Financial Theory: Lecture 8 Transcript
September 29, 2009
Professor John Geanakoplos:
So we're spending a couple classes these days learning basic facts and
vocabulary about finance, and along the way we're trying to apply the simple lessons that Irving Fisher taught
about turning a financial problem into a general equilibrium problem and making use in particular of the
That very simple budget set we wrote down at the very beginning turns out to be quite useful and people
often can get quite confused. So the last issue we ended with, I'm going to take up again. Suppose that you've
got a very long-lived institution like Yale. How should Yale think of how much to spend every year? What is
Yale's budget set?
Almost every big institution like Yale creates a fiction of an annual budget and they talk about the deficit and
having to bring the deficit under control and making cuts to close the deficit gap, but really there is no such
thing as a one-year budget set. I mean, why one year? Why not one month? Why not one day? Nobody
expects Yale to balance its budget every day. Some expenditure comes in one day. They have to hire an
electrician to fix something unexpected. They're going to spend more money than they take in student tuition
that day. So the fact that they're supposed to budget the balance every year is just a fiction.
Irving Fisher taught us that Yale really has--if you can borrow and lend and you don't have to worry about
risk there's one infinite-lived budget set. It's an infinite horizon budget set where you just take the present
value of all the expenditures, that's the left hand side, and the present value of all the revenue, that's the right
hand side, and make sure that the left hand side is smaller than the right hand side over the whole course of
So that simple principle has a tremendous implication which was overlooked, to the chagrin of the last Yale
president. So as I said, the issue was in 1997, I believe, it could have been '96 something like that, 1997,
Benno Schmidt, who was then the Yale president, released a white paper, he called it, documenting the fact
that Yale had deferred maintenance in the buildings, he called it, and a study that he commissioned, a very
good study that he commissioned, argued that the deferred maintenance--Yale could be brought up to snuff
and then go on afterwards as a normal running institution provided it spent 100 million dollars a year for ten
years, and that included fixing every college--they're going to do more than one a year over a 10 year period.
So Yale's total budget, as I told you, was about 1 billion dollars at the time, and then here all of a sudden was
this 100 million dollar a year expense for 10 years. That's 10 percent of the Yale budget. And a lot of the
costs you can't change. You have to have the lights on. You have to heat the buildings.