The Realism of Assumptions Does Matter: Why Keynes-Minsky Theory Must Replace Efficient Market Theory as the Guide to Financial Regulation Policy

Abstract

The radical deregulation of financial markets after the 1970s wasa precondition for the explosion in size, complexity, volatilityand degree of global integration of financial markets in the pastthree decades. It therefore contributed to the severity and breadthof the recent global financial crisis. It is not likely that deregulationwould have been so extreme and the crisis so threatening had mostfinancial economists adopted Keynes-Minsky financial market theory,which concludes that unregulated financial markets are inherentlyunstable and dangerous. Instead, they argued that neoclassical efficientfinancial market theories demonstrate that lightly regulated generateoptimal security prices and risk levels, and prevent booms and crashes.Efficient market theory became dominant in spite of the fact thatit is a fairly-tale theory based on crudely unrealistic assumptions.It could only have been adopted by a profession committed to MiltonFriedman�s fundamentally flawed positivist methodology, which assertsthat the realism of assumptions has no bearing on the validity ofa theory. Keynes argued persuasively that only realistic assumptionscan generate realistic theories. Keynes-Minsky theory, which is derivedfrom a realistic assumption set, should be the profession�s guideto regulation policy.