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Behavioural Finance Lecture 11 Part 2 Financial Instability Hypothesis The Global Financial Crisis Minsky’s “Financial Instability Hypothesis” • Essential point “it is necessary to have an economic theory which makes great depressions one of the possible states in which our type of capitalist economy can find itself.” (Can "It” Happen Again? A Reprise) • Time-&-debt-aware model: – Economy in historical time – Debt-induced recession in recent past – Firms and banks conservative re debt/equity, assets – Only conservative projects are funded • Recovery means most projects succeed – Firms and banks revise risk premiums • Accepted debt/equity ratio rises • Assets revalued upwards… The Euphoric Economy • Period of tranquility causes expectations to rise… – “Stability—or tranquility—in a world with a cyclical past and capitalist financial institutions is destabilizing.” (The Financial Instability Hypothesis: A Restatement) • Self-fulfilling expectations – Decline in risk aversion causes increase in investment • Investment expansion causes economy to grow faster – Asset prices rise • speculation on assets profitable – Increased willingness to lend increases money supply • Money supply endogenous money, not under Fed control – Riskier investments enabled, asset speculation rises • The emergence of “Ponzi” financiers – Cash flow less than debt servicing costs – Profit by selling assets on rising market – Interest-rate insensitive demand for finance The Assets Boom and Bust • Eventually: – Rising rates make conservative projects speculative – Non-Ponzi investors sell assets to service debts – Entry of new sellers floods asset markets – Rising trend of asset prices falters or reverses • Ponzi financiers go bankrupt: – Can no longer sell assets for a profit – Debt servicing on assets far exceeds cash flows • Asset prices collapse, increasing debt/equity ratios • Endogenous expansion of money supply reverses • Investment evaporates; economic growth slows • Economy enters a debt-induced recession – Back where we started... Crisis and Aftermath • Low Inflation? – Debts cannot be repaid – Bankruptcies affect even non-speculative businesses – Economic activity remains suppressed: a Depression • Combination of falling output and deflation • High inflation – Rising nominal cash flows service debt – Inflation reduces debt to GDP ratio – “Stagflation”: low growth but moderate inflation • 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 • Next: modelling FIH with Goodwin’s “growth cycle” model – based on Marx’s model of cycles in income distribution and employment: Modelling Minsky & Endogenous Money… • Marx’s cyclical growth model in Capital I Ch. 25: – “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...” (Marx 1867) Modelling Minsky & Endogenous Money… • Marx’s model (1867) – High wages low investment low growth rising unemployment falling wage demands increased profit share rising investment high growth high employment High wages: cycle continues • Goodwin (1967) draws analogy with biology “predatorprey” models – Rate of growth of prey (fish = capitalists!) depends +ively on food supply and -ively interactions with predator (sharks = workers) – Rate of growth of predator depends -ively on number of predators and +ively on interactions with prey: • OK; now let’s build it. First, the maths… Modelling Minsky & Endogenous Money… Y w L I k K dK k Y K dt K Depreciation Investment function Phillips curve productivity • First stage: Goodwin’s predator-prey model “accelerator” of Marx’s cyclical growth theory K Y • Causal chain v – Capital (K) determines Output (Y) Y L – Output determines employment (L) a – Employment determines wages (w) – Wages (wL) determine profit (P) – Profit determines investment (I) dw L w f – Investment I determines capital K dt N – chain is closed Modelling Minsky & Endogenous Money… • Capital K determines output Y via the accelerator: K 1/3 Accelerator Y • Y determines employment L via productivity a: Y l r 1 a Labour Productivity / L • L determines employment rate l via population N: L l r 100 N Population / l • l determines rate of change of wages w via P.C. + .96 "NAIRU" 10 WageResponse * PhillipsCurve • (Linear Phillips curve for now) dw/dt • Integral of w determines W (given initial value) 1 Initial Wage dw/dt + 1/S + Integrator w L * W • Y-W determines profits P and thus Investment I… Y W + - Pi I dK/dt • Closes the loop: 1 Initial Capital dK /dt + 1/S + Integrator Modelling Minsky & Endogenous Money… • Model generates cycles (but no growth since no population growth or technical change yet)…: K 1/3 Accelerator l r 1 a Labour Productivity 1 Population .96 "NAIRU" + 10 WageResponse Goodwin's cyclical growth model 1.50 / L / Employment Wages 1.25 l 1.00 .75 PhillipsCurve * dw/dt .50 1 Initial Wage Y l r N Y w L + 1/S + Integrator + - * 0 2 4 6 Time (Years) 8 10 W Goodwin's cyclical growth model 1.3 Pi I 1.2 dK/dt 3 Initial Capital + 1/S + Integrator Wages 1.1 1.0 .9 .8 .7 .9 .95 1 Employment 1.05 • Cycles caused by essential nonlinearity: • Wage rate times employment • Behavioural nonlinearities not needed for cycles; • Instead, restrain values to realistic levels Modelling Minsky & Endogenous Money… • Let’s “do that again”, in stages – This time with • exponential growth in population & technology • Nonlinear Phillips curve • “Rates of change” first – The investment to capital relation is easy: dK I dt Initial capital stock 300 + Investment 1/S + dK dt K I Capital Modelling Minsky & Endogenous Money… • Next step is easy—output is capital stock divided by the accelerator: Initial capital stock 300 + Investment 1/S + Capital 3 v l / r Output • 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… Modelling Minsky & Endogenous Money… • Constant % rate of growth of productivity means exponential growth over time Initial productivity Productivity 0.03 * 1 1/S + + Productivity Plot 30 20 10 0 0 25 50 75 100 Time (years) Initial population • Ditto for population: Population 0.02 * 110 1/S + + Population Plot 900 500 100 0 25 50 Time (years) 75 100 Modelling Minsky & Endogenous Money… • Output divided by labour productivity gives needed number of workers Initial capital stock 300 + Investment 1/S + Capital 3 l / r v Output l / r Initial productivity Productivity 0.03 * 1 1/S + + Productivity Plot 30 20 10 0 0 25 50 Time (years) 75 100 Employment Modelling Minsky & Endogenous Money… • Workforce divided by population gives rate of employment Plot 900 Initial population 500 100 0 Population 0.02 25 50 75 110 1/S * + + Population 100 Time (years) Initial capital stock 300 + Investment 1/S + l / r Capital 3 l / r v Output l / r Initial productivity Productivity 0.03 * 1 1/S + + Productivity Plot 30 20 10 0 0 25 E_rate 50 Time (years) 75 100 Employment • Now things get a bit messy, so we hide bits we know about in compound blocks Modelling Minsky & Endogenous Money… • The same model, with internal complexity simplified by compound blocks: Capital Output Productivity l / r Employment Population l / r E_rate • Now we need a wage change block—employment 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 Modelling Minsky & Endogenous Money… min 4% xval 96% • Feed in yval 0 sval 2 • minimum rate of change (-4%) sval • (x,y) coordinates for xxval y min val one point (.96,0) min y (x) yval min e • Slope at this point (2) • And you get the 0.2 exponential curve that fits these 0.1 y ( x) values: 0 • In flowchart form, this is… 0.1 0.8 0.85 0.9 x 0.95 Modelling Minsky & Endogenous Money… y min x s y min + - + - + exp * * min l / r + + • Sometimes an equation is easier to read, isn’t it? • Nonetheless, if we feed the employment rate in one end, we get the wage change out the other: Capital Output Productivity l / r Employment Population l / r E_rate 0.96 0 2 -0.04 Exponential: x, y, slope at (x,y), min. Phil_Curve • Now we need to multiply this by the current wage to get the rate of change of wages: Modelling Minsky & Endogenous Money… • Wage change function: dw L w P dt N wagerate dw L w w P dt N + + 1/S 1 Initial wage * • So now the whole system is: Phil_Curve wagerate Modelling Minsky & Endogenous Money… Capital Output Productivity l / r Employment Population wagerate l / r + + E_rate 0.96 0 2 -0.04 1/S 1 Initial wage Exponential: x, y, slope at (x,y), min. * Phil_Curve wagerate • Now we need to work out profit: – Profit = Output – Wages – Wages = Wage Rate times Employment… Modelling Minsky & Endogenous Money… Capital Profit + - Output Productivity Wages l / r * Employment Population wagerate l / r + + E_rate 0.96 0 2 -0.04 1/S 1 Initial wage Exponential: x, y, slope at (x,y), min. * Phil_Curve wagerate • 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: Modelling Minsky & Endogenous Money… Capital Profit Output Productivity + - Wages l / r * Employment Population wagerate l / r + + E_rate 0.96 0 2 -0.04 1/S 1 Initial wage Exponential: x, y, slope at (x,y), min. * Phil_Curve wagerate • Testing this out by adding some graphs; if it works, we should get cycles in the employment rate: Modelling Minsky & Endogenous Money… Capital Profit Output Productivity + - Wages l / r * Employment Population wagerate Employment rate 1.1 l / r + + E_rate 0.96 0 2 -0.04 1/S 1 Initial wage Exponential: x, y, slope at (x,y), min. * Phil_Curve wagerate 1.0 .9 .8 0 20 40 60 80 100 Time (Years) • Voila! Now to tidy things up a bit using compound blocks… Modelling Minsky & Endogenous Money… Capital Output Productivity l / r Employment Population Output Profit Wages Limit Cycle 2.0 1.5 .95 1.0 .90 .5 .725 .85 .975 Employment WageShare 1.00 .85 .6 Wage Change Wage Change Function WageShare E_rate 1.05 Employment Rate l / r 1.1 0 0 / Wage Share l r 1.1 Wages Output Employment rate 1.0 .9 5 10 15 Time (Years) 20 25 .8 0 5 10 15 20 25 Time (Years) • Now at last we have the basis on which to build a Minsky model 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: Low— invest nothing; Medium—invest as much as earn; High—invest more than earn 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 – Investment=Profit at profit rate of 3% – Investment>Profit at profit rate > 3% – Investment<Profit at profit rate < 3% – Slope of change at 3%=2 – Minimum investment –1% output (depreciation easily introduced) Modelling Minsky & Endogenous Money… Meter -.1-.06 .02 .08 .14 .2 + - Profit Profit Rate l / r Capital Plot Exponential: x, y, slope at (x,y), min. 0.03 0.03 1.5 -0.01 .5 Meter -.1 0 -.05 Output 0 .05 .1 .1 .2 .3 .4 .5 .6 .7 .15 Investment % output • Makes no substantive difference to model behaviour… * Modelling Minsky & Endogenous Money… WageShare E_rate 1.05 Wages Output l / r Limit Cycle 1.1 1.00 1.0 .95 .9 .90 .8 .85 .7 .80 .6 .725 .85 .975 1.1 .6 0 WageShare E_rate Wage Share 1.1 Employment rate 1.0 .9 5 10 15 Time (Years) 20 25 .8 0 5 10 15 20 25 Time (Years) • But prepares the way for introducing debt to finance investment when investment>profits – Rate of change of debt is investment minus profits – Profits now net of interest on outstanding debt 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… 0.03 Initial Debt 0 Investment Profit + - 1/S r + + * / l r Debt Output • Profit is now net of both wages and interest payments: Profit Output • And the whole model is: + + Wages Interest Modelling Minsky & Endogenous Money… • Notice debt becomes negative • Capitalists accumulate • Equilibrium is stable in Fisher’s sense… Capital Output Productivity l / r Employment Population l / r Employment Rate Graphs Output Profit 0.03 Initial Debt 0 Investment Profit 1 + - + + Wages Interest r + + 1/S * / l r Debt Output Debt/Output Debt 0 0 -25000000000 -1 -2 0 -50000000000 100 200 Time (Years) 300 400 0 200 Time (Years) 400 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 of the kind Fisher describes: “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: Modelling Minsky & Endogenous Money… Capital • Higher initial level of unemployment leads to disaster… • Technical reason requires 7.5 advanced 5.0 maths to 2.5 explain, 0 but… 0 Output Productivity l / r Employment Population l / r Employment Rate Graphs Investment Profit Output + + Wages Interest 0.03 r Profit Debt * 134 Output l / r Initial_Population Debt Debt/Output 750000 500000 250000 0 50 100 Time (Years) 150 0 50 100 Time (Years) 150 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, a^3 is less than a^2 is less than a • But above 1, a^3 is bigger than a^2 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… Modelling Minsky & Endogenous Money… • CAVEAT! – Dynamic modelling can capture many elements of Minsky’s theory and endogenous money, BUT – There are elements that cannot be modelled this way • Evolutionary change in the system • Non-systemic events—such as for example, people being persuaded by the failure of the system that the system must be changed – There is a limit to modelling—institutions 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…) Modelling Minsky & Endogenous Money… • Finally (without bringing in price dynamics), government: – In Minsky’s 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 – Modelled by presuming government pays subsidy (can be negative) to firms, where change in subsidy is a function of the rate of employment… • Constant parameters means model government “resolute” against unemployment • Actual governments have clearly shifted on this… • Use same generalised exponential for g(), with different parameters… dG L Y g dt N Modelling Minsky & Endogenous Money… • Revised function gives negative exponential slope • Government – Keeps subsidy constant if unemployment=5% – Increases it gradually if U>5% – Reduces gradually if U<5% E_rate 0.95 0 -0.5 Output Exponential: x, y, slope at (x,y), min. 0 * + + 1/S • Profit is now net of wages, interest, and government subsidy… Output Wages Profit + + - Interest G Modelling Minsky & Endogenous Money… • We get… cyclical instability (depending on slope parameter of government reaction function) 1.05 Limit Cycle 1.1 1.00 1.0 .95 .9 .90 .8 .85 .7 .80 .6 .725 .85 .975 1.1 .6 0 Wage Share Employment rate 2.0 1.5 1.0 .5 100 200 300 0 0 400 100 Time (Years) Debt/Output 4 .80 200 300 400 Time (Years) Government spending to output .55 2 .30 0 -2 0 .05 100 200 Time (Years) 300 400 -.20 0 100 200 Time (years) 300 400 Modelling Minsky … Conclusion • Essentials of Financial Instability Hypothesis can be modelled using dynamic tools • Nuances of FIH require evolutionary perspective – Evolution of financial intermediaries over time… – Change in government policy… • Prices introduced in next lecture – Result is the “Fisher paradox” • Falling prices increase real debt burden even as actual debt levels reduced • Wrap up: main polemic weakness of debt-deflation hypothesis – (inability of Fisher, Keynes, Minsky to develop mathematical model)… • easily overcome with modern dynamic methods Applying Minsky—the Global Financial Crisis • Knowledge of Minsky’s theory is why I predicted the GFC – Developed previous Minsky model in my PhD (1998) – Intended writing book-length version • Finance and Economic Breakdown (Edward Elgar Publishers) – Diverted to write Debunking Economics (Pluto Press & Zed Books 2001) • Disputes with neoclassicals occupied next 4 years – Late 2005, wrote Expert Witness report over predatory lending for NSW Legal Aid • Realised Debt/GDP on path to crisis • Predicted crisis in court testimony, March 2006 Perpetual Trustees vs Cooks Expert Witness Report • Presented both data and Minskian analysis of crisis: Debt Deflation awareness campaign... • Began public media campaign • Debtwatch newsletters Debt Deflation awareness campaign... • Established a blog in March 2007 • www.debtdeflation.com/blogs • Now has 5-10,000 readers a day • 50,000 unique readers each month • 6500 subscribers • 2000 RSS readers • Growing about 5% per month... • Main message still dangers of debt deflation...