Financial Markets (2011)

Lecture 1 - Introduction and What this Course Will Do for You and Your

Purposes [January 10, 2011]

Chapter 1. Introduction to the Course [00:00:00]

Professor Robert Shiller: OK. Welcome to Economics 252. This is Financial Markets, and

I'm Robert Shiller. This is a course for undergraduates. It doesn't presume any prerequisites

except the basic Intro Econ [Introductory Economics] prerequisite. It's about--well, the title

of the course is Financial Markets. By putting "markets" in the title of the course, I'm trying

to indicate that it's down to earth, it's about the real world, and, well, to me it connotes that

this is about what we do with our lives. It's about our society. So, you might imagine it's a

course about trading since it says "markets," but it's more general than that.

Finance, I believe, is, as it says in the course description, a pillar of civilized society. It's the

structure through which we do things, at least on a large scale of things. It's about allocating

resources through space and time, our limited resources that we have in our world. It's

about incentivizing people to do productive things. It's about sponsoring ventures that bring

together a lot of people and making sure that people are fairly treated, that they contribute

constructively and that they get a return for doing that. And it's about managing risks, that

anything that we do in life is uncertain. Anything big or important that we do is uncertain.

And to me that's what financial markets is about.

To me, this is a course that will have a philosophical underpinning, but at the same time

will be very focused on details. I'm fascinated by the details about how things work. It can

be boring, and I hope I'm not boring in this course, but it's in the details that things happen.

So, I want to talk about particular institutions, and I'm interpreting finance broadly in this

course. I want to talk about banking, insurance --sometimes people don't include insurance

as part of finance, but I don't see why not, so we'll include it. It's about securities, about

futures markets, about derivatives markets, and it's going to be about financial crises. And

it's also about the future. I like to try to think about the future, although it's hard to do so.

Where are we going?

This course will have a U.S. bias since we live in the United States. I know the U.S. better

than any other country, but at the same time, I recognize that many of you, or even most of

you, will work outside the U.S., and so it's important that we have a world perspective,

which is something I will try my utmost to incorporate in this course.

The world perspective also particularly matters since we have other viewers for this course

besides those people in this room. This course is one of a couple dozen courses that Yale

University is offering free to the world as part of Open Yale. And that means there's a

cameraman back there if you've noticed. That's Dan Cody filming the course. And it will be

eventually posted on the Internet and it will be available through Open Yale, and then by

proliferation, you'll find it on many other websites as well. This is the second time this

course has been filmed for Open Yale. The first time was in 2008, three years ago. And I'm

very pleased to report that I have a lot of people in every imaginable country who have

watched these lectures. And I get emails from them, so I know that they're out there.

But I thought that this course needs updating, probably more than any course on Open

Yale. You know, a course in physics only has to be updated for the last three years of

research in physics, and it's probably not a big thing for an undergraduate course. But

finance really has to be updated, I think, because it's going through such turmoil and change

right now. We've had the worst financial crisis since the Great Depression, and it's been a

worldwide crisis. And governments around the world are working on changing our

financial institutions. We have organizations of governments, notably the G20, which is

very involved in finance. It's one of the top items on their agenda for international

cooperation; it's changing our financial markets. So, I think that that's another reason why I

want to try to keep as international a focus as I'm good at doing in this course.

But I hope that those of you who are in this room are not disturbed by the camera and feel

you can ask questions. You don't have to be on camera. I think I'm just being filmed. So,

that's where we are.

Chapter 2. Broader Context of the Course [00:06:12]

Now, I wanted to put this in a little bit broader context. The other major finance course that

we have here at Yale is Economics 251 and it's taught by Professor John Geanakoplos, who

is a mathematical economist and also a practitioner. He's research director for Ellington

Capital. So, he's somewhat like me in that he's interested both in theory and practice. But

his course is definitely more theoretical and mathematical than mine. His is entitled

"Financial Theory." And I can read some of the topics that--and his course also will appear

on Open Yale shortly. You can take the whole course. But I don't know--it's not up at this

moment. It will be up in a matter of months.

So, I encourage you, if you want to, to take Open Yale Econ 251. But the things that he

talks about in that course, if you read the topics in this course you'll see that they're more

mathematical and technical than mine. He talks about ''Utilities, Endowments and How It

Leads to Equilibrium,'' ''Assets and Time,'' ''The Mathematical Theory of Bond Pricing,''

''Dynamic Present Value,'' ''Social Security and the Overlapping Generations Model,''

''Uncertainty and Hedging.'' I'm quoting his titles. ''State Pricing.'' That's kind of an abstract

theory. We talk about the price of a state of nature. I won't explain that. He talks in some

length about the ''Theory of Risk'' and the ''Capital Asset Pricing Model,'' and about the

''Leverage Cycle,'' which is relevant to our crises.

So, I recommend you take Econ 251, but I don't expect you to take it. This course is self-

contained. And I'm going to keep mathematics to the minimum in these lectures. But the

idea here is that we can't avoid it completely. I personally am mathematically inclined, too,

but I'm understanding that we have divided our subject matter. So, John Geanakoplos is

doing the math and the theory, and I'm doing the real world. It's not a complete division like

that, but it's something like that. So, I'm going to stay to that. I'm going to talk more about

institutions and history than about mathematics.

Since I know that most of you or many of you will not take Economics 251, what we are

doing is, I'll give a little indication of the mathematical principles, more intuitive, and we

have review sessions with our teaching assistants. We plan to have six of those. And those

will be on a Friday in this room. And they won't be on Open Yale. Those will cover the

theory, and it will be like a short form of Geanakoplos' course. And then we'll have

problem sets. And there will be six problems sets, one for each of those sessions. So, there

will be some math in this course.

I wanted to talk about the purpose of this course, to clarify it. One thing is, what do I

imagine you're going to do with this course? Well, first of all, I pride myself that I think I

teach--if I might boast for a minute--I think I teach one of the most useful courses in Yale

College. At least that's the way I think about it. Because this course really prepares you to

do things in the world. By the way, I've been teaching this course now for 25 years. I first

taught it in the fall of 1985. Now I don't know if that's depressing or not. To me, it's great. I

like to be able to keep moving ahead. I wonder what my 1985 course looked like?

Unfortunately, they didn't do Open Yale and I can't go back and look at it. But I think I've

gotten more philosophical and maybe more real world oriented as time has gone by. But the

excitement I have is when I go--I give a lot of public talks, and it's often on Wall Street.

And when I do one on Wall Street, I like to ask people for a show of hands. How many of

you were in my Economics 252 class? And I typically get one or two at least who raise

their hand. So, that's a source of pride to me, that I was involved in the beginning of their

careers. And I hope I instilled some kind of moral sense to what they do.

But I should say I don't think that most of you will go into finance, because I think that

most of you have other purposes. What does it mean to go into finance? Well, it sounds like

that means you would be listed as someone who is very focused on finance. But I think

everyone should know finance. This should be a required course, actually, at Yale College,

because finance is so fundamental to what we do and the structure of our lives that I don't

see how you can avoid doing finance if you want to do something big and important.

Maybe you don't want to do that either, so you might want to become a hermit and then you

don't need finance. But to me, I like to think that many of you have a sense of purpose in

life. I should say--that sounded funny, didn't it? But what I'm saying is your purpose is not

to make money. And this is one thing about finance that bothers me, is that people think

that it's a field for money-grubbing people who just want to go out and make money. And I

don't think so. I think it's a technology for doing things, and you don't want to be mystified

by it. When someone talks some financial jargon, you don't want to say, I don't have a clue

what that's about, because what that's about is how we make things happen. And so, I hope

that you have other purposes in life besides finance, even those of you who go into finance.

But the question is whether this is a vocational course. Here at Yale College there has been

a long tradition that we are not a vocational school--I suppose you know that--that Yale is a

liberal arts [college]-- we teach you the arts and sciences. I actually went to look at the

charter and the act of the Connecticut government in 1701 that founded this university. This

university was initially mostly a training ground for the ministry. But I actually read in the

Acts of the Governor and Company of the Colony of Connecticut: "Yale College is

founded for the educating and instructing of youth in good literature, arts, and sciences." I

think that is the motive here for this university. And so, I think it is in some level

vocational, but it's not vulgar vocational. I want you to think about what we're doing and

how it fits into what you do for your life.

So, I think of finance as a kind of engineering in a way. But it's an engineering that works

not with what we call a technical apparatus, but with people. And so, if we want to

understand how to do these things, we have to get some technical apparatus under our belt.

And that's what I'm going to try to do in this course.

The textbook that I chose for this course is by Frank Fabozzi, who is a professor at the Yale

School of Management--well, with two co-authors. We have Franco Modigliani, for whom

I have some personal affection, because he was my dissertation adviser at MIT, and who

unfortunately died in 2003, and Frank Jones of Guardian Life Insurance Company. I've also

written joint papers with, well, two of the three authors. I've written joint papers with

Fabozzi and with Modigliani--research papers. But they're similar to me in many ways.

They're interested in the details. I hope you get interested in the details.

I find this textbook fascinating for me. Well, I first read this book when I first started

assigning it. I was going on vacation with my friend Jeremy Siegel and our families, who's

a professor at the Wharton School, and I brought this book as my poolside reading. And I

was sitting there with this book. Other people were reading novels and fun things. I don't

know what they thought of me reading this textbook by the pool, but I thought this is great

because I thought I knew most of what's in here, but there's a lot of things that I still didn't

know and it was answering all kinds of questions. Things you always wanted to know

about real estate securities, OK, but you never found out. Well it's all answered here. So, I

hope you can take that spirit in reading the textbook. That's the only book you have to

purchase for this course. And it's the main work that you have.

So, I'm going to ask you about the details on exams. The kinds of municipal securities we

have and how the rating agencies rate them, that's part of this course. I believe the details

matter. And so I'm not going to just ask you broad generalities on the exam. I can ask you

the details. It's a little bit like teaching a language, right? Learning a language is really

important, and you've got to learn all the words, right? There's thousands of them. It's like

that. You're going to be learning the words of finance.

So, I have another book also, which is actually not done yet, but you can access it through

Classes*v2, and later it will come out as a published book. But I'm working on a book

called--well, I don't know what it will be called finally. When you're writing a book, one

thing you learn as an author is you can never be sure what the title of the book will be.

Because if somebody else uses the same title and you're done, somebody else gets to it first,

you've got to change your title.

But at this moment the title of my book is "Finance and the Good Society." I'm not sure

when it will be out. I was hoping next year, but now I'm thinking it might take longer than

that. So, you have something that's imperfect. I hope youll excuse me when you look at the chapters of this book. You don't have quite all the chapters either. But I just thought it was

a good thing to put it in process for you to--maybe if you have ideas you can tell me and the

book will change with your input. To me it's a good way to write a book, is to be writing a

book and teaching a class at the same time on the same topic. It's more social. You know,

you just sit in your office and write and you end up feeling sterile. So, this makes it more

alive to me to do that at the same time.

But I'll tell you what my book is about. The title that I now have, "Finance and the Good

Society," may sound to some people like an oxymoron because they're kind of

incompatible. People are angry about finance these days. We've had--and this is going to be

an important part of this course--we've had the worst financial crisis since the Great

Depression of the 1930s. And it's been a worldwide financial crisis and it isn't over yet, or

it's not clear that it's over yet. And people are angry. People are angry about finance, people

who seem to be getting rich often it seems at the expense of others. Or they seem to be

lobbying their governments to give them breaks and bailouts, and they walk home with

billions of dollars. Something seems immoral and wrong. Well, I'm sure some immoral

things are happening, but I don't think that finance, as a whole, is wrong. And I think of it

as a noble profession. So I wanted to try to put it in perspective. And it's especially

important when talking to young people like yourselves because you're launching out on a

career, and I want that to be a moral and purposeful career. And I want to put finance in the

perspective.

So, the theme that I want to develop in my book is that part--you know, we live in a

capitalist world now and this world is increasingly built on finance. Some people call it

we're living in the era of financial capitalism. We have these big multinational institutions

that are owned by huge numbers, maybe millions, of shareholders dispersed all over the

world. And what makes the whole thing work and click? It's the financial arrangements.

The world is discovering the importance of finance.

When I go to a foreign country and give a talk, I find that people--it doesn't matter what

country--they're generally very interested in finance, because they think that our modern

financial techniques are part of what's making so many places in the world grow at rapid

rates now. We're living in a time in history when [the] developing world is exploding with

growth, and these countries that are doing that are countries that are adopting modern

finance. So, I want this to go right, and I want this to be developing a good society. By

good society, I mean a just and fair society that allows people to develop their talents and

expertise.

Chapter 3. Finance as an Occupation [00:22:41]

So, another thought I had was that the field of finance-- let me give you another slide. I said

I view this course as one of the most important courses in Yale College, at least from a

standpoint of your lives and careers. I wanted to compare finance jobs with jobs. And I

don't mean to put down other departments, but at least vocationally, let's put this in

perspective. I wanted to compare jobs in finance with jobs in other fields. So, this is a chart

that I constructed using data from the Bureau of Labor Statistics. And what it has is the

number of people in various occupations in 2008 and their projections for the same in 2018.

So, the red bar is for 2018, and we'll emphasize that because you'll be just getting into your

careers when that comes.

So, it says, if you look at financial analysts in the United States there's almost 300,000.

Financial managers, it's over half a million. Personal financial advisers, a quarter of a

million, all right? These are people who specialize entirely in one form of finance or

another. But compare that with economists. Look at that. What is that? About 20,000? I

think they're excluding professors. But, you know, just economists out there--not very

many. How about astronomers? OK. I can't even read that. I love astronomy by the way,

but I think I made the right choice when I decided--well, I shouldn't say that, you never

know. We all have to do something different. And you could become an astronomer, but

there aren't many jobs in astronomy. Sociologists, political scientists, just not many

compared to--this is just enormously bigger. Or mathematicians.

I also put one oddball field on here: massage therapists, OK? The number of massage

therapist jobs outnumbers any of those other fields by, what is it, 100:1. So this is the kind

of disappointment that people face. You go to the college or university--this is very much

on my mind--you go to the university and you develop special skills, and you leave and

then you end up driving a taxi. That doesn't mean that I want to become vocational. I mean,

I don't want to just train you for a job, but I want to be relevant. And it seems to me that I

can be relevant in talking about finance. And so that's the basic core that I wanted to get.

I mentioned before that people think that finance is the field for people who want to get

rich, who want to make a lot of money. Well, I think that's right, actually.

[LAUGHTER]

I don't advise you to take that as your--but I wanted to talk about that a little bit. So, one

thing that you'll note, Forbes Magazine has an annual list of the 400 richest people in

America. So, I looked at that list. Who do you think they are? Most of you probably have

not read this list. You might think that, well, who makes a lot of money? Well, it's athletes.

Football players, right? Baseball players. And who else? Oh, movie stars, right? They make

a lot of money. So how many do you think of those are on the Forbes 400 of the richest

people in America?

Well, as I read the list I didn't see a single movie star or a single athlete. There is--it

depends on how you define it. Oprah Winfrey is on the list. OK? You've heard of her. She's

in the entertainment business. But you know, she's also a finance person. She runs big

businesses. She's into making things happen. And I can assure you that she knows finance,

at least some basic finance. You see, finance gets you to build organizations. That's how it's

done. And it means raising capital to make things happen on a big scale. You know, no

athlete is as powerful as one of these random guys on the Forbes 400 list.

It's interesting. I looked down the list and I didn't spot a single Nobel Prize winner. Maybe I

missed one. I looked for best selling authors. I found one: Bill Gates, who wrote a book

called The Road Ahead. But there are not many best selling authors either. What do they

have in common? Now about a third of them just inherited it from their parents, but most of

them did it themselves. They just made huge sums of money. And what do they do? Well,

they're typically in some boring line of business. They make something, but they're doing it

on a vast scale. And so that means they're making deals, they're putting things together,

they're buying companies, they're absorbing other companies into theirs. There's something

powerful about an ability to do that. And I think that it's good for you to understand and

appreciate that.

By the way, Forbes has another list called the Forbes Celebrity 100. And to be on that list,

you have to be a celebrity. It's a completely different list. Oprah is on both lists, but she's

practically the only one. Steven Spielberg is on both lists, I think. He makes movies, but he

has a whole company called DreamWorks, and he finances all kinds of movies, so he's a

businessperson as well. So I don't think of finance as a mathematical--I mean it is

mathematical, it has a core element of that. But to me, it's about making things happen and

about putting together deals and getting people incentivized to do something, and getting

capital, getting resources in a massive scale so that something can happen. And so that's

what this course is about. Oh, Jerry Seinfeld is listed by Forbes as a possibility--he's about

the only one--to make the list of the Forbes 400. But he isn't there yet.

I don't mean to diminish these celebrity people, but there's something else that goes on in

finance, and it's quiet. It's behind the--actually, most of the Forbes 400 you've never heard

of. They're kind of behind the scenes doing things that are big and important, but they don't

get on the news so much. It's one of the ironies of life. You might aspire to do this, to get

on the Forbes 400. You can do it and still nobody knows who you are or cares. So that's just

as well, I think, for many people.

Chapter 4. Using Wealth for a Purpose [00:30:40]

So then the question is: Suppose you get on the Forbes 400, what are you going to do with

it? In other words, to get on the Forbes 400 you have to have made at least a billion dollars.

So that means, you have in your own portfolio a thousand million dollars. That's the

minimum to make the list. So what are you going to do with a thousand million? Any ideas,

what would you do with it? You could buy cars, right? How many sports cars could you

buy for that? What could you do? You could buy 20 houses. But that doesn't begin--you

could buy 20 houses and so what? You know, you still have 900 million leftover. So what

are you going to do with all that money? And that's a question.

Now, some people who do that, who make all this money, try to see if they can maximize

their appearance of wealth. They try to show to the world how rich they are. So, you just

build the biggest mansion and you do something really spectacular. But when you got a

billion dollars, there isn't a house in the country you could buy for a billion dollars. You can

only stay in one at a time, right? So, what are you going to do? But there are people who do

that, and I think that there's a history of disgust for those people, a long history.

We don't like people who do that. It's almost like it's a big mistake. Why would you do that

when people don't like people who show off their wealth? There's evidence that people feel

that way in many different countries and cultures, because lots of countries in history have

what are called sumptuary laws. It goes back at least to 700 BC in Ancient Greece with the

Locrian code. These are laws prohibiting people from conspicuous consumption. And

they've been in so many different countries that I think it's evidence that something is amiss

with making wealth as the objective of your life.

So, one of the themes in the beginning of our reading list is--I think there's a movement

afoot today around the world of thinking about this problem, that you can get so big and

powerful if you build a business and you use the financial techniques that are successful for

other people, but it's meaningless unless you give it away. And so, what else can you do

with all this wealth but plan to give it away.

So, one thing I have on the reading list right at the beginning is a chapter from a book--

well, the title of the book is The Gospel of Wealth and Other Essays and it was written by

Andrew Carnegie. Actually, he wrote a short article in a magazine called "Wealth" in 1889.

And in the final paragraph he used the term "gospel of wealth" and it was picked up all over

the world as just outrageous. And so it became named The Gospel of Wealth. So, later in

the early 20th century he came out with a book entitled The Gospel of Wealth. And that's

what I have assigned. You can click on it on the reading list. And Andrew Carnegie was

one of these--they didn't have Forbes 400, but he was one of the richest men in America

through his Carnegie Steel Company, very much steeped in finance.

But he decided when he wrote his essay, The Gospel of Wealth, in 1889 that once a person

reaches middle age, like 50 or 55, and has made a lot of money, they really have to go into

philanthropy. There's a moral imperative. So the theme of The Gospel of Wealth was some

people are just better at what he called affairs than other people. That means business.

Some people have a sense of how to make things happen. These people have a moral

obligation to make this work for the benefit of humankind. And that means, while they're

still young, they have to take their fortune and give it all away before they die. Because if

they don't give it all away, it's nonsense. If you make a billion dollars and you leave it to

your children, chances are they're not like you. They're not going to be interested in

working hard and making things happen. They're just going to squander it. And so that's

what the moral obligation is. You have to stop at age, let's say 55--OK, you still got time

left--and then use your same talents.

So, it was almost a theory of capitalism--it is a theory of capitalism. It is a theory that some

people are just more practical and hardworking and business-oriented, and these people can

find things to do that benefit mankind, and they should do it. So, there's a natural selection.

This is Carnegie. I'm not endorsing this entirely. I think there's an element of truth to The

Gospel of Wealth, but it's not exactly true. But the element of truth is right, that people like

Carnegie who was a very gifted person--you know what he did? He set up the Carnegie

Institute of Technology, now called Carnegie Mellon University. He set up the Carnegie

Endowment for World Peace, Carnegie Hall in New York. He probably gave something to

Yale, too. Anyone know? Is there a Carnegie? He gave to like every imaginable university.

I know at Princeton they have a Lake Carnegie. He was visiting Princeton and someone

pointed out this kind of swampy land and said we'd like to really create a lake. So he said,

fine. He gave them money to create Lake Carnegie. And he also gave the money for the

prize for the first true competition on Lake Carnegie. So, he just had all kinds of gifts he

gave it away.

I also have--it's interesting, I found this on the web. Thomas Edison, the inventor, was so

impressed with Carnegie's The Gospel of Wealth that Edison was developing the sound

movie, I think it was 1914, but he didn't perfect it. But he said the first sound movie should

involve geniuses of our time. So, he made a sound movie of Carnegie reading from his The

Gospel of Wealth. Unfortunately, the visual side of it somehow got lost. Maybe it didn't

work. We only have the soundtrack from the movie. So, you can listen to Carnegie reading

from this book in 1914, and it's the only recording of Carnegie's voice that survived.

Since then, Bill Gates and Warren Buffett and others of the Forbes 400 have done a

campaign to get billionaires around the world to commit to give most of their wealth away,

while they're still alive. And I'm trying to get one of these people to speak to our class, but I

haven't yet arranged that.

I also have on the website a review from 1890 of Carnegie's original essay from a

California newspaper, and they were so negative about it. They said, Carnegie thinks that

making wealth and giving it away is a noble cause. That cannot possibly be right. These

people who make money are not the most enlightened and smart people in our world. I

think that the truth lies somewhere in between. But we do have a society now where

people--we have an increasing concentration of wealth at the top, and I don't know what

we're going to do about this. This is a trend that may continue.

And so, this is the thing I want to think about in this course. I don't think finance

necessarily does this. It may be a bubble, that there is currently a bubble in financial careers

and that you are going to be disappointed because 20 or 30 years from now if you go into a

finance-related field, you'll find that it's not as lucrative as you hoped. That kind of

happens, right? When a field becomes known for having a lot of successful people, then

more young people go into it and they swamp the field. On the other hand, I think that it

will always be true that just because of the power of the technology the top wealthiest

people in the world will be finance-related. And I think that they will have a moral

obligation to give their wealth away in a productive way.

Chapter 5. Outside Speakers and Teaching Assistants [00:40:30]

So, I have several outside speakers, and I tried to bring in people that are connected to the

world in a positive way. I'm trying to bring in inspirations for you as outside speakers. And

they're people who are in finance but who are not selfish. They may be rich but they are

good people.

So, the first person that I'm going to bring in, as I've done in previous years, is David

Swensen, who is Chief Investment Officer for Yale University. Swensen also teaches a

course, Economics 450, with Dean Takahashi, which you might want to take. But I have

him here just for one lecture. And what Swensen has done is turn the Yale endowment into

a huge number. He came to Yale in 1985, and at that time, Yale had less than $1 billion in

its endowment.

Swensen is the most successful university endowment manager of the United States. He

turned less than $1 billion into $22.9 in 2008. The financial crisis hit and the endowment

fell, but as of June of 2010, it was still 16.7 billion. So, he has done so much to make Yale

a success. But it matters. That's a lot of money. And it's all for a good cause. Now I say, I

believe Swensen is a good person. I think he turned down opportunities to make much

more on Wall Street, because he is known--and he's continually turning them down--as an

investment genius. He can command huge salaries and bonuses if he wanted to, but he stays

here with Yale. I don't think that people in finance are money-grubbers, and this is an

example of someone who's not.

The second speaker I have is Maurice "Hank" Greenberg, who founded AIG. It started out

in 1962. In 1962, he was put in charge of North American operations of the American

International Group, an insurance company, which was then failing. The head of the

company, C.V. Starr, put him in this to try to turn the company around. He turned it, over

many years as CEO of AIG, into the biggest insurance company in the world, and he ran it

until 2005.

The company--have you heard of this, AIG? You must have heard of this. In the recent

financial crisis it has encountered some problems. And, in fact, it was the biggest bailout of

all. It was bailed out by the U.S. government. And there's a scandal about that because the

bailout was so huge. It was in the hundreds of billions. Record-setting bailout. And some

people are angry with Greenberg. But I think that's completely unfair, because it all

happened after he left AIG. And the problems were in a particular unit within AIG that he

was not really responsible for.

But Greenberg is a person who has, I think, a moral purpose that I want to illustrate for you.

He's been criticized. Anyone who does business on that scale is going to be criticized for

being too tough or too aggressive at times. But he's a very involved person. He's the Vice

Chairman for the Council on Foreign Relations, which is a think tank that thinks about the

United States and its place in the world. It's a very important think tank. He's also a major

philanthropist and he's given to Yale. Notably, he gave the Greenberg Center, which is right

next to the Center for Globalization. A beautiful new building. So he has agreed to come.

I'm very pleased to have him.

The third outside speaker that I have now is Laura Cha, although she won't be here in

person. We're going to have her image up on the screen because she is in Hong Kong. And

she is a non-official member of the Executive Council of Hong Kong. She's a member of

the government of the People's Republic of China at the vice-ministerial rank. She's the first

non-Chinese delegate to the National People's Congress representing Hong Kong, and has

been vice chair of the China Securities Regulatory Commission. So she is very involved in

finance. She's also been affiliated with Yale and helped some of our initiatives. She'll have

to get up very late at night, I think, to be on for 9:00 in the morning for us from Hong

Kong. I might get one or two other speakers, but that's where it stands right now.

So, I wanted also to tell you about our teaching assistants. We have four teaching assistants

now. We might get another, but at this point. The first is Oliver Bunn who is from

Germany, University of Bonn, and is a PhD student in economics. He's also our head TA

who coordinates the whole operation.

And then we have--the second one is Elan Fuld from the United States. And he's doing an

interesting study of the pizza delivery industry. It sounds funny, but it's an interesting

application of economic theory to very much the real world.

Bige Kahraman is from Bilkent University in Turkey, and she's interested in Behavioral

Finance. That means--I should have said this. It's also an interest of this course. I've skipped

by it in my notes. Behavioral Finance is the application of psychology, sociology, and other

social sciences to finance. I don't know how I omitted mentioning that. It's about people in

finance--well, I didn't really completely omit mentioning it. You've got the sense that I'm

interested in people. But there's been a revolution in finance over the last 20 years. Twenty

years ago, finance was thought of in academia as an essentially mathematical discipline,

that and nothing more. Well, maybe I'm exaggerating a little bit. But what's happened since

then is people think of finance as involving psychology. We have to bring people with

knowledge of human beings in.

And so, her dissertation topic, a major theme of it, is how mutual funds operate. Mutual

funds are companies that offer investment vehicles to the general public, and she finds that

the mutual fund companies have complicated fee schedules and they offer different choices

to people. And what sense does this make? Why are there all these different choices? You

look at the fee schedules and you think--it's just like your cell phone plan, right? It's got

different choices and you don't know which one I should take. Why are they doing all this?

Well, she tries to analyze what's going on and she finds that sometimes it seems like clients

are steered toward a fee schedule that's really not in their interest and that the mutual fund

managers are doing some things that maybe we don't want them to do. Maybe it's not ideal.

They're pushed by competitive pressures into offering products that are a little bit

manipulative of people.

And her dissertation also brings up another theme, which I thought I perhaps should have

emphasized, that all is not well in the financial world. Lots of bad things happen. Or not

necessarily awful things, but, you know, not socially conscious things. And that's why we

need regulators. That's another reason why I brought in Laura Cha, by the way. She's a

regulator. I wanted to have a voice from that side, because I personally admire regulators

and think that they have a very important function in our society. So, her work fits more

into that regulatory side of finance.

And then, finally, our fourth teaching assistant is Bin Li from Beijing, although he went to

college at University College London. And he has broad interests including Leveraged

Asset Pricing and also Behavioral Finance. So, those are the teaching assistants.

Chapter 6. Outline of the Lectures [00:50:26]

So, let me just give a brief outline of the course. There are 20 lectures that I'm giving in this

course. This is the first. Let me just go through what's the content of these lectures.

So, Lecture 2, that would be on Wednesday of this week, I want to talk about the core

concept of risk and also about financial crises. The one reason why I wanted to update this

course with Open Yale this year is because I wanted to talk about the financial crisis that

we've been through, though I thought this lecture would start with something about the

theory of probability, but I'm not going to get into that very much. That will be more for a

TA section that will come in later.

But even so, this is not a probability course. I just want to kind of remind you of the

concepts of probability. And there's a concept of independent risks. If risks are independent

you can diversify away them, and you can put together a portfolio that minimizes the risks.

The law of large numbers says if you have a lot of independent risks, they'll average out if

you have a large number of these different risks in your portfolio and there's no risk left.

That's if they're independent. But in fact, risks are not as independent as you think, and

that's one reason why we had a financial crisis. And so a lot of people were making plans

based on portfolio theory in finance, but the plans assumed that there won't be a crisis, that

maybe one of our investments will go bad, but they can't all go bad or a large number of

them can't go bad. So, that was a failure of the independence assumption in finance.

That failure created the financial crisis that we've been through. It was a near miss onto

another Great Depression. The financial crisis that began in 1929--I'll talk about that briefly

in that lecture--started with the stock market crash of 1929 and the economy spiraled down

until 1933. It just kept getting worse and worse. More and more bankruptcies, more and

more layoffs. So, by 1933, 25% of the U.S. population was unemployed. And it wasn't just

the U.S., it was all over the world. It was a horrible crisis. And we didn't get over that crisis

until World War II. It's like we couldn't get out of it. The crisis got so bad that nobody in

the world could figure out what to do. And I think that part of the reason we had World

War II was because of the anxieties and animosities caused by this massive unemployment.

But we got out of it because World War II created a huge stimulus program. I mean, they

drafted all the unemployed and made them fight. What an awful outcome, but that's what

happened. It's terrible.

And so this time we saw the beginnings of a similar crisis. We saw crashes in the stock

market and the real estate market, we saw bankruptcies appearing, we saw runs on banks.

And this time the Government decided on a controversial bailout package. And so, Ben

Bernanke and Mervyn King and other central bankers and government policymakers

around the world had the idea that we can't let it happen the same way this time. So, there

was massive bailouts, controversial bailouts, because they seemed to be unfair to many

people. So, it's a huge and interesting story.

I've written three books, by the way, about this crisis. Well, two of them with co-authors.

So, it's something that fascinates me. But I don't want to dwell on it too much in this

course, because I'm hopeful that it will heal itself and we can put it behind us.

And the financial crisis doesn't call into question the basic principles of finance. Not in my

mind. The vulnerability to a crash that we see in financial markets is like the same thing as

the vulnerability to crash of airplanes. Airplanes crash from time to time. You must know

that when you get on one. But that doesn't mean we shouldn't have airplanes. And I think

the financial system is advancing in the world with such speed and such impressiveness

that this crisis is just a blip on the screen of that, and not something I think we should worry

too much about.

The third lecture is about technology and invention in finance. Finance is a technology just

like engineering or mechanical engineering. It has principles, it has techniques, and it

involves inventing of details. That is, financial institutions are complicated. They're

complicated in the same way automobiles or airplanes or nuclear power reactors are. You

can see this complexity if you read some of the documents that are associated with the

modern corporation. There's a lot there. And the way the cash flows are divided up among

different people, involving options and derivatives and other complicated financial

instruments, are part of the technology. And this technology is advancing, and it will

advance a lot over the time of your career.

I don't have an ability to predict the future with any accuracy, but I want to try to think

about what we can say about the future. I wrote a book in 2003 called The New Financial

Order, and it was my take on the future. But the problem is nobody really knows the future

very well. You kind of have to just invent it or dream about what it might be like. That's

what I did. I kind of thought about principles of financial theory and where they might go

with the advance of information technology and the globalization of the world. So, I have

just a chapter from that for that section of the course.

Then, Lecture 4 is about portfolio diversification, how risks are spread. And we'll talk

briefly about the Capital Asset Pricing Model. Now again, the Capital Asset Pricing Model

is a mathematical theory of diversification. A very important theory, and it's something that

John Geanakoplos will cover with more rigor in Econ 251 that I already mentioned. But for

me, I will talk briefly about the capital asset pricing model, and one of our teaching

assistants will give a section on it. But I want to also think about, since this is a course

about the real world, I want to think about financial institutions, and so many of our

institutions are offering diversification one way or another. And so, again, I wanted to talk

about the real world component of this.

The fifth lecture is about insurance. And the insurance industry developed over the

centuries. It goes, actually, all the way back to Ancient Rome, but only minimally. People

didn't have the concepts until the 1600s when probability theory was invented. There was

an intuitive concept that, sure, I could start an insurance company, I could put together a lot

of insurance policies and charge for them, and probably I won't--you just have intuitive

sense about law of large number or independence of risks. Probably, I'll be OK and I can

make good on the policies I wrote. But it was never clear until probability theory was

developed. Since then, it's been growing and it's becoming a bigger and bigger part of our

lives. And I think that insurance is actually a lifesaver.

I'll give you one example. You note that in the earthquake in Haiti--what was that, about a

year ago? There was a tremendous loss of life, but the earthquake in San Francisco decades

earlier was of the same magnitude and had very little loss of life. Also, the loss suffered by

people in terms of destruction of their homes and their office buildings was vastly higher in

Haiti. Well, it turns out that Haiti, a less developed country, didn't have much of the

modern insurance industry, so that people were uninsured against risk of collapse of their

structure and you didn't have insurance industries going in and policing building codes. If

the insurance company is liable to the risk then they go in and say, we won't insure you

unless you fix this. Since it didn't happen, so many people died.

I think that Haiti will come along. There is already a Caribbean insurance initiative that was

starting. We want to see the developing world get these institutions. I want to try to give a

sense of the reality of that, that we tend to think of Haiti as an opportunity for our charity,

and a lot of us gave money to help these people. But, you know, charity doesn't work on a

big enough scale. Going around to people on the street and asking them to give money to

help the Haitian earthquake victims, it doesn't amount to a lot. What really becomes big and

important is the insurance industry, which is doing the same thing as a business model. And

that's the real world and it matters enormously.

The sixth lecture is about efficient markets. This is about a theory that developed in the

1960s, that financial markets are wonderfully perfect. I'm saying I'm a little bit skeptical of

this theory, although I think it has an element of truth. Efficient Markets Theory is the idea

that you really can't make money by trading in financial markets because the markets are so

competitive that the price is always pushed to an optimal level that incorporates all

information that anyone could ever have about the security. And the theory has been that

it's hopeless to try to invest and beat the market. Well, I think there's an element of truth to

that but it's not quite true, and people like David Swensen are counterexamples, that it is

possible for professional money managers to beat the market. And that's something I want

to think about and talk about in that lecture.

Lecture 7 is about debt markets. We have a lot of money that's lent. The Federal Reserve

manages these markets. It tries to coordinate the markets through open market operations

and through what now is called Quantitative Easing. But the markets are huge and

international. They involve errors that people make. A lot of people get overly indebted and

make mistakes over their lives. But they also offer opportunities, that debt markets are

fundamental to the things we want to do in our lives. For example, when you are a little bit

older, many of you will want to buy a house, right? But you won't be in that point in the life

cycle when you have the money to buy a house, most of you, so you'll be borrowing. It's

elementary. You take out a mortgage. That seems obvious. But still today in many

countries of the world, the mortgage market is not very developed, and you can't do that.

So, there's a good side to borrowing as well as a bad side. I want to put it in perspective.

We've got our review session. We'll talk a little bit, somewhat, with one of our teaching

assistants about the mathematics of debt.

Lecture 8 will be about the stock market. Again, I think of the stock market not as

something that we're going to beat. I think it's something that is an invention to motivate

people to get people working together. So, the basic idea of a stock investment: You and

your friends want to set up a company, OK? How do you do that? Well, the company needs

money to start. So, somebody's got to contribute capital. Well, some of you have more

money to contribute than others, so you should have a bigger share in the company. Some

of you have no money at all to contribute, but you're going to contribute your time and

energy. So, you want to give a share in the company to these other people as well in order

to incentivize them.

So, you devise a whole scheme to set up a company that involves the creation of stock. And

then you start trading the stock and then it gets all the more interesting. And then there are

options on these stock certificates. But it's all for a purpose. The purpose is to make some

enterprise happen. And it really is important that we have these institutions, and if you don't

have them, your little group trying to do something is going to fall apart. Someone's going

to get angry and leave. It's just not going to work. And so I think of the stock market as

doing these functions. Now I know Karl Marx said he thought it was a big casino, but we're

not communists here. This is about modern finance.

Lecture 9 is about real estate--another fascination for me. I've been working for years about

real estate. And, in fact, with my colleague Karl Case, we have our own home price indices

called the Standard and Poor Case-Shiller Home Price Indices. We'll talk about those. But

it's really important for this crisis that we've just seen, because the financial crisis was

caused substantially by a bubble in home prices, I believe, a psychologically induced

excitement or euphoria about home prices in the United States and in other countries that

collapsed around 2006. These bubbles are restarting in other parts of the world more

recently. And the real estate market is getting very speculative and psychological, I believe.

And the outlook right now for the economy hinges on how these markets behave. So, that

will be, I think, an important lecture for this course.

Lecture 10 is about Behavioral Finance. It's about psychology in finance. I talked about

that. It's another long-standing interest of mine to try to incorporate psychology into our

theory.

So, lecture 12 is about banking, multiple expansion of credit, the money multiplier, and

bank regulation, which is something that is a fascinating topic because we almost lost our

banking system. We had to bail them out massively. We have international accords now.

Notably, a new one just came out called Basel III from Basel, which is the city in

Switzerland, and it was endorsed by the G-20 countries at their Korean meeting in Seoul.

So, we're seeing a change in bank regulation that will, we hope, prevent another crisis like

the one we just went through.

Lecture 13 is about forwards and futures markets. Forward markets are markets for

contracts that deliver in the future. Over-the-counter contracts, they're called, that are done

one-on-one between parties with the help of an investment bank. Or futures contracts,

which are traded on organized futures exchanges, like the Chicago Mercantile Exchange. I

have some involvement with this because we worked with the Chicago Mercantile

Exchange to create a futures market for single-family homes using the S&P Case-Shiller

Index. So, I'm involved in this. And we have that market functioning at a rather low level,

but it is functioning and it seems to be growing lately. I'm hopeful for that market.

Lecture 14 is about options markets. These are most typically stock options, which are

contracts that allow you to purchase a share of a stock or to sell a share at a pre-specified

price. These are traded on options exchanges. They have a price that goes up and down.

This is an example of a derivative contract that injects a lot of complexity into financial

theory.

Lecture 15 is about monetary policy. It's about the central banks of the world. For example,

our central bank, called the Federal Reserve in the United States. And it's about what they

do and how they help prevent crises like the one we've just seen. They did help prevent it. I

think they staved off disaster.

Lecture 16 is about investment banking. I know this is of great interest because we place a

lot of students in good jobs in investment banking. Companies like Goldman Sachs, the

most talked about one. Investment bankers help companies raise capital, issue securities,

retire securities. And we're going to talk about how they're regulated. And I didn't mention

Dodd-Frank, by the way, but we have a new bill that just passed in July in the United States

that changes the regulatory structure for investment banks and a whole array of financial

institutions. And I want to talk about that.

The European Parliament has created a number of new laws and organizations that

somewhat resemble Dodd-Frank. And other countries have also done financial regulation

reform that affects investment banking and other aspects of finance. It's extremely

complicated. I don't want to give you too many details but I want to give you some sense of

the revolution that we're seeing.

Lecture 17 is about professional money managers like David Swensen, people who manage

portfolios. You don't have to be a billionaire to manage a billion-dollar portfolio. In fact,

some of you may be doing it sooner than you realize if you get the right kind of job.

Managing a portfolio means managing the risks, putting them in the right places. You think

of institutional investors, big money managers, as just trying to make money. But when you

get into that field you realize that you have power as an institutional investor. When you

own a big share of some company, you can go to the board meeting and talk to these

people, or the stockholders' meeting, and you will get heard if you own 10% of the shares

of a company. Then you suddenly realize that you are a steward of the public interest. And

I think institutional investors are recognizing that more and more.

Lecture 18 is about exchanges, brokers, dealers, clearinghouses, like the New York Stock

Exchange or the London Stock Exchange. They are proliferating around the world.

Whereas there were just a few 30 years ago, now almost every country has a stock

exchange and a complicated list of exchanges. They're increasingly electronic; they have

interesting new features, like microsecond trading that's going on, computers trading with

other computers. We'll talk about where this is going.

Lecture 19 is about public and nonprofit finance. So, I think this is very important.

Nonprofit finance would include organizations like Yale University, or churches and

charities and other things like that. But I'm also including in this lecture public finance. And

that means governments financing projects. So, for example, you take it for granted that our

city here of New Haven has roads, it has schools, it has sewers, it has water. All this kind of

comes without you even asking. But all of these things had to be financed. And the City of

New Haven, like other cities, is issuing debt and it's a complicated business. I want to get

you into some of the details because it matters, because this is how you make things

happen. You can go to your city government and you can propose that they issue revenue

bonds to start some new product. You would know--that's what I want you to do, is to know

how these things are done so that it's not just imagination, you can make it happen. And

also nonprofits. I want you to understand that you can set up your own nonprofits, and

there's a lot of advantages to doing that. That's an organization that has a financial structure

but no shareholders. Nobody takes home the money. It all goes to some cause.

And, finally, my last lecture, Lecture 20, I'm calling it ''Finding your Purpose in Finance.'' I

just want to come back in the last lecture to the idea that this is a course not about making

money. I don't want you to give a billion dollars to your children and grandchildren, which

they will then squander in conspicuous consumption. The idea is a moral purpose. And

that's one thing I wanted to try to convey, partly with outside speakers, maybe with other

examples that I can give, that I think that many people who are wealthy and who have

succeeded in finance really don't care about spending the money on themselves. They really

do have a purpose. And even if that's not true of many of them.

There's an interesting book by Robert Frank, I don't have it on the reading list, called

Richistan, who talks about what wealthy people are like these days. And if you read his

book sometimes they are disgustingly rich and spending the money on silly things. But

there is an idea among many of them that they are going to do their good things for the

world. I think many of you will do these things; I want to think about the purpose that you'll

find in finance.

So, that's just the closing thought. I'll see you again on Wednesday. But the closing thought

is that this is about making your purposes happen. OK.

[end of transcript]