or, last class, first class,

I'll say a couple words about what happened,

basically four words.

The course is really made of up four different elements.

The first part is the standard financial theory course that

grew up in the last ten years at a lot of major universities,

pioneered by a bunch of guys who won Nobel Prizes in business

schools.

And it's the method, some of them quite clever and I

think fun, methods for pricing financial assets and making

optimal financial decisions.

So you're going to learn all these tricks and how the

financial system works, and you'll learn it both from a

theoretical point of view, the way they thought of it in

these finance schools, and also from a practical point

of view since many of these very same problems come up all the

time in the hedge fund I helped start.

So that'll be the main part of the course, but there are three

other things that I want to concentrate on in the course.

So the second point is reexamining the logic of

laissez-faire and regulation.

This is a dramatic moment in our history now where there's

tremendous pressure on-- temporarily anyway--on the

government to establish all sorts of new regulations.

There's also tremendous resistance to establishing the

new sorts of regulations.

So there's a debate going on now in Congress and in the halls

of academia about what kind of regulations should we put in

place, what regulations would have

prevented the crisis we've just lived through.

The crisis, by the way, which I don't think we're done

with yet.

So there's a very powerful argument in economics.

The most famous argument in economics,

the invisible hand argument that basically says markets work

best when they're not encumbered by government interventions.

So we're going to reexamine that argument in the context of

financial markets.

Then the third thing I'm going to discuss in this course at

some length is the mortgage market and the recent crisis.

After all, my hedge fund is a mortgage hedge fund.

We founded it in 1994, by the way, which was--

the five years before that I was running the Fixed Income

Research Department at Kidder Peabody,

which was the biggest player in the mortgage market then on the

sell side.

The hedge funds buy mortgages, investment banks create and

sell the mortgage securities.

So I was running the research department at the firm that did

twenty percent of the market in what's called CMOs,

and then I changed to the buy side and was at a hedge fund

that bought those kinds of CMOs, and bought sub-prime mortgage,

CDOs, everything.

So it seems I suffered greatly through the last two years of

the mortgage crisis and it would just be foolish not to explain

what was going on and what it felt like to be in a mortgage

hedge fund while the rest of the world was collapsing around us.

And for quite a while it's given me some great

embarrassment to have been part of it all.

On the other hand, now I feel like one of those

survivors.

Hundreds of our counter-parties and much bigger mortgage players

went out of business and we didn't,

so I don't feel quite as bad about it as I did before.

And I don't know every detail of what went on in my hedge

fund, because after all I'm only part

time there, but there's a lot I do know

about and so I'll try and tell you some of that.

And then the fourth thing is Social Security.

This is the biggest government program and it's a financial

problem what to do about retirement,

and Social Security is the biggest government program of

all.

The only thing close is the military budget in terms of

annual expenditures.

And so I'm going to explain how that works, and what the problem

is, and how it arose, and what I think the solution

is.

So those are the four things the course is going to

concentrate on.

The mechanics of the course, again,

are homeworks, every week there's going to be

a homework with little problems illustrating what we're talking

about.

So there's one already on the web, Tuesday,

today, every Tuesday there will be one on the web.

It'll be due the next Tuesday.

The sections will always meet between Thursday and Monday,

so the problem set will come Tuesday.

You'll have two days of classes on the material that the problem

set will cover and then you can talk to the TAs about stuff

between Thursday and Tuesday when I presume you'll do the

problem set.

And that's twenty percent of the grade.

Twenty percent is the first midterm.

Twenty percent is the second midterm and forty percent is the

final.

Two midterms takes a lot of class time, on the other hand,

and it also takes a tremendous amount of effort by the TAs.

And so I appreciate their willingness to grade two

midterms, but I think you'll find it's

helpful to study the course in two pieces than try to do the

whole thing-- It'll be much better for you I

found in the past to have two midterms.

Oh, and one warning.

The course doesn't require difficult mathematics,

but for me, as I said in the first class,

it's very interesting that there are so many subtle things

that affect a financial decision,

and you have to think about what you know and all the

different things you know.

You have to think about what the other guy knows who's taking

the other side of the market.

You have to think about what he knows about what you know,

and you have to think about what he knows about what you

know about what he knows, and all that thing in the end

boils down to one number, the price.

So it's a philosophically interesting problem,

interactive epistemology.

Some people have described economics as interactive

epistemology.

It's more complicated than standard epistemology and

philosophy because there they go in circles thinking about what

one person knows and whether you can know that you know and stuff

like that.

In economics you have to worry about what you know,

what the other guy knows, what you know about what he

knows about what you know etcetera.

So it's a more complex problem, and yet at the end there's just

one number which can be right or wrong.

And so when I was a freshman here at Yale my roommate who was

a classics major said that his subject was much harder than

mine-- that was math--because all I

had to do was be right.

And so I'm going to take advantage of that simplicity and

every problem is going to have a number that you're supposed to

find.

And so it's not complicated mathematics, but it involves

lots of numbers.

And so if you hate numbers you shouldn't take this course.

And as I said before, there have always been people

who, you know, you can be very smart.

You can also have a great future in finance and not like

numbers.

You can like making deals and things like that not thinking in

terms of numbers.

So just because you don't like numbers and maybe shouldn't take

this course doesn't mean you should be discouraged about

finance.

It's just how I happen to teach the course because that's what's

comfortable for me.

So I'm just warning you about it.

It won't be hard, but it'll be relentless.

I want to talk today about that second problem,

about the logic of the free market and to do that I'm going

to have to introduce a model.

So it raises the question of what is a model in economics.

Many of you have taken economics before.

You sort of know what this idea is, but I think it's worth

spending a minute on it because it represented a revolution in

thought.

So for an economist a model means you distinguish exogenous

variables from endogenous variables.

The exogenous things people can't control.

They're just the weather and things like that.

The endogenous variables are things they can control and

you're trying to predict what the endogenous variables are

going to turn out to be like, what will the prices be,

what will the consumptions be, things like that.

How much income will people have?

Those are the endogenous variables.

So you have a theory.

So the theory is couched in terms of equilibrium.

There's a bunch of equations which have to be satisfied,

F of E and X.

So given the endogenous variables and the exogenous

variables, exogenous and endogenous,

I wrote them in that order, there's a set of simultaneous

equations, F, that have to be satisfied.

And so you find equilibrium when given the exogenous

variables E you find the endogenous variables X of E that

solve that system of simultaneous equations.

All our equilibrium models are going to have that form,

and one very important thing they allow you to do,

which is the heart of economic analysis is comparative statics.

If you change the exogenous variable E it'll require a

different X to solve the equation.

So E has an effect on X in order to restore equilibrium.

And so the prediction that a change in E has a certain effect

on X is called comparative statics.

Now, how would a historian describe that?

A historian would say, "Well, that's

counterfactual reasoning.

The environment is E.

Why are you bothering to tell me about what would happen if

the environment changed from E to E-prime?"

Well, that's the heart of economic analysis.

So in history you hardly ever get much.

People talk about it a little just to raise the question.

How would the Vietnam War have gone if Kennedy hadn't been

assassinated?

So they all bring that up, but you get two sentences.

"Oh, he was really going to pull out,"

or "Oh, he had been sending more

advisors.

It would have gone the same way."

That's about it.

In economics the heart of the thing is to go off on a tangent

and figure out what would have happened if the environment had

been different.

So why do a model?

Well, because many different settings can be described by the

same model.

So it just saves time.

It makes things much simpler.

From the counterfactual reasoning you're making

predictions.

It helps your understanding.

And then for the purposes of the next few lectures the most

important thing is there's some properties of equilibrium.

Like, for example, equilibrium is so good you

wouldn't want to interfere with equilibrium because it makes

everyone so well off and it would be a terrible thing to

regulate.

So those properties of equilibrium are what we have to

test the logic of.

So there's an obvious critique you can make of modeling.

The first person to make a model was Ricardo,

who you I'm sure have heard of, the principle of comparative

advantage.

He was the first guy who didn't write verbally.

He said, "Okay, I'm talking about international

trade and why free trade is a good idea.

I could make a verbal argument.

That's what everyone else has done, but I'm not going to do

it.

I'm going to say, 'Suppose that England produced

with one hour of labor three bottles of wine' and so on,

" and he had a little numerical example.