Finance Education “After” the Crisis

Steve KeenUniversity of Western Sydney

Debunking Economicswww.debtdeflation.com/blogs

www.debunkingeconomics.com

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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!”

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)

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)

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…

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?

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)

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CPI-Deflated DJIA Since 2000

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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…

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

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)

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)

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

Actual credit money creation process• Basic process of endogenous money creation• Entrepreneur approaches bank for loan

Assets Liabilities

• 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)

• New loan puts additional spending power into circulation

• Adds to aggregate demand

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

Empirical dynamics of Credit• Private debt bubbles caused “Roaring Twenties” &

“Noughty Nineties”

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• Bursting of bubbles caused Great Depression & Great Recession

Empirical dynamics of Credit• Change in Private Debt drives both booms and busts

R2=-0.79 R2=-0.96

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• 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

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Credit AcceleratorUnemployment Change

Credit Accelerator & Change in Unemployment

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Credit Accelerator & Change in Unemployment

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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…

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Credit Impulse (Left Hand Scale)Change in DJIA (Right Hand)

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Empirical dynamics of the Credit Accelerator• Credit Accelerator affects sharemarket

performance…

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R2=0.37 R2=0.23

• Complex, unstable lead/lag relationships between Credit acceleration, asset prices, economic growth…– Combined monetary economics/finance theory

needed to understand it

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)

Modeling monetary dynamics• Input basic financial flows in table:

Assets Liabilities Equity

Reserve Loan Firm Deposit

Worker Deposit

Bank Equity

BR FL FD WD BE

Lend -A A

Record Loan

A

Interest B

Pay Interest -B B

Record -B

Wages -C C

Consumption

D+E -D -E

Repay Loan F -F

Record -F

New Money G

Record G• System of dynamic equations derived automatically:

Modeling monetary dynamics• Prior to

substitutions…R

F

D

D

E

dB A F

dtdF A F G

dtdF A B C D E F G

dtdW C D

dtdB B E

dt

• Simple linear modelR

V

L L

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B r F

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FG

R LR

V L

R L DF

V L M

R D D E L DD L L

V F W B L M

D DD

F W

EE L L

B

B FdB

dt

B F FdF

dt

B F W B F FdF r F

dt

F WdW

dt

BdB r F

dt

• Implemented in easy to use GUI program– Prototype “QED”:

www.debtdeflation.com/blogs/QED– Professional version “Minsky” under development

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

DesirableDesirable

ActualActual

Direction

DirectionAcademic 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…

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Finance sector (& profits) 4-6 times larger than they should be

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

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

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

NPV C t C t e dt IIr t

start

end

afb g af z

2

2

1

2

tr t T

o

Payback C t C t e e dt II

• Yet another reason why finance has economic effects

– “Payback period” pro-cyclical: extends during booms, contracts during slumps

• A new economics & finance needed…

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 Honeychurch mike.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

References• Anderson, P. W. (1972). "More Is Different." Science 177(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

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Finance, and Complexity." Journal of Behavioral Finance 4(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 Perspectives 22(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,

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