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Financial Economics Lecture Twelve

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Debt and Big Government... Dynamic modelling an introduction. Some general principles ... Big Government? Anti-cyclical spending and taxation of government ... – PowerPoint PPT presentation

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Title: 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)
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