The STDP theory of financial crises

Diamondopoulos, John (2020) The STDP theory of financial crises. MPhil thesis, Birkbeck, University of London.

Abstract

Crises are difficult to predict with the most recent and notable example being the failure of the economic profession to see the 2007-2008 Credit Crunch. Why? The quantitative approach to financial crises depends on one key assumption –the comparability of financial crises. Thus, we should ask: how comparable are crises? An important consideration is the context –social, political and institutional. Next, if financial crises are comparable to a certain extent, then we should be able to make predictions. This naturally leads one to ask: how predictable are crises? Not only did this approach fail to predict crises, but an understanding and explanation of crises was also lacking. In short, a comprehensive theory of financial crises was needed to account for context and thus improve our understanding and explanation of financial crises. Thus, the failure of the quantitative approach due to the relative non-comparability of crises, led to a search for an alternative approach. Two possibilities were psychological and/or sociological explanations. Additionally, the assumptions of rational agents, cognitive biases (behavioural finance) and the Efficient Market Hypothesis (EMH) need to be critically reviewed. To this end, the methodological approach undertaken was to look at the world through the ‘eyes’ of market actors trading in the market. This unorthodox approach is underpinned by the abductive research strategy. A quasi-experimental study was conducted with postgraduate students engaged in a two-month virtual trading exercise. Three different cohorts were studied during the years 2010 to 2012. The data was mainly interpreted using content and thematic analysis methods. The goal was to find out how prior financial discourse (education) shaped their views and subsequent trading strategies. In addition, the relative importance of psychology and sociology in trading decisions was examined in detail. Ultimately, this would lead to an ‘ideal’ type market actor or actors for a theory of financial crises. The result of this study supports a ‘multiple equilibria’ and ‘heterogeneous agents’ view of the market that is counter to the prevailing financial discourse in finance of the EMH. To provide structure and to build the theory of financial crises, a complimentary methodology that allowed for the widest latitude, or license if you will, was needed. The retroductive research strategy combined with a modified version of the Beach and Pederson (2013) Y-centric theory building process-tracing method was utilized. The result was the development of The STDP Theory of Financial Crises. The social, political and institutional context, which is left out in quantitative approaches, was now at the core of this theory. This is a process-oriented theory with a focus on understanding and explaining crises. It is also multi-disciplinary in scope. To this end, crises proceed through four steps: Social, Trigger, Disruption and Psychological. Three case studies on financial crises were conducted to test the theory and to gain further insights.

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