Krugman would definitely subtitle a post like this “Wonkish”!

Click here for this post in PDF: Debtwatch; CfESI

This is a paper I’ve recently submitted by invitation to an Australian economics journal. I have been very quiet on the blog while finishing this in the last 2 weeks. I’m likely to remain quiet for the next fortnight, since I leave for the Fields Institute in Toronto on June 1^st, where I’ll be working for a month with the mathematicians there to analyze and refine my various models of financial instability. Grasselli and Costa Lima have already done a brilliant job analyzing my 1995 model in this paper.

Abstract

The “Global Financial Crisis” is widely acknowledged to be a tail event for neoclassical economics (Stevens 2008), but it was an expected outcome for a range of non-neoclassical economists from the Austrian and Post Keynesian schools. This article will provide a survey of the relevant Post Keynesian approaches for readers who are not familiar with this literature. Though it will cover the history of how Post Keynesian economics came to diverge so much from the neoclassical mainstream, the focus will be on the current state of Post Keynesian macroeconomics and its alternative indicators of macroeconomic turbulence, rather than historical exegesis.

1. A “Black Swan”?

   I do not know anyone who predicted this course of events. This should give us cause to reflect on how hard a job it is to make genuinely useful forecasts. What we have seen is truly a ‘tail’ outcome—the kind of outcome that the routine forecasting process never predicts. But it has occurred, it has implications, and so we must reflect on it.(Stevens 2008, p. 7)

RBA Governor Stevens’ remarks succinctly expressed the Neoclassical reaction to the “Global Financial Crisis” (GFC). It was not anticipated by any Neoclassical economic model—au contraire, in 2007 all conventional models predicted a continuance of “the Great Moderation” (Bernanke 2004; Bernanke 2004), with the OECD’s observation that “the current economic situation is in many ways better than what we have experienced in years” (OECD 2007, p. 7) being typical of official forecasts for 2008.

In the wake of that dramatically wrong forecast, the crisis that began in late 2007 and continues to this day is regarded as an inherently unpredictable event, due to the scale of unanticipated and unforeseeable exogenous shocks. Once shocks of the required magnitude and variability are injected into DSGE models, the behavior at the time of the crisis emerges (McKibbin and Stoeckel 2009; Ireland 2011) [but see Solow 2003, p. 1], but this behavior could not have been anticipated prior to the crisis.

Figure 1: The sudden transition from Great Moderation to Great Recession in the USA

On the other hand, a number of economists and market commentators claim to have anticipated the crisis (Bezemer 2009; see also Fullbrook 2010). Bezemer identified twelve individuals with a legitimate claim to having foreseen this crisis, on the basis of four selection criteria:

Only analysts were included who provide some account on how they arrived at their conclusions. Second, the analysts included went beyond predicting a real estate crisis, also making the link to real-sector recessionary implications, including an analytical account of those links. Third, the actual prediction must have been made by the analyst and available in the public domain, rather than being asserted by others. Finally, the prediction had to have some timing attached to it. (Bezemer 2009, p. 7)

However, only two of the twelve were guided by mathematical models: Wynne Godley (Godley and Wray 2000; Godley and Izurieta 2002; Godley and Izurieta 2004; Godley and Lavoie 2007) and myself (Keen 1995, 1996, 1997, 2000, 2007)—see Table 1, which is adapted from Bezemer (Bezemer 2009, p. 9). To evaluate whether this crisis could have been forecast, one has to compare like with like: are there mathematical models of the macroeconomy that did what Neoclassical models did not—anticipate the Global Financial Crisis?; and are there empirical indicators that are not included in Neoclassical macroeconomic models that did indicate that a crisis was approaching?

Table 1: Predictors of the Global Financial Crisis (adapted from Bezemer, 2009, Table 1)

On the record, there are only two contending mathematical approaches—the “Stock-Flow Consistent” framework developed by Godley, and the complex systems approach I use to model Minsky’s “Financial Instability Hypothesis” (Minsky 1977); and two key indicators—sectoral imbalances identified by Godley’s approach, and the ratio of private debt to GDP that plays a key role in my models.

Both Godley and I self-identify as Post-Keynesian, though there are large differences in our approaches. This survey article will introduce our models to an audience far more familiar with Neoclassical modelling. Some attention will be given to criticisms of Neoclassical macroeconomics, “What Keynes Really Meant” textual exegesis, and the development of our approaches in the context of earlier Post Keynesian research, but these are only preliminaries to describing our approaches to macroeconomic modeling to an audience that is not familiar with them. This paper is also not a history of Post Keynesian economics—for that, see (King 2003; King 2012). What history there is a “Whig history” of the evolution of my and Godley’s approaches to monetary macroeconomics.

1. Divergence: Equilibrium, Expectations, Microfoundations and Money

There are 5 key areas in which modern Post-Keynesian macroeconomics differs from Neoclassical macroeconomics: the role of equilibrium, the nature of expectations, the need for microfoundations, the model of production, the role of money, and the role of government. The reasons for these differences are set out below, not in an attempt to persuade Neoclassical readers on these issues, but to establish that the fact that Post Keynesian models do not conform to Neoclassical principles does not provide an a priori reason to reject these approaches to macroeconomic modeling.

1. Equilibrium

It is well-known that the IS-LM model was developed by Hicks rather than Keynes (Hicks 1937), but was accepted “as a convenient synopsis of Keynesian theory” (Hicks 1981, p. 139) by the vast majority of economists. The development of Post Keynesian macroeconomics began with economists like Joan Robinson in the UK (Robinson 1964) and Paul Davidson in the USA (Davidson 1969) who instead rejected ‘Mr Keynes & the “Classics”‘ (Hicks 1937) as “an article which … misses Keynes’ point completely” (Minsky 1969, p. 225).

What is less well known is that the elder Sir John Hicks agreed with the critics, and disowned the IS-LM model as an inadequate basis for macroeconomics. Whereas Neoclassical economics also rejected IS-LM, on the basis that the model did not have good microfoundations, Hicks rejected it because, he argued, it required the unacceptable assumption that the economy was in equilibrium at all times.

Reflecting on his creation in 1981, Hicks observed firstly that it was not a model of Keynes General Theory, since he had conceived of IS-LM “before I wrote even the first of my papers on Keynes” (Hicks 1981, p. 140), and secondly that it was Walrasian rather than Keynesian in origin (Hicks 1981, p. 141-142).

One essentially Walrasian foundation of IS-LM was the representation of a 3-market system as a 2 market model under the assumption that, if two of the markets were in equilibrium, then so was the third by Walras’ Law. Hicks therefore ignored the market for loanable funds (and also the labor market) in the IS-LM model:

‘One did not have to bother about the market for “loanable funds,” since it appeared, on the Walras analogy, that if these two “markets” were in equilibrium, the third must be also. So I concluded that the intersection of IS and LM determined the equilibrium of the system as a whole.’ (Hicks 1981, p. 142)

However, this Walrasian analogy applied in reverse in disequilibrium: if one of the two markets in IS-LM was out of equilibrium, then necessarily so was the other—and/or the other markets ignored in equilibrium had also to be considered. Consequently, the only point in the IS-LM diagram that “makes any claim to representing what actually happened” (Hicks 1981, p. 149) is the intersection of the IS and LM curves. This in turn requires assuming that the economy is always in equilibrium.

This had to be rejected, Hicks argued, because assuming continuous equilibrium also meant assuming that expectations were fulfilled at all times, whereas at crucial turning points in the economy “the system was not in equilibrium. There were plans which failed to be carried through as intended; there were surprises.” (Hicks 1981, p. 150). Macroeconomics therefore had to be about disequilibrium—which he described as “the traverse”

When one turns to questions of policy … the use of equilibrium methods is still more suspect. … There can be no change of policy if everything is to go on as expected—if the economy is to remain in what (however approximately) may be regarded as its existing equilibrium. It may be hoped that, after the change in policy, the economy will somehow, at some time in the future, settle into what may be regarded, in the same sense, as a new equilibrium; but there must necessarily be a stage before that equilibrium is reached. There must always be a problem of traverse. For the study of a traverse, one has to have recourse to sequential methods of one kind or another. (Hicks 1981, pp. 152-153)

This proposition that macroeconomics must be a study of disequilibrium states is a common theme in Post-Keynesian economics (Fisher 1933; Kaldor 1940; Kaldor 1951; Goodwin 1967; Kornai 1971; Robinson 1974; Goodwin 1986). Our macroeconomic models fit within this theme, with Godley’s model expressed in difference equations while I employ nonlinear differential equations.

1. Expectations

A long line of non-Neoclassical economists have emphasized the role of uncertainty in economics, and especially in Keynes’s analysis. Keynes once famously described economic theory prior to his work as “one of these pretty, polite techniques which tries to deal with the present by abstracting from the fact that we know very little about the future” (Keynes 1937, p. 215). To Post Keynesians, the “Rational Expectations Revolution” replaced this with an even prettier but less polite technique that assumed that the future could be predicted by agents endowed with “rational expectations”.

The transition from IS-LM to Rational Expectations macroeconomics began the Lucas Critique (Lucas 1976), and its well-founded objections to using historical relations in large scale macroeconomic models to predict behavior under future policy regimes. However, that paper continued a research agenda into the “Natural Rate Hypothesis” (NRH) in which Lucas had previously acknowledged that the NRH required the assumption that inflationary expectations are accurate, and that assuming “expectations are rational in the sense of Muth” was equivalent to adding the assumption that inflationary expectations were accurate “simply … as an additional axiom” (Lucas 1972, p. 55).

This was more than one axiom too far for Post Keynesian economists, who insisted that expectations formation under uncertainty was a crucial aspect of reality, and that this had to allow for investors on occasions making decisions that “in a more sober expectational climate, they would have rejected” (Minsky 1972; Minsky 1982, p. 117). Rational expectations, to coin a phrase, meant “never having to say you were drunk”. Godley’s models and mine allow for expectations to be based on inaccurate estimates of future outcomes, while still being derived from rational responses to current information, given the inherent uncertainty of the future (Blatt 1979; Blatt 1980).

1. Microfoundations

Lucas’s observation that “Nobody was satisfied with IS-LM as the end of macroeconomic theorizing” pithily summarizes the key motivation behind the evolution of Neoclassical macroeconomics from the time of Keynes: “The idea was we were going to tie it together with microeconomics and that was the job of our generation” (Lucas 2004, p. 20). The major argument in favor of a micro-founded macroeconomics was that micro analysis could provide the “deep parameters” that were invariant to policy changes (Estrella and Fuhrer 1999; Estrella and Fuhrer 2003; Ljungqvist and Sargent 2004, pp. xxvi-xxvii ), in contrast to the parameters of large-scale econometric models which would be subject to drift as policy changed (Lucas 1976, p. 39). This led initially to Real Business Cycle models in which the entire economy was modeled by a “representative agent” (Kydland and Prescott 1982), and ultimately to New Keynesian macroeconomics (Gordon 1982; Woodford 2009).

Post Keynesians rejected the argument that macroeconomics could be derived from microeconomics (Kregel 1985). Though this position is contrary to Neoclassical practice, it is in fact supported by well-known but poorly understood Neoclassical research: the Sonnenschein-Mantel-Debreu theorems (Shafer and Sonnenschein 1993). While these are portrayed in textbooks as arguing simply that “stringent conditions” are needed to ensure that a representative agent can be used to model aggregate behavior (Varian 1984, p. 268), their real import is that the “Law of Demand” does not apply at the level of a single market, even if all consumers in that market are rational utility maximizers:

Can an arbitrary continuous function … be an excess demand function for some commodity in a general equilibrium economy? … we prove that every polynomial … is an excess demand function for a specified commodity in some n commodity economy… every continuous real-valued function is approximately an excess demand function. (Sonnenschein 1972, pp. 549-550)

The fact that demand in a single market cannot be legitimately modeled as being derived from a representative agent (and thus subject to the Law of Demand) strongly implies that aggregate demand cannot be modeled that way either: microeconomic “deep parameters” are therefore lost in the interactions between agents. This is an instance of a common phenomenon arising from the interaction of multiple entities in a system, which physicists have dubbed “Emergent Properties”: the system itself cannot be understood from the properties of the entities themselves, since its behavior depends on nonlinear interactions between the entities. As Physics Nobel Laureate Philip Anderson put it:

The behavior of large and complex aggregates of elementary particles, it turns out, is not to be understood in terms of a simple extrapolation of the properties of a few particles. Instead, at each level of complexity entirely new properties appear, and the understanding of the new behaviors requires research which I think is as fundamental in its nature as any other… (Anderson 1972, p. 393)

Anderson continued that “Psychology is not applied biology, nor is biology applied chemistry” (Anderson 1972, p. 393), and Post Keynesians similarly assert that “Macroeconomics is not applied microeconomics”. Godley’s models work at the level of economic sectors—households, firms, the government and banks—while my models work at the level of social classes, in line with Andrew Kirman’s reaction to the SMD conditions that “we may well be forced to theories in terms of groups who have collectively coherent behavior…. The idea that we should start at the level of the isolated individual is one which we may well have to abandon.” (Kirman 1989, p. 138).

1. Production

Substitutability of inputs, rising marginal cost and diminishing marginal productivity are familiar elements of Neoclassical micro and macroeconomics. Post-Keynesian micro and macroeconomics instead assume fixed proportions between inputs, constant or even falling marginal costs, abjure the relevance of marginal productivity, and in particular reject the Cobb-Douglas production function (see section 7).

The Post Keynesian position is based on almost 80 years of empirical research—commencing with the Oxford Economists Research Group in 1934 in the UK (Hall and Hitch 1939; Lee 1981; Besomi 1998; Simon and Slater 1998) and Gardiner Means in the USA (Means 1936)—which has found that, despite its a priori appeal, diminishing marginal productivity and rising marginal cost are the exception rather than the rule for industrial companies.

The most recent work confirming this result was done by Alan Blinder, who after a careful survey of 200 firms that collectively accounted for 7.6% of US GDP {Blinder, 1998 #297, p. 68}, reported that:

The overwhelmingly bad news here (for economic theory) is that, apparently, only 11 percent of GDP is produced under conditions of rising marginal cost. .. (Blinder 1998, p. 102)… Firms … rarely report the upward-sloping marginal cost curves that are ubiquitous in economic theory. Indeed, downward-sloping marginal cost curves are more common. (Blinder 1998, p. 302)

Table 2: Blinder’s survey results on firm cost structures (pp. 100-106)

This result is consistent with inputs being used in fixed proportions, and Post Keynesian macroeconomic models treat production as linearly related to labor and intermediate good inputs (with variable utilization of fixed capital in some instances), a position first put logically by Sraffa (Sraffa 1926).

1. Money

Money neutrality—certainly in the long run and, under Rational Expectations, also in the short run—is an essential aspect of the Neoclassical approach, in which macroeconomic models abstract from the existence of money, private debt, and banks. To Neoclassicals, the argument that changes in monetary variables impact upon real economic variables smacks of the fallacy of money illusion, and the difficulty lies in reconciling this principle with the empirical record:

It is natural (to an economist) to view the cyclical correlation between real output and prices as arising from a volatile aggregate demand schedule that traces out a relatively stable, upward-sloping supply curve. This point of departure leads to something of a paradox, since the absence of money illusion on the part of firms and consumers appears to imply a vertical aggregate supply schedule, which in turn implies that aggregate demand fluctuations of a purely nominal nature should lead to price fluctuations only. (Lucas 1972, p. 51)

Post Keynesian economists initially rejected money neutrality on the basis of Keynes’s argument that a monetary economy “is essentially one in which changing views about the future are capable of influencing the quantity of employment and not merely its direction” (Keynes 1936, p. xxii), thus conflating money with uncertainty. They also rejected the applicability of the concept of money illusion in a credit-based economy with nominal debts, since even Friedman’s statement of it conceded that it was only strictly true if debts were denominated in real terms:

nothing is so unimportant as the quantity of money expressed in terms of the nominal monetary unit … let the number of dollars in existence be multiplied by 100; that, too, will have no other essential effect, provided that all other nominal magnitudes (prices of goods and services, and quantities of other assets and liabilities that are expressed in nominal terms) are also multiplied by 100. (Friedman 1969, p. 1; emphasis added)

Later work into the mechanics of money creation strengthened the case for distinguishing the macroeconomics of a monetary economy from a non-monetary one. Basil Moore (Moore 1979) argued that bank lending was not effectively constrained by the reserve-setting behavior of Central Banks, using both empirical analysis and the mechanics of Federal Reserve behavior. As Federal Reserve Bank of New York Vice President Alan Holmes put it in his arguments opposing Monetarism in 1969:

The idea of a regular injection of reserves … also suffers from a naive assumption that the banking system only expands loans after the System (or market factors) have put reserves in the banking system. In the real world, banks extend credit, creating deposits in the process, and look for the reserves later… the reserves required to be maintained by the banking system are predetermined by the level of deposits existing two weeks earlier. (Holmes 1969, p. 73)

The relationship of loans and deposits leading and reserves lagging is more pronounced today, with the reserve lag now being 30 days (O’Brien 2007, Table 12, p. 52). The European Central Bank has also recently confirmed that the Post Keynesian position that “loans create deposits, and determine reserves with a lag” accurately describes private and Central Bank procedures:

In fact, the ECB’s reserve requirements are backward-looking, i.e. they depend on the stock of deposits (and other liabilities of credit institutions) subject to reserve requirements as it stood in the previous period, and thus after banks have extended the credit demanded by their customers. (ECB 2012, p. 21)

These operational perspectives on the endogenous creation of money by banks were confirmed by empirical work into the timing of economic variables by Kydland and Prescott, where they concluded that

the monetary base lags the cycle slightly… The difference of M2-M1 leads the cycle by … about three quarters… The fact that the transaction component of real cash balances (M1) moves contemporaneously with the cycle while the much larger nontransaction component (M2) leads the cycle suggests that credit arrangements could play a significant role in future business cycle theory. Introducing money and credit into growth theory in a way that accounts for the cyclical behavior of monetary as well as real aggregates is an important open problem in economics. (Kydland and Prescott 1990, pp. 4, 15)

More recently, the collapse in the ratio of broad money to base money during and after the crisis inspired an FRB Discussion Paper which concluded that:

the relationships implied by the money multiplier do not exist in the data for the most liquid and well-capitalized banks. Changes in reserves are unrelated to changes in lending, and open market operations do not have a direct impact on lending. We conclude that the textbook treatment of money in the transmission mechanism can be rejected. (Carpenter and Demiralp 2010, pp. 27-28)

However these empirical realities alone are not sufficient to support a critical role for banks, money and debt in macroeconomics: there must also be a link between change in monetary variables and change in real economic activity. The proposition that there is such a link was first put by Schumpeter, when he argued that the dominant source of funds for entrepreneurial investment was the creation of additional spending power by banks—not by transferring funds from savers to borrowers, but by the process of simultaneously creating both a deposit and a debt for a borrower without reducing the spending capacity of savers.

In Schumpeter’s model, entrepreneurs were individuals with concepts that could transform production or distribution in a discontinuous way—and thus yield “super-normal” profits to themselves—but no money with which to put these concepts into action. They therefore had to borrow:

the entrepreneur … can only become an entrepreneur by previously becoming a debtor… his becoming a debtor arises from the necessity of the case and is not something abnormal, an accidental event to be explained by particular circumstances. What he first wants is credit. Before he requires any goods whatever, he requires purchasing power. He is the typical debtor in capitalist society.’ (Schumpeter 1934, p. 102)

Schumpeter conceded that some of this finance could arise from saving—abstaining from consumption—but argued that this was minor compared to the endogenous creation of additional spending power by banks:

‘Even though the conventional answer to our question is not obviously absurd, yet there is another method of obtaining money for this purpose, which … does not presuppose the existence of accumulated results of previous development, and hence may be considered as the only one which is available in strict logic. This method of obtaining money is the creation of purchasing power by banks… It is always a question, not of transforming purchasing power which already exists in someone’s possession, but of the creation of new purchasing power out of nothing… (Schumpeter 1934, p. 73)

This theoretical argument received empirical support from research by Fama and French. Using the Compustat database of company reports from publicly-traded US non-financial corporations between 1951 & 1996, Fama and French calculated aggregate non-financial corporate investment, and correlated it with equity issue, retained earnings, and new debt (see Figure 2).

Figure 2: Correlations of investment to new equity, retained earnings and new debt (Fama & French 1999, p. 1954)

They concluded that “the source of financing most correlated with investment is long-term debt”:

Figure 3 shows investment and its financing year by year. The figure suggests that new net issues of stock do not move closely with investment. In fact, when the variables are measured relative to book capital … the correlation of investment, It, and new net issues of stock, dSt, is only 0.19… retained cash earnings move more closely with investment. The correlation between It and RCEt is indeed higher, 0.56, but far from perfect. The source of financing most correlated with investment is long-term debt. The correlation between It and dLTDt is 0.79. The correlation between It and new short-term debt is lower, 0.60, but nontrivial. These correlations confirm the impression from Figure 3 that debt plays a key role in accommodating year-by-year variation in investment. (Fama and French 1999, p. 1954)

There is thus a very important link between changes in monetary aggregates and real economic activity. This relationship is reflected in Godley’s and my models, with debt financing investment and liability structures arising from debt playing a key role in the predictions our models provide. The banking sector is also essential, since its financing of investment by the endogenous expansion of the money supply is a vital component of a growing economy. In both sets of models, money and debt are created simultaneously and endogenously by the bookkeeping operations of banks (Graziani 1989; Graziani 2003).

1. Government

With its view of a market economy as self-equilibrating, the Neoclassical school has had a tendency towards a critical perspective on the role of government, which culminated in the “Policy Inefffectiveness Proposition” that:

by virtue of the assumption that expectations are rational, there is no feedback rule that the authority can employ and expect to be able systematically to fool the public. This means that the authority cannot expect to exploit the Phillips Curve even for one period. (Sargent and Wallace 1976, p. 178)

Post Keynesian work has instead adhered to Keynes’s perspective that the market economy can generate insufficient aggregate demand to guarantee full employment (Keynes 1936, p. 25). This in turn leads Post Keynesians in general to argue that the government has both a responsibility and a capacity to boost aggregate demand during recessions, though there are differences in how effective such policies are expected to be.

Godley’s sectoral balance approach argues that a government surplus can force the private sector into a deficit, while government deficits are needed to enable the private sector to restore its balance sheet (Godley and Wray 2000, p. 204). My 1995 paper argued that counter-cyclical government spending could prevent a debt-induced recession by attenuating speculative euphoria during a boom and providing cash flows to service debts during a slump (Keen 1995, pp. 625-632).

1. Convergence: Structure, Dynamics and Minsky

That concludes an overview of the ways in which, in common with the broad Post-Keynesian tradition, Godley and I diverge from Neoclassical practice. The next topic is the positive themes in Post Keynesian economics that our approaches share.

1. Structure

Though the extent to which Post-Keynesian practice has lived up to its rhetoric can be disputed, Post-Keynesian theory has stressed the need to accurately model the institutions and structure of the economy that set the constraints on individual and collective behavior, in contrast to the Neoclassical emphasis upon methodological individualism (Krugman 1996). This emphasis can be dated to Sraffa’s empirically-oriented criticism of Marshall (Sraffa 1926; Robertson, Sraffa et al. 1930), which led to his input-output equilibrium critique of Neoclassical production theory (Sraffa 1960) and the development of an input-output oriented approach to macrodynamics (Pasinetti 1973; Pasinetti 1988; Salvadori and Steedman 1988; Kurz and Salvadori 1993; Pasinetti 1993; Salvadori 1998; Kurz and Salvadori 2006). This has caused conflict within the broad Post-Keynesian tradition akin to the Saltwater-Freshwater divide in Neoclassical economics between those who insist that input-output relations are a “brute fact about modern industrial economies” (Steedman 1992, p. 126) and those who develop “corn economy” models (Kriesler 1992; Sawyer 1992; Steedman 1993; but see Keen 1998). Though input-output dynamics are absent from Godley’s work, the emphasis upon modeling structure of the economy is common to both of us.

1. Dynamics

Post Keynesian models emphasize dynamics and disequilibrium rather than comparative statics and equilibrium, in a tradition that dates back to Kalecki (Kalecki 1935; Kalecki 1937) and Harrod (Harrod 1939; Harrod 1960). Post Keynesian macroeconomic models are iterative in nature and do not have a long-run equilibrium towards which the economy is assumed to converge (Arestis 1989; Sawyer 1995; Sawyer 1995).

Both Godley and I have developed not simply models (like, for example, Arestis 1989; Keen 2000, pp. 84-89), but modeling frameworks from which a wide variety of related models can be derived.

1. Minsky: Can “It” Happen Again?

Can “It”—a Great Depression—happen again? And if “It” can happen, why didn’t “It” occur in the years since World War II? These are questions that naturally follow from both the historical record and the comparative success of the past thirty-five years. To answer these questions it is necessary to have an economic theory which makes great depressions one of the possible states in which our type of capitalist economy can find itself. (Minsky 1982, p. 5)

In this “Chicago” view there exists a financial system … which would make serious financial disturbances impossible. It is the task of monetary analysis to design such a financial system, and of monetary policy to execute the design… The alternative polar view, which I call unreconstructed Keynesian, is that 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. (Minsky 1969; Minsky 1982, p. 279)

Hyman Minsky’s “Financial Instability Hypothesis” has become a unifying vision in Post Keynesian economics, crystallizing the many differences between this school’s approach and the Neoclassical model. Since he is still unfamiliar to Neoclassical economists, it is important to set out his analysis at length here.

Minsky’s initial intellectual foundations were his PhD supervisor Schumpeter’s inherently cyclical and monetary vision of capitalism (Schumpeter 1928), and Irving Fisher’s “Debt-Deflation” explanation of the Great Depression (Fisher 1933). After reading Keynes 1937 essay “The General Theory of Employment” (Keynes 1937) in 1968, Minsky realized that IS-LM was not an accurate rendition of Keynes’s theory, and Keynes’s focus upon expectations formation under uncertainty in this paper (Keynes 1937, p. 214) provided the final component in his Hypothesis. This explains the puzzle that his first exposition of the Financial Instability Hypothesis was in a book whose title implied it was a biography of Keynes (Minsky 1975). It was instead an exposition of Minsky’s thesis in a book whose title paid homage to Keynes as an intellectual pioneer.

Minsky’s verbal model of a financial cycle begins at a time when the economy is doing well (the rate of economic growth equals or exceeds that needed to reduce unemployment), but firms are conservative in their portfolio management (debt to equity ratios are low and profit to interest cover is high), and this conservatism is shared by banks, who are only willing to fund cash-flow shortfalls or low-risk investments.

The cause of this high and universally practiced risk aversion is the memory of a not too distant system-wide financial failure, when many investment projects foundered, many firms could not finance their borrowings, and many banks had to write off bad debts. Because of this recent experience, both sides of the borrowing relationship prefer extremely conservative estimates of prospective cash flows: their risk premiums are very high.

However, the combination of a growing economy and conservatively financed investment means that most projects succeed. Two things gradually become evident to managers and bankers: “Existing debts are easily validated and units that were heavily in debt prospered: it pays to lever” (Minsky 1982, p. 65). As a result, both managers and bankers come to regard the previously accepted risk premium as excessive. Investment projects are evaluated using less conservative estimates of prospective cash flows, so that with these rising expectations go rising investment and asset prices. The general decline in risk aversion thus sets off both growth in investment and exponential growth in the price level of assets, which is the foundation of both the boom and its eventual collapse.

More external finance is needed to fund the increased level of investment and the speculative purchase of assets, and these external funds are forthcoming because the banking sector shares the increased optimism of investors (Minsky, 1980, p. 121). The accepted debt to equity ratio rises, liquidity decreases. and the growth of credit accelerates.

This marks the beginning of what Minsky calls “the euphoric economy” (Minsky 1982, pp. 120-124), where both lenders and borrowers believe that the future is assured, and therefore that most investments will succeed. Asset prices are revalued upward as previous valuations are perceived to be based on mistakenly conservative grounds. Highly liquid, low-yielding financial instruments are devalued, leading to a rise in the interest rates offered by them as their purveyors fight to retain market share.

Financial institutions now accept liability structures for both themselves and their customers “that, in a more sober expectational climate, they would have rejected” (Minsky 1980, p. 123). The liquidity of firms is simultaneously reduced by the rise in debt to equity ratios, making firms more susceptible to increased interest rates. The general decrease in liquidity and the rise in interest paid on highly liquid instruments triggers a market-based increase in the interest rate, even without any attempt by monetary authorities to control the boom. However, the increased cost of credit does little to temper the boom, since anticipated yields from speculative investments normally far exceed prevailing interest rates, leading to a decline in the elasticity of demand for credit with respect to interest rates.

The condition of euphoria also permits the development of an important actor in Minsky’s drama, the Ponzi financier (Minsky 1982, pp. 70, 115; Galbraith, 1954, pp. 4-5). These capitalists are inherently insolvent, but profit by trading assets on a rising market, and must incur significant debt in the process:

A Ponzi finance unit is a speculative financing unit for which the income component of the near term cash flows falls short of the near term interest payments on debt so that for some time in the future the outstanding debt will grow due to interest on existing debt… Ponzi units can fulfill their payment commitments on debts only by borrowing (or disposing of assets)… a Ponzi unit must increase its outstanding debts.’ (Minsky 1982, p. 24)

The servicing costs for Ponzi debtors exceed the cash flows of the businesses they own, but the capital appreciation they anticipate far exceeds their debt servicing costs. They therefore play an important role in pushing up the market interest rate, and an equally important role in increasing the fragility of the system to a reversal in the growth of asset values.

Rising interest rates and increasing debt to equity ratios eventually affect the viability of many business activities, reducing the interest rate cover, turning projects that were originally conservatively funded into speculative ones, and making ones that were speculative “Ponzi.” Such businesses will find themselves having to sell assets to finance their debt servicing—and this entry of new sellers into the market for assets pricks the exponential growth of asset prices. With the price boom checked, Ponzi financiers now find themselves with assets that can no longer be traded at a profit, and levels of debt that cannot be serviced from the cash flows of the businesses they now control. Banks that financed these assets purchases now find that their leading customers can no longer pay their debts—and this realization leads initially to a further bank-driven increase in interest rates. Liquidity is suddenly much more highly prized; holders of illiquid assets attempt to sell them in return for liquidity. The asset market becomes flooded and the euphoria becomes a panic, the boom becomes a slump.

As the boom collapses, the fundamental problem facing the economy is one of excessive divergence between the debts incurred to purchase assets, and the cash flows generated by them—with those cash flows depending upon both the level of investment and the rate of inflation.

The level of investment has collapsed in the aftermath of the boom, leaving only two forces that can bring asset prices and cash flows back into harmony: asset market deflation, or current goods inflation. This dilemma is the foundation of Minsky’s iconoclastic perception of the role of inflation, and his explanation for the stagflation of the 1970s and early 1980s.

Minsky argues that if the rate of inflation is high at the time of the crisis, then though the collapse of the boom causes investment to slump and economic growth to falter, rising cash flows rapidly enable the repayment of debt incurred during the boom. The economy can thus emerge from the crisis with diminished growth and high inflation, but few bankruptcies and a sustained decrease in liquidity. Thus, though this course involves the twin “bads” of inflation and initially low growth, it is a self-correcting mechanism in that a prolonged slump is avoided.

However, the conditions are soon reestablished for the cycle to repeat itself, and the avoidance of a true calamity is likely to lead to a secular decrease in liquidity preference.

If the rate of inflation is low at the time of the crisis, then cash flows will remain inadequate relative to the debt structures in place. Firms whose interest bills exceed their cash flows will be forced to undertake extreme measures: they will have to sell assets, attempt to increase their cash flows (at the expense of their competitors) by cutting their margins, or go bankrupt. In contrast to the inflationary course, all three classes of action tend to further depress the current price level, thus at least partially exacerbating the original imbalance. The asset price deflation route is, therefore, not self-correcting but rather self-reinforcing, and is Minsky’s explanation of a depression.

The above sketch basically describes Minsky’s perception of an economy in the absence of a government sector. With big government, the picture changes in two ways, because of fiscal deficits and Reserve Bank interventions. With a developed social security system, the collapse in cash flows that occurs when a boom becomes a panic will be at least partly ameliorated by a rise in government spending—the classic “automatic stabilizers,” though this time seen in a more monetary light. The collapse in credit can also be tempered or even reversed by rapid action by the Reserve Bank to increase liquidity.

Thus, though Minsky argued that financial instability was inevitable, he argued that Depressions could be avoided by a combination of deficits resulting from “Big Government” and “Lender of Last Resort” interventions by the Central Bank—so long as, in addition, we “establish and enforce a ‘good financial society’ in which the tendency by business and bankers to engage in speculative finance is constrained” (Minsky 1977; Minsky 1982, p. 69).

Minsky’s ambition in his PhD thesis (Minsky and Papadimitriou 2004) was to provide a mathematical model of a finance-driven trade cycle by which financial cycles could lead to a Depression, and this resulted in only AER publication (Minsky 1957). After his PhD, he largely abandoned mathematical methods (apart from a flirtation with Kalecki’s macroeconomic identities Kalecki 1942; Kalecki 1971) and developed the verbal account given above of how debt-financed investment and speculation, in a world with an cyclical past and an uncertain future, could lead to a Great Depression caused, not by bad monetary policy, but by the inherent nature of capitalism.

Minsky’s decision not to pursue a mathematical treatment of his hypothesis reflected partly the less advanced state of dynamic modelling at the time he learnt mathematics, and partly the fundamental flaws of the “Hicks-Hansen-Samuelson” second order difference equation model of the trade cycle on which he attempted to build his model. With the advantage of having learnt mathematics after the development of complexity theory, I saw Minsky’s model as eminently suited to a complex systems treatment, and undertook to build such a model in my own PhD.

1. Anticipating the Black Swan I—Debt-Deflation and Complexity

An essential aspect of Schumpeter and Minsky’s shared vision of capitalism is that it is inherently cyclical, rather than a system that tends to equilibrium. Schumpeter saw this as a strength of capitalism, and essential to its vitality (Schumpeter 1928). Minsky was rather less sanguine:

Stable growth is inconsistent with the manner in which investment is determined in an economy in which debt-financed ownership of capital assets exists, and the extent to which such debt financing can be carried is market determined. It follows that the fundamental instability of a capitalist economy is upward. The tendency to transform doing well into a speculative investment boom is the basic instability in a capitalist economy. (Minsky 1977; Minsky 1982, p. 67)

A cyclical model was thus required to underpin Minsky’s Hypothesis. I used Goodwin’s growth cycle model for this purpose (Goodwin 1967), following Blatt’s advice that, from the perspective of an applied mathematician, it was the “most hopeful”, and that its flaw “of an equilibrium which is not unstable” could be remedied by the “introduction of a financial sector, including money and credit as well as some index of business confidence” (Blatt 1983, pp. 210-211; Harvie 2000; Harvie, Kelmanson et al. 2007; Keen 2009).

1. Goodwin’s Growth Cycle

Goodwin’s model can easily be laid out in a causal chain:

• The level of capital K determines output Y via the accelerator relation v:
• Output determines employment L via labour productivity a:
• Employment determines the rate of employment ? given population N:
• The employment rate determines the rate of change of the wage rate w—a Phillips curve relation:
• Output minus the wage bill determines profits ?:
• All profits are invested, so that where investment I is of course the rate of change of capital:
• Goodwin assumed constant growth in labor productivity and constant population growth .

The model reduces to two system states in the employment rate and the wages share of output (for a simple exposition of the derivation see Blatt 1983, pp. 211-216):

Though Phillips insisted the employment-rate-wage-change relationship was nonlinear (and that the rate of change of employment and inflation were also factors in wage determination– see Phillips 1958, pp. 283-284), Goodwin used a linear form for his model:

Blatt employed a nonlinear form:

As Goodwin illustrated, this model has a non-trivial equilibrium which is neutral, resulting in the model generating a closed curve in space for any non-equilibrium initial conditions, whatever form is assumed for the Phillips curve. The model’s sustained cycles occur even if the model’s behavioral form is linear, because the cycles emanate from inherent nonlinearities, such as multiplying the two variables w and L together to derive profits (and hence the level of investment). Nonlinear behavioral relations are used, not to cause cycles, but to add realism—in Blatt’s case, to ensure that the employment rate could not exceed 100%.

As a prelude to modeling Minsky, I added a similar nonlinear function for investment, replacing the unrealistic assumption that capitalists invest all their profits with an investment function where the level of investment as a percentage of GDP depended on the rate of profit (which equals , where is the profit share of income:):

With depreciation introduced as well, Goodwin’s equations are now:

The dynamics of the three versions of the Goodwin model are illustrated in Figure 3 (parameter values and initial conditions are given in Appendix 3: Parameter values for Goodwin Model,).

Figure 3: Closed cycle in the original Goodwin model

1. Modelling Minsky

I extended Goodwin’s model to represent the core of MInsky’s Hypothesis by adding the relationship later empirically confirmed by Fama and French, that “debt plays a key role in accommodating year-by-year variation in investment” (Fama and French 1999, p. 1954). They put this even more clearly in an earlier working paper version of this paper: “More investment tends to generate more debt, while higher earnings are used to reduce debt.” (Fama and French 1999, p. 9). In dynamic terms, this says that the rate of change of debt D is investment minus profits (where profits are now net of interest payments, which equal the interest rate r times the debt level):

This introduced a third system state into the model: the ratio of debt to output, d. The basic Minsky model is thus:

This third dimension introduces the possibility of complex behavior and sensitive dependence upon initial conditions: an equilibrium that is technically stable can nonetheless be a repeller rather than an attractor for some initial conditions (Li and Yorke 1975; May and Oster 1976). The many equilibria of this system depend on inverse functions of the nonlinear Phillips and Investment functions:

The model’s general mathematical properties are fully explored in (Grasselli and Costa Lima), where they identify two non-trivial equilibria: one with positive values for the first two system states and a finite value for , and the other with zero values for and but an infinite value for : this is the debt-deflationary terminal point of a Depression (though sans deflation in this non-price model). On the latter equilibrium, Grasselli and Costa Lima observe that what appears to be a desirable situation from a Neoclassical point of view—in that it is a condition that guarantees the absence of rational bubbles—leads to Depression in this dynamic model:

a sufficient condition for (?₂, ?₂, u₂) = (0, 0, 0) to be a locally stable equilibrium … is that the real interest rate r exceeds the growth rate of the economy at the equilibrium (?₁, ?₁, d₁), which resembles the condition derived by Tirole for the absence of rational bubbles in an overlapping generation model, corresponding to an “efficient” economy. (Grasselli and Costa Lima, p. 11)

My own simulations in Keen 1995 illustrated this possibility of a debt-induced collapse if the rate of interest was too high. For a low rate, a convergence to equilibrium occurred:

 

 

 

Figure 4: Convergence to equilibrium with a low real interest rate (Keen 1995, Figure 6, p. 622)

At a higher rate, the system approached the infinite debt to output ratio equilibrium, but in a curious way: the cycles in employment and income distribution diminished as the crisis approached. An economic theory which ignored the role of private debt could therefore interpret this process as indicating a trend towards stability rather than breakdown.

Figure 5: Apparent stability and then breakdown with a high real interest rate (Keen 1995, Figure 8, p. 624)

The conclusion of my 1995 paper focused on this striking characteristic of the model:

From the perspective of economic theory and policy, this vision of a capitalist economy with finance requires us to go beyond that habit of mind which Keynes described so well, the excessive reliance on the (stable) recent past as a guide to the future. The chaotic dynamics explored in this paper should warn us against accepting a period of relative tranquility in a capitalist economy as anything other than a lull before the storm. (Keen 1995, p. 634)

Unfortunately, the declining volatility in inflation and unemployment from 1980 till mid-2007 shown in Figure 1 (and reproduced in smoothed form in Figure 6) was interpreted as “the Great Moderation” by many Neoclassical macroeconomists, with Bernanke in particular eulogizing it as “this welcome change in the economy” (Bernanke 2004).

Figure 6: US Inflation & Unemployment trends from 1980

From the point of view of my Minsky model, where the debt ratio is a crucial variable omitted by Neoclassical macroeconomics, this period was really the “lull before the storm” (see Figure 7). The transition from the Great Moderation to what was originally dubbed the “Great Recession” was inexplicable from a Neoclassical point of view, but could be inferred from my Minsky model.

Figure 7: Inflation, Unemployment and Debt till June 2007

However this was still only an inference, since the 1995 model lacked price dynamics. I have since developed a strictly monetary version of Minsky’s model so that price dynamics could also be explored (Keen).

1. Monetary Macroeconomics

The monetary flows in a simple model economy can be derived from the flows between bank accounts in a stylized financial system. The simplest possible monetary model of Minsky’s Hypothesis—which abstracts from the institutional features of and regulatory attempts to control banks today, and therefore resembles the 19^th century experiment with “Free Banking” (Rockoff 1974; Rolnick and Weber 1986; Sechrest 1991; White 1991; Dow and Smithin 1992; Dwyer 1996; Hickson and Turner 2002; Lakomaa 2007)—has a single banking sector with accounts for the firm sector, workers, and the banking sector itself:

• A “Bank Vault” in which bank notes are stored while not in circulation;
• A “Firm Loan” account, a ledger that records the loans currently extant to the firm sector;
• A “Firm Deposit” account, where money lent to firms is stored;
• A “Worker Deposit” account into which wages are paid; and
• A “Bank Safe” account, through which interest payments pass.

Table 3 shows the basic flows in this economy, including—on rows 12 and 13—the financing of investment by the endogenous expansion of the money supply. The table does not follow the Flow of Funds convention (which is employed by Godley) but a systems engineering one, in which outflows from a system state have a negative sign, and inflows to a system state have a positive sign.

Table 3: Monetary flows in a stylized pure credit economy

			Assets		Liabilities		Equity
	Account name		Vault	Loans	Firms	Workers	Safe
	Symbol		BV	FL	FD	WD	BS
Row	Transaction	Type
1	Loan	MT	-Loan		Loan
2	Record Loan	LE		Loan
3	Compound Debt	LE		Compound
4	Pay Interest	MT			-Compound		Compound
5	Record Payment	LE		-Compound
6	Deposit Interest	MT			DepF		-DepF
7	Wages	MT			-Wages	Wages
8	Deposit Interest	MT				DepW	-DepW
9	Consumption	MT			ConsW + ConsB	-ConsW	-ConsB
10	Repay Loan	MT	Repay		-Repay
11	Record Repayment	LR		-Repay
12	Investment Finance	MT			Invest
13	Record Finance	LE		Invest

 

Since the entries in each row represent the flows into and out of the bank accounts, the symbolic sum of each column describes the rate of change of each bank account—see Equation .

The “placeholder” entries in equation are replaced by nonlinear behavioural relations for lending, debt repayment and investment based on the rate of profit, and, for simplicity, linear consumption functions.

Behavioral relations, a wage-setting relation, a dynamic price-setting equation, and a monetary investment function link these financial equations to a Goodwin model of the physical economy.

The wage setting equation includes all 3 elements noted by Phillips: a nonlinear reaction to the level of employment, plus reactions to the rate of change of employment and the rate of inflation:

The price equation was derived by equating the equilibrium rate of flows of demand and supply in a steady state economy, and then expressing the rate of change of prices as a lagged convergence to this equilibrium price (Keen 2010, pp. 18-19). In an unexpected result, this equation corresponded to the Kaleckian markup-pricing equation. This implies the Neoclassical-Post Keynesian dispute over “supply & demand equilibrating” versus “cost plus mark-up” pricing may be a “sham fight” rather than a substantive one (Langlois 1989), since the former yields the latter in equilibrium:

The complete model is shown in Equation :

The behavior of this model under a reasonable but uncalibrated set of parameter values confirms the intuition from both Minsky’s verbal Hypothesis and the earlier non-price model: a period of a falling trend of diminishing cycles in unemployment and inflation can be the prelude to a debt-deflation (see Figure 8).

Figure 8: Debt-deflation in a monetary Minsky model

The modeling framework, which I call “Monetary Circuit Theory”, can be taken much further than shown here, and in particular can be extended to multiple sectors with non-equilibrium input-output dynamics (Schandl, Alexander et al. 2011, pp. 153-180. See Figure 9), but a discussion of this model is beyond the scope of this paper.

Figure 9: A multi-sectoral Minsky model with sustainable cycles (Schandl et al., 2011, Figure 7.2 (b), p. 159)

1. Alternative Macroeconomic Indicators: Debt to GDP

The key indicator that Minsky’s Hypothesis adds to the economic Panopticon is the ratio of private debt to GDP, and in particular its first and second derivatives with respect to time. The ratio of debt to GDP alone is an indicator of the degree of financial stress on an economy, while its servicing cost can depress both investment (as indicated by the equations for the rate of profit and investment in equations and ) and consumption (when debt is owed by households as well as firms, as is heavily the case today). Though an optimum ratio of debt to GDP cannot be defined, a strong divergence from historic norms is a useful indicator of macroeconomic troubles to come.

On this basis alone, the potential for a severe economic crisis was implied by the level of private debt (the aggregate of household, non-financial business and finance sector debt) compared to GDP, which by early 2000 had exceeded the peak reached during the severe deflation of 1932 (see Figure 10). On this basis, I published my expectation that a financial crisis would occur in the near future in (Keen 2001, p. 254-257, 311-12; Keen 2011, pp. 1-6), and I began to warn of an imminent debt-induced crisis on the basis of both Australian and US private debt data from April 2005 (Keen 2005; Keen 2005; Keen 2006; Keen 2007; Keen 2007).

Figure 10: US debt levels 1920-2012

Since that correct prediction, I have attempted to develop improved indicators that can actually isolate debt-induced turning points in the economic cycle. These began from Schumpeter and Minsky’s arguments that the change in debt adds to aggregate demand from income alone—financing both investment (Schumpeter 1934, p. 73) and speculation on asset prices (Minsky, Okun et al. 1963; Minsky 1982, p. 6)—which implied the need to generalise Walras’ Law for a credit-based economy. Whereas aggregate supply is aggregate demand in a non-monetary economy, aggregate demand is income plus the change in debt in a monetary economy. Income is primarily expended on consumption goods, while the change in debt primarily financing both investment goods purchases and net speculation on asset markets—where this depends on the level of asset prices , the quantity of assets , and the annual turnover of assets . This implies relation of the form shown in equation —though this ignores feedback effects between the change in debt and the growth of income:

A sudden decline in the rate of growth of debt will therefore mean a sudden decline in the level of aggregate demand. As Figure 1 indicates, such a decline did occur in 2008, and it reduced aggregate demand from the private sector alone from $18 trillion p.a. in 2008 to under $12 trillion in 2010 (see Figure 11)

Figure 11: The plunge in debt-financed demand in 2008

The time derivative of indicates that the acceleration of debt is a major factor in causing changes in the level of output—and hence employment—and the rate of change of asset prices:

This is related to the “Financial Accelerator” (Bernanke, Gertler et al. 1996) but far more powerful because it involves not merely a change in the velocity of money, but a change in the rate of growth of the volume of money. Biggs, Mayer and Pick proposed the ratio of the acceleration of debt to GDP as an indicator of this effect, and dubbed it “The Credit Impulse” (Biggs and Mayer 2010; Biggs, Mayer et al. 2010). I prefer the term “Credit Accelerator”, since impulse implies a transient phenomenon. The correlations of this indicator with both change in employment and change in asset prices are striking.

Figure 12: USA Credit Acceleration and Unemployment Change 1990-2012

Figure 13:Mortgage acceleration and real house price change

 

1. Anticipating the Black Swan II—Stock-Flow Consistent Macroeconomics

Godley’s prediction of an impending crisis (Godley and Wray 2000; Godley 2001; Godley and Izurieta 2002; Godley and Izurieta 2004) was derived from models of the macroeconomy that were developed using an accounting framework which he christened Stock-Flow Consistent (SFC) dynamic modeling (Cripps and Godley 1976; Godley 1999; Godley 1999; Godley 2004; Godley 2004; Godley and Lavoie 2005; Godley and Lavoie 2007; Godley and Lavoie 2007; Godley and Lavoie 2007; Taylor 2008). International, public and private sector imbalances identified using this approach led Godley to anticipate a severe recession from early 2000 (Godley and Wray 2000; Godley 2001; Godley and Izurieta 2002; Godley and Izurieta 2004; Godley, Izurieta et al. 2005).

Godley’s approach to macroeconomic modeling was influenced by his period in the British Treasury (1956-1970) which he described as “they heyday of ‘stop-go’ policies when we tried to forecast what would happen during the following 18 months and then design a budget which would rectify anything likely to go wrong”. His Damascene moment occurred when he realized that “measured at current prices, the government’s budget deficit less the current account deficit is equal, by definition, to private saving net of investment” (Godley and Lavoie 2007, p. xxxvi). This realization that the balance of payments could be deduced from the budget deficit and private net saving inspired him to create the Stock-Flow Consistent approach to constructing macroeconomic models, in which a framework of consistent accounts between sectors had to be set out before behavioural relations were introduced into the model.

Godley and Lavoie contrast their emphasis upon sectoral balances with pre-DSGE macroeconomics by considering what a standard national income equation looks like when portrayed in terms of transactions between sectors. They start from equation in which GDP (Y) is broken down into consumption (C) plus investment (I) plus government expenditure (G), and also equated to the sum of wages (WB) plus profits (F):

Table 4 sets out equation in terms of transactions between sectors, where, for example, consumption expenditure C involves a transfer of money from households to firms. The table is constructed according to the conventions of the Flow of Funds:

Note that all sources of funds in a sectoral account take a plus sign, while the uses of these funds take a minus sign. Any transaction involving an incoming flow, the proceeds of a sale or the receipts of some monetary flow, thus takes a positive sign; a transaction involving an outgoing flow must take a negative sign. (Godley and Lavoie 2007, p. 40)

Table 4: Equation laid out as a transactions matrix

		Business
	Households	Current	Capital	Government	Sum
Consumption	-C	+C			0
Government expenditure		+G		-G	0
Investment		+I	-I		0
[GDP (memo)]		[Y]
Wages	+WB	-WB			0
Profits	+F	-F			0
Tax net of transfers	-T			+T	0
Sum	SAVING	0	INVESTMENT (—)	GOVERNMENT SURPLUS	0

 

Godley and Lavoie point out that, expressed in this manner, deficiencies in equation become obvious: for example, if there is an excess of income over expenditure, where does it go and how does it affect the rest of the economy, “where does the finance for investment come from? And how are budget deficits financed?” Their revised table provides answers to these omissions by including a banking sector, and “showing a relatively simple comprehensive system of accounts which describes all the intersectoral transactions implied … but not shown” by Table 4 (Godley and Lavoie 2007, p. 6).

Table 5: A simple transactions matrix implied by equation (Godley & Lavoie 2007, Table 1.2, p. 7)

		Production Firms
	Households	Current	Capital	Banks	Government	Sum
Consumption	-C	+C				0
Investment		+I	-I			0
Government expenditures		+G			-G	0
Wages	+WB	-WB				0
Profits	+FD	-F	+FU			0
Taxes	-T				+T	0
Change in Loans			+?L	-?L		0
Change in Cash	-?Hh			-?Hb	+?H	0
Change in Deposits	-?M			+?M		0
Change in Bills	-?Bh			-?Bb	+?B	0
Change in Equities	-?e.pe		+?e.pe			0
Sum	0	0	0	0	0	0

 

As well as indicating that a complicated dynamic system is needed to properly express equation , Table 5 also showcases Godley’s guiding principle that in a monetary economy “everything comes from somewhere and goes somewhere”, so that in his tables “all rows and all columns sum to zero” (Godley and Lavoie 2007, p. 6).

Godley and Lavoie and the community of Stock-Flow Consistent modelers that has developed around them derive systems of difference equations from tables like these, which range from simple models that abstract from private credit creation, to complicated ones that incorporate government and bank money creation and international trade.(Zezza and Dos Santos 2004; Berglund 2005; Dos Santos 2005; Godley and Lavoie 2007; Santos and Zezza 2007).

Godley and Lavoie provide a simple example of the procedure needed to derive a simulation model from a SFC table with the abstraction of a pure fiat money economy in which the government finances deficits by issuing currency only, and where firms make no profits (Godley and Lavoie 2007, pp. 57-98).

Table 6: The accounting matrix for the SIM model (Godley & Lavoie 2007, p. 62, Table 3.3)

	Households	Production	Government	Sum
Consumption	-Cd	+Cs		0
Government Expenditures		+Gs	-Gd	0
[Output]		[Y]		0
Wages	+W.Ns	-W.Nd		0
Taxes	-Ts		Td	0
Money stock changes	??Hh		??Hs	0
Sum	0	0	0	0

 

The discrete time model derived from this table makes behavioral assumptions about taxes (a constant ? times the wage bill) and consumption (a constant ?₁ times net income plus ?₂ times household wealth—which is entirely in the form of cash H_h—in the previous year) to derive a set of 11 equations:

They simulate this model with government expenditure of $20 p.a. (G_d=$20), tax rate of 20% (?=0.2), a wage rate of $1 p.a. (W=1), consumption out of income of 0.4 (?₁=0.6) and out of wealth of 0.4 (?₂=0.4)—see Table 7.

Table 7: Simulation of SIM model

Period	1	2	3
G	20	20	20	20
Y=G+C	0	38.5	47.9	100
T=?.Y	0	7.7	9.6	20
C=?1.YD+?2.H-1	0	18.5	27.9	80
?Hs=G-T	0	11.3	10.4	0
?Hh=YD-C	0	12.3	22.7	80
H=?H+H-1

This extremely simple model is followed by others that include banks and private credit creation as well as government money, bonds, other securities and portfolio issues, the impact of expectations failing to be realized, production and international trade.

1. Alternative Macroeconomic Indicators: Sectoral Imbalances

The Stock-Flow-Consistent emphasis upon sectoral balances enabled Godley to predict the Global Financial Crisis from as long ago as 2000 (Godley and Wray 2000; Godley 2001; Godley and Izurieta 2002; Godley and Izurieta 2004; Godley, Izurieta et al. 2005). The principal insight that enabled Godley to predict an imminent crisis was that, when the government sector, the private sector and the international economy are treated as aggregates, the sectoral balances must sum to zero:

By definition, the private sector surplus must equal the public sector deficit plus the trade account surplus. Thus, the public sector could run a surplus, which if more than offset by a trade account surplus, could still be associated with a private sector surplus. On the other hand, if the public sector runs a surplus and the trade account is negative, the private sector, by definition, must be in deficit. (Godley and Wray 2000, p. 202)

The US sectoral position at the end of the 1990s and beginning of the 2000s was precisely that case: a public sector surplus and trade sector deficit along with a private sector deficit. They noted that the private sector deficit was 5.3% of GDP in 2000, while the government surplus was 2.2% of GDP and the balance of payments deficit was 3.1%. The US economy was, they argued:

in uncharted territory, with a private sector deficit that is five times greater than anything achieved in the past (relative to GDP) and that has already persisted for twice as long as any past deficits. (Godley and Wray 2000, p. 204)

Using the CBO’s projections of GDP growth rates and growing government surpluses, and “reasonable assumptions about continued deterioration of the U.S. trade account”, they argued that these trends implied a private sector deficit “equal to 8 percent of GDP within five years”. This made a recession inevitable:

We hasten to add that we do not believe this projection. The economy will not continue to grow; the projected budget surpluses will not be achieved; private sector spending will not continue to outstrip income; and growth of private sector indebtedness will not accelerate. We present these projections only to show what would have to happen to the financial situation of the private sector in order for the CBO’s projections to unfold. As soon as private sector spending stops growing faster than private sector income, GDP will stop growing. When the recession hits, the public sector budget will move from surplus to deficit, and our trade account will improve (because imports will fall). Together, these will generate private sector surpluses. (Godley and Wray 2000, p. 204)

Figure 14: Prediction of unsustainable private sector deficits given CBO expectations of sustained government surpluses (Godley & Wray 2000, Figure 1, p. 203)

1. Conclusion: A New Macroeconomics?

What was a “tail event” for Neoclassical macroeconomic models (Stevens 2008, p. 7) was thus a core prediction of two Post Keynesian approaches to macroeconomic modeling. While Neoclassical macroeconomists have felt compelled to publish articles with titles like “How Did Economists Get It So Wrong?” (Krugman 2009), Post Keynesian economists have been emboldened by their success. They take no joy from the continued gloom in the global economy, but their research agenda is vibrant, with both “Monetary Circuit Theory” and Stock-Flow Consistent modeling undergoing rapid development today (Grasselli and Costa Lima ; Keen ; Dos Santos 2003; Zezza and Dos Santos 2004; Zezza and Dos Santos 2006; Lavoie 2008; Le Heron 2008; van Treeck 2009; Santos and Macedo e Silva 2010; Dallery and van Treeck 2011; Keen 2011; Lavoie and Daigle 2011; Le Heron 2011).

The confidence that Neoclassical economists had in the state of macroeconomic modeling prior to the GFC (Bernanke 2004; Blanchard 2009) was characterized by “separate development”, with Neoclassical theory paying no attention to the work of Post Keynesian economists, though as shown here, the Post Keynesian approach developed in part in reaction to Neoclassical thought. Perhaps after the GFC, and as the “Lesser Depression” continues, it is time for rapprochement to occur.

1. Appendix 1: The Cobb-Douglas Production Function

Take the national income identity that income equals wages plus profits:

Introduce uniform real wage and profit rates, and the quantity of labour and capital:

Differentiate with respect to time:

Divide by Y to derive the percentage rate of change of income:

Convert all terms to percentage rates of change:

All terms on the right hand side now include income shares. Define :

Since income shares change slowly over time, treat ? as approximately a constant and integrate:

Take exponentials and rearrange:

This is the “Cobb-Douglas Production Function” under constant returns, with the technology term replaced by a transformation of the real wage times a transformation of the real rate of profit. So the “Cobb-Douglas Production Function” can be derived from the true-by-definition accounting identity using only one reasonably valid assumption (the relative constancy of income shares over time). Therefore the high correlation between a Cobb-Douglas Production Function and actual data is to be expected, and does not provide empirical support for the validity of the Neoclassical model of production (Shaikh 1974; McCombie 2000; Shaikh 2005).

1. Appendix 2: The invalidity of the Hicks-Hansen-Samuelson trade cycle model

Minsky’s used a standard Hicks-Hansen-Samuelson multiplier-accelerator model (Samuelson 1939) as the foundation of his attempt to develop a mathematical model of a financially-driven trade cycle. His basic equation was:

This class of models should never have been given credence, since it is easily shown that the only solution is the trivial solution. A condition for a difference equation to have a non-trivial solution is that the matrix form of the equation is non-invertible. The matrix form of is:

This matrix is invertible:

Therefore the only solution to is , and the “cycles” generated by this model are merely fluctuations on the convergent path to this trivial solution.

The model is invalid because it is derived by equating an equation for actual savings (as a lagged function of income) to desired investment (as a lagged function of income), and there is no school of thought—Keynesian or otherwise—that argues these two are equal to each other. See {Keen, 2000 #141, pp. 84-89} for more detail and a properly derived model with a non-trivial solution and growth.

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