 So we have with us today again Professor Jim Crowdy, Meredith's professor at the University of Massachusetts Amherst and an expert on financial markets, financial theory, economic crisis. Thanks Jim for being with us. Welcome. So we have this big financial crisis that we haven't yet seen the end of and the question is what kind of economic theory is there out there that can help us understand how we got into this mess and how we might get out of it? Well essentially we could say something which would be a little bit too simple but it's not too far from the truth. There are two kinds of theories about how financial markets work. One kind is the standard mainstream financial economist theory which is sometimes referred to as efficient markets theory which argues that the right way to understand financial markets and the right way therefore to understand regulation, the way to inform regulation, is to use a theory based on the idea that people actually know what the future values and yields on economic security, financial securities are. So the theory begins with the assumption that people know the future, at least they know the kind of statistical distributions that will generate the actual profits and cash flows and interest flows of bonds and that they then can use this information to calculate a desired portfolio of securities for themselves which will optimally balance risk and return. So they can get the return that they need at the minimum risk or can get the minimum return at the maximum risk at the maximum return. And it's an equilibrium model which means it's a picture of an economy or a set of financial markets sitting without movement. It's just in this ideal situation where everything's price just right, the prices reflect the actual risk, everyone has an optimal portfolio, no one is confused, everything is clear, no one is taking risks that they are not aware of. And nothing can happen. I stress the fact that it's equilibrium because it means it's not a dynamic model, it isn't something which says that well we're here for this instant but there'll be decisions coming in response to where we are which will change where we are. There are many variants of that but that's the main picture that the profession presents and has presented to government regulators over decades which has helped government regulators decide that with such a beautiful and perfect set of financial markets there's no reason for the government to regulate very much and they didn't. There's an alternative view which is almost kind of the inverse view which looks at financial markets as an ongoing historical dynamic process with its own internal sources of motion and change. There's many of these theories that the ones that people are most commonly associated with are John Maynard Keynes and then a modern follower of Keynes whose name was Hyman Minsky although it's also the case that the general ideas that they have about financial markets were similar to the ideas that Karl Marx had about financial markets. So there are ideas that are following. Nobody knows the future. The future is absolutely unknowable. Keynes referred to it as uncertain or fundamentally uncertain. So the entry point for this theory is the exact opposite of the entry point for the efficient markets theory is that no one can know the future because the future is not yet determined. If you think about the efficient markets theory the only way that people could know the correct future cash flows coming up securities was if the future already existed or at least was already determined. But the future isn't determined we have to make decisions now in the light of ignorance of what's going to happen in the future which will then influence what happens in the economy who invests you know what new technologies come up you know how wealth is distributed and so on and so forth and these will then affect the future they'll determine the future path. So once you assume that people can't know the future but have to make decisions about financial markets and investment and other things in spite of the fact that they don't have an ignorance of the future you get this system which kind of at any point in time people are have to kind of guess what's going to happen in the future make decisions based on this this will move the economy forward it will change the economy which means people will have to make new guesses and and so on. So this kind of dynamic system in motion is associated with ideas of Keynes-Mitski and so forth. So the idea basically is here okay we don't know the future people don't know the future in order to make decisions about anything including what to do in financial markets they have to make forecasts or extrapolation or guesses or form expectations about the uncertain future. They don't know how to do that so there's no way to do that perfectly so they use heuristics just conventions about how to do this. So the main convention which is stressed by these guys which is the which makes tremendous sense is that unless there's good reason not to do this people tend to kind of just extrapolate where we've been recently to where we're going to go. So if the stock market has been kind of drifting upward for a while people will begin to assume the most likely guess it's not the truth but the most likely guess is that it's going to continue to drift up. So if if the stock market or other financial markets are in fact drifting up for a while people will begin to build that into their expectations formation of forecasting mechanism. So if the the the relevant past has been pretty optimistic it's been a pretty good path for securities they'll begin to project that it will continue to be a good path. Now because this is all just guesses and this is a psychological activity not an engineering or mathematical activity people are also have to assess not only where they think the markets are going is the stock market going to go up is it going to go up by five percent next year ten percent they have to ask themselves how confident am I that my forecast is going to actually be true. So if I think the market is going to go up by ten percent next year but I'm not so sure about that I'll be hesitant to be too aggressive in buying stocks I'll be hesitant about borrowing too much money to buy stuff but if you have a bubble developing a kind of a financial upswing developing at people's forecast become more optimistic but not only that their confidence that the forecaster right will increase so you begin to think not only is the stock market likely to go up but I'm I'm more and more sure that that's the truth and therefore I definitely want to buy stocks and I maybe I want to go to my broker and say I want to borrow to buy stock so there's a process which is kind of reasonable and seems reasonable in which people begin to become more optimistic as the boom proceeds and they begin to become more confident in their optimisms boom proceeds they begin to borrow more money to buy stocks as the boom proceeds the people who are most aggressive and most confident in whatever in the market will be the people who make the most money they'll be making a lot of money money will be raining down on these people and other people will look it's a psychological process and social process and they'll they'll begin to want to emulate them like you know if you're married you'll go home and you'll tell your partner that you've been cautious in the market you know and you're trying to you know watch out and she and she or he will say uh well our next door neighbor has been pretty aggressive in the market and they've got a new car and a new vacation home and and you know and they're doing great and what do we don't so why is this a problem why doesn't this just lead to perpetual prosperity um because because well according to anybody saying we have certain limitations on the actual growth of the economic system and the growth of the the goods and services that people can that people can get command over so the financial markets can grow five percent a year ten percent a year fifteen percent a year twenty percent a year from 1995 to 2000 the stock market grew 25 percent a year annually i suppose that's what happens every year it's annual um the economy can't grow 25 percent a year the economy at best can grow three percent four percent a year on average so at some point the the the projection and expectations get kind of disconnected from the ability of the economic system to deliver and and and that will then show up it will turn out that corporations can make that many much profit it will turn out that uh workers can't and make the wages that are required to buy the products that would require the economy to keep moving it would turn out that the technological innovations which are supposed to be able to raise double productivity actually can only increase it by five percent this clash comes up minskie's term is the financial system gets increasingly financially fragile which means it it increasingly people are committing their expected cash flows their wages and profits and so forth to financial assets um and that anything that goes wrong in the economy which can upset these cash flows right reduced profits reduced you know lower jobs lower wages lower household incomes and whatever will then smack people in the face and say our expectations run realistic now and we get a reverse now people say that this current crisis was caused by too much leverage too much borrowing is this somehow connected with that process and what do it is connected with that process although quite frankly i think both kane's and minskie kane's writing you know in from the the early 1900s and died in 1946 and minskie i think died in 1990 or something like that so their models are mostly about the financial system kind of getting pumping up and pumping up around an investment in growth process that can't follow and that sooner or later this this mismatch is discovered and people then say oh my god uh the profits can't be high enough my stocks are overpriced let me sell and then everyone wants to sell uh before everyone else sells otherwise they won't get you know their money back they only get 90 percent or 80 percent or 70 percent and we get this financial collapse which then pulls the real sector down in this case the the triggers were mostly about securities innovative securities complicated innovative securities that the financial markets had created so-called asset-backed securities that based on the most importantly based on mortgages and then we had all these these financial innovations asset mortgage-backed securities things called collateralized debt obligations and then things caused collateralized debt obligations squared and and and synthetic collateralized debt obligations at all these multiples of complicated house of tolerance built on mortgage flows and house prices and in the process of the of the financial markets the firms buying all these mortgages securitizing them selling them off to other financial firms who then sold them off to other financial firms we had this huge development this tremendous explosion of inter financial market debt so we got financial markets became increasingly indebted the numbers i don't have the numbers off the top of my head but something like in the 1980 or whatever financial market debt was 20% of GDP and by by we entered the 2000s and it's 100 or 120% of GDP so the financial market indebtedness was a big part of this problem because partly of these Keynesian minsky and ideas about the endogenous movements and people becoming more confident and becoming more optimistic and partly because of the particular compensation bonus-based compensation system which incentivize all these guys make these decisions in financial markets to take on more and more risk and more and more debt and more and more short-term debt we got we got the the the vulnerable point the real fragile point was within financial markets themselves and and the prices was triggered fundamentally by the the unpredicted at least by the financial market players end of the housing price bubble and then the exposure of the vulnerability of many of the mortgages that were written particularly towards the 2006 2007 people were the financial firms were giving mortgages to people who could possibly pay them back because they needed the mortgages to get into asset-backed securities and collateralized debt allegations because that's what make them all the bonuses so so that whole thing collapsed so it was the what triggered the the economic crisis was the the was the housing market which had been used as a kind of the basis of a pyramid of of a financial market gambler now many politicians and economists have said that nobody could have foreseen the crisis and that if we just have better information about about what's going on in the economy that we can forestall a future crisis well i i want to know what you and and kainz and minsky would say about it i would agree that if we had better information about the future some of these problems would go away but since we can't have information about the future at all that's not that's not going to help us first of all it isn't true that nobody foresaw the the the crisis there was a fairly widespread set of people in the college and university community in the financial community who who's looked at this thing and said you know this is getting riskier and riskier and riskier every index of risk that we can see is getting bigger and bigger and bigger bigger um i remember reading reports by the bank of england during this period which saying oh my god look at look at the debt that's that that the large banks are are generating and look at how how huge their responsibilities their liabilities are getting uh and and and look at how many liabilities are hidden in complicated accounting phenomena called special investment vehicles and so on which are kind of off their balance sheets there there's even more risk hidden there um and look how much how how the investment banks and others are buying these big complicated debt loaded securities like collateralized debt obligations which um have no market they're so complicated they just occasionally traded from one firm to another there's no market for them nobody knows what's in them they're not transparent whatever and they're and they're long term 30 year you know securities you don't get your money back until 30 years from now and the investment banks are borrowing half of their money overnight to buy these securities so if anything starts to go wrong with the securities half of their assets half of the money that they have to buy can leave overnight so lots of people saw this number one number two anyone who has any even a cursory knowledge of the history of capitalist financial markets knows that always and ever at all times in all centuries under all institutional structures the markets go up and the markets come down there's no such thing as as as you know markets that aren't subject to these problems so um the first thing is that lots of people foresaw this if i may say so i foresaw this um but lots of more important people than i saw this lots of insiders saw this secondly uh you have to be almost a religious fanatic about efficient markets theory to to look at history and say history's gone now not last time not in the 1990s not 1980s not 1930s not you know but now all of these pressures that always brings bubbles have disappeared or you have to have to be heavily incentivized with tens or hundreds of millions of dollars to pretend that you don't see it so lots of insiders saw this thing um i'll bet lots of people in the regulatory apparatus kind of saw this thing but nobody wanted to do anything about it nobody was incentivized including the regulators to do anything about it thank you very much you're welcome