Monetary Macroeconomic Modeling Steve Keen Kickstarter:

From the Great Moderation to the Lesser Depression Sudden decay of economic conditions in :

From the Great Moderation to the Lesser Depression Crisis not anticipated by DSGE models: –OECD Economic Outlook June 2007 –“the current economic situation is in many ways better than what we have experienced in years… –Our central forecast remains indeed quite benign: a soft landing in the United States, a strong and sustained recovery in Europe,… In line with recent trends, sustained growth in OECD economies would be underpinned by strong job creation and falling unemployment.” (Cotis 2007) Great Moderation & Depression anticipated by Minsky-oriented model –“From the perspective of economic theory and policy, this vision of a capitalist economy with finance requires us to go beyond that habit of mind which Keynes described so well, the excessive reliance on the (stable) recent past as a guide to the future. –The chaotic dynamics explored in this paper should warn us against accepting a period of relative tranquility in a capitalist economy as anything other than a lull before the storm.” (Keen 1995)

From the Great Moderation to the Lesser Depression Key empirical difference: focus on role of private debt… Growing debt ratio Collapse in debt growth

Minsky approach compared to DGSE approach Non-equilibrium & instability rather than equilibrium dynamics –“Stability—or tranquility—in a world with a cyclical past and capitalist financial institutions is destabilizing” (Minsky 1978) Euphoric rather than Rational Expectations –“Once euphoria sets in … Financial institutions … accept liability structures … that, in a more sober expectational climate, they would have rejected” (Minsky 1972) Complexity & Emergent Properties rather than Microfoundations –“every polynomial … is an excess demand function for a specified commodity in some n commodity economy…” (Sonnenschein 1972) Linear production rather than diminishing marginal productivity –“Firms … rarely report the upward-sloping marginal cost curves that are ubiquitous in economic theory. Indeed, downward-sloping marginal cost curves are more common.” (Blinder 1998)

Minsky approach compared to DGSE approach Endogenous money rather than money neutrality –“It is always a question, not of transforming purchasing power which already exists in someone's possession, but of the creation of new purchasing power out of nothing…” (Schumpeter 1934) –“Debt plays a key role in accommodating year-by-year variation in investment.” (Fama and French 1999) Government homeostatic stabilizer rather than “Policy Ineffectiveness” –“Big government prevents the collapse of profits which is a neces­ sary condition for a deep and long depression…” (Minsky 1982) Non-equilibrium methods needed to model Fisher/Minsky processes –“Theoretically … there must be over-or under-production, …over- or under-investment … and over or under everything else. –It is as absurd to assume that, for any long period of time, the variables in the economic organization … will "stay put," in perfect equilibrium, as to assume that the Atlantic Ocean can ever be without a wave.” (Fisher 1933)

The Financial Instability Hypothesis 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… “Stability is destabilising” –Period of tranquility causes expectations to rise… Self-fulfilling expectations –Decline in risk aversion causes increase in investment –Investment expansion causes economy to grow faster Rising expectations leads to “The Euphoric Economy”…

The Financial Instability Hypothesis Asset prices rise: speculation on assets profitable Increased willingness to lend increases money supply –Money supply endogenous, not controlled by CB 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 Rising debt levels & interest rates lead to crisis –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

The Financial Instability Hypothesis Boom turns to bust Ponzi financiers first to 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... Process repeats once debt levels fall –But starts from higher debt to GDP level Final crisis where debt burden overwhelms economy Turning verbal argument into a model…

Cyclical foundations of Minsky model Goodwin’s cyclical growth model (1967) As a reduced system of ODEs (in &  = w/a): Generalized for nonlinear investment function & depreciation: As dynamic flowchart – –Capital K determines output Y via accelerator v: – –Y determines employment L via labour productivity a: – –L determines employment rate given population N: – – determines rate of change of the wage rate w: – –Output minus the wage bill determines profits  : – –All profits are invested: System has neutral equilibrium – –(Dominant eigenvalue has zero real part) Cycles even with linear Phillips curve…

Cyclical foundations of Minsky model System inherently cyclical—structural nonlinearity that wage bill = w.L Nonlinear functions add realism, not cycles themselves Additional realism to introduce Minsky – –Nonlinear investment function: investment exceeds profits during boom, below profits during slump No structural change to model, but more realistic simulated values:

Minsky model: introducing debt Next element of realism: debt-financed investment: –“More investment tends to generate more debt, while higher earnings are used to reduce debt.” (Fama and French 1999) In equations: –Rate of change of debt equals investment minus profits –Profit net of interest payments on debt Significant structural change to model Now 3 dimensions: – –Rate of employment – –Wages share of output – –Debt to output ratio

Minsky (without government) As system of ODEs: Li and Yorke (1975), “Period Three Implies Chaos” – –Stability now dependent on initial conditions, parameters – –“Inverse tangent route to chaos” (Pomeau and Manneville 1980) Equilibrium convergence for some initial conditions Divergence for others – –Apparent convergence to stability followed by breakdown

Finance & Economic Breakdown Stability for some initial conditions & parameter values…

Finance & Economic Breakdown Apparent stability followed by instability for others –“Great Moderation” followed by “Great Depression”…

Finance & Economic Breakdown Model has 2 equilibria: –“Good equilibrium”: Positive incomes, positive employment, & finite debt –“Bad equilibrium”: Zero wage & profit income, zero employment, & infinite debt Size of basin of attraction of good equilibrium a negative function of debt to output ratio… Outside this basin, convergence to bad equilibrium likely Stability of good equilibrium –Eliminated by “Ponzi” behavior Debt-financed speculation on asset prices –Expanded by government counter-cyclical spending Cash flow to private sector enables debts to be serviced, repaid Role of private debt in economy crucial…

Finance & Economic Breakdown Higher debt ratio gives lower range of stable initial conditions… Higher debt level reduces economic stability

Destabilizing a bad stable equilibrium Bad equilibrium similar to astronomical Black Hole –Escape once economy enters its “Event Horizon” impossible unless Debt is reduced by bankruptcy, debt jubilees –Like “Hawkins Radiation”: reduce mass of Black HoleHawkins Radiation Reduce real interest rate –Like reducing gravitational constant Non-discretionary government spending can destabilize this bad stable equilibrium –Government spending rises when unemployment rises; –Government tax revenues fall when unemployment rises –Spending gives business cash flow to service/repay debt Modelled by introducing government net spending as a function of the employment rate:

Destabilizing a bad stable equilibrium Results in 4-dimensional system: Counter-cyclical government spending – –Destabilizes bad equilibrium Basin of attraction substantially reduced Economy can be moved from bad equilibrium with large stimulus – –Makes good equilibrium stable but cyclical…

Destabilizing a bad stable equilibrium Cyclical stability around good equilibrium –Stability not absence of cycles but absence of breakdown…

A strictly monetary macroeconomic model Preceding model implicitly monetary –Debt finances investment in excess of retained earnings Explicitly monetary model needed to –Consider impact of inflation, deflation –Properly incorporate banking sector into macroeconomics Innovation: using accounting tables to build financial flow models –Explicitly include bank accounts in macroeconomic model Firm Debt, Household Debt, Government Debt, etc. Deposit accounts of Firms, Households, Government too Model endogenous money creation process…

A strictly monetary macroeconomic model Monetary foundation enables explicit inflation modeling –Price dynamics derived from lagged demand-supply convergence – –Monetary wages with employment, rate of change of employment, and inflation-compensation dynamics – –Simple model with Bank lending to Firms only Deposit and wage income to households Generates stylized facts of Great Moderation/Depression – –Decline in employment & inflation volatility – –Then sudden collapse into deflation & rising unemployment

A strictly monetary macroeconomic model Model equations:

Monetary Macroeconomic Model & Economic Data Uncalibrated model output… Smoothed actual US data…

Monetary Macroeconomic Model & Economic Data Income distribution dynamics matter –Profit share behavior gives no warning of impending crisis –Rising bank income a sign of danger…

Extending Monetary Macroeconomic Modelling Monetary modelling clearly adds to our understanding of the economy Preceding model still very simple & incomplete New research agenda: building a platform for monetary modelling Extend existing “system dynamics” technology to handle money flows Innovation: accounting double-entry creates stock-flow consistent monetary dynamics –Bank accounts in columns –Transactions between accounts in rows –Multiple banks—including Central Bank—easily modelled –Double-entry to ensure stock-flow consistency –Complex system of financial flow ODEs built with ease…

Extending Monetary Macroeconomic Modelling Enter flows in double entry table: Define flows visually:

Extending Monetary Macroeconomic Modelling Simulate numerically:

Extending Monetary Macroeconomic Modelling Generate stock-flow consistent system of ODEs automatically: Easily linked to physical production system Extensible to multiple banks, multiple sectors, input-output dynamics, international trade and financial flows…

Extending Monetary Macroeconomic Modelling Multiple banks with Central Bank as clearing house…

Extending Monetary Macroeconomic Modelling Multiple sectors, input-output dynamics can be modelled…

Conclusion Economic crisis shows need for macro models to incorporate financial sector, debt & money dynamics Minsky’s Hypothesis provides insights missing in DSGE models Monetary macro models should be added to toolkit of Treasuries, Central Banks Technology to make monetary modelling straightforward now exists – Let’s jointly develop the technology & the models…