After the Crisis Steve Keen University of Western Sydney Debunking Economics wwwdebtdeflationcomblogs wwwdebunkingeconomicscom Finance the Humpty Dumpty of Academia I dont know what you mean by glory Alice said ID: 313152
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Slide1
Finance Education “After” the Crisis
Steve KeenUniversity of Western SydneyDebunking Economicswww.debtdeflation.com/blogswww.debunkingeconomics.comSlide2
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!”Slide3
Humpty Dumpty’s Dictionary“Efficient Market”: NounSystem capable of accurate prophesyProphesy—see “Rational”
System in which all agents can predict the futureSystem where any agent can borrow infinite amount at risk-free rateE.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)Slide4
Humpty Dumpty’s DictionaryE.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)Slide5
Humpty Dumpty’s Dictionary“Expected Value (E.V.)”: NounWhat you won’t get in a one-off gambleWhat your lecturer says the gamble is worthCorrect answer in multiple choice
questionRationalAble to predict future course of complex systemSee 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”: NounStandard deviation of return around expected return…Slide6
Humpty Dumpty’s DictionaryE.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 riskSee Expected Value; ORCertainty 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?Slide7
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)Slide8
Reform: Integrated economics & financeNeoclassical macro and neoclassical finance have to goNeoclassical Finance/Economics divide
Money neutrality, no role for debt in macroBarter model of capitalismDebt financing no impact on firm value in financeEquilibrium analysis of financeBoth nonsense in credit-based dynamic economyIntegrated economics & finance insteadPlus uncertainty-aware finance subjectsAlmost all of neoclassical economics & finance falseBut above all else, abandon fetishes of equilibrium & strong reductionism (Anderson 1972)
Especially in mathematical modeling…Slide9
Integrated financial economicsWalras’ Law false in a credit driven economyBarter economySum of all excess demands is zero
Aggregate demand is aggregate supplySavings create loansAggregate debt has no macro impactCredit economySum of all excess demands equals change in debtAggregate demand = Aggregate supply + DdebtLoans create DepositsMoney supply endogenousChange in debt drives growth
& asset bubblesSlide10
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)Slide11
Neoclassical macro naïve about money & debtKrugman: 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)Slide12
Naïve “savings creates loans” modelPatient 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
analysisSlide13
Actual credit money creation processBasic process of endogenous money creationEntrepreneur 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 demandSlide14
Empirical dynamics of CreditIn credit-driven economy, aggregate demand spent on both goods & services (GDP) and existing assetsAD = Income + DDebt = GDP + Net Asset Sales (NAS)
NAS = PA * fraction sold * QA= PA.sA.QA D
AD = D GDP + DDDebt = DGDP + D(PA.
s
A
.Q
A
)
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 pricesSlide15
Empirical dynamics of CreditPrivate debt bubbles caused “Roaring Twenties” & “Noughty Nineties”
Bursting of bubbles caused Great Depression & Great RecessionSlide16
Empirical dynamics of CreditChange in Private Debt drives both booms and busts
R
2=-0.79
R
2
=-0.96
Differences Now vs Then
Bigger debt-driven boom Now than Then
Business less indebted now, households & finance more
Much bigger/faster Government response to crisis
Faster turnaround in fall in private debtSlide17
Empirical dynamics of the Credit Accelerator
Great Depression & Great Recession both commenced with collapse in Credit Accelerator
R
2
=-
0.53
R
2
=-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
…Slide18
Empirical dynamics of the Credit Accelerator
Credit Accelerator affects sharemarket performance…
R
2
=0.37
R
2
=0.23
Complex
, unstable lead/lag relationships between
Credit acceleration, asset prices, economic growth…
Combined
monetary
economics/finance theory
needed to understand itSlide19
Monetary Circuit Theory (MCT)Neglected “Classical” economists the right foundation for the futureMarx, Keynes, Schumpeter, Keynes, Minsky
+ European “Circuitists” (Graziani)+ Complexity theory (Goodwin & many others)Monetary, dynamic integrated finance/macro modelStarting point:All demand monetaryMoney creation via bank double-entry bookkeepingEnter financial flows into “Godley Table”Generate dynamic model of money creation
Coupled to nonlinear non-equilibrium production model (Goodwin)Slide20
Modeling monetary dynamicsInput basic financial flows in table:
AssetsLiabilities
EquityReserveLoan
Firm Deposit
Worker Deposit
Bank Equity
B
R
F
L
F
D
W
D
B
E
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:Slide21
Modeling monetary dynamicsPrior to substitutions…
Simple linear model
Implemented in easy to use GUI program
Prototype “QED”:
www.debtdeflation.com/blogs/QED
Professional version “
Minsky
” under developmentSlide22
Modeling monetary dynamicsWith nonlinear functions + cyclical production model:Slide23
Desirable
Desirable
Actual
Actual
Direction
Direction
Academic finance: A more limited role
No longer separate discipline from
economics
Ancillary role for discussion of
Structure of finance markets/institutions
Investment decision-making
under uncertainty
History
of financial crises
If we
forget
again
,
we will
relive
again
…
Finance sector (& profits) 4-6 times larger than they should beSlide24
Academic finance: A more limited roleBehavioural Finance? Some role, but as usual, based on misreading (or not reading) original literatureStandard practice: Subjective probabilityv.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 probabilitySlide25
Academic finance: A more limited roleBounded rationalitySensible, but unlikely foundation for new economicsBetter “top down” logic than bottom up, given emergent properties of macro & finance
See “More is different”, Anderson 1972Multi-agent modelling as adjunct to system dynamicsNetLogo, etc.Complexity, chaos theory & econophysicsFar 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 equilibriumSlide26
Academic finance: A more limited roleConsider investment under uncertaintyAs in Blatt 1979, 1982“Sophisticated” NPV ignores uncertainty
“Unsophisticated” Payback period considers uncertainty
Investment Time Horizon
Yet another reason why finance has economic effects
“Payback period” pro-cyclical: extends during booms, contracts during slumps
A new economics & finance needed…Slide27
Some resourcesDebunking 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/lecturesSlide28
ReferencesAnderson, 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
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: 1-26
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Graziani
, A. (2003).
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. 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.Slide29
ReferencesLucas, 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”.
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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
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