1. Stock-flow-consistent post-Keynesian models in theory and practice
Gennaro Zezza
Department of Economics
Università di Cassino (Italy)
and
Levy Economics Institute (U.S.)
Workshop on Non-equilibrium Monetary Dynamics, Trento, 28/5/2009
Gennaro Zezza
Dipartimento di Scienze Economiche – Università degli Studi di Cassino
Levy Economics Institute of Bard College – U.S.

2. Outline Stock-Flow Consistent PK models Applied SFC-PK models
General principles
A theoretical model
Applied SFC-PK models
The Levy Model
Our interpretation of the current crisis

3. 1. Stock-flow-consistent models

4. 1.1 Background
Macroeconomics is based on the system of national accounts of the UN 1953 (Richard Stone) (flow national income and product accounts)
This system left out flow-of-funds and balance sheets
French and Dutch national accountants bitterly complained then
“When total purchases of our national product increase, where does the money come from to finance them? When purchases of our national product decline, what becomes of the money that is not spent?” (Copeland 1949)
The 1968 new System of National Accounts (SNA) remedies to all this (and again in SNA 1993). But to no avail.

5. 1.2 Tobin
Introduces balance sheets, with several distinct assets and liabilities
Behavioural equations defining portfolio decisions, based on rates of return
The debts of a sector are the assets of another sector: Financial interdependence
Adding-up portfolio conditions: if you desire less of an asset, you want more of another

6. 1.3 Godley & Cripps A response to monetarism
Keynesians did not pay enough attention to money and other financial assets
Keynesians did not pay enough attention to inflation accounting
Need to introduce the constraints which adjustments of money and other financial assets impose on the economy.
Money stocks and flows must satisfy accounting identities in sectoral budgets, most notably
The NAFA of private sector (net financial saving of private sector) = PSBR + current account balance

7. 1.4 Recent work and research teams
Lavoie – Godley, JPKE
Godley – Lavoie, “Monetary Economics”, 2006
Lavoie and associates on growth and open economy models
Lance Taylor, Barbosa-Filho etc. on SF models and the business cycle
Taylor, Eatwell, Mouakil on financial markets
Cripps, Izurieta etc. on world model
Jacques Mazier, Clévenot, Guy: financialization, open economy models
Van Treeck, Le Héron, etc. on financialization
Zezza – Dos Santos, growth models
Zezza, SF growth models, income distribution and housing

8. 1.5 Main features #1: No “black holes”
“The fact that money stocks and flows must satisfy accounting identities in individual budgets and in an economy as a whole provides a fundamental law of macroeconomics analogous to the principle of conservation of energy in physics”. (Godley and Cripps 1983)
Everything must add up.
The simplest way to make sure that nothing has been forgotten is to construct matrices.
This consistency requirement is particularly important and useful in the case of portfolio choice with several assets, where any change in the demand for an asset, for a given amount of expected or end-of-period wealth, must be reflected in an overall change in the value of the remaining assets which is of equal size but opposite sign (cf. Tobin)

9. 1.6 Main features #2: The quadruple entry principle
This principle is attributed to Copeland (1949).
Any change in the sources of funds of a sector must be compensated by at least one change in the uses of funds of the same sector.
But any transaction must have a counterparty. Therefore the above two changes must be accompanied by at least two changes in the uses and sources of funds of another sector.

10. 1.7 Main features #3: Consistent Stocks Accounting
Balance sheets
Hous. (top 5%)
Hous. (b. 95%)
Firms
Banks
Central
Bank
Govern­ment
Total
1. Productive Capital
p·K
2. Homes
ph·H1
ph·H2
ph·H
3. Cash
+HPh1
+HPh2
+HPb
-HP
4. Central Bank advances -A +A
5. Bank deposits
+M1
+M2 -M
6. Loans to firms -L +L
7. Mortgages
-Mo
+Mo
8. Treasury bills
+Bh
+Bb
+Bc -B
9. Equities
+E·pe
-E·pe
TOTAL
Vh1
Vh2 Vf

11. 1.8 Main features #4: Consistent Flows Accounting
Social Accounting Matrix
Prod.
Hous.
Top 5%
B.95%
Firms
Banks C.
Bank
Govt
Capital
Account
Total
1. Production
+p·C1
+p·C2
p·G
p·ΔK +
pb·ΔH
p·Y
2. Households (top 5%)
+WB1
+Rents
+FD
+iM1
+Fb
+iBh
+Yh1
2. Households
(bottom 95%)
+WB2
+iM2
+Yh2
3. Firms
+FT
4. Banks
+iMo
+iL
+iBb
+Yb
5. Central Bank
+iA
+iBc
+Yc
6. Government
+Ti
+Td1
+Td2
+Tf
+Fc
+Yg
7. Capital Account
+Sh1
+Sh2
+FU
+Sg
+SAV
TOTAL
+p·Y

12. 1.9 Linking stocks to flows
A flow-of-funds matrix describes issuing of financial assets, according to the quadruple entry principle
A revaluation matrix (capital gains) links financial (and real) flows to balance sheets entries
The accounting system implies a redundant equation
Accumulation of stocks is relevant for future flows (interest payments etc.)

13. 1.10 From SF to PK-SF models
The methodology so far should be common to any macroeconomic model
In practice, however, SF models relying on market clearing through instantaneous changes in prices are usually unstable, while disequilibrium models based on buffers perform well

14. 1.11 SFC-PK models Demand led models Portfolio adjustment a la Tobin
Inflation as outcome of a conflict over the distribution of income
Distribution between wages and profits relevant
Money is endogenous
(Dis)equilibrium in financial markets relevant
Stocks matter trough:
Adjustment to desired stock-flow norms
Interest payments
Availability of finance for investment/consumption

15. 1.12 A model with the housing market
We develop a model to address some puzzles of (pre-2007) U.S. growth which led to the crisis, namely:
The shift in the distribution of income
The decline in the saving rate
The bubble in the housing market (which followed the bubble in the equity market)

16. 1.13 A model with the housing market
Households are split into “capitalists” and “workers” with different propensity to save and different approaches to portfolio management
The top 5% of households manages its portfolio of real and financial assets following a Tobinesque approach, for a given target wealth/income ratio.
Demand for housing depends on income and relative real rates of return.
Bank deposits act as a buffer when expectations are not met.
The bottom 95% of households also follows a given target wealth/income ratio, with a higher propensity to spend out of disposable income.
Wealth is accumulated in housing and bank deposits. Deposits act as a buffer when saving is sufficient, otherwise households borrow from banks.

17. 1.14 Modeling the housing market
Demand for homes, for the richest part of the population, depends on relative rate of returns
Demand for homes from “workers” depend:
on income growth
on population growth
on a mortgage affordability ratio
Production of new buildings depends on:
expected demand
expected home prices
the stock of unsold houses
The discrepancy between supply and demand changes the stock of unsold houses.
As the stock of unsold houses decreases, the price increases. If there is excess supply, the price decreases.

18. 1.15 Model simulation
Model properties can only be explored through numerical simulation, for a given set of parameters, starting values for stocks and values for exogenous variables.
Some general results for stability of this class of models have however been obtained in Zezza-Dos Santos (2007)
In steady growth, the distribution of income is stable, and per-capita income in the two classes of households grows at the same rate.
If real income grows at the same rate for our two households groups, relative income is stable, but the disparity is increasing.

19. 1.16 Model features and results
The distribution of income between “capitalists” and “workers” is only partially endogenized
An (exogenous) shift in the distribution towards “capitalists” should increase the saving rate…
…unless we introduce an imitation effect on consumption for “workers”

20. 1.17
Introduction of imitation effects on consumption have a permanent effect on the saving rate, and thus on growth

21. 2. The Levy model of the U.S. economy

22. 2.1 Levy model projection – Nov 2007

23. 2.2 Household Debt
One of the reasons for our projection was the unsustainable path of household debt relative to disposable income, along with the dynamics of the price of homes.

24. 2.3

25. 2.4 Financial balances
In Godley’s approach, analysis of financial balances gives clues to where the economy is going in the medium term.
From national accounting it is easy to show that financial balances are linked through the identity
(Sh - Ir) + (P - Ik - In) = GD + BP
Where Sh = household saving; Ir = residential investment; P = undistributed profits; Ik = non-residential investment; In = change in inventories; GD = government deficit; BP = balance of payments on current account

26. 2.5 Financial balances in textbooks
A standard presentation of this identity in textbooks is based on the idea that in equilibrium with competitive markets profits are zero, so the identity is rewritten as
Sh - I = GD + BP
Where now I measures gross investment (including inventories). In a closed economy, the identity reduces to
Sh - I = GD
The identity in this simple form is then (mis)used to support the claim, say, that since saving is given, any increase in government deficit implies complete crowding out of investment.

27. 2.6 Financial balances and RE
A more complex approach is that of Barro, which claims that any government deficit immediately results in increased saving. In this case, the foreign balance should not be affected and government and private sector balance should move together. He used this argument recently to attack Obama’s Fiscal Stimulus.
His argument, however, has already been falsified (see Barbosa-Filho et al. 2007) against available evidence.

28. 2.7 The “New Cambridge hypothesis”
In the 1970s, Godley and his group used this identity as the basis for a model of the UK economy. For the private sector as a whole, the difference between saving and investment is equal to the net acquisition of financial assets (NAFA), which in turn are equal on (the increase in) liabilities of the government or the rest of the world
NAFA = GD + BP
This approach was unconventional, since it merged households and business analyzing the private sector as a whole.
The “New Cambridge hypothesis” was that NAFA was stable, relative to GDP, and this gave rise to a theory for “twin deficits”, i.e. any imbalance in the foreign account was matched by an imbalance in the government account.
In the face of crisis which called for an expansionary fiscal policy on Keynesian lines, it was thus necessary to adopt measures to counter the implied widening of the current account imbalance (some kind of protectionism).

29. 2.8 The “New Cambridge hypothesis”
The “New Cambridge hypothesis” was based on empirical grounds (see Mata, 2006 for a nice reconstruction of the debate at the time), and the evidence in favor of the stability of NAFA/GDP vanished after some years, so that the approach was progressively neglected.
In my view, however, this approach is still at the heart of Godley’s empirical work. It is not, however, grounded in the stability of NAFA, but rather on how financial balances are moving, with a strong emphasis on boundaries for balances.
Since each balance also measures the net increase in a sector net debt, values of the balances above a given level point to instability in stock-flow ratios which may trigger either some adjustment or a crisis.

30. 2.9 How we read the 3 balances chart
In the chart the three balances are drawn for each sector as the net contribution to expenditure (i.e. expenditure less receipts), so that a positive value implies a net contribution to demand, while a negative value implies a leakage.
This does not imply necessarily that the growth rate of the economy depends on the position of the balances. However, when one balance is changing its impact on demand is changing.

31. 2.10 Levy Model – S.A.M. Production Private sector Government
Production
Private sector
Government
Rest of the World
Capital Account
Total
1. Production
Private expenditure
Government expenditure
Exports
Aggregate demand
2. Private sector
Wages
Govt. transfers to private s.
Net income payments
Private s. Income
3. Government
Net indirect taxes and s.c.
Direct taxes and s.c.
Govt. receipts
4. Rest of the World
Imports
Private s. net transfers to RoW
Govt. net transfers to RoW
Payments to RoW
7. Capital Account
Net Acq. of Fin. Assets
Govt. surplus
-BoP
TOTAL
Value of output
Private s. income
Govt. outlays
Receipts from RoW

32. 2.11 Levy Model - stocks
Financial balances are linked to stocks of net assets
Government debt
Financial assets abroad
Financial liabilities with R.o.W.

33. 2.12 Capital gains
Capital gains and losses (bubbles in the equity market first, and the housing market later) played a major role.
At present we are not modeling capital gains explicitly: rather, we estimate the impact of the stock market and the housing market in private expenditure through price variables (no stocks at market prices).
We are working to a new version of the model which will incorporate stock-flow-consistent accounting of capital gains.

34. 2.13 Levy model – estimation strategy
Our estimation strategy is based on ECM whenever possible, keeping in mind that the model is not meant to provide short-term forecasts.
Special attention is given to:
Weak exogeneity of regressors (IV estimates when needed)
Parameter stability (structural breaks)

35. 2.14 Levy model – private sector expenditure
Our crucial equation is the private sector expenditure function, which – under a standard assumption in new Cambridge models a la Godley – implies a long-run stock-flow norm.
PXt = c0 + c1YDt + c2FAt-1 + Zt
Where Z is a vector of stationary variables which influence the propensity to spend out of income

36. 2.15 Levy model – capital gains etc
More specifically, Z includes:
The “real” price of equities
The “real” price of housing
Household borrowing
Business borrowing

37. 2.16 An interpretation of the crisis
For the U.S., it became clear, in the second half of the 1990s, that the private sector had started to reduce systematically its NAFA, getting into debt. The “new economy” period could then be interpreted as debt-fuelled growth, as suggested in Godley (1999), implying an ever-growing current account deficit (for stable fiscal policy).
The current financial crisis could have started in 2001, with the burst of the stock market bubble. However, the drop in private sector borrowing, and the consequent recession, was countered by an expansionary fiscal policy which filled the gap in aggregate demand, but kept household debt (and foreign debt) growing. At the time Godley started to insist on the need to take policy actions to counter the foreign imbalance.

38. 2.17 A mainstream interpretation
In a recent article, Taylor (“How Government Created the Financial Crisis”, WSJ, 9 feb 2009) claims
“The classic explanation of financial crises is that they are caused by excesses -- frequently monetary excesses -- which lead to a boom and an inevitable bust. (…) Monetary excesses were the main cause of the boom. The Fed held its target interest rate, especially in , well below known monetary guidelines that say what good policy should be based on historical experience. Keeping interest rates on the track that worked well in the past two decades, rather than keeping rates so low, would have prevented the boom and the bust”
But, if our view is correct, keeping the interest rate to a higher level after the 2001 recession would have prevented households from borrowing at a high rate. This may have prevented the major crisis we are now witnessing, but would have implied lower growth, and a sensible rise in unemployment.
In our view, the crisis was not generated by either the government or the Central Bank, but rather by the shift in private sector behavior (with strong emphasis on excessive consumption).

39. 2.18 Why “excessive” consumption?
The change in NAFA, or excessive consumption, remains to be explained.
The interpretation suggested earlier, based on a SFC model with wage earners and capitalists, was that excessive consumption – in the face of a changing distribution of income – can only be explained if relative consumption matters. This “keep up with the Joneses” approach has gained more ground (Stiglitz, 2008; Cynamon-Fazzari, 2008)

40. 2.19

41. 2.20 The housing bubble
The chart shows how imbalances will get reflected in the NAFA. For most of the post-war period, household saving was higher than residential investment, and mortgages were typically covering only part of capital expenditure.
However, starting in the 1980s, the propensity to save has dropped with mortgages taking on an increasing part of new home purchases. In the 2000s the housing bubble started, as signaled by new mortgages exceeding residential investment.

42. 2.21

43. 2.22 Business NAFA
The relation between business investment, retained profits and borrowing has been less clear-cut in the last few years. An increased access to borrowing has not been used to finance an increase in investment, but rather for financial investment (buying back equities).

44. 2.23 Conclusions and policies
Fiscal policy is needed to close the gap in aggregate demand generated by the collapse in private sector borrowing
A huge fiscal stimulus will imply an explosive path for the government debt relative to GDP. However, if interest rates remain low the impact on future government deficits will be small, and the debt can (eventually) be reduced when growth has recovered
What is not solved by the fiscal stimulus is the external imbalance, which will again get worse

45. 2.24
The “New Cambridge Hypothesis” holds in our model in the long-run.

46. 2.25 Policies
One way to handle the foreign imbalance is through protectionism
…or expansionary policies in surplus countries (Germany, China)
It would be worth exploring other ways, such as a reform of the international monetary system which introduces automatic stabilizers for deficit (and surplus!) countries, along the lines of the Clearing Union proposed by Keynes

47. 2.26 Income distribution?
Little attention is given to the relationship between the dynamics of income distribution, aggregate demand and household borrowing and debt
If real wages keep growing less than productivity, economies will remain on unsustainable growth paths