CAPM and the risk free rate

In a recent post, I was musing about Sharpe and Lintner's decision to treat the risk free rate as an external fact about the world, and not endogenous to their model.  I noted that if you do this, then the curvy efficient frontier flattens down and becomes the capital market line.  Instead we have a set of risky assets and an additional tangent mechanism whereby the line running from the risk free (a.k.a. zero volatility) rate to the tangent point on the efficient frontier is introduced into the CAPM world.

I found out subsequently, re-reading the excellent Fischer Black biography that he considered it endogenous.   In his 1969 initial extension of CAPM, Black sees no role for the monetary authority, and models the risk free rate as the equilibrating rate which satisfies those timid investors who prefer to have larger fractions of their wealth in safe assets and who therefore want to lend all their money (via depositing it with the bank) to leveraged and more aggressive investors, who are happy to borrow that money and climb up past the tangency point on the CML.  

In this model, having a monetary authority messing with the risk free rate in order to stabilise the price level or even worse, to manipulate the economy, implied the system was in a non-equilibrium state, and hence had opportunities for profit.

There's something temptingly beautifully simple in this model of people having two choices for their wealth, and their changing distribution of animal spirits driving not only the price of money but also the price of risk.  It certainly doesn't much correspond to reality but then again nor did option prices much coalesce around the famous Black-Scholes formula pre-1973.  On the other hand, it says nothing about the origins of those animal spirits which stir up price discovery for the prices of money and risk.  Perhaps the only institution the libertarian radical markets theorist needs is human psychology.

Mill on Comte : clever but absurdly consistent fascist

I'm just finishing up the great J.S. Mill book on August Comte.  In the end Mill spotted Comte's fascist tendencies, which clearly abhorred him, whilst appreciating his great intellectual abilities (especially early in Comte's career).  Mill finishes the book by highlighting the danger of what Emerson would later call a 'foolish consistency of small minds' but what Mill himself would call the absurd consistency of great minds.  Emerson tagged this kind of foolish consistency as indicative of small minds, ironically enough, in an essay encouraging people to be more self-reliant, individualists, non-conformist; this is the non-fascist perspective, precisely the opposite of the Comtian view of how humanity ought to be managed.  Mill labels Comte with Descartes and Leibniz in the same category, saying: 

"they were ... the most consistent, and for that reason often the most absurd, because they shrank from no consequences, however contrary to common sense, to which their premisses appeared to lead.  Accordingly their names have come down to us associated with grand thoughts,..., and also with some of the most extravagantly wild and ludicrously absurd conceptions and theories, which ever were propounded by thoughtful men."  

 I mention this because this argument about how free a model builder is to use input assumptions which differ substantially from reality is a very modern one in economics, just as it was in Ricardo and Malthus's time.  I hope to come back to it in later postings.

To my mind, what most resembles this frenzied French systematiser within the scope of economics is a well-described mathematical model of some aspect or other of economic behaviour, together with a set of (usually unrealistic) assumptions.  I hope to develop this idea further when reading other works on economic methodology.

It is also amusing to me that not only did Comte's life work contain inspiration for what would be the positive approach to economics, but also his life itself provided a model for a model-driven quasi-human not unlike the  Homo Economicus beloved of the neoclassical economist fraternity.  Mehrling, in his wonderful biography of Fisher Black, paints a similar picture of a man driven to change his very own behaviour in a way which made it conform to the CAPM model, an recent mathematical model of Homo economicus.  Mehrling refers often to Black as 'CAPM Man'.  I'm also reminded of John Searle's Chinese room experiment, which captures some aspect of this form of constraint on human behaviour.  When we behave according to the diktats of the model, are we debasing our humanity, or are we bringing light where otherwise there was emotional floundering?  In answering this question, it is worth remembering the conclusions concerning performativity as discussed in "An engine, not a camera".