Prof: So anyway,
the course I’m going to teach is called Financial Theory.
I’m going to teach an actual
class. I’m going to spend the first
half of the class talking about the course and why you might be
interested in it, and then I’m going to start
with the course. There are not that many
lectures available in the semester so I’m not going to
waste this one. So the first half of the class
is going to be about why to study it and the mechanics of
the course, and the second half of the
lecture is going to be actually the first part of the course.
It’ll give you maybe an idea of
whether you’ll find the course interesting too.
So I think I’ll turn this–I
won’t have too much PowerPoint here.
So you should know that finance
was not taught until ten years ago at Yale.
It was regarded by the deans
and the classically minded faculty of the arts and sciences
as a vocational subject not worthy of being taught to Yale
undergraduates. It was growing more and more
famous, however, in the world and there
was a band of business school professors,
Fischer Black, Robert Merton,
William Sharpe, Steve Ross, Myron Scholes,
Merton Miller, who had a huge following in
business schools teaching the subject,
and whose students went off to Wall Street,
and more or less dominated the investment banking parts of Wall
Street, and became extremely successful.
Finance became the most highly
paid profession. It became the most highly paid
faculty in the university, although they were all in
business schools. There are more physics PhDs
working in finance now than there are working in physics.
So this merry band of financial
theory professors didn’t really believe in regulation.
They believed markets left
unfettered worked best of all. They believed in what they
called efficient markets and the idea that asset prices reflect
all the available possible information.
So an implication of that is
that if you want to find out whether a company’s doing well
or not you don’t have to take the trouble to read all their
financial reports, just look at their stock price.
If you wanted to know whether a
country’s doing well or not you don’t have to study its entire
political system and current events,
just look at the general stock market of the country and
that’ll tell you. They believed that you could
make as good returns in the market as a lay person as you
could as an expert because all the experts were competing to
try and get the best possible price,
and so the price itself reflected all their knowledge
and wisdom and opinions and so the lay person could take
advantage of that by buying stocks.
Everybody should be an
investor, they felt. A monkey throwing darts at a
dart board would do as well as any of the greatest experts.
Now, their own theory was
basically contradicted by their own experience because all of
them seemed to go out into the world and invest,
and almost all of them made extraordinary returns and made a
huge amount of money all of which made them even less
popular in the faculty of arts and sciences.
So, a critical part of their
theory was that the markets were so efficient,
driven by people like them who are competing to exploit every
advantage, and therefore compete away
every advantage, and by doing that put all the
information they have into the prices.
The implication of that theory
is that there’s an extraordinarily clever way of
computing the value of most investment assets,
and about deciding when a financial decision’s a good
thing to do or not, and that was the heart of what
they taught in these business schools,
these algorithms for valuing assets and making optimal
financial decisions. One striking thing is that the
people they studied, the business people and the
investment bankers they studied adopted their language.
So this had never happened in
academia before. I mean, anthropologists study
primitive tribes and different kinds of people all the time and
not one of them, I venture to say,
has ever taken over all the language invented by
anthropologists to behave themselves in their own
societies, but the business people that
these professors were studying ended up using exactly the
language created in academia. Now, Yale was very different.
There was no divide between
economists and finance people, the business school finance
people. At Yale the greatest economists
in Yale’s history were actually very interested in finance.
Maybe they were financial
economists to begin with. So the greatest Yale economist
of the first half of the twentieth century was Irving
Fisher who you hear a lot about. He wrote, possibly,
the first economics PhD at Yale.
There was no economist to teach
him so he had to write his PhD with Gibbs, maybe the greatest
American physicist of the time. There’s a building,
as you know, on Science Hill named after
Gibbs, and you’ll hear more about his
dissertation in the 1890s, but he was a mathematical
economist, an econometrician but he
invented almost all of this economics in order to study
finance. The most famous Yale economist
of the second half of the twentieth century was James
Tobin, a famous macroeconomist,
the most famous macroeconomist, possibly, of the second half of
the twentieth century after Keynes,
a great Keynesian. But he got the Nobel Prize for
work he did on finance in economics.
Finance was incredibly
interesting to him. So Bob Shiller and I went to
Yale and we basically said to the deans,
“There’s a long tradition of finance and economics
hand-in-hand at Yale, and so it’s not a vocational
subject. It’s actually central to
economics, and central to understanding the economy,
and central to understanding the global economy.
So we’d like to teach it to
Yale undergraduates, and we believe a few of them
will actually take the course,”
and so they agreed to let us do it,
and so we’ve been teaching it now for the last ten years.
So as you know Shiller has been
very critical of the business efficient markets tradition.
He feels that these finance
professors left something essential out of the whole
story. What they left out was
psychology. They left out the idea of fads,
and rumors, and narratives,
which he thinks has as big an effect on prices as the hard
information about profits that the business school professors
imagined drove profits. I myself have been quite
critical of the financial theory.
I started off as a straight
pure mathematical economist. To me economics was almost a
branch of logic and philosophy that happened to tell you
something about the world. So I got my PhD with Ken Arrow,
who you’ll hear a lot about very shortly.
And I came to Yale,
I’d been a Yale undergraduate, I came back to Yale and I
joined the Cowles Foundation. And the Cowles Foundation’s
motto was basically, “Can we make economics
more mathematical? Economics, a social science,
ought to be amenable to mathematical analysis just like
physics or chemistry is,” and people didn’t believe this
at first. And the Cowles Foundation,
which you’ll hear a lot about in these lectures,
led the revolution in economics transforming it from a verbal
subject, political economy,
into a mathematical subject. Well, I decided around 1989
that since I did mathematical economics,
and there were all these finance people doing all kinds
of mathematical things on Wall Street and doing it very
successfully, I thought I might just check
out what they were doing. So it might be fun to see what
they were up to. So I went to Wall Street and I
joined–most people I knew, in fact, professors I knew went
to Goldman Sachs. There was a famous finance
professor, who I had mentioned before, named Fischer Black who
was there at the time and he attracted a lot of people.
And so that was the traditional
thing to do, but I decided to go to a
littler firm called Kidder Peabody,
and it was the seventh biggest investment bank at the time.
And one thing led to another,
and they decided that they wanted to reorganize their
research department in fixed income.
And since I was a professor
there, and I did mathematical economics,
and I was there for the whole year somebody said,
the director of the Fixed Income Department said,
“Why don’t you take charge of it and hire a new Fixed
Income Research Department for me.
So I did, and ultimately there
were seventy-five people in the department.
All the time I was a professor
at Yale. And after five years Kidder
Peabody, even though it was a hundred
thirty-five years old, formed by a famous family,
the name should sound– Peabody–familiar to you,
it closed down after a hundred thirty-five years,
five years after I got there. I had to invite the
seventy-five people I’d hired into my office and say,
“You’re fired.” And then I went next door to
the office next to mine and the guy there said,
“You’re fired.” And so that was my first taste
of Wall Street. And after that six of us
founded a hedge fund called Ellington Capital Management,
which was a mortgage hedge fund, and we had–
I’ll tell you a lot about it. It started after the Kidder
closing as a rather small hedge fund,
but it grew into a very big mortgage hedge fund,
in fact the biggest mortgage hedge fund in the country.
(Although recently we found out
that practically everybody who trades mortgages is basically a
hedge fund. Fannie Mae, Freddie Mac,
they’ll all basically hedge funds, so it doesn’t mean
anything anymore to say that you’re a big mortgage hedge
fund.) But anyway, we almost went out
of business in ’98 a subject, a story I’ll tell you at great
length, and then we just suffered
through this disastrous last year or two,
but we’re still here. So these experiences,
of course, have colored my understanding of Wall Street and
my approach to the subject. So I took on,
in my theoretical work, finance and economic theory on
its own terms. I didn’t think like Shiller to
introduce psychology into economics I just take it on in
its own terms, in its own mathematical terms.
And what I found was that there
are two things missing in the Standard Theory.
One is that it implicitly
assumes you can buy insurance for everything.
It’s the assumption that’s
called complete markets. And secondly it leaves out
collateral entirely so you’ll never see, almost in any single
economics textbook, the idea of collateral or
leverage. And those, I think,
the idea that you can’t get insurance for everything and
that you need collateral, you know, you have to be able
to convince someone you’re going to pay them back if you borrow
money and collateral is the most convincing way of persuading him
he’s going to be paid back, the lender.
Those two things were missing
from the Standard Theory, so I built a theory around
incomplete markets and leverage, which is a critique of the
Standard Theory. So in a way Shiller and I have
been vindicated by the crash. I mean, so let me just show you
a picture here. Well, maybe I will,
you know, how bad the crash was.
So let’s look at the Dow Jones.
The Dow Jones is an average of
thirty stocks and what their value is.
We’ll talk more about it later.
But here it is back to 1913
moving along breezily going up and up and up,
you know, there are a few blips which we’ll come to later like
this one in 1929, and then–but look what
happened lately. Look at that.
The Dow Jones was up at 14,000
and it dropped to 6,500, something like that,
more than a fifty percent drop and now it’s gone fifty percent
up again. So if you believe these finance
professors you’d have to say that everybody realized that
future profits in America were going to be less than half what
they thought they were going to be before and that’s why the
stock market dropped. And then miraculously when it
hit a bottom everybody figured, “Oh, my gosh,
we misunderstood things. Actually it’s not nearly that
bad and things are fifty percent higher because now people think
that profits really weren’t going to go,
you know, didn’t drop in half, didn’t drop by fifty percent,
they only dropped by twenty-five percent.
And that was the only way,
according to the old theory, to explain what happened.
Now Shiller would just say,
“Well, everybody’s–they’re crazy.
They got this into their head
that the world was just going to be great and then some rumor
started, and things were so high,
and the narrative changed and they thought things were
terrible,” and this his story.
And I’m not sure how he gets it
to go up again. They changed their mind again.
By the way it’s a little bit
better to look at the Dow correcting for inflation and
then you see that the 1929 crash looks–
and this is on a log scale, remember before the Depression
the stock market was so low. It’s grown so much over a
hundred years that it hardly seemed like anything was
happening. Well, now in log scale–going
up two of these is multiplying by ten–
you see that in the Depression in 1929 through the early ’30s
the stock market fell. I don’t remember what it is.
It looks like it’s almost two
things. It looks like it’s eighty or
ninety percent, and the fall this time has been
much smaller, fifty percent,
not ninety percent. So it’s a whole thing down but
not two things down. It’s not a whole thing down.
It’s less than that.
A whole thing down would be the
square root of ten or a third. It didn’t go down two thirds.
It went down less than two
thirds. It went down fifty percent,
so the actual percentage drop was much worse in the Depression
than it is now. We’re going to come back to all
these things. What else can we get out of
these numbers? I just want you to notice a
couple other things. So these numbers are all very
interesting. If you’re mathematical these
are the sorts of things you pay attention to.
So these efficient markets
guys, they looked at the change in price every month.
So there’s a lot to say for
their theory. They said, “Look,
it goes up and down randomly.”
In fact we’ll see that there
are all kinds of tests about whether you can predict it’s
going to go up tomorrow on the basis of how it did yesterday,
and the answer’s no. It’s very difficult to predict
whether the stock market is going up or down.
It seems to be random.
Well, it’s random and they used
to think it was normally distributed.
A lot of people argued it was
normally distributed, but it’s hard.
You never get these gigantic
outliers if things are normally distributed.
They’re just way too unlikely
to happen. So Mandelbrot,
who was a Yale professor who retired a couple years ago,
although he wasn’t when he formed his theories,
the inventor of fractals, he said this couldn’t possibly
be a random walk in the traditional Brownian motion
sense of the word because you’d never get these big outliers,
but he offered no explanation for why they might be there,
and I don’t know if Shiller has an explanation either.
I mean, is it that people
suddenly get shocked one day and then the next week they change
their mind and things aren’t so bad after all?
But you’ll see that the theory
of collateral and margins does explain these kinds of things.
Let’s just look at the Dow.
We just looked at the Dow.
Let’s look at another,
the S&P 500. Where’s the S&P 500?
Here’s the S&P 500 data.
Here’s the history of the
S&P 500. It looks very similar to the
Dow, except we have longer history back to 1871,
so I just want to point out one more thing in the S&P 500.
So this is an average of
five-hundred stocks, not just thirty,
but it’s more or less the same. But let’s look at the same
thing taking the logarithm and check for inflation.
So you see here that there are
these four cycles. Things seemed low in 1871.
They go up and they go down.
Then you’ve got another up and
a down. Then you’ve got another up and
a down. Then you’ve another up and a
down. Four times the same thing has
happened. Now this could be just
meaningless accidents, but it will turn out that the
demography of the country, the baby boom cycle,
we haven’t had just one baby boom we’ve had four of them,
so this cycle of stock prices, which they’re each time a
generation long, happens to correspond exactly
to the rise, the different age distribution
in the population. So another theory of the stock
market, which wouldn’t have been
entertained by these original financial theorists,
is that demography has something to do with the stock
market, not information about profits
and returns but the distribution of ages in the population.
So I’m not saying this theory
is correct, although I was one of the
proponents of it, but it shows that there’s room,
I think, in finance for economic things,
for demography to matter, for leverage to matter and not
just for expectations about future profits.
So let me show you another
picture. So this is a second way in
which Shiller became famous. He said, “Well,
look at housing prices,” the Case Shiller Housing Index.
So he’s also famous because he
had the idea of collecting housing prices.
So it’s quite amazing,
every town has to record, by law you have to record in
the town directory, and they’re often on the
internet, what the price is of every sale of every house.
So everybody has it and it’s
all publicly available on the internet, or most of it is
publicly available on the internet.
And nobody thought to gather
all this information together and take the average and write
down an index until Shiller did it.
So here’s the Shiller Index.
All right, so you can see that
housing prices were pretty stable throughout the ’80s and
then in and around 2000 they started taking off,
so this is when the stock market was taking off too.
So Shiller says this is
irrational exuberance. People just went crazy.
They somehow think things can
never go down, and they’re just going to keep
going up, and they keep buying because
they think things are going to go up,
and it’s crazy. Psychology–eventually a new
narrative is going to start. Somebody’s going to say,
“Oh, they’ve been going up so long they can’t continue to
go up. Things have to go down,”
and things went down. I think there’s something to
psychology so there was something missing in the
original finance story. The finance guys,
by the way, they would say, “Well, the rise is not so
surprising. Look at the mortgage rates.
(This is the interest rate you
have to pay if you get a mortgage.)
There’s been an incredible
decline in mortgage rates over the years, so it’s less costly
to buy housing. If you take the present value
of your expenditures you just have to pay less.
You pay over a long period of
time, and so the interest rate is
less, so the value of the houses is worth more because you’re
discounting the future benefits at a lower rate.
(You’ll hear all about
discounting later.) So there’s no mystery.”
On the other hand nothing
happened to interest rates. They kept getting lower so
there’s no reason why the market should have crashed.
So, again, this seems like a
vindication for Shiller. Now, it also,
in a way, is a vindication for my theory which is
non-psychological. So I’m distrustful a little bit
of psychology because it can be anything, although I agree it’s
important. So my theory is when you take a
loan you have to negotiate two things, the interest rate and
how much collateral you put up. Who’s going to trust you to pay
back? When you buy a house they say,
“You can’t just borrow the whole value of the house.”
They say, “Well,
make a down payment of twenty percent.
Borrow eighty percent of the
value of a house.” And so what I say is that
instead of paying all your attention to the interest rate
think about the collateral rate. Why is it twenty percent that
you have to put down? Maybe it should be ten percent
or forty percent. Well, in fact,
that number changes all the time.
So here what I’ve done is–the
pink line from 2000 to the future, that pink line is
Shiller’s Housing Index inverted.
So you notice the scale on the
right is the housing prices, but I’ve inverted it,
and on the left I have the down payment percentage.
These are non-agency loans.
We’ll come back to the graph
later– I don’t have time to explain
exactly how I got it– but what you see is that from
2000 onwards the down payment people were asked to make to buy
their house got lower, and lower, and lower,
and lower and it got down to three percent.
You could put down three
percent of the value of the house and borrow the other
ninety-seven percent of the value of the house to buy it.
So amazingly the prices go up
and down just with what’s called the leverage.
So why is it called leverage?
Because the cash you put down
payment, say ten percent,
you can lever it up and own an asset that’s worth a hundred
even though you put down ten dollars.
So you’re leveraged 10:1.
If you put down three dollars
and you get a hundred dollar house you’ve leveraged it 30:1
or 33:1. So that’s why it’s called
leverage. So anyway, the point is that
leverage went way up. The margins kept going down and
down and down and just at the peak of the housing cycle,
which is the bottom of that curve, that’s when collateral
started getting tougher and people started asking for more
money down again, and sure enough the prices
turned around. So if you look at the prices of
mortgages, again, the inverse on the
right, and you look at the margins on the left,
not for buying houses but for buying securities–
I don’t have time to explain this whole graph,
but the blue line is the buying securities.
So ’98 is a big crisis,
the margins spike up, I don’t have pricing data back
until then. That’s the blue line.
And now from 2007 to 2009 you
see the margins spiking up. So to buy a toxic mortgage
security investors don’t pay cash, they borrow part of the
money to buy it. They used to put down only five
percent to buy it. Now they have to put down
seventy percent to buy it on average.
Well, what happened to prices?
Prices–this is the inverse of
prices–in 2007 they started to collapse.
So this going up means prices
are collapsing. So once again,
the margins–tougher margins means lower prices and as the
margins came down recently the prices have gone up recently.
So it’s an alternative theory.
So what else do I want to show
you? So it doesn’t mean that the
standard financial theory is wrong.
After all, I helped run a hedge
fund. Six of us founded it and we’ve
been in business for fifteen years.
We must believe in standard
financial theory because that’s how we’ve been making a lot of
our money. We exploit all those algorithms
and those are the things I’m going to teach you,
so I certainly believe it and it’s very important to teach you
that again this semester, but there’s more to the theory
than just that. I want to show you one more
thing in the Dow Jones or the S&P which I forgot to
mention. And where is this?
Oh, I can’t get it out of that.
Let’s try Dow.
Okay, so Dow.
Where was the peak of the Dow?
It was right over here.
Now what was the date?
The date’s supposed to flash
here. So it’s October 1st 2007.
So that’s when people started
to realize something was wrong with the world and things headed
down. Until then nothing bad seemed
to be happening in the world, but suppose that you look not
at the Dow, suppose you looked–sorry.
Here’s a graph,
suppose you looked at the sub-prime mortgage index.
So you see it’s a hundred.
You’ll understand what these
things are. So a hundred means nobody
thinks there’s going to be a default.
Over here January 2007,
that’s ten months before the stock market starts to go
down–before it hits its peak. The stock market is still going
up here. A month later,
this is April 2007, a month later the sub-prime
index starts to collapse. You see it goes from a hundred
to sixty. We’re already–In February or
March 2007. So that means the people,
those experts trading mortgages, already realized
there was a calamity about to happen.
This was long before anyone
else perceived anything happening,
long before the stock market moved,
long before the government did anything to correct the problem.
So just as financial theory
says if you pay attention to the prices you can learn a lot about
the world. The people trading those
things–their life depends on fixing the right prices.
Probably they know stuff that
you don’t know. The prices are going to reflect
their opinion. If the price collapsed part of
the reason it collapsed, maybe margins and something had
something to do with it, but part of the reason it
collapsed was because they knew something bad was happening.
So for two and half years we’ve
known there’s going to be a major catastrophe in the
mortgage market. To go from a hundred to sixty
and since to twenty is a total calamity.
So you know that there are one
point seven million people who have already been thrown out of
their houses. Another three and a half
million aren’t paying their debts and are seriously
delinquent. Probably all of them will be
thrown out of their houses, and another four or five
million after them might default and have to be thrown out of
their houses. So it’s a major catastrophe and
the market told us and warned us about it two and a half years
ago and nobody’s done anything about it,
basically, until now as we’ll find out.
So it’s not that I think
financial theory, the standard financial theory
is wrong I think it’s incredibly useful.
I just think it has to be
supplemented by a more general and richer theory.
Maybe I should show you how my
hedge fund has done just so that you don’t think that it was a
total failure. Oh dear, where is my returns?
Here we go, EMG returns,
it’s sort of interesting. So Kidder Peabody went out of
business in 1994. There was a tremendous crash in
the market, a low of the leverage cycle.
The purple is Ellington,
that’s the hedge fund. You’ll see that these are other
investment opportunities. The S&P 500 is the green
thing which looked like it was doing great for a while.
Emerging markets is the blue
one, and high yield is the green one,
and then there are bunch of other things like treasuries,
and this is Libor which is what banks lend to each other at.
So this says if you put your
money into any of those strategies,
in Libor, keep lending your money each month to a bank and
seeing what interest you get and seeing how much money you
accumulate, or putting your money in
Ellington and looking at the purple,
or putting your dollar into the stock market and see what
happens, the S&P 500,
this is what happens. So you see there was a crash
here. You’re fired, you’re fired.
So we start Ellington and
Ellington does great, and so we have all these years
we’re doing great. Then ’98 there’s another crash.
Look what happened.
we lost a huge amount of money. We almost went out of business.
Long Term Capital,
which, by the way, was run partly by two Nobel
Prize winners, Merton Miller,
not Merton Miller, Myron Scholes and Robert
Merton, two of the guys I mentioned who
were the leaders of the financial crisis [correction:
leading finance academics], they bankrupted their company
and they went out of business. And why did they go out of
business? Because they weren’t aware of
the leverage cycle, in my view.
Anyway, so the prices collapsed.
Then look it,
all these returns shoot up again and the world seems to be
doing great, the stock market, everybody’s doing great.
Then there’s another crisis in
2007. Everything plummets all
together this time and then everything is going up again.
So it’s hard to see this and to
live through that. So I remember in ’98,
for example, when there was a margin call.
Our lenders called and said,
“We want more money. We don’t believe that the
assets are worth as much as they were and so the collateral is
not covering the loan anymore.”
And we said,
“You can’t make a margin call.
It’s not legal.
You promised not to change the
margins on us for six months. You can’t make a margin
call.” And they said,
“Well, blah, blah, blah, we don’t really
know about that. We’re making a margin
call.” So we called up Warren Buffett
and we said, “This is terrible.
They’re making a margin call.
They can’t do this.
We have great bonds.
There’s nothing wrong with the
bonds. They’re going to force us to
sell all the bonds to pay them the money, and how can they
force us to do that? They shouldn’t force us to do
that. We’ve got great bonds,
it’s a great business, it’s a great company and
they’re going to run us out of business.
You can’t let this happen.
Warren Buffett why don’t you
buy part of the company and save us and you’ll get rich and it’ll
be great.” He said, “Say that
again.” And we said,
“Well, they’re going to force us to sell all the bonds
on Tuesday to meet their margin call and we’ll get terrible
prices for the bonds and we’ll be driven out of business,
even though they’re great bonds, just because they’re
making a margin call. You can’t let this happen to us.
Buy part of the business and
save us and you’ll get rich. You’ll own part of a great
company.” And he said,
“Hell, it sounds like I should just show up on Tuesday
and buy the bonds.” So we survived.
I’ll tell you more about what
we did. We survived that,
no thanks to Warren Buffett, although he had a pretty good
idea, and then we survived the last crash.
So we survived all these
crashes, but the fact is things go up, they crash,
they go up, they crash, they go up.
Could it all be my fault?
I decided it can’t be all my
fault. It’s got to be there’s
something more basic at work and that’s why I’m going to tell you
about the leverage cycle. Now, of course,
I realize that my pet theories may not turn out to be right,
although I think more and more people are starting to think
there’s something to it. So I’m not going to spend a
huge portion of the course just talking about my pet theories.
I mean, I recognize that I have
to teach partly what’s standard. So the course is going to be
divided in the following way. I’m going to talk about the
standard no-arbitrage Financial Theory,
and I’m going to talk about it theoretically and mathematically
and from a practical point of view,
because helping to run the hedge fund–
lots of the things that I’ll be teaching are things that we
actually confronted in the hedge fund.
And so you’ll get the standard
financial theory course taught from a hedge fund perspective
both theoretically and from a practical point of view.
On the other hand,
I’ve lived now through three mortgage crises and so it seems
silly for me not to describe how the mortgage market works,
even through you’ll find almost none of that in any standard
finance textbooks, how the mortgage market works,
and what’s going on, and what happened in the
crises, and how we survived and how other people didn’t.
And I’ll talk about the
leverage cycle. I’ll also spend some time–I
think it’s quite important–on the mathematical logic of the
invisible hand argument. That’s the most important
argument in economics that the free market does good for the
economy and a huge number of people believe it.
And part of that argument and
part of the sort of hazy knowledge of that argument is
what drives resistance to a lot of government programs.
I mean, the government can only
screw things up is what people generally believe.
Is it a prejudice or is there
some actual argument behind that?.
Well, I want to go over that
argument and show you precisely how it works and how it doesn’t
work in the financial sphere. And then, I want to talk about
Social Security. That’s one more program.
That’s the biggest program in
the budget. It’s as big as defense and the
two of those are much bigger than everything else,
vastly bigger than every other thing in the budget.
So I want to talk about Social
Security and should it be privatized and should it be
reformed and why did it go bankrupt.
It’s also an interesting
mathematical problem because Social Security critically
involves the belief that things will go on forever,
so there’s an infinity in it. Each generation the young are
paying for the old. Nobody would do that if they
thought they were going to be the last generation paying to
the old, and when they got old nobody would help them.
So Social Security rests on
this world going on forever which makes it mathematically
interesting. Anyway, so I got interested in
it from a theoretical point of view and then I got put on all
these National Academy panels on Social Security and privatizing.
And so I know quite a bit about
it so I might as well talk about something I know about,
so that’s why I’m going to talk about that.
All right, so this is too hard
for you to read so let’s do this.
So let me just give you a few
examples. Uh-oh, I hope I didn’t do a
terrible thing. No.
So let me just give you a few
examples here of the kinds, just so you realize there’s
something to the Standard Theory.
There’s a lot to it.
So I’m going to give you ten
examples very quickly, of the Standard Theory.
So these are things that I’m
guessing you’ll have, at least some of them,
trouble figuring out how to answer now,
but by the end of the course this should be totally obvious
to you. So suppose you win the lottery,
forty million dollars, it’s a hundred million dollars,
the lottery. Now they always give you the
choice. Do you want to take five
million a year over twenty years or just get forty million
dollars right now? Which would you do and how do
you think about what to do? So now you get tenure at Yale
at the age of 50, say.
You’re making a hundred fifty
thousand dollars a year and you think professors–
it’s going to go up with the rate of inflation,
and that’s about it for the next twenty years until you
retire. So that’s twenty years of that
and then you’re going to live another twenty years when you’re
going to be making nothing. So how much of the
hundred-fifty-thousand, and let’s say inflation is
three percent, and what you’d like to do is
consume inflation corrected the same amount every year after you
retire and before you retire, and so how much of the
hundred-fifty-thousand should you spend this year and how much
should you save? You’ll learn very quickly how
to do a problem like that. Now, President Levin wrote a
few months ago, the end of last year if you
remember, he said that, “Well, the crisis was bad.
Yale was going to weather it,
but Yale had lost twenty-five percent, probably,
of its endowment. That’s five-billion dollars
almost of the twenty-three-billion dollar
endowment. So how much should he choose to
cut? It’s his decision.
How much should Yale reduce
spending every year? The total spending at Yale is a
little over two-billion. So the endowment goes down by
five-billion what cuts should you take to the budget.
Should faculty salaries be cut,
be frozen, should you get three TAs instead of four TAs?
What should you do?
How big a cut should you take?
Now, the same question faced
Yale in 1996 or so. I’ve forgotten exactly the year.
Ten or twelve years ago the
previous president, Benno Schmidt,
he suddenly noticed that there was deferred maintenance,
as he called it, a billion dollars to fix the
Yale buildings. That’s why, incidentally,
every year another college gets fixed.
They decided there was deferred
maintenance of a billion dollars.
A hundred million dollars every
year for ten years had to be spent.
The whole endowment then was
three billion, and now we had a one billion
dollar deferred maintenance problem.
The budget was about one
billion then. So how much should you cut the
Yale budget at that time? So Benno Schmidt said,
“I’m firing fifteen percent of the faculty.”
He announced he was firing
fifteen percent of the faculty. That was on the front page of
the New York Times, “Yale to fire
faculty.” Well, did he make the right
decision? Rick Levin took over as
president three months later, so probably not.
What mistake did he make in his
calculations? What should he have done?
What was the right response?
We’re going to talk about it.
It’s not that hard a problem.
Now, let’s take a slightly more
complicated one. You’re a bookie.
The World Series is coming up.
The Yankees are playing the
Dodgers, let’s say, and you know that
the teams are evenly matched and you’ve got a bunch of friends
who you know every game will be willing to bet at even odds on
either side because they think it’s a tossup.
Well, one of your customers
comes to you and says, he’s a Yankee fan,
he’s sure the Yankees are going to win the series.
He’s willing to put up three
hundred thousand dollars to bet on the Yankees.
So if the Yankees win he gets
two hundred thousand, but if the Yankees lose he
loses three hundred thousand. So 3:2 odds he’s willing to bet
on the Yankees winning the series.
Well, you say,
“This guy’s sort of a sucker here.
I can take big advantage of him.
On the other hand it’s a lot of
money, two hundred thousand I might lose if I have to pay off
and the Yankees win. So even though I think that my
expected profit is positive, because he’s putting up three
hundred thousand to make only two hundred when they’re even
odds, in fact–the fact is it’s such
a big number I’m a little worried about that.”
So what do you do?
So what can you do?
You’ve got these friends who
are willing to bet at even odds each game by game,
so how much money–Presumably the first night you’re going to
bet with one of your friends. You take the guy’s bet,
the customer, you take his three hundred
thousand. You promise to deliver him five
hundred back if the Yankees win and to keep it if the Yankees
lose. What should you do with your
friends? Should you bet on the Yankees
with your friends? Should you bet on the Dodgers
with your friends and how much should you bet at even odds the
first night? So the answer is,
well, I don’t want to give all the answer now,
but so there’s a way of skillfully betting with your
friends and not betting two hundred or three hundred
thousand the first night with your friends at even odds.
You bet some different number
than that, which you’ll figure out how
much to bet so that if you keep betting through the course of
the World Series you can never lose a penny.
How do you know how much that
is? Well, that’s the kind of clever
thing that these finance guys developed and you’re going to
know how to do. So let’s do another example
like that. I’m running out of time a
little bit, but an example. Suppose there’s a deck of
cards, twenty-six red and twenty-six black cards.
Somebody offers to play a game
with you. They say, “If you want to
pick a card and it’s black I’ll give you a dollar.
If it’s red you give me a
dollar.” So if I’m picking,
I’m in the black, I get a dollar,
it’s in the red I lose a dollar, I have to throw away the
card after I pick it. The guy says,
“By the way, you can quit whenever you
want.” So should you pick the first
card? It looks like an even chance of
winning or losing. Let’s say you pick the first
card, it’s black, you win a dollar.
Now the guy says,
“Do you want to do it again?”
You picked a black one so
there’s twenty-six red left and twenty-five black.
So now the deck is stacked
against you. Should you pick another card?
Well, it doesn’t sound like you
should pick another card. But you should pick another
card and I can even tell you how many cards to pick.
Even if you keep getting blacks
you should keep picking and picking.
So how could that be?
It sounds kind of shocking.
Well, it’s going to turn out to
be very simple for you to solve half way through the course.
So, a more basic question.
There are thirty year mortgages
now you can get for five and three-quarter percent interest.
There are fifteen-year
mortgages you can get for less, like five point three percent
interest. One’s lower than the other.
Should you take the
fifteen-year mortgage or the thirty year mortgage?
How do you even think about
that? Why do they offer one at a
lower price than the other? One more example,
suppose you’re a bank and you hold a bunch of mortgages.
That means the people in the
houses, you’ve lent them the money, they’re promising to pay
you back. And you value all those
mortgages at a hundred million dollars.
The interest rates go down.
The government lowers the
interest rates. Half of them take advantage to
refinance. They pay you back what they owe
and they refinance into a new mortgage.
So now you’ve only got half the
people left. Let’s say all the people had
the same size mortgage and everything.
Half the people are left.
That shrunken pool,
half as big as the original pool,
is that worth fifty-million, half of what it was before,
or more than fifty-million, or less than fifty-million?
How would you decide that?
Again, this is a question which
might be a little puzzling now, but actually you should be able
to get the sign of that today even,
and we’ll start to analyze it. So that’s what mortgage traders
have to do. They see interest rates went
down. A bunch of people acted.
The people who are left in the
pool are different from the people who started in the pool.
Now we’ve got to revalue
everything and rethink it all, so how should we do that?
Let’s say you run a hedge fund
and some investor comes to you and says, “Oh,
things are terrible. Look at all the money you lost
for me last year. I know you’re doing great this
year and you’ve made it all back that you lost last year,
but I don’t want to run that risk.
So I want to give you my money,
a billion dollars, I want to get these superior
returns you seem to earn, but you have to guarantee that
you don’t lose me a penny. I don’t want to run any risk.
I want a principal guarantee
(it’s called) that when I give you a hundred dollars you’ll
always return my hundred dollars,
and hopefully much more, but never less than a hundred
dollars.” So is there any way to do that?
You know that you’ve got a
great strategy, but of course it’s risky.
You could lose money.
You’ve lost money a bunch of
times before. So how can you guarantee the
guy that he’ll get all his money back and still have room to run
your strategy? Well, it sounds like you can’t
do it, but of course a lot of people want to invest that way,
so there must be a way to do. So you’ll figure out–we’ll
learn how to do that. So, three more short ones.
A scientist discovers a
potential cure for AIDS. If it works he’s going to make
a fortune. He started a company.
He’s a Yale scientist,
he’s–medical school, started this startup company.
Yale, of course,
is going to take all his profits, but anyway it’s his
startup company and if his thing really works he’s going to make
a fortune. If it doesn’t work it’s going
to be totally zero. You calculate,
and let’s say you believe your calculation,
that the expected profits that he’ll make if it works,
the probability of it working times the profit,
that expected profit is equal to the profits of all of General
Electric. Should his company be worth
more than General Electric, the same as General Electric,
or less than General Electric since it’s got the same expected
profits? Well, I can tell you the answer
to this one because I think most of you would think,
first you’d think, “Well, maybe the
same.” Then you’d say,
“Well, this AIDS thing it’s so risky.
It’s either going to be way up
here or nothing, and that’s so risky,
and General Electric is so solid,
probably General Electric is worth more.”
But the answer is the AIDS
Company is worth more. So how could that be?
So another question,
suppose you believed in this efficient market stuff and you
rank all the stocks at the end of this year from top to bottom
of which stock had the highest return over the year.
It’s 2010, let’s say 2010,
this year’s a weird year. So let’s say you do it in 2010.
All the stocks the highest
return to the lowest return. Now, suppose you did the same
thing in 2011 with the same stocks?
Would you expect to get the
same order, or the reverse order, or random order?
Now again, if you believe in
efficient markets and the market’s really functioning,
the prices are fair and all, I’ll bet most of you will say,
you won’t know, but you might say it should be
random the next time, because firms only did better
or worse by luck, but that’s not right either.
So you’re going to know how to
answer that question by the end of the class.
One last one,
the Yale endowment over the last fifteen years has gotten
something like a fifteen percent annualized return.
A hedge fund,
that I won’t name, has gotten eleven percent over
the last fifteen years counting all its losses and stuff like
that. So is it obvious that the Yale
endowment has done better than the hedge fund?
Would you say that the Yale
manager is better than the hedge fund manager?
Its return was fifteen percent.
The hedge fund only got eleven
percent. So I’m asking the question,
and I would say that David Swensen would think about it the
same way I think about it. So suppose I even told you that
the Yale hedge fund had lower volatility–
the Yale hedge fund?–the Yale endowment had lower volatility
than the hedge fund, which it surely does,
would that convince you now that the Yale endowment had been
managed better than the hedge fund?
Well, we’re going to answer
this question again, and you’re going to see that
the answer’s a little surprising.
It won’t be so surprising–I
wouldn’t have brought it up otherwise.
But anyway, that’s the kind of
thing that in finance you’re taught to think about.
So the crisis of 2007,
which we’re going to spend a long time talking about,
I just want to get back to that subject.
So that list of questions were
the kinds of things that I used to teach for years before I was
confident about my theory of crises,
and this is the kind of questions you have to face all
the time in hedge funds, and decisions you have to make,
and things you have to tell investors,
and so that’s the basic part of the course,
but I want to say more. So I want to talk about the
crisis of 2007-2009. It started as a mortgage crisis.
Now, how could it be that
everything goes wrong in mortgages?
I mean, they’re four thousand
years old. The Babylonians invented
mortgages. What is a mortgage?
You lend somebody money.
They put up collateral.
They don’t pay you take the
house or you take the guys life, he’s a slave or something,
but it’s the same thing. You borrow money and the guy
promises you can confiscate something if he doesn’t pay.
Four thousand years and we
screwed it up. How could that be?
And why should a screw up in
the mortgage market have such a big effect on the rest of the
economy? Were sub-prime mortgages a
terrible idea? Was there some logic to it?
And how did we get out of the
crisis? How is it, that everybody was
saying this is the worst crisis since the Depression,
may be another Depression and things seem to have turned
around. What is it that we did to get
things to turn around? I don’t think we’re out of it
yet, but things are a lot better than they were a year ago.
So what is it that the
government did to turn things around?
It didn’t do nearly enough,
I think, but it did something. What exactly did it do?
Now, Shiller would talk about
the whole thing was irrational exuberance.
I’m going to say it’s all the
leverage cycle, but anyway so that’s the
mortgage crisis. Now, are free markets good?
I want to talk about the
argument. The argument was first made by
Adam Smith about the invisible hand.
The modern mathematical
argument is Ken Arrow’s, my thesis advisor.
And of course everybody knows
that monopoly and pollution and things like that interfere with
the free market and they have to be regulated.
But the financial markets,
there’s no monopoly. As long as there’s no monopoly
and there’s no pollution shouldn’t the free market
function there? So I want to go over that
argument and show you what was missing in it,
as I said before, and then lastly we’re going to
talk about Social Security and how could that system be going
bankrupt. I mean, it just seems shocking.
There’s a two-trillion dollar
trust fund that’s going to run out in 2024 or something and
after that the system will be broke.
So how did it happen?
Why is it broke?
What can we do to fix it?
So George Bush said,
“Well, it’s terrible. Even if we manage to sort of
get the trust fund rehabilitated young people like you are going
to get a two percent rate of return.
If you put your money in the
stock market, even allowing for the last
crash, over the long haul, the returns have been six
percent. So it’s terrible,
Social Security. Something’s wrong with the
system. We should privatize it and let
young people like you put your money in stocks instead.”
Well, Gore, in the debate in
2000 said, “You can’t do that because
then the old people who are expecting their money can’t get
paid.” And both of them agreed that it
was all the baby-boomers’ fault. People like me we’re getting
old, we’re going to retire. That’s why the system’s going
to get broke. So that’s the conventional
wisdom. All three of those things are
wrong, so we’re going to find out why.
So in summary,
why study finance? It’s to understand the
financial system, which is really part of the
economic system. It’s to make informed choices.
Is privatizing Social Security
a good or bad thing? Is regulation of financial
markets a good thing? The language that you learn is
the language that’s spoken on Wall Street, and was created by
professors and yet practitioners use it.
For me it’s incredibly fun,
all these little puzzles. As J.P. Morgan said,
“Money’s just a way of keeping score.”
You have to figure out what
something’s worth in the end and if you get it right you’ve
solved the puzzle right and it’ll help you make good
financial decisions in a pensioned career.
That’s the standard reason to
take Finance. Now, the prerequisites of the
course, so I want to make this clear, you don’t really need
ECON 115. It would be helpful because
this logic of the free market being good or bad,
that was already started in ECON 115.
That’s what they call it now,
right? It’s still called 115.
I used to teach it but I
haven’t done it for years. So anyway, what you really need
is mathematical self-confidence. It’s not going to be high math.
It’s going to be simple math,
but it’s relentless over and over again.
And I can tell you that every
year there’s the five percent of you,
let’s five or ten out of the hundred-twenty are going to just
get bored doing problem after problem and you’re probably not
that, you know, those ten maybe
haven’t that much experience doing it,
don’t feel very confident doing it,
stop coming to the class and then really have no idea what’s
going on. My sister is probably much
smarter than I am, but she doesn’t like math.
She wouldn’t take this course.
So if you’re not confident
doing little mathematical problems just don’t take the
course. You’ll save yourself a lot of
trouble. I don’t know how to say this
any better. I want to warn you not to do it.
It’s easy math,
but it never stops. Every week there’s going to be
a problem set. The exam–there are problem
sets. The exam is doing problems just
like the problem sets, but if you don’t like that,
you know, to me finance is a quantitative subject.
What’s so beautiful about it in
one aspect I really like is that you have these complicated
different things you have to weigh,
but at the end you have to come up with one number.
What is the price you’re
willing to pay for something? It’s very concrete.
I’m going to take advantage of
the concreteness by turning every question into a number.
I hate it when you get on the
one hand and on the other hand. It’s a number.
So if you don’t like numbers
it’s not a good course to take. So what are the kinds of things
you have to know? You have to understand the
distributive law of arithmetic (which, I have little kids and I
see that’s not so easy to understand).
Anyway, and then you have to
understand the idea of a function which is a contingent
plan. Simultaneous equations;
that’s what we do for equilibrium in arbitrage.
Taking a derivative,
that’s marginal utility. The idea of diminishing
marginal utility, a concave function looks like
that. That’s risk aversion.
Bankers invented the logarithm,
compound interest, so you have to know what taking
a logarithm and exponential means,
and you have to understand how to take probability weighted
averages of things. And we’re going to use Excel
for a lot of the problems which we’ll teach you.
By the end of a day you’ll be
better at it than I am. So my office hours are four to
six. My secretary assistant is
Rendé, there’s an accent missing as
she always tells me, Wilson.
She just started three days ago
but I’m sure she’ll be great. There are going to be two
lectures a week and a TA section.
So every Tuesday there’ll be a
problem set starting this Tuesday due the next Tuesday.
There will be two midterms.
There’s a lot of stuff to learn
and so I found, everybody I think agrees who’s
taken the course, if you take the midterm it’ll
focus your mind and make it a lot easier,
so I give two of them so you only have half the course to
study. It makes the final much easier
to study for. I recognize that some of you
will have problems on one of them,
like especially the first mid-term,
and if you do vastly worse on one exam than the rest I’ll tend
to ignore that, but most people don’t,
by the way, do vastly worse on one exam than the rest.
So the final’s forty,
the problem set’s twenty, and the two midterms are twenty
percent. Tuesday to Thursday,
and so all the TA sessions are Thursday to Monday so they’re
going to start next Thursday. So you see the classes are
Tuesday-Thursday then the next Tuesday.
There’s a long time in-between
here so all the TA sessions will meet there.
So they’re at the same moment
in the class. There are all these textbooks,
all by the Nobel Prize winners, all by those financial greats.
You can buy any one of them,
but I have my own lecture notes because as I say I teach a
slightly unconventional course and there’s a huge list of books
on the crisis. Some of them are incredibly
interesting and fun, and so they’re all on the
reading list you can take a look at.
I mean, there’s never been a
more fun time to read this stuff now.
So course improvements, anyway.
So that’s it.
Are there any questions about
how the course runs, or how I will run it,
or whether you think you should take the course,
or whether your preparations–So if you haven’t
taken ECON 15 it’s okay, 115, but you’ve got to be
confident that you can solve problems,
otherwise don’t do it. Any questions?
Student: So the first
problem set will be assigned next Tuesday?
so next Tuesday it’s going to be due the Tuesday after.
So I know that’s early,
but you probably already know whether you’re going to take the
course or not. Yes?
Student: Will you teach
this next year? Prof: Will I teach it
next year? Actually I probably won’t
because I’m going to go on leave, but I might,
but probably not. Someone else will teach it.
Student: Which of the
books do you suggest we buy? Prof: They’re all good.
They’re all famous people
who’ve written. They’re trying to sell copies
so they’re pitched at a quite low level, but they’re very
good. Anyone of them is good.
Merton’s book is good.
Steve Ross is a friend of mine.
He used to teach at Yale,
so his book is good. So any one of those is very
good, but they’re not quite at the same mathematical level
because they’re trying to sell thousands of books,
and they stick pretty closely to this financial view of the
world that everything is efficient.
Student: Will the taped
lectures be available online? Prof: That’s a good
question. I don’t think so.
No, they’re shaking their head.
So it won’t be in time for you,
but it will be if you want to look back in your old age,
“I was there. I saw the leverage cycle.”
Student: Are the lecture
slides posted before or after the lecture?
the lecture notes are all posted already before the class.
So the first twelve of them are
there, and I’m changing them each year so there’ll be some
changes. So last year’s first twelve are
there and they might change a little bit, but you can already
get an idea of what they’re about.
This first lecture is not on,
but the rest of them are. Any other questions?
Student: When do we sign
up for the TA sections? Prof: Oh,
you should be signing up now. I don’t know how to do this.
It’s online or something, right?
You sign up online.
Yeah, so you should pick your
sections. We might add another section if
all of you stay, but probably you won’t,
but if we do we’ll add another TA section.
Student: What’s the
grade distribution? Prof: The grade
distribution? I don’t know.
The standard Yale junior level
course grade distribution which is when I was at Yale things
were much tougher, so it’s the standard
distribution. I don’t remember it offhand.
But I’ll tell you all about the
distribution at the midterm. So there will be a midterm
before–you’ll have chance to drop the course after the
midterm and then there will be another midterm right at the end
of the course. Yes?
Student: What level of
math and type of math should we be comfortable with to take the
course? Prof: I was trying to
say that. I’m glad you asked me again.
So I went over the things that
you have to know. If you have 3x-4x^(2) you have
to be able to take the derivative of that which is
3-8x. If you’ve got the log natural
of x you have to take the derivative.
It’s one over x.
If you’ve got 3x 5=10 and
2x-7=12 you have to be able to solve that simultaneous
equation. So that’s the kind of thing you
have to do, and you have to be able to do it quickly and with
total confidence that you’re doing it right.
And for many of you that’s no
problem, but for some of you who are
maybe even smarter than everybody else that’s a problem,
and so you’ll have to judge yourself whether you can do that
comfortably so you don’t have to worry about the mechanics of
doing that. You can think conceptually
about what the question is asking.
When does this end,
ten of or quarter of? Student: Ten of.
Prof: Ten of,
so we have 13 minutes. I want to end with one
experiment. So (Teaching Assistant),
can you help me with this? So this is something we’re not
going to have time to figure out the answer to.
So I need sixteen volunteers.
How about the first two rows?
Why don’t you just volunteer.
and I know it’s a drag but you’ll do it.
What I’m going to do now is I’m
going to run an auction. So please stand up and eight of
you go this side and eight come over here.
That’s okay, you’ll be okay.
I know everyone’s reluctant to
do this. So I only need sixteen.
(TA), help me count them.
Two, four, six,
eight, you guys have to come the other way.
The TAs aren’t going to
participate. You’re not in this, right?
Two, four, six,
eight so we only need eight, you both sat down.
So would you like to
participate? Come on.
We could use another woman here.
Two, four, six,
eight, there are eight of them? So can you mix these up?
There are going to be eight
sellers and eight, we say seller,
right? Buyer, so shuffle them up and
hand one to each. So we’ve got eight,
and these are the football, they’re selling.
So we’ve got eight sellers and
eight buyers, and I don’t know whether you’ve
ever seen this experiment before, but shuffle them,
right? Student: They’re all
sellers though. Prof: They’re all
sellers, but you’ve got to shuffle them.
On the other side there’s a
number. So we’ve got eight sellers here
and eight buyers. So each seller knows what his
football ticket is worth, or hers, so please take one.
Student: I have a seller
one. Prof: Oh,
you have a seller one? That’s bad.
Prof: I’m blind.
Student: Thank you.
Prof: Buyer, thank you.
Does this say buyer and buyer?
You should be one short.
Here’s an extra.
So there are eight sellers and
eight buyers. They’ve got the football
tickets. Each of them knows what the
football ticket is worth to her. There are three women here and
only two, so these are the “hers”.
She knows exactly what it’s
worth to her. So say it’s fifteen.
The football ticket’s worth
fifteen. Now if she can sell it for more
than fifteen she’s going to do it.
She’s going to make a profit.
If she sells it for less than
fifteen she’s not a very good trader.
She’s not going to do that.
She’s going to say,
“If I can get more than the football ticket is worth I’m
going to sell it. If I can’t get more than it’s
worth I won’t sell it.” So everybody knows what the
football ticket is worth to herself.
All these guys,
they know what the ticket is worth to them.
So say someone thinks it’s
worth thirty that guy’s going to say,
“If I can get it for less than thirty,
like for fifteen, I’m going to get it.
That’ll give me a profit of
fifteen. If I can only get it for forty
I’m sure not going to do that because I’m paying more than I
think it’s worth. So you all got that?
You have a reservation value
yourself. You don’t want to pay more than
it’s worth because then you’re losing money,
and they want to sell it for more than they think it’s worth
because then they’re making money.
So nobody knows anybody else’s
valuation. The information is distributed
completely randomly across the class.
Now this is a famous experiment.
I’m not the first one to run
it, although I’ve done it for ten years.
I do it in my graduate class,
in my undergraduate class, the undergraduates,
by the way, always do better than the graduate students.
So this knowledge is
distributed in the whole environment,
and we’re going to see what happens when I start a chaotic
interaction between all of these sixteen people.
What’s going to happen?
And you would think it’d be
total chaos and nothing sensible is going to happen.
And if that does happen it’ll
be very embarrassing for me. But what the efficient markets
guys would say is, “Something amazing is
going to happen. The market is going to discover
what everybody thinks it’s worth and figure out exactly the best
and right thing to do and that’s what’s going to happen.”
Now, it’s hard to believe that
with this little preparation that you’ve had,
zero, zero training, zero experience,
and you’re only going to have two minutes to do this.
So see the class has got eight
minutes to go. You’re going to miss the grand
finale. Anyway, so you’ve only got
eight minutes to go. So with only two minutes of
training they’re going to get to a result,
which if I had to do it myself and read all the numbers and
sort them out and sort through them would take me much more
than two minutes, and all this is going to happen
in two minutes. It’s hard to believe.
It probably won’t happen this
time. So here are the rules.
I’m going to put you all
together. Start inching your way towards
each other, and try not–now, when I say go,
which won’t be for two minutes you’re going to start yelling
out an offer. So if you think it’s worth
fifteen and you’re a seller you’re not going to sell it for
fifteen. You’re going to say give me
twenty, or give me thirty, or give me twenty-five.
You’re going to try and get as
much as you can. You have to yell it out.
The buyers are going to be
making their offers. When two of you see that
there’s a deal you have to shake hands, exchange the football,
and leave, and tell your numbers to (TA).
(TA), you’re going to stand
outside the group that way. So once you make a deal you
just leave and tell what’s happened to (TA) who’s now
standing back here, back there.
So it has to be public outcry.
It’s very important that you’re
yelling these things publically and all the other people can
hear you, and you’ve only got two minutes.
Now two minutes sounds like an
incredibly short period of time, which it is,
but it’s much longer than you think, wait, quiet here.
You shouldn’t trade–I’m giving
you valuable advice– you should not trade in the
first ten or fifteen seconds because you have to hear what
everybody else is offering. If you trade right away you’re
probably doing something really stupid.
though, it sounds short, is actually a very long period
of time. So be patient.
Try to get the best possible
price and we’ll see what happens.
Any questions about what you’re
doing? And now, in the heat of the
moment you might be so frustrated that you can’t sell
when you think it’s worth fifteen that you sell it for
ten. I’m going to expose you in
front of all these people if you do that, so keep track of what
you think the thing is worth. All right, any questions
anybody about what is going on? So you have two minutes.
Is there a second hand there?
I can’t see it.
Student: It’s on the
ten, or coming to. Prof: Where is it?
Student: Now it’s on the
three. Student: It’s moving.
Prof: It’s on the three.
I think I see something.
When it gets to the four we’re
going to start. So start, go.
>Prof: Oh, no collusion.
>Prof: Come out and tell
(TA). If you made a deal tell (TA).
>Prof: How much time is
left? One minute left,
plenty of time, one minute.
Any other deal made?
Write down the price and the
two, what price they agreed. How much time?
Twenty-five seconds, stay cool.
How much time?
How much time?
I can’t see.
Don’t make any mistakes,
ten, five, four, three, two, one,
stop. Did you get all the numbers?
>Prof: Give me back the
tickets. Student: Was this
designed to make us look bad on camera?
Prof: Give me back the
tickets. Student: You designed
this to make us look bad on camera.
you’re going to look great on camera, you are.
Give me all the tickets back.
(TA), you getting done there?
Teaching Assistant: Yeah.
Prof: All the tickets.
I need them all back,
all the stuff. God, you’re big folders here.
These tickets have lasted ten
years until you guys took over. They’re all crumpled up.
All the tickets,
I need them all back. You can sit down now.
Everybody’s reported in?
Now let’s see what happened.
You’ve got them all?
Teaching Assistant: Five
traded. Prof: Five bought and
sold. So here’s what happened.
Here were the numbers.
So we have five minutes just to
look at this. So all the buyer prices are in
blue, forty-four, forty, thirty-six,
you should recognize these you buyers, and the red ones were
the sellers. So you notice that every
seller, for everybody there’s a seller who’s underneath.
So it could have happened that
thirty-eight sold to forty-four, and thirty-four sold to forty
at thirty-seven, and twenty-eight sold to
thirty-six at thirty-two. You could have had eight trades.
So what did happen?
Nothing like that happened.
You had five trades,
five pairs of people traded, and there are those three poor
schlumps, pairs of people at the end
looking despondent, hopeless, unable to trade,
worried that they were on camera.
Now, let’s see,
who are the people who traded? So, (TA), name the buyers who
bought. Teaching Assistant: I
don’t know the names. Prof: The prices.
Teaching Assistant: The
seller got it for nine and managed to sell it for twenty
dollars. It was all quick so I don’t
have everybody’s name, because they were all rushing.
Prof: You got them.
Teaching Assistant: I
got them.. Prof: That’s
everything, great. Teaching Assistant: I
just don’t have their names. Prof: Here’s what
happened. Mister seller ten sold to
thirty-six at a price of twenty. Mister seller nine sold to
buyer twenty, so nine, there is no nine.
Teaching Assistant: Six.
Prof: Nine sold to
twenty at a price of what? Six.
Sorry. Prof: That’s okay.
So seller six sold to twenty at
a price of twenty. Student: Yeah,
even though it’s cheaper>
no, buyer twenty paid twenty, so seller six did well.
We won’t ask who buyer twenty
is. Buyer twenty is going to screw
everything up. So Buyer fourteen through–I
can’t read this either. Teaching Assistant:
Forty-four. Prof: Buyer fourteen
sold to buyer forty-four for twenty,
and buyer twenty sold to buyer forty for twenty-two,
and seller twenty-four sold to buyer thirty for twenty-five.
So five people traded,
now which five were they? The sellers were ten,
six, fourteen and twenty-four, one, two, three,
four, five, the bottom five. The five buyers were
thirty-six, twenty, forty-four, forty and thirty.
So basically forty-four,
forty, thirty-six, thirty, twenty-six didn’t buy,
twenty bought instead. So if you look at it,
so it’s not quite the way theory would have predicted,
but almost. If you look at it,
if you just shuffle the order and you put the sellers,
instead of from top to bottom you put them from bottom to top,
you get what looks like a demand curve and a supply curve.
And so what happened?
All these five people ended up
selling, one, two, three, four,
five, those are exactly the sellers.
The price they sold for was all
between twenty and twenty-five, and the five buyers were
forty-four, forty, thirty-six, thirty.
Twenty-six didn’t manage to
buy, but twenty bought. So what is the theory of the
free market? The theory of the free market
says, “This chaotic situation
where they had less than two minutes to decide what to do
could be analyzed as if you put a demand curve together with a
supply curve and there was one price that they miraculously
knew. Here it should have been
twenty-five. It turned out to be twenty or
twenty-two that all the trade took place at.
At that one price you get all
the trades happening. The people have the highest
valuation buyers they’re the ones who get the tickets.
The people with the lowest
valuation sellers sell it. So the people who end up with
the tickets are these red guys at the top and the blue guys at
the top. All the tickets go from the
people who value the stuff least to the people who value it more.
So the market has done an
extraordinary thing in two minutes.
So there was one mistake.
Mister or miss twenty,
whose identity we are protecting, although I’m
searching the faces, mister or miss twenty got a
very bad deal. She or he, let’s say he,
bought at twenty when the value was twenty.
That was a horrible deal.
He didn’t get any extra out of
it. So he should probably have only
bought if the price were lower, and then twenty-six would have
bought instead of twenty. So twenty sort of squeezed his
way into the market, so twenty-six and twenty
between them somehow there was a slight inefficiency.
But basically with no training,
no background, no practice,
these sixteen undergraduates managed to reproduce–
they gathered all the information in the whole
economy, and they discovered who were
the eight people who valued the tickets the most and they ended
up with all the tickets. For me to do it and sort it out
would have taken longer. The market solves a complicated
problem, and gets information incredibly quickly,
and puts things into the hands of the people who value it the
most. And the marginal buyer thought
it was worth about twenty-five or twenty and that’s what the
price turned out to be. So anyway, we’re going to come
back to this parable at the beginning of the next class.