Financial Instability Hypothesis The Global Financial Crisis 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… 2

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 3

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... 4

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 “predator-prey” 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… First stage: Goodwin’s predator-prey model of Marx’s cyclical growth theory Causal chain Capital (K) determines Output (Y) Output determines employment (L) Employment determines wages (w) Wages (wL) determine profit (P) Profit determines investment (I) Investment I determines capital K chain is closed “accelerator” Chain is closed productivity Rate of change terms vital Phillips curve Depreciation Now as a flowchart... Investment function

Modelling Minsky & Endogenous Money… Capital K determines output Y via the accelerator: Y determines employment L via productivity a: L determines employment rate l via population N: l determines rate of change of wages w via P.C. (Linear Phillips curve for now) Integral of w determines W (given initial value) Y-W determines profits P and thus Investment I… Closes the loop:

Modelling Minsky & Endogenous Money… Model generates cycles (but no growth since no population growth or technical change yet)…: 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:

Modelling Minsky & Endogenous Money… Next step is easy—output is capital stock divided by the accelerator: 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 Ditto for population:

Modelling Minsky & Endogenous Money… Output divided by labour productivity gives needed number of workers

Modelling Minsky & Endogenous Money… Workforce divided by population gives rate of 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: 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… Feed in minimum rate of change (-4%) (x,y) coordinates for one point (.96,0) Slope at this point (2) And you get the exponential curve that fits these values: In flowchart form, this is…

Modelling Minsky & Endogenous Money… 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: 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: So now the whole system is:

Modelling Minsky & Endogenous Money… Now we need to work out profit: Profit = Output – Wages Wages = Wage Rate times Employment…

Modelling Minsky & Endogenous Money… 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… Testing this out by adding some graphs; if it works, we should get cycles in the employment rate:

Modelling Minsky & Endogenous Money… Voila! Now to tidy things up a bit using compound blocks…

Modelling Minsky & Endogenous Money… 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… Makes no substantive difference to model behaviour…

Modelling Minsky & Endogenous Money… 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… Profit is now net of both wages and interest payments: And the whole model is:

Modelling Minsky & Endogenous Money… Notice debt becomes negative Capitalists accumulate Equilibrium is stable in Fisher’s sense…

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… Higher initial level of unemployment leads to disaster… Technical reason requires advanced maths to explain, but…

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…

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% Profit is now net of wages, interest, and government subsidy…

Modelling Minsky & Endogenous Money… We get… cyclical instability (depending on slope parameter of government reaction function)

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:

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