Financial Economics Lecture Twelve

1
Financial Economics Lecture Twelve

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

2
Recap

• Last week we built
• A working version of the Goodwin model
• An extension to incorporate a nonlinear
  investment function
• This week
• Adding debt
• Adding a government sector
• Conclusions on endogenous money
• Starting with a reminder of where we got to

3
Modelling Minsky Endogenous Money

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

4
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

5
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)

6
Modelling Minsky Endogenous Money

• Makes no substantive difference to model
  behaviour

7
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

8
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

9
Modelling Minsky Endogenous Money

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

10
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

11
Modelling Minsky Endogenous Money

• Higher initial level of unemployment leads to
  disaster

• Technical reason requires advanced maths to
  explain, but

12
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

13
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)

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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

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Modelling Minsky Endogenous Money

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

• Profit is now net of wages, interest, and
  government subsidy

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Modelling Minsky Endogenous Money

• We get cyclical instability (depending on slope
  parameter)

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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

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Conclusion

• So if we can model it, can it happen?
• 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

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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?

20
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.

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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

22
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

23
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

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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

25
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

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Next week

• Essay due Monday those doing exam on Tuesday can
  drop it in then
• Extensions feasible, but remember this will take
  time away from studying other subjects
• Current list of results on Platform Web
• Exam
• Tuesday 2pm, Lecture Room 17, Building 10
• 90 minutes duration plus 10 minutes reading time
• Questions based on Chapters 3,4,5, 6 (which is
  incorrectly printed as chapter 5), and
• Verghiss lecture on monetary policy
• 3 out of 5 questions to be attempted
• Students who failed mid-session and are
  re-sitting can only get a pass those who did not
  sit the mid-session (medical reasons etc.) can
  get a higher result

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Next Year?

• If you enjoyed this subject
• Consider doing Political Economy next year
• and History of Economic Thought if you havent
  previously done Economic Thought and Methodology
• Let School know your thoughts about this subject
  (no longer being offered due to reduced resources
  and inability to support a large range of
  options) maybe we will be able to offer it again
  in the future
• Email Brian Pinkstone, Head of School of
  Economics Finance B.pinkstone_at_uws.edu.au