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Finance Education - PPT Presentation

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

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.

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).

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. Cambridge, Massachusetts, Harvard University Press.

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Sonnenschein

(1993). “Market demand and excess demand functions”.

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Intriligator

, Elsevier. 2: 671-693

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Sharpe, W. F. (1964). "Capital Asset Prices: A Theory of Market Equilibrium under Conditions of Risk."

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' 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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