Developing a monetary model of financial instability…

1. Developing a monetary model of financial instability… Steve KeenUniversity of Western Sydney

2. Minsky’s Financial Instability Hypothesis • A non-neoclassical vision of capitalism: • “capitalism is inherently flawed, being prone to booms, crises and depressions. • This instability, in my view, is due to characteristics the financial system must possess if it is to be consistent with full-blown capitalism. • Such a financial system will be capable of both generating signals that induce an accelerating desire to invest and of financing that accelerating investment.” (1969: 224; emphasis added) • Foundations in Marx, Schumpeter, Fisher, & Keynes Skip Quotes

3. Marx • Theoretical: a “dialectical” theory of prices • “What ... is … the price of the loaned capital?... What the buyer of an ordinary commodity buys is its use-value; what he pays for is its value. What the borrower of money buys is likewise its use-value as capital; but what does he pay for? Surely not its price, or value, as in the case of ordinary commodities.” (Marx 1894: 352) • Colourful: a sceptical view of banking: • “...The credit system … gives this class of parasites the fabulous power, not only to periodically despoil industrial capitalists, but also to interfere in actual production in a most dangerous manner—and this gang knows nothing about production and has nothing to do with it." (Marx 1894: 544-45)

4. Schumpeter • Well-known cyclical view of capitalism • Creative destruction, clusters of innovations, etc. • Less well-known endogenous view of credit: • “[I]n so far as credit cannot be given out of the results of past enterprise … it can only consist of credit means of payment created ad hoc, which can be backed neither by money in the strict sense nor by products already in existence... (Schumpeter 1934: 106) • “this again leads us to … the heresy that money, and … other means of payment, perform an essential function…” (95)

5. Fisher • Debt-deflation theory of Great Depressions: • Non-equilibrium analysis: • “New disturbances are, humanly speaking, sure to occur, so that, in actual fact, any variable is almost always above or below the ideal equilibrium” (1933: 339) • “two dominant factors” are “over-indebtedness to start with and deflation following soon after” • “Thus over-investment and over-speculation are often important; but they would have far less serious results were they not conducted with borrowed money… • I fancy that over-confidence seldom does any great harm except when, as, and if, it beguiles its victims into debt.” (Fisher 1933: 340-341)

6. Keynes • Well-known (if neglected) views on uncertainty • Formalised in Kalecki’s “principle of increasing risk” (Kalecki 1937, 1990: 285-293) • Investment limited not by declining marginal efficiency of capital but increasing financial risk • Also post-General Theory “two-price level” analysis • The scale of production of capital assets • “depends, of course, on the relation between their costs of production and the prices which they are expected to realise in the market.” (Keynes 1937a: 217) • All blended by Minsky to produce “Financial Instability Hypothesis”:

7. Financial Instability Hypothesis • Economy in historical time • Debt-induced recession in recent past • Firms and banks conservative re debt/equity ratios, asset valuation • Only conservative projects are funded • Recovery means conservative projects succeed • Firms and banks revise risk premiums • Accepted debt/equity ratio rises • Assets revalued upwards

8. The Euphoric Economy • Self-fulfilling expectations • Decline in risk aversion causes increase in investment • Investment causes economy to grow faster • Asset prices rise • Speculation on assets becomes profitable • Increased willingness to lend increases money supply • Credit money endogenous • Riskier investments enabled, more asset speculation • Emergence of “Ponzi” financiers • Cash flow always less than debt servicing costs • Profits made by selling assets on a rising market • Interest-rate insensitive demand for finance

9. The Assets Boom and Bust • Initial profitability of asset speculation: • reduces debt and interest rate sensitivity • drives up supply of and demand for finance • market interest rates rise • But eventually: • rising interest rates make many once conservative projects speculative • forces non-Ponzi investors to attempt to sell assets to service debts • entry of new sellers floods asset markets • rising trend of asset prices falters or reverses

10. Crisis and Aftermath • Ponzi financiers go bankrupt: • can no longer sell assets for a profit • debt servicing on assets far exceeds cash flows • Asset prices collapse, drastically increasing debt/equity ratios • Endogenous expansion of money supply reverses • Investment evaporates; economic growth slows or reverses • Economy enters a debt-induced recession ... • High Inflation? • Debts repaid by rising price level • Economic growth remains low: Stagflation • Renewal of cycle once debt levels reduced

11. Crisis and Aftermath • Low Inflation? • Debts cannot be repaid • Chain of bankruptcy affects even non-speculative businesses • Economic activity remains suppressed: a Depression • Big Government? • Anti-cyclical spending and taxation of government enables debts to be repaid • Renewal of cycle once debt levels reduced • Persuasive verbal model; but no successful mathematical rendition • My research objective

12. Mathematical Foundations • Goodwin’s “predator-prey” growth cycle model: • Verbal truisms: • “Workers share of output will rise if (real) wage demands exceed sum of population growth and labour productivity” • “Employment will rise if the rate of economic growth exceeds the rate of population growth” • In mathematical form, two coupled differential equations: Phillips Curve Depreciation, Productivity & Population growth rates Workers share of output Investment Function Employment rate

13. Mathematical Foundations • Generates closed cycle: • Add financial truisms: • “Banks finance investment and charge interest” • Generates 3rd order system • Debt to output ratio added: Profit now net of interest payments Net real interest rate

14. The beginnings of chaos • Two classes of outcome • Convergence to equilibrium… • If capitalists accumulate “negative debt” • But if they don’t…

15. The beginnings of chaos • An unstable cycle… • And debt that “ratchets up” over time to a debt-crisis… • How well does this simple model match empirical data? • Not very… • Because the empirical data is much worse!

16. The Ponzi Economy • Australia’s private debt to GDP ratio has risen exponentially at 4.2% p.a. for over 43 years: • Not for the first time in our history either • Long term RBA data released last month in speech by Deputy Governor Ric Battellino: • (augmented by data from RDP1999-06)

17. The Ponzi Economy And Our Generation? The Baby Boomers Follies 1890s Depression Great Depression Melbourne Land Boom Roaring Twenties What comes next?

18. The Ponzi Economy • Correlation isn’t causation, but… Clearly exponential process Biggest bubble in our history • There is a macroeconomic link: • Aggregate demand = GDP + change in debt • As debt rises, dependence on change in debt has risen • Now accounts for 18% of aggregate demand • Unemployment increasingly linked to change in debt…

19. The Ponzi Economy • Correlation debt’s contribution to aggregate demand of to unemployment initially trivial • Exceeds -0.9 by early 1980s • Formation of debt also increasingly dominated by speculation rather than investment:

20. Ponzi Households • Lending for housing rises from 5-25% of GDP: • Back to modelling: • Clear omissions from basic Minsky model are • Endogenous money • Speculative lending… • Proportion that financed housing construction falls from 30% to under 10%:

21. Endogenous Money • Exponential growth in credit despite regulatory regime implies endogenous (market-determined) money • Common belief in non-neoclassical schools of thought • Empirically supported by Kydland & Prescott: • But no accepted mathematical model of process • One can be derived from double-entry book-keeping: Skip Systems Note

22. A simple approach to dynamic systems • Each column represents a stock (system state) • Each row entry represents a flow between stocks • Specify relations between system states across rows… Relations Equations • To generate the model, add up each column • Sum of column is “differential equation” for stock

23. Money creation in a pure credit economy • Stylized linear model with three (classes of) agents: • Banks: • lend money to firms • record all transactions • Firms: • own factories that produce output; and • Workers: • work in factories. • Model starts with loan $L from bank to firm • Created “out of thin air”—simply simultaneous recording of asset (debt) and liability (deposit) in bank’s double-entry book-keeping system:

24. “Money from nothing, but your cheques ain’t free” • Loan an asset of bank • Simultaneously creates liability of money in firm’s deposit account: • Sets off series of obligations: • Interest charged on loan at rL% p.a. • Interest paid on deposit at rD% p.a. where rL > rD • Third account needed to record this: Bank Deposit BD

25. “Money from nothing, but your cheques ain’t free” • Full system is: Interest flows: bank<―>firm Add up terms Wage flows: firm―>workers Interest flows: bank―>workers Consumption flows: bank & workers―>firms • System of coupled differential equations: Get equation • System conservative: • Amount of money • (& debt) • remains constant

26. “Money from nothing, but your cheques ain’t free” • Growth in output requires new money to • Hire more workers • Pay for intermediate inputs • Simultaneous creation of new debt and new money: • System stable but no growth: Skip Quotes • Violates “Walras’ ‘Law’” • Supports Schumpeter & Minsky on credit New money flows: bank―>firm

27. “Money from nothing, but your cheques ain’t free” • Schumpeter • “in so far as credit cannot be given out of the results of past enterprise … it can only consist of credit means of payment created ad hoc, which can be backed neither by money in the strict sense nor by products already in existence...” (Schumpeter 1934: 106) • Minsky • “If income is to grow, the financial markets … must generate an aggregate demand that … is ever rising. For real aggregate demand to be increasing, . . . it is necessary that current spending plans, summed over all sectors, be greater than current received income… • It follows that over a period during which economic growth takes place, at least some sectors finance a part of their spending by emitting debt or selling assets.” (Minsky 1963 [1982]: 6)

28. “Money from nothing, but your cheques ain’t free” • Money and debt now grow over time: • System dissipative: • Rate of growth of money • = rate of growth of debt

29. Repayment and Re-lending of Principal • Model so far omits loan repayment • Easily added by including “seignorage free” bank “Vault” • Repaid loans have to go somewhere • If into bank deposit account, bank can pay for goods using its money as “IOU”s • NOT the same as re-lending deposited “fiat” money • Pure credit money system requires “quarantining” of bank asset accounts from income (deposit) accounts • Bank assets now sum of • Outstanding Loans • Loan Repayments

30. Repayment and Re-lending of Principal • Repayments of Loans; and • Recycling of Loans • Transfer money from income to asset accounts: • Surplus from production drives all net income • P is turnover period • s is share going to firms • (1-s) goes to workers Wages flow shown as share of production surplus Repayment flows: firm―>bank Relending flows: bank―>firm

31. “Would you like a credit card with that?” • Can now see what happens to bank income as • New Money is created • Loans are repaid • Repaid money is re-lent • Surprise surprise! • Bank income rises if • Loans are repaid slowly (or not at all) • Repaid money is recycled more quickly; and • More new money is created • Bank profits by extending more credit… • Structural explanation for real world phenomenon of rising debt to GDP ratio

32. For future research • Combine two models to produce monetary Minsky model • Speculative investment motivated by increase in asset price index • Adds to debt; does not add to productive capacity • First stage: a monetary Goodwin model • Also includes Phillips’s “full Monty” • Wage change related to • Rate of employment • Rate of change of employment • Lagged response to inflation: Skip Model

33. A monetary Goodwin model • Now six system states • But remarkably simple model Physical Capital Money Wage • Generates open cyclical model Inflation Lagged wage response Technical change&Population growth • With “Phillips surface” rather than Phillips curve inflation and unemployment dynamics

34. Meanwhile, in the real world… • Combination of record Debt/GDP, high nominal interest rates and low inflation means huge real interest burden: • Debt burden; • Aggregate demand effect of debt reduction • Serious downturn inevitable • Counter forces • China boom • Possible global warming/peak oil inflation

35. Selected References • Joseph Schumpeter (1934), The Theory of Economic Development: An Inquiry into Profits, Capital, Credit, Interest, and the Business Cycle (republished 2004 by Transaction Publishers, New Brunswick) • Charles Whalen, “The U.S. Credit Crunch of 2007: A Minsky Moment”, http://ideas.repec.org/p/lev/levppb/ppb_92.html • Some web-accessible references on Minsky’s work: • http://www.debunkingeconomics.com/FinancialInstability.htm • A Google Scholar search on Minsky • http://scholar.google.com.au/scholar?q=hyman+minsky&hl=en&lr= • Some web-accessible references on endogenous money • http://www.debunkingeconomics.com/Lectures/Index.htm#FE