1. Money, Credit and Finance Marc Lavoie University of Ottawa

2. Outline 1. The main claims of the post-Keynesian views on money, credit and finance 2. PK monetary theory in historical perspective 3. The horizontalist and structuralist controversies 4. New developments in monetary policy implementation 5. Implications for public finance theory and for open- economy monetary economics 6. Implications for monetary policy implementation in the aftermath of the subprime financial crisis 7. The integration of PK monetary economics into PK macroeconomics

3. Part I The main claims

4. Post-Keynesian monetary sub-schools Post- Keynesian Monetary Economics Structuralists Chartalists UMKC school Horizontalists Accommodationists Circuit theory Paris and Naples Emissions theory Dijon Free University of Berlin School

5. Neoclassical monetary sub-schools Neoclassical monetary schools MonetaristsIS/LM New Paradigm Keynesian (Stiglitz Greenwald) Wicksellian New Consensus (NKE +RBC)

6. M i Horizontalists (+ New Consensus) Monetarists IS/LM Verticalists Structuralists (+ New Paradigm) MsMs MsMs MsMs A simplified overview of endogenous money

7. Endogenous money supply: A PK claim now accepted by many schools Post-Keynesians Neo-Austrians New Keynesians –(New consensus authors), Woodford, Taylor, Roemer, Meyer –(New Paradigm Keynesians, focus on credit) Stiglitz, Greenwald, Bernanke Real business cycle theorists –Barro, McCallum Goodhart

8. Main features in monetary economics FeaturesPK school Neoclassical MoneyHas counterpart entries Falls from an helicopter Money is tied toProductionExchange The supply of money is EndogenousExogenous Main concern withDebts, creditsAssets, money CausalityReversed: credits make deposits Free reserves lead to money creation Credit rationing due toLack of confidenceAsymetric information

9. Main features, interest rates FeaturesPK SchoolNeoclassical Interest ratesAre distribution variables Arise from market laws Liquidity preferenceDetermines the differential relative to base rate Determines the interest rate Base ratesAre set by the central bank Are influenced by market forces The natural rateTakes multiple values or does not exist Is unique, based on thrift and productivity

10. Main features, macro implications FeaturesPK SchoolNeoclassical A restrictive monetary policy Has negative effects in short and long run Has negative effects only in the short run Schumpeter’s distinction Monetary analysis (monetized production economy) Real analysis (money neutrality, inessential veil) Macro causalityInvestment determines saving Saving determines investment InflationThe growth in money stock aggregates is caused by the growth in output and prices Price inflation is caused by an excess supply of money

11. Two kinds of financial systems, according to Hicks 1974 The overdraft financial system Firms are in debt towards commercial banks Commercial banks are in debt towards the central bank The auto or asset-based financial system Firms finance investment with retained earnings Commercial banks have large amounts of T-bills in assets

12. Overdraft vs Asset-based systems Overdraft systems 90% or more of the world financial systems (including the pre-euro Bundesbank) Ignored by textbooks No control on HPM, except through credit control Clarifies how the monetary system functions In a sense, all systems are of the overdraft type: no central bank controls directly the supply of money Asset-based systems Only in some anglo-saxon countries Described by mainstream textbooks Based on open-market operations; is said to be efficient in controlling the money stock Puts a veil on the operating procedures of monetary systems

13. Simplified neoclassical view Central bank balance sheet AssetsLiabilities Foreign reservesBanknotes Domestic T-billsReserves of commercial banks

14. Simplified PK view Central bank balance sheet AssetsLiabilities Foreign reservesBanknotes Domestic T-bills (and repos) Reserves of commercial banks (deposit facilities) Loans to domestic banks (lending facilities) Government deposits (Central bank bills)

15. Part II PK monetary theory in historical perspective

16. Cambridge proverbs The Cambridgian hare: « Economic ideas move in circles: stand in one place long enough, and you will see discarded ideas come round again. » (A.B. Cramp 1970) Most of modern monetary controversies can be brought back to the 1844 Currency school (Ricardo) and Banking school (Thomas Tooke) debates. The Radcliffe commission view (1959), endorsed by Kaldor and Kahn, which was considered dépassé in the 1970s and 1980s, is now back into fashion. –« There still do exist in England men whose minds were formed in 1939, and who haven’t changed a thought since that time, and who … say money doesn’t matter. They have embalmed their views in the Radcliffe Committee, one of the most sterile operations of all time» Samuelson 1969

17. 1844 Currency school vs Banking school Ricardo and Currency school (Monetarism) Only coins and Bank of England notes are money The stock of money determines aggregate demand Aggregate demand determines prices Tooke and the Banking School (PKE) The definition of money is more complicated Aggregate demand determines the stock of money If controls are needed to influence prices, control credit

18. Quantity theory of money (Academics) vs the Radcliffe Commission 1959 (Central bankers and Kaldor and Kahn) Quantity theory Control of the money supply, in particular reserves, by central banks The velocity of money and the money multiplier are quasi constants Causality runs from money to prices Radcliffe Commission The central bank controls interest rates, but very indirectly only money aggregates The velocity of money is unstable (many substitutes): « general liquidity » concept Monetary policy only has a moderate effect on inflation, which depends on many other factors Credit controls?

19. Keynes, a source of confusion? «In one sense, we are all Keynesians now», says Milton Friedman (1965), at the height of the IS/LM frenzy. This can be better understood by reading Kaldor (1982), according to whom Keynes’s 1936 monetary theory is « a modification of the quantity theory of money, not its abandonment». Keynes 1930 (The Treatise on Money), despite some of its innovations and some indications about money endogeneity, is still very much in the Quantity tradition: –He objects to those who believe that interest rate ought to be the main operational target of central banks; –He approves of the money multiplier (Phillips 1920); –He supports the use of quantitative instruments for the conduct of monetary policy: open market operations and changes in reserve coefficients, which, at that time, were only advocated by Americans and the Fed.

20. The scourge of monetarism induces a post-Keynesian reaction Until 1970, even 1980, the PK monetary theory is unclear. Its best exposition can be found in Joan Robinson’s 1956 book, The Accumulation of Capital, but it is towards the end of the book, after a complex exposition of growth theory and value theory, so that hardly anybody pays attention to her monetary theory. Before 1970, the main criticisms against the quantity theory are based on the instability of the velocity of money or that of the money multiplier (Kaldor 1958, Minsky 1957). Only Robinson and Kahn (1958) have a proper understanding of the crucial issue Starting in 1970, the more essential issue of reversed causality is brought to the forefront by a number of authors.

21. Reverse causality: three groups of authors Researchers at the Fed (Holmes 1969, Lombra, Torto, Kaufman, Feige+McGee) Post-Keynesians –Cramp 1970, Kaldor 1970 and 1980, Robinson 1970 –Davidson and Weintraub 1973, Moore 1979 and 1988 Iconoclasts: Le Bourva 1959 and 1962, F.A. Lutz 1971

22. Part III The Structuralist vs Horizontalist PK controversies

23. “A storm in a tea cup” (Moore 2001) ? The first exponents of money endogeneity were mainly “horizontalists”: Robinson, Kahn, Le Bourva, Kaldor, Moore, and the French “circuitists”. The main “structuralist” critics were Le Héron, Dow, Wray, Howells, Pollin, and Palley, many of which got their inspiration from Minsky. As Fontana (2003) puts it, “structuralists took over where the accommodationists had stopped”.They brought some clarifications and provided new details. For instance, they insisted that spreads between interest rates could quickly vary, due to assessed default risks or changes in liquidity confidence. Sometimes, however, they constructed a “horizontal strawman” in an attempt to highlight the originality of their contributions. To a large extent, the controversy has petered out, for reasons that will soon be given (although Rochon has rekinkled some excitement by editing a forthcoming book on the topic!).

24. The horizontalist claims 1. The supply curve of money (or high powered money) can best be represented as a flat curve, at a given interest rate. The short-term interest rate can be viewed as exogenous, under the control of the central bank, within a reasonable range. 2. There can never be an excess supply of money. 3. The supply curve of credit can best be represented as flat curves, at a given interest rate (or set of interest rates). 4. Central banks cannot exert quantity constraints on the reserves of banks.

25. The structuralist points 1a. What about the reaction function of the central bank? [Chick 1977, Rousseas 1986, Palley 1991, Musella and Panico 1995] 1b. Long-term and other market-determined rates “cause” the overnight rate [Pollin 1991] 2. If loans create deposits, how do we know that households wish to hold these deposits? [Howells 1995] 3a. What about credit rationing (shape of credit supply curve)? [Dow2 1989] 3b. What about borrower’s risk? [Minsky 1975, Dow and Earl 1982] 3c. and lender’s risk (liquidity preference of banks)? [Dow2, Wray 1989, Chick and Dow, Bibow 2009] 4a. What about financial innovation, with changes in the velocity of money and liability management, which are the main sources of money endogeneity [Pollin 1991, Palley 1994] 4b. Surely the central bank does not always “accommodate” and hence exerts quantity constraints on bank reserves [Pollin 1991] In italics, points that were off the mark!

26. The horizontalist answers I 1. On the horizontal supply of HPM: –New operating procedures, based on a target overnight rate, show clearly that central banks control the overnight rate and can set it at will, notwithstanding what “markets” think; –Of course, if, in general, higher economic activity is accompanied by higher inflation rates, then, through the central bank reaction function, higher interest rates are likely to accompany higher economic activity, and thus the supply of money or HPM will appear to be upward-sloping through time.

27. Horizontalist answers II 2. On the impossibility of excess money: –The main argument is the “reflux principle”. –The stock-flow consistent models of Godley have shown that, despite the presence of an apparently independent money demand function and the presence of a supply of money function based on the supply of loans, flow-of-funds accounting is such that deposits must equate loans despite no such condition being inserted into the model. –In more sophisticated models, changes in liquidity preference by households will induce changes in relative interest rates; but this was never denied by Horizontalists.

28. Horizontalist answers III 3. On the horizontal supply of credit: –It has been shown by Wolfson (1996) that there is no incompatibility between credit rationing and horizontalism. It was never denied that banks could modify their lending norms. –It is now clearly established that higher economic activity does not necessarily entail higher debt ratio for firms (contradicting the essence of Minsky’s financial fragility hypothesis). This is now recognized by Wray, a student of Minsky. –But of course, as firms move from one risk class to another, they will trigger higher interest rates. –Recent events have clearly shown that interest rate spreads rise in times of crisis, or when the economy is brought down, not when the economy is quickly expanding.

29. Loans Interest rate Notional demand Credit- worthy demand i2i2 AN  i1i1 Credit rationing when there is a reduction in bank confidence (Credit-worthy demand: demand with appropriate collateral: Cf. De Soto, and Heinsohn and Steiger) A’  N’  ibib

30. Horizontalist answers IV 4. On quantity restraints on bank reserves: –There is no incompatibility between horizontalism and bank innovations or liability management. –New central bank operating procedures clearly show what was hidden before: central banks passively try to provide the reserves being demanded by the banking system.

31. Conclusion The original horizontalist depiction, that of Kaldor and Moore, is still the most appropriate. But Structuralists have helped to fill in many details. As Wray (2006) concludes: «There cannot be any automatic and necessary impact of spending on interest rates because loans and deposits can and normally do increase as spending rises. The overnight rate will change only if and when the central bank decides to allow it to do so. Short-term loan and deposit retail rates can be taken as a somewhat variable mark-up and mark-down from the overnight rate.»

32. Part IV New developments in monetary policy implementation by central banks

33. New operating procedures and horizontalism Central banks have new operating procedures, although they are not that much different from what they used to be. They bring central banks closer to the « overdraft economy», and further away from the «asset-based econonomy» as defined by Hicks. The procedures of some central banks are more transparent (than they were and than those of other central banks), so the horizontalist story is more obvious: Canada, Australia, Sweden The procedures of other central banks are less transparent; but when interpreted in light of horizontalism, we can see that their operational logic is identical to that of the more transparent central banks (like the Fed, until 2008, or Brazil, see Carvalho de Rezende IJPE 2009).

34. The new operating procedures put in place in Canada and other such countries are fully compatible with the PK monetary theory Central banks set a target overnight rate, and a band around it Commercial banks can borrow as much as they can at the discount rate There are no compulsory reserves and no free reserves (zero net settlement balances) The target rate is (nearly) achieved every day Central banks only pursue defensive operations, trying to achieve zero net balances. When there are tensions, as during the recent subprime financial crisis, they try their best to supply the extra amount of balances demanded by direct clearers (mainly banks)

35. Settlement balances Overnight rate 0 + (surplus) - (overdraft) Target rate TR Bank rate = TR+25pts Rate on positive balances = TR-25pts The Bank of Canada corridor system (nearly similar system at the Fed since 2008 only)

36. Two different justifications for the current interest rate procedures ? Post-Keynesians Based on a microeconomic justification Tied to the inner functioning of the clearing and settlement system Linked to the day-by- day, hour-per-hour, operations of central banks New Consensus Based on the 1970 Poole article A macroeconomic justification If the IS curve is the most unstable, use monetary targeting If the LM curve is unstable (money demand is unstable), use interest rate targets

37. Poole 1970 Interest rate Output A IS LM MTIT LM A = IT MT IS Investment is unstable: Use monetary targeting MT Less variability in output Demand for money is unstable: Use interest rate targeting No variability in output IT

38. The microeconomic justification for interest rate targeting Central bank interventions are essentially « defensive ». Their purpose is to compensate the flows of payments between the central bank and the banking sector. These flows arise from: a) collected taxes and government expenditures; b) interventions on foreign exchange markets; c) purchases or sales of government securities, or repurchase of securities arrriving at maturity; d) provision of banknotes to private banks by the central bank. Without these defensive interventions, bank reserves or clearing balances would fluctuate enormously from day to day, or even within an hour. The overnight rate would fluctuate wildly.

39. Authors who support the microeconomic explanation Several central bank economists –Bindseil 2004 ECB, Clinton 1991 BofC, Lombra 1974 and Whitesell 2003 Fed Some post-Keynesian authors – Eichner 1985, Mosler 1997-98, Wray 1998 and neo-chartalists in general Institutionalists – Fullwiler 2003 et 2006

40. Bank of Sweden: overdraft system « Lending to the banking system currently comprises a significant part of the Riksbank’s assets…. Stage 1 involves a forecast of … how much liquidity needs to be supplied or absorbed for the banks to be able to avoid using the deposit and lending facilities during the coming week …. Stage 3 involves executing open market operations to parry the daily fluctuations in the banking system’s current payments so the banking system will not need to utilise the facilities » –Mitlind and Vesterlund, Bank of Sweden Economic Review, 2001

41. And it is the same for the ECB ! ‘The logic of the ECB’s liquidity management... can be summarised very roughly as follows: The ECB attempts to provide liquidity through its open market operations in a way that, after taking into account the effects of autonomous liquidity factors, counter-parties can fulfil their reserve requirements as an average over the reserve maintenance period. If the ECB provides more (less) liquidity than this benchmark, counterparties will use on aggregate the deposit (marginal lending) facility’ Bindseil and Seitz 2001

42. This was understood a long time ago by some PK economists “The Fed’s purchases or sales of government securities are intended primarily to offset the flows into or out of the domestic monetary- financial system” (Eichner, 1987, p. 849). “Fed actions with regards to quantities of reserves are necessarily defensive. The only discretion the Fed has is in interest rate determination” Wray (1998, p. 115).

43. There is no relationship between open market operations and bank reserves “No matter what additional variables were included in the estimated equation, or how the equation was specified (e.g., first differences, growth rates, etc.), it proved impossible to obtain an R 2 greater than zero when regressing the change in the commercial banking system’s nonborrowed reserves against the change in the Federal Reserve System’s holdings of government securities....”(Eichner, 1985, pp. 100, 111).

44. Why was the federal funds rate sometimes different from the target rate ? In Canada, the Bank is able to know with perfect certainty the demand for settlement (clearing) balances. In the States, the Fed forecasts the net demand. Without reserve averaging, the federal funds rate would have fluctuated widely between zero and the discount rate, as the set daily supply would be different from the given demand (two vertical curves). With reserve averaging, banks can speculate on future values of the federal funds rate, and get extra reserves when the rate turns out to be low. The daily supply is still fixed, but the demand is interest elastic.

45. Problems with no corridor and a not so credible target: central bank needs to be very precise in its daily forecast of reserves demand (Whitesell 2003) Reserves Expected Fed funds rate Lending rate Deposit rate Demand for reserves S S’ Target Fed rate

46. The case of the ECB (and the new Fed): reserve averaging with a corridor Reserves Target rate Lending rate Deposit rate Demand for reserves SS’

47. The Cambridgian hare! « Today’s views and practice on monetary policy implementation and in particular on the choice of the operational target have returned to what economists considered adequate 100 years ago, namely to target short-term interest rates » Ulrich Bindseil 2004, ECB, formerly from the Bundesbank

48. Principles of central banking (Fullwiler 2009) 1: The Fed’s daily operations are mostly about the payments system, not reserve requirements. 2: The Fed’s operating target is necessarily an interest rate target. The money multiplier framework is inapplicable and untenable in practice 3: The Fed’s operations accommodate banks’ demand for reserve balances while offsetting changes to its balance sheet inconsistent with such accommodation. 4: Reserve requirements have to do with interest rate targeting, not money supply targeting. 5: Potential deviations in the federal funds rate from the target rate are set by the Fed’s collateralized lending rate and the remuneration rate. 6: Implementing a new target interest rate does not require any open-market operation (the so-called liquidity effect). 7: The Fed’s operations, overall, are about “price,” not “quantity.”

49. Part V Implications for: Public finance theory and Open-economy monetary economics

50. Neo-chartalism: A new PK controversy? UMKC group: Wray, Forstater, Bell-Kelton Newcastle group (Australia): Mitchell Chartalism (Knapp 1924, Keynes) vs Metallism (an improvement over barter in market exchange) Money is a creature of the State The value of money derives from the State (the need to make payments, to pay tax liabilities, in a given form) Citizens can pay their taxes only if the government has spent and provided the medium of payment beforehand

51. Why neo-chartalism? UMKC economists favour ELR (the State as an employer of last resort for unemployed workers) They wish to demonstrate that financing government deficits to pay for ELR programs or other public program does not pose a problem. It is a response to the crowding-out argument, according to which government deficits lead to higher interest rates Neo-chartalists show instead that government deficits tend to reduce overnight interest rates

52. Government deficits lead to lower overnight interest rates ! This is a consequence of the payment and clearing system. When the government pays for its expenditure through its account at the central bank, settlement balances (reserves) are added to the clearing system. This tends to reduce the overnight rate (the fed funds rate) (cf. Mosler 1994) Keeping the rate at its target level requires a defensive intervention of the central bank Might as well let the overnight rate fall to zero, its “natural” level, say some neo-chartalists !

53. Neo-chartalism: conclusions A subset of PK monetary analysis, but perhaps overly concerned with the origins of money Focus on the clearing and payment system As a consequence, it has vindicated the horizontalist approach on the links between banks and the central bank It has helped to reconcile Horizontalists and Structuralists

54. Open economies: Are interest rates exogenous? Wray 2006 argues that interest rates are clearly exogenous in flexible exchange rate regimes and endogenous in fixed exchange rate regimes, because the central bank must protect its reserves (but what about China!) My position and that of Godley (The PK horizontalist position ?) is that interest rates are exogenous both in flexible and in fixed exchange rate regimes. By contrast sophisticated neoclassical authors argue that interest rates are exogenous in neither flexible nor fixed exchange rate regimes. Or, within the Mundell-Fleming model, IS/LM neoclassical authors argue that monetary policy is effective in a flexible exchange rate regime, but powerless in a fixed exchange rate regime, because the supply of money is then endogenous, as it varies in line with the balance of payments.

55. A critique of the Mundell-Fleming model in a regime of fixed exchange rates In the Mundell-Fleming model, the supply of money is endogenous, but still supply-led (through foreign reserves); demand must adjust to it. In PKE, the supply of money is endogenous, but it is demand-led, as in a closed economy. Any increase in foreign reserves will be compensated by a decrease in another asset of the central bank, or will be compensated by an increase in some liability of the central bank (Principle 3 of Fullwiler 2009). This is the compensation thesis, or the thesis of endogenous sterilization (Godley and Lavoie 2005-06), first emphasized by Banque of France officials (1960s).

56. The compensation thesis Central bank balance sheet AssetsLiabilities Foreign reservesBanknotes Domestic T-billsReserves of commercial banks Loans to domestic banks Government deposits (Central bank bills)

57. Historical example of the compensation thesis: The Bundesbank 1992-1993 31 August 1992 30 Sept. 1992 15 July 1993 Foreign reserves 104181108 Domestic credit 237144236 Total assets 341325344

58. A critique of the sophisticated neoclassical model in flexible exchange regimes The neoclassical argument is that changes in expected future spot exchange rates determine the forward rate relative to the spot rate. This differential, through the covered interest parity condition, which is known to hold at all times, determines the domestic interest rate relative to world rates. The answer to this claim is, once again, reverse causality (Smithin 1994, Lavoie 2000, 2002-3). –It is the differential between domestic and world interest rates that determines, nearly as an identity, the differential between the forward and the spot exchange rates. –The forward rate has nothing to do with the expected spot rate. Forward rates in no way predict future spot rates (Moosa 2004). –Even with perfect capital mobility, as long as assets are imperfect substitutes, central banks have room to set the interest rates of their choice.

59. PART VI Implications for monetary policy implementation in the aftermath of the subprime financial crisis

60. The fallouts of the crisis The crisis has demonstrated that interest rates have no positive relationship with government deficits or debt (as the case of Japan had already proven) The crisis has shown there is no necessary relationship between the size of the central bank’s balance sheet and the monetary base The crisis has clearly shown the limits of monetary policy (zero-interest rate lower bound), and has rehabilitated fiscal policy The crisis has demonstrated that central bank independence is an illusion: in the crux, the central bank needs to be backed by central governments The crisis has forced the Fed to adopt the corridor system of the ECB and of the Bank of Canada (remunerating reserves)

61. Bank of Canada balance sheet (in billions of dollars) Assets 53.5 80.4Liabilities Aug 2008 March 2009 Aug 2008 March 2009 Bills22.413.8Notes50.051.2 Bonds30.831.5Govt deposits 2.328.1 Repos0.234.8Bank reserves 00 There is (nearly) no increase in the monetary base despite the increase in the size of the balance sheet

62. What to do when overnight interest rates have reached zero? Credit easing: act through the asset side of the balance sheet, in the hope of reducing longer- term interest rates on public and private assets. –OK! Quantitative easing: act through the liability side of the balance sheet, flooding banks with reserves, in the hope that banks will make more loans. –Useless!

63. BanksBank of Canada AssetsLiabilitiesAssetsLiabilities Long-term securities -$30 Clearing balances +$30 Term repos +$30 Clearing balances -$30 T-bills +$30Government deposits +$30 T-bills +$30 Clearing balances -$30 T-bills -$30 Clearing balances +$30 Term securities -$30 T-bills +$30 Clearing balances $0 Term Repos +$30 Clearing balances $0 Government deposits +$30 Credit easing through repo operations, when the balance sheet of central banks is rising

64. Quantitative easing In the US and Canada, there is an excess amount of clearing balances (free reserves). As a result, the overnight interest rate is at the bottom of the corridor, equal to the rate of interest on positive clearing balances (0.25%). Quantitative easing is a return to monetarism, the belief that excess reserves lead to more loans and a higher money supply, and more inflation (“Quantitative easing injects additional central bank reserves into the financial system, which deposit-taking institutions can use to generate additional loans” (Bank of Canada 2009)). It did not work in Japan in 2001-2004, and it won’t work now. The problem instead is a scarcity of creditworthy and willing borrowers, as well as banks with insufficient own capital to face defaulting loans.

65. Part VII The integration of PK monetary economics into PK macroeconomics

66. (a) in PK models competing with New Consensus models, Rochon and Setterfield 2007 (b) in PK growth and distribution models (c) through the stock-flow consistent approach (SFC) tied to flow-of-funds analysis.

67. The integration of PK monetary economics into PK models of growth and distribution Very early on, it was pointed out that neo-Keynesian models of growth were neglecting monetary factors (Kregel 1985, “Hamlet without the Prince”). For instance, Davidson (1972) pointed out that the famous neo-Pasinetti model of Kaldor (1966), which, in a very astute way, introduced stock market equities in a neo-Keynesian model, was omitting money balances. The same drawback hurt early Kaleckian growth models. The situation started to change only in the early 1990s, when the impact of interest rates was considered explicitly, and when debt ratios also got introduced, along with cash-flow issues or interest payments relative to profits.

68. The case of the Kaleckian model The canonical Kaleckian growth model is made up of three equations: an investment function, a saving function, and a pricing function. Obviously the interest rate can be introduced into the investment function. Should it be the real interest rate (higher opportunity costs) or the nominal interest rate (lower cash flow, lower retained earnings)? But if so, an increase in the interest rate also has an impact on the saving function (reducing the overall saving rate). And the interest rate may also have an impact on the normal profit rate (the Banking School argument, picked up by Sraffians), thus having an impact on the markup of the pricing function. And all these will have an impact on the debt ratio, and hence may have a feedback effect on the investment function. Things quickly get more complicated. Despite assuming short-run stability, there may not be long-run stability (the debt ratio may explode in the long run). What if we introduce inflation and unemployment. More complications! [See Hein’s book 2008]

69. The stock-flow consistent approach The Holy Grail of PKE has always been the full integration of monetary and real macroeconomic analysis, i.e., provide a true “Monetary” analysis in the Schumpeter sense. Until recently, this seemed like a rather impossible task. Godley (1996, 1999) has now done it, under the name of SFC. [Other authors, around Willi Semmler and Peter Flaschel, also achieve something nearly similar] Portfolio and liquidity preference issues, along with banking and financial stocks of assets and liabilities, are now tied with flows of production, income, and expenditures. Deflated and monetary variables can also be carefully distinguished. The method is presented in the Godley and Lavoie book (2007). In my view, the method is particularly appropriate to model the interaction between (Minsky) financial crises and real crises, or to deal with financialisation issues. At an aggregate level, it makes use of the fundamental identity, underlined by Godley in the 1970s: (S – I) = (G – T) + (X – IM + NFY)

70. The fundamental identity in a closed economy (Krugman 2009): (S – I) = (G – T) GDP Private Surplus Public Deficit Private Deficit Public Surplus Private Financial Balance E D R P Less investment More saving E starting point D without automatic stabilizers (1930s) R with automatic stabilizer P also with stimulus plan Public Balance

71. The impact, relative to baseline, of an increase in the flow of new loans to personal income, in a SFC model

72. 2009: the worse of two worlds The real estate market crashed before these long-run negative effects could really take effect. But now we have two negative effects operating at once on consumption: –The long-run negative effects of high household debt –The short-run negative effects of high saving rates, directly from higher propensities to save, and indirectly from a lower propensity to take on new debt