Managerial Economics

1. Managerial Economics Lecture Nine: Alternative theories of macroeconomic behaviour

2. Recap • Last week • Empirical data on economic cycle contradicts neoclassical economics: • Prices anti-cyclical • Wages pro-cyclical • No “diminishing marginal productivity” • Credit leads cycle, money base follows • Not “quantity theory of money” but “endogenous credit & money creation” • Complements Blinder’s survey research • Supports Schumpeter’s theory of cycle • K&P conclude with fascinating statement:

3. Money, credit and business cycles… • “The fact that the transaction component of real cash balances (M 1) 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.” • This “open problem” the focus of Hyman Minsky’s research…

4. Like father, like son… • Minsky a student of Schumpeter’s • & influenced by Keynes … and Marx • Built on foundations of all three (but never admitted to inspiration from Marx—worked during “McCarthyist” period in USA when reading Marx effectively a crime) • Did first degree in mathematics before economics Phd • During longest period of sustained prosperity in America’s history, developed the “Financial Instability Hypothesis” • Key proposition: “The most significant economic event of the era since World War II is something that has not happened: there has not been a deep and long-lasting depression.” (Minsky 1982: xi) • Why is this significant? Because…

5. Financial Instability Hypothesis • “As measured by the record of history, to go more than thirty­five years without a severe and protracted depression is a striking success. • Before World War II, serious depressions occurred regularly. The Great Depression of the 1930s was just a "bigger and better" example of the hard times that occurred so frequently. This postwar success indicates that something is right about the institutional structure and the policy interventions that were largely created by the reforms of the 1930s..” (xi) • So what were these structures & interventions? • Restrained use of debt • Public spending to ameliorate any downturn • Both developed in response to Great Depression:

6. 10 years to restore output levels 30% fall in output in 4 years The Great Depression WW II

7. The Great Depression To 25% in 3 years WW II Brings Sustained Recovery From effectively zero...

8. Minskian Economic History • Minsky’s reading of Depression: • Final in series of financial crises in which accumulated debt & falling prices overwhelmed system • Deflation (prices fell by up to 10% p.a.) meant real rate of interest exceeded 15% • Nominal debt fell but real debt (ratio nominal debt to nominal DGP) ballooned • Irving Fisher claimed debt/GDP ratio was • 60% in 1929 • 160% by 1933 • Complex price dynamics, mechanics of bankruptcy, government public works, etc. partially reduced debts; • World War II reduced them to trivial levels…

9. USA Interest Rates 1918-2000 Huge deflation caused by post-WWIreturn to the Gold Standard by UK Korean War Inflation Negative real rates during WW II Even more negative real rate during Post-War recovery Massive positive “real” rates due to deflation in Great Depression Post-War stability and then... chaos!

10. Minskian Economic History • Post-War success due to • Reduction of private debt to historically low levels • Culture of prudence after WWII, Great Depression • versus excess of “Roaring Twenties” stock market boom • “Big government” • Large government spending/taxing role counterbalanced private sector tendencies to excess during boom, frugality during slump • Institutions designed to attenuate excessive behaviour in borrowing, lending, investing… • Emphasis upon income equality • Less money for speculation by wealthy • More for income-financed stable mass consumption

11. Minskian Economic History • Gradual development of problems since WWII due to gradual • Increase in debt to income levels over many business cycles • Decline in fear of financial collapse as GD forgotten • Relaxation of prudent financial arrangements • Financial fragility rising from 1950 till early 1960s • Financial crises in USA but still high growth/employment • 1973: major financial crisis in period of high employment: • Income distribution (high wages) and raw materials (high prices) driven inflation • “Stagflation”: first major post WWII financial crisis

12. Financial Instability Hypothesis • To understand why we’ve had crises but not a Depression, we need • “an economic theory which makes great depressions one of the possible states in which our type of capitalist economy can find itself. • We need a theory which will enable us to identify which of the many differences between the economy of 1980 and that of 1930 are responsible for the success of the postwar era.” (xi) • Neoclassical & conventional “Keynesian” models can’t do this because they are timeless equilibrium models • might explain equilibrium but • Can’t explain location of equilibrium itself • Omit time processes that are evolutionary and non-equilibrium

13. Financial Instability Hypothesis • Minsky knew suitable model had to • treat financial crises as normal events in unconstrained capitalist economy • Explain why such events hadn’t happened in 1948-1966: • “The first twenty years after World War II were characterized by financial tranquility. No serious threat of a financial crisis or a debt­deflation process took place. • The decade since 1966 has been characterized by financial turmoil. Three threats of financial crisis occurred, during which Federal Reserve interventions in money and financial markets were needed to abort the potential crises.” (1982: 63) • Minsky on the historical record 1948-1978

14. Financial Instability Hypothesis • “The first post-World War II threat of a financial crisis that required Federal Reserve special intervention was the so-called "credit crunch" of 1966. This episode centered around a "run" on bank-negotiable certificates of deposit. • The second occurred in 1970, and the immediate focus of the difficulties was a "run" on the commercial paper market following the failure of the Penn­Central Railroad. • The third threat of a crisis in the decade occurred in 1974-75 … can be best identified as centering around the speculative activities of the giant banks. In this third episode the Franklin National Bank of New York, with assets of $5 billion as of December 1973, failed after a "run" on its overseas branch.” (63)

15. Financial Instability Hypothesis • The lessons from this history?: • “Since this recent financial instability is a recurrence of phenomena that regularly characterized our economy before World War II, it is reasonable to view financial crises as systemic, rather than accidental, events. • From this perspective, the anomaly is the twenty years after World War II during which financial crises were absent, which can be explained by the extremely robust financial structure that resulted from a Great War following hard upon a deep depression. • Since the middle sixties the historic crisis-prone behavior of an economy with capitalist financial institutions has reasserted itself…” (63)

16. Financial Instability Hypothesis • Minsky’s view of unbridled capitalism supported by record of 19th century trade cycle: • Procyclical prices • Frequent wage falls • Financial crisesroughly every20 years

17. Financial Instability Hypothesis • But post-1973 still differs from pre-WWII periods of instability: • The past decade differs from the era before World War II in that embryonic financial crises have been aborted by a combination of support operations by the Federal Reserve and the income, employment, and financial effects that flow from an immensely larger government sector. This success has had a side effect, however; accelerating inflation has followed each success in aborting a financial crisis.” (63) • So how to turn these historical insights into a theory? • Firstly, build on your antecedents…

18. Brief HET of Minsky • Parents met at a Communist Party social function • No prizes for guessing early formative influences! • Fought in US Army in WWII, decamped post-war to do a degree • Educated during McCarthyist “communist witch hunt” period—no mention ever of Marx in his research, for obvious reasons • PhD supervisor Joseph Schumpeter: the archetypal theorist of cycles • Foundation influences thus Marx & Schumpeter—and not Keynes • With degree in mathematics, attempted to build mathematical model of trade cycle (based on Hicks’s difference equation model, extended by Kalecki’s “principle of increasing risk”)

19. Brief HET of Minsky • Kalecki argued investment restrained by increasing risk (uncertainty) as capital grows • Minsky used this at macro level in model of trade cycle Model was • Minsky made b dependent on financial conditions • b declines as economy grows, thus giving turning point to upward explosive movement: • "the accelerator coefficient ... is in part based on the productive efficiency of investment, but it is also related to the willingness of investors to take risks and the terms in which investors can finance their endeavours..." (Minsky 1965: 261)

20. Brief HET of Minsky • Model went nowhere, but Minsky began to explore implications of finance for economic behaviour • Initially tried from conventional understanding of Keynes: • “If we make the Keynesian assumption that consumption demand is independent of interest rates, but assume that investment demand, and hence the b coefficient, depends on interest rates, then a rising set of interest rates will lower the b coefficient.” (Minsky 1965, 1982: 262) • Also went nowhere… • Then, one day, by chance, he read Keynes’s 1937 papers… • “My interpretations of Keynes is not the conventional view which is mainly derived from Hicks' "Mr. Keynes and the Classics," an article which I believe misses Keynes' point completely…” (Minsky 1982: 280)

21. There’s more than one “Keynes” • Keynesian economics of IS-LM & AS-AD more due to Hicks than Keynes; • Different theme in Ch. 12 & Ch. 17: • Rather than investment regulated by rate of interest: • investment motivated by the desire to produce “those assets of which the normal supply-price is less than the demand price” (Keynes 1936: 228) • Demand price determined by prospective yields, depreciation and liquidity preference. • Supply price determined by costs of production • “Two price levels” in capitalism: • Normal commodities basically “cost plus” • Assets “expectations under uncertainty”

22. There’s more than one “Keynes” • Two price level analysis becomes more dominant subsequent to General Theory: • 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) • “Marginal Efficiency of Investment” (MEI or MEC for “Capital”) analysis akin to view that uncertainty can be reduced “to the same calculable status as that of certainty itself” via a “Benthamite calculus”, whereas • uncertainty in investment is that about which “there is no scientific basis on which to form any calculable probability whatever. We simply do not know.” (Keynes 1937a: 213, 214)

23. There’s more than one “Keynes” • Three aspects to expectations formation under true uncertainty • Presumption that “the present is a much more serviceable guide to the future than a candid examination of past experience would show it to have been hitherto” • Belief that “the existing state of opinion as expressed in prices and the character of existing output is based on a correct summing up of future prospects” • Reliance on mass sentiment: “we endeavour to fall back on the judgment of the rest of the world which is perhaps better informed.” (Keynes 1936: 214) • Fragile basis for expectations formation thus affects prices of financial assets

24. What is “uncertainty”? • Imagine you are very attracted to someone • This person has accepted invitations from 1 in 5 of the people who have asked him/her out • Does this mean you have a 20% chance of success? • Of course not: • Each experience of attraction is unique • What someone has done in the past with other people is no guide to what he/she will do with you in the future • His/her response is not “risky”; it is uncertain. • Ditto to individual investments • success/failure of past instances give no guide to present “odds”

25. How to cope with relationship uncertainty? • We try to “find out beforehand” • ask friends—eliminate the uncertainty • We do nothing… • paralysed into inaction • We ask regardless… • compel ourselves into action • We follow conventions • “follow the herd” of the social conventions of our society • “play the game” & hope for the best • So what about investors?

26. There’s more than one “Keynes” • In the midst of incalculable uncertainty, investors form fragile expectations about the future • These are crystallised in the prices they place upon capital asset • These prices are therefore subject to sudden and violent change • with equally sudden and violent consequences for the propensity to invest • The “marginal efficiency of capital/investment” is simply ratio of yield from asset to its current demand price, and therefore there is a different “marginal efficiency of capital” for every different level of asset prices (Keynes 1937a: 222)

27. There’s more than one “Keynes” • In 1969, Minsky states that his own ideas about uncertainty "seem to be consistent with those of Keynes" (1969a, 1982: 191, footnote 6), citing Keynes 1937 • Eventually concludes • “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 1969b: 224) • Combines elements of Marx, Keynes & Schumpeter • Christens his model the “Financial Instability Hypothesis”:

28. Financial Instability Hypothesis • “The natural starting place for analyzing the relation between debt and income is to take an economy with a cyclical past that is now doing well. • The inherited debt reflects the history of the economy, which includes a period in the not too distant past in which the economy did not do well. • Acceptable liability structures are based upon some margin of safety so that expected cash flows, even in periods when the economy is not doing well, will cover contractual debt payments. • As the period over which the economy does well lengthens, two things become evident in board rooms. Existing debts are easily validated and units that were heavily in debt prospered; it paid to lever.” (65)

29. Financial Instability Hypothesis • “After the event it becomes apparent that the margins of safety built into debt structures were too great. • As a result, over a period in which the economy does well, views about acceptable debt structure change. In the deal­making that goes on between banks, investment bankers, and businessmen, the acceptable amount of debt to use in financing various types of activity and positions increases. • This increase in the weight of debt financing raises the market price of capital assets and increases investment. As this continues the economy is transformed into a boom economy…” (65) • This transforms a period of tranquil growth into a period of speculative excess:

30. Financial Instability Hypothesis • “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.” (65) • This characteristic of capitalism necessarily missed by IS-LM/AS-AD analysis because process fundamentally non-equilibrium in nature:

31. Financial Instability Hypothesis • Whether neoclassical or Keynesian, IS-LM/AS-AD analysis omits time and debt • Difference between “Keynesian” (1950-1973) and “Neoclassical” (1973+) economic management outcomes may reflect deterioration of economy • but neither theory could have seen it coming • Minsky notes Hicks also rejects IS-LM • John R. Hicks, "Some Questions of Time in Economics," in Evolution, Welfare and Time in Economics: Essays in Honor of Nicholas Georgescu­Roegen (Lexington, Mass.: Lexington Books, 1976), pp. 135-151. In this essay Hicks finally repudiates the potted equilibrium version of Keynes embodied in the IS-LM curves: he now views IS-LM as missing the point of Keynes and as bad economics for an economy in time.” (Minsky 1982: 70)

32. Financial Instability Hypothesis • But both equilibrium theories missed causal factors behind deterioration: • Evolution of riskier behavior & financial arrangements as long period of tranquility changed expectations: • “Stability—or tranquility—in a world with a cyclical past and capitalist financial institutions is destabilizing.” • Resulting cyclical/secular increase in debt levels made economy more fragile, more susceptible to financial crises • Spelling Minsky’s model out step by step:

33. 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

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

35. 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

36. 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

37. 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 reduce

38. Minskian Economic History • Since WWII • Debt has risen in ratchet-like manner • Rise during boom • Peak & then fall during slump • Cycle renews with higher initial debt level • Government spending rescued system in each slump • Massive inflation in asset prices as by-product • Monetarist/Neoclassical policy has • reduced “counter-vailing” impact of government spending • driven down inflation rate to near-deflation levels • Debt levels now highest in history, inflation near zero…

39. Minskian Economic History of Australia • Data from recent (2004) PhD thesis: • Luke Reedman, "As assessment of the Development of Financial Fragility in the Australian economy“ • Rise in debt to GDP from 50% to 135% 1960-2000:

40. Minskian Economic History of Australia • Interest payments peaked in 1989/90 • Corporate indebtedness decreased since 1990: • BUT Household debt levels rising…

41. Minskian Economic History of Australia • BUT Corporate indebtedness decreased since 1990: • BUT overall fragility higher given debt repayments:

42. Minskian Economic History of Australia • AND situation of Sydney households worst in history… • Debt & financial fragility has risen as Minsky predicted…

43. Minskian Economic History of Australia • Household & corporate sector now more susceptible to financial crisis than ever before… Note key acceleration point of mid-1970's…

44. Minskian Economic History of Australia • Cyclical “ratcheting up” of gap between expenditure and debt over last 40 years • Household & corporate sector now net borrowers • “A positive gap means that capital expenditures exceed available internal funds.” (153)

45. Modelling Financial Instability • Minsky’s verbal model appears confirmed by data • But (for better or worse…!) only mathematical models “cut it” with economists • Vigorous methodological debates about role of mathematics in economics • Considered in History of Economic Thought • Whatever outcome of debate, reality is that mathematical models are key part of “rhetoric” of economics • If you can’t “say it” with maths, economists won’t listen • Can this be modelled mathematically? • Yes but not with “equilibrium” tools • Need something like what Minsky tried: mathematical models that incorporate time

46. Modelling Financial Instability • Mathematical models that incorporate time are • Differential equations • Difference equations • Not taught at undergraduate level in most universities (including UWS) • Sometimes taught at advanced (Masters/PhD) level • But frequently at inadequate level • Modern sciences (biology, physics, maths itself) show differential equations only able to model real-world processes when they are • Nonlinear • Involve three or more variables (“third order”) • Most economics courses don’t go beyond linear second order equations

47. Modelling Financial Instability • Several attempts to model Minsky in literature • See references in final slide • My model based on Goodwin’s trade cycle model (next slide) • Key component of dynamic model is “rate of change of x with respect to time” • Mathematically shown as dx/dt: • Similar to calculus you have done in Maths 1.3 etc.; BUT • One key difference: calculus considers equations of form • Rate of change of dependent variable a function of value of independent variable • Differential equations “rate of change of dependent variable a function of its own value”

48. Modelling Financial Instability • Maths gets quite complicated (overview only here!); but • Dividing by dependent variable puts equation in “percentage change” form: • Rate of change • Percentage rate of change • % rate of change thinking therefore essentially dynamic • Often complicated models easily expressed in “percentage rate of change” terms • Applying this to model “a cyclical economy” • “The natural starting place for analyzing the relation between debt and income is to take an economy with a cyclical past that is now doing well…” (Minsky 1982: 65)

49. Modelling Financial Instability • First stage: Goodwin’s model (of Marx’s cyclical growth theory) • Causal chain • Capital (K) determines Output (Y) • Output determines employment (L) • Employment determines wages (w) • Wages (wL) determine profit (P) • Profit determines investment (I) • Investment I determines capital K • chain is closed “accelerator” Chain is closed productivity Rate of change terms vital Phillips curve Investment function Depreciation

50. Modelling Financial Instability • Goodwin’s model reduces to two “% rate of change” expressions: • “% rate of change of employment rate equals % rate of economic growth minus % rate of population growth and technical change” • “Employment will rise if the rate of economic growth exceeds the sum of population growth & technical change” • “% rate of change of wages share of GDP equals % increase in wages (Phillips curve) minus % rate of technical change” • “Workers share of output will rise if the increase in wages exceeds the rate of technical change”