The Global Financial Crisis is far from over...

1. The Global Financial Crisis is far from over... Steve Keen University of Western Sydney Debunking Economics www.debtdeflation.com/blogs www.debunkingeconomics.com

2. The New Macroeconomic Puzzle • How did we go from this… • To this? • A Minskian explanation: debt-deflation

3. First Principles • Debt has macroeconomic impact; contra Bernanke: • “Fisher’s idea was less influential in academic circles, though, because of the counterargument that debt-deflation represented no more than a redistribution from one group (debtors) to another (creditors).” (Bernanke 2000, p. 24) • Minority of economists who predicted crisis displayed: • “a further concern, that growth in financial wealth and the attendant growth in debt can become a determinant (instead of an outcome) of economic growth …” (Bezemer (2009, p. 10)) • Basic mechanisms: • Debt expands aggregate demand • Endogenous money creation • Financial instability

4. Rising debt increases aggregate demand • Schumpeter: growing debt adds demand beyond that generated by sales of goods & services • Debt essential for entrepreneurial function • Entrepreneur often has idea but no money • Needs purchasing power before has goods to sell • Gets purchasing power via loan from bank • Entrepreneurial demand thus not financed by “circular flow of commodities” but by new bank credit • Since entrepreneurial activities essential feature of growing economy, in real life “total credit must be greater than it could be if there were only fully covered credit. The credit structure projects not only beyond the existing gold basis, but also beyond the existing commodity basis.” (Schumpeter 1934, p. 101)

5. Endogenous money: “Loans create deposits” • “In the real world banks extend credit, creating deposits in the process, and look for the reserves later” (Moore (1979, p. 539)—quoting Fed economist) • “There is no evidence that … the monetary base … leads the cycle, although some economists still believe this monetary myth…, if anything, the monetary base lags the cycle slightly… • The difference of M2-M1 leads the cycle by even more than M2 with the lead being about three quarters." (Kydland & Prescott, 1990, p. 14)

6. Financial instability • “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 1982, p. 67) • Current debt-assets price dual bubble biggest in history…

7. Rising debt increases aggregate demand • Asset bubbles & rising debt to GDP

8. Rising debt increases aggregate demand • Aggregate demand: Income + change in debt • “Great Moderation” and “Great Recession” debt-driven R2=-.644 • As is current apparent recovery…

9. Rising debt increases aggregate demand • Change in AD: Change in GDP + acceleration in debt • Debt & disequilibrium-aware model needed to capture these processes • Minsky’s Financial Instability Hypothesis R2=-.73 (Debt leading by 3 months)

10. Minsky’s “Financial Instability Hypothesis” • Economy in historical time • Debt-induced recession in recent past • Firms and banks conservative re debt/equity, assets • Only conservative projects are funded • Recovery means most projects succeed • Firms and banks revise risk premiums • Accepted debt/equity ratio rises • Assets revalued upwards… • “Stability is destabilising” • Period of tranquility causes expectations to rise… • Self-fulfilling expectations • Decline in risk aversion causes increase in investment • Investment expansion causes economy to grow faster

11. The Euphoric Economy • Asset prices rise: speculation on assets profitable • Increased willingness to lend increases money supply • Money supply endogenous , not under RBA control • Riskier investments enabled, asset speculation rises • The emergence of “Ponzi” (Bond, Skase…) financiers • Cash flow less than debt servicing costs • Profit by selling assets on rising market • Interest-rate insensitive demand for finance • Rising debt levels & interest rates lead to crisis • Rising rates make conservative projects speculative • Non-Ponzi investors sell assets to service debts • Entry of new sellers floods asset markets • Rising trend of asset prices falters or reverses

12. The Assets Boom and Bust • Ponzi financiers go bankrupt: • Can no longer sell assets for a profit • Debt servicing on assets far exceeds cash flows • Asset prices collapse, increasing debt/equity ratios • Endogenous expansion of money supply reverses • Investment evaporates; economic growth slows • Economy enters a debt-induced recession • Back where we started... • Process repeats once debt levels fall • But starts from higher debt to GDP level • Eventually final crisis where debt burden overwhelms economy

13. A Strictly Monetary Minsky Model • Foundations • Goodwin (1967) growth cycle model (Keen 1995) • Pure credit economy model (Graziani 1989) • Built using tabular system of ODEs (Keen 2008) Symbolic sum of columns • See blog www.debtdeflation.com/blogs for details • Especially Roving Cavaliers of Credit post

14. Modelling Minsky: The full system • Nonlinear functions for investment, wage change, loan repayment, lending from capital • 3 factor Phillips curve: employment, rate of change of employment, inflation • In equations…

15. Modelling Minsky: The full system • In new program QED QED

16. Modelling Minsky: The outcome • Monetary factors

17. Modelling Minsky: The outcome • Production, employment, wages and inflation

18. References • Bernanke, B. S. (2000). Essays on the Great Depression. Princeton, Princeton University Press. • Bezemer, D. J. (2009). “No One Saw This Coming”: Understanding Financial Crisis Through Accounting Models. Groningen, The Netherlands, Faculty of Economics University of Groningen. • Blatt, J.M., Dynamic Economic Systems: A Post Keynesian Approach, ME Sharpe, Armonk. • Goodwin, R. (1967). “A growth cycle” in C. H. Feinstein (ed.), Socialism, Capitalism and Economic Growth. Cambridge, Cambridge University Press: 54-58. • Graziani, A. (1989). "The Theory of the Monetary Circuit." Thames Papers in Political Economy Spring: 1-26. • Keen, S. (1995). "Finance and Economic Breakdown: Modeling Minsky's 'Financial Instability Hypothesis.'." Journal of Post Keynesian Economics 17(4): 607-635. • Keen, S. (2008). Keynes’s ‘revolving fund of finance’ and transactions in the circuit. Keynes and Macroeconomics after 70 Years. R. Wray and M. Forstater. Cheltenham, Edward Elgar: 259-278.

19. References • Kydland, F. E. and E. C. Prescott (1990). "Business Cycles: Real Facts and a Monetary Myth." Federal Reserve Bank of Minneapolis Quarterly Review 14(2): 3-18. • Minsky, H. P. (1982). Can "it" happen again? : essays on instability and finance. Armonk, N.Y., M.E. Sharpe. • Moore, B. J. (1979). "The Endogenous Money Stock." Journal of Post Keynesian Economics 2(1): 49-70. • Schumpeter, J. A. (1934). The theory of economic development : an inquiry into profits, capital, credit, interest and the business cycle. Cambridge, Massachusetts, Harvard University Press.