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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.

Suggested Citation

  • James Crotty, 2011. "The Realism of Assumptions Does Matter: Why Keynes-Minsky Theory Must Replace Efficient Market Theory as the Guide to Financial Regulation Policy," Working Papers wp255, Political Economy Research Institute, University of Massachusetts at Amherst.
  • Handle: RePEc:uma:periwp:wp255
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    References listed on IDEAS

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    1. Rabin, Matthew, 2002. "A perspective on psychology and economics," European Economic Review, Elsevier, vol. 46(4-5), pages 657-685, May.
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    Cited by:

    1. 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.
    2. Holian, Matthew & Joffe, Marc, 2013. "Assessing Municipal Bond Default Probabilities," MPRA Paper 46728, University Library of Munich, Germany.
    3. Giancarlo Bertocco, 2011. "Finance and risk: does finance create risk?," Economics and Quantitative Methods qf1115, Department of Economics, University of Insubria.

    More about this item

    Keywords

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

    JEL classification:

    • B41 - Schools of Economic Thought and Methodology - - Economic Methodology - - - Economic Methodology
    • B5 - Schools of Economic Thought and Methodology - - Current Heterodox Approaches
    • G10 - Financial Economics - - General Financial Markets - - - General (includes Measurement and Data)
    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates

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