Behavioural Finance

1. Behavioural Finance Lecture 11 Part 1 Financial Instability Hypothesis The Global Financial Crisis

2. The Exam Structure 20 Multiple Choice 1 mark each (no negative marks) Based on lectures: study lecture notes for this section 5 short answer questions (4 marks each): Write a summary and your own assessment of 5 papers 1 essay (20 marks) Requires understanding of Circuit theory and tabular approach to building models of credit dynamics Use QED program to build models prior to exam Closed book

3. Short answer questions: summarise & evaluate Kirman, AP 1992, 'Whom or what does the representative individual represent?', The Journal of Economic Perspectives, vol. 6, no. 2, pp. 117-36. Sharpe, WF 1964, 'Capital asset prices: a theory of market equilibrium under conditions of risk', The Journal of Finance, vol. 19, no. 3, pp. 425-42. Fama, EF & French, KR 2004, 'The Capital asset pricing model: theory and evidence', The Journal of Economic Perspectives, vol. 18, no. 3, pp. 25-46. Minsky, HP 1977, 'The Financial instability hypothesis: an interpretation of Keynes and an alternative to ‘standard’ theory', Nebraska Journal of Economics & Business, vol. 16, no. 1, pp. 5-16. Graziani, A. 2003, The monetary theory of production, Cambridge University Press, Cambridge, UK, pp. 1-32.

4. Essay question Does the repayment of debt destroy money? Consider the verbal arguments for and against this proposition. Construct two pure credit economy models with constant output (no economic growth), one in which debt repayment destroys money, and one in which it does not. Discuss the dynamics of the two models.

5. Recap Circuit model still skeletal But already reaches different economic policy results to standard models Model extended to multiple commodities Will be extended to include fixed capital, government, and Financial Instability Hypothesis This week The Financial Instability Hypothesis

6. The Financial Instability Hypothesis Developed by Hyman Minsky on simple proposition: Capitalism has suffered several Depressions Depression every 20 or so years in 19th century “Great Depression” of 1930s merely biggest So since market economies can have Depressions… “it is necessary to have an economic theory which makes great depressions one of the possible states in which our type of capitalist economy can find itself.” (Can "It” Happen Again? A Reprise) Theory combined insights from Marx, Schumpeter, Keynes & Irving Fisher Key foundation Fisher’s “Debt-Deflation Theory of Great Depressions”…

7. Fisher & Debt Deflation Irving Fisher the “Paul Krugman” of his time Famous (neoclassical) economist Developed early 1900 precursor to “Efficient Markets Hypothesis” Wealthy as inventor of “Rolodex” card system Columnist on New York Times Stock Market “Bull” Believed Market in 1920 reflected growth prospects for US economy Heavily invested in market Huge margin loans Supported financial position with theory of finance

8. Fisher & Debt Deflation Theory extended standard neoclassical “supply and demand” model to finance Rate of interest as “price in the exchange between present and future goods.” (Fisher 1930: 61), Three forces determine price Subjective preferences of individuals for present goods over future goods determines supply of funds Objective possibilities for profitable investment determines demand for funds Market mechanism brings these into equilibrium

9. Fisher & Debt Deflation Twist compared to standard supply & demand theory In market for apples, supply is objective, demand subjective Objective conditions of production determine supply curve for apples Subjective preferences of consumers detemines demand curve for apples But in finance Objective factor determines demand Subjective factor determines supply Reverse of relationship for standard markets

10. Fisher & Debt Deflation Subjective preferences of individuals for present goods over future goods determines supply of funds a low time preference prefers to lend now rather than consume most likely a lender high time preference prefers to consume now rather than later most likely a borrower. Borrowing how those with a high preference for present goods acquire the funds they need now at the expense of later income.

11. Fisher & Debt Deflation Objective side of the equation Marginal productivity of investment or “marginal return over cost” (1930: 182) Determines demand for funds High return means high demand for funds Low return means low demand Willingness to borrow/lend not enough must be opportunities for borrowed money to be invested and earn a rate of return

12. Fisher & Debt Deflation Market equates subjective and objective forces Supply: High rate of interest even those with high time preference will lend supply of funds will be quite high Low rate of interest only those with low time preference will lend supply of funds will be small Demand: High rate of interest most investments will be unviable demand for funds will be low Low rate of interest most investments have positive net present value demand for funds will be high

13. Fisher & Debt Deflation So far sounds just like standard supply & demand: Supply & demand set equilibrium interest rate But still one curly problem: Standard market model ignores time However time explicitly part of exchanges in finance Borrow money now, repay later So Fisher extended standard timeless supply & demand model with two assumptions: “(A) The market must be cleared—and cleared with respect to every interval of time. (B) The debts must be paid.” (1930: p. 495) Great assumptions to make in 1930—Not!

14. Fisher & Debt Deflation As well as one of world’s most prominent economists, Fisher was also a newspaper columnist (a risky business...) On Wednesday, October 15, 1929, Fisher comments “Stock prices have reached what looks like a permanently high plateau. I do not feel that there will soon, if ever, be a fifty or sixty point break below present levels, such as Mr. Babson has predicted. I expect to see the stock market a good deal higher than it is today within a few months.” On October 23rd, 1929, Black Wednesday: Dow Jones loses almost 10% in a single day 4 years later, the broad market was 1/6th of its peak, and Irving Fisher had lost over $10 million.

15. The Wall Street Crash

16. From Sage to Laughing Stock… Fisher’s reputation destroyed by wrong predictions In aftermath, developed theory to explain the crash “The Debt Deflation Theory of Great Depressions” based on rejection of conditions (A) and (B) above Previous theory assumed equilibrium but real world equilibrium short-lived since “New disturbances are, humanly speaking, sure to occur, so that, in actual fact, any variable is almost always above or below the ideal equilibrium.” (1933: 339) Disequilibrium the rule in economy & finance markets Fisher realised a disequilibrium theory needed too

17. Debt Deflation Theory of Great Depressions Key disequilibrium forces are debt and prices The “two dominant factors” which cause depressions are “over-indebtedness to start with and deflation following soon after” “Thus over-investment and over-speculation are often important; but they would have far less serious results were they not conducted with borrowed money. That is, over-indebtedness may lend importance to over-investment or to over-speculation. The same is true as to over-confidence. I fancy that over-confidence seldom does any great harm except when, as, and if, it beguiles its victims into debt.” (Fisher 1933: 341; emphasis added!)

18. Debt Deflation Theory of Great Depressions When overconfidence leads to overindebtedness, a chain reaction ensues: “(1) Debt liquidation leads to distress selling and to (2) Contraction of deposit currency, as bank loans are paid off, and to a slowing down of velocity of circulation. This contraction of deposits and of their velocity, precipitated by distress selling, causes (3) A fall in the level of prices, in other words, a swelling of the dollar. Assuming, as above stated, that this fall of prices is not interfered with by reflation or otherwise, there must be (4) A still greater fall in the net worths of business, precipitating bankruptcies and

19. Debt Deflation Theory of Great Depressions (5) A like fall in profits, which in a "capitalistic," that is, a private-profit society, leads the concerns which are running at a loss to make (6) A reduction in output, in trade and in employment of labor. These losses, bankruptcies, & unemployment, lead to (7) Pessimism and loss of confidence, which in turn lead to (8) Hoarding and slowing down still more the velocity of circulation. The above eight changes cause (9) Complicated disturbances in the rates of interest, in particular, a fall in the nominal, or money, rates and a rise in the real, or commodity, rates of interest.” (1933: 342)

20. Debt Deflation Theory of Great Depressions Theory fundamentally nonequilibrium in nature Fisher’s statement is a powerful argument for disequilibrium analysis in macroeconomics and finance: “9. We may tentatively assume that, ordinarily and within wide limits, all, or almost all, economic variables tend, in a general way, toward a stable equilibrium… 10. Under such assumptions … it follows that, unless some outside force intervenes, any "free" oscillations about equilibrium must tend progressively to grow smaller and smaller, just as a rocking chair set in motion tends to stop… 11. But the exact equilibrium thus sought is seldom reached and never long maintained.

21. Debt Deflation Theory of Great Depressions New disturbances are, humanly speaking, sure to occur, so that, in actual fact, any variable is almost always above or below the ideal equilibrium… Theoretically there may be—in fact, at most times there must be—over-or under-production, over-or under-consumption, over-or under-spending, over-or under-saving, over-or under-investment, and over or under everything else. It is as absurd to assume that, for any long period of time, the variables in the economic organization, or any part of them, will “stay put,” in perfect equilibrium, as to assume that the Atlantic Ocean can ever be without a wave.” (Fisher 1933, p. 339; emphases added)

22. Debt Deflation Theory of Great Depressions Two classes of far from equilibrium events explained Ordinary cycles Deflation or debt but not both Depressions Both debt and deflation…

23. Debt Deflation Theory of Great Depressions Cycles, when one occurs without the other with only overindebtedness or deflation, growth eventually corrects problem; it is … “more analogous to stable equilibrium: the more the boat rocks the more it will tend to right itself. In that case, we have a truer example of a cycle” (Fisher 1933: 344-345) Great Depression: overindebtedness and deflation with deflation on top of excessive debt, “the more debtors pay, the more they owe. The more the economic boat tips, the more it tends to tip. It is not tending to right itself, but is capsizing” (Fisher 1933: 344).

24. Debt Deflation Theory of Great Depressions Fisher’s new theory ignored Old theory made basis of modern finance theory Debt deflation theory revived in modern form by Minsky Fisher’s macroeconomic contribution (which emphasised the need for reflation and “100% money” during the Depression) overshadowed by Keynes’s “General Theory” Many similarities and synergies in Keynes and Fisher, but different countries meant one largely unaware of others work

25. Keynes and Debt-deflation Some discussion of debt-deflation when discussing reduction in money wages (neoclassical proposal): “Since a special reduction of money-wages is always advantageous to an individual entrepreneur ... a general reduction … may break through a vicious circle of unduly pessimistic estimates of the marginal efficiency of capital … On the other hand, the depressing influence on entrepreneurs of their greater burden of debt may partially offset any cheerful reactions from the reductions of wages. Indeed if the fall of wages and prices goes far, the embarrassment of those entrepreneurs who are heavily indebted may soon reach the point of insolvency—with severe adverse effects on investment.” (Keynes 1936: 264)

26. Keynes and Debt-deflation “The method of increasing the quantity of money in terms of wage-units by decreasing the wage-unit increases proportionately the burden of debt; whereas the method of producing the same result by increasing the quantity of money whilst leaving the wage-unit unchanged has the opposite effect. Having regard to the excessive burden of many types of debt, it can only be an inexperienced person who would prefer the former.” (1936: 268-69) Keynes’s focus here more physical and macro (impact on investment) than Fisher; Keynes’s main contributions on finance relate to Dual Price Level hypothesis Analysis of expectations and behaviour of finance markets

27. Keynes and the Dual Price Level Hypothesis In most of General Theory, Keynes argued that investment motivated by relationship between marginal efficiency of investment schedule (MEI) and the rate of interest In Chapter 17 of General Theory, “The General Theory of Employment” and “Alternative theories of the rate of interest” (1937), instead spoke in terms of two price levels: commodities (cost price) & assets (speculative) investment motivated by the desire to produce “those assets of which the normal supply-price is less than the demand price” (Keynes 1936: 228) Demand price determined by prospective yields, depreciation and liquidity preference. Supply price determined by costs of production

28. Keynes and the Dual Price Level Hypothesis Two price level analysis becomes more dominant subsequent to General Theory: The scale of production of capital assets “depends, of course, on the relation between their costs of production and the prices which they are expected to realise in the market.” (Keynes 1937a: 217) MEI analysis akin to view that uncertainty can be reduced “to the same calculable status as that of certainty itself” via a “Benthamite calculus” whereas the kind of uncertainty that matters in investment is that about which “there is no scientific basis on which to form any calculable probability whatever. We simply do not know.” (Keynes 1937a: 213, 214) So how do investors form expectations?

29. Keynes and the Dual Price Level Hypothesis Given incalculable uncertainty, investors form fragile expectations about the future These are crystallised in the prices they place upon capital asset Given fragile basis for expecations, asset prices are subject to sudden and violent change with equally sudden and violent consequences for the propensity to invest Seen in this light, the marginal efficiency of capital is simply the ratio of the yield from an asset to its current demand price, and therefore there is a different “marginal efficiency of capital” for every different level of asset prices (Keynes 1937a: 222)

30. Keynes on Uncertainty and Expectations Three aspects to expectations formation under true uncertainty Presumption that “the present is a much more serviceable guide to the future than a candid examination of past experience would show it to have been hitherto” Belief that “the existing state of opinion as expressed in prices and the character of existing output is based on a correct summing up of future prospects” Reliance on mass sentiment: “we endeavour to fall back on the judgment of the rest of the world which is perhaps better informed.” (Keynes 1936: 214) Fragile basis for expectations formation thus affects prices of financial assets

31. Schumpeter on Cycles & Credit Joseph Schumpeter leading “Evolutionary Economist” Applying theory of evolution to economics His “Theory of Economic Development” emphasised cyclical nature of capitalism Credit played important role in cycle Supervised Minsky’s PhD direct influence on Minsky’s thought Rejected neoclassical view of money “veil over barter” “Money neutrality: Double all prices & incomes, no-one better or worse off” Nonsense assumption in a world with debt…

32. Schumpeter’s model: money has real effects Schumpeter accepts neoclassical view as true for existing products, production techniques, etc., in general equilibrium But new products, new methods, disturb “the circular flow”. Money plays essential role in this disequilibrium phenomenon Affects the price level and output Doubling all prices & incomes would make some better off, some worse Those with debts would be better off Including entrepreneurs…

33. Schumpeter’s model: money has real effects Conventional theory suffers from “barter illusion” Existing producers using existing production methods exchanging existing products “Walras’ Law” applies Major role of finance is initiating new products / production methods etc.; For these equilibrium-disturbing events, classic “money a veil over barter” concept cannot apply. “From this it follows, therefore, that in real life total credit must be greater than it could be if there were only fully covered credit. The credit structure projects not only beyond the existing gold basis, but also beyond the existing commodity basis.” (101) “Walras’ Law” false for growing economy…

34. Schumpeter’s model: credit has real effects “[T]he entrepreneur needs credit … [T]his purchasing power does not flow towards him automatically, as to the producer in the circular flow, by the sale of what he produced in preceding periods. If he does not happen to possess it … he must borrow it… He can only become an entrepreneur by previously becoming a debtor… his becoming a debtor arises from the necessity of the case and is not something abnormal, an accidental event to be explained by particular circumstances. What he first wants is credit. Before he requires any goods whatever, he requires purchasing power. He is the typical debtor in capitalist society.” (102)

35. Schumpeter’s model: credit has real effects In normal productive cycle, income from production finances purchases; credit can be used, but not essential “[T]he decisive point is that we can, without overlooking anything essential, represent the process within the circular flow as if production were currently financed by receipts.” (104) Effectively, Say’s Law applies: “supply creates its own demand” Aggregate demand equals aggregate supply (with maybe some sectors above, some sectors below) But credit-financed entrepreneurs very different Expenditure (demand) not financed by current receipts (supply) but by credit Aggregate Demand exceeds Aggregate Supply

36. Schumpeter’s model: credit has real effects Credit finance for entrepreneurs thus endogenous: not “deposits create loans” but “loans create deposits”: “[I]n so far as credit cannot be given out of the results of past enterprise … it can only consist of credit means of payment created ad hoc, which can be backed neither by money in the strict sense nor by products already in existence... It provides us with the connection between lending and credit means of payment, and leads us to what I regard as the nature of the credit phenomenon.” (106)

37. Schumpeter’s model: credit has real effects Say’s Law & Walras’ Law apply in circular flow, but not entrepreneurial credit-financed activity: “In the circular flow, from which we always start, the same products are produced every year in the same way. For every supply there waits somewhere in the economic system a corresponding demand, for every demand the corresponding supply. All goods are dealt in at determined prices with only insignificant oscillations, so that every unit of money may be considered as going the same way in every period. A given quantity of purchasing power is available at any moment to purchase the existing quantity of original productive services, in order then to pass into the hands of their owners and then again to be spent on consumption goods.” (108)

38. Aside: “Marx with different adjectives” Schumpeter here similar to Marx’s “Circuits of Capital” Commodity—Money—Commodity Equivalent to Schumpeter’s “circular flow” Essentially Say’s Law applies Sellers only sell in order to buy Money—Commodity—Money Equivalent to Schumpeter’s entrepreneurial function Say’s Law doesn’t apply: “The capitalist throws less value in the form of money into the circulation than he draws out of it... Since he functions ... as an industrial capitalist, his supply of commodity-value is always greater than his demand for it. If his supply and demand in this respect covered each other it would mean that his capital had not produced any surplus-value... His aim is not to equalize his supply and demand, but to make the inequality between them ... as great as possible.” (Marx 1885: 120-121)

39. Schumpeter’s model: credit has real effects So Schumpeter’s dynamic view of economy Overturns “money doesn’t have real effects” bias of neoclassicals/monetarists Breaches “supply creates its own demand” Say’s Law view of self-equilibrating economy Breaches Walras’ Law “if n-1 markets in equilibrium, nth also in equilibrium” general equilibrium analysis Links finance and economics: without finance there would not be economic growth, but Finance can affect economic growth negatively as well as positively (if entrepreneurial expectations fail)…

40. Integration: Financial Instability Hypothesis Minsky combined concepts of Fisher: debt deflationary mechanism, Role of commodity price inflation Schumpeter: entrepreneurial role of credit Keynes & “2 price levels” analysis Expectations formation under uncertainty Behaviour of financial markets Finance ? Investment ? Savings causal loop (Also Kalecki: Finance as limit on investment) Marx: Tendency to cycles & crisis in capitalism To produce Financial Instability Hypothesis