Download Keeping track of the intertwined real and

Post-Keynesian
economics:
Keeping track of
the intertwined real
and financial issues
Marc Lavoie
PRELIMINARIES
University of Iceland, Reykjavik, 4 May 2012
The financial crisis of 2007-????:
No one saw it coming?
• « Why did nobody notice? » (Queen Elizabeth II,
2008)
• « How did economists get it so wrong? » (Krugman,
2009)
• « The unfortunate uselessness of most ‘state of the
art’ academic monetary economics » (Buiter, 2009)
• « On the dismal state of a dismal science? » (Kurz,
2010)
University of Iceland, Reykjavik, 4 May 2012
The financial crisis: mainstream
theory could not see it coming
• « Exponents of ‘state of the art’ monetary models inhabited a
world where the events of 2007-2008 simply could not happen;
it is no wonder they could not foresee them » (Rogers, 2009)
• « Both the New Classical and New Keynesian complete markets
macroeconomics theories not only did not allow questions about
insolvency and illiquidity to be answered. They did not allow
such questions to be asked. » (Buiter, 2009)
• « Indeed the typical macroeconomics and monetary economics
training received at Anglo-American universities during the past
30 years or so, may have set back by decades serious
investigations of aggregate economic behaviour and economic
policy relevant understanding. » (Buiter, 2009)
University of Iceland, Reykjavik, 4 May 2012
The financial crisis: some economists
saw it coming
• « ‘Accounting’ (or flow-of-funds) models of the economy turn out
to be the shared mindset of a large subset of those analysts who
worried about a credit-cum-debt crisis followed by recession,
before the policy and academic establishment did.»
• « They are ‘accounting’ models in the sense that they represent
households’, firms’ and governments’ balance sheets and their
interrelations, and that accounting identities play a major role in
the model structure and outcomes.» (Bezemer, 2010)
• Bezemer (2010) and J. Galbraith (2012) identify post-Keynesian
economists and Wynne Godley in particular among those that
produced public predictions accompanied by reasoned
analytical mechanisms.
University of Iceland, Reykjavik, 4 May 2012
The financial crisis and dissenters in
economics
Heterodoxy
Orthodoxy
Dissenters
University of Iceland, Reykjavik, 4 May 2012
Mainstream
Examples of orthodox dissenters
• J.M. Keynes 1936 ?
• Milton Friedman in the 1950s (became mainstream in
the late 1960s)
• H.A. Simon, R. Coase, Leontief, Vickrey, Sen,
Akerlof, Stiglitz, Krugman, Dan Rodrick, Robert
Shiller (getting a Nobel Prize helps to be a dissenter!)
• Complex or chaos economics, multi-agent modeling,
some of behavioural economics
University of Iceland, Reykjavik, 4 May 2012
Heterodox schools in economics
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Post-Keynesians
Marxists, Radicals
Structuralists (Development Latin-American school)
French Regulation School
(Old) Institutionalists
Social economics and Humanistic economics
Economists of « conventions »
Schumpeterians and Evolutionary Economics
Feminist economics
Ecological Economics
• …. And no doubt many others (Ghandi economics, Henry George,
Gesell, Neo-Austrians ?, etc.)
University of Iceland, Reykjavik, 4 May 2012
A key feature (among others) of these
heterodox schools
• Heterodox economists do not believe that the
analysis must start with the study of the individual
(they reject methodological individualism).
• They do not believe that useful analysis must start
from the individual agent under constrained
maximization.
• The world is more than the sum of atomized agents.
• The whole is more than the sum of its parts.
• Heterodox authors give pride of place to
macroeconomic paradoxes.
University of Iceland, Reykjavik, 4 May 2012
Some crisis-related macro paradoxes
Paradox of thrift (Keynes)
Higher saving rates lead to
reduced output
Paradox of costs (Kalecki-inspired) Higher real wages lead to higher
profit rates
Paradox of public deficits (Kalecki) Government deficits raise private
profits
Paradox of debt (Steindl)
Efforts to de-leverage might lead
to higher leverage ratios
Paradox of tranquillity (Minsky)
Stability is destabilizing
Paradox of liquidity (Nesvetailova)
(liquidity illusion)
Liquidity innovations end up
reducing liquidity
Paradox of risk (Wojnilower)
Availability of individual risk cover
leads to more risk overall
University of Iceland, Reykjavik, 4 May 2012
MONETARY THEORY
University of Iceland, Reykjavik, 4 May 2012
Two traditions in monetary economics
according to Schumpeter (1954)
• Real Analysis
• All the essential features of the economy can be understood in
real terms
• Money is nothing more than a veil
• Credit money poses no problem as long as it can be made to
behave as if it were commodity money
• Monetary Analysis
• Money is not a veil but an integral part of the capitalist process
• Both real and monetary forces determine the evolution of an
economy
• One needs (or should try) to integrate real and monetary forces
University of Iceland, Reykjavik, 4 May 2012
Real analysis
• The most sophisticated mainstream models today either
assume that there exist markets for every contingency, forever
in the future (Arrow-Debreu general equilibrium models):
complete markets.
• Or they assume that market participants possess rational
expectations regarding all future possible outcomes, and that
these can be properly assessed by the statistical past.
• It is also assumed that market participants never default on their
contractual obligations.
• In such models, money is inessential. Money is added to
models where it is no needed. There is no need for means of
final settlement.
• Liquidity becomes an empty concept.
University of Iceland, Reykjavik, 4 May 2012
Post-Keynesian monetary analysis
• Four closely related traditions in PKE:
– Fundamental uncertainty and the liquidity motive
(Paul Davidson)
– The financial fragility hypothesis (Hyman Minsky)
– The theory of endogenous money (RobinsonKaldor-Moore-Eichner)
– The stock-flow consistent method (Wynne Godley)
University of Iceland, Reykjavik, 4 May 2012
Fundamental uncertainty and the liquidity
motive (Davidson)
• The future is uncertain; we cannot list all the possible future
occurrences.
• Some people are unable to meet their contractual obligations
when they come due. Money discharges contractual obligations,
and hence it is the most liquid asset.
• Some other assets are liquid as long as their market price can
change in an « orderly manner ».
• Thus, when there are one-way markets, there must either be a
« market maker », who has sufficient cash and the will to swim
against the tide, or a buffer that will absorb the excess net
demand.
• Computerized systems do not do this.
University of Iceland, Reykjavik, 4 May 2012
The financial fragility or financial instability
hypothesis (Minsky)
• Can « It » Happen Again? Essays on Instability and Finance
(1982); Stabilizing an Unstable Economy (1986)
• Households and firms are willing to take more risks and more
debt after a period of tranquil growth.
• Banks will relax their lending criteria, based on conventions.
• Agents will hold smaller proportions of liquid assets.
• Gross debt ratios will rise although net debt may not.
• Stability breeds instability.
• Monetary authorities are likely to raise interest rates and/or
impose a credit crunch.
• This will produce debt deflation and feedback on the real
economy, unless big government deficit spends.
University of Iceland, Reykjavik, 4 May 2012
Minsky (1986): Regulation is based on the
assumption that markets are efficient and
that a crisis will never occur.
• «The dominant economic theory, however, leads to the view
that regulatory arrangements reflect primitive superstition and
ignorance…. This view holds that instability … is mainly due to
the ill-advised efforts to contain and offset instability ».
• « Institutions … which were introduced in an effort to control and
contain disorderly conditions in banking and financial markets,
are now slaves of an economic theory that denies the existence
of such conditions ».
• « Only an economics that is critical of capitalism can be a guide
to succesful policy for capitalism .»
University of Iceland, Reykjavik, 4 May 2012
Minsky quotes
• « No theory of the behavior of a capitalist economy has merit
unless it shows how the normal functioning of a capitalist
economy leads to conditions conducive to a financial crisis »
(Minsky 1979).
• « The broadest hypothesis is that the behavior of an economic
system with respect to the real variables is not independent of
the financial structure of the economy… .» (Minsky 1964).
• «The tendency to transform doing well into a speculative
investment boom is the basic instability in a capitalist economy »
(Minsky 1977)
• «Banks are important exactly because they do not operate
under the constraints of a money lender – banks do not need to
have money on hand in order to lend money » (Minsky 1986)
University of Iceland, Reykjavik, 4 May 2012
The post-Keynesian view of money creation
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Banks look for credit-worthy borrowers first.
Then they try to find the reserves they need.
Loans make deposits, deposits make reserves
Reserves are demand-determined: Central banks provide the
reserves (and the banknotes) needed by the system, at the rate
of interest of their choice (the target rate).
Central banks essentially pursue defensive operations
The money supply is demand-determined
The money multiplier is an accounting identity
– It plays no behavioural role.
– It must be banned from all textbooks.
If anything, there is a credit divisor.
Money and credit supply are endogenous
University of Iceland, Reykjavik, 4 May 2012
Contrast this to the mainstream view
of money
• “Banks don’t create demand out of thin air
….; and banks are just one channel linking
lenders to borrowers.” (Paul Krugman, blog
29th of March 2012)
• So here we have the view that banks are only
financial intermediaries;
• At best they facilitate payments;
• Banks simply lend the deposits which they
obtained earlier, by some miracle.
University of Iceland, Reykjavik, 4 May 2012
Paul Krugman again, in his NYT blog, 30
March 2012
• As I read various stuff on banking…I often see the view that
banks can create credit out of thin air. There are vehement
denials of the proposition that banks’ lending is limited by their
deposits, or that the monetary base plays any important role;
banks, we’re told, hold hardly any reserves (which is true), so
the Fed’s creation or destruction of reserves has no effect.”
• “This [the PK view] is all wrong….First of all, any individual bank
does, in fact, have to lend out the money it receives in deposits.
Bank loan officers can’t just issue checks out of thin air; like
employees of any financial intermediary, they must buy assets
with funds they have on hand. I hope this isn’t controversial…
the recipient of the loan can and sometimes does quickly
withdraw the funds, not as a check, but in currency. And
currency is in limited supply — with the limit set by Fed
decisions.”
University of Iceland, Reykjavik, 4 May 2012
Money creation: no need for reserves
City bank
Assets
Liabilities
Loan +100
Deposit of
customer +100
Country bank
Assets
Deposit of
customer -100
Loan +100
Liabilities
Deposit of seller
+100
Advance from
country bank
+100
Overnight loan to
city bank +100
Advance from
country bank
+100
Overnight loan
to city bank
+100
University of Iceland, Reykjavik, 4 May 2012
Deposit of
seller +100
The balance sheet of the central bank:
they pursue defensive operations
Assets
Liabilities
Foreign reserves
Banknotes
Bank reserves
Claims on domestic
government (Treasury bills)
Government deposits
Claims on domestic banks
(advances)
Central bank bills
Loans from foreign
institutions
University of Iceland, Reykjavik, 4 May 2012
The corridor system, the floor system,
and the ceiling system
Overnight rate
S4
S1
S2
S3
Lending rate
Central bank
target rate
Deposit rate
Demand for reserves
Reserves
University of Iceland, Reykjavik, 4 May 2012
THE GODLEY STOCK-FLOW
COHERENT APPROACH
University of Iceland, Reykjavik, 4 May 2012
A tradition based on flows of funds
• There has always been a small group of researchers handling
flows of funds:
• Tobin and his associates at Yale (1968, 1982);
• Bain (1973), Roe (1973), Davis (1987), Patterson and
Stephenson (1988), Dawson (1996), Lawrence Klein (2003);
• Computable general equilibrium models (S. Robinson, World
Bank), financial computable general equilibrium models
(Bourguignon, OECD);
• Flaschel, Semmler, Chiarella, Franke, Charpe and others
(2000s).
University of Iceland, Reykjavik, 4 May 2012
Mainstream macroeconomics
University of Iceland, Reykjavik, 4 May 2012
Drawback of standard macro accounting
• Based on national income and product accounts,
avoids flows of funds (UN SNA 1953)
• There is no room or no role for banks
• What about the central bank, where does it fit?
• Households and firms are often netted out
(representative agent)
• Where does personal saving go?
• What are the liability counterparts of this saving?
• What sector provides the counterparty to the
transaction?
• How are government deficits financed?
• What role do financial stocks play?
University of Iceland, Reykjavik, 4 May 2012
Balance sheet of a hyper-simple
model, with only two assets
University of Iceland, Reykjavik, 4 May 2012
Flow of funds of same model
University of Iceland, Reykjavik, 4 May 2012
A method without black holes….
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«The fact that money stocks and flows must satisfy
accounting identities in individual budgets and in an
economy as a whole provides a fundamental law of
macroeconomics analogous to the principle of
conservation of energy in physics.» (Godley and Cripps,
1983)
• «The structure of an economic model that is relevant for
a capitalist economy needs to include the interrelated
balance sheets and income statements of the units of
the economy. The principle of double entry bookeeping,
where financial assets and liabilities on a balance sheet
and where every entry on a balance sheet has a dual in
another balance sheet, means that every transaction in
assets requires four entries» (Minsky, 1996).
University of Iceland, Reykjavik, 4 May 2012
… With behavioural assumptions …
• Agents are assumed to pursue stock-flow norms (wealth to
disposable income ratio, inventories to sales ratio, fixed capital
to sales ratio, target rates of return, return on equity ratio), flowflow norms (additional debt to personal income ratio), or other
targets (liquidity ratio, capital adequacy ratio).
• Agents gradually adjust to mistakes or to observed disequilibria.
• Norms or targets get slowly revised as a function of past
realized results.
University of Iceland, Reykjavik, 4 May 2012
… that may be useful today …
• « By building an accounting framework that follows the
circulation of money through the economy, we can therefore
ensure that we account for all the critical flows of financing that
lead to the stocks of assets and liabilities in which financial
fragility can build….Looking ahead, we hope that using a
framework that draws out the linkages between activity and
balance sheets of the financial sectors can make a contribution
towards the detection of growing financial fragilities.» (Barwell
and Burrows, 2011, Bank of England).
Similar assessment, Bê Duc and Le Breton 2009, ECB
University of Iceland, Reykjavik, 4 May 2012
Effect of a one-time increase in the
ratio of the flow of gross household
loans to personal income
University of Iceland, Reykjavik, 4 May 2012
Effect of a one-time increase in the
ratio of the flow of gross household
loans to personal income
University of Iceland, Reykjavik, 4 May 2012
The eurozone: Effect on various balances of an increase
in the propensity of the ‘& Greece’ country to import
products from the ‘$’ country (flexible euro/$ rate)
Germany
Greece
University of Iceland, Reykjavik, 4 May 2012
Conclusion
• There has been a long tradition of heterodox economics that
rejected the Quantity theory of money, starting in particular with
Thomas Tooke (1844) and John Fullarton.
• There is also a tradition of heterodox economists who never
embarked on the succession of fads: monetarism, rational
expectations, new classical economics, supply-side economics,
efficient market hypothesis, DSGE models. This was the case in
particular of post-Keynesian economists.
• Instead their goal was to develop a monetary analysis, by
contrast with a real analysis.
• Some of them set on the task of keeping track of the intertwined
real and financial issues.
• This is the Holy Grail of macroeconomics.
University of Iceland, Reykjavik, 4 May 2012