Financial Economics Lecture Twelve

1. Financial Economics Lecture Twelve Modelling endogenous money/debt deflation… Debt and Big Government…

2. Recap • Last lecture: • Minsky’s Financial Instability Hypothesis (FIH) • Integration of • Fisher’s Debt Deflation Theory of Great Depressions • Keynes on expectations under uncertainty • Kalecki on investment & increasing risk • Presumes cyclical economy • Foundations here Schumpeter & Marx • This lecture: • Modelling FIH with Goodwin’s “growth cycle” model • based on Marx’s model of cycles in income distribution and employment:

3. Modelling Minsky & Endogenous Money… • Marx’s cyclical growth model in Capital I Ch. 25: • “a rise in the price of labor resulting from accumulation of capital implies ... accumulation slackens in consequence of the rise in the price of labour, because the stimulus of gain is blunted. The rate of accumulation lessens; but with its lessening, the primary cause of that lessening vanishes, i.e. the disproportion between capital and exploitable labour power. The mechanism of the process of capitalist production removes the very obstacles that it temporarily creates. The price of labor falls again to a level corresponding with the needs of the self-expansion of capital, whether the level be below, the same as, or above the one which was normal before the rise of wages took place...” (Marx 1867)

4. Modelling Minsky & Endogenous Money… • Marx’s model (1867) • High wages low investment  low growth  rising unemployment  falling wage demands  increased profit share  rising investment  high growth  high employment  High wages: cycle continues • Goodwin (1967) draws analogy with biology “predator-prey” models • Rate of growth of prey (fish=capitalists!) depends +ively on food supply and -ively interactions with predator (shark=workers) • Rate of growth of predator depends -ively on number of predators and +ively on interactions with prey: • OK; now let’s build it. First, the maths…

5. Modelling Minsky & Endogenous Money… • First stage: Goodwin’s predator-prey 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 Depreciation Now as a flowchart... Investment function

6. Modelling Minsky & Endogenous Money… • Capital K determines output Y via the accelerator: • Y determines employment L via productivity a: • L determines employment rate l via population N: • l determines rate of change of wages w via P.C. • (Linear Phillips curve for now) • Integral of w determines W (given initial value) • Y-W determines profits P and thus Investment I… • Closes the loop:

7. Modelling Minsky & Endogenous Money… • Model generates cycles (but no growth since no population growth or technical change yet)…: • Cycles caused by essential nonlinearity: • Wage rate times employment • Behavioural nonlinearities not needed for cycles; • Instead, restrain values to realistic levels

8. Modelling Minsky & Endogenous Money… • Let’s “do that again”, in stages • This time with • exponential growth in population & technology • Nonlinear Phillips curve • “Rates of change” first • The investment to capital relation is easy:

9. Modelling Minsky & Endogenous Money… • Next step is easy—output is capital stock divided by the accelerator: • Output divided by labour productivity gives the necessary employment level • Employment divided by the available workforce gives us the rate of employment • So we need a productivity component and a population component…

10. Modelling Minsky & Endogenous Money… • Constant % rate of growth of productivity means exponential growth over time • Ditto for population:

11. Modelling Minsky & Endogenous Money… • Output divided by labour productivity gives needed number of workers

12. Modelling Minsky & Endogenous Money… • Workforce divided by population gives rate of employment • Now things get a bit messy, so we hide bits we know about in compound blocks

13. Modelling Minsky & Endogenous Money… • The same model, with internal complexity simplified by compound blocks: • Now we need a wage change block—employment rate determines rate of change of wages • Wage change function more complicated because involves “Phillips curve” (Phillips researched the stats in the first place to build a model like this) • Next component is “generalised exponential function” set to reproduce same fit as Phillips curve

14. Modelling Minsky & Endogenous Money… • Feed in • minimum rate of change (-4%) • (x,y) coordinates for one point (.96,0) • Slope at this point (2) • And you get the exponential curve that fits these values: • In flowchart form, this is…

15. Modelling Minsky & Endogenous Money… • Sometimes an equation is easier to read, isn’t it? • Nonetheless, if we feed the employment rate in one end, we get the wage change out the other: • Now we need to multiply this by the current wage to get the rate of change of wages:

16. Modelling Minsky & Endogenous Money… • Wage change function: • So now the whole system is:

17. Modelling Minsky & Endogenous Money… • Now we need to work out profit: • Profit = Output – Wages • Wages = Wage Rate times Employment…

18. Modelling Minsky & Endogenous Money… • Since in the simple Goodwin model, capitalists invest all their profits, we simply need to link profit to capital (whose input is investment) and we have built the model:

19. Modelling Minsky & Endogenous Money… • Testing this out by adding some graphs; if it works, we should get cycles in the employment rate:

20. Modelling Minsky & Endogenous Money… • Voila! Now to tidy things up a bit using compound blocks…

21. Modelling Minsky & Endogenous Money… • Now at last we have the basis on which to build a Minsky model

22. Modelling Minsky & Endogenous Money… • Essential step to introduce Minsky/endogenous money is debt • For debt, essential that (at least) capitalists wish to invest more than they earn • “Debt seems to be the residual variable in financing decisions. Investment increases debt, and higher earnings tend to reduce debt.” (Fama & French 1997) • “The source of financing most correlated with investment is long-term debt… These correlations confirm the impression that debt plays a key role in accommodating year-by-year variation in investment.” (Fama & French 1998) • A nonlinear investment function needed for firms investment to be a function of rate of profit: Low—invest nothing; Medium—invest as much as earn; High—invest more than earn

23. Modelling Minsky & Endogenous Money… • Important (normal) feature of dynamic modelling: increasing generality of model makes it more realistic • No need for absurd assumptions to maintain fiction of equilibrium, coherent micro/macro behaviour • Use same exponential form as for Phillips, but with different parameters • Investment=Profit at profit rate of 3% • Investment>Profit at profit rate > 3% • Investment<Profit at profit rate < 3% • Slope of change at 3%=2 • Minimum investment –1% output (depreciation easily introduced)

24. Modelling Minsky & Endogenous Money… • Makes no substantive difference to model behaviour…

25. Modelling Minsky & Endogenous Money… • But prepares the way for introducing debt to finance investment when investment>profits • Rate of change of debt is investment minus profits • Profits now net of interest on outstanding debt

26. Modelling Minsky & Endogenous Money… • Investment increases debt; profit decreases it • Debt rises if investment exceeds profits • Debt also increases due to interest on outstanding debt… • Profit is now net of both wages and interest payments: • And the whole model is:

27. Modelling Minsky & Endogenous Money… • Notice debt becomes negative • Capitalists accumulate • Equilibrium is stable in Fisher’s sense…

28. Modelling Minsky & Endogenous Money… • “we may tentatively assume that, ordinarily and within wide limits, all, or almost all, economic variables tend, in a general way, towards a stable equilibrium” (Fisher 1933: 339) • BUT… • This stability of the kind Fisher describes: “so delicately poised that, after departure from it beyond certain limits, instability ensues” (Fisher 1933: 339). • Start further from equilibrium, and the system becomes unstable:

29. Modelling Minsky & Endogenous Money… • Higher initial level of unemployment leads to disaster… • Technical reason requires advanced maths to explain, but…

30. Modelling Minsky & Endogenous Money… • Technical reason is that nonlinear model can be • Locally stable around equilibrium (where “linear” component of system dominates) but • Globally unstable: past a certain range, higher power forces overwhelm linear component • Just as below one, a^3 is less than a^2 is less than a • But above 1, a^3 is bigger than a^2 is bigger than a • So if you start too far from equilibrium, you will suffer a debt-induced collapse • How do you get far from equilibrium? Tendency Minsky outlined for “euphoric expectations” to lead capitalists into excessive investment/optimism during a boom…

31. Modelling Minsky & Endogenous Money… • CAVEAT! • Dynamic modelling can capture many elements of Minsky’s theory and endogenous money, BUT • There are elements that cannot be modelled this way • Evolutionary change in the system • Non-systemic events—such as for example, people being persuaded by the failure of the system that the system must be changed • There is a limit to modelling—institutions and evolution and human agency must also be understood… • But we do at least get a better handle on the system by knowing its characteristic dynamics (even if we ignore that these characteristics can evolve…)

32. Modelling Minsky & Endogenous Money… • Finally (without bringing in price dynamics), government: • In Minsky’s view, government spending works by • providing firms with cash flow they otherwise would not have during a slump, thus letting them pay off their debts; • Restraining corporate cash flow during a boom, thus attenuating how euphoric expectations can get • Modelled by presuming government pays subsidy (can be negative) to firms, where change in subsidy is a function of the rate of employment… • Constant parameters means model government “resolute” against unemployment • Actual governments have clearly shifted on this… • Use same generalised exponential for g(), with different parameters…

33. Modelling Minsky & Endogenous Money… • Revised function gives negative exponential slope • Government • Keeps subsidy constant if unemployment=5% • Increases it gradually if U>5% • Reduces gradually if U<5% • Profit is now net of wages, interest, and government subsidy…

34. Modelling Minsky & Endogenous Money… • We get… cyclical instability (depending on slope parameter of government reaction function)

35. Modelling Minsky … Conclusion • Essentials of Financial Instability Hypothesis can be modelled using dynamic tools • Nuances of FIH require evolutionary perspective • Evolution of financial intermediaries over time… • Change in government policy… • Still have to add prices (done in mathematical format) • Result is possibility for the “Fisher paradox” • Falling prices increase real debt burden even as actual debt levels reduced • Wrap up: main polemic weakness of debt-deflation hypothesis • (inability of Fisher, Keynes, Minsky to develop mathematical model)… • easily overcome with modern dynamic methods

36. The FIH & the data • We can model debt-deflation • So if we can model it, can “it” happen (again)?… • Yes!: • Japanese experience of • “Bubble economy” during 1980s • Debt-induced downturn with deflation in 1990s • Has been in debt-deflation for 15 years… • Asian crisis arguably a Minsky crisis • Added element of sudden collapse of currencies once debt-crisis commenced • See Kregel paper

37. The FIH & the data • The USA? • Bubble Economy of 1990s • Obvious bubble in hindsight for some (Greenspan) • during the event for others (Schiller, etc.)! • massive mal-directed investment in telecommunications, internet • Huge (historically high) debt in both physical and financial sectors • Current state: continued housing bubble + massive government deficits… • Future prospects? • Australia? • Historically unprecedented debt levels have accumulated in Minskian cyclical fashion…

38. Minskian perspective on Australia • Australian data on debt now worrying RBA: • Still “not sure” whether should target asset price inflation, but recognises dangers of excessive debt: • “it is really the leverage that accompanies asset-price movements which is the issue, rather than the asset-price movements themselves… all sizeable asset-price misalignments presumably do some damage, but the ones which do the most damage are those which were associated with a big build-up in leverage, which always carries the risk of forcing abrupt changes in behaviour by borrowers and their lenders when the prices turn. To coin a phrase, `it's the leverage, stupid'.” (Glenn Stevens) • RBA 2003 Conference: Asset Prices and Monetary Policy • http://www.rba.gov.au/PublicationsAndResearch/conferences/2003/index.html

39. Minskian perspective on Australia • Leverage in Australia now extreme • Following data from RBA Sources: • D02 Lending And Credit Aggregates • G12 Gross Domestic Product - Income Components. • Credit to GDP ratio was • 40% in 1976 • 137% in 2005 • Housing debt to GDP ratio was • 12% in 1976 • 75% in 2005 • Growth exponential (3% p.a. growth in debt/GDP ratio since 1953!) • Not simply reaction to lower interest rates • Interest to GDP ratio 1% in 1976; • 5.3% in 2005

40. Minskian perspective on Australia • Consistent pattern for post-WWII period • Growth in Credit/GDP ratio literally exponential: • Americans speculate on shares; Australians speculate on houses: • Business debt stabilised post 1990…

41. Minskian perspective on Australia • Australian business debt blew out during 1980s: • But relatively stable since 1995 • Though at higher level, & rising with China boom now… • Household debt, on the other hand…

42. Minskian perspective on Australia • At unprecedented levels… • Housing debt now largest component of private debt • Next chart separated “standard” home loans from “Low Doc Loans” (source of most recent growth):

43. Minskian perspective on Australia • Businesses “repaired balance sheets” post 1990 • Households kept right on borrowing… • Very different dynamics for interest rates…

44. Minskian perspective on Australia • Interest rates plummeted since 1990 peak… • Interest burden kept on rising… • But in very Minskian cyclical fashion… • Ratio almost twice 1990s level • Despite interest rates 2/3rds lower!

45. Meanwhile, Back in the USA… • USA debt levels high too, but ours comparable… • High USA Government debt may reflect ‘seignorage’ problems of world monetary system… • Note high financial corporations debt

46. Minskian perspective on Australia • RBA now accepts that most of borrowing has simply inflated house prices… • “With house prices rising, households were comfortable in increasing their indebtedness. And banks were happy to lend. But much of the credit was used to further bid up the prices of houses.” (Anthony Richards, Head, Economic Analysis RBA; SMH March 3rd 2006)

47. Conclusion • One of 2 pre-conditions for debt-deflation now in place • Inflation also at very low levels… • What to do if a debt-deflation happens? Not much! • Capitalism fundamentally unstable, so escaping from a collapse therefore no picnic; essential lesson is we should avoid debt deflations in the first place • by developing and maintaining institutions and policies which enforce "a 'good financial society' in which the tendency by businesses and bankers to engage in speculative finance is constrained" (Minsky 1977, 1982: 69). These include • close and discretionary supervision of financial institutions and financial arrangements • non-discretionary countercyclical fiscal arrangements • bias towards income equity rather than inequality…

48. Conclusion • But if we fail (as we have!) on these fronts?… • Deliberate inflation • Problem is one of two price levels • Asset bubble has caused asset price level which is unsustainable in terms of commodities price level (and hence profit margins) • Two ways to get in balance • Either deflate asset prices, or • Inflate commodity prices • Former approach exacerbates the problem—falling asset prices will cause rising debt burden, declining commodity prices (Fisher’s paradox) • Latter may “right the system”, but at short-term cost to financiers.

49. Conclusion • How to do it? • Japan—comparatively simple • Japan a creditor nation, vast majority of (crippling) Japanese financial system debts owed to Japanese lenders (huge apparent household savings) • Price inflation via fiscal/monetary stimulus ineffective • (with good reason!) Super-cautious Japanese simply increase savings • Post Keynesian theory (no diminishing marginal productivity) indicates fiscal/monetary stimulus won’t necessarily increase prices anyway • But price inflation via deliberate centralised wage increase would work:

50. Conclusion • Increase in wages would necessarily cause (lesser—say by 2-3% depending on productivity) increase in consumer prices • Consumers forced to spend to purchase current commodities • Inflationary spiral would feed through system for several years, reducing real debt burden • But policy not adopted • Inflation-averse and market-fundamentalist economists likely to oppose such measures, even in Japan • Instead tried monetary stimulus to boost prices… • With not much success: