Financial Economics Lecture Twelve

1
Financial Economics Lecture Twelve

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

2
Dynamic modellingan introduction

• Some general principles
• Dynamic models can (usually do) have unstable and
  multiple equilibria
• Systems often remain in permanent but changing
  disequilibrium
• Nonlinear relations essential for interesting
  results (cycles without breakdown), but
• Nonlinearity can arise naturally (e.g., price
  times quantity gives nonlinear results) rather
  than out of arbitrary assumed nonlinear
  behaviours

3
Recap on principles of endogenous money

• (1) Kydland and Prescott rule out deterministic
  causes of business cycles on grounds that
• "Theories with deterministic cyclical laws of
  motion may a priori have had considerable
  potential for accounting for business cycles but
  in fact they have failed to do so. They have
  failed because cyclical laws of motion do not
  arise as equilibrium behaviour for economics with
  empirically reasonable preferences and
  technologiesthat is, for economies with
  reasonable statements about people's ability and
  willingness to substitute." (KP 5)
• BUNKUM! Cant rule out far-from-equilibrium model
  on basis of behaviour of a different equilibrium
  model!
• On the othe hand

4
Recap on principles of endogenous money

• Circuitist results from Kaleckian algebra
• Money prices independent of quantity of money,
  etc
• But Kaleckian identities presume equilibrium
  while model of money formation required
  disequilibrium otherwise level of money in
  economy falls to zero
• An assumption is therefore required for the
  existence of a money stock, namely that
  wage-earners spend their money incomes gradually
  over time It is a necessary assumption if we do
  not want money to disappear altogether from the
  system. (6)
• Need base model that generates cyclical,
  far-from-equilibrium behaviour

5
Recap on principles of endogenous money

• KP working from the data (rather than
  theoretical leanings, as earlier)
• "This finding that the real wage behaves in a
  reasonably strong procyclical manner is counter
  to a widely held belief in the literature." (KP
  13-14)
• Income distribution dynamics form part of the
  trade cycle

6
Recap on principles of endogenous money

• Model has to give credit a key role in cycles
• "The fact that the transaction component of real
  cash balances (M1) moves contemporaneously with
  the cycle while the much larger nontransaction
  component (M2) leads the cycle suggests that
  credit arrangements could play a significant role
  in future business cycle theory. Introducing
  money and credit into growth theory in a way that
  accounts for the cyclical behaviour of monetary
  as well as real aggregates is an important open
  problem in economics." (17)
• Credit and debt go hand in hand
• Credit money carries with it debt obligations
  (whereas fiat or commodity money does not),
  therefore debt dynamics are an important part of
  the monetary system

7
Recap on principles of endogenous money

• Blowout in inside to outside money ratios,
  but Debt to broader money measures (M2, M3)
  fairly constant
• Debt a proxy for credit

(Dip in M2,3/M1 rise in Debt/M2,3 ratios due to
bailout activities in post-87/9 slump)
8
Recap on principles of endogenous money

• Empirical work by Fama and French (Efficient
  Markets Hypothesis proponents) finds
• Debt seems to be the residual variable in
  financing decisions. Investment increases debt,
  and higher earnings tend to reduce debt. (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. (1998)

9
Recap on principles of endogenous money

• Key activity in capitalist system is
  accumulation
• Marx sees market economy as dominated by desire
  of capitalists to accumulate wealth
• Accumulate! Accumulate! That is Moses and the
  prophets! (Capital I, Ch 24.3 p. 558 Progress
  Press)
• Store of value and unit of account crucial here
  what matters to capitalists is not consumption
  per se, but accumulation. Abstract unit by which
  to measure accumulation therefore vital
• Accumulation of assets (bank balances, productive
  capital) key activity in capitalism

10
Recap on principles of endogenous money

• Key Circuitist insight cannot collapse banks and
  firms into one sector
• Banks and firms must be considered as two
  distinct kinds of agents. Firms are present in
  the market as sellers or buyers of commodities
  and make recourse to banks in order to perform
  their payments banks on the other hand produce
  means of payment, and act as clearing houses
  among firms. In any model of a monetary economy,
  banks and firms cannot be aggregated into one
  single sector. (Graziani 4)
• Need to separate bank activities accumulation
  from firm activities accumulation

11
Recap on principles of endogenous money

• Fisher key role of excessive debt and falling
  prices on economic processes
• 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).
• Key roles of accumulation of debt and price
  dynamics out of equilibrium

12
Recap on principles of endogenous money

• Minsky on impact of Big Government?
• Anti-cyclical spending and taxation of government
  enables debts to be repaid
• Renewal of cycle once debt levels reduced
• Stability is not avoidance of cycles, but
  avoidance of complete breakdown

13
Recap on principles of endogenous money

• Can blend all these insights into model of
  financial instability
• Cyclical model of real economy Goodwins
  predator-prey model
• Driven by Phillips curve
• Add debt as source of investment credit (a la
  Fama French)
• Debt as proxy for credit (endogenous money
  component, accommodating as per Moore)
• Government counter-cyclical spending as
  stabiliser a la Minsky
• Markup price dynamics (commodities) and
  expectation price dynamics (assets) as further
  destabilisers

14
Modelling Minsky Endogenous Money

• First stage Goodwins predator-prey model of
  Marxs cyclical growth theory provides
  foundation of cyclical economy with
  far-from-equilibrium dynamics (Fishers
  Circuitist insights)
• 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...

15
Modelling Minsky Endogenous Money

• Marxs model
• High wages--gtlow investment--gtlow growth--gtrising
  unemployment--gtfalling wage demands--gtincreased
  profit share--gtrising investment--gthigh
  growth--gthigh employment--gtHigh wages cycle
  continues
• Goodwin draws analogy with biology
  predator-prey models
• Rate of growth of prey (fish--gtcapitalists!)
  depends ively on food supply and -ively
  interactions with predator (shark--gtworkers)
• 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

16
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
Investment function
Depreciation
17
Modelling Minsky Endogenous Money

• So how does that look in flowcharts?
• Lets do the rates of change first
• The investment to capital relation is easy

18
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

19
Modelling Minsky Endogenous Money

• Constant rate of growth of productivity means
  exponential growth over time

• Ditto for population

20
Modelling Minsky Endogenous Money

• Output divided by labour productivity gives
  needed number of workers

21
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

22
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

23
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

24
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

25
Modelling Minsky Endogenous Money

• Wage change function

• So now the whole system is

26
Modelling Minsky Endogenous Money

• Now we need to work out profit
• Profit Output Wages
• Wages Wage Rate times Employment

27
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

28
Modelling Minsky Endogenous Money

• Testing this out by adding some graphs if it
  works, we should get cycles in the employment
  rate

29
Modelling Minsky Endogenous Money

• Voila! Now to tidy things up a bit using compound
  blocks

30
Modelling Minsky Endogenous Money

• Now at last we have the basis on which to build a
  Minsky model

31
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

32
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)

33
Modelling Minsky Endogenous Money

• Makes no substantive difference to model
  behaviour

34
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

35
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

36
Modelling Minsky Endogenous Money

• Notice debt becomes negative
• Capitalists accumulate
• Equilibrium is stable in Fishers sense

37
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 is also of the kind Fisher
  describes, that it is 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

38
Modelling Minsky Endogenous Money

• Higher initial level of unemployment leads to
  disaster

• Technical reason requires advanced maths to
  explain, but

39
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

40
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)

41
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
• Both these can be modelled by presuming that the
  government pays a subsidy (which can be negative)
  straight to firms, where that change in that
  subsidy is a function of the rate of employment

• Use same generalised exponential for g(), with
  different parameters

42
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

43
Modelling Minsky Endogenous Money

• We get cyclical instability (depending on slope
  parameter)

44
Conclusion

• Essentials of Financial Instability Hypothesis
  can be modelled using dynamic tools
• Nuances of FIH require evolutionary perspective
• Evolution of financial intermediaries over time
• 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
  hypothesisinability of proponents (Fisher,
  Keynes, Minsky) to develop mathematical
  modeleasily overcome with modern dynamic methods

45
Exam questions

• Chaos theory suggests, among other things, that
  financial asset prices behave according to a
  series of complex non-linear relations. Despite
  the well-known failure of simple linear asset
  pricing models such as the CAPM to adequately
  describe long-term asset risk and return,
  empirical evidence of chaos in financial markets
  is questionable at best. If these non-linear
  models are also unable to properly describe asset
  price behaviour, does this imply that chaos
  theory, like CAPM, is of limited use for
  investors?
• Identifying and managing the various financial
  and operating risks is paramount to the continued
  successful operation of any firm. Discuss how
  these risks may be managed and the underlying
  risks involved by undertaking an active risk
  management strategy. Why do many firms not manage
  all of their risks?
• In what ways does the view that the money supply
  is endogenous alter our perceptions of how the
  macroeconomy andin particular its finance
  sectorfunctions?
• Explain Fishers Debt Deflation Theory of Great
  Depressions and provide an evaluation of the
  recent economic history of Japan for the past two
  decades in the light of it.

46
Conclusion

• Previous lecture shows we can model
  debt-deflation
• So if we can model it, can it happen (again)?
• Japanese experience of
• Bubble economy during 1980s
• Debt-induced downturn with deflation in 1990s,
  beginning of 2000s
• USA system with obvious (in hindsight for some,
  during the event for others!)
• Bubble Economy of 1990s
• massive mal-directed investment in
  telecommunications, internet
• Huge (historically high) debt in both physical
  and financial sectors
• Appears on brink of debt-deflation now

47
Conclusion

• 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
• a bias towards income equity rather than
  inequality.
• But if we fail (as we have!) on these fronts?

48
Conclusion

• Deliberate inflation
• Problem is one of two price levels
• Asset bubble has given asset price level which is
  unsustainable in terms of price level (and hence
  profit margins) from sale of commodities
• Two ways to get in balance
• Either deflate assets, or
• Inflate commodities
• 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 highly unlikely to be adopted
• Inflation-averse and market-fundamentalist
  economists likely to oppose such measures, even
  in Japan
• Many years more of stagnation likely

51
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 financing 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

52
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

53
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
• An aside two other analyses of finance by
  engineers physicists (useful for Craigs
  question both on PlatformWeb)
• But first some words from Marek Michaela

54
Next Year?

• If you enjoyed this subject
• Consider doing Political Economy next year
• and History of Economic Thought (if you havent
  previously done it)