 Today I'm talking to Professor James Crotty, Emeritus Professor here at the University of Massachusetts Amherst, and one of the world's greatest experts on macroeconomics and finance. We're going to talk to Jim today about efficient markets. Based on paper, realism of assumptions does matter. Why Keynes-Minsky theory must replace efficient market theory as the guide to financial regulation policy. Jim, thanks for being here. It's a pleasure. So you start off the paper by saying that financial deregulation was one of the main causes of the financial crisis that we're now experiencing, and that the efficient markets theory put together by economists helped facilitate this deregulation. Can you talk about that a bit? Sure. The efficient markets theory that economists have proposed and defended isn't the only reason why we got deregulation. We got deregulation probably mainly because financial market people, Wall Street people, knew that if they could get rid of all the regulations that constraints on their activities, they could make much more money, much bigger profits, much bigger bonuses that could enrich themselves, which in fact is what happened. But it would have been hard to do if they basically were going to Congress and the regulators saying, remove restrictions on what we can do, on what kind of risk we can take, on how dangerously we can play, on how much debt or leverage we can use, and because we want to get rich. So it's easier for Congress people and regulators to kind of be convinced or seduced or whatever if the Wall Street people come in and say, it would be really good for the economy and good for everybody and good for jobs and good for economic efficiency, good for workers if we didn't put artificial constraints on the ways in which the financial institutions can help sustain the economy. And the economics profession tells us that lightly regulated or almost unregulated financial markets are the most efficient of all. And then they could bring all these economists to Congress and people could write papers and say that you should really do this, that this is very good. So then the regulators and the politicians could say to themselves, I'm not just doing this because Wall Street wants to do it. I'm not just doing it because I expect when I retire shortly to go work for a Wall Street bank and make a lot of money, I'm doing this because the economics profession tells me it's good for the country. So in your paper you argue that they can say that because of this theory, this efficient markets theory developed by economists. Can you describe the main aspects of that theory? Well, the efficient financial markets theory is essentially an approach to understanding how financial markets operate, which is built on a set of assumptions which are selected specifically to produce the results that financial markets operate perfectly. By efficient financial markets we mean financial markets which establish prices and yields on securities, which reflect accurately and transparently the actual earnings that the securities will have over the indefinite future. So financial markets are efficient if they use all the information available and the information is complete and correct about what will happen to future cash flows associated with the securities and then will create prices which truly reflect the risks and returns on these securities and price them that way and then everyone in the market can select just the right balance of risk and return that is optimal for them. However, in order to do this you have to have a long list of assumptions in your theory which are very unrealistic, do not reflect what actually goes on in financial markets and seems kind of silly to the outsider. Well, what are some of the key assumptions that go into that that you think are really crucial and that really in your view are unrealistic? Well, there's a long set of assumptions that go into these basic models and almost all of them are profoundly unrealistic. For example, what information is available to investors in financial markets that will tell them about the cash flows associated in the future with whatever security they buy or whatever portfolio of securities that they buy? Well, you think the answer is who knows, right? Who knows what's going to happen in the future to the returns on general motor stocks or whatever. But the assumption is, excuse me, that the people in the market know the actual returns on these securities in through the indefinite future. Now, they don't know numbers like general motors is always going to have a profit rate of 8%, but they know the correct probability distributions which will generate the numbers for general motors profits over the indefinite future. So it's kind of like going to play roulette and you don't know what number is going to come up. But you know the true odds that every number is equally likely if it's an honest roulette game. So this is an assumption in which everyone knows the future correctly, confidently, when in fact a realistic assumption is that no one knows the future and everyone would believe that. No one outside the economics profession would accept the assumption that people know the future. So once you know all the information about the future, then you can choose just those sets of securities which will have characteristics which will give you the kind of risk return rewards that you seek. You cannot, you can compose a portfolio of securities which will give you the maximum return for any given risk level or the minimum risk level for any given return. And this then is good for everybody. That's one of the key assumptions. I mean there are other assumptions for example like everyone has the same information. If everyone has the true information then everyone has the same information. Whereas what we know is in the markets there are people who think general motors is going up and people who think it's not going to go up and that's what causes trading. And there's massive trading in the economy. On the other hand in the model there's no trading. It's an equilibrium model in which this information is available to investors, all the information about what's going to happen to securities and they formulate their their best investment so their best portfolio and then the model sits there in equilibrium until something changes. So if you're in an equilibrium in which everyone's sitting on their portfolios there's no trading at all. It assumes that people don't change their attitudes towards risk. They don't become more risk loving or more risk averse or whatever based on what's happening to them over time. They're just I guess born with some degree of relationship to whether they should take risky chances in the market. When in fact we know that when there's a kind of a bubble in the market and all security prices are rising people get more and more happy with risk and debt and so on. Now are there some examples from the recent crisis that suggested some of these assumptions really are unrealistic that you could point to? Well the list of unrealistic assumptions is huge. I mean just for example no one can default, no one fails, no one can go bankrupt in the model. I mean well we know everyone can go bankrupt. Liquidity is perfect in the model which means that you can always sell a security at its equilibrium correct price all the time. When in fact in the real world when there's a kind of boom and everyone wants to buy securities you can everyone can sell for a price greater than they pay but then they paid for. And when the economy or the financial markets are in a state of collapse no one can find anyone who'll pay them the equilibrium the so-called equilibrium price. So this is a tremendous a tremendous long unbelievable intellectually repugnant unrealistic set of assumptions that are required to produce this model. So for example are there no bankruptcies and no defaults? There were defaults on all these mortgages. There were defaults by financial institutions. Did everyone know what was going to happen in the future? Well no in 2007 everyone thought that the future would be beautiful and perfect and would go on forever and you couldn't lose money on houses or how mortgages or securities created from mortgages like collateralized debt obligations complicated securities which by the way no one understood and were completely non-transparent. And then all of a sudden when the crisis developed we had mortgage bankruptcies falling house prices indebtedness of individual excessive indebtedness of households and financial institutions nobody could sell mortgage back securities for for anything but at a great loss and so on. So the whole the whole everything that happened in the financial crisis is impossible under the theory of efficient financial market. So given that there's this theory that economists seem to believe and then could help justify deregulation yet they seem to be based on these assumptions which are unrealistic and in fact contradicted by the facts that you just described why is it that economists believe this theory? This is a great question. Why is it that Muslims believe what they believe? Why is it that Jews believe what they believe? In part it's almost semi-religious you get indoctrinated as a graduate student to believe that markets are efficient and while they may have this little problem or that little problem if you don't believe markets are reasonably efficient you have a tough time as an economics graduate student or as a professional. So this is a history of socialization and and incentive structures and whatever but there is this tradition in economics there's this a kind of methodology how do economists do what they do or what are the rules that economists apply to the creation of their theories and their models and there is a fairly long tradition associated closely with Milton Friedman in the Chicago School addressed most specifically in Milton Friedman's 1953 essay the methodology of positive economics which says that economists should follow the following sets of rules when they make their theories up. The first one is that the realism of assumptions is irrelevant to the usefulness of the hypothesis drawn from the theory. Now this sounds really funny the idea that it doesn't make any difference if you want to explain how a corporation makes investment decisions if you assume that these investment decisions are made by puppy dogs seeking to maximize the amount of green cheese they can eat okay it doesn't make any difference the realism doesn't matter. The completeness of the assumption set like are you really taking into account most of the key factors doesn't matter. Friedman argues that it's impossible anyway to tell which assumptions are more realistic than others which I don't think any normal social scientist believes I mean we can we can check well let me give you the most obvious one do we have any reason to reject the assumption that everyone knows the future perfectly well no one would accept that as a reasonable assumption and no one can ever default or on a loan no one would accept this so the methodology is that the realism of assumptions doesn't matter the completeness of the assumption sets doesn't matter and by the way even if you're not happy with that we can't figure out which assumptions are more realistic than other assumptions so that raises the question of why would anybody do this what would anyone want to argue that you can get the best theory of financial markets or core markets or any markets by composing a set of assumptions for you theory would seem to be not only not exactly like the way financial markets work all theories have to abstract a little bit from the complexity of reality but to make assumptions that are the exact opposite of reality like we know everything about the future is the assumption and we don't know anything about the future is the truth so I say after trying to think about this puzzle for many decades it's because I think that economists in general and particularly conservative economists free-market economists want to demonstrate that free-market models not interfered with or regulated by governments or whatever produced the most efficient results all the time or that unregulated free-market capitalism produces the best results all of the time well if we look at history this isn't true