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  • Prof: So for those of you who weren't here yesterday--

  • or, last class, first class,

  • I'll say a couple words about what happened,

  • basically four words.

  • The course is really made of up four different elements.

  • The first part is the standard financial theory course that

  • grew up in the last ten years at a lot of major universities,

  • pioneered by a bunch of guys who won Nobel Prizes in business

  • schools.

  • And it's the method, some of them quite clever and I

  • think fun, methods for pricing financial assets and making

  • optimal financial decisions.

  • So you're going to learn all these tricks and how the

  • financial system works, and you'll learn it both from a

  • theoretical point of view, the way they thought of it in

  • these finance schools, and also from a practical point

  • of view since many of these very same problems come up all the

  • time in the hedge fund I helped start.

  • So that'll be the main part of the course, but there are three

  • other things that I want to concentrate on in the course.

  • So the second point is reexamining the logic of

  • laissez-faire and regulation.

  • This is a dramatic moment in our history now where there's

  • tremendous pressure on-- temporarily anyway--on the

  • government to establish all sorts of new regulations.

  • There's also tremendous resistance to establishing the

  • new sorts of regulations.

  • So there's a debate going on now in Congress and in the halls

  • of academia about what kind of regulations should we put in

  • place, what regulations would have

  • prevented the crisis we've just lived through.

  • The crisis, by the way, which I don't think we're done

  • with yet.

  • So there's a very powerful argument in economics.

  • The most famous argument in economics,

  • the invisible hand argument that basically says markets work

  • best when they're not encumbered by government interventions.

  • So we're going to reexamine that argument in the context of

  • financial markets.

  • Then the third thing I'm going to discuss in this course at

  • some length is the mortgage market and the recent crisis.

  • After all, my hedge fund is a mortgage hedge fund.

  • We founded it in 1994, by the way, which was--

  • the five years before that I was running the Fixed Income

  • Research Department at Kidder Peabody,

  • which was the biggest player in the mortgage market then on the

  • sell side.

  • The hedge funds buy mortgages, investment banks create and

  • sell the mortgage securities.

  • So I was running the research department at the firm that did

  • twenty percent of the market in what's called CMOs,

  • and then I changed to the buy side and was at a hedge fund

  • that bought those kinds of CMOs, and bought sub-prime mortgage,

  • CDOs, everything.

  • So it seems I suffered greatly through the last two years of

  • the mortgage crisis and it would just be foolish not to explain

  • what was going on and what it felt like to be in a mortgage

  • hedge fund while the rest of the world was collapsing around us.

  • And for quite a while it's given me some great

  • embarrassment to have been part of it all.

  • On the other hand, now I feel like one of those

  • survivors.

  • Hundreds of our counter-parties and much bigger mortgage players

  • went out of business and we didn't,

  • so I don't feel quite as bad about it as I did before.

  • And I don't know every detail of what went on in my hedge

  • fund, because after all I'm only part

  • time there, but there's a lot I do know

  • about and so I'll try and tell you some of that.

  • And then the fourth thing is Social Security.

  • This is the biggest government program and it's a financial

  • problem what to do about retirement,

  • and Social Security is the biggest government program of

  • all.

  • The only thing close is the military budget in terms of

  • annual expenditures.

  • And so I'm going to explain how that works, and what the problem

  • is, and how it arose, and what I think the solution

  • is.

  • So those are the four things the course is going to

  • concentrate on.

  • The mechanics of the course, again,

  • are homeworks, every week there's going to be

  • a homework with little problems illustrating what we're talking

  • about.

  • So there's one already on the web, Tuesday,

  • today, every Tuesday there will be one on the web.

  • It'll be due the next Tuesday.

  • The sections will always meet between Thursday and Monday,

  • so the problem set will come Tuesday.

  • You'll have two days of classes on the material that the problem

  • set will cover and then you can talk to the TAs about stuff

  • between Thursday and Tuesday when I presume you'll do the

  • problem set.

  • And that's twenty percent of the grade.

  • Twenty percent is the first midterm.

  • Twenty percent is the second midterm and forty percent is the

  • final.

  • Two midterms takes a lot of class time, on the other hand,

  • and it also takes a tremendous amount of effort by the TAs.

  • And so I appreciate their willingness to grade two

  • midterms, but I think you'll find it's

  • helpful to study the course in two pieces than try to do the

  • whole thing-- It'll be much better for you I

  • found in the past to have two midterms.

  • Oh, and one warning.

  • The course doesn't require difficult mathematics,

  • but for me, as I said in the first class,

  • it's very interesting that there are so many subtle things

  • that affect a financial decision,

  • and you have to think about what you know and all the

  • different things you know.

  • You have to think about what the other guy knows who's taking

  • the other side of the market.

  • You have to think about what he knows about what you know,

  • and you have to think about what he knows about what you

  • know about what he knows, and all that thing in the end

  • boils down to one number, the price.

  • So it's a philosophically interesting problem,

  • interactive epistemology.

  • Some people have described economics as interactive

  • epistemology.

  • It's more complicated than standard epistemology and

  • philosophy because there they go in circles thinking about what

  • one person knows and whether you can know that you know and stuff

  • like that.

  • In economics you have to worry about what you know,

  • what the other guy knows, what you know about what he

  • knows about what you know etcetera.

  • So it's a more complex problem, and yet at the end there's just

  • one number which can be right or wrong.

  • And so when I was a freshman here at Yale my roommate who was

  • a classics major said that his subject was much harder than

  • mine-- that was math--because all I

  • had to do was be right.

  • And so I'm going to take advantage of that simplicity and

  • every problem is going to have a number that you're supposed to

  • find.

  • And so it's not complicated mathematics, but it involves

  • lots of numbers.

  • And so if you hate numbers you shouldn't take this course.

  • And as I said before, there have always been people

  • who, you know, you can be very smart.

  • You can also have a great future in finance and not like

  • numbers.

  • You can like making deals and things like that not thinking in

  • terms of numbers.

  • So just because you don't like numbers and maybe shouldn't take

  • this course doesn't mean you should be discouraged about

  • finance.

  • It's just how I happen to teach the course because that's what's

  • comfortable for me.

  • So I'm just warning you about it.

  • It won't be hard, but it'll be relentless.

  • I want to talk today about that second problem,

  • about the logic of the free market and to do that I'm going

  • to have to introduce a model.

  • So it raises the question of what is a model in economics.

  • Many of you have taken economics before.

  • You sort of know what this idea is, but I think it's worth

  • spending a minute on it because it represented a revolution in

  • thought.

  • So for an economist a model means you distinguish exogenous

  • variables from endogenous variables.

  • The exogenous things people can't control.

  • They're just the weather and things like that.

  • The endogenous variables are things they can control and

  • you're trying to predict what the endogenous variables are

  • going to turn out to be like, what will the prices be,

  • what will the consumptions be, things like that.

  • How much income will people have?

  • Those are the endogenous variables.

  • So you have a theory.

  • So the theory is couched in terms of equilibrium.

  • There's a bunch of equations which have to be satisfied,

  • F of E and X.

  • So given the endogenous variables and the exogenous

  • variables, exogenous and endogenous,

  • I wrote them in that order, there's a set of simultaneous

  • equations, F, that have to be satisfied.

  • And so you find equilibrium when given the exogenous

  • variables E you find the endogenous variables X of E that

  • solve that system of simultaneous equations.

  • All our equilibrium models are going to have that form,

  • and one very important thing they allow you to do,

  • which is the heart of economic analysis is comparative statics.

  • If you change the exogenous variable E it'll require a

  • different X to solve the equation.

  • So E has an effect on X in order to restore equilibrium.

  • And so the prediction that a change in E has a certain effect

  • on X is called comparative statics.

  • Now, how would a historian describe that?

  • A historian would say, "Well, that's

  • counterfactual reasoning.

  • The environment is E.

  • Why are you bothering to tell me about what would happen if

  • the environment changed from E to E-prime?"

  • Well, that's the heart of economic analysis.

  • So in history you hardly ever get much.

  • People talk about it a little just to raise the question.

  • How would the Vietnam War have gone if Kennedy hadn't been

  • assassinated?

  • So they all bring that up, but you get two sentences.

  • "Oh, he was really going to pull out,"

  • or "Oh, he had been sending more

  • advisors.

  • It would have gone the same way."

  • That's about it.

  • In economics the heart of the thing is to go off on a tangent

  • and figure out what would have happened if the environment had

  • been different.

  • So why do a model?

  • Well, because many different settings can be described by the

  • same model.

  • So it just saves time.

  • It makes things much simpler.

  • From the counterfactual reasoning you're making

  • predictions.

  • It helps your understanding.

  • And then for the purposes of the next few lectures the most

  • important thing is there's some properties of equilibrium.

  • Like, for example, equilibrium is so good you

  • wouldn't want to interfere with equilibrium because it makes

  • everyone so well off and it would be a terrible thing to

  • regulate.

  • So those properties of equilibrium are what we have to

  • test the logic of.

  • So there's an obvious critique you can make of modeling.

  • The first person to make a model was Ricardo,

  • who you I'm sure have heard of, the principle of comparative

  • advantage.

  • He was the first guy who didn't write verbally.

  • He said, "Okay, I'm talking about international

  • trade and why free trade is a good idea.

  • I could make a verbal argument.

  • That's what everyone else has done, but I'm not going to do

  • it.

  • I'm going to say, 'Suppose that England produced

  • with one hour of labor three bottles of wine' and so on,

  • " and he had a little numerical example.

  • And he solved it and he showed that in that numerical example

  • it's better to have free trade as paradoxical as it might have

  • sounded at the time.

  • The Portuguese had such lower labor costs why shouldn't

  • English workers be afraid of being thrown out of their jobs

  • when trading with Portugal where the labor was so much less

  • expensive.

  • Well he explained why that turned out not to be the case,

  • but in terms of a model.

  • So Malthus, who you've also heard of,

  • a contemporary of his and his rival but also his friend,

  • said, "This model stuff is ridiculous because if you start