Finance Education “After” the Crisis

1. Finance Education “After” the Crisis Steve Keen University of Western Sydney Debunking Economics www.debtdeflation.com/blogs www.debunkingeconomics.com

2. Finance: the Humpty Dumpty of Academia • “I don’t know what you mean by ‘glory,’ ” Alice said. • Humpty Dumpty smiled contemptuously. “Of course you don’t—till I tell you. • I meant ‘there’s a nice knock-down argument for you!’” • “But ‘glory’ doesn’t mean ‘a nice knock-down argument’,” Alice objected. • “When I use a word,” Humpty Dumpty said, in rather a scornful tone, • “it means just what I choose it to mean—neither more nor less.” • “The question is,” said Alice, “whether you can make words mean so many different things.” • “The question is,” said Humpty Dumpty, “which is to be master—that’s all.” • Alice was too much puzzled to say anything, so after a minute Humpty Dumpty began again. “They’ve a temper, some of them—particularly verbs, they’re the proudest—adjectives you can do anything with, but not verbs—however, I can manage the whole lot! • Impenetrability! That’s what I say!”

3. Humpty Dumpty’s Dictionary • “Efficient Market”: Noun • System capable of accurate prophesy • Prophesy—see “Rational” • System in which all agents can predict the future • System where any agent can borrow infinite amount at risk-free rate • E.g. (1): “In order to derive conditions for equilibrium in the capital market we invoke two assumptions. • First, we assume a common pure rate of interest, with all investors able to borrow or lend funds on equal terms. • Second, we assume homogeneity of investor expectations… • Needless to say, these are highly restrictive and undoubtedly unrealistic assumptions….” (Sharpe ‘64)

4. Humpty Dumpty’s Dictionary • E.g. (2): • “Sharpe (1964) and Lintner (1965) add two key assumptions to the Markowitz model to identify a portfolio that must be mean-variance-efficient. • The first assumption is complete agreement: given market clearing asset prices at t-1, investors agree on the joint distribution of asset returns from t-1 to t. • And this distribution is the true one—that is, it is the distribution from which the returns we use to test the model are drawn.” (Fama and French 2004, p. 26)

5. Humpty Dumpty’s Dictionary • “Expected Value (E.V.)”: Noun • What you won’t get in a one-off gamble • What your lecturer says the gamble is worth • Correct answer in multiple choice question • Rational • Able to predict future course of complex system • See Prophetic, (Nostradamus, as in) • E.g., Lucas 1972 (p. 54) “one is led simply to adding the assumption that [the gap between actual and expected inflation] is zero as an additional axiom… or to assume that expectations are rational in the sense of Muth.” • “Risk, capital markets, in”: Noun • Standard deviation of return around expected return…

6. Humpty Dumpty’s Dictionary • E.g.: “investors are assumed to agree on the prospects of various investments—the expected values, standard deviations and correlation coefficients…” (Sharpe 1964) • “Uncertainty”: Noun • Certainty with risk • See Expected Value; OR • Certainty without risk (Debreu 1959) • “… A contract … now specifies… an event on the occurrence of which the transfer is conditional… a theory of uncertainty free from any probability concept and formally identical with the theory of certainty developed in the preceding chapters.” • Is it any wonder that Humpty didn’t see The Fall coming?

7. Humpty Dumpty had a great fall… • “Unfortunately, the empirical record of the model is poor—poor enough to invalidate the way it is used in applications… • the failure of the CAPM in empirical tests implies that most applications of the model are invalid.” (Fama and French 2004, p. 25)

8. Reform: Integrated economics & finance • Neoclassical macro and neoclassical finance have to go • Neoclassical Finance/Economics divide • Money neutrality, no role for debt in macro • Barter model of capitalism • Debt financing no impact on firm value in finance • Equilibrium analysis of finance • Both nonsense in credit-based dynamic economy • Integrated economics & finance instead • Plus uncertainty-aware finance subjects • Almost all of neoclassical economics & finance false • But above all else, abandon fetishes of equilibrium & strong reductionism (Anderson 1972) • Especially in mathematical modeling…

9. Integrated financial economics • Walras’ Law false in a credit driven economy • Barter economy • Sum of all excess demands is zero • Aggregate demand is aggregate supply • Savings create loans • Aggregate debt has no macro impact • Credit economy • Sum of all excess demands equals change in debt • Aggregate demand = Aggregate supply + Ddebt • Loans create Deposits • Money supply endogenous • Change in debt drives growth & asset bubbles

10. Neoclassical macro naïve about money & debt • “The idea of debt-deflation goes back to Irving Fisher… • Fisher's idea was less influential in academic circles, though, because of the counterargument that debt-deflation represented no more than a redistribution from one group (debtors) to another (creditors). • Absent implausibly large differences in marginal spending propensities among the groups, it was suggested, pure redistributions should have no significant macro-economic effects…” (Bernanke 2000, p. 24)

11. Neoclassical macro naïve about money & debt • Krugman: Good start after the crisis… • “Given both the prominence of debt in popular discussion of our current economic difficulties …, one might have expected debt to be at the heart of most mainstream macroeconomic models… • Perhaps somewhat surprisingly, however, it is quite common to abstract altogether from this…” (p. 2) • But returns to same old a priori nonsense: • “the overall level of debt makes no difference to aggregate net worth—one person's liability is another person's asset… • we begin by setting out a flexible-price endowment model in which “impatient” agents borrow from “patient” agents.” (Krugman & Eggertsson, 2010, p. 3)

12. Naïve “savings creates loans” model • Patient lends to Impatient • Patient’s spending power goes down • Impatient’s spending power goes up • No change in aggregate demand • Banks merely intermediaries & ignored in analysis

13. Actual credit money creation process • Basic process of endogenous money creation • Entrepreneur approaches bank for loan • Bank grants loan & creates deposit simultaneously • Alan Holmes, Senior Vice-President New York Fed, 1969: • “In the real world, banks extend credit, creating deposits in the process, and look for the reserves later.” (1969, p. 73) Assets Liabilities • New loan puts additional spending power into circulation • Adds to aggregate demand

14. Empirical dynamics of Credit • In credit-driven economy, aggregate demand spent on both goods & services (GDP) and existing assets • AD = Income + DDebt = GDP + Net Asset Sales (NAS) • NAS = PA * fraction sold * QA= PA.sA.QA • D AD = D GDP + DDDebt = DGDP + D(PA.sA.QA) • Acceleration of debt ignored by neoclassical economists • Neoclassicals wrong • Finance & economics entwined by dynamics of debt • Credit Accelerator correlated • With Change in output; • With Change in employment; and • With Change in asset prices

15. Empirical dynamics of Credit • Private debt bubbles caused “Roaring Twenties” & “Noughty Nineties” • Bursting of bubbles caused Great Depression & Great Recession

16. Empirical dynamics of Credit • Change in Private Debt drives both booms and busts R2=-0.79 R2=-0.96 • Differences Now vs Then • Bigger debt-driven boom Now than Then • Business less indebted now, households & finance more • Much bigger/faster Government response to crisis • Faster turnaround in fall in private debt

17. Empirical dynamics of the Credit Accelerator • Great Depression & Great Recession both commenced with collapse in Credit Accelerator R2=-0.53 R2=-0.75 • Recent apparent recovery in US economy largely due to slowdown in rate of decline of private debt—a positive Credit Accelerator (CA) • Same true for sharemarket…

18. Empirical dynamics of the Credit Accelerator • Credit Accelerator affects sharemarket performance… R2=0.23 R2=0.37 • Complex, unstable lead/lag relationships between Credit acceleration, asset prices, economic growth… • Combined monetary economics/finance theory needed to understand it

19. Monetary Circuit Theory (MCT) • Neglected “Classical” economists the right foundation for the future • Marx, Keynes, Schumpeter, Keynes, Minsky • + European “Circuitists” (Graziani) • + Complexity theory (Goodwin & many others) • Monetary, dynamic integrated finance/macro model • Starting point: • All demand monetary • Money creation via bank double-entry bookkeeping • Enter financial flows into “Godley Table” • Generate dynamic model of money creation • Coupled to nonlinear non-equilibrium production model (Goodwin)

20. Modeling monetary dynamics • Input basic financial flows in table: • System of dynamic equations derived automatically:

21. Modeling monetary dynamics • Simple linear model • Prior to substitutions… • Implemented in easy to use GUI program • Prototype “QED”: www.debtdeflation.com/blogs/QED • Professional version “Minsky” under development

22. Modeling monetary dynamics • With nonlinear functions + cyclical production model:

23. Academic finance: A more limited role • No longer separate discipline from economics • Ancillary role for discussion of • Structure of finance markets/institutions • Investment decision-making under uncertainty • History of financial crises • If we forget again, we will relive again… Actual Finance sector (& profits) 4-6 times larger than they should be Actual Direction Direction Desirable Desirable

24. Academic finance: A more limited role • Behavioural Finance? Some role, but as usual, based on misreading (or not reading) original literature • Standard practice: Subjective probability • v.s. von Neumann: “Probability has often been visualized as a subjective concept more or less in the nature of an estimation. • Since we propose to use it in constructing an individual, numerical estimation of utility, the above view of probability would not serve our purpose. • The simplest procedure is, therefore, to insist upon the alternative, perfectly well founded interpretation of probability as frequency in long runs.” (Von Neumann and Morgenstern 1953 p. 19) • All “paradoxes of behavioural economics”—Ellsberg, Allais, etc.—disappear with objective probability

25. Academic finance: A more limited role • Bounded rationality • Sensible, but unlikely foundation for new economics • Better “top down” logic than bottom up, given emergent properties of macro & finance • See “More is different”, Anderson 1972 • Multi-agent modelling as adjunct to system dynamics • NetLogo, etc. • Complexity, chaos theory & econophysics • Far more important—complex systemic behaviour as explanation for “can’t beat the market” “efficiency” • Peters (2003), Lux (2001), McCauley (2004)… • www.unifr.ch.econophysics • Technically, teach the mathematics of dynamics—differential equations, systems—not equilibrium

26. Academic finance: A more limited role • Consider investment under uncertainty • As in Blatt 1979, 1982 • “Sophisticated” NPV ignores uncertainty • “Unsophisticated” Payback period considers uncertainty Investment Time Horizon • Yet another reason why finance has economic effects • “Payback period” pro-cyclical: extends during booms, contracts during slumps • A new economics & finance needed…

27. Some resources • Debunking Economics II: almost all the economics you didn’t learn from the textbooks… • Available September 2011 • My blog www.debtdeflation.com/blogs • Minskian explanation of the crisis • Free software program “Minsky” • “Monetary Macro-dynamics for dummies” • Being develeoped using INET grant • Mathematica version in development (Mike Honeychurchmike.honeychurch@gmail.com) • Prototype available on my blog: www.debtdeflation.com/blogs/QED • Lectures on history of economic thought, non-neoclassical monetary macroeconomics: http://www.debtdeflation.com/blogs/lectures

28. References • Anderson, P. W. (1972). "More Is Different." Science177(4047): 393-396. • Bernanke, B. S. (2000). Essays on the Great Depression. Princeton, Princeton University Press. • Bezemer, D. J. (2009). “No One Saw This Coming”: Understanding Financial Crisis Through Accounting Models. Groningen, The Netherlands, Faculty of Economics University of Groningen. • Bezemer, D. J. (2011). "The Credit Crisis and Recession as a Paradigm Test." Journal of Economic Issues45: 1-18. • Bezemer, D. J. (2010). "Understanding financial crisis through accounting models." Accounting, Organizations and Society35 (7): 676-688. • Blatt, J. M. (1979). "Investment Evaluation Under Uncertainty." Financial Management AssociationSummer 1979: 66-81. • Blatt, J. M. (1980). "The Utility of Being Hanged on the Gallows: Reply." Journal of Post Keynesian Economics3(1): 132-134. • Blatt, J. M. (1983). Dynamic economic systems : a post-Keynesian approach. Armonk, N.Y, M.E. Sharpe. • Debreu, G. (1959). Theory of value :an axiomatic analysis of economic equilibrium. New Haven :, Yale University Press. • Fama, E. F. and K. R. French (2004). "The Capital Asset Pricing Model: Theory and Evidence." The Journal of Economic Perspectives18(3): 25-46. • Goodwin, R.M. (1967). A growth cycle. Socialism, Capitalism and Economic Growth. C. H. Feinstein. Cambridge, Cambridge University Press: 54-58. • Goodwin, R. M. (1990). Chaotic economic dynamics. Oxford, Oxford University Press. • Graziani, A. (1989). "The Theory of the Monetary Circuit." Thames Papers in Political EconomySpring: 1-26. • Graziani, A. (2003). The monetary theory of production. Cambridge, UK, Cambridge University Press. • Keen, S. (1995). "Finance and Economic Breakdown: Modeling Minsky's 'Financial Instability Hypothesis.'." Journal of Post Keynesian Economics 17(4): 607-635. • Keen, S. (2011). "A monetary Minsky model of the Great Moderation and the Great Recession." Journal of Economic Behavior & OrganizationIn Press, Corrected Proof. • Kirman, A. (1989). "The Intrinsic Limits of Modern Economic Theory: The Emperor Has No Clothes." Economic Journal 99 (395): 126-139.

29. References • Lucas, R. E., Jr. (1972). Econometric Testing of the Natural Rate Hypothesis. The Econometrics of Price Determination Conference, October 30-31 1970. O. Eckstein. Washington, D.C., Board of Governors of the Federal Reserve System and Social Science Research Council: 50-59. • Lux, T. (2001). "Turbulence in Financial Markets: The Surprising Explanatory Power of Simple Cascade Models." Quantitative Finance1(6): 632-640. • Kydland, F. E. and E. C. Prescott (1990). "Business Cycles: Real Facts and a Monetary Myth." Federal Reserve Bank of Minneapolis Quarterly Review 14(2): 3-18. • McCauley, J. (2004). Dynamics of Markets: Econophysics and Finance. Cambridge, Cambridge University Press. • Marx, K. and F. Engels (1885). Capital II. Moscow, Progress Publishers. • Mas-Colell, A., M. D. Whinston, et al. (1995). Microeconomic theory. New York :, Oxford University Press. • Minsky, H. P. (1982). Can "it" happen again? : essays on instability and finance. Armonk, N.Y., M.E. Sharpe. • Peters, E. (2003). "Simple and Complex Market Inefficiencies: Integrating Efficient Markets, Behavioral Finance, and Complexity." Journal of Behavioral Finance4(4): 225-233. • Solow, R. M. (2001). From Neoclassical Growth Theory to New Classical Macroeconomics. Advances in Macroeconomic Theory. J. H. Drèze. New York, Palgrave. • Solow, R. M. (2003). Dumb and Dumber in Macroeconomics. Festschrift for Joe Stiglitz. Columbia University. • Solow, R. (2008). "The State of Macroeconomics." The Journal of Economic Perspectives22(1): 243-246. • Samuelson, P. A. and W. D. Nordhaus (2010). Microeconomics. New York, McGraw- Hill Irwin. • Schumpeter, J. A. (1934). The theory of economic development : an inquiry into profits, capital, credit, interest and the business cycle. Cambridge, Massachusetts, Harvard University Press. • Shafer, W. and H. Sonnenschein (1993). “Market demand and excess demand functions”. Handbook of Mathematical Economics. K. J. Arrow and M. D. Intriligator, Elsevier. 2: 671-693. • Sharpe, W. F. (1964). "Capital Asset Prices: A Theory of Market Equilibrium under Conditions of Risk." The Journal of Finance19(3): 425-442. • Sonnenschein, H. (1973). "Do Walras' Identity and Continuity Characterize the Class of Community Excess Demand Functions?" Journal of Economic Theory 6(4): 345-354. • Varian, H. R. (1984, 1992). Microeconomic analysis. New York, W.W. Norton. • Von Neumann, J. and O. Morgenstern (1953). Theory of games and economic behavior. Princeton, New Jersey :, Princeton University Press.