Financial Economics Lecture Twelve

1
Financial Economics Lecture Twelve

• Modelling endogenous money/debt deflation
• Debt and Big Government

2
Recap

• Last lecture
• Minskys Financial Instability Hypothesis (FIH)
• Integration of
• Fishers 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 Goodwins growth cycle model
• based on Marxs model of cycles in income
  distribution and employment

3
Modelling Minsky Endogenous Money

• Marxs 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

• Marxs 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 (fishcapitalists!)
  depends ively on food supply and -ively
  interactions with predator (sharkworkers)
• Rate of growth of predator depends -ively on
  number of predators and ively on interactions
  with prey
• OK now lets build it. First, the maths

5
Modelling Minsky Endogenous Money

• First stage Goodwins predator-prey model of
  Marxs 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

• Lets 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 easyoutput 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 blockemployment 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

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Modelling Minsky Endogenous Money

• Sometimes an equation is easier to read, isnt 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
  Lowinvest nothing Mediuminvest as much as
  earn Highinvest 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
• InvestmentProfit at profit rate of 3
• InvestmentgtProfit at profit rate gt 3
• InvestmentltProfit at profit rate lt 3
• Slope of change at 32
• Minimum investment 1 output (depreciation
  easily introduced)

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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 investmentgtprofits
• Rate of change of debt is investment minus
  profits
• Profits now net of interest on outstanding debt

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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 Fishers 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

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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, a3 is less than a2 is less
  than a
• But above 1, a3 is bigger than a2 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

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Modelling Minsky Endogenous Money

• CAVEAT!
• Dynamic modelling can capture many elements of
  Minskys theory and endogenous money, BUT
• There are elements that cannot be modelled this
  way
• Evolutionary change in the system
• Non-systemic eventssuch as for example, people
  being persuaded by the failure of the system that
  the system must be changed
• There is a limit to modellinginstitutions 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 Minskys 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

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Modelling Minsky Endogenous Money

• Revised function gives negative exponential slope
• Government
• Keeps subsidy constant if unemployment5
• Increases it gradually if Ugt5
• Reduces gradually if Ult5

• 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/conf
  erences/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 problemfalling
  asset prices will cause rising debt burden,
  declining commodity prices (Fishers paradox)
• Latter may right the system, but at short-term
  cost to financiers.

49
Conclusion

• How to do it?
• Japancomparatively 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
  wont necessarily increase prices anyway
• But price inflation via deliberate centralised
  wage increase would work

50
Conclusion

• Increase in wages would necessarily cause
  (lessersay 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

51
Conclusion

• Exogenous money case expects increase in M1 to
  drive increase in M2, M3 and eventually prices

• Correlation of changes in Japan M1 with CPI
  actually negative
• Inflation lower in 2003 than 1991 despite 12
  years of high growth in M1

52
Conclusion

• Japan may now be emerging from debt-deflation
• Emergence due to time rather than policy
• Bankruptcies reducing outstanding debt
• Gradual debt repayment despite low monetary
  profits
• Japan worlds richest economy when crash began

• Has fallen behind USA because of debt deflation
• What if USA succumbs?

53
Conclusion

• America? Tough and largely insoluble problems
• USA now worlds biggest debtor nation
• Insights from Circuitists here
• International payments system gave USA right of
  seigniorage
• Other countries trading in US dollars OK, but
• USA paying for goods with US dollars amounts to
  exchanging good for IOUs
• Two cornered exchange aspect of system has
  distorted trade/debt flows
• Can only last for as long as third parties
  willing to accept US IOUs when this breaks, US
  dollar could plunge
• Plunge itself would generate new problems

54
Conclusion

• US international debt would rise in terms of
  other currencies
• International debts a fraction of domestic debt,
  but all the same
• Economy not as self-contained as Japan
• Cant easily reflate prices internally
• Even more resistant to meddling with price system
  than Japan
• But more likely to break the rules when all
  else fails for many years.
• Minsky/endogenous money analysis predicts a
  pretty rough start to the 3rd Millennium

55
Conclusion

• Endogenous money thus involves fundamental
  changes in economic reasoning
• Move from the village fair paradigm of
  neoclassical economics to the Wall Street
  finance view of Minsky et al cannot be done just
  by tacking money on to a barter model of the
  economy
• Result is a much more complex vision of the
  economy
• Since money is an essential aspect of a
  capitalist economy, analysing it properly results
  in essential changes in economic theory

56
Next Lecture?

• Craig Ellis takes you on a fractal journey
  through finance
• A brief overview

57
Random Walk Down Wall Street?

• EMH/CAPM argues returns cant be predicted
• Random walk/Martingale/Sub-martingale (see
  previous lectures)
• Distribution of returns should be Gaussian
• Non-EMH theories (Coherent Market Hypothesis,
  covered in Craigs lectures) argue distribution
  should be non-random
• Fat tailsmany more extreme events than random
  distribution
• Extreme events of any magnitude possible vs
  vanishingly unlikely for random
• If random, odds of 5 fall of DJIA are less than
  2 in a million
• How many years needed to see one 5 fall?

2500!
58
Random or Fractal Walk Down Wall Street?

• Power law distribution very different to
  Gaussian
• Number of size X events ? X raised to some power

• Result of statistical relation a straight line
  between size of event and event frequency when
  graphed on log-log plot

• Log of number of events of size X -a times
  log(X)
• Rule applies to huge range of phenomena
• Does it apply to stock market?

59
Random or Fractal Walk Down Wall Street?

• Power law fit Dow Jones

Power law predicts6 10 daily movementsper
century
Actual number was 8
1 means 10110events per century
-1 means 10-110 daily change

• Does this tell us anything the EMH doesnt?

60
Random or Fractal Walk Down Wall Street?

• You betcha!

• Random walk prediction OK for small movements
• /-3 780 reality v 718 random prob.
• Hopeless for large
• /-6 57 v 1
• /- 8 11 v 1 in a million chance

-2 means 10-2 onesuch event predictedevery
century
11 lastcentury
10-6 1 event predictedevery 1 million centuries
Actual number 57
10-1.18 change
-1.2 means 10-1.26 daily change
61
Random or Fractal Walk Down Wall Street?

• Belief system is
• in equilibrium
• changes due to random shocks
• Results in prediction that huge events
  vanishingly rare
• Actual data manifestly different

• Daily movements in stock exchange
• Any size crash feasible
• Likelihood far higher than predicted by
  random/equilibrium model
• Crashes not aberrations but normal behaviour

62
Random or Fractal Walk Down Wall Street?
63
Random or Fractal Walk Down Wall Street?
64
Random or Fractal Walk Down Wall Street?
7 s.d. events 10,000,000
times more frequently than random...
65
Random or Fractal Walk Down Wall Street?

• Data clearly not random
• Many more sophisticated analyses (Craigs
  lectures) confirm this
• Fractal hypothesis fits data much better
• Underlying process behind stock market therefore
• Partly deterministic
• Highly nonlinear
• Interacting Bulls Bears
• Underlying economic-financial feedbacks
• Economics needs
• a theory of endogenous money
• A theory of nonlinear, nonequilibrium finance
• Why do most economists still cling to the EMH?

66
CAPM The original belief

• CAPM fitted belief in equilibrium behaviour of
  finance markets, but required extreme assumptions
  of
• a common pure rate of interest, with all
  investors able to borrow or lend funds on equal
  terms. Second, we assume homogeneity of investor
  expectations investors are assumed to agree on
  the prospects of various investments the expected
  values, standard deviations and correlation
  coefficients
• Justified on basis of methodology and agreement
  with theory
• Needless to say, these are highly restrictive
  and undoubtedly unrealistic assumptions. However,
  since the proper test of a theory is not the
  realism of its assumptions but the acceptability
  of its implications, and since these assumptions
  imply equilibrium conditions which form a major
  part of classical financial doctrine, it is far
  from clear that this formulation should be
  rejected-especially in view of the dearth of
  alternative models leading to similar results.
  (Sharpe 1964 433-434)
• Fama (1969) applied the proper test and hit
  paydirt

67
Fama 1969 Data supports the theory

• For the purposes of most investors the efficient
  markets model seems a good first (and second)
  approximation to reality. In short, the evidence
  in support of the efficient markets model is
  extensive, and (somewhat uniquely in economics)
  contradictory evidence is sparse. (Fama 1969
  436)
• Famas paper reviewed analyses of stock market
  data up till 1966
• Table 1, 1957-66 Ball Brown 1946-66 Jensen
  1955-64
• Lets look at the DJIA data over the longer term

68
The CAPM Evidence
21 years ahead of trend...

• Fit shows average exponential growth 1915-1999
• index well above or below except for 1955-1973

Crash of 73 45 fall in 23 months
Sharpes theory paper published
Jan 11 73 Peaks at 1052
Dec 12 1974 bottoms at 578
Bubble takes off in 82
CAPM fit doesnt look so hot any more
Famas empirical data window
Steady above trend growth 1949-1966
CAPM fit to this data looks pretty good!
69
Fama French 2004 Data kills the theory

• The attraction of the CAPM is that it offers
  powerful and intuitively pleasing predictions
  about how to measure risk and the relation
  between expected return and risk.
• Unfortunately, the empirical record of the model
  is poorpoor enough to invalidate the way it is
  used in applications. (Fama French 2004 25)

• So founding fathers of CAPM have abandoned
  their child
• Why do economists still teach it?

70
Random or Fractal Walk Down Wall Street?

• Many dont know that developers of CAPM have
  abandoned it
• Most dont know that any alternative exists, so
  teach what they know
• But alternatives do exist
• Fractal/Coherent/Inefficient Markets in finance
• In Economics?
• Key aspect of CAPM
• How investments are financed doesnt affect value
  of firm (determined solely by net present value
  of investments)
• As a result, finance doesnt affect economics
• Since CAPM is false, finance does affect
  economics
• More from Craig next week