This paper presents a dynamic, stochastic game-theoretic model of financial fragility. The model has two essential features. First, interrelated portfolios and payment commitments forge financial linkages among agents. Second, iid shocks to investment projects ’ operations at a single date cause some projects to fail. Investors who experience losses from project failures reallocate their portfolios, thereby breaking some linkages. In the Pareto-efficient symmetric equilibrium studied, two related types of financial crises can occur in response. One occurs gradually as defaults spread, causing even more links to break. An economy is more fragile ex post the more severe this financial crisis. The other type of crisis occurs instantaneously when forward-looking investors preemptively shift their wealth into a safe asset in anticipation of the contagion affecting them in the future. An economy is more fragile ex ante the earlier all of its linkages break from such a crisis. The paper also considers whether fragility is worse for larger economies.

The theory of capital investment is the cornerstone of the theory of macroeconomic dynamics, and the question of whether or not the agents involved in the investment decision have the information needed to make individually and collectively optimal choices is central to capital accumulation theory. New Classical and neoclassical theory assume that they do. Keynesian and Post Keynesian theory assume that they do not. The outcome of many significant debates in macrotheory depends on which theory is correct about this. In section 1 of this essay I argue that the Keynesians are right about the information question and that once Keynes’s views are accepted, neoclassical theory has little to tell us about how to theorize agent choice. We are then confronted with the question: Are a coherent theory of agent choice and a coherent theory of the macroeconomy possible in the seemingly chaotic world of Keynesian uncertainty? And, if they are, how do we construct these theories? Alternatively, was Lucas correct when he pronounced that “in cases of uncertainty, economic reasoning will be of no value ” (1981, p. 224)? Is it true that Keynesian uncertainty is “analytically nihilistic...[creating an] all- embracing subjectivism ” (Coddington 1983, p. 61)? The main thesis of this paper is that economists can indeed construct, coherent theories of agent choice and macrodynamics in a Keynesian world as long as they are willing to add new research methods to their analytical tool kit. Section 2 shows why decision making under uncertainty exhibits what I call “conditional stability, ” a situation in which behavioral equations will be relatively stable under conditions that hold most of the time. Section 3 then briefly discusses the centrality of institutions to the creation of conditional macroeconomic coherence; however, these sections also argue that both the micro- and macrofoundations of coherence are contradictory in that they create the potential for outbursts of instability even as they help stabilize the economy. Section 4 reiterates the conclusions of the paper.

iii Frederick Douglass once said “If there is no struggle, there is no progress. ” I think this statement describes my PhD experience here at Caltech well. In ways the past four and half years have been more challenging than I expected yet also more rewarding than I anticipated. This journey would not have been possible without the financial and emotional support of my family and the guidance of my advisors present and past: Professors Fred Culick (Caltech), Victoria Coverstone (University of Illinois at Urbana–Champaign), and Alec Gallimore (University of Michigan). Their support of my education transformed a possibility of a PhD from a dream, to a hope, and now to a reality. I want to thank my Ph. D. advising committee: Professors Erik Antonsson, Jim Beck, and John Ledyard. All three provided invaluable insight and knowledge, especially Professor Beck who assisted with the subset simulation work. Along with Professor Culick, my advising committee gave me the liberty to pursue research ideas and shielded me from many bureaucratic and financial issues a PhD requires. I also thank Dr. Joel Sercel who provided the initial impetus and research ideas that this thesis became and Melinda Kirk for administrative support. This thesis builds upon work by a variety of researchers including Professor Ivan Au

This paper is intended to provide a selective yet fairly comprehensive assessment of how several authors associated with the new institutional economics (NIE hereafter) have dealt with some issues pertaining to the theory of economic behaviour under uncertainty. Among the issues selected are: (1) the concept of uncertainty; (2) the influence of institutions on economic behaviour; and (3) the concept of rationality. The paper attempts to contribute to classifying different views on these issues and, thus, to organizing the debate about them. Some recent and significant developments in this debate are considered. In addition to their interest for the theory of economic behaviour per se, all these issues are important for understanding how NIE relates to neoclassical economics, as well as to other alternatives to the latter

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Mr. Keynes's aggregates conceal the most fundamental mechanisms of change. (Hayek, 1931)

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charles j. whalen