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Summary of 14 pages for the course Macroeconomic Analysis at School of Oriental and African Studies (Coursework material)

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  • June 7, 2021
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Macroeconomics Analysis – Course summary and notes
Reading 5 - The Realism of Assumptions does matter: Why Keynes – Minsky theory must replace efficient
market theory as the guide to financial regulations? – James Crotty

Financial deregulation (1970s) = precondition for explosion in:

- Size
- Complexity
- Volatility
- Degree
 of global integration of financial markets  contributing to severity + breadth of global
financial crisis.

Keynes – Minsky theory = unregulated financial markets = inherently unstable + dangerous

SO: if financial economists had adopted Keynes – Minsky theory  crisis would not have been that bad

BUT instead adoption of  neoclassical efficient financial market theory  arguing that:

lightly regulated financial markets generate: optimal security prices + risk

levels; prevent: booms + crashes.

Efficient market theory = dominant despite its unrealistic assumptions  only ok if considered under
Friedman’s (fundamentally flawed) positivist methodology = saying that the realism of assumption has no
bearing on the validity of the theory

BUT VS Keynes: arguing only realistic assumptions could render a theory realistic:

 AND SO: Keynes-Minsky theory based on realistic assumptions should be the guide to
regulation policies.

INTRODUCTION

After 1929 Great Depression + before 1970s  tightly regulated US economy (belied that unregulated
markets= very bad + led to crises)

After 1970s  neoclassical macro theory of financial markets: efficient market theory  self-regulating

Self-correcting markets leading to:

- Equilibrium
- Efficiency
- Utility maximization
- Full-employment

+ scarce resources allocated to generate maximum results SO also reaching efficiency in real-world!!

AND SO since markets = self-regulating  no need for regulatory policies!!

After 1970s  deregulation of the economy

BUT some disagreed with neoclassical theory:

- Behavioral financial theorists + economists (saying that irrationality didn’t lead to efficiency);
- Because there is incomplete information as prices do not carry all relevant information (asymmetry
of information) vs. neoclassical theory saying the opposite;

, - Because of principal-agent conflicts;
- Because of incomplete contracts.

BUT  all these are not wholesale rejection of the neoclassical theory, they are just amendments to it =
they do not challenge the paradigm which is thought to be great, but only some aspect of it that need
revision.

SO  policy regulators felt entitled to deregulate the economy because legitimated by the economic
science.

BUT truth is that both government officials + economists were bought/corrupted by Wall Street:

- Either paying for government officials’ campaigns + providing them jobs in financial institutions;
- Letting academics go to more remunerative jobs in central banks + hedge funds

AND SO  deregulation!!

BUT even then there were some that argued that this theory was fundamentally flawed:

- because of its unrealistic assumptions
- because of weak empirical support as many empirical tests were disappointing
 Then how was it possible that they were willing to not see that the theory was both built on
assumptions that had no resemblance to real-world financial markets + no empirical support??
 Why do financial economists reject Keynes-Minsky theory: realistic + able to explain the crisis??

2 reasons:

1. reliance on Milton Friedman’s “positivist methodology”  according to this: realism of assumptions =
does not matted to assess the validity of a theory;

2. bought off/corrupted so incentive to not see reality!! (greed)

- quotes on this as proof by: Stiglitz + Fukuyama
1. “The economics profession bears more than a little culpability [for the global financial and
economic crisis]. It provided the models that gave comfort to regulators that markets could be self-
regulated; that they were efficient and self-correcting. The efficient markets hypothesis – the notion
that market prices fully revealed all the relevant information – ruled the day. Today, not only is our
economy in a shambles but so too is the economic paradigm that predominated in the years before
the crisis – or at least it should be.”
2. “Wall Street seduced the economics profession not through overt corruption, but by aligning
the incentives of economists with its own. It very easy for academic economists to moved from
universities to central banks to hedge funds - tightly knit world in which everyone shared the same
views about the self-regulating and beneficial effects of open capital markets. The alliance was
enormously profitable for everyone: The academics got big consulting fees, and Wall Street got
legitimacy. And it has kept the system going despite the enormous policy failures it has generated,
not to exclude the recent crisis.”

FRIEDMAN’S POSITIVISM AND THE DOMINANCE OF THE THEORY OF OPTIMAL FINANCIAL MARKETS

Theory of efficient/perfect financial market  2 main assumptions:

(1) there is perfect information efficiency: all relevant information = efficient market hypothesis.

(2) market prices = optimal equilibrium prices set by rational + utility-maximizing agents who have perfect
information about the cash-flows associated with securities.

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