Lecture Nine

1
Lecture Nine

• Fisher and Debt Deflation

2
Fishera father with two children

• Irving Fisher (1867-1947) began as a
  mathematically-oriented neoclassical economist
• Also a mechanical tinkerer, food freak,
  teetotaller and prohibitionist, and eugenicist
• Main relevance of this for economics he invented
  the Rolodex, sold it to the Rand Corporation, and
  became a substantial stock holder of which more
  later
• In 1907, published The theory of interest,
  which became the signature neoclassical text on
  finance until Sharpe developed the Efficient
  Markets Hypothesis
• In 1933, published The debt-deflation theory of
  Great Depressions, which rejected foundations of
  neoclassical theory of money

3
An equilibrium theory of finance

• Fishers 1907 book made systematic Benthams
  argument that Putting money out at interest, is
  exchanging present money for future (Bentham
  1787, In Defence of Usury)
• The rate of interest expresses a price in the
  exchange between present and future goods.
  (Fisher 1930 61 rewrite of 1907 book for
  popular audience),
• This price is the product of three forces
• the subjective preferences of individuals for
  present goods over future goods
• the objective possibilities for profitable
  investment
• and a market mechanism for loanable funds which
  brings these two forces into equilibrium.

4
An equilibrium theory of finance

• The subjective preferences of individuals for
  present goods over future goods determines supply
  of funds
• a low time preference
• most likely a lender
• high time preference (prefers to consume now
  rather than later)
• most likely a borrower.
• Borrowing thus means by which those with a high
  preference for present goods acquire the funds
  they need now, at the expense of later income.

5
An equilibrium theory of finance

• The objective side of the equation
• the marginal productivity of investment or
  marginal return over cost (1930 182).
• willingness to borrow/lend not enough
• must also be possible for borrowed money to be
  invested and earn a rate of return.

6
An equilibrium theory of finance

• Market mechanism brings subjective and objective
  forces into harmony
• Supply
• A high rate of interest
• even those with a very high time preference will
  lend
• supply of funds will be quite high
• Low rate of interest
• only those with a very low time preference will
  lend
• very small supply of funds

7
An equilibrium theory of finance

• Demand
• High rate of interest
• most investments will be unviable
• demand for funds will be low
• Low rate of interest
• most investments have positive net present value
• demand for funds will be high
• Market mechanism
• Forces of supply and demand determine equilibrium
  interest rate at which the funds demanded and the
  funds supplied are equal.

8
An equilibrium theory of finance

• Two conditions needed for market to perform in
  Fishers equilibrium model
• (A) The market must be cleared--and cleared with
  respect to every interval of time.
• (B) The debts must be paid. (1930 495)
• i.e.
• No disequilibrium
• No bankruptcy/default
• Unrealistic, but...

9
An equilibrium theory of finance

• Fisher cognisant of
• social basis to time preference
• the smaller the income, the higher the
  preference for present over future income (71)
• If a person has only one loaf of bread he would
  not set it aside for next year even if the rate
  of interest were 1000 per cent for if he did so,
  he would starve in the meantime (71-72)
• the effect of poverty is often to relax
  foresight and self-control and to tempt us to
  trust to luck for the future, if only the
  all-engrossing need of present necessities can be
  satisfied (72)

10
An equilibrium theory of finance

• Effect of time pattern and expectations on time
  preference
• A man who is now enjoying an income of only
  5000 a year, but who expects in ten years to be
  enjoying one of 10,000 a year, will today prize
  a dollar in hand far more than the prospect of a
  dollar due ten years hence. His great
  expectations make him impatient to realize on
  them in advance. He may, in fact, borrow money to
  eke out this year's income and promise repayments
  out of his supposedly more abundant income ten
  years later (73)
• Akin to lending to poor/lending to prodigals in
  Smiths reasons to restrain the rate of interest
• Both reasons why preconditions (A) and (B) may
  not be met in the real world

11
An equilibrium theory of finance

• But this supply and demand theory of the rate of
  interest was accepted wisdom at time of 1929
  Crash
• Analysis of finance/stock markets similar
• markets let suppliers of funds (stock purchasers)
• and demanders of funds (corporations issuing
  shares)
• establish equilibrium price for shares which
  produces
• exchange present money (share price)
• for dividend stream
• whose NPV exactly equals share price discounted
  at prevailing rate of interest
• Fisher believed what he preached accepted high
  valuations of 1920s market as reflecting
  rationally expected rosy prospects for US
  economy.

12
From Utility to Depression

• As well as one of worlds most prominent
  economists, Fisher was also a newspaper columnist
  (a risky business...)
• On Wednesday, October 15, 1929, Fisher
  commentsStock prices have reached what looks
  like a permanently high plateau. I do not feel
  that there will soon, if ever, be a fifty or
  sixty point break below present levels, such as
  Mr. Babson has predicted. I expect to see the
  stock market a good deal higher than it is today
  within a few months.
• Best statement of this Panglossian attitude made
  to Bankers forum on October 23 1929
• but first his October 22 headlines

13
How to lose money and influence on people (1)

• Fishers New York Times headline before the
  crash
• Tuesday, October 22, 1929, Page 24, Col. 1
• FISHER SAYS PRICES OF STOCKS ARE LOW
• Quotations Have Not Caught Up With Real Values As
  Yet, He Declares SEES NO CAUSE FOR SLUMP
  Economist Tells Credit Men that Market Has Not
  Been Inflated, But Merely Readjusted
• Next day, in a talk to bankers, Fisher dismisses
  a 6 fall as just an aberration due to a lunatic
  fringe of speculators

14
Faith in the market

• Began by recounting facts of market advance in
  1920s
• Shares had doubled in value since 1926
• Investor who followed the herd and bought and
  sold shares simply on popularity would have
  increased wealth tenfold in those three years.
• Prices had risen so much that dividend yields
  were below bond yields.
• Margin call lending was at its highest level in
  history.
• All these observations supported the notion that
  the market seems too high and to warrant a major
  bear movement (Fisher 1929).
• BUT

15
Faith in the market

• We are now applying science and invention to
  industry as we never applied it before. We are
  living in a new era, and it is of the utmost
  importance for every businessman and every banker
  to understand this new era and its
  implications... All the resources of modern
  scientific chemistry, metallurgy, electricity,
  are being utilizedfor what? To make big incomes
  for the people of the United States in the
  future, to add to the dividends of corporations
  which are handling these new inventions, and
  necessarily, therefore, to raise the prices of
  stocks which represent shares in these new
  inventions. (Fisher 1929)
• Sound familiar?

16
Faith in the market

• This wave of invention, with returns in future
  years, meant that it was quite natural for the
  ratio of share price to historic earnings to
  rise. In fact, these new firms should be expected
  to make losses as they established their new
  inventions
• In the airline industry very little attention is
  paid to the earnings today, because the price of
  the stock is purely a speculation on the far
  bigger returns that are expected in the future.
  Any new invention ... at first does not give any
  profit (Fisher 1929)
• Sound familiar?

17
Faith in the market

• Low to zero dividend payments not a worry, since
  reinvestment of dividends, was a positive force
• Firms that paid no dividendsrather than handing
  dividends back to investorswere able to grow
  more rapidly. Hence
• many of the stocks which sell the highest on the
  stock exchange and which have had the most
  spectacular rise are not paying any dividends
  (Fisher 1929).
• Sound familiar?

18
Faith in the market

• The public had changed how it estimated risk,
  because Edgar Smiths influential book Common
  Stocks as Long Term Investments had shown that
  over the longer term, stocks outperformed bonds.
  As a result
• There has been almost a stampede towards stocks,
  and away from bonds (Fisher 1929)
• Sound familiar? (Hassett Glassmans Dow 36,000).

19
Trust the professionals

• Growth of market had led to establishment of
  investment professionals
• investment counselling and
• investment trusts which
• can afford to make studies of stocks which the
  individual investor could not study (Fisher
  1929)
• As well as diversifying and spreading risk, these
  institutions enabled stocks to be scientifically
  selected. This explained why
• our stock market is highly selective today
• As a result,

20
Trust the professionals

• Half of the stocks during the last year have
  fallen in spite of the fact that the average as
  shown by the index numbers had risen. The leaders
  are becoming fewer and fewer, and those stocks
  that are leading have a greater and greater
  scarcity value. (Fisher 1929)
• Not a problem though, is it?
• And as for speculation, not a problem!

21
The lunatic fringe causes downturns

• There is a certain lunatic fringe in the stock
  market, and there always will be whenever there
  is any successful bear movement going on... they
  will put the stocks up above what they should be
  and, when frightened, ... will immediately want
  to sell out. (Fisher 1929)
• Wednesdays 6 fall made him slightly less
  sanguine about how dangerous speculators were in
  a down movement (though not a boom!), but the
  other fourteen causes are far more important than
  this one cause itself.
• Now was buying shares on margin or with borrowed
  money a problem

22
Rational borrowing

• To a certain extent it is normal that during an
  era such as we are now passing through, where the
  income of the people of the United States is
  bound to increase faster perhaps than ever before
  in its history, and it has during the last few
  years increased amazingly, that we should try to
  cash in on future income in advance of its
  occurring, exactly on the principle that when a
  young man knows he has been given unexpectedly a
  large bequest, and that it will be in his hands
  inside a year, he will borrow against it in
  advance. In other words, there ought to be a big
  demand for loans at a high rate of interest
  during a period of great increase in income.
  (Fisher 1929)

23
Faith in the market

• So what does the future hold?
• Great prosperity at present and greater
  prosperity in view in the future ... rather than
  speculation ... explain the high stock markets,
  and when it is finally rid of the lunatic fringe,
  the stock market will never go back to 50 per
  cent of its present level... We shall not see
  very much further, if any, recession in the stock
  market, but rather ... a resumption of the bull
  market, not as rapidly as it has been in the
  past, but still a bull rather than a bear
  movement. (Fisher 1929)
• And what happened the next day?
• Black Thursday 10 fall in the Dow Jones in one
  day

24
How to lose money and influence on people (2)

• In afternoon edition, the news and Fishers
  opinion
• Thursday, October 24, 1929, Page 1, Col. 1
• PRICES OF STOCKS CRASH IN HEAVY LIQUIDATION,
  TOTAL DROP OF BILLIONS PAPER LOSS 4,000,000,000
  2,600,000 Shares Sold In The Final Hour In
  Record Decline MANY ACCOUNTS WIPED OUT
• But No Brokerage House Is In Difficulties, As
  Margins Have Been Kept High ORGANIZED BANKING
  ABSENT Bankers Confer On Steps To Support Market
  - Highest Break Is 96 Points
• Page 2, Col. 1
• SAYS STOCK SLUMP IS ONLY TEMPORARY
• Professor Fisher Tells Capital Bankers Market
  Rise Since War Has Been Justified. ECONOMIC
  REASONS CITED "Public Speculative Mania," He
  Declares, is Least Important Cause of Price
  Inflation.

25
The Wall Street Crash
From 32 at its zenith
To below 5at its nadir
in less than 3 years
26
From Utility to Depression

• Fishers reputation destroyed by erroneous
  prediction, but turned to developing theory to
  explain the crash
• The Debt Deflation Theory of Great Depressions
• based on rejection of conditions of previous
  analysis
• (A) The market must be cleared--and cleared with
  respect to every interval of time.
• (B) The debts must be paid. (1930 495)
• Previous theory assumed equilibrium but real
  world equilibrium short-lived since New
  disturbances are, humanly speaking, sure to
  occur, so that, in actual fact, any variable is
  almost always above or below the ideal
  equilibrium (1933 339)
• As a result, any real world variable is likely to
  be over or under its equilibrium level--including
  confidence speculation

27
The Debt Deflation Theory of Great Depressions

• Key problems debt and prices
• The two dominant factors which cause
  depressions are over-indebtedness to start with
  and deflation following soon after
• Thus over-investment and over-speculation are
  often important but they would have far less
  serious results were they not conducted with
  borrowed money. That is, over-indebtedness may
  lend importance to over-investment or to
  over-speculation. The same is true as to
  over-confidence. I fancy that over-confidence
  seldom does any great harm except when, as, and
  if, it beguiles its victims into debt. (Fisher
  1933 341)
• When overconfidence leads to overindebtedness, a
  chain reaction ensues

28
The Debt Deflation Theory of Great Depressions

• (1) Debt liquidation leads to distress selling
  and to
• (2) Contraction of deposit currency, as bank
  loans are paid off, and to a slowing down of
  velocity of circulation. This contraction of
  deposits and of their velocity, precipitated by
  distress selling, causes
• (3) A fall in the level of prices, in other
  words, a swelling of the dollar. Assuming, as
  above stated, that this fall of prices is not
  interfered with by reflation or otherwise, there
  must be
• (4) A still greater fall in the net worths of
  business, precipitating bankruptcies and

29
The Debt Deflation Theory of Great Depressions

• (5) A like fall in profits, which in a
  "capitalistic," that is, a private-profit
  society, leads the concerns which are running at
  a loss to make
• (6) A reduction in output, in trade and in
  employment of labor. These losses, bankruptcies,
  and unemployment, lead to
• (7) Pessimism and loss of confidence, which in
  turn lead to
• (8) Hoarding and slowing down still more the
  velocity of circulation. The above eight changes
  cause
• (9) Complicated disturbances in the rates of
  interest, in particular, a fall in the nominal,
  or money, rates and a rise in the real, or
  commodity, rates of interest. (1933 342)

30
The Debt Deflation Theory of Great Depressions

• Fisher thus concurs with ancient charge against
  usury, that it maketh many bankrotts (Jones
  1989 55)
• While such a fate largely individual in a feudal
  system, in a capitalist economy a chain reaction
  ensues which leads the entire populace into
  crisis
• Theory nonequilibrium in nature
• argues that 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
• but though stable, equilibrium is so delicately
  poised that, after departure from it beyond
  certain limits, instability ensues (Fisher 1933
  339).

31
The Debt Deflation Theory of Great Depressions

• Two classes of far from equilibrium events
  explained
• Great Depression, when overindebtedness coincides
  with deflation
• with deflation on top of excessive debt, the
  more debtors pay, the more they owe. The more the
  economic boat tips, the more it tends to tip. It
  is not tending to right itself, but is capsizing
  (Fisher 1933 344).
• Cycles, when one occurs without the other
• with only overindebtedness or deflation, economic
  growth eventually corrects situation it
• is then more analogous to stable equilibrium
  the more the boat rocks the more it will tend to
  right itself. In that case, we have a truer
  example of a cycle (Fisher 1933 344-345)

32
The Debt Deflation Theory of Great Depressions

• Fishers new theory ignored
• Old theory made basis of modern finance theory
• Debt deflation theory revived in modern form by
  Minsky
• Fishers macroeconomic contribution (which
  emphasised the need for reflation and 100
  money during the Depression) overshadowed by
  Keyness General Theory
• Many similarities and synergies in Keynes and
  Fisher, but different countries meant one largely
  unaware of others work

33
Keynes and Debt-deflation

• Some consideration of debt-deflation in General
  Theory when discussing reduction in money wages
  (neoclassical proposal)
• Since a special reduction of money-wages is
  always advantageous to an individual entrepreneur
  ... a general reduction ... may break through a
  vicious circle of unduly pessimistic estimates of
  the marginal efficiency of capital... On the
  other hand, the depressing influence on
  entrepreneurs of their greater burden of debt may
  partially offset any cheerful reactions from the
  reductions of wages. Indeed if the fall of wages
  and prices goes far, the embarrassment of those
  entrepreneurs who are heavily indebted may soon
  reach the point of insolvency--with severe
  adverse effects on investment. (Keynes 1936 264)

34
Keynes and Debt-deflation

• The method of increasing the quantity of money
  in terms of wage-units by decreasing the
  wage-unit increases proportionately the burden of
  debt whereas the method of producing the same
  result by increasing the quantity of money whilst
  leaving the wage-unit unchanged has the opposite
  effect. Having regard to the excessive burden of
  many types of debt, it can only be an
  inexperienced person who would prefer the
  former. (1936 268-69)
• Keyness focus here more physical and macro
  (impact on investment) than Fisher Keyness main
  contributions on finance relate to
• Dual Price Level hypothesis
• Analysis of expectations and behaviour of finance
  markets

35
Keynes and the Dual Price Level Hypothesis

• In most of General Theory, Keynes argued that
  investment motivated by relationship between
  marginal efficiency of investment schedule (MEI)
  and the rate of interest
• In Chapter 17 of General Theory, The General
  Theory of Employment and Alternative theories
  of the rate of interest (1937), instead spoke
  in terms of two price levels
• 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

36
Keynes and the Dual Price Level Hypothesis

• 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)
• MEI analysis akin to view that uncertainty can be
  reduced to the same calculable status as that of
  certainty itself via a Benthamite calculus,
  whereas the kind of uncertainty that matters 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)

37
Keynes and the Dual Price Level Hypothesis

• 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
• Seen in this light, the marginal efficiency of
  capital is simply the ratio of the yield from an
  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)

38
Keynes on Uncertainty and Expectations

• 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

39
Keynes on Finance Markets

• Conventional theory says prices on finance
  markets reflect net present value capitalisation
  of expected yields of assets
• But, says Keynes, far from being dominated by
  rational calculation, valuations of finance
  markets reflect fundamental uncertainty and are
  driven by whim
• all sorts of considerations enter into the
  market valuation which are in no way relevant to
  the prospective yield (1936 152)
• ignorance
• day to day instability
• waves of optimism and pessimism
• the third degree

40
Keynes on Finance Markets

• Ignorance due to dispersion of share ownership
  (shades of Telecom?)
• As a result of the gradual increase in the
  proportion of equity ... owned by persons who ...
  have no special knowledge ... of the business...
  the element of real knowledge in the valuation of
  investments ... has seriously declined (1936
  153)
• Impact of day to day fluctuations
• fluctuations in the profits of existing
  investments, which are obviously of an ephemeral
  and non-significant character, tend to have an
  altogether excessive, and even an absurd,
  influence on the market (1936 153-54)

41
Keynes on Finance Markets

• Waves of optimism and pessimism
• In abnormal times in particular, when the
  hypothesis of an indefinite continuance of the
  existing state of affairs is less plausible than
  usual ... the market will be subject to waves of
  optimistic and pessimistic sentiment, which are
  unreasoning and yet in a sense legitimate where
  no solid basis exists for a reasonable
  calculation. (1836 154)
• The Third Degree
• Professional investors further destabilise the
  market by attempting to anticipate its short term
  movements and react more quickly
• As Geoff Harcourt once remarked, Keynes writes
  like an angel. The next few slides are in
  Keyness own words.

Jump Keynes cites
42
Keynes on Finance Markets

• It might have been supposed that competition
  between expert professionals ... would correct
  the vagaries of the ignorant individual...
  However,... these persons are, in fact, largely
  concerned, not with making superior long-term
  forecasts of the probable yield of an investment
  over its whole life, but with foreseeing changes
  in the conventional basis of valuation a short
  time ahead of the general public... For it is not
  sensible to pay 25 for an investment of which you
  believe the prospective yield to justify a value
  of 30, if you also believe that the market will
  value it at 20 three months hence. (1936 154-55)

43
Keynes on Finance Markets

• Of the maxims of orthodox finance none, surely,
  is more anti-social than the fetish of liquidity,
  the doctrine that it is a positive virtue on the
  part of investment institutions to concentrate
  their resources upon the holding of liquid
  securities. It forgets that there is no such
  thing as liquidity of investment for the
  community as a whole. The social object of
  skilled investment should be to defeat the dark
  forces of time and ignorance which envelop our
  future. The actual, private object of most
  skilled investment today is to beat the gun, as
  the Americans so well express it, to outwit the
  crowd, and to pass the bad, or depreciating,
  half-crown to the other fellow. (1936 155)

44
Keynes on Finance Markets

• professional investment may be likened to those
  newspaper competitions in which the competitors
  have to pick out the six prettiest faces from a
  hundred photographs, the prize being awarded to
  the competitor whose choice most nearly
  corresponds to the average preferences of the
  competitors as a whole ... It is not a case of
  choosing those which, to the best of one's
  judgment, are really the prettiest, nor even
  those which average opinion genuinely thinks the
  prettiest. We have reached the third degree where
  we devote our intelligences to anticipating what
  average opinion expects the average opinion to
  be. And there are some, I believe, who practise
  the fourth, fifth and higher degrees. (1936 156)

45
Keynes on Finance Markets

• If the reader interjects that there must surely
  be large profits to be gained from the other
  players in the long run by a skilled individual
  who, unperturbed by the prevailing pastime,
  continues to purchase investment on the best
  genuine long-term expectations he can frame, he
  must be answered, first of all, that there are,
  indeed, such serious-minded individuals and that
  it makes a vast difference to an investment
  market whether or not they predominate in their
  influence over the game-players. But we must also
  add that there are several factors which
  jeopardise the predominance of such individuals
  in modern investment markets.

46
Keynes on Finance Markets

• Investment based on genuine long-term
  expectation is so difficult today as to be
  scarcely practicable. He who attempts it must
  surely lead much more laborious days and run
  greater risks than he who tries to guess better
  than the crowd how the crowd will behave and,
  given equal intelligence, he may make more
  disastrous mistakes. There is no clear evidence
  from experience that the investment policy which
  is socially advantageous coincides with that
  which is most profitable. It needs more
  intelligence to defeat the forces of time and
  ignorance than to beat the gun.

47
Keynes on Finance Markets

• Moreover, life is not long enough--human nature
  desires quick results, there is a peculiar zest
  in making money quickly, and remoter gains are
  discounted by the average man at a very high
  rate. The game of professional investment is
  tolerably boring and over-exacting to anyone who
  is entirely exempt from the gambling instinct
  whilst he who has it must pay to this propensity
  the appropriate toll.
• Furthermore, an investor who proposes to ignore
  near-term market fluctuations needs greater
  resources for safety and must not operate on so
  large a scale, if at all, with borrowed money...

48
Keynes on Finance Markets

• Finally it is the long-term investor ... who
  will in practice come in for most criticism,
  wherever investment funds are managed by
  committees or banks. For it is in the essence of
  his behaviour that he should be eccentric,
  unconventional and rash in the eyes of average
  opinion. If he is successful, that will only
  confirm the general belief in his rashness and
  if in the short run he is unsuccessful, which is
  very likely, he will not receive much mercy.
  Worldly wisdom teaches us that it is better for
  reputation to fail conventionally than to succeed
  unconventionally. (Keynes 1936 156-58)

49
Keynes plus Fisher plus Kalecki

• Keynes thus augments Fisher
• Fisher explains the dynamic consequences of
  overindebtedness and deflation
• Keynes explains how expectations formation can
  lead to excessive valuations being placed upon
  financial assets
• Kalecki explains the link between finance and
  real investment with The Principle of Increasing
  Risk (Kalecki 1937, 1990 285-293)
• Rejects argument that conditions of production
  (relation of marginal cost to marginal revenue)
  determine level of investment

50
The Principle of Increasing Risk

• Consider entrepreneur with capital k to invest,
  given method of production, expected stream of
  returns and hence an expected internal rate of
  return e. These can be combined to yield the
  prospective gross profit

• Prospective net gain g derived by deducting
  market rate of return r, and allowance for
  riskiness, s.

51
The Principle of Increasing Risk

• Micro theory assumes
• expected gain g is a function of capital employed
  k
• function has a single maximum turning point
  (diminishing returns again)
• the second differential of g with respect to k is
  negative.
• The zero of first differential therefore tells us
  the optimal amount of capital to invest
• condition for the maximum prospective gain is

52
The Principle of Increasing Risk

• Conventional micro
• expected profit p increasing but diminishing
  function of capital k
• no relationship between capital and the interest
  rate or capital and risk

• So that optimal investment condition is

Firm invests until rate of change of profit wrt
capital equals sum of market return plus risk
premium for investment
53
The Principle of Increasing Risk

• Colloquial explanation amount of investment is
  constrained either by diseconomies of scale as k
  rises, or by imperfect competition (or similar
  real barriers to expansion).
• Kalecki rejects both
• True, every machine has an optimum size, but why
  not have 10 (or more) machines of this type?,
• not relevant when an investor can put his funds
  into a portfolio of projects across a range of
  industries.
• dp/dk therefore constant
• no effective real (non-monetary) barrier to the
  optimal size of k for a single investor (Kalecki
  1937 286-287)

54
The Principle of Increasing Risk

• Instead to expand k, investor must borrow
• the more he borrows the greater is his risk s.
• If investor not cautious, then it is the
  creditor who imposes on his calculation the
  burden of increasing risk, charging the
  successive portions of credits above a certain
  amount with a rising rate of interest (1937
  288).

• Thus either

• for maximum profitable size of investment
• so increasing risk (and conditions of finance)
  restrains the size of an individual capitalists
  investment, not physical yield of investment.

55
The Principle of Increasing Risk

• Principle of Increasing Risk provides a link
  between finance and investment
• Finance thus limits entrepreneurs investment.
• Same conclusion reached by Keynes in 1937
• it is, to an important extent, the financial
  facilities which regulate the pace of new
  investment
• Not a lack of savings which inhibits investment,
  but a lack of finance consequent upon too great
  a press of uncompleted investment (Keynes 1937b
  247)
• Causal loop is thus FinanceInvestmentSavings
  rather than InvestmentSavings as in GT or
  Savings Investment as in neoclassical economics

56
Integration the Financial Instability Hypothesis

• Concepts of
• Fisher
• debt deflationary mechanism, role of commodity
  price inflation
• Keynes
• two price levels, expectations formation under
  uncertainty, behaviour of financial markets,
  FinanceInvestmentSavings causal loop
• Kalecki
• Finance as one of two limits on amount of
  investment (other is heterogeneity of products
  and consumer demand)
• blended by Minsky to produce Financial
  Instability Hypothesis. Briefly

57
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

58
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

59
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

60
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

61
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 reduced

62
Weaknesses in Dual Price Level Analysis

• Fisher, Keynes, Minsky originate in
  Marshallian/neoclassical tradition
• Micro theory based on utility maximisation,
  marginal cost pricing, equilibrium
• Difficult to explain two price levels on this
  analysis
• Different theoretical foundation needed for price
  analysis
• Instead, a philosophical foundation in Marx
• Direct inspiration only for Kalecki of above
• But Marxs dialectical theory provides a
  microfoundation for Dual Price Hypothesis

63
Marx and the Dual Price Level Hypothesis

• Marxs early theory of value based on labour
• Value is socially necessary labour-time
• An effort theory of value vs utility theory as
  per neoclassicals
• Labour the source of all value
• Equilibrium exchange value of all commodities
  reflects socially necessary labour--time
  contained in them
• Analysis of money an extension of this
• gold the money commodity
• price of gold reflects socially necessary
  labour-time required to produce gold
• Fairly pedestrian analysis however

64
Marx and the Dual Price Level Hypothesis

• Alternative monetary analysis exists in Capital I
  after Chapter 7, and throughout Grundrisse and
  Theories of Surplus Value.
• Based on philosophy of Dialectics
• Philosophy of Dynamics, developed by Hegel
• Sought to explain processes of social change
• Provides dynamic explanation of behaviour of
  prices for financial assets

65
Marx and the Dual Price Level Hypothesis

• Essence of Dialectical social analysis
• Any Unity (person, thing, etc.) exists in society
• Society focuses on some aspects of unity brings
  to foreground
• Forces other aspects into background
• But unity cannot exist without background aspects
• Dynamic tension created between
  foreground/background aspects
• Tensions can transform unity/society itself

66
Dialectics
Dialectical Tension
(But early on, Marxs philosophy dominated by
reading of classical economics)
67
Marx and the Dual Price Level Hypothesis

• Discovery of central application of dialectics
  to economics by Marx somewhat tortuous
• Revelation occurs while writing Grundrisse, the
  rough draft of Capital, after chance re-reading
  of Hegel
• Considering classical economists (Smith, Ricardo)
  discussion of use-value and exchange-value and
  dismissal of use-value
• Utility then is not the measure of exchangeable
  value, although it is absolutely essential to
  it. (Ricardo 1819 5-6)
• Price set solely by exchange-value (cost of
  production), use-value a necessary pre-requisite
  but irrelevant to price (contrast with
  neoclassical price determination)

68
Marx and the Dual Price Level Hypothesis

• Before the Grundrisse and 1857, Marx accepted
  Smith/Ricardo on use-value exchange-value
• No role for use-value beyond pre-requisite to
  exchange
• During drafting of Grundrisse, Marx realises
  these have a dialectical form
• unity value
• capitalism brings exchange-value into foreground
• pushes use-value into background
• A dialectic between use-value and
  exchange-value, muses Marx

69
Marx and the Dual Price Level Hypothesis

• Is not value to be conceived as the unity of
  use-value and exchange-value? ... is value as
  such the general form, in opposition to use-value
  and exchange-value as particular forms of it?
  Does this have significance in economics? ... If
  only exchange-value as such plays a role in
  economics, then how could elements later enter
  which relate purely to use-value... This is not
  in the slightest contradicted by the fact that
  exchange-value is the predominant aspect In any
  case, this is to be examined with exactitude in
  the examination of value, and not, as Ricardo
  does, to be entirely abstracted from, nor like
  the dull Say, who puffs himself up with the mere
  presupposition of the word utility. (Marx
  1857 267-68)

70
Marx and the Dual Price Level Hypothesis

• Dialectic between use-value and exchange-value
  becomes Marxs fundamental concept
• Believed (erroneously) that this supported
  preceding labour theory of value
• Used to consider numerous other issues in
  economics, including pricing of money (rate of
  interest) and capital assets
• Provides a sound basis for two price level theory
• Bu first, application to labour and source of
  profit, wages

71
Marx and the Dual Price Level Hypothesis

• In capitalist, Exchange-Value of work brought to
  foreground
• Exchange-Value of workersubsistence wage
• Use-Value of worker in background irrelevant to
  wage
• But Use-Value of worker to capitalist purchaser
  of labour-timeability to produce commodities for
  sale
• Gap between (objective, quantitative) UV and EV
  of worker is source of surplus-value (SV)
• The past labour that is embodied in the labour
  power, and the living labour that it can call
  into action the daily cost of maintaining it,
  and its daily expenditure in work, are two
  totally different things. The former determines
  the exchange value of the labour power, the
  latter is its use-value. (Marx 1867 199)

72
Marx and the Dual Price Level Hypothesis

• Exchange-Value of machine cost of production
• Use-Value of machine ability to produce
  commodities for sale, as with worker
• As with worker, gap between Use-Value
  Exchange-Value machine a source of Surplus Value
• Contradicts Labour Theory of Value
• All commodity inputs to production potential
  source of profits
• As an aside
• No transformation problem
• No tendency for rate of profit to fall
• No inevitability of socialism

73
Marx and the Dual Price Level Hypothesis

• Dialectical method extended by Marx when
  considering peculiar commodities labour-time
  and money
• Labour-time and money are both commodities and
  non-commodities
• Commodities bought and sold on the market
• Non-commodities not produced for profit not
  produced by means of other commodities
• Commodity/non-commodity dialectic additional to
  use-value/exchange-value dialectic

74
Marx and the Dual Price Level Hypothesis

• Worker both a commodity (labor-power) and
  non-commodity (person)
• Capitalism focuses on commodity aspect, pushes
  non-commodity aspects into background
• Pure commodity--paid subsistence wage only
• Non-commodity--demands share in surplus
• Dialectical tension
• struggle over minimum wage, social wage, etc.
• Wage normally exceeds subsistence subsistence
  wage a minimum (when commodity aspect dominant
  and worker power minimal)

75
Marx and the Dual Price Level Hypothesis

• Money a commodity/non-commodity
• Exchanged, and essential for exchange,
• Not produced by means of commodities
• What ... is the price of the loaned
  capital?... What the buyer of an ordinary
  commodity buys is its use-value what he pays for
  is its value. What the borrower of money buys is
  likewise its use-value as capital but what does
  he pay for? Surely not its price, or value, as in
  the case of ordinary commodities. (Marx 1894
  352)
• Dialectic of money Exchange-value set by
  use-value

76
Marx and the Dual Price Level Hypothesis

• Rate of interest (price of a loan) set
• not by cost involved in issuing a loan
• but by the use-value of the loan itself, and
• Its use-value, however, lies in producing
  profit (1892 355. See also Marx 1861 Part III
  457-58).
• Result extended to assets (1861 III 458-459
  1861II 249 1894 353-356)
• Ricardo explains the price of minerals in situ on
  the basis of their "value
• but no labor (or capital) has gone into their
  production, therefore they contain no value
• mining rights free if could purchase for cost of
  production

77
Marx and the Dual Price Level Hypothesis

• But mining rights have obvious potential
  quantitative use-value
• Quantitative use-value of minerals in situ
• expected sale price of the estimated quantity of
  ore
• As with loaned capital, exchange-value of assets
  is determined not by their costs of production,
  but by their perceived use-value
• that of being a potential source of
  exchange-value
• But uncertainty fundamental aspect of price
• Thus two broad classes of commodities
• Standard commodities, price determined by
  exchange-value (cost of production)
• Non-commodities, determined in part by use-value

78
Marx and the Dual Price Level Hypothesis

• Non-commodities include
• Labour-time (Hence struggle over distribution of
  income)
• Money (Hence interest rate for loans)
• Capital assets (Hence speculative and cyclical
  prices for shares, companies, etc.)
• Capital equipment (Hence machinery prices
  pro-cyclical Also claimed by Minsky 1982 64,
  80))
• New products (Not yet part of input-output
  scheme, hence not yet full commodities)

79
Marx and the Dual Price Level Hypothesis

• Hence Marx provides a firm basis for 2 price
  level analysis of Fisher, Keynes, Minsky
• commodities cost-price
• profits made as realisation of surplus generated
  in production
• with problem of effective demand, etc.
• assets speculative
• prices rise and fall with trade cycle
• debt accumulation a necessary component of asset
  dynamics
• Next week Minsky in more detail, and the
  beginnings of developing a mathematical model of
  debt deflation
• Final week the model plus recap on endogenous
  money