Towards a post-Keynesian consensus in macroeconomics: Reconciling the Cambridge and Wall Street views Marc Lavoie University of Ottawa

Problem statement ► The current financial crisis, which started to unfold in August 2007, is a reminder that macroeconomics cannot ignore financial relations, otherwise financial crises cannot be explained. ► It was not always clear how Cambridge economists did integrate financial relations in their real models.

American PK vs Cambridge PK ► American PK: Money, debt, liquidity, interest rates, cash flows  Fundamentalist PK  Financial Keynesianism  Wall Street Keynesianism ► Cambridge PK: Real economy, actual and normal profit rates, pricing, rates of utilization  Kaleckians  Kaldorians  Sraffians

Purpose of paper ► Recall frustrations of American PK strand ► Recall early efforts to remedy ► Discuss efforts in the mid 1980s and early 1990s ► Discuss stock-flow consistent models as means to reconciliation and provide some sort of consensus method

Cambridge macroeconomics without money ► Jan Kregel (1985, p. 133):  “Money plays no more than a perfunctory role in the Cambridge theories of growth, capital and distribution developed after Keynes”. ► Cambridge macroeconomic without money is like Hamlet without the Prince. ► Kregel (1986) calls for the introduction of Bulls and Bears into heterodox Keynesian analysis, and for a generalization of liquidity preference theory.

A few efforts by Cambridge authors to insert monetary factors ► Pasinetti (1974) distinguishes between interest rate and the rate of return of capitalists. ► Kaldor’s (1966) neo-Pasinetti model inserts stock market shares, but omits money deposits, as pointed out by Davidson (1968, 1972). ► Several chapters on money and credit in Robinson’s (1956) The Accumulation of Capital.  the loaned amounts depend on the interest covering ratio, that is, the ratio of (profit) income to due interest payments.  the borrowing power of entrepreneurs will depend on “the strictness of the banks’ standards of creditworthiness” and the state of mind of individual investors, as well as “the subjective attitude of potential lenders”. ► Joseph Steindl (1952) pays attention to the debt ratio of firms, and the possible contradiction in the evolution of the target and the actual debt ratios

The Sraffian contribution ► Garegnani (179), Pivetti (1985) and Panico (1988) argue that the trend rate of interest and the normal profit rate are linked one on one. ► There is a link with target return pricing and normal-cost pricing, where the interest rate determines the target rate of return that will help to set the markup. ► Raising interest rates to slow down the economy can have inflationary consequences. ► This approach has been extended within a Kaleckian model by Dutt (1992), Lavoie (1993), Hein (2006).

Minsky-Cambridge models ► The Taylor and O’Donnel (1985) model ► The Semmler and Franke (1991) model  Both have portfolio choice (deposits, equities)  Both have an investment function that depends on confidence  Both have a differential equation determining confidence (spread profit- interest rates, leverage ratio) and producing cycles. ► The Delli Gatti and Gallegati (1990s) models.  Investment is a function of q ratio and a multiple of retained earnings, this multiple changing pro-cyclically (Minsky 2-price diagram). ► The Jarsulic 1988, early 1990s models  Ad hoc non-linearities, effect of debt ratios, chaos ► Palley (1991, 1994) models  Introduce loans to consumers.  An extension of Minky’s FIH to the consumer sector.  initially, the higher debt taken on by borrowers leads to higher economic activity; but then, as more interest payments must be made, this slows down economic activity. ► Skott’s models (1981, 1988, 1989)  An earlier forgotten effort at synthesis, which is stock-flow consistent

Drawbacks of previous models: Sometimes …. ► Models are not fully stock-flow consistent ► Models do not incorporate growth ► Money is exogenous, or set by the government deficit ► The leverage ratio is not considered explicity ► There is no stock market, or, ► The stock market value of equities is determined by fundamentals, and not by the market supply and demand

Stock-flow consistent models ► The main claim of the present paper is that stock-flow consistent models (SFC models), inspired in particular by the work of Wynne Godley, are the likely locus of some form of post-Keynesian consensus in macroeconomics, as it allows to entertain both monetary and real issues within a single model.

SFC models and Minsky ► ► It is interesting to note that the possible links between flow-of-funds analysis and balance sheet accounts on the one hand, and the Minskyan view of Wall Street economics on the other hand, were already underlined by Alan Roe (1973). ► ► Roe argued that that individuals and institutions generally follow stock-flow norms, but that during expansion they may agree to let standards deteriorate. He was also concerned with sudden shifts in portfolio holdings. ► ► Roe explicitly refers to the work of Minsky on financial fragility, showing that a stock-flow consistent framework is certainly an ideal method to analyze the merits and the possible consequences of Minsky’s financial fragility hypothesis.

Minsky and SFC models ► “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” (Minsky 1996, p. 77). ► Thus starting out with an appropriate balance sheet matrix insures that economists “analyze how financial commitments affect the economy” (Minsky 1986, p. 221), by taking into account all the interrelated cash flows of the various sectors. ► Still, different behavioural equations will lead to different results.

A complete balance sheet

The simple Lavoie and Godley ( ) balance sheet

Split households, add loans to consumers

Add government and the central bank

Focus instead on the porfolio of banks

Add housing and mortgages

Rich Households Other Households FirmsBanksGovtCentral Bank ∑ Productive capital + p k.k f + K f Homes+ p h.h rh + p h.h oh + K h Bills+ B rh + B f + B b − B+ B cb 0 Cash+ HPM rh + HPM oh + HPM b − HPM0 Advances− A+ A0 Deposits+ D rh + D oh − D0 Loans− L f + L0 Mortgages− M oh + M Equities+ p f.ef rh - p f.ef0 Net worth− NW h − NW f 0− NW g 0−K ∑000000

How about mortgage-backed financial assets?

Conclusion ► This tour should dispel the notion that Cambridge economics was impervious to the challenge posed by the earlier fundamentalist Post Keynesians, who were very much concerned with a monetary production economy. ► The SFC approach, despite its complexities, is far superior to the New consensus approach (new neoclassical synthesis), which however extended, cannot take into account the financial commitments of banks and other agents of the economy – a constraint that has turned up to be so important for our banking and financial system during the recent financial crisis.