Unformatted text preview: ernalities paradigm, it does not require a vengeful god to intervene exogenously with tail‐
risk events to unleash the dynamics of a downward spiral. Instead, it has its own fully endogenous dynamics, with favorable returns and optimism feeding each other on the way up, adverse returns and pessimism on the way down. The dynamics are akin to Schumpeter’s creative destruction, where cycles are a natural part of the evolutionary process. However, unlike the traditional Schumpeterian process, where some do well while others perish at every point in the cycle, the dynamics in the mood swings paradigm are more like “Schumpeter on steroids”, as financial innovation cycles can have a devastating systemic impact because everyone follows the same path, up thebubble and down the abyss. The mood swings paradigm, however, is not free of puzzles and difficulties. In particular, uncertainty‐
driven mood swings are easy to invoke but harder to model.70 To be sure, one would expect rationality (even if bounded) and path dependence to constrain feasible outcomes. However, unlike incentive distortions under the moral hazard and externalities paradigms, which are firmly grounded in traditional economic theory, modeling mood shifts may require some departure from orthodox theory.71 In any event, it is also rather surprising that market participants were seemingly oblivious to the risks underlying the process of financial innovation. Did such obliviousness simply reflect a difficulty to look outside the box and connect the dots? Did such difficulty reflect the fact that markets do not reward (current and future), risk might be more efficiently spread over existing debt holders by using debt equity swaps as an alternative to unconditional bail outs (see Veronesi and Zingales, 2008). 70 The importance of mood swings for financial bubbles and panics has been widely recognized. It finds its roots in Keynes’ animal spirits and Hyman Minsky’s writings on financial crises (see Minsky, 1975). More recently, it was popularized by Kindleberger (1996) and Shiller (2006). While many attempts have been made to model mood driven‐cycles within the traditional world of rational expectations with full information (see the seminal contribution of Azariadis, 1981), the conditions for such rational bubbles to exist have been shown to be rather limited (Santos and Woodford, 1997). However, moods play a much more important role once one assumes problems with the information (imprecision or uncertainty) or the way one deals with it, which, in turn, may (or may not) require abandoning the assumption of full rationality. Epstein and Wang (1994), and more recently Fostel and Geneakoplos (2008), showed that multiple priors can lead to models where beliefs influence asset prices in a fully rational world. In addition, Geweke (2001) and Weitzman (2007) showed that, when there is too much uncertainty, fully rational human behavior may not conform to the precepts of traditional economic theory as defined by the standard expected‐utility framework. Abandoning the ass...
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