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Australian Debt & monetary model of financial instability… Steve Keen University of Western Sydney Conventional Finance Theory • Finance and Economics completely independent • Finance markets – In equilibrium – Efficient… • The data according to CAPM founder Eugene Fama? – “the failure of the CAPM in empirical tests implies that most applications of the model are invalid.” (Fama & French 2004: 25) • New model needed to explain empirical data – Most striking feature: growth of debt relative to GDP • E.g., Australia 1964-2008: Australia’s debt driven economy… Percent • Australia’s private debt to GDP ratio has risen exponentially at 4.2% p.a. for over 43 years: • Not an isolated Australia's Debt to GDP Ratio 160 phenomenon: Ratio 140 Exponential Fit – 15 other 120 OECD nations 100 have similar debt to GDP 80 data: 60 40 20 0 1950 1960 1970 1980 1990 2000 2010 The global debt-driven economy • 3 decades of growing debt to GDP across OECD: • Empirical questions – Where would Romania fall on this continuum? – Why is France an exception? • Theoretical question: – How to explain phenomenon? • An alternative theory: Minsky’s Financial Instability Hypothesis • A non-neoclassical vision of capitalism: – “capitalism is inherently flawed, being prone to booms, crises and depressions. – This instability, in my view, is due to characteristics the financial system must possess if it is to be consistent with full-blown capitalism. – Such a financial system will be capable of both generating signals that induce an accelerating desire to invest and of financing that accelerating investment.” (1969: 224; emphasis added) • Foundations in Marx, Schumpeter, Fisher, & Keynes Skip Quotes Marx • Theoretical: a “dialectical” theory of prices – “What ... is … the price of the loaned capital?... What the buyer of an ordinary commodity buys is its usevalue; what he pays for is its value. What the borrower of money buys is likewise its use-value as capital; but what does he pay for? Surely not its price, or value, as in the case of ordinary commodities.” (Marx 1894: 352) • Colourful: a sceptical view of banking: – “...The credit system … gives this class of parasites the fabulous power, not only to periodically despoil industrial capitalists, but also to interfere in actual production in a most dangerous manner—and this gang knows nothing about production and has nothing to do with it." (Marx 1894: 544-45) Schumpeter • Well-known cyclical view of capitalism – Creative destruction, clusters of innovations, etc. • Less well-known endogenous view of credit: – “[I]n so far as credit cannot be given out of the results of past enterprise … it can only consist of credit means of payment created ad hoc, which can be backed neither by money in the strict sense nor by products already in existence... (Schumpeter 1934: 106) – “this again leads us to … the heresy that money, and … other means of payment, perform an essential function…” (95) Fisher • Debt-deflation theory of Great Depressions: – Non-equilibrium analysis: • “New disturbances are, humanly speaking, sure to occur, so that, in actual fact, any variable is almost always above or below the ideal equilibrium” (1933: 339) – “two dominant factors” are “over-indebtedness to start with and deflation following soon after” • “Thus over-investment and over-speculation are often important; but they would have far less serious results were they not conducted with borrowed money… • I fancy that over-confidence seldom does any great harm except when, as, and if, it beguiles its victims into debt.” (Fisher 1933: 340-341) Keynes • Well-known (if neglected) views on uncertainty – Formalised in Kalecki’s “principle of increasing risk” (Kalecki 1937, 1990: 285-293) • Investment limited not by declining marginal efficiency of capital but increasing financial risk • Also post-General Theory “two-price level” analysis – The scale of production of capital assets • “depends, of course, on the relation between their costs of production and the prices which they are expected to realise in the market.” (Keynes 1937a: 217) • All blended by Minsky to produce “Financial Instability Hypothesis”: Financial Instability Hypothesis • Economy in historical time • Debt-induced recession in recent past • Firms and banks conservative re debt/equity ratios, asset valuation • Only conservative projects are funded • Recovery means conservative projects succeed • Firms and banks revise risk premiums – Accepted debt/equity ratio rises – Assets revalued upwards The Euphoric Economy • Self-fulfilling expectations – Decline in risk aversion causes increase in investment • Investment causes economy to grow faster – Asset prices rise • Speculation on assets becomes profitable – Increased willingness to lend increases money supply • Credit money endogenous – Riskier investments enabled, more asset speculation • Emergence of “Ponzi” financiers – Cash flow always less than debt servicing costs – Profits made by selling assets on a rising market – Interest-rate insensitive demand for finance The Assets Boom and Bust • Initial profitability of asset speculation: – reduces debt and interest rate sensitivity – drives up supply of and demand for finance – market interest rates rise • But eventually: – rising interest rates make many once conservative projects speculative – forces non-Ponzi investors to attempt to sell assets to service debts – entry of new sellers floods asset markets – rising trend of asset prices falters or reverses Crisis and Aftermath • Ponzi financiers go bankrupt: – can no longer sell assets for a profit – debt servicing on assets far exceeds cash flows • Asset prices collapse, drastically increasing debt/equity ratios • Endogenous expansion of money supply reverses • Investment evaporates; economic growth slows or reverses • Economy enters a debt-induced recession ... • High Inflation? – Debts repaid by rising price level – Economic growth remains low: Stagflation – Renewal of cycle once debt levels reduced Crisis and Aftermath • Low Inflation? – Debts cannot be repaid – Chain of bankruptcy affects even non-speculative businesses – Economic activity remains suppressed: a Depression • Big Government? – Anti-cyclical spending and taxation of government enables debts to be repaid – Renewal of cycle once debt levels reduced • Persuasive verbal model; but no successful mathematical rendition – My research objective Mathematical Foundations • Goodwin’s “predator-prey” growth cycle model: – Verbal truisms: • “Workers share of output will rise if (real) wage demands exceed sum of population growth and labour productivity” • “Employment will rise if the rate of economic growth exceeds the rate of population growth” – In mathematical form, two coupled differential equations: Phillips Curve d ( t) (share t) PCgof ( ( toutput )) Workers dt Investment Function d ( t) dt I 1 ( t) g v rate Employment ( t) v Depreciation, Productivity & Population growth rates Mathematical Foundations • Generates closed cycle: Goodwin Growth Cycle • Add financial truisms: – “Banks finance investment and charge interest” • Generates 3rd order system – Debt to output ratio added: Employment Linear Nonlinear 0.9 0.8 0.7 0.2 0.4 0.6 0.8 1 Wages Share Profit now net of interest payments d dt d( t) Net real interest rate I 1 ( t) r d( t) v I 1 ( t) r d( t) ( 1 ( t) r d( t) ) d( t) k k v v The beginnings of chaos • Two classes of outcome – Convergence to equilibrium… Goodwin & Minsky Cycles • If capitalists accumulate “negative debt” 1 Nonlinear Goodwin Stable Minsky Employment 0.98 Debt to GDP Ratio 0 0.96 1 0.94 0.92 0.6 2 0.7 Wages Share 0.8 0.9 3 This stability was dependent, however, upon initial conditions that generated a "negative" equilibrium ratio of debt to GDP--or in other words, capitalists accumulating net positive financial assets. 4 • But if they don’t… 0 20 40 60 80 100 The beginnings of chaos • An unstable cycle… Stable and Unstable Minsky Cycles 1.1 • And debt that “ratchets up” over time to a debt-crisis… Debt to GDP Ratio 6 Employment 1 Stable Unstable 4 0.9 2 0.8 0.7 0.4 Stable Unstable 0.6 0.8 1 Wages Share 1.2 0 1.4 2 4 0 20 40 60 • How well does this simple model match empirical data? – Not very… • Because the empirical data is much worse! The Ponzi Economy Percent • Australia’s private debt to GDP ratio has risen exponentially at 4.2% p.a. for over 43 years: • Not for the first Australia's Debt to GDP Ratio 160 time in our Ratio 140 history either Exponential Fit 120 • Long term RBA 100 data shows three bubbles in 80 Australia’s 60 financial history 40 – Current 20 bubble is the 0 2010 2000 1990 1980 1970 1960 1950 biggest by far! The Ponzi Economy Debt to GDP: The Long Term View 160 Percent of nominal GDP 140 120 Debt Ratio Trend 1964-Now Trend 1880-1892 Trend 1925-1932 100 80 60 40 20 0 1880 1890 1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 2000 2010 The Ponzi Economy • Correlation isn’t causation, but… 0 T 1 2 3 0 "Variable" "Credit" "Credit" "Credit" 1 "Compared to" "GDP" "GDP" "GDP" 2 "Start Date" 1880 1925 1964.5 3 "End Date" 1892.5 1932 2007.7 4 "Growth Rate" 9.2 9.5 4.2 5 "Correlation %" 6 "Doubling Period" 7.5 7.3 16.6 7 "Duration" 12.5 7 43.2 8 "Initial Value" 33.9 40.3 24.7 9 "Final Value" 103.9 76.2 159.5 10 Clearly exponential process 97.9 97.6 Biggest bubble in our history "Increase %" 206.5 88.8 99.1 546.9 • There is a macroeconomic link: – Aggregate demand = GDP + change in debt – As debt rises, dependence on change in debt has risen • Now accounts for 18% of aggregate demand – Unemployment increasingly linked to change in debt… The Ponzi Economy • Correlation debt’s contribution to aggregate demand of to unemployment initially trivial • Exceeds -0.9 by early 1980s Change in Debt, Politics, & Unemployment Unemployment & Debt Contribution to Demand 16 14 12 Debt Change Whitlam 72-75 Fraser 75-83 Hawke 83-96 Hewson Howard 96-07? Unemployment 10 10 9 0 10 8 20 7 10 8 6 30 6 40 5 50 4 60 4 3 70 2 2 80 0 1 90 2 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 Unemployment 18 11 20 Percent Percentage Contribution to Aggregate Demand 20 0 100 2010 1960 Correlation Whitlam Fraser Hawke 1965 1970 1975 1980 1985 • Formation of debt also increasingly dominated by speculation rather than investment: 1990 1995 2000 Ponzi Households • Lending for housing rises from 5-25% of GDP: Aggregate New Lending for Housing Housing Construction 25 15 10 5 Percent of Total Lending Percent of GDP 20 70 60 Owner Occupiers Investors 50 40 30 20 10 0 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 • Proportion that financed housing construction falls from 30% to under 10%: 0 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 • Back to modelling: – Clear omissions from basic Minsky model are – Endogenous money – Speculative lending… Endogenous Money • Exponential growth in credit despite regulatory regime implies endogenous (market-determined) money • Common belief in non-neoclassical schools of thought • Empirically supported by Kydland & Prescott: • But no accepted mathematical model of process • One can be derived from double-entry book-keeping: Skip Systems Note A simple approach to dynamic systems • Each column represents a stock (system state) • Each row entry represents a flow between stocks • Specify relations between system states across rows… Dynamic System “System States” Stock A Stock B … Stock Z Accounting + Flow 1 - Flow 1 … … Sum … … + Flow 2 - Flow 2 Sum Flows d d B t Z t A t dt dt • To generate the model, add up each column – Sum of column is “differential equation” for stock d dt Money creation in a pure credit economy • Stylized linear model with three (classes of) agents: – Banks: • lend money to firms • record all transactions – Firms: • own factories that produce output; and – Workers: • work in factories. • Model starts with loan $L from bank to firm – Created “out of thin air”—simply simultaneous recording of asset (debt) and liability (deposit) in bank’s double-entry book-keeping system: “Money from nothing, but your cheques ain’t free” • Loan an asset of bank • Simultaneously creates liability of money in firm’s deposit account: • Sets off series of obligations: – Interest charged on loan at rL% p.a. – Interest paid on deposit at rD% p.a. where rL > rD – Third account needed to record this: Bank Deposit BD “Money from nothing, but your cheques ain’t free” • Full system is: Add up terms Interest flows: bank<―>firm Wage flows: firm―>workers Interest flows: bank―>workers Consumption flows: bank & workers―>firms • System of coupled differential equations: • System conservative: • Amount of money – (& debt) • remains constant d FL dt d FD dt d BD dt d WD dt 0 rD FD rL FL w FD BD WD Get equation rL FL rD FD rD WD BD w FD rD WD WD “Money from nothing, but your cheques ain’t free” • System stable but no growth: Account Balances, No New Money 20 100 15 FL( t ) BD( t ) 10 FD( t ) 50 WD( t ) 5 0 0 0.5 1 1.5 0 2 • Growth in output requires new money to – Hire more workers – Pay for intermediate inputs • Simultaneous creation of new debt and new money: t Firm Loan Firm Deposit Bank Deposit Workers Deposit Skip Quotes • Violates “Walras’ ‘Law’” • Supports Schumpeter & Minsky on credit New money flows: bank―>firm “Money from nothing, but your cheques ain’t free” • Schumpeter – “in so far as credit cannot be given out of the results of past enterprise … it can only consist of credit means of payment created ad hoc, which can be backed neither by money in the strict sense nor by products already in existence...” (Schumpeter 1934: 106) • Minsky – “If income is to grow, the financial markets … must generate an aggregate demand that … is ever rising. For real aggregate demand to be increasing, . . . it is necessary that current spending plans, summed over all sectors, be greater than current received income… – It follows that over a period during which economic growth takes place, at least some sectors finance a part of their spending by emitting debt or selling assets.” (Minsky 1963 [1982]: 6) “Money from nothing, but your cheques ain’t free” • Money and debt now grow over time: Account Balances, New Money Creation 200 20 FL( t ) BD( t ) F D( t ) WD( t ) 100 0 10 0 2 4 6 t Firm Loan Firm Deposit Bank Deposit Workers Deposit 8 • System dissipative: • Rate of growth of money • = rate of growth of debt 0 10 d FL dt d FD dt d BD dt d WD dt nM FD rD FD rL FL w FD BD WD nM FD rL FL rD FD rD WD BD w FD rD WD WD Repayment and Re-lending of Principal • Model so far omits loan repayment • Easily added by including “seignorage free” bank “Vault” – Repaid loans have to go somewhere – If into bank deposit account, bank can pay for goods using its money as “IOU”s • NOT the same as re-lending deposited “fiat” money – Pure credit money system requires “quarantining” of bank asset accounts from income (deposit) accounts • Bank assets now sum of – Outstanding Loans – Loan Repayments Repayment and Re-lending of Principal • Repayments of Loans; and • Recycling of Loans – Transfer money from income to asset accounts: • Surplus from production drives all net income Wages flow shown as share of production surplus • P is turnover period • s is share going to firms Repayment flows: firm―>bank • (1-s) goes to workers Relending flows: bank―>firm “Would you like a credit card with that?” 12 10 8 6 4 2 • Can now see what happens to bank income as – New Money is created • Surprise surprise! – Loans are repaid – Repaid money is re-lent • Bank income rises if – Loans are repaid slowly Bank Net Income and Bank Parameters (or not at all) Standard – Repaid money is recycled New Money Loan Repayment more quickly; and Recycling Loans – More new money is created • Bank profits by extending more credit… • Structural explanation for real world phenomenon of rising debt to GDP ratio 0 2 4 6 8 10 “Would you like a credit card with that?” Bank Net Income and Bank Parameters 12 • Surprise surprise! • Bank income rises if 10 – Loans are repaid slowly (or not at all) 8 – Repaid money is recycled more 6 quickly; and – More new money is created 4 2 Standard New Money Loan Repayment Recycling Loans 0 2 4 6 8 • Lenders profits by extending more credit… – Structural reason for lenders creating rising debt • What if they decide to change direction? – Impact of “credit crunch”… 10 “I’m sorry, you can’t have a credit card with that!” • US Economy now experiencing a “Credit Crunch” – New money created less quickly – Loans repaid more quickly – Reserves re-lent more slowly? • Key relation is link between creation of bank assets and liabilities – In growing economy, growth of bank liabilities (active deposit accounts) positive; – In a credit crunch, growth of liabilities turns negative FL BR d L nM FD 0 dt D M “Dude, Who Moved My Economy?” 100 5 • “Credit Crunch”: rate of money creation drops – & repayment of loans increases – & relending drops… 0 300 0 5 10 15 10 15 15 Firm Loan Bank Reserve Firm Deposit Worker Deposit Bank Deposit Assets Bank Reserves Firm Loan 300 200 10 200 100 5 100 0 0 5 10 15 0 0 0 5 • Loans (Assets in circulation) fall even without bankruptcy Assets Bank Reserves • Economy falls into recession: Firm Loan – Credit-driven economic reversal… 300 0 For future research • Combine two models to produce monetary Minsky model • Speculative investment motivated by increase in asset price index – Adds to debt; does not add to productive capacity • First stage: a monetary Goodwin model – Also includes Phillips’s “full Monty” • Wage change related to – Rate of employment – Rate of change of employment – Lagged response to inflation: Skip Model For future research • Combine two models to produce monetary Minsky model • Speculative investment motivated by increase in asset price index – Adds to debt; does not add to productive capacity • First stage: a monetary Goodwin model – Also includes Phillips’s “full Monty” • Wage change related to – Rate of employment – Rate of change of employment – Lagged response to inflation: Skip Model A monetary Goodwin model • Now six system states • But remarkably simple model • Generates open cyclical model Goodwin Growth Cycle d Kr dt Kr I K K Capital Physical d W dt d W Ph dW dp Money d t Wage 100 Employment Rate Percent Linear Nonlinear With Prices d PC dt 90 70 20 40 60 80 PC ( 1 ) W Inflation a a( t ) Technical change & d N ( t )Population N ( t) growth dt d a( t ) dt Cycles in prices and unemployment 30 Inflation Rate P 100 Wages Share Percent 20 10 0 1 1 1 d dW dW [ 1 ( 1 ) ] dp wage dp response Lagged P dt W 80 0 2 4 6 8 Unemployment Rate 10 12 • With “Phillips surface” rather than Phillips curve inflation and unemployment dynamics Meanwhile, in the real world… • Combination of record Debt/GDP, high nominal interest rates and low inflation means huge real interest burden: • Debt burden; • Aggregate demand 15 effect of debt 10 reduction • Serious downturn 5 inevitable 0 • Counter forces 5 – China boom 10 – Possible global 1880 1890 1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 2000 2010 warming/peak oil inflation Inflation-adjusted interest payment burden Percent of GDP 20 Selected References • • • • • Joseph Schumpeter (1934), The Theory of Economic Development: An Inquiry into Profits, Capital, Credit, Interest, and the Business Cycle (republished 2004 by Transaction Publishers, New Brunswick) Charles Whalen, “The U.S. Credit Crunch of 2007: A Minsky Moment”, http://ideas.repec.org/p/lev/levppb/ppb_92.html Some web-accessible references on Minsky’s work: – http://www.debunkingeconomics.com/FinancialInstability.htm A Google Scholar search on Minsky – http://scholar.google.com.au/scholar?q=hyman+minsky&hl=en&lr= Some web-accessible references on endogenous money – http://www.debunkingeconomics.com/Lectures/Index.htm#FE