Problem Set 8 Fall 2019 Solutions PDF

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Download Problem Set 8 Fall 2019 Solutions PDF

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Econ 136: Financial Economics Problem Set #8 – Solutions Due Date: November 15, 2019 General Instructions: • Please upload a PDF of your problem set to Gradescope by 11:00 pm. • Late homework will not be accepted. • Please put your name and student ID number at the top of the first page.

1. Minsky (p. 13) observes that “ . . . the fundamental instability of a capitalist economy is upward. The tendency to transform doing well into a speculative investment boom is the basic instability in a capitalist economy.” Briefly describe how the three assumptions that Keynes discussed in his General Theory paper lead to incentives that align with the creation of an investment boom. Solution: When the economy is improving the three assumptions: (a) “We assume that the present is a much more serviceable guide to the future than a candid examination of past experience would show it to have been hitherto.” (b) “We assume that the existing state of opinion as expressed in prices and the character of existing output is based on a correct summing up of future prospects . . . .” (c) “Knowing that our own individual judgement is worthless, we endeavor to fall back on the judgement of the rest of the world which is perhaps better informed.” lead investors to believe that all is well and more is better. Further economic improvement under these conditions validates these assumptions and doing well on the part of economic agents generally and on the part of bankers in particular then leads to a speculative investment boom. 2. How does Keynes characterize the stability of a theory of the future built on these assumptions (or principles)? Solution: As “. . . based on [a] flimsy foundation [and] subject to sudden and violent changes.” 1

3. Concerning Charles Ponzi:1 (a) Briefly describe who Charles Ponzi was and why we remember him today in the world of finance. Solution: Charles Ponzi is known for his eponymous investment strategy or “scheme” in which interest payment to investors are taken directly from cash deposited by other investors. Since no investment of the investors money is made, maintaining these interest payment relies on increasing the investor pool. When the investor pools stops growing the scheme collapses. We remember him today because his scheme or ones very like it, known collectively as “Ponzi Schemes” continue to be sold to investors. (b) What aspect of Minsky’s work references Ponzi and why? Solution: Minsky identified three (3) forms of finance, on of which is known as Ponzi Finance where “cash payment commitments on debt are met by increasing the about of debt outstanding.” (c) How is the work of Bernie Madoff related to that of Charles Ponzi? Solution: Both ran investment frauds that are known as “Ponzi schemes,” with Madoff having run “the largest Ponzi scheme in American history.” (p. 111, Kindleberger & Aliber, 2011) 4. Briefly compare and contrast your expectation of safety in pharmaceuticals that you buy with the product safety of financial products discussed by Senator Warren. Solution: My expectation of safety in pharmaceutical products is that they have been shown to be effective, that the benefits (efficacy) outweigh the costs (e.g., toxicity) by a wide margin, and that I will be able to make a fully informed decision as to their use.

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The answer to some of these questions will require you to read beyond the assigned reading in Kindleberger & Aliber. For this purpose use the index.

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5. For the following please refer to the article by Senator Warren. (a) List three (3) of the problems that can afflict families that deal with dangerous financial products. Solution: Your list should include three from the following (p. 9, Warren, 2007): i. wiped-out savings. ii. lost homes. iii. higher costs for car insurance iv. denial of jobs. v. troubled marriages. vi. bleak retirements. vii. broken lives. (b) How did a VP at Booz Allen Hamilton characterize “most bank products”? Solution: As “too complex for the average consumer to understand.” (p. 12, Warren, 2007) (c) According to Senator Warren, what is the implication for a market “when a lender can bury a sentence at the bottom of 47 lines of text saying it can change any term at any time for any reason.”? Solution: “[T]he market is broken.” (p. 19, Warren, 2007)

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