What are the changes needed in teaching finance?

I just wrote an article in Mint on changes needed in teaching economics. I could not expand but the changes apply to finance classrooms as well. So just added one line that similar changes are needed in finance curriculum as well. Having studied finance before the crisis, I was always get surprised how little weight both teachers and students put on knowing and understanding economics. So you had pure finance teachers which only focused on financial sector related issues.

In this superb speech Jean Boivin, Deputy Governor of the Bank of Canada points to the deficiencies in finance teaching before the crisis. He was an economics professor at HEC Montréal, a business school.  So he links the issues really well:

Many students wanted to pursue a career in finance. In such an environment, where macroeconomic stability was taken as a permanent feature of the economy, students asked why they should “waste time and money” sitting through a core macroeconomics class. Why not jump immediately to the important stuff – finance? We even changed the name of the course to make it more appealing: “Macroeconomics” became “The Global Economic Environment.”

I don’t know that this was very effective… 

To be fair to my former students, at the turn of the century, they weren’t the only ones to downplay the links between finance and the macroeconomy. Professionals and academics alike shared this view. I noticed a big change in attitude, however, when I last taught this course in the summer of 2009. Students took for granted that the connections between the economy and finance were crucial.

He then looks at the linkages between economics and finance and there is a decent history behind it. And this helped in taking measures to prevent the second depression. What was not understood is finance and economics meet in unspecified places:

Many of the connections between the economy and finance were perceived to be relevant mainly to countries in crisis, limiting interest to the study of historical episodes or economies with poorly developed financial markets. Consequently, many of the models used by economists to analyze usually stable, advanced economies abstracted from features of the financial sector. This was seen as a reasonable approximation.

But as we know, the recent crisis detonated in advanced economies after a long period of exceptional calm, often referred to as the “Great Moderation.”

How does the economy shift from stability to crisis?

While the links between the financial sector and the real economy are sometimes smooth and continuous, they can also be highly non-linear. These non-linear effects can manifest themselves by the slow buildup of imbalances in stable times – when many have been lulled into a false sense of security – followed by abrupt crashes.

This underlines the need to improve our understanding of where the economy and finance meet during stable times and how crises erupt:

  • First, we need better tools to understand the highly non-linear dynamics through which financial imbalances build up and affect the real economy. This involves improving our models, but also developing indicators that can help us to better track the risk of potential financial disruptions to the overall economy.
  • Second, we need to improve our understanding of how the real economy and system-wide forces can contribute to the development of financial imbalances, particularly through risk-taking behaviour.

In the end he says:

As we move away from the crisis, we all have an obligation to remember that imbalances build during periods of calm. Our vigilance is required at all times, not just during a crisis.

Better tools will help us to identify risks and better understand the human behaviour behind risk-taking. And certainly, system-wide supervision and regulation will do much to improve the global financial system.

However, as I conclude tonight, I would like to reinforce the fact that all of us here are part of the “system.” Economists, finance professionals, business school professors and students are part of this “system.” We have a role, and a responsibility, to improve our understanding of, and account for, the system-wide consequences of our individual actions. We have a chance to ensure that the painful lessons of the last few years lead to a better financial system, and by extension, to a more prosperous and stable world.

Useful speech. Interesting explanations of how economics meets finance and vice-versa.

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