Introduction

Edward L. Glaeser, Tano Santos, and E. Glen Weyl

The past three decades have been characterized by phenomenal upheavals in financial markets: the United States has witnessed two remarkable cycles both in the stock market during the late 1990s and in real estate during the first decade of the 21st century, followed by the Great Recession, the Japanese banking crisis that itself followed two equally impressive cycles in that country's stock and real estate markets, the larger Asian crisis of 1997, and the Eurozone banking crisis that still is ongoing at the time of this writing. These crises have occurred not in politically unstable countries without sound governance institutions and stable contractual environments, but at the heart of the developed world: the United States, Japan, and the Eurozone. The fact that all these events have led to a flurry of books, papers, journal special issues, and so on exploring the causes of, consequences of, and remedies for large systemic financial crises, which some had thought a thing of the past, is therefore not surprising. What are the origins of these speculative cycles? Are modern financial systems inherently prone to bubbles and instabilities? What are the effects on the real economy?

This volume follows in this tradition but takes a distinct perspective. The chapters in this book consist of papers presented at a conference held at the Columbia Business School in the spring of 2013 in honor of José Scheinkman's 65th birthday. These papers are centered on the lessons learned from the recent financial crisis, issues that have been high in José's agenda for some time now. They are all written by José's coauthors and former students during his remarkable and ongoing career as an economist. José's contributions span many different fields in economics, from growth to finance and pretty much everything in between. In this volume, we sought to use this diversity to bring new ideas to bear on the events of the past three decades. In doing so, we recruited José's closest colleagues from a variety of fields to speak to his most recent interests, in financial economics, which he has pursued for the past decade and a half.

We begin this introduction by focusing on the core financial contributions contained in the volume and gradually connect the papers outward from there, returning in our discussion of the final chapter to the core themes we take away from this collection.

1 Asset Pricing

Asset pricing not only lies at the core of finance, but also the core of José's intellectual interests. His first contribution to the field is an unpublished manuscript from 1977, Notes on Asset Pricing. Starting this volume with the contribution that fits squarely in this field is therefore only appropriate.

The law of one price implies prices can always be expressed as the inner product of the asset's payoff and another payoff that we term the stochastic discount factor. The stochastic discount factor is of interest to economists because, in the context of general equilibrium models, it encodes information about investors' intertemporal preferences as well as their attitudes toward risk. Information about these preferences is important because, for example, they determine the benefits of additional business-cycle smoothing through economic policy. A long literature in macroeconomics and finance derives specific models for the stochastic discount factors from first principles and tests the asset-pricing implications of these models. Since Hansen and Singleton's (1982) seminal paper that rejected the canonical consumption-based model, we have learned much about what is required from models that purport to explain asset prices. But our current models, such as those based on habits or long-run risks, have difficulty explaining the kind of cycles described in the opening lines of this introduction. Still, we have sound reasons to believe elements of those models have to eventually be part of "true" stochastic discount factor, because not even the most devoted behavioral finance researcher believes asset prices are completely delinked from macroeconomic magnitudes at all frequencies.

In sum, our current models for the stochastic discount factors are misspecified. Lars Hansen and José himself contribute the most recent product of their remarkable collaboration with a paper that explores a powerful representation of the stochastic discount factors, one outside standard parametric specifications. By a felicitous coincidence, Lars received the 2013 Nobel Prize, together with Eugene Fama and Robert Shiller, partially for his work on asset pricing. The inclusion of his work in this volume is thus doubly warranted.

In their paper, José and Lars explore the possibility that some components of that representation may be errors arising from an imperfectly specified model that may provide an accurate description of risk-return trade-offs at some frequencies but not others. This decomposition is important, because it will allow the econometrician to focus on particular frequencies of interest, say, business-cycle frequencies, while properly taking into account that the model may not be able to accommodate high-frequency events, such as fast-moving financial crises or even short-term deviations of prices from their fundamental values. This flexible representation of the stochastic discount factor thus captures our partial knowledge regarding its proper parameterization while maintaining our ability to conduct econometric analysis.

In addition, this approach opens the way for further specialization in the field of asset pricing. Some financial economists may focus on those components of the stochastic discount factor with strong mean-reverting components and explore interpretations of these components as liquidity and credit events or periods of missvaluation, for example. Others may focus on those business-cycle frequencies to uncover fundamental preference parameters that should be key in guiding the construction of macroeconomic models geared toward policy evaluation. What arises from the type of representations José and Lars advance in their work is a modular vision of asset pricing — one that emphasizes different economic forces determining risk-return trade-offs at different frequencies.

2 Financial Intermediation

Although the...