Financial Theory: Lecture 3 Transcript
September 10, 2009
Professor John Geanakoplos:
Now, the course, just to summarize again, the course is the standard financial
theory course that was made popular over the last ten years in a bunch of business schools, and those guys
who developed this material basically thought that markets were great and finance was almost a separate
part--could be walled off from much of economics. So here at Yale we've never taught finance that way.
We've always taught it as a part of economics and the crisis recently, I think, has made it clear that that's
probably the way one should really think about the problem. So it's become very fashionable now to say that
financial theorists had everything all wrong and to ask how it is that they got everything all wrong. Why
didn't they anticipate the crash? And the two standard critiques of standard financial economics are a) it didn't
allow for psychology, and you'll hear about that from Shiller next semester, and b) it didn't take into account
collateral. And it was all done in a very special case, a knife-edge case.
If you looked at it a little more broadly you would realize that the kind of crisis we've had now is not such an
unfathomable thing. In fact it's happened many times before. So that's the perspective I'm going to take in this
class. So to put it a different way, Krugman, very recently in the New York Times, you may have read his
magazine article, wrote exactly that, that there are two problems. The financial theory has failed us. Why has
it failed us? Well, because it didn't have psychology and it didn't have collateral.
And he didn't talk much about the collateral which is obviously something he's not thought very much about
before. But together with the collateral he sort of said it's too much--how did he put it? He said, "Too much
seduction by mathematics. The financial economists were seduced by their own mathematics into believing
stuff that a sensible person who didn't pay so much attention to mathematics wouldn't do."
Well, although the critique in this course is going to be partly based on collateral the rest of what Krugman
said I completely disagree with. I regard that as a kind of Taliban approach to economics. The more
technology and firepower you use the more you're going to be misled. That's what the Taliban believe, and
they want to get rid of modern technology and return to first principles. So I think, in fact, the problem with
modern finance was not too much mathematics, but too little mathematics, and they made these very special
simplifying assumptions and didn't realize how important the assumptions were to the conclusions. So we're
going to reexamine all that and that's what we're starting at now.
We're going to consider, first of all, the argument that free markets work best. So we started with a little
example. Oh, by the way, the first problem set, if I didn't mention it, is due Tuesday. So you need to bring it
to class and there will be a box with each of your section leaders' names on it. So supposedly you've been