 In the segment today, I'm going to talk about financial markets and I'm going to talk about competing theories of financial markets. There are different ways in which economists understand financial markets. So what are financial markets? Well, the text will explain this to you in some detail, I assume, but they're basically institutions where people and financial firms come together to buy and sell securities, to borrow and to lend, to buy and sell insurance on various things, and to gamble. Those are the things that are basically done. What's the purpose of this? Well, the purpose of this is to provide a place where excess savings can be used by people who have a productive need to do this, or where people can put their savings so they can save them to retire and they can make some money on them. The gambling part is really big nowadays. You can gamble on stocks, you can gamble on bonds, and increasingly you can gamble on something called derivatives. And the derivative is simply a bet that something will or won't happen in financial markets. So for example, I could bet you that General Motors Stock is going to go up, and you could bet me that General Motors Stock is going to go down. We don't have to buy General Motors Stock to see what happens. We just have to make this bet with each other. That's called a derivative, and they're enormous, these bets. There's some $600 trillion in what are called over-the-counter derivatives. These are bets which are not done through markets, but just between one financial institution or another, or a financial institution and a person. So how do economists think about the way economists function, I'm sorry, the way financial markets function? They disagree. The predominant view much of the time is that financial markets are really efficient and work really well. There's an alternative view that says financial markets are kind of gambling casinos, and they're very volatile and they don't always work well. I don't know if this surprises you, because there's a conflict between economists on this issue, but economics is in physics, and economics is in chemistry. We don't have laws of nature. We theorize about how people and individuals and groups of people and institutions behave, and so we're kind of like psychology or sociology, and it's easy enough to come to disagreements about this. There is a kind of dominant theory, we'll call it mainstream theory, some people call it neoclassical theory, it's the one that's essentially used in the textbook, and it essentially says that financial markets are our friends. They never hurt us, they solve our problems, they're good. What is it that they do that's so helpful? One is they take people's savings and they collect them, and they allocate them the argument goes to the most productive uses. So they not only collect our savings, but through financial markets they transmit them to the firms that have the most productive investment projects. They're kind of like the brains of capitalism. They also help stabilize the macroeconomy. If the economy starts to fall back, aggregate demand declines, interest rates will fall, that's the argument, and when interest rates falls then there'll be more investment and more consumption through borrowing than there would have been otherwise, and that will help stabilize the economy. They also allow people to get the best deal for the holding of their wealth, that is they can allow people to maximize the return they get on their wealth portfolio or the securities that they buy and minimize the risk and become more wealthy safely. Why is it that it's thought that financial markets operate so efficiently and are so helpful? Basically because this theory is based on very unrealistic assumptions, the most unrealistic assumption is something called rational expectations. The assumption, suppose I want to buy a Ford, I'm thinking about whether I should buy a Ford stock, so what do I need to know? I need to know will Ford be profitable in the future? Next year two years from now, three years from now, five years from now, that's what I need to know to buy a Ford stock. What do I know about this? Well mainstream theory with rational expectations says I know what's going to happen to the profits on Ford over the next three or five years. I don't know exactly what's going to happen. It's a kind of like a bell distribution with the middle point being the most likely or the mean expected profits and the width of that bell indicating the risk or the weight might bounce around from year to year, but we assume that we know the future. If we know the future and we know what's going to happen, therefore we have the information to make the best optimal decisions in financial markets. Financial markets can't fool us. So if profits look good, the price should go up. If it looks bad, it shouldn't go up. And since individuals have knowledge of, perfect knowledge of the future and financial markets are competitive and they operate efficiently, it's assumed that financial markets will be helpful and will stabilize the economy.