Financial Economics Lecture Twelve

Financial Economics Lecture Twelve
Spring 2006 Financial Economics Lecture Twelve Modelling endogenous money/debt deflation… Debt and Big Government…

Recap Last lecture: Minsky’s Financial Instability Hypothesis (FIH)
Spring 2006 Recap Last lecture: Minsky’s Financial Instability Hypothesis (FIH) Integration of Fisher’s Debt Deflation Theory of Great Depressions Keynes on expectations under uncertainty Kalecki on investment & increasing risk Presumes cyclical economy Foundations here Schumpeter & Marx This lecture: Modelling FIH with Goodwin’s “growth cycle” model based on Marx’s model of cycles in income distribution and employment:

Modelling Minsky & Endogenous Money…
Spring 2006 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)

Spring 2006 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 (shark=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…

Spring 2006 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

Spring 2006 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:

Spring 2006 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

Spring 2006 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:

Spring 2006 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…

Spring 2006 Modelling Minsky & Endogenous Money… Constant % rate of growth of productivity means exponential growth over time Ditto for population:

Spring 2006 Modelling Minsky & Endogenous Money… Output divided by labour productivity gives needed number of workers

Spring 2006 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

Spring 2006 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

Spring 2006 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…

Spring 2006 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:

Spring 2006 Modelling Minsky & Endogenous Money… Wage change function: So now the whole system is:

Spring 2006 Modelling Minsky & Endogenous Money… Now we need to work out profit: Profit = Output – Wages Wages = Wage Rate times Employment…

Spring 2006 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:

Spring 2006 Modelling Minsky & Endogenous Money… Testing this out by adding some graphs; if it works, we should get cycles in the employment rate:

Spring 2006 Modelling Minsky & Endogenous Money… Voila! Now to tidy things up a bit using compound blocks…

Spring 2006 Modelling Minsky & Endogenous Money… Now at last we have the basis on which to build a Minsky model

Spring 2006 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

Spring 2006 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)

Spring 2006 Modelling Minsky & Endogenous Money… Makes no substantive difference to model behaviour…

Spring 2006 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

Spring 2006 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:

Spring 2006 Modelling Minsky & Endogenous Money… Notice debt becomes negative Capitalists accumulate Equilibrium is stable in Fisher’s sense…

Spring 2006 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:

Spring 2006 Modelling Minsky & Endogenous Money… Higher initial level of unemployment leads to disaster… Technical reason requires advanced maths to explain, but…

Spring 2006 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…

Spring 2006 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…)

Spring 2006 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…

Spring 2006 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…

Spring 2006 Modelling Minsky & Endogenous Money… We get… cyclical instability (depending on slope parameter of government reaction function)

Modelling Minsky … Conclusion
Spring 2006 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… Still have to add prices (done in mathematical format) Result is possibility for 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

The FIH & the data We can model debt-deflation
Spring 2006 The FIH & the data We can model debt-deflation So if we can model it, can “it” happen (again)?… Yes!: Japanese experience of “Bubble economy” during 1980s Debt-induced downturn with deflation in 1990s Has been in debt-deflation for 15 years… Asian crisis arguably a Minsky crisis Added element of sudden collapse of currencies once debt-crisis commenced See Kregel paper

The FIH & the data The USA? Bubble Economy of 1990s
Spring 2006 The FIH & the data The USA? Bubble Economy of 1990s Obvious bubble in hindsight for some (Greenspan) during the event for others (Schiller, etc.)! massive mal-directed investment in telecommunications, internet Huge (historically high) debt in both physical and financial sectors Current state: continued housing bubble + massive government deficits… Future prospects? Australia? Historically unprecedented debt levels have accumulated in Minskian cyclical fashion…

Minskian perspective on Australia
Spring 2006 Minskian perspective on Australia Australian data on debt now worrying RBA: Still “not sure” whether should target asset price inflation, but recognises dangers of excessive debt: “it is really the leverage that accompanies asset-price movements which is the issue, rather than the asset-price movements themselves… all sizeable asset-price misalignments presumably do some damage, but the ones which do the most damage are those which were associated with a big build-up in leverage, which always carries the risk of forcing abrupt changes in behaviour by borrowers and their lenders when the prices turn. To coin a phrase, `it's the leverage, stupid'.” (Glenn Stevens) RBA 2003 Conference: Asset Prices and Monetary Policy

Spring 2006 Minskian perspective on Australia Leverage in Australia now extreme Following data from RBA Sources: D02 Lending And Credit Aggregates G12 Gross Domestic Product - Income Components. Credit to GDP ratio was 40% in 1976 137% in 2005 Housing debt to GDP ratio was 12% in 1976 75% in 2005 Growth exponential (3% p.a. growth in debt/GDP ratio since 1953!) Not simply reaction to lower interest rates Interest to GDP ratio 1% in 1976; 5.3% in 2005

Spring 2006 Minskian perspective on Australia Consistent pattern for post-WWII period Growth in Credit/GDP ratio literally exponential: Americans speculate on shares; Australians speculate on houses: Business debt stabilised post 1990…

Spring 2006 Minskian perspective on Australia Australian business debt blew out during 1980s: But relatively stable since 1995 Though at higher level, & rising with China boom now… Household debt, on the other hand…

Spring 2006 Minskian perspective on Australia At unprecedented levels… Housing debt now largest component of private debt Next chart separated “standard” home loans from “Low Doc Loans” (source of most recent growth):

Spring 2006 Minskian perspective on Australia Businesses “repaired balance sheets” post 1990 Households kept right on borrowing… Very different dynamics for interest rates…

Spring 2006 Minskian perspective on Australia Interest rates plummeted since 1990 peak… Interest burden kept on rising… But in very Minskian cyclical fashion… Ratio almost twice 1990s level Despite interest rates 2/3rds lower!

Meanwhile, Back in the USA…
Spring 2006 Meanwhile, Back in the USA… USA debt levels high too, but ours comparable… High USA Government debt may reflect ‘seignorage’ problems of world monetary system… Note high financial corporations debt

Spring 2006 Minskian perspective on Australia RBA now accepts that most of borrowing has simply inflated house prices… “With house prices rising, households were comfortable in increasing their indebtedness. And banks were happy to lend. But much of the credit was used to further bid up the prices of houses.” (Anthony Richards, Head, Economic Analysis RBA; SMH March 3rd 2006)

Conclusion One of 2 pre-conditions for debt-deflation now in place
Spring 2006 Conclusion One of 2 pre-conditions for debt-deflation now in place Inflation also at very low levels… What to do if a debt-deflation happens? Not much! Capitalism fundamentally unstable, so escaping from a collapse therefore no picnic; essential lesson is we should avoid debt deflations in the first place by developing and maintaining institutions and policies which enforce "a 'good financial society' in which the tendency by businesses and bankers to engage in speculative finance is constrained" (Minsky 1977, 1982: 69). These include close and discretionary supervision of financial institutions and financial arrangements non-discretionary countercyclical fiscal arrangements bias towards income equity rather than inequality…

Conclusion But if we fail (as we have!) on these fronts?…
Spring 2006 Conclusion But if we fail (as we have!) on these fronts?… Deliberate inflation Problem is one of two price levels Asset bubble has caused asset price level which is unsustainable in terms of commodities price level (and hence profit margins) Two ways to get in balance Either deflate asset prices, or Inflate commodity prices Former approach exacerbates the problem—falling asset prices will cause rising debt burden, declining commodity prices (Fisher’s paradox) Latter may “right the system”, but at short-term cost to financiers.

Conclusion How to do it? Japan—comparatively simple
Spring 2006 Conclusion How to do it? Japan—comparatively simple Japan a creditor nation, vast majority of (crippling) Japanese financial system debts owed to Japanese lenders (huge apparent household savings) Price inflation via fiscal/monetary stimulus ineffective (with good reason!) Super-cautious Japanese simply increase savings Post Keynesian theory (no diminishing marginal productivity) indicates fiscal/monetary stimulus won’t necessarily increase prices anyway But price inflation via deliberate centralised wage increase would work:

Spring 2006 Conclusion Increase in wages would necessarily cause (lesser—say by 2-3% depending on productivity) increase in consumer prices Consumers forced to spend to purchase current commodities Inflationary spiral would feed through system for several years, reducing real debt burden But policy not adopted Inflation-averse and market-fundamentalist economists likely to oppose such measures, even in Japan Instead tried monetary stimulus to boost prices… With not much success:

Spring 2006 Conclusion “Exogenous money” case expects increase in M1 to drive increase in M2, M3… and eventually prices… Correlation of changes in Japan M1 with CPI actually negative Inflation lower in 2003 than 1991 despite 12 years of high growth in M1

Conclusion Japan may now be emerging from debt-deflation
Spring 2006 Conclusion Japan may now be emerging from debt-deflation Emergence due to time rather than policy… Bankruptcies reducing outstanding debt Gradual debt repayment despite low monetary profits & Japan world’s richest economy when crash began: Has fallen behind USA because of debt deflation What if USA succumbs?

Conclusion America? Tough and largely insoluble problems
Spring 2006 Conclusion America? Tough and largely insoluble problems USA now world’s biggest debtor nation Insights from Circuitists here: International payments system gave USA right of seigniorage Other countries trading in US dollars OK, but USA paying for goods with US dollars amounts to exchanging good for IOUs Two cornered exchange aspect of system has distorted trade/debt flows Can only last for as long as third parties willing to accept US IOUs; when this breaks, US dollar could plunge Plunge itself would generate new problems…

Spring 2006 Conclusion US international debt would rise in terms of other currencies International debts a fraction of domestic debt, but all the same… Economy not as self-contained as Japan Can’t easily reflate prices internally Even more resistant to meddling with price system than Japan But more likely to “break the rules” when all else fails for many years. Minsky/endogenous money analysis predicts a pretty rough start to the 3rd Millennium…

Spring 2006 Conclusion Endogenous money thus involves fundamental changes in economic reasoning Move from the “village fair” paradigm of neoclassical economics to the “Wall Street finance” view of Minsky et al cannot be done just by tacking money on to a barter model of the economy Result is a much more complex vision of the economy Since money is an “essential” aspect of a capitalist economy, analysing it properly results in “essential” changes in economic theory…

Spring 2006 Next Lecture? Craig Ellis takes you on a fractal journey through finance A brief overview…

Random Walk Down Wall Street?…
Spring 2006 Random Walk Down Wall Street?… EMH/CAPM argues returns can’t be predicted Random walk/Martingale/Sub-martingale (see previous lectures) Distribution of returns should be “Gaussian” Non-EMH theories (Coherent Market Hypothesis, covered in Craig’s lectures) argue distribution should be non-random “Fat tails”—many more extreme events than random distribution Extreme events of any magnitude possible vs vanishingly unlikely for random If random, odds of 5% fall of DJIA are less than 2 in a million… How many years needed to see one 5% fall? 2500!

Random or Fractal Walk Down Wall Street?…
Spring 2006 Random or Fractal Walk Down Wall Street?… Power law distribution very different to Gaussian: Number of size X events  X raised to some power Result of statistical relation: a “straight line” between size of event and event frequency when graphed on log-log plot: “Log of number of events of size X = -a times log(X)” Rule applies to huge range of phenomena Does it apply to stock market?

Spring 2006 Random or Fractal Walk Down Wall Street?… Power law fit Dow Jones: Power law predicts 6 10% daily movements per century Actual number was 8 1 means 101=10 events per century -1 means 10-1=10% daily change Does this tell us anything the EMH doesn’t?

Spring 2006 Random or Fractal Walk Down Wall Street?… You betcha! “Random walk” prediction OK for small movements +/-3% 780 reality v 718 random prob. Hopeless for large +/-6%: 57 v 1 +/- 8%: 11 v 1 in a million chance… -2 means 10-2: one such event predicted every century 11 last century 10-6: 1 event predicted every 1 million centuries Actual number 57 10-1.1: 8% change -1.2 means =6% daily change

Spring 2006 Random or Fractal Walk Down Wall Street?… Belief system is in equilibrium changes due to random shocks Results in prediction that huge events vanishingly rare Actual data manifestly different: Daily movements in stock exchange Any size crash feasible Likelihood far higher than predicted by random/equilibrium model “Crashes” not aberrations but normal behaviour

Spring 2006 Random or Fractal Walk Down Wall Street?…

Spring 2006 Random or Fractal Walk Down Wall Street?… 7 s.d. events 10,000,000 times more frequently than random...

Spring 2006 Random or Fractal Walk Down Wall Street?… Data clearly not random Many more sophisticated analyses (Craig’s lectures) confirm this “Fractal” hypothesis fits data much better Underlying process behind stock market therefore Partly deterministic Highly nonlinear Interacting “Bulls” & “Bears” Underlying economic-financial feedbacks Economics needs a theory of endogenous money… A theory of nonlinear, nonequilibrium finance… Why do most economists still cling to the EMH?

CAPM: The original belief
Spring 2006 CAPM: The original belief CAPM fitted belief in equilibrium behaviour of finance markets, but required extreme assumptions of: “a common pure rate of interest, with all investors able to borrow or lend funds on equal terms. Second, we assume homogeneity of investor expectations: investors are assumed to agree on the prospects of various investments the expected values, standard deviations and correlation coefficients… Justified on basis of methodology and agreement with theory: “Needless to say, these are highly restrictive and undoubtedly unrealistic assumptions. However, since the proper test of a theory is not the realism of its assumptions but the acceptability of its implications, and since these assumptions imply equilibrium conditions which form a major part of classical financial doctrine, it is far from clear that this formulation should be rejected-especially in view of the dearth of alternative models leading to similar results.” (Sharpe 1964: ) Fama (1969) applied “the proper test” and hit paydirt…

Fama 1969: Data supports the theory
Spring 2006 Fama 1969: Data supports the theory “For the purposes of most investors the efficient markets model seems a good first (and second) approximation to reality. In short, the evidence in support of the efficient markets model is extensive, and (somewhat uniquely in economics) contradictory evidence is sparse.” (Fama 1969: 436) Fama’s paper reviewed analyses of stock market data up till 1966… Table 1, ; Ball & Brown ; Jensen ; Let’s look at the DJIA data over the longer term…

21 years ahead of trend... The CAPM: Evidence
Spring 2006 The CAPM: Evidence 21 years ahead of trend... Fit shows average exponential growth : index well above or below except for Crash of ’73: 45% fall in 23 months… Sharpe’s theory paper published Jan 11 ’73: Peaks at 1052 Dec : bottoms at 578 Bubble takes off in ‘82… CAPM fit doesn’t look so hot any more… Fama’s empirical data window Steady above trend growth CAPM fit to this data looks pretty good!

Fama & French 2004: Data kills the theory
Spring 2006 Fama & French 2004: Data kills the theory “The attraction of the CAPM is that it offers powerful and intuitively pleasing predictions about how to measure risk and the relation between expected return and risk. Unfortunately, the empirical record of the model is poor—poor enough to invalidate the way it is used in applications.” (Fama & French 2004: 25) So “founding fathers” of CAPM have abandoned their child… Why do economists still teach it?

Spring 2006 Random or Fractal Walk Down Wall Street?… Many don’t know that developers of CAPM have abandoned it Most don’t know that any alternative exists, so teach what they know But alternatives do exist “Fractal/Coherent/Inefficient” Markets in finance In Economics? Key aspect of CAPM: How investments are financed doesn’t affect value of firm (determined solely by net present value of investments…) As a result, finance doesn’t affect economics Since CAPM is false, finance does affect economics… More from Craig next week…

Financial Economics Lecture Twelve

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Financial Economics Lecture Twelve

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