Financial Economics Lecture Eleven

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Financial Economics Lecture Eleven

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Title: Financial Economics Lecture Eleven

1
Financial Economics Lecture Eleven

Minsky the Financial Instability Hypothesis
Modelling endogenous money/debt deflation

2
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.

3
Brief HET of Minsky

Parents met at a Communist Party social function
No prizes for guessing early formative
influences!
Fought in US Army in WWII, decamped post-war to
do a degree
Educated during McCarthyist communist witch
hunt periodno mention ever of Marx in his
research, for obvious reasons
Began with degree in mathematics, attempted to
build mathematical model of trade cycle based on
Hickss difference equation model, extended by
Kaleckis principle of increasing risk (last
lecture)

4
Brief HET of Minsky

Kalecki argued investment restrained by
increasing risk (uncertainty-style!) as capital
grows
Minsky used this at macro level to give an
otherwise explosive model of trade cycle a
turning point
Model was

Where Minsky made b a variable dependent on
financial conditions
b declines as economy grows, thus giving turning
point to upward explosive movement
"the accelerator coefficient ... is in part based
on the productive efficiency of investment, but
it is also related to the willingness of
investors to take risks and the terms in which
investors can finance their endeavours..."
(Minsky 1965 261)

5
Brief HET of Minsky

Model went nowhere, but Minsky began to explore
implications of finance for economic behaviour
Initially tried to do this from conventional
understanding of Keynes
If we make the Keynesian assumption that
consumption demand is independent of interest
rates, but assume that investment demand, and
hence the b coefficient, depends on interest
rates, then a rising set of interest rates will
lower the b coefficient. (Minsky 1965, 1982
262)
Also got nowhere
Then, one day, by chance, he read Keyness 1937
papers

6
Brief HET of Minsky

In 1969, Minsky states that his own ideas about
uncertainty "seem to be consistent with those of
Keynes" (1969a, 1982 191, footnote 6), citing
Keynes 1937
Eventually concludes
capitalism is inherently flawed, being prone to
booms, crises and depressions. This instability,
in my view, is due to characteristics the
financial system must possess if it is to be
consistent with full-blown capitalism. Such a
financial system will be capable of both
generating signals that induce an accelerating
desire to invest and of financing that
accelerating investment. (Minsky 1969b 224)
Christens his model the Financial Instability
Hypothesis

7
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

8
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

9
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

10
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

11
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

12
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

13
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

14
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
Quick exposition of dialectics

15
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
Putting this graphically

16
Dialectics
Dialectical Tension
(But early on, Marxs philosophy dominated by
reading of classical economics)
17
Marx and the Dual Price Level Hypothesis

Discovery of central application of dialectics
to economics by Marx somewhat tortuous (see
History of Economic Thought lectures for detail)
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)

18
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

19
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)

20
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

21
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)

22
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
Key interest here explanation for 2 price
levels commodities assets

23
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

24
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)

25
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

26
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

Ricardo never uses the word value for utility or
usefulness or "value in use". Does he therefore
mean to say that the "compensation" is paid to
the owner of the quarries and coalmines for the
"value" the coal and stone have before they are
removed from the quarry and the minein their
original state? Then he invalidates his entire
doctrine of value. Or does value mean here, as it
must do, the possible use-value and hence the
prospective exchange-value of coal or stone?
(Marx 1861 Part II 249. Emphasis added.)

28
Marx and the Dual Price Level Hypothesis

Mining rights have little exchange-value embodied
in them, but 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

29
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)

30
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, objective
profits made as realisation of surplus generated
in production
with problem of effective demand, etc.
Assets speculative, expectations based
prices rise and fall with trade cycle
debt accumulation a necessary component of asset
dynamics

31
Modelling Minsky

How can we produce an economic (mathematical)
model of process Minsky describes?
First, some mathematical preliminaries
Minskys model essentially dynamic, and therefore
cannot be modelled either using equilibrium tools
or static drawings
Basic tool of dynamic analysis is the
differential equation
Quick introduction to this, then
Graphical tools for simulating dynamic processes
Insights from endogenous money argument

32
Dynamic modellingan introduction

Dynamic systems necessarily involve time
Simplest expression starts with definition of the
percentage rate of change of a variable
Population grows at 1 a year
Percentage rate of change of a variable y is
Slope of function w.r.t. time (dy/dt)
Divided by current value of variable (y)
So this is mathematically

This can be rearranged to

Looks very similar to differentiation, which you
have done but essential difference rate of
change of y is some function of value of y itself.

33
Dynamic modellingan introduction

Dependence of rate of change of variable on its
current value makes solution of equation much
more difficult than solution of standard
differentiation problem
Differentiation also normally used by economists
to find minima/maxima of some function
Profit is maximised where the rate of change of
total revenue equals the rate of change of total
cost (blah blah blah)
Take functions for TR, TC
Differentiate
Equate
Easy! (also wrong, but thats another story)
However differential equations

34
Dynamic modellingan introduction

Have to be integrated to solve them

Rearrange
Integrate
Solve
Take exponentials

Constant is value of y at time t0

35
Dynamic modellingan introduction

Simple model like this gives
Exponential growth if agt0
Exponential decay if alt0
But unlike differentiation technique (most
functions can be differentiated)
Most functions cant be integrated no simple
solution can be found and also
Models can also be inter-related
Two variables x y (and more w z )
y can depend on itself and x
x can depend on itself and y
All variables are also functions of time
Models end up much more complicated

36
Dynamic modellingan introduction

Simple example relationship of fish and sharks.
In the absence of sharks, assume fish population
grows smoothly
The rate of growth of the fish population is a
p.a.

Rearrange
Integrate
Solve
Exponentials
37
Dynamic modellingan introduction

Simulating gives exponential growth if agt0

38
Dynamic modellingan introduction

Same thing can be done for sharks in the absence
of fish
Rate of growth of shark population equals c p.a.
But here c is negative

But we know fish and sharks interact
The rate of change of fish populations is also
some (negative) function of how many Sharks there
are

The rate of change of shark population is also
some (positive) function of how many Fish there
are

39
Dynamic modellingan introduction

Now we have a model where the rate of change of
each variable (fish and sharks) depends on its
own value and the value of the other variable
(sharks and fish)

This can still be solved, with more effort (dont
worry about the maths of this!)

40
Dynamic modellingan introduction

But for technical reasons, this is the last level
of complexity that can be solved
Add an additional (nonlinearly related)
variablesay, seagrass levelsand model cannot be
solved
But there are other ways
Mathematicians have shown that unstable processes
can be simulated
Engineers have built tools for simulating dynamic
processes.

41
Dynamic modellingan introduction

Express model as vector equation

Provide values for constants a,b,c,d, initial
values for Fish, Shark numbers (ratio a/b gives
equilibrium for sharks, c/d for fish)

42
Dynamic modellingan introduction

Express as vector differential equation and
simulate using Runge-Kutta algorithm (like
sophisticated Taylors expansion)

43
Dynamic modellingan introduction

Graph results

A far from equilibrium model with just 2
variables and constant coefficients
System will never reach equilibrium
(What odds that the actual economy is in
equilibrium)

44
Dynamic modellingan introduction

Thats the hard way now for the easy way
Differential equations can be simulated using
flowcharts
The basic idea
Numerically integrate the rate of change of a
function to work out its current value
Tie together numerous variables for a dynamic
system
Consider simple population growth
Population grows at 2 per annum

45
Dynamic modellingan introduction