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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 (wL) 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
 xxval
 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...