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The Realism of Assumptions Does Matter: Why Keynes-Minsky Theory Must Replace Efficient Market Theory as the Guide to Financial Regulation Policy

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  • James Crotty

Abstract

The radical deregulation of financial markets after the 1970s was a precondition for the explosion in size, complexity, volatility and degree of global integration of financial markets in the past three decades. It therefore contributed to the severity and breadth of the recent global financial crisis. It is not likely that deregulation would have been so extreme and the crisis so threatening had most financial economists adopted Keynes-Minsky financial market theory, which concludes that unregulated financial markets are inherently unstable and dangerous. Instead, they argued that neoclassical efficient financial market theories demonstrate that lightly regulated generate optimal security prices and risk levels, and prevent booms and crashes. Efficient market theory became dominant in spite of the fact that it is a fairly-tale theory based on crudely unrealistic assumptions. It could only have been adopted by a profession committed to Milton Friedman’s fundamentally flawed positivist methodology, which asserts that the realism of assumptions has no bearing on the validity of a theory. Keynes argued persuasively that only realistic assumptions can generate realistic theories. Keynes-Minsky theory, which is derived from a realistic assumption set, should be the profession’s guide to regulation policy.

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Paper provided by Political Economy Research Institute, University of Massachusetts at Amherst in its series Working Papers with number wp255.

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Date of creation: 2011
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Handle: RePEc:uma:periwp:wp255

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Keywords: efficient financial market theory; Keynes-Minsky financial theory; Friedman's positivism; financial regulation; financial crises;

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  1. Fama, Eugene F, 1991. " Efficient Capital Markets: II," Journal of Finance, American Finance Association, vol. 46(5), pages 1575-617, December.
  2. Robert J. Shiller, 1992. "Market Volatility," MIT Press Books, The MIT Press, edition 1, volume 1, number 0262691515, December.
  3. Matthew Rabin, 2003. "A Perspective on Psychology and Economics," General Economics and Teaching 0303003, EconWPA.
  4. James Crotty, 2010. "The Bonus-Driven “Rainmaker” Financial Firm: How These Firms Enrich Top Employees, Destroy Shareholder Value and Create Systemic Financial Instability (revised)," Working Papers wp209_revised3, Political Economy Research Institute, University of Massachusetts at Amherst.
  5. James Crotty, 2009. "Structural causes of the global financial crisis: a critical assessment of the 'new financial architecture'," Cambridge Journal of Economics, Oxford University Press, vol. 33(4), pages 563-580, July.
  6. Lawson, Tony, 1985. "Uncertainty and Economic Analysis," Economic Journal, Royal Economic Society, vol. 95(380), pages 909-27, December.
  7. Burton G. Malkiel, 2005. "Reflections on the Efficient Market Hypothesis: 30 Years Later," The Financial Review, Eastern Finance Association, vol. 40(1), pages 1-9, 02.
  8. Murray Glickman, 1994. "The Concept of Information, Intractable Uncertainty, and the Current State of the "Efficient Markets" Theory: A Post Keynesian View," Journal of Post Keynesian Economics, M.E. Sharpe, Inc., vol. 16(3), pages 325-349, April.
  9. Carmen M. Reinhart & Kenneth S. Rogoff, 2009. "This Time Is Different: Eight Centuries of Financial Folly," Economics Books, Princeton University Press, edition 1, volume 1, number 8973.
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Cited by:
  1. Giancarlo Bertocco, 2011. "Finance and risk: does finance create risk?," Economics and Quantitative Methods qf1115, Department of Economics, University of Insubria.
  2. Giancarlo Bertocco, 2011. "Housing bubble and economic theory: is mainstream theory able to explain the crisis?," Economics and Quantitative Methods qf1116, Department of Economics, University of Insubria.
  3. Holian, Matthew & Joffe, Marc, 2013. "Assessing Municipal Bond Default Probabilities," MPRA Paper 46728, University Library of Munich, Germany.

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