Monetary Macroeconomic Modeling

1. Monetary Macroeconomic Modeling Steve Keenwww.debtdeflation.com/blogs Kickstarter: http://t.co/rzFwjEnJ

2. From the Great Moderation to the Lesser Depression • Sudden decay of economic conditions in 2007-08:

3. From the Great Moderation to the Lesser Depression • Crisis not anticipated by DSGE models: • OECD Economic Outlook June 2007 • “the current economic situation is in many ways better than what we have experienced in years… • Our central forecast remains indeed quite benign: • a soft landing in the United States, a strong and sustained recovery in Europe,… In line with recent trends, • sustained growth in OECD economies would be underpinned by strong job creation and falling unemployment.” (Cotis 2007) • Great Moderation & Depression anticipated by Minsky-oriented 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)

4. From the Great Moderation to the Lesser Depression • Key empirical difference: focus on role of private debt… Growing debt ratio Collapse in debt growth

5. Minsky approach compared to DGSE approach • Non-equilibrium & instability rather than equilibrium dynamics • “Stability—or tranquility—in a world with a cyclical past and capitalist financial institutions is destabilizing” (Minsky 1978) • Euphoric rather than Rational Expectations • “Once euphoria sets in … Financial institutions … accept liability structures … that, in a more sober expectational climate, they would have rejected” (Minsky 1972) • Complexity & Emergent Properties rather than Microfoundations • “every polynomial … is an excess demand function for a specified commodity in some n commodity economy…” (Sonnenschein1972) • Linear production rather than diminishing marginal productivity • “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)

6. Minsky approach compared to DGSE approach • Endogenous money rather than money neutrality • “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) • “Debt plays a key role in accommodating year-by-year variation in investment.” (Fama and French 1999) • Government homeostatic stabilizer rather than “Policy Ineffectiveness” • “Big government prevents the collapse of profits which is a neces­sary condition for a deep and long depression…” (Minsky 1982) • Non-equilibrium methods needed to model Fisher/Minsky processes • “Theoretically … there must be over-or under-production, …over- or under-investment … and over or under everything else. • It is as absurd to assume that, for any long period of time, the variables in the economic organization … will "stay put," in perfect equilibrium, as to assume that the Atlantic Ocean can ever be without a wave.” (Fisher 1933)

7. The 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 • Rising expectations leads to “The Euphoric Economy”…

8. The Financial Instability Hypothesis • Asset prices rise: speculation on assets profitable • Increased willingness to lend increases money supply • Money supply endogenous, not controlled by CB • Riskier investments enabled, asset speculation rises • The emergence of “Ponzi” 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

9. The Financial Instability Hypothesis • Boom turns to bust • Ponzi financiers first to 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 • Final crisis where debt burden overwhelms economy • Turning verbal argument into a model…

10. Cyclical foundations of Minsky model • Goodwin’s cyclical growth model (1967) • Capital K determines output Y via accelerator v: • Y determines employment L via labour productivity a: • L determines employment rate l given population N: • l determines rate of change of the wage rate w: • Output minus the wage bill determines profits P: • All profits are invested: • As a reduced system of ODEs (in l & w = w/a): • As dynamic flowchart • Cycles even with linear Phillips curve… • Generalized for nonlinear investment function & depreciation: • System has neutral equilibrium • (Dominant eigenvalue has zero real part)

11. Cyclical foundations of Minsky model • System inherently cyclical—structural nonlinearity that wage bill = w.L • Nonlinear functions add realism, not cycles themselves • Additional realism to introduce Minsky • Nonlinear investment function: investment exceeds profits during boom, below profits during slump • No structural change to model, but more realistic simulated values:

12. Minsky model: introducing debt • Next element of realism: debt-financed investment: • “More investment tends to generate more debt, while higher earnings are used to reduce debt.” (Fama and French 1999) • In equations: • Rate of change of debt equals investment minus profits • Profit net of interest payments on debt • Significant structural change to model • Now 3 dimensions: • Rate of employment • Wages share of output • Debt to output ratio

13. Minsky (without government) • As system of ODEs: • Li and Yorke (1975), “Period Three Implies Chaos” • Stability now dependent on initial conditions, parameters • “Inverse tangent route to chaos” (Pomeau and Manneville 1980) • Equilibrium convergence for some initial conditions • Divergence for others • Apparent convergence to stability followed by breakdown

14. Finance & Economic Breakdown • Stability for some initial conditions & parameter values…

15. Finance & Economic Breakdown • Apparent stability followed by instability for others • “Great Moderation” followed by “Great Depression”…

16. Finance & Economic Breakdown • Model has 2 equilibria: • “Good equilibrium”: • Positive incomes, positive employment, & finite debt • “Bad equilibrium”: • Zero wage & profit income, zero employment, & infinite debt • Size of basin of attraction of good equilibrium a negative function of debt to output ratio… • Outside this basin, convergence to bad equilibrium likely • Stability of good equilibrium • Eliminated by “Ponzi” behavior • Debt-financed speculation on asset prices • Expanded by government counter-cyclical spending • Cash flow to private sector enables debts to be serviced, repaid • Role of private debt in economy crucial…

17. Finance & Economic Breakdown • Higher debt ratio gives lower range of stable initial conditions… Higher debt level reduceseconomic stability

18. Destabilizing a bad stable equilibrium • Bad equilibrium similar to astronomical Black Hole • Escape once economy enters its “Event Horizon” impossible unless • Debt is reduced by bankruptcy, debt jubilees • Like “Hawkins Radiation”: reduce mass of Black Hole • Reduce real interest rate • Like reducing gravitational constant • Non-discretionary government spending can destabilize this bad stable equilibrium • Government spending rises when unemployment rises; • Government tax revenues fall when unemployment rises • Spending gives business cash flow to service/repay debt • Modelled by introducing government net spending as a function of the employment rate:

19. Destabilizing a bad stable equilibrium • Results in 4-dimensional system: • Counter-cyclical government spending • Destabilizes bad equilibrium • Basin of attraction substantially reduced • Economy can be moved from bad equilibrium with large stimulus • Makes good equilibrium stable but cyclical…

20. Destabilizing a bad stable equilibrium • Cyclical stability around good equilibrium • Stability not absence of cycles but absence of breakdown…

21. A strictly monetary macroeconomic model • Preceding model implicitly monetary • Debt finances investment in excess of retained earnings • Explicitly monetary model needed to • Consider impact of inflation, deflation • Properly incorporate banking sector into macroeconomics • Innovation: using accounting tables to build financial flow models • Explicitly include bank accounts in macroeconomic model • Firm Debt, Household Debt, Government Debt, etc. • Deposit accounts of Firms, Households, Government too • Model endogenous money creation process…

22. A strictly monetary macroeconomic model • Monetary foundation enables explicit inflation modeling • Price dynamics derived from lagged demand-supply convergence • Monetary wages with employment, rate of change of employment, and inflation-compensation dynamics • Simple model with • Bank lending to Firms only • Deposit and wage income to households • Generates stylized facts of Great Moderation/Depression • Decline in employment & inflation volatility • Then sudden collapse into deflation & rising unemployment

23. A strictly monetary macroeconomic model • Model equations:

24. Monetary Macroeconomic Model & Economic Data • Uncalibrated model output… • Smoothed actual US data…

25. Monetary Macroeconomic Model & Economic Data • Income distribution dynamics matter • Profit share behavior gives no warning of impending crisis • Rising bank income a sign of danger…

26. Extending Monetary Macroeconomic Modelling • Monetary modelling clearly adds to our understanding of the economy • Preceding model still very simple & incomplete • New research agenda: building a platform for monetary modelling • Extend existing “system dynamics” technology to handle money flows • Innovation: accounting double-entry creates stock-flow consistent monetary dynamics • Bank accounts in columns • Transactions between accounts in rows • Multiple banks—including Central Bank—easily modelled • Double-entry to ensure stock-flow consistency • Complex system of financial flow ODEs built with ease…

27. Extending Monetary Macroeconomic Modelling • Enter flows in double entry table: • Define flows visually:

28. Extending Monetary Macroeconomic Modelling • Simulate numerically:

29. Extending Monetary Macroeconomic Modelling • Generate stock-flow consistent system of ODEs automatically: • Easily linked to physical production system • Extensible to multiple banks, multiple sectors, input-output dynamics, international trade and financial flows…

30. Extending Monetary Macroeconomic Modelling • Multiple banks with Central Bank as clearing house…

31. Extending Monetary Macroeconomic Modelling • Multiple sectors, input-output dynamics can be modelled…

32. Conclusion • Economic crisis shows need for macro models to incorporate financial sector, debt & money dynamics • Minsky’s Hypothesis provides insights missing in DSGE models • Monetary macro models should be added to toolkit of Treasuries, Central Banks • Technology to make monetary modelling straightforward now exists • http://sourceforge.net/p/minsky/home/Home/ • Let’s jointly develop the technology & the models…