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Financial Markets: Lecture 1 Transcript

January 14, 2008

Professor Robert Shiller: This is Economics 252, Financial Markets, and I'm Bob Shiller. Let me begin by introducing the teaching fellows for this course; and so I have them up here. We have five teaching fellows at this time and they're from all over. I like to put their pictures up so you'll know who they are. The teaching fellows are very international and that reflects my intention to make this a course that is also very international because finance is something about the whole world today, not just the United States. So we cover the world very well with our T.A.'s.

Usman Ali is from Pakistan, Lahore, and he graduated from the LUMS, Lahore University of Management Sciences. He's a PhD candidate now in Economics and he's doing his doctoral dissertation on stock analysts' recommendations and the relation to returns in the stock market. He's also interested in behavioral finance, which is the application of psychology to finance. The second teaching assistant--I see him right there, if you could raise your hand--Santosh Anagol, who is a representative of the United States, although he seems to have connections to India as well. He actually has a publication already in the American Economic Review on the Return to Capital with Ghana. He did this jointly with the Chairman of the Economics Department here, Chris Udry and he has spent time in India looking at the village economies. You were going to be giving away cows, did you do that?
Student: No, I'm still working on cows but we're not giving them away.

Professor Robert Shiller: Okay, that's the last time you'll hear about cows in this course. The idea was to give cows away to village farmers and to observe the outcome. It's a big change in some of these very poor villages to get a cow.

Christian Awuku-Budu is from Ghana, Accra, but he, again, went to college in the United States at Morehouse College. He is also a PhD candidate in Economics at Yale and he's been doing research on financial markets in developing countries.

Yaxin Duan is from China. She got her undergraduate degree from Nanjing University. No? You are from Nanjing, did I get a detail wrong? Where did you go to college? Okay, well I'm sorry about that. She is also a PhD candidate in Economics and is doing research on the behavior of options prices in a phenomenon called the "options smile," as she's smiling at me right now. She is also interested in behavioral finance, which is great to me because that's one of my interests. She is shown here standing precariously on a cliff. It makes me nervous to look at it overlooking Machu Picchu in Peru. She also loves astronomy, which is incidentally an interest of mine too, but you won't hear about it again in this course.
Finally, Xiaolan Zhou is our fifth teaching assistant and she's also from China, Hubei Province. She graduated from Wuhan University and is a PhD candidate in Economics at Yale. She is doing research on bank mergers.

 

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Let me say, I've been teaching this course now for over twenty years and I'm very proud of all of my alumni. Many of them are in the field of finance. In fact, I like sometimes when I give--I give a lot of public talks. When I give a talk on Wall Street or even somewhere else in the world I sometimes ask my audience, "Did you take my course?" It's not infrequent that I'll get one or even two people raising their hand that they took Economics 252 from me. But I'm also proud of my alumni in this course who are not in the world of finance. I think this course goes beyond--It's not just for people who are planning careers in finance because finance is a very important technology and it's very important to know finance to understand what happens in the real world. Just about any human endeavor involves finance. Now, you might say, "I could be a poet and what does that have to do with finance?" Well, it probably ends up having something to do with finance because as a poet you probably want to publish your poetry and you're going to be talking to publishers. Before you know it, they're going to be talking about their financial situation and how you fit into it.

I believe it's fundamental and very important. I think you will find this course as not a vocational course--not primarily a vocational course--but an intellectual course about how things really work. I see finance as the underpinning of so much that happens. It's a powerful force that goes behind the scene and I hope we can draw that out in this course. There is another course--we have two basic courses in finance for undergraduates at Yale. The other one is Economics 251, Financial Theory; this is Financial Markets, that one is Financial Theory. Last year it was taught by Rafael Romeu, because John, Geanakoplos who usually teaches the course, was on leave and so we had to find someone else. I assume that next fall John Geanakoplos will be teaching 251 again.

So what happened? Why do we have these two courses? Well it was something like eight years ago that we reached the present situation with two finance courses. John Geanakoplos and I had a meeting and we tried to divide up the subject matter of finance into two courses. We thought Financial Theory and Financial Markets would be the two. But the problem was that both John and I are interested in both theory and applications. John Geanakoplos is actually Chief Economist for a large investment called Ellington Capital in Greenwich, Connecticut, which you'll see a lot in the news. It has been very successful. He is very much interested in the real world and I am interested in financial theory, so we find it--we decided, after talking about it, that we really can't divide up the subject matter of finance into separate courses on theory and practice. If you tried to do one alone it would not work, so we decided to divide it up imperfectly and there may be some repetition between our two courses. Both of them are self-contained courses, so you could take either 251 or 252, or you could take both. I think maybe the best option is to take both if you're really interested in the subject matter. It is true though that his course is more tuned into theoretical detail than mine. John is a mathematical economist and we both love mathematics, but maybe John is going to do more of it than I am.

This course actually will not use a heavy amount of mathematics. I try to keep it so that people who are not comfortable with a lot of math can take this course and I wanted to emphasize that this is--I've said that it's--I think this course is vocational preparation in a sense. I pride myself on the fact that people who have taken this course find it useful in their subsequent lives, but on the other hand, I think that it's really interesting. At least I find it really interesting and so I hope that you will too. Now I don't know, I may be different than other people, but I think organic chemistry is really interesting. How many of you have that feeling? Can I get a show of hands, who is interested in organic chemistry? I'm not getting a lot of hands raised. Unfortunately, I've never taken a course in it, but I've started reading it lately out of just my broad intellectual interest. That is a course that has a bad reputation, doesn't it? Because people say I've got to take that if I want to be pre-med. But, you know, to me there's a lot of detail in organic chemistry. To me, when you read the detail you're getting into something deep and important about the way everything works and so I start to find it interesting.

So I don't know how people feel about taking--maybe I'm turning you off by saying this--There's going to be a lot of detail in this course. Maybe I made a big mistake by likening it to an organic chemistry course--I don't mean to turn you off. The idea in this course is that by being a financial markets course, you have to know how the world works. We're going to be thinking about that in connection with Financial Theory, but we have to get into the details; so we are going to be learning about facts.

Let me start by talking about the textbook. So the principal textbook is Frank Fabozzi, the other authors are Modigliani, Jones and Ferri, Foundations of Financial Markets and Institutions. This textbook is very detailed and it may be--I've had some reaction by students--more than you wanted to know.

I actually had a great experience reading it. Actually, it was an earlier edition, when I first assigned this book in the year 2000, I took it with me on vacation. I was going to the Bahamas with my family and with Jeremy Siegel's family--we'll come back to Jeremy Siegel in a minute. I sat down by the pool with this book. Other people were reading novels and I don't know what else, but I was reading Fabozzi. I had such a great time with it, so I'm telling you my experience. Maybe it was because it was filling in gaps in my knowledge--things I've always wanted to know and was always curious about. That's partly what you have to develop when you get interested in a field: some sense of curiosity about all the details. So I read the whole book, 650 pages, maybe I kind of read fast because I knew a lot of it. It might take you a little longer to get through it, but I wanted you to have the same experience.

I've been assigning this book, now it's in another edition and--Fabozzi is working on a fourth or next edition, I forget what number. I've been assigning--I've gotten some complaints from students that this book is tough going because there's so much information in it. I used to tell people, " I'm assigning the whole book and you have to know everything in the book." That's a little ambitious. I finally backed down because I met a man on Wall Street, a very prominent Wall Street person, and he said, "You know, my son started to take your course." I said, "What do you mean started the course?" He said, "Well, he dropped out when he saw this book and the requirements." I didn't like that. I don't want students to drop out. So what I decided is that you need to know the whole book in the sense that you need to know all of the key terms and key points. Now if you look at the structure of this book, it has sections that say Key Points and Key Terms. Anything that's mentioned there is fair game for me in an exam and that's the way I've done it. There are key points and key terms. Also, anything in my lecture is of course fair game for the exam. Let me also add that I have a reading list that has clickable things on it and also things that are on reserve in the library. Anything that's clickable is required reading. I don't expect you go to the library, however, because I think that we're moving into an age where you tend to want to be online, right? So the library books are all optional background.

Fabozzi, a faculty member here at Yale, has offered to give me--we have at least one chapter from the new edition that hasn't come out yet. I'm going to put that on reserve in the library; but again, I think that the edition that you have is reasonably up to date and so that's all that I'm expecting you to read. The other author, Franco Modigliani--in the book, the second author--was my teacher at MIT. He died in 2003. He is also a Nobel Prize winner and I think has a remarkable intellect. So this book, Fabozzi, et al.--Fabozzi, Modigliani, Jones and Ferri--is a very solid book about financial markets.

The second book that I'm assigning is Jeremy Siegel, Stocks for the Long Run. This is an old friend of mine. I met him in graduate school. Funny story, I met him because at MIT they signed us all up for chest x-rays alphabetically--that's the way MIT does things, an orderly way. Shiller and Siegel are next to each other in the alphabet, so I was standing in line with him for an x-ray and was talking with him and I've known him ever since. A funny coincidence is that since our names are close in the alphabet--you often find our books right together in bookstores because Shiller and Siegel--if they're shelving alphabetically--would end up together. He wrote a book called Stocks for the Long Run, starting in 1993. It just came out with the fourth edition and that book was a best seller. I think it sold over a half million copies. I'm not sure where it is now but it has done very well. It's been a perennial classic. It emphasizes the long run performance of the stock market, but it's really a general treatise of financial markets. I get a very good reaction from students about this book. This one is very readable. It's not as intense as Fabozzi, et al. Jeremy Siegel holds the unique distinction--Business Week did a poll asking MBA's about their favorite professor. This was about ten years ago. They ranked business school professors according to their popularity. He came out number one in the United States as business school professor. I think you'll like this book.

The next book is my own and called Irrational Exuberance. This is the last book--That's a phrase that was coined by Allen Greenspan in 1996 and it refers to the stock market boom of the 2000s--of the 1990s and the boom and the bust--well I think it's related to the bust that came out later, after 2000. I wrote this book in 2000 right at the peak of--fortunately right at the peak of the stock market. But what I'm assigning to you is the second edition, which came out in 2005, pretty much at the peak of the housing market. We're going to talk about both the housing market and the stock market in these different books.

These books are all on sale at Labyrinth Books, which is an independent bookstore here in New Haven. I put it there because, well, I think the major chain bookstores fulfill an important function but I also like to support independent bookstores. I don't know if you know the story, but Labyrinth Books is independent, it's not a chain, and independent bookstores are trying–struggling--to survive. This is finance. In the book business, there's something difficult about maintaining an independent operation. Labyrinth was at Columbia University and Yale. For some reason they shut down their Columbia bookstore, but they've opened up now in Princeton. There was this famous bookstore in Princeton on Nassau Street called Micawber's, which is a wonderful bookstore. I've been in there a number of times. But they just went out of business. Labyrinth has moved in to take their place. Anyway, that's where all the books are and they are available now.

We're going to have these lectures on Mondays and Wednesdays. We're going to have T.A. sections in the second part of the week. We're going to ask you to look at your schedule sometime before our next lecture and think about when you can come to a teaching assistant section. They will be Wednesday, Thursday, and Friday and we have six problem sets. The six problem sets are due generally on Mondays and we'll go over the problem sets in the teaching sections, several days after you turn them in. This is one of the biggest classes at Yale, but I think we've got it so it will be a good and satisfying experience for you. We have very qualified--I'm very impressed with our teaching assistants. The important thing is for you to stay with them and get to know them and I urge you to attend the T.A. sections. The course is going to be graded. We have two mid-terms and one final. The in class mid-terms--the grades will be roughly 10% problem sets, 20% first mid-term, 30% second mid-term, 40% final. But we will also use judgment and I'm going to appeal to the T.A.'s to help me on judging the grading. Also, I ask the teaching assistants to give me little capsule descriptions of you so that if in ten years, or 20 years from now, I get a call from a reporter asking about this illustrious person who was once my student, I can have something to prod my memory. That's why I hope you'll stay with--you'll each find a teaching assistant and will stay with that person.

I want to say something about a particular interest of mine because it is part of this course, although not the entire course. Behavioral finance refers to a revolution in finance that has occurred over the last ten or 20 years and that is incorporated--Behavioral finance is the theory of finance mixed in with the theories of other social sciences, notably psychology, sociology, political science, and anthropology. I think it's the most important revolution in finance of the last couple decades. Maybe I'm biased because I've been very much involved in it. I've been organizing workshops in behavioral finance at the National Bureau for Economic Research since 1991 with Dick Thaler at the University of Chicago. We think that we're avant-garde of a major revolution. The unity of the social sciences is, I think, very important. It's a mistake to try to consider finance in isolation. There is a whole array of other information related to finance. This will be a theme of my course and also a theme of this book, Irrational Exuberance. That's what exuberance refers to--it's a psychological term. So that's an important element of this course.

Another thing that I will be talking about is less important to this course but you have heard of this: the subprime crisis. This is the big financial event that is hitting the United States and the entire world right now. I'm actually writing another book about this. It's not done in time for you to read but I think I will have it done at some time during this semester. What does it mean? "Subprime" refers to the mortgages that were made mostly over the last ten years or so to subprime borrowers. A "subprime borrower" is somebody who has a poor credit history or some other indication that would suggest that they might not be able to repay the mortgage--they might default. The industry, subprime lending, has grown dramatically over the last ten years and, as you probably know, it's in big trouble now. What's happening is the housing market is dropping, home prices are falling, people are defaulting in record numbers, and there are foreclosures. What happens if you don't pay your mortgage? If you buy a house and you don't pay the mortgage, the contract says you lose the house--you're out--you've got to pay or it goes back to the mortgage originator. This crisis is very interesting to me because it's had so many ramifications throughout the financial world. It's exposing defects in many of our biggest financial institutions and every day we see more news about failures, huge losses, resignations, or firings of top finance people. So it's a very interesting time in finance. These things happen from time to time, but they happen with enough regularity that there's something we really want to understand as a systematic phenomenon. So that's another thing that I will be talking about.

Let me make another point about technology. Finance, I believe, is a technology and that means it is a way of doing things. It has a lot of detail. A financial instrument is like an engineering device. Here I'm tying to the engineering--Is anyone here from engineering? A couple of you, well this could be--In fact, some engineering schools offer courses in finance, did you know that? Engineers find it congenial because they have a way of thinking constructively about the world that is kind of parallel to finance. We have theories--mathematical theories--that lead us to devise financial structures, which are complicated devices just like engines or nuclear reactors. They have a lot of components and they have to work right. When people first devise some new financial instrument it typically has trouble. Like when they devised the first engines or the first nuclear reactors, it didn't work so well at first and then from the experience of many people working on it, over many years, a body of knowledge emerges and that's what we call technology. So technology is a powerful force in our society and I respect power of this kind. That's why I like to follow it up. But technology is also dangerous. Nuclear power, for example, may be our salvation when we run out of oil--or virtually run out of oil--it seems to be coming up over the next several decades--we're going to have to do that, we're going to need nuclear power. But it's also dangerous, as you know.

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