finance education “after” the crisis
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Finance Education “After” the Crisis
Steve KeenUniversity of Western Sydney
Debunking Economicswww.debtdeflation.com/blogs
www.debunkingeconomics.com
0 1 2 3 4 5 6 7 8 9 10 11 12 1325
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Great Depressionincluding GovernmentGreat Recessionincluding Government
Debt-financed demand percent of aggregate demand
Years since peak rate of growth of debt (mid-1928 & Dec. 2007 resp.)
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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)
2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 201250
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CPI-Deflated DJIA Since 2000
www.debtdeflation.com/blogs
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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”
1920 1930 1940 1950 1960 1970 1980 1990 2000 2010 20200
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US Private Debt to GDP
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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
1920 1922 1924 1926 1928 1930 1932 1934 1936 1938 1940 19421412108
642
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Change in DebtUnemployment
Change in Private Debt and Unemployment
Year; Source Census, BLS, BEA
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.a.
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1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 20121412108
642
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14 0
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Change in DebtUnemploymentUnemployment (U6)
Change in Private Debt and Unemployment
Year; Source Census, BLS, BEAP
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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
1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 201220
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Credit AcceleratorUnemployment Change
Credit Accelerator & Change in Unemployment
www.debdeflation.com/blogs
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1920 1922 1924 1926 1928 1930 1932 1934 1936 1938 194020
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Credit AcceleratorUnemployment Change
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…
1920 1922 1924 1926 1928 1930 1932 1934 1936 1938 1940 194230
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96
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Credit Impulse (Left Hand Scale)Change in DJIA (Right Hand)
Credit Impulse and Change in Real Share Prices
Year; Source Census, BLS, BEA
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Empirical dynamics of the Credit Accelerator• Credit Accelerator affects sharemarket
performance…
1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 201230
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Credit Impulse (Left Hand Scale)Change in DJIA (Right Hand)
Credit Impulse and Change in Real Share Prices
Year; Source Census, BLS, BEA
00
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
D
F
D
W
E
B
L
L
D
M
BA
B r F
FC
WD
BE
FF
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…
1860 1870 1880 1890 1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 2000 2010 20200
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Australia's Private Debt to GDP Ratio
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1920 1930 1940 1950 1960 1970 1980 1990 2000 2010 20200
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US Private Debt to GDP
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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
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 Issues 45:
1-18.• Bezemer, D. J. (2010). "Understanding financial crisis through accounting models." Accounting,
Organizations and Society 35 (7): 676-688.• Blatt, J. M. (1979). "Investment Evaluation Under Uncertainty." Financial Management Association Summer
1979: 66-81.• Blatt, J. M. (1980). "The Utility of Being Hanged on the Gallows: Reply." Journal of Post Keynesian Economics
3(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 Perspectives 18(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 Economy Spring: 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 & Organization In Press, Corrected Proof.• Kirman, A. (1989). "The Intrinsic Limits of Modern Economic Theory: The Emperor Has No Clothes."
Economic Journal 99 (395): 126-139.
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 Finance 1(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 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,
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 Finance 19(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
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