Transcript Modelling the Monetary Circuit

Developing a monetary model of financial instability…
Steve Keen
University of Western Sydney
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
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 usevalue; 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)
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)
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)
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”:
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
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
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
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
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
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


d
 ( t)
 (share
t)  PCgof
(  ( toutput
))  
Workers
dt
Investment Function
d
 ( t)
dt
 I  1   ( t) 



 g

v rate


Employment
 ( t)  
  
v


Depreciation,
Productivity &
Population growth
rates
Mathematical Foundations
• Generates closed cycle:
Goodwin Growth Cycle
• Add financial truisms:
– “Banks finance investment
and charge interest”
• Generates 3rd order system
– Debt to output ratio added:
Employment
Linear
Nonlinear
0.9
0.8
0.7
0.2
0.4
0.6
0.8
1
W ages Share
Profit now net of
interest payments
d
d( t)
dt
Net real
interest rate
 I  1   (t)  r d(t) 





v
I  1   (t)  r d(t)   (1   (t)  r d(t))  d(t)   k 
 
 k


v
v
 




The beginnings of chaos
• Two classes of outcome
– Convergence to equilibrium…
Goodwin & Mi nsky Cycles
• If capitalists accumulate
“negative debt”
1
Non line ar Goo dwin
S table Mins ky
Employment
0.98
Debt to GDP Ratio
0
0.96
1
0.94
0.92
0.6
2
0.7
0.8
W age s Sh are
0.9
3
This s tability was dependent , howev er, upon init ial condit ions t hat generat ed a "negat iv e"
equilibrium rat io of debt to GD P--or in ot her words, c apit alis ts ac cumulat ing net posit iv e
f inancial as sets .
4
• But if they don’t…
0
20
40
60
80
100
The beginnings of chaos
• An unstable cycle…
S table and Unstable Minsky Cycles
1.1
• And debt that “ratchets up”
over time to a debt-crisis…
Debt to GDP Ratio
6
Employment
1
S table
Un stable
4
0.9
2
0.8
0.7
0.4
S table
Un stable
0.6
0.8
1
W age s S h are
1.2
0
1.4
2
4
0
20
40
60
• How well does this simple model match empirical data?
– Not very…
• Because the empirical data is much worse!
The Ponzi Economy
Percent
• Australia’s private debt to GDP ratio has risen
exponentially at 4.2% p.a. for over 43 years:
• Not for the first
Australia's Debt to GDP Ratio
160
time in our
Ratio
140
history either
Expon e nti al Fit
120
• Long term RBA
100
data released
last month in
80
speech by Deputy
60
Governor Ric
40
Battellino:
20
– (augmented by
0
1950
1960
1970
1980
1990
2000
2010
data from
RDP1999-06)
The Ponzi Economy
Debt to GDP: The Long Term View
160
Percent of nominal GDP
140
120
De bt Ratio
Tre nd 1964-Now
Tre nd 1880-1892
Tre nd 1925-1932
100
80
60
40
20
0
1880 1890 1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 2000 2010
The Ponzi Economy
• Correlation isn’t causation, but…
0
T
1
2
3
0
"V ariable"
"C redit"
"C redit"
"C redit"
1
"C ompared to"
"G DP "
"G DP "
"G DP "
2
"S tart Date"
1880
1925
1964.5
3
"E nd Date"
1892.5
1932
2007.7
4
"G row th Rate"
9.2
9.5
4.2
5
"C orrelation % "
6
"D oubling P eriod"
7.5
7.3
16.6
7
"D uration"
12.5
7
43.2
8
"Initial V alue"
33.9
40.3
24.7
9
"F inal V alue"
103.9
76.2
159.5
10
Clearly exponential
process
97.9
97.6
Biggest bubble
in our history
"Increase % "
206.5
88.8
99.1
546.9
• 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…
The Ponzi Economy
• Correlation debt’s contribution to aggregate demand of
to unemployment initially trivial
• Exceeds -0.9 by early 1980s
Change i n Debt, Politics, & Unemployment
Unemployment & Debt Contribution to Demand
16
14
12
10
8
6
De bt Ch an ge
W h itlam 72-75
Frase r 75 -83
Hawke 83-96
He wson
Howard 96-07?
Un e m ploym e n t
10 10
9
0
 10
8
 20
7
 30
6
 40
5
 50
4
 60
4
3
 70
2
2
 80
0
1 90
Unemployment
18
11 20
Percent
Percentage Contribution to Aggregate Demand
20
2
0 100
1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010 1960
C orre lation
W h itlam
Frase r
Hawke
1965
1970
1975
1980
1985
• Formation of debt also increasingly dominated by
speculation rather than investment:
1990
1995
2000
Ponzi Households
• Lending for housing rises from 5-25% of GDP:
Aggregate New Lendi ng for Housing
Housing Construction
25
15
10
5
Percent of Total Lending
Percent of GDP
20
70
60
O wn e r O ccu pie rs
In ve s tors
50
40
30
20
10
0
1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008
• Proportion that financed
housing construction falls
from 30% to under 10%:
0
1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008
• Back to modelling:
– Clear omissions from
basic Minsky model are
– Endogenous money
– Speculative lending…
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
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…
Dynamic System
“System States”
Stock A
Stock B
…
Stock Z
Accounting
+ Flow 1
- Flow 1
…
…
Sum
…
…
+ Flow 2
- Flow 2
Sum
Flows
d
Z t 
A  t  dtd B  t 
dt
• To generate the model, add up each column
– Sum of column is “differential equation” for stock
d
dt
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:
“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
“Money from nothing, but your cheques ain’t free”
• Full system is:
Add up
terms
Interest flows: bank<―>firm
Wage flows: firm―>workers
Interest flows: bank―>workers
Consumption flows: bank & workers―>firms
• System of coupled
differential equations:
• System conservative:
• Amount of money
– (& debt)
• remains constant
dF
L
dt
dF
D
dt
dB
D
dt
dW
D
dt
0
r D F DGet
r L F
L w F D BD W D
equation
r L F L r D F D r D WD BD
w F D r D WD WD
“Money from nothing, but your cheques ain’t free”
• System stable but no growth:
Account Balances, No New Money
20
100
15
FL( t )
BD( t )
10
FD( t ) 50
WD( t )
5
0
0
0.5
1
1.5
0
2
• Growth in output
requires new money
to
– Hire more workers
– Pay for
intermediate
inputs
• Simultaneous
creation of new debt
and new money:
t
Firm Loan
Firm Deposit
Bank Deposit
Workers Deposit
Skip Quotes
• Violates “Walras’ ‘Law’”
• Supports Schumpeter & Minsky on credit
New money flows: bank―>firm
“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)
“Money from nothing, but your cheques ain’t free”
• Money and debt now grow over time:
Account Balances, New Money Creation
200
20
FL( t )
BD( t )
F D( t )
WD( t )
100
0
10
0
2
4
6
• System dissipative:
• Rate of growth of money
• = rate of growth of debt
0
10
8
t
Firm Loan
Firm Deposit
Bank Deposit
Workers Deposit
dF
L
dt
dF
D
dt
dB
D
dt
dW
D
dt
n M F D
r D F D r L F L w F D BD WD n M F D
r L F L r D F D r D WD BD
w F D r D WD WD
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
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
Wages flow shown as share of production surplus
• P is
turnover
period
• s is share
going to
firms
Repayment flows: firm―>bank
• (1-s) goes
to workers
Relending flows: bank―>firm
“Would you like a credit card with that?”
12
10
8
6
4
2
• Can now see what happens to bank income as
– New Money is created
• Surprise surprise!
– Loans are repaid
– Repaid money is re-lent • Bank income rises if
– Loans are repaid slowly
Bank Net Income and Bank Parameters
(or not at all)
Standard
New Money
– Repaid money is recycled
Loan Repayment
more quickly; and
Recycling Loans
– More new money is
created
• Bank profits by extending
more credit…
• Structural explanation for
real world phenomenon of
rising debt to GDP ratio
0
2
4
6
8
10
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
A monetary Goodwin model
• Now six system states
• But remarkably simple model
• Generates open cyclical model
Goodwin Growth Cycle
d
Kr
dt
I       Capital

KrPhysical
     
K
K
d
W
dt
   d   d WWage

W  PhMoney

d p
 dt

100
Employment Rate Percent
Linear
Nonlinear
W ith Pr ices
d
PC
dt
90
70
20
40
60
80
100
d
a( t )
dt
W ages Share P ercent
Cy cles in prices and unemployment
Inflation Rate
30
d
N ( t)
dt
20
10
0



W
 PC Inflation
 ( 1  )  
P 
a
1
1  wage 1response 
d Lagged
d Wd p
 d Wd p 
 [ 1  ( 1  )  ]
W
P
dt


80
0

2
4
6
8
Unemployment Rate
10
12
Technical

 a( t )
change
&
Population
growth
  N ( t)
• With “Phillips surface” rather
than Phillips curve inflation and
unemployment dynamics
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
15
effect of debt
10
reduction
• Serious downturn
5
inevitable
0
• Counter forces
5
– China boom
 10
– Possible global
1880 1890 1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 2000 2010
warming/peak
oil inflation
Inflation-adjusted interest payment burde n
Percent of GDP
20
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