I’ve had a series of interesting conversations with thoughtful, articulate, and intelligent academics who span disciplinary boundaries (finance, economics, sociology, and psychology) about what the future of the field of financial economics should/will/might look like. In light of the financial crisis, this has been a popular topic of conversation.

There have been two recurring themes:

1. Are the fundamental assumptions about human behavior associated with the dominant paradigm in financial economics appropriate?
2. Is shareholder wealth maximization the appropriate objective function?

With respect to the former, I have been engaged in conversations with folks who echo some of Willem Buiter’s concerns. In a brilliant blog post (see State of the Art Uselessness) Buiter contends:

The most influential…theorists all worked in what economists call a ‘complete markets paradigm’. In a world where there are markets for contingent claims trading that span all possible states of nature (all possible contingencies and outcomes), and in which intertemporal budget constraints are always satisfied by assumption, default, bankruptcy and insolvency are impossible. As a result, illiquidity – both funding illiquidity and market illiquidity – are also impossible…

[The] complete markets…theories not only did not allow questions about insolvency and illiquidity to be answered.  They did not allow such questions to be asked.

It is clear that, when searching for an appropriate simplification to address the intractable mess of modern market economies, the starting point of ‘no markets’…is a much better one than that of ‘complete markets’.

My Comment: One of the things that drew me to the field of strategy in the first place (versus finance or economics) is that we start with a baseline assumption that markets are incomplete, and markets break down. But back to Buiter:

In…approaches to monetary theory…the strongest version of the efficient markets hypothesis (EMH) was maintained.  This is the hypothesis that asset prices aggregate and fully reflect all relevant fundamental information, and thus provide the proper signals for resource allocation.

My Comment: I would go one step further and suggest that associated with the EMH-dominated financial economics view is an assumption that there is a true, objective, underlying fundamental price for an asset. We might deviate from that price in the short run; but in the long run, the fundamental price will prevail. Buiter alludes to that as well, although he does not come right out and say it:

The efficient markets hypothesis assumes that there is a friendly auctioneer at the end of time – a God-like father figure – who makes sure that nothing untoward happens with long-term price expectations or (in a complete markets model) with the present discounted value of terminal asset stocks or financial wealth.

What this shows, not for the first time, is that models of the economy that incorporate the EMH…are not models of decentralised market economies, but models of a centrally planned economy.

My Comment: Interesting, so in treating human behavior as governed by the tenets of homo economicus, our agentic models actually obviate agency.

In one of the conversations that I had with a prominent game theorist and a well-regarded entrepreneurship scholar, some of these issues came up. For example, we discussed the importance of incorporating the varying belief-structures of the participants in a market into the value equation. The participants themselves may have such varying beliefs about the market that, in effect, they might actually be playing different games governed by different rules. In such a circumstance it might be better to analytically treat assets as not having an intrinsic (fundamental) value, but rather, to treat the “value” of the assets as contingent upon participants’ subjective beliefs – i.e., the value of the asset is only worth what the next guy is willing to pay for it.

With respect to the second issue (shareholder wealth maximization), I have had more than a few conversations with prominent economists and sociologists about the social implications of a dogmatic adherence to models of shareholder wealth maximization. Unfortunately, if incentives are structured such that they exclusively reward shareholders (and in some cases, managers) at the expense of other constituents (stakeholders), this could lead to suboptimal social outcomes.

As an alternative, a group of scholars in strategy have offered a Stakeholder view of the firm. Stakeholder Theory, most closely associated with Edward Freeman (see wikipedia for a brief overview), suggests that firms ought to incorporate the interests of various stakeholders into their decision calculus, and not simply what’s best for shareholders. They argue that this would result in a firm that generates value not just for shareholders, but also for stakeholders (suppliers, customers, employees, communities, etc.). It shifts the maximization problem from one of individual utility maximization (in the interest of shareholders) toward one of joint utility maximization (balancing the disparate concerns of various interested parties).

Shareholder maximization vs. Stakeholder maximization has been a topic of considerable debate in the strategy literature over the past 15-20 years. And given the social costs of this financial crisis, I would not be surprised to see the Stakeholder view gain more traction in the years to come.

All told, I think the field of financial economics would be well served to be more inclusive when it comes to behavioral approaches to human behavior (whether from economics or psychology) and behavioral views of the firm (whether informed by psychology, sociology, or economics). Thankfully, not only are both processes well underway, but in some quarters, they have been for some time.

As I mentioned several weeks ago (see Visit to the FT), I recently spent some time with Adam Jones, author of the FT Management Blog, and Business Education Editor at the Financial Times. Adam conducted a brief interview in which we discussed Business Schools, and job prospects for Business School graduates. The interview appeared in the on-line version of the Financial Times 2009 Business School Rankings.

Below is a brief overview of my comments.

On applications:

• applications to full-time MBA programs near all-time highs
• applications to Ph.D. programs near all-time highs
• applications to corporate-sponsored, and executive, programs way down

On job prospects:

• the current job market (for 2009 graduates) is extremely challenging
• the job market for 2010 graduates will likely be worse
• the job market for 2011 graduates is uncertain but likely difficult, as the post-recession recovery will be slow

On majors, course selection, and job opportunities for finance students:

• finance students are becoming more flexible (looking in consulting, general management, accounting, and other fields)
• finance students are looking in non-traditional markets (Dubai, Abu Dhabi, continental Europe, and Asia)
• increasing interest among students in general management courses, and in general management as a major

As promised, a link to the web page with full video is below. Unfortunately, the Financial Times would not allow me to embed the video on my site.

I am currently in London, spending the month as a visiting scholar at the London Business School. Since I have been hanging around town, Adam Jones, author of the FT Management Blog, and Business Education Editor at the Financial Times, invited me in to do an interview about the economic downturn, and how it has been impacting applications to Business Schools, and the job prospects of Business School graduates. The interview is scheduled to be aired on January 26th, concurrent with the release of the 2009 FT Business School Rankings (I will post a link to the rankings and the video when they become available).

Adam and I had a nice discussion. We went over some of the points I raised in my post Crisis for MBA Grads Seeking Jobs, …and more.

Adam began by asking about Business School applications. We discussed the following:

• applications to full-time MBA programs are at an all-time high
• applications to Ph.D. programs are at an all-time high

Both of those effects are to be expected, as business school applications generally run counter-cyclically with the economy. However, I noted that for Business Schools that rely on corporate-sponsored programs (executive MBA, non-degree granting executive programs, and custom executive programs) for a good chunk of their revenue, this downturn will be especially difficult. The outlook for executive programs is particularly grim, as corporations rein in discretionary spending, and demand for such programs experience a sharp decline.

Adam then asked about the job prospects for Business School graduates. I answered:

• the job market has been challenging (to say the least) for graduates of the class of 2009
• as bad as it has been for the class of 2009, unfortunately things are shaping up to be worse (dare I say awful) for graduates from the class of 2010. While economic recovery seems likely sometime in late 2009/early 2010, layoffs continue for some time after recessions officially end. This is because those industries that start coming out of recession do not hire quickly enough to offset losses in the industries that continue to feel the effects of the recession. In addition, even when growth begins again, firms are reluctant to hire at first so as not to expand if there is a reversion to recession (i.e., a double-dip recession). Instead, they prefer to do more with less (asking existing workers to put in more hours, work overtime, etc.).
• the job prospects for 2011 graduates are uncertain, as I expect the post-recession recovery to be a slow one. To me, the immediate growth engine for the U.S. economy moving forward is unclear. I see some potential in alternative energy, nano-technology, and biotech (specifically, genome mapping and its associated applications). However, whether those industries will truly grow fast enough to bring robust growth back to the economy is uncertain. Moreover, although it is likely that the global economy will return to growth in 2011, there is a decent probability (at least in the U.S.) that the recovery will be a jobless one.

We also discussed several other topics. For example,

• Adam asked how finance students were faring given that there had been so many layoffs in the financial sector. To that I responded that my experiences have been that finance students, in particular, were becoming more flexible with respect to the kinds of positions they have been willing to consider. Many are now open to consulting, general management, accounting, and other fields. In addition, I shared some anecdotes about students of mine who had been looking for jobs in non-traditional markets – exploring opportunities in places like Dubai, Abu Dhabi, continental Europe, and Asia. At this point, many are willing to go just about anywhere for gainful employment.
• Adam also asked about the types of electives that students were considering in this environment. I mentioned that I had been noticing an increasing interest general management courses, and in general management as a major.

More to come…

It should come as no surprise that university tuition has been rising at a rate faster than inflation, and faster than income growth. In fact, Tamar Lewin at the New York Times recently published a fascinating article about tuition trends (see Higher Education May Soon Be Unaffordable). She writes:

The rising cost of college — even before the recession — threatens to put higher education out of reach for most Americans, according to the biennial report from the National Center for Public Policy and Higher Education.

Over all, the report found, published college tuition and fees increased 439 percent from 1982 to 2007 while median family income rose 147 percent. Student borrowing has more than doubled in the last decade…

“If we go on this way for another 25 years, we won’t have an affordable system of higher education,” said Patrick M. Callan, president of the center, a nonpartisan organization that promotes access to higher education.

Although I agree with the premise, I am not sure I agree with the inference.

Yes, tuition has been rising at an unsustainable pace. Yes, a university education may be priced higher than the fundamentals will currently bear. Yes, it is a problem that American families have funded tertiary education by relying increasingly on debt (but c’mon, haven’t American families funded much of their recent consumption with debt??).

I agree that the cost of higher education might price some out of the market entirely. However, I do not think the effect will be as large as the author believes. Rather, the cost of higher education, coupled with what I view as a fundamental shift in consumer behavior as a result of the recession, will more likely usher in a shift in consumption versus an end to consumption.

Gone are the days of taking on exorbitant amounts of debt to send children to private institutions with tuition (not including living expenses) of $40,000 per year, or more. Instead, families will increasingly opt  for public universities with tuition in the $10,000-$15,000 range.

For example, families in Texas might start asking tough questions like, “Is the difference in the price between Harvard and the University of Texas really worth the $120,000 difference?” I am not willing to argue that real differences between being educated at a private university and a public university do not exist; however, I am not sure whether those “benefits” (to the extent that they do, in fact, exist) justify the additional premium in all cases. And those considerations are likely to impact the decisions of consumers.

Let’s face it, frugality is here (see Mish on Frugality or BusinessWeek’s The New Age of Frugality). I view this largely as a welcome development. After years of spending well beyond our means, Americans have discovered discipline.

The question for universities (private and public alike) is whether this frugality represents a temporal or structural shift in consumption patterns. In my opinion, the shift toward thrift is likely to persist for some time. If frugality represents a fundamental structural shift in consumer mentality and behavior (as I believe it does), individual universities (private universities especially) would be well served to carefully consider what that might mean for their institution in the coming years, and prepare accordingly.

One thing’s for certain: Frugality is likely to hold tuition increases in check for the foreseeable future.

This summer I wrote about what I saw as a particularly grim job market for the business school graduates of 2009 (see Job Market Update and Job Prospects for B-school Grads). Back then I wrote:

The students who will really, truly feel this recession are the graduates of 2009 (and maybe even the graduates of 2010). I expect the job market moving forward to be abysmal, and for the hiring season of 2008-2009 to largely be a bust.

There is now growing evidence that this is the case (see Crisis Hits the Business Schools). Alison Damast of BusinessWeek writes:

Second-year students…without job offers appear to be in the most precarious position. According to a survey by the umbrella group MBA Career Services Council, about 70% of the 77 schools surveyed said they saw a downturn in full-time recruiting opportunities in financial services in October. Meanwhile, about half of the schools said overall full-time job postings and on-campus recruiting this fall was either flat or down 5% during the same period, with some indicating it has fallen as much as 10%.

In the coming year, the job market for MBAs may begin to bear a striking similarity to the period following the dot-com bust when some banks and consulting firms rescinded or renegotiated job offers they had extended to second-year students. That hasn’t happened this time around—yet.

As bad as that may sound, I think that those are rosy numbers. The worst is yet to come, and this job market will turn out to be far worse than that of the dot-com bust. This economic recession is far deeper and more broad-based than that of 2001-2002. In fact, I have been hearing anecdotally from sources (both internal and external to my university) that while recruiters have continued to visit and interview, there are increasingly fewer and fewer offers.

So I still anticipate an extremely difficult year for MBA grads looking for jobs. And unfortunately, I have had to revise my estimates for the next academic year. It is starting to look like it will be worse for the class of 2010.

I sincerely hope I am wrong.

I was recently informed that my blog has been named one of the “Top 50 Business Professor Blogs” by MBAExplorer.

At first I was flattered. It was a nice gesture, and it certainly feels great to be recognized as one of the top bloggers in the field.

But after thinking it over, I can’t help but wonder – Are there really 50 business professors who have blogs??

So while I thank the MBAExplorer for recognizing this blog, I must conclude that my blog most likely qualifies for the list by default

But seriously, they have compiled a nice list of blogs by business school academics. I encourage you to take a gander at what some of my colleagues have been writing.

I came across the following article in CFO magazine last night (see Ports in a Storm). The article details how applications have been picking up at business schools over the past year, and how such a stylized fact hints at an economic slowdown.

Anyone wanting further proof that the world economy is in trouble need look no further than the nearest business school. Many schools are hailing a bumper year for their full-time Master of Business Administration (MBA) programmes, which are popular with executives looking to hone their moneymaking skills while sitting out a downturn.

…Preliminary figures from the Graduate Management Admission Council (GMAC), an international organisation of business schools, show that 77% of full-time programmes have reported higher demand for places this year.

Applications to full-time MBA programs generally run counter-cyclically with the economy. In good times, fewer folks want to go back to school because there is ample opportunity to make good money, and leaving money on the table can be difficult. In fact, I remember during the dotcom boom that MBA students were dropping out of school in droves to open e-businesses that promised to make them rich. We all know how that turned out.

In bad times, people go back to school not only because their earning potential is lower, but also because many find themselves out of work, and with few alternatives. Going back to school allows students to wait out the economy.

But it would be wrong to look at a boom in applications and assume that it translates into a boon to the bottom-line. Although full-time applications tend to go up during economic downturns, other B-school offerings suffer – e.g., part-time MBA, executive MBA, and executive education programs.

During recessions, businesses reign in discretionary spending. One easy way for businesses to decrease costs is to eliminate spending on educational benefits for employees. Businesses often sponsor candidates for part-time and executive MBA degrees. And corporations are prime clients for custom executive programming. These lines of business (part-time, executive MBA, and exec ed) are generally more profitable for business schools than full-time MBA programs.

I anticipate corporate funding for these programs will dry up.

And although applications were up for most business schools this past year, it is likely that they will continue to increase in the coming years. As the article explains:

Worryingly for those betting on a swift economic recovery, business schools reckon that next year could yield an even bigger crop of applicants.

This does not bode well for our economy.

A nice article appeared in the Washington Post yesterday detailing the difficulty that graduates from the Class of 2008 have been having finding employment (see Graduates’ Job Hunts: Majorly Frustrating). In that article, Nancy Trejos follows the plight of several recent graduates, all of whom are either unemployed or underemployed.

During robust economic times, college students in undergraduate and graduate school programs would easily get multiple offers. As the economy teeters on the edge of recession, college graduates this year face a tough job market, leaving many without work in their fields or doing jobs that people without college degrees can do…

I do not dispute that recent graduates are having difficulty finding employment. In fact, I wrote about that several months ago (see Job Prospects for B-school Grads). My point back then was that although those who graduated without a job (those who were not fortunate enough to lock-in early in the hiring season) were certain to encounter difficulty; in the aggregate, graduates from the Class of 2008 did not have it all that bad.

Most of the problem for recent graduates will come in the form of underemployment versus unemployment. For example, as the article details:

Paul Harrington, an economist at Northeastern University, also found that about 38 percent of young college graduates are “underemployed,” or doing work for which they are overqualified.

“It’s a loss of resources. It’s a social loss. These are bright people who could be engaged in more productive activities but . . . we haven’t figured out how to move them into productive activities,” he said. “That’s the tragedy of a recession.”

That is a prescient comment, and in my opinion “underemployment” will most likely plague 2008 graduates, …for a few years at least.

But again, all things considered, given what the economy has endured, that isn’t the worst of fates. At the least, employers still seemed to be hiring last year.

Employers were expected to increase hiring 8 percent for the class of 2008, sharply below the 17.4 percent surge for the class of 2007.

So if you think the 2007-2008 academic year was bad, just wait until the 2008-2009 year, when the year-over-year hiring rates will likely decrease. In my opinion then, prospects for the Class of 2009 look particularly grim. And unfortunately, we ain’t seen nothin’ yet…

Last night I read an article about the difficulty students are having borrowing money to fund their education (see No Funds to Lend to 40,000 Students). This is not a new story. Bernanke testified on the topic back in February (see Bernanke on Student Loans). There have even been ongoing conversations on the topic at my institution for the better part of eight months now. But this is the first I’ve heard of the crunch putting students at immediate risk for the upcoming semester (which starts in as little as 5 weeks).

According to the Boston Globe article:

The Massachusetts Educational Financing Authority yesterday said it will not be able to provide student loans this fall for the first time in its 26-year history, leaving more than 40,000 families without an important source of tuition funds just weeks before college classes begin.

“As a result of our problems and the continued dislocation of the capital markets, we have been unable to raise funds for the coming academic year,” said Thomas M. Graf, the authority’s executive director.

Across the country, more than 50 lenders have stopped making federal or private student loans this year, largely because of the turmoil in the nation’s credit markets that began with the subprime mortgage crisis last summer.

This news saddens me. I am saddened that the financial crisis has had such extensive a reach that financial institutions are not able to fund one of our nation’s most valuable investments – education. I am also saddened that otherwise qualified students, who might not be able to afford the substantial costs of tuition on their own, may be forced to accept uncompetitive loans at very high rates, or in the extreme, forced to sit out of school until the economy improves.

I have one proposal.

Since many universities have amassed fantastic endowments (see Wikipedia on Endowments), now might be the time for them to tap those endowments to make loans on a temporary basis (until conditions improve) to their own students. Now there are obviously large disparities across universities in their endowments; however, I suspect that many universities are in a position to support such programs. After all, it would not represent a pure expense for the school (in the form of a non-repayable grant), but rather, an investment with a potentially healthy return.

My wife and I had dinner over the weekend with some close friends who were visiting from Washington DC. One of our friends just so happens to be Chief of Staff for a U.S. Congressman. He was interested in my views of the financial crisis, and the conversation quickly turned to the recent SEC-imposed ban of naked short-selling on a host of financial institutions (see SEC Restricts Shorting 19 Financial Stocks for background).

My friend and I agree on many issues. This was not one.

It is his view (and by extension, that of his boss) that short-sellers (UPDATE FOR CLARITY: He meant short-sellers in general, naked or otherwise) are to blame for much of the ills that have befallen U.S. banking stocks. He believes that by talking their books, hedge fund managers have effectively caused runs on banks. Moreover, he suggested that rumors passed from fund managers to CNBC, then reported on CNBC as fact (even if only as “alleged” fact), exacerbate the problem.

C’mon now, are you kidding me???

As much respect as I have for this friend, who is quite intelligent, I think he’s misguided on this issue. Blaming short-sellers for the failure of banks is as ludicrous as blaming Charles Schumer for the failure of IndyMac.

It is not the short-sellers that have caused the problems, but the banks themselves for lending irresponsibly thereby impairing their own balance sheets. Short-sellers are simply calling it as they see it, making logical deductions from the information at their disposal.

Now this does not mean that there are not instances of fraud, and I agree that fraud and attempts at outright manipulation should be prosecuted to the fullest extent of the law. However, to make a well-reasoned case for why certain banks are not healthy (even if consistent with your underlying trading position) is not fraud. Concerns about the health of banks not only should be raised – they deserve to be raised. The public ought to know what professionals truly believe about a company, for good and for bad. And for whatever it’s worth, the short-sellers often have it right (see Nasty, Brutish and Short).

Short-sellers provide a vital service to the functioning of our capital markets. Restricting their behavior is not only myopic, but also raises questions about the legality of those restrictions, and the “fairness” of the system (see Naked Fear for a nice summary of key issues).

And the point about how information relayed by CNBC can lead to a run – again, who’s joking whom? By the time information is disseminated by CNBC, it’s old news.

If you truly want to know about the health of a bank, there are two places to look – its balance sheet (if you’re so inclined to pore over such minutiae) and/or the credit default swap market (as bond traders are fairly keen at evaluating the health of corporations).

For what it’s worth, the credit default swap market has recently been sounding the alarm over Washington Mutual (see WaMu: Liquidity Options Running Low, Credit Default Swaps on WaMu, Uninsured Depositors at WaMu Begging for Trouble, or Death Spiral Financing at WaMu), among others.

To my knowledge, there has been no run on WaMu yet reported by CNBC. But if WaMu were to fail, I would not be surprised.

And that would have nothing to do with this post.