Much of BWL's work involves my fascination with and belief in the power of financial transactions and the capital markets they take place in.

Typically, standard economics deals with trades where a product or service is exchanged for some form of money. Financial economics deals with trades where money sits on both sides of the trade.

A clear statement of why the "stimulus approach" is flawed... at a fundamental level

by EUGENE F. FAMA

There has been lots of response to my little essay on bailouts and stimulus plans. I will only comment on the negative ones that I think have merit and are overlooked in my original paper.

First, however, I want to restate my argument in simple terms.

1. Bailouts and stimulus plans must be financed.

2. If the financing takes the form of additional government debt, the added debt displaces other uses of the funds.

3. Thus, stimulus plans only enhance incomes when they move resources from less productive to more productive uses.

Are any of these statements incorrect?

The size of the stimulus plan increases every day, currently to more than $800 billion (which president-elect Obama calls a down payment). Finding productive uses becomes an ever more daunting challenge.

To date there is just one valid negative comment on my essay, from J. Bradford DeLong (Fama's Fallacy, Take I: Eugene Fama Rederives the "Treasury View"), and I think his point is actually consistent with my argument.

He accuses me of not understanding that private investment includes inventory investment, and some inventory investment may be involuntary, the result of a general decline in demand. I am aware of the point, and I think he is right that government expenditures can, in whole or in part, reverse this bad investment by giving people funds to buy up the unwanted inventories. I think possibilities like this are covered by a statement that appears a couple of times in my essay,

"And bailouts and stimulus plans only enhance future incomes when the activities they favor are more productive than the activities they displace."
Inventory investments that turn bad are just an example of an unproductive private use of resources, and perhaps I should have used this example in my essay. I just didn't think it's a big enough deal. The relevant numbers are provided by the Department of Commerce.

Inventories rise during 2008, but if I'm reading the numbers correctly, the total increase from November 2007 to November 2008 is only about $47 billion. There is, of course, no guarantee that all of this is a bad investment. Even if it is, and even in the unlikely case that a dollar of stimulus reduces unwanted inventories by a dollar, we would have to find $753 billion of other unproductive private activities to justify an $800 billion stimulus.

The New Yorker 's John Cassidy has a conducted a series of seven interviews with the famous in finance at the University of Chicago.... in the light of recent events and what they mean for the main thrust of the economics and finance professions. They represent the state of debate amongst the world's top thinkers as of January 2010.

This is an extraordinary treasure trove - Fama, Posner, Becker, Cochrane and the bankers Rajan, Murphy et al. I have gathered all these together and shall post as one paper here then six discussions.

These debates are not for the faint hearted - but they are central to much of what we do. They also represent about three years right up to date financial economics thinking in a concentrated form - as close as it gets to listening in at the Chicago tea room debates.

First: Richard Posner

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Second: Eugene Fama


I met Eugene Fama in his office at the Booth School of Business. I began by pointing out that the efficient markets hypothesis, which he promulgated in the nineteen-sixties and nineteen-seventies, had come in for a lot of criticism since the financial crisis began in 1987, and I asked Fama how he thought the theory, which says prices of financial assets accurately reflect all of the available information about economic fundamentals, had fared.

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Third: John Cochrane

I interviewed John Cochrane in his office at the Booth School of Business, and I began by asking him about the economics of today’s Chicago, and how it differed from the strident free-market school of a bygone era—the Chicago of Milton Friedman and George Stigler.

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Interview Four:Gary Becker

I met Becker in his office at the economics department. I began by telling him I had been speaking with his friend and co-blogger Richard Posner, and I asked whether he agreed with Posner that the events of the past two years had called Chicago School economics into question.

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Interview Five: James Heckman

I interviewed Heckman by telephone in late October. I began by referring to a piece in the University of Chicago Magazine in which he appeared to absolve Chicago economics of any blame in causing the financial crisis.

How did he react, then, to the recent criticisms of Chicago School economics from Joseph Stiglitz, Paul Krugman, and others?

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Interview Six: Kevin Murphy

Kevin Murphy is one of the best-known Chicago economists from the post-Lucas, post-Fama generation. In 1997, he was the recipient of the John Bates Clark Medal, which is presented to the best American economist under forty. Although he is primarily a microeconomist, Murphy has published articles on a wide range of subjects, including income inequality, the value of medical research, economic growth, and unemployment. He wasn’t available to see me when I was in Chicago, but I subsequently talked to him on the telephone, and these are the notes of our conversation.

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Interview Seven: Raghuram Rajan


I met Rajan in his office at the Booth School of Business. I began by asking him about the academic work he and several colleagues at the business school did in the years leading up to 2007 on banking and liquidity. In addition to exploring theoretical issues that turned out to be important, Rajan, in the summer of 2005, issued a prescient warning about the dangers of a financial blowup involving the credit markets.

It was striking, I remarked, that despite Chicago’s image as a bastion of market efficiency, it was also home to much more questioning research in the financial system.

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This is an extract from an article on economics in virtual worlds. Even working through the logic is worthwhile.

Edward Castronova had hit bottom. Three years ago, the thirty-eight-year-old economist was, by his own account, an academic failure. He had chosen an unpopular field—welfare research—and published only a handful of papers that, as far as he could tell, “had never influenced anybody.” He’d scraped together a professorship at the Fullerton campus of California State University, a school that did not even grant Ph.D.s. He lived in a lunar, vacant suburb. He’d once dreamed of being a major economics thinker but now faced the grim sense that he might already have hit his plateau. “I’m a schmo at a state school,” he thought. And since his wife worked in another city, he was, on top of it all, lonely.

To fill his evenings, Castronova did what he’d always done: he played video games. In April 2001, he paid a $10 monthly fee to a multiplayer online game called EverQuest. More than 450,000 players worldwide log into EverQuest’s “virtual world.” They each pick a medieval character to play, such as a warrior or a blacksmith or a “healer,” then band together in errant quests to slay magical beasts; their avatars appear as tiny, inch-tall characters striding across a Tolkienesque land. Soon, Castronova was playing EverQuest several hours a night.

Then he noticed something curious: EverQuest had its own economy, a bustling trade in virtual goods. Players generate goods as they play, often by killing creatures for their treasure and trading it. The longer they play, the more powerful they get—but everyone starts the game at Level 1, barely strong enough to kill rats or bunnies and harvest their fur. Castronova would sell his fur to other characters who’d pay him with “platinum pieces,” the artificial currency inside the game. It was a tough slog, so he was always stunned by the opulence of the richest players. EverQuest had been launched in 1999, and some veteran players now owned entire castles filled with treasures from their quests.

Things got even more interesting when Castronova learned about the “player auctions.” EverQuest players would sometimes tire of the game, and decide to sell off their characters or virtual possessions at an online auction site such as eBay. When Castronova checked the auction sites, he saw that a Belt of the Great Turtle or a Robe of Primordial Waters might fetch $40; powerful characters would go for several hundred or more. And sometimes people would sell off 500,000-fold bags of platinum pieces for as much as $1,000.

As Castronova stared at the auction listings, he recognized with a shock what he was looking at. It was a form of currency trading. Each item had a value in virtual “platinum pieces”; when it was sold on eBay, someone was paying cold, hard American cash for it. That meant the platinum piece was worth something in real currency. EverQuest’s economy actually had real-world value.

He began calculating frantically. He gathered data on 616 auctions, observing how much each item sold for in US dollars. When he averaged the results, he was stunned to discover that the EverQuest platinum piece was worth about one cent US—higher than the Japanese yen or the Italian lira. With that information, he could figure out how fast the EverQuest economy was growing. Since players were killing monsters or skinning bunnies every day, they were, in effect, creating wealth. Crunching more numbers, Castronova found that the average player was generating 319 platinum pieces each hour he or she was in the game—the equivalent of $3.42 (US) per hour. “That’s higher than the minimum wage in most countries,” he marvelled.

Then he performed one final analysis: the Gross National Product of EverQuest, measured by how much wealth all the players together created in a single year inside the game. It turned out to be $2,266 per capita. By World Bank rankings, that made EverQuest richer than India, Bulgaria, or China, and nearly as wealthy as Russia.

It was the seventy-seventh richest country in the world. And it didn’t even exist.

Castronova sat back in his chair in his cramped home office, and the weird enormity of his findings dawned on him. Many economists define their careers by studying a country. He had discovered one.