Neoclassical Finance (Princeton Lectures in Finance)

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It seems that there is potential for specifying dynamic preferences, technologies, constraints and rules of the market game that roughly reproduce the serial correlation and cross- correlation patterns in a given collection of time series measuring market outcomes. Banerjee REStud [In earlier literature on epidemic models in economics], no attempt is made to derive an optimal decision rule for each decision maker.

In this paper, the decision to believe in the rumour and to pass it on is based on optimizing behaviour. Ben Bernanke is like nothing more than the janitor who could turn down the thermostat in a conflictual conference room at a tense moment. The next day was quiet, but the following Monday, the index dropped almost 7 percent. In successive days, it rose 4. Keynesian beauty contest Peculiar timing of public reaction to near default may repeat this month. Chapter 11 Classical Business Cycle Analysis: Next page The Stock Market: My presentations Profile Feedback Log out.

Auth with social network: Registration Forgot your password? The relative strengths of neoclassical and behavioral finance for understanding bubbles and systemic crises. Download ppt "Neoclassical Finance and Reality Lecture 1: Stocks, Stock Markets, and Market Efficiency. Thus, over and above the floating of exchange rates, precisely when the loss of a nominal anchor the fixed exchange rate system required as a trade-off increased regulation of financial markets, the opposite happened: Yet these direct causes did not emerge from thin air, nor can they be explained simply by natural greed.

Most of them were the outcome of 1 the deliberate deregulation of financial markets and 2 the decision to not regulate financial innovations and treasury banking practices. Regulation existed but was dismantled. Thus, deregulation and the decision to not regulate innovations are the two major factors explaining the crisis. In consequence, the financial instability that, since the suspension of the convertibility of the dollar in , was threatening the international financial system was perversely restored.

But whereas commercial globalization was a necessary development of capitalism, insofar as the diminution of the time and the cost of transport and communications support international trade and international production, financial globalization and financialization were neither natural nor necessary: Globalization could have been limited to commerce, involving only trade liberalization; it did not need to include financial liberalization, which led developing countries, except the fast-growing Asian countries, to lose control of their exchange rates and to become victims of recurrent balance of payment crises.

It is not by chance that the fast-growing Asian countries engaged actively in commercial globalization but severely limited financial liberalization. Institutions do not exist in a vacuum, nor are determined; they are dependent on values and political will, or politics. The immediate cause of the crisis was the practical bankruptcy of US banks as a result of households default on mortgages that, in an increasingly deregulated financial market, were able to grow unchecked. When the fraud came to light and the banks failed, the confidence of consumers and businesspeople, which was already deeply shaken, finally collapsed, and they sought protection by avoiding all forms of consumption and investment; aggregate demand plunged vertically, and the turmoil, which was at first limited to the banking industry, became an economic crisis.

Confidence was lost not only for economic and political reasons. A moral issue does lurk at the root of the crisis. It is not sufficient to say that neoliberalism is radical economic liberalism. It is more instructive to distinguish the two ideologies historically. While, in the eighteenth century, liberalism was the ideology of a bourgeois middle class pitted against an oligarchy of landlords and military officers and against an autocratic state, in the last quarter of the twentieth century neoliberalism emerged as the ideology of the rich against the poor and the workers, and against a democratic and social state.

Neoliberalism or neo-conservatism as neoliberalism is often understood in the United States is characterized by a fierce and immoral individualism. There is a moral issue involved. Virtue and civic values were forgotten, or even ridiculed, in the name of the invisible hand or of an overarching market economy rationale that claimed to find its legitimacy in neoclassical mathematical economic models.

Meanwhile businesspeople and principally finance executives became the new heroes of capitalist competition. Fraud became a regular practice in financial markets. Bonuses became a form of legitimizing huge performance incentives. Instead of regarding the state as the principal instrument for collective social action, as the expression of the institutional rationality that each society is able to attain according to its particular stage of development, neoliberalism saw it simply as an organization of politicians and civil servants, and assumed that these officials were merely corrupt, making trade-offs between rent-seeking and the desire to be re-elected or promoted.

With such political reductionism, neoliberalism aimed to demoralize the state. The consequence is that it also demoralized the legal system, and, more broadly, the value or moral system that regulates society. A practical confirmation of their ingrained immorality is present in the two surveys undertaken by Robert Frank, Thomas Gilovich, and Dennis Regan , , and published in the Journal of Economic Perspectives , one of the journals of the American Economic Association.

In both cases they came to a dismal conclusion: They reflect the vicious brotherhood between neoliberalism and the neoclassical economics taught in graduate courses in the United States. It happened because neoliberal ideas became dominant, because neoclassical theory legitimized its main tenets, and because deregulation was undertaken recklessly while financial innovations principally securitization and derivative schemes and new banking practices principally commercial banking, also becoming speculative remained unregulated.

This action, coupled with this omission, made financial operations opaque and highly risky, and opened the way for pervasive fraud. How was this possible? How could we experience such retrogression? So why did the world regress into neoliberalism and financial instability?

First, a few words on the fear of socialism. Ideologies are systems of political ideas that promote the interests of particular social classes at particular moments. While economic liberalism is and will be always necessary to capitalism because it justifies private enterprise, neoliberalism is not. It could make sense to Friedrich Hayek and his followers because in their time socialism was a plausible alternative that threatened capitalism.

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Yet, after Budapest , or Prague , it became clear to all that the competition was not between capitalism and socialism, but between capitalism and statism or the technobureaucratic organization of society. And after Berlin , it also became clear that statism had no possibility of competing in economic terms with capitalism.

Statism was effective in promoting primitive accumulation and industrialization; but as the economic system became complex, economic planning proved to be unable to allocate resources and promote innovation. In advanced economies, only regulated markets are able to efficiently do the job. Thus, neoliberalism was an ideology out of time. It also implied a generalized process of eroding the social trust that is probably the most decisive trait of a sound and cohesive society.

When a society loses confidence in its institutions and in the main one, the state, or in government here understood as the legal system and the apparatus that guarantees it , this is a symptom of social and political malaise. This is one of the more important findings by American sociologists since the s. According to Susan Pharr and Robert Putnam For sure, a neoliberal will be tempted to argue that, conversely, it was the malfunctioning of political institutions that caused neoliberalism.

But there is no evidence to support this view; instead, what the surveys indicate is that confidence falls dramatically after the neoliberal ideological hegemony has become established and not before. Neoclassical economics except Marshallian microeconomics have a major responsibility for this crisis.

The method allows them to use mathematics recklessly, and such use supports their claim that their models are scientific. Although they are dealing with a substantive science, which has a clear object to analyze, they evaluate the scientific character of an economic theory not by reference to its relation to reality, or to its capacity to explain economic systems, but to its mathematical consistency, that is, to the criterion of the methodological sciences Bresser-Pereira They do not understand why Keynesians as well as classical and old institutionalist economists use mathematics sparingly because their models are deduced from the observation of how economic systems do work and from the identification of regularities and tendencies.

This is not surprising: Besides, economic liberalism is the ideology of markets, whereas economics is the theory of how markets coordinate economic systems. Marx denounced the ideological character of classical political economics, but acknowledged the major contributions of Smith, Malthus and Ricardo to explaining economic systems.

Schumpeter was a great economist and the greatest ideologue of capitalism. Economics was mixed with ideology, but it was reasonably truthful and oriented economic policymaking. After the s, however, when neoclassical economics recovered its dominance after 30 years of Keynesianism, there was a major turn in academic economic theory as it became either extremely empiricist or extremely mathematical.

The empiricist turn was the outcome of the development of econometric research methods and of the need of academic economists to publish papers. It is the practice of normal science in the Kuhnian sense; it has limited scope, but is valuable because it checks theories. The mathematical turn, however, had disastrous consequences for economics in so far as it led economists on to a false and highly ideological path. This was a wrong path that, nevertheless, produced a great economist, Alfred Marshall, who developed microeconomics.

Yet, if we assume that economics is the science of economic systems, while economic decision-making science studies choice between economic alternatives, Marshallian microeconomics was not a major advance in economics itself but rather in economic decision-making theory complemented later by game theory. As the Great Depression demonstrated, while neoclassical microeconomics proved helpful in making choices in markets, neoclassical economics was not an effective instrument for macroeconomic policymaking.

This opened the way for the Keynesian macroeconomic revolution that remained dominant up to the s. These facts defined the setting for the return of neoclassical economics to the mainstream position. But three things were lacking for that: Neoclassical economists now had at their disposal a consistent theoretical model explaining economic systems: A great model that instead of using a historical-deductive method uses a fully hypothetical-deductive method that is suited to methodological sciences, but is unacceptable in a science attempting to explain the real world, as economics is supposed to do.

Neoclassical economists seek to adorn these models with certain concepts that they believe to be neoclassical, such as, for instance, the concepts of confidence and of transparency. They are, essentially, harmful ideological theories. Their models tend to be radically unrealistic, assuming, for instance, that markets are self-regulating, or that insolvencies cannot occur, or that financial intermediaries have no role in the model, or that the price of a financial asset reflects all available information that is relevant to its value, etc.

For sure, they acknowledge market failures many neoclassical economists won the Nobel Prize for discovering new market failures , and, so, when analyzing specific cases, they attempt to drop the unrealistic assumptions. But this is an arduous effort, soon forgotten. As The Economist b: Actually, neoclassical economists use mathematics as tool not to advance knowledge but to assert the scientific character of their models.

They evaluate the scientific character of an economic theory by reference not to its approximation to reality or its ability to explain the behavior of economic systems, but to its mathematical consistency. For Keynesians, economic systems are open systems that must be explained by correspondingly open and, for that reason, simple models. Instead, neoclassical economists use the hypothetical-deductive method, which proceeds from the assumptions of rationality and of complete and efficient markets.

This is the method of the methodological sciences, principally mathematics, but also econometrics and economic decision theory. It is an intrinsically logical method that opens the way for the reckless use of mathematics. Yet it is not an adequate method for substantive sciences, which have a reality to explain, and particularly for a social science like economics, which seeks to explain economic systems.

Neoclassical macroeconomists and neoclassical financial economists, however, decided to conclude this pact with the devil.

The global financial crisis, neoclassical economics, and the neoliberal years of capitalism

To achieve precision and consistency, they gave up adequacy. To respond to this question we must distinguish, within the capitalist class, 1 the active capitalists or entrepreneurs from 2 the rentiers or non-active capitalists or stockholders; and, within the professional class, three groups: Additionally, we must consider the two major changes that took place in the s: It was also a long-term consequence of the transition from capital to knowledge as the strategic factor of production as the supply of capital had become abundant, or, in other words, as the supply of credit from inactive capitalists to active capitalists had exceeded the usual demand for it.

These short-term and long-term factors meant that either the profit rate the interest rate which, in principle, is part of the profit rate should be smaller or that the wage rate should increase more slowly than the productivity rate, or a combination of the two so as to create space for the remuneration of knowledge. We have already observed that the new role assigned to monetary policy in the s was instrumental in increasing the interest rate, but nevertheless, given the low profit rates prevailing from the s up to the mids, discontent was mounting, principally among capitalist rentiers.

Actually, the financial innovations did not increase the profits achieved from production, but, combined with speculation, they increased the revenues of financial institutions, the bonuses of financists, and the value of financial assets held by rentiers. This crisis contributes to eliminating these doubts in so far as, among the three major issues that came to the fore, one was the bonuses or, more broadly, the compensation that financists receive the other two issues were the need to regulate financial markets and the need to curb fiscal havens.

Stephen Ross (economist)

Compensation and benefits in the major investment banks are huge. Statistics distinguishing the salaries and bonuses received by the professional class and, in this case, a fraction of that class, the financists, from other forms of revenue are not available, but there is little doubt that such compensation increases as knowledge replaces capital as the strategic factor of production. If we take into consideration the fact that the number of employees in investment banks is smaller than those in other service industries, we will understand how big their remuneration is as the Goldman Sachs example demonstrates , and why, in recent years, in the wealthy countries income became heavily concentrated in the richest two percent of the population.

The adversaries of this political coalition of rentiers and financists included not only the workers and the salaried middle classes, whose wages and salaries would be dutifully reduced to recompense stockholders, but also the top professional executives of the large business corporations, the financists that I am defining as the top executives in financial institutions, and the traders. In similar vein, John E. Bogle in published a book with the suggestive title The Battle for the Soul of Capitalism , which he begins by dramatically asserting: We need to reverse its course so that the system is once again run in the interests of stockholders-owners rather than in the interest of managers… We need to move from being a society in which stock ownership was held directly by individual investors to one overwhelmingly constituted by investment intermediaries who hold indirect ownership on behalf of the beneficiaries they represent.

They may have some grievance about the bonuses of the top professional managers who run the great corporations and decide their own remuneration and of the financial traders get, but the reality is that today they are no longer able to manage their wealth on their own: Their real adversaries are certain left-wing public intellectuals who have not stopped criticizing the new financial arrangement since the early s, and the top public bureaucracy that was always ready but unable to regulate finance.

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It should, however, be emphasized that this outcome also reflected competition from immigration and exports originating in low-wage countries, which pushed down wages and middle-class salaries. Commercial globalization, which was supposed to be a source of increased wealth in rich countries, proved to be an opportunity for the middle-income countries that were able to neutralize the two demand-side tendencies that abort their growth: These countries shared with the rich in the developed countries that were benefited by direct investments abroad or for the international delocalization process the incremental economic surplus originating in the growth of their economies, whereas the workers and the middle class in the latter countries were excluded from it insofar as they were losing jobs.

Income share of the richest one percent in the United States, — Three-year moving averages 1 including realized capital gains; 2 excluding capital gains. As Gabriel Palma In his paper, Palma stresses that it not sufficient to understand the neoliberal coalition as responding to its economic interests, as a Marxian approach would suggest. These four responses were in the right direction. They realized that modern capitalism does not require deregulation but regulation; that regulation does not hamper but enable market coordination of the economy; that the more complex a national economy is, the more regulated it must be if we want to benefit from the advantages of market resource allocation or coordination; that economic policy is supposed to stimulate investment and keep the economy stable, not to conform to ideological tenets; and that the financial system is supposed to finance productive investments, not to feed speculation.

Thus, their reaction to the crisis was strong and decisive. As expected, it was immediate in expanding the money supply, it was relatively short-term in fiscal policy, and it was medium-term in relation to the most complex problem of regulation. For sure, mistakes have been made. The most famous was the decision to allow a great bank like Lehman Brothers to go bankrupt. The October panic stemmed directly from this decision. As a trade-off, Europeans seem more engaged in re-regulating their financial systems than are the United States or Britain. Rich countries are usually exempt from this second type of crisis because they usually do not take foreign loans but make them, and, when they do take loans it is in their own currency.

For developing countries, however, balance of payments crises are a financial scourge. The policy of growth with foreign savings that rich countries recommend to them does not promote their growth; on the contrary, it involves a high rate of substitution of foreign for domestic savings, and causes recurrent balance of payments crises Bresser-Pereira Or, as Michel Aglietta Middle-income countries like China and Brazil are already recovering.

But although rich countries are already showing some signs of recovery, their prospects are not good. Rich countries long taught developing countries that they should develop with foreign savings. The financial crises in middle-income countries in the s, beginning with Mexico in , passing through four Asian countries, and ending with the major Argentinean crisis, were essentially the consequence of the acceptance of this recommendation.

The dollar showed its strength, but such confidence cannot be indefinitely abused. Thus, the rest of the world will have to find sources of additional aggregate demand. China, whose reaction to the crisis was strong and surprisingly successful, is already seeking this alternative source in its domestic market.

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In this it will certainly be followed by many countries, but meanwhile we will have an aggravated problem of insufficient demand. Yet the bold fiscal policies adopted almost everywhere led the state organizations to become highly indebted. It will take time to restore sound public debt ratios. Meanwhile, present and future generations will necessarily pay higher taxes. Now, after the global crisis, what new regime of accumulation will succeed it?

First of all, it will not be based on financialized capitalism in so far as this latest period has represented a step backwards in the history of capitalism. Or, in other words, the political coalition between rentiers and financists will cease to be dominant. Yet financists are part of the professional class whose power and privilege will probably continue to grow. Merit continues to legitimize large differences in income. In the economic realm, globalization will continue to advance in the commercial and productive sector, not in the financial one; in the social realm, the professional class and knowledge-based capitalism will continue to thrive; as a trade-off, in the political realm the democratic state will become more socially oriented, and democracy more participative.

We should not confuse globalization with financialization. Only financial globalization was intrinsically related to financialization; commercial and productive globalization was not. China, for instance, is fully integrated commercially with the rest of the world, and is increasingly integrated on the production side, but remains relatively closed in financial terms. There is no reason to believe that commercial and productive globalization as well as social and cultural globalization and even political globalization the increasing political coordination sought and practiced by the main heads of state will be halted by this crisis.

On the contrary, especially the latter will be enhanced, as we have already seen, by the creation and consolidation of the G Yet this latter process will require time. Meanwhile, little advance of social justice and political emancipation will be achieved if fight for human rights and social criticism continues to be directed only against capital, instead of also encompassing the meritocratic ideology that legitimizes the extraordinary gains of the professionals. Inequality will originate in, on one side, the relative monopoly of knowledge, and, on the other, the downward pressure on wages from immigration and from imports from fast-growing developing countries using cheap labor.

As for developing countries, we also should not expect, in the short run, greater equality because many of them are in the concentration phase of capitalist development. The only major source of falling inequality in the short run will not be internal to the countries: Globalization, which in the s was thought of as a weapon of rich countries and as a threat to developing ones, proved to be a major growth opportunity for the middle-income countries that count with a national development strategy.

And this catching up will reduce global inequalities. Social learning will eventually prevail. Finance-based capitalism dismantled the institutions and forgot the economic theories we learned after the Great Depression of thes; it recklessly deregulated financial markets and shunned Keynesian and developmentalist ideas. Now nations will be engaged in re-regulating markets. I do not believe that they will forget again the lesson learned from this crisis. There is no reason to repeat mistakes indefinitely. The rich will be less rich, but they will continue to be rich, and the poor will become poorer; only the middle-income countries engaged in the new developmentalist strategy will emerge stronger from this crisis.

In November , the G leaders signed a statement committing themselves to a firm re-regulation of their financial systems; in September , they reaffirmed their commitment. But the resistance that they are already facing is great. On this matter, the unsuspecting The Economist c: This possibility should concern us all, but it is not reasonable to assume that people are not learning from the present crisis.

The main task now is to restore the regulatory power of the state so as to allow markets to perform their economic coordinating role. There are several financial innovations or practices that should be straightforwardly banned. All transactions should be much more transparent. Financial risk should be systematically limited.

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