtaining that end.
In Principles of Political Economy With Some of Their Applications to Social Philosophy, Mill defended Thomas Malthus’ An Essay on the Principle of Population, which focused on scarcity. Mill was writing at a time when Europe was struck by the Cholera pandemic of 1829–1851 and the famines of 1845–1851 and while Lord Tennyson was describing nature as “red in tooth and claw”. At this time, society’s fear of uncertainty seems to have been replaced by a fear of scarcity, and these standards of objectivity dominated economic thought through the twentieth century. Almost a hundred years after Mill, Lionel Robbins defined economics as “the science which studies human behaviour as a relationship between ends and scarce means which have alternative uses”. Dichotomies emerge in the aftermath of the Cartesian revolution that aims to remove doubt from philosophy. Theory and practice, subject and object, facts and values, means and ends are all separated. In this environment ex cathedra norms, in particular utility (profit) maximisation, encroach on commercial practice.
In order to set boundaries on commercial behaviour motivated by profit maximisation, particularly when market uncertainty returned after the Nixon shock of 1971, society imposes regulations on practice. As a consequence, two competing ethics, functional Consequential ethics guiding market practices and regulatory Deontological ethics attempting stabilise the system, vie for supremacy. It is in this debilitating competition between two essentially theoretical ethical frameworks that we offer an explanation for the Financial Crisis of 2007-2009: profit maximisation, not speculation, is destabilising in the presence of radical uncertainty and regulation cannot keep up with motivated profit maximisers who can justify their actions through abstract mathematical models that bare little resemblance to actual markets. An implication of reorienting financial economics to focus on the markets as centres of ‘communicative action’ is that markets could become self-regulating, in the same way that the legal or medical spheres are self-regulated through professions. This is not a ‘libertarian’ argument based on freeing the Consequential ethic from a Deontological brake. Rather it argues that being a market participant entails restricting norms on the agent such as sincerity and truth telling that support knowledge creation, of asset prices, within a broader objective of social cohesion. This immediately calls into question the legitimacy of algorithmic/high- frequency trading that seems an anathema in regard to the principles of communicative action.