 Hi, this is Professor Gerald Friedman, University of Massachusetts at Amherst, and we're here today to talk about efficient market theory, which seems a little abstract for a course on the Great Recession, but bear with me. This is the theory that underlay the drive to deregulate financial markets. When we think about where the theory went wrong, we see directly where some of the financial crisis came from. So let's first talk about what we want out of financial markets, why we have financial markets, why we have financial intermediaries. And we can go back, if we want, because this is the way efficient market theory is derived, we can go back to Robinson Crusoe. Robinson Crusoe, some days, liked to work really hard. Some days, the fish were popping. There were lots of coconuts, there was a lot to do. And on those days, when he was feeling energetic, he might say to himself, I'm going to work hard today, so that tomorrow I can sleep late, build sand castles, and have a really relaxed, easy day. And during the days that I don't work hard, I will live off of the proceeds, the surplus from today. So today I'll work hard, and I'll put some of the coconuts I make today and some of the fish I catch today, I'll put them away, I'll call them savings. And I'll consume them tomorrow. That's the basic idea behind financial markets and investment decisions. Investments are things we do today to shift consumption into the future. So instead of consuming today, we consume tomorrow. The way we do that, the way we shift consumption over time is either by building up an inventory, putting more coconuts in the garage, making a big pile of fish in the freezer, or by investing in productive activities. So building a canoe so I can fish more efficiently tomorrow or building a ladder so I can get more coconuts. That's working today so I can consume in the future. That's the idea behind financial markets. What happens in financial markets is these are companies that organize the inter-temporal shift in consumption. Now if you think about Robinson Crusoe, you can get a sense of the problems of risk and uncertainty. Risk is the danger that what you do today will not lead to consumption tomorrow. For example, your fish may spoil. You put them in the freezer but the freezer broke down or a bear came and ate your fish. You had a lot of Chinese takeout, you put it in your refrigerator thinking you'll eat it tomorrow morning and instead your roommate shows up late at night with the munchies and boom, your food's gone. So there's risk in any inter-temporal activity. This risk comes from the danger that the activity you're doing may not work. There's also the risk that you may not be alive. You went to sleep thinking in the morning you'll wake up and have Chinese food for breakfast, you die overnight. That's too bad that Chinese food's wasted. Maybe there are other problems with that too. There's also the danger that you will change. You go to sleep thinking you like Chinese food, you wake up in the morning, you want pizza for breakfast. So there's risk. Now some of that risk can be calculated. We don't know what will happen in the future but the future's often kind of predictable to the extent that the risk is calculable. You will discount it. You figure there's a 5% chance that your roommate will eat your food so you discount the value of your food by 5%. So you put it away and you think there's only a 95% chance that this will actually be here tomorrow. So I would have liked the food but if there's only a 95% chance then I won't bother. Just eat it now. There's calculable risk but then there's uncertainty. Uncertainty is where you just don't know what's going to happen. You have no idea where your roommate is. You have no idea whether the power will fail. You think about invading another country. You have no idea whether they're going to welcome you with flowers and open arms or with IEDs and active guerrilla resistance. Who knows? Nobody knows. That's uncertainty. You may choose to discount uncertainty by even more. You may say, I'm not going to invade another country. No way. I have no idea what's going to happen too risky or too much uncertainty. Somebody else may say, I'm happy to take the risk. I'm happy to deal with the uncertainty. I love uncertainty. That's where you get financial intermediation and insurance. You have no idea whether you will have a heart attack or get cancer or get sick in some other way in the next year. If you did, it would be a really, really, really terrible thing. You want some protection against that. That's where you buy insurance. You buy health insurance. You give up a little money now because you want some protection in the uncertain chance that something really, really bad will happen in the future. Much of financial activity involves insurance. It starts out as intertemporal substitution consumed tomorrow save today. But in the process, much of what goes on in financial industries is actually insurance. We put our money in the bank, accepting that they're going to be keeping some of it for themselves on the idea that that will protect the money from being stolen. Why don't you leave your cash under your bed? Somebody may break in your house. A rat may come and eat the paper. All sorts of weird things can happen. So you put it in the bank. You know that the bank's going to be making lots of money on it, more money than they give you back. But still, that's a better deal for you because you are protected. You are buying an insurance policy that ensures you that a certain amount of your money will still be there. A lot of what we do in financial markets is involved in insurance. Now that leads to a final problem. Efficient market theory says that everything that goes on in financial markets has to do with providing intertemporal substitution and insurance efficiently. Meaning that consumers get what they want at the best possible price. The price being guaranteed and protected were protected against exploitation by competition among providers. If there are lots of banks out there, we will get the highest rate of return possible. If there's lots of insurance companies out there, we will get the best insurance rate possible. Otherwise, if somebody is making extra profits off us, then other companies will jump in, sell the products to us at a better price, so we will get a higher rate of return or a lower insurance premium until the point where everything is perfectly efficient and optimal. If anybody is taking advantage of us, competition will drive them out of business, assuring us of the best return that's possible. That's great in theory, but think about real financial markets. First of all, there is no competition. The New York Stock Exchange is a monopoly. There are a certain limited number of companies allowed to deal on the stock exchange. The Nasdaq and every other stock community, Beowulf, is all tangled up now. That said, there are also a limited number of banks. Only certain people can operate banks. Now, why do we have restrictions on these things? Why do we restrict the number of banks and the number of insurance companies? It's not only to maintain monopoly profits, although that's probably part of it, but the real reason is we don't trust everybody. How do you know if your bank is being honest? There's a whole giant problem of asymmetric information. Financial activities are complicated. I've tried to give you a 10-minute summary of what it's all about, but you get down to the basics. You get the small print, you get, who knows what's really going on? The only people who really know what's really going on are the people in the companies. They know more than we do about what they're doing with our money. We want regulators to come in and protect us. Otherwise, what happens? Banks and insurance companies are in a great opportunity to commit fraud, to take your money and then run with it, to embezzle in one form or another. If you have any questions about that, I suggest you Google Enron or Bernie Madoff, and there are many others. There's two that come right to mind, and you're talking about billions and billions of dollars embezzled or from smart people who you think would have known better. That's what happens in unregulated financial markets. We can't trust the efficient markets, we can't trust that financial markets will be efficient because they are inherently subject to asymmetric information in the transfer of assets from now to sometime in the future or in the provision of insurance. Next time, we'll talk about the housing bubble, well, deregulation, and then we'll talk about the housing bubble. Thank you, and have a nice day. Bye-bye.