The Global Financial Crisis Empirical Data & Modelling Behavioural Finance Lecture 12 Part 2 The Global Financial Crisis Empirical Data & Modelling

Modelling financial instability Financial Instability Hypothesis only theory that makes sense of this data Model in previous lecture Had only “implicit” money Omitted Ponzi Finance Omitted role of deflation This lecture Model with Ponzi finance Combining Minsky and the Circuit Full monetary model of capitalism

Modelling financial instability Firstly: last week’s Goodwin model in equations Causal chain: capital determines output Closes Cycle Output determines employment Employment rate determines rate of change of wage (Phillips curve PH) Wages (w.L) determine profit P Profit P determines investment = rate of change of capital Population growth & technical change drive the system:

Modelling financial instability System has 4 “differential equations”: Some calculus needed to work out other terms: Deriving g… Full system is…

Modelling financial instability 4 differential equations & 7 algebraic relations Real growth rate Real wage Productivity Population Simulating this, gives same cyclical pattern as last week’s “systems engineering” model

Modelling financial instability Cyclical growth… Limit cycle in wages & employment Then add in debt…

Modelling financial instability Firms borrow when desired investment exceeds profits: Profit now net of interest payments A new system state: debt to GDP ratio Very different dynamics but stable system

Modelling financial instability Now add in Ponzi Finance Borrowing $ to speculate on rising asset prices Adds to debt without adding to productive capital Modelled as a function of rate of economic growth Higher rate of growth, higher level of speculation Aggregate debt now includes Ponzi Finance

Modelling financial instability Now a six-dimensional model: Debt dynamics Ponzi finance Very different dynamics… With Ponzi switch set to zero, same as before With Ponzi “on”…

Modelling financial instability Dynamics Borrow money to finance investment during a boom Repay some of it during a slump Debt/ Income ratio rises in series of booms/busts Eventually one boom where debt accumulation passes “point of no return”…

Modelling financial instability Driving force is debt to GDP ratio…

Are We “It” Yet? Can summarise model’s equations in 4 “stylised facts” Employment rises if growth exceeds productivity + population increase Wages share grows if wage rises exceed productivity Bank lend money to finance investment & speculation Speculation rises when growth rises Same model in flowchart form (with different parameters)…

Click here to download Vissim viewer program Are We “It” Yet? Minsky: Ponzi finance extension to Keen 1995 Click here to download Vissim viewer program Click on icon to run simulation after installing Vissim Viewer

Are We “It” Yet? Weakness of previous model Implicit money only—deflationary process ignored No explicit treatment of aggregate demand Overcome by blending Minsky with the Circuit Lay out basic macro operations in accounts table See “Roving Cavaliers of Credit” for basic approach Also “Circuit Theory & Post Keynesian Economics” Generate financial flows dynamics Couple with Goodwin cycle model

Are We “It” Yet? The financial flows table: Nonlinear functions for placemarkers C, I and J:

Rate of change of employment Are We “It” Yet? Fully specified Phillips function for wage setting: Employment Rate of change of employment Rate of inflation adjustments Phillips Curve Rate of change of employment Inflation

Are We “It” Yet? Investment, debt repayment and money relending functions:

Are We “It” Yet? Overall model: 14 equations (11 ODEs, 3 algebraic) 5 equations for financial sector 1 for prices 1 for wages 7 for physical economy

Are We “It” Yet? Same system in QED:

Are We “It” Yet? Integrating Minsky & the Circuit Debt-deflationary dynamics in strictly monetary Minsky-Circuit model “The Great Moderation”, then “The Great Crash”

Are We “It” Yet? Stability is destabilizing...

Are We “It” Yet? Income inequality Not worker vs capitalist but worker vs banker

Are We “It” Yet? Can government policy save us? Simple model with fiat injection implies can succeed against credit crunch alone:

Are We “It” Yet? My expectation: best outcome of government policy alone will be Japanese Stalemate Government monetary injections neutralise private sector deleveraging Outcome “Turning Japanese”: Long-term stagnation and borderline deflation Need debt abolition & real financial reform Cancel debts that should never have been issued Cauterise financial sector in the process Reform assets to minimise chance of future bubbles Shares on secondary market expire in 30 years Property leverage limited to 10 times annual rental