Edición 51, Finance

What We Should Teach in Finance – and How

By: Renata Herrerías
Instituto Tecnológico Autónomo de México

One of the many aspects brought into question after the great crisis of 2008 is whether what we teach in finance and economics, and how we do it, is still appropriate. In recent years, academics from universities in the United States have raised the question, what should we tell our students about our theories and our models?

What should be taught about the new paradigms of financial markets? Should traditional theories of finance continue to be taught? (Fabozzi, Focari and Jonas, 2014).

Financial Theory

Teaching finance and economics is not easy. Economics is the science that studies the management of resources to meet human needs, from its creation or production to distribution and consumption. Finance, on the other hand, is the field in which optimal investment portfolios are designed. Both study extremely complex phenomena that are difficult to analyze under replicable methodologies and in a systematic manner. The human factor plays a central role in both fields, and it is very difficult to elaborate good scientific theories. In fact, some academics consider that so far, there is no adequate way to generate good theories and it is likely that it will take a long time to reach that point. Part of the dissatisfaction with teaching finance and economics is that the models that are given in the classroom are ephemeral and therefore do not serve students in real life.

Having no good and lasting theories – and therefore no systematic way to predict major economic events such as financial crises – the cause of these is attributed to the economy and finance. They become the favorite culprit of major crises. Finance is the villain responsible for the sudden disappearance of the wealth of families, businesses and governments, and we forget that the fundamental role of finance and financial innovation is to be the means to achieve the life goals of individuals and institutions. Andrew Lo of MIT says, “Blaming financial innovation for the crisis is like blaming accounting and accounting standards for the big frauds of public companies in the United States. Unfortunately, the misuse and abuse of financial tools is what causes the crises, not the tools per se.”

Teaching Finance

What should we teach future generations about finance? Should we point to the great villain destructor of capital and highlight its shortcomings? Or should we teach finance as the vehicle that can make a wider range of individuals, and not just the privileged sectors, more prosperous?

In his book Finance and the Good Society (Princeton University Press, 2012), Robert J. Shiller postulates that educators had a role in the creation of the mortgage crisis of 2008 by putting too much emphasis on the efficient markets theory, which helped create speculative bubbles. According to this theory, agents are rational and information is available to everyone. The errors the market made by valuing instruments will be corrected with time and market equilibrium will prevail, even without ethical behavior. Unfortunately, sometimes prices deviate too much from their fundamental value because of unethical conducts, panics or excessive excitement, and systemic crises arise as consequence: first the excitement and greed, and then panic and runs afterwards. Prices will correct eventually, but wealth destruction is inevitable when deviations are so big.

Shiller suggests that, in addition to teaching theory and applied tools, finance should be explained and understood as a force for the common good. Finance that is well understood contributes to creating a better society, what he calls “a good society.” Finance is not an end in itself. It is a functional science that exists to support the goals of society. Those who study finance must find a purpose beyond it. Finance is a means to an end. The “end” is defined by the people. Finance experts should be only “administrators” or “protectors” of resources to achieve that end.

A Vocation in Finance

Financial tools and financial innovation are only useful to the extent that they help reach the goals of individuals, companies and governments, but always contributing to the building of a “good society.” The financial profession must be vocational; the financier should want to be a “facilitator” for others to achieve their goals.

What do financial professionals do? Mainly, Shiller explains, they “close deals” between entities with complementary needs, facilitating the arrangement that translates into real actions between persons or real entities. Any activity, from the design of an infrastructure project or sale of company stocks on the stock exchange, to a credit card transaction or a savings account, means an actual interaction between real persons or between real companies. Financial professionals – through financial institutions – make it possible for these transactions to exist.

In addition to a vocation, very specific skills are needed. The financial professional must cultivate expert thinking, which implies having a broad vision of the world and the ability to interpolate various sources of information and evaluate it from different perspectives. He/she also needs complex communication skills that combine interpersonal abilities and the capacity to understand complex situations. With these skills, the financial professional meets a client’s needs with options that best serve them. The financier must understand the technical complexities of the tools and services and apply that knowledge and sensitivity to resolve people’s problems. Therefore, teaching finance went from being descriptive and based on the memorization of concepts, to being a mathematical and empirical science. Today, we need to learn about abstract theory, practical applications and ethical issues that sustain the business. What is taught should focus more on what is not known to what is already known, given the enormous number of unpredictable elements in markets and economies.

In What Direction Do We Need to Go?

Shiller says that our integrity as educators must lead us to acknowledge before students the weaknesses of financial theory. On the other hand, it is clear that in most universities, ideas have emerged that have helped to create new instruments and make markets work more efficiently every day. In the universities, students should learn the mission of “protectors” and “administrators” of other’s resources, and it should be where they are given the tools for managing these resources.

Most of the time financial innovation has brought significant benefits. Simple instruments such as credit cards, or slightly more complex ones, like options or private capital, greatly facilitate the daily work in an economy. A more elaborate example that Shiller (2013) presents is the cap and trade initiative, which regulates carbon dioxide emissions from companies by setting maximum limits. Whoever exceeds the limit makes an “exchange” with another company that has reduced its emissions, that is, it purchases a certain amount of extra CO2, which it can emit. Today, there are five stock markets in the world where carbon emissions are exchanged under the cap and trade system.

Financial innovation should not be limited, but on the contrary, its area of operation should be increased, correcting past mistakes and aligning the incentives of all the participants again. What should be done in the classrooms is to incorporate points of view of other social sciences such as psychology, sociology, political science and anthropology without losing sight of the central role of institutions already established. When financial institutions focus on supporting the societies they serve to achieve their ideals and goals, those societies will be more successful. The central point is that when finance functions correctly, it has the unique potential to promote high levels of prosperity for the majority.

Referencias

    • Fabozzi, F. J., Focardi, S.M., Jona, C. (2014). Investment Management: A Science to Teach or an Art to Learn? CFA Institute Research Foundation, May 2014, Vol. 2014, No. 3.
    • Shiller, R. J. (2010). How Should the Financial Crisis Change how We Teach Economics? The Journal of Economic Education, 41(4).
    • Shiller, R. J. (2012). Finance and the Good Society. Princeton: Princeton University Press.

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