The Sad State of Financial Economics Teaching
[The Economics of Money, Banking and Financial Markets • By Frederic S. Mishkin • Prentice Hall; 9th edition (July 17, 2009) • 768 pages]
Overall, Frederic S. Mishkin's The Economics of Money, Banking, and Financial Markets is a well-written textbook. It is also one of — if not the — most widely used textbooks available. Its high reputation among professors should therefore say a lot regarding the state of teaching in mainstream money, banking, and financial economics.
Its relative formal clarity is no doubt an asset. However, this makes the weaknesses of its theories more visible. I am not complaining about the failure of the book to be entirely or even partly Austrian. One should not expect Austrian theorizing in a textbook written to explain mainstream views. One could complain that Austrian or praxeological theory is not mainstream, but that is another matter. Instead, I am speaking of some internal weaknesses of mainstream views and pedagogy, weaknesses on their own terms.
Let us look at some examples from interest-rate theory. Mishkin presents two views, the neoclassical "loanable-funds" framework, and the Keynesian "liquidity-preference" framework. So far, so good. But Mishkin explains of the 6th edition,
The reason that we approach the determination of interest rates with both frameworks is that the loanable funds framework is easier to use when analyzing the effects from changes in expected inflation, whereas the liquidity preference framework provides a simpler analysis of the effects from changes in income, the price level, and the supply of money. (p. 114)
Now that is a fascinating claim. The criteria are "easier to use" and "simpler analysis." But what about their validity? Is the whole purpose of economic theorizing not to grasp the truth on the subject matter, or, if one accepts the mainstream method, to approach it via falsification procedures? If it is truth that matters, one would have expected instead the two views to be presented in order to let the reader decide which, if either, is valid, (whether in whole or in part). Yet this is not Mishkin's justification.
Another example of a problematic claim: both in the "theory of asset demand" (the theory of demand for bonds in the loanable-funds framework) and the theory of demand for money (in the liquidity-preference framework), one factor that is supposed to positively influence demand is "wealth." Mishkin explains that
The conclusion we have reached is that in a business cycle expansion with growing wealth, the demand for bonds rises and the demand curve for bonds shifts to the right. (p. 101)
Or, for the liquidity-preference approach:
The liquidity preference framework thus generates the conclusion that when income is rising during a business cycle expansion (holding other economic variables constant) interest rates will rise. (p. 117)
The problem is that, at this point in the book, no business-cycle theory has been explained. So business-cycle expansion or higher wealth or income appear here as unexplained events happening for undetermined reasons and independent of any interest-rate considerations (in the same way, a sudden "deterioration in banks' balance sheets, increase in interest rates, a stock market crash or an increase in uncertainty" are presented later in the book as unexplained, exogenous causes of financial crises).
Now, in the introduction Mishkin tried to answer the question, "Why study financial markets?" saying among other things that
Because interest rates have important effects on individuals, financial institutions, and the overall economy, it is important to explain fluctuations in the interest rate that have been substantial over the past twenty years. (p. 4)
So, interest rates have an impact on the overall economy. But wait a minute! In the explanation regarding the demand for assets or the demand for money (determinants of the interest rate in the two approaches explored), the only causal link one finds between the overall economy and demand is that a particular state of the overall economy (business-cycle expansion or wealth growth) determines demand and therefore partly determines interest, not the other way around.
If students adopt this kind of circular reasoning in their future endeavors as researchers, one should not be surprised at the degree of nonsense and low-quality research they produce.
And let's take a look at the other determinants of demand for assets in the loanable-funds framework:
- Expected returns on bonds relative to alternative assets,
- Risk of bonds relative to alternative assets,
- Liquidity of bonds relative to alternative assets. (p. 101)
Mishkin elaborates on this. Here is an example:
If people suddenly became more optimistic about the stock market and began to expect higher stock prices in the future, both expected capital gains and expected returns on stocks would rise. With the expected returns on bonds held constant, the expected return on bonds today relative to stocks would fall, lowering the demand for bonds and shifting the demand curve to the left. (p. 103)
But say, for example, that people do not expect higher stock prices in the future, and that this change therefore does not occur. A more important question would remain: why could people earn a positive return on bonds in the first place? I am afraid the discussion on the determinants of the demand for assets does not answer this question. The same issue arises regarding the demand for money in the liquidity-preference approach.
Bonds, the only alternative asset to money in Keynes's framework, have an expected return equal to the interest rate i. As this interest rate rises (holding everything else unchanged), the expected return on money falls relative to the expected return on bonds, and as the theory of asset demand tells us, this causes the demand for money to fall.
We can also see that the demand for money and the interest rate should be negatively related by using the concept of opportunity cost, the amount of interest (expected return) sacrificed by not holding the alternative asset — in this case, a bond. (p. 115)
Demand for money is also supposedly determined by wealth or income and by the price level (because people care about the amount of money they hold in real terms [p. 116]). But again, for money to have an opportunity cost in terms of interest lost, one must be able to earn a positive-interest income. So why do bonds command any interest in the first place? The answer is not to be found in Mishkin's discussion of the liquidity-preference approach, but let's not blame Mishkin for that, because the issue was already there in Keynes's General Theory. (As Murray Rothbard noticed, it is not clear in the Keynesian approach if the interest rate determines the demand for money or if demand and supply for money determines the interest rate, as orthodox Keynesians have claimed. So the phenomenon of interest exists, but we do not really know why.) Is this not seriously problematic, even on mainstream grounds?
Now, maybe it would not be entirely fair to say that there is no interest-rate theory in Mishkin's textbook. Or would it? It is true that Mishkin says more than I have just quoted. After all, the interest rate might have something to do with the idea of time preference:
The concept of present value is based on the common sense notion that a dollar paid to you one year from now is less valuable to you than a dollar paid to you today. (p. 69)
But witness how this view is justified:
This notion is true because you can deposit the dollar in a savings account that earns interest and have more than a dollar in one year.
Freddie, are you kidding me? The question is, Why can I earn interest? The answer should be a theory of interest. It cannot assume the existence of interest. (Austrians have some proposals regarding a time-preference theory of interest, by the way.)
This is embarrassing. Here we have a textbook on money, banking, and financial markets, where, presumably, interest-rate theory should play a central role. But there is no theory of interest here. Plus we have growth or business-cycle booms sometimes considered as unexplained causes, sometimes as effects of other unexplained causes. Finally, truth in these matters is apparently less important than the models' ease of use. Now, why is this textbook an important tool in the students' curriculum if not that most teachers consider all of this acceptable?
The good news for Austrians is, of course, that insofar as students and others see through this nonsense, we have opportunities to advance alternative paradigms.