Modern Finance, Methodology and the Global Crisis Esteban Pérez Caldentey and Matías Vernengo

[Working Paper No. 01/2011]

The conceptually unified theoretical core of modern finance, which includes the efficient market hypothesis, the CAPM, the Modigliani-Miller theorem and the Black-Scholes-Merton approach to option pricing, has been instrumental in the growth of the financial services industry, financial innovation, globalisation, and deregulation. The elevation of finance to the stature of a scientific discipline was successful in rendering irrelevant the long-standing moral concerns associated with capitalism and laissez-faire. This success was somewhat of a paradox, since the core theories/theorems were based on wildly unrealistic assumptions and did not stand out for their empirical strength. Overcoming this paradox required a methodological twist, whereby theories were devised to create rather than to interpret or predict reality. This view led to a series of financial practices that increased the fragility and vulnerability of financial institutions, setting the context for the occurrence of financial crises including the recent one.

01_2011 (Download the full text in PDF format)