Written by Steve Keen, Steve Keen’s Debtwatch
Minsky’s Financial Instability Hypothesis (FIH) is an emergent property of macroeconomic models derived directly from macroeconomic definitions.
This is a paper presented at the International Conference Minsky at 100 Revisiting Financial Instability, December 16-17 2019 – Universita Cattolica del Sacro Cuore Milano.
Please share this article – Go to very top of page, right hand side, for social media buttons.
The natural starting place for analyzing the relation between debt and income is to take an economy with a cyclical past that is now doing well … As the period over which the economy does well lengthens, two things become evident in board rooms. Existing debts are easily validated and units that were heavily in debt prospered; it paid to lever … It follows that the fundamental instability of a capitalist economy is upward. The tendency to transform doing well into a speculative investment boom is the basic instability in a capitalist economy
. . (Minsky 1982, pp. 66-67. Emphasis added)
This paper is posted in five parts:
Part 1: Deriving a Minsky Model (this article)
Part 2: Simulating Loanable Funds and BOMD
Part 3: Accounting For The Great Moderation & The Great Recession
Part 4: Nonlinearity and Realism
Part 5: Appendix and References
Abstract
Though Minsky developed a compelling verbal model of the “Financial Instability Hypothesis” (FIH), he abandoned his early attempts to build a mathematical model of financial instability (Minsky 1957). While many mathematical models of the FIH have been developed since (Taylor and O’Connell 1985; Jarsulic 1989; Keen 1995; Charles 2005; Cruz 2005; Tymoigne 2006; Charles 2008; Fazzari, Ferri et al. 2008; Santos and Macedo e Silva 2009), the criticism that these models are “ad hoc” lingers (Rosser 1999, p. 83).
In this paper I show that the essential characteristics of Minsky’s hypothesis are emergent properties of a complex systems macroeconomic model which is derived directly from macroeconomic definitions, augmented by the simplest possible assumptions for relations between system states, and the simplest possible behavioural postulates.
I also show that credit – which I define as the time differential of private debt:
– is an essential component of aggregate demand and aggregate income, given that bank lending creates money (Holmes 1969; Moore 1979; McLeay, Radia et al. 2014).
Minsky’s Financial Instability Hypothesis is thus derived from sound macrofoundations. This stylized complex-systems model reproduces not only the core predictions of Minsky’s verbal hypothesis, but also empirical properties of the real world which have defied Neoclassical understanding, and which were not predictions of Minsky’s verbal model: the occurrence of a “Great Moderation” – a period of diminishing cycles in employment, inflation, and economic growth – prior to a “Minsky Moment” crisis; and a tendency for inequality to rise over time (Piketty 2014). Throughout this paper, I showcase the Open Source system dynamics program Minsky, which was named in Minsky’s honour.
Deriving a Minsky model from macroeconomic definitions
The core definitions are:
(1) This is commonly called “labor productivity”, but the expression “output to employment ratio” is more strictly correct.
When the first three of these are differentiated with respect to time, three true-by-definition dynamic statements result:
The employment rate will rise if economic growth exceeds the sum of change in the output to labour ratio and population growth;
The wages share of output will rise if the total wages grow faster than GDP; and
The private debt to GDP ratio will rise if private debt growth exceeds the rate of economic growth
The statements above are shown in Equation [Field]:
where
The following simplifying assumptions are used to turn these definitions into an economic model:
Table 1: Simplifying Assumptions
Applying these assumptions, and signifying the real growth rate as
leads to the model shown in Equation (1.2)
As shown in the Appendix, this inherently nonlinear model (2) has two meaningful equilibria:
- one with a positive employment rate, positive wages share, and debt to GDP ratio, which Grasselli & Costa Lima dubbed the “good equilibrium”;
- another with zero employment, zero wages share, and an infinite debt to GDP ratio, which they dubbed the “bad equilibrium” (Grasselli and Costa Lima 2012).
(2) While the behavioural equations in the model are linear, the multiplication of one system state by another generates structural nonlinearities that generate its complex behaviour. See the Appendix for details. Nonlinear behavioural relations are introduced later in the paper.
The key parameter that determines the stability of these two equilibria is the slope of the investment function.
With a low desire to invest
(which on the surface would appear to imply a poorer level of economic performance) the “good equilibrium” is stable (see Figure 1), with the system converging over a large number of cycles.
Figure 1: Model simulated for 100 years with S=5
Click for large and super-large image. Hit return arrow to return to paper.
However, with a high desire to invest
(which on the surface would appear to imply a higher level of economic performance) the “bad equilibrium” is stable (see Figure 2).
Figure 2: Model simulated for 100 years with S=10
Click for large and super-large image. Hit return arrow to return to paper.
The approach to the bad equilibrium follows what is known as the “intermittent route to chaos” (Pomeau and Manneville 1980), in which systemic turbulence appears to decline, only to subsequently rise once more. This reproduces several of the stylized facts of recent macroeconomic data:
A rising level of private debt compared to GDP;
An initial apparent decline in the volatility of employment, growth and wage demands (3) – a “Great Moderation” – followed by increasing volatility and (ultimately) an economic collapse – a “Great Recession”; and
Rising inequality, as the increased share going to bankers (in this three-class system) comes at the expense not of capitalists – who are the only ones borrowing in this simple model – but at the expense of the workers’ share of income.
(3) These are a proxy for inflation in this non-price model. Inflation is introduced in a later model in the paper.
A simple model derived directly from macroeconomic definitions thus reproduces the essence of Minsky’s FIH: the faster cyclical growth of debt relative to income over a series of credit-driven boom and bust cycles, leading to a period of increasing volatility and, in this model without bankruptcy or government, ultimate a terminal economic breakdown.
One essential aspect of this model is the proposition that the change in debt finances part of investment, and thus part of aggregate demand – loans are not “pure redistributions” (Bernanke 2000, p. 24) as portrayed in Neoclassical literature, but increases in bank assets which simultaneously create both money and additional aggregate demand and income. This can be proven using the key macroeconomic identity that expenditure is income.
The role of credit in aggregate demand and aggregate income
Central Banks have recently relieved Post Keynesian economists of the necessity of insisting that their “Endogenous Money” model of banking behaviour is structurally correct (Holmes 1969; Moore 1979; Moore 1988; Moore 1988; Dow 1997; Rochon 1999; Fullwiler 2013), while the Neoclassical models of “Loanable Funds” and the “Money Multiplier” are incorrect (McLeay, Radia et al. 2014; Deutsche Bundesbank 2017). However, the macroeconomic significance of Endogenous Money is still not fully appreciated in Post Keynesian and Modern Monetary Theory (MMT) circles. In a recent blog post, Wray argued that “in retrospect the endogenous money literature is trivial for several reasons“:
- First, the modern endogenous money research largely just recovered the pre-Friedmanian views that were common in the 1920s;
- Second the endogenous money approach was rather quickly adopted by heterodoxy; and
- Third all the central banks of the rich, developed countries have also adopted the endogenous money approach.
The policy recommendation that comes out of it is to direct central banks to target interest rates, not reserves or money supply …
By contrast, we have been pushing the MMT approach to fiscal finance since the early 1990s and it still remains highly controversial … Why? Because the implications of understanding fiscal finance are huge. By comparison, the implications of endogenous money are trivial – which is why it was relatively easy to get the theory adopted. (Wray 2019)
In the following tables (which I term “Moore Tables” (4) in honour of Basil Moore) I use the key macroeconomic identity that expenditure is income to show endogenous money is far from macroeconomically trivial, since it is essential to credit being a component of aggregate demand and income. This insight strengthens MMT, by showing that endogenous money is macroeconomically critical, since without it, credit would indeed play no significant role in macroeconomics. Since banks do originate money and debt, then endogenous money – which I prefer to describe as “Bank Originated Money and Debt” (BOMD) – results in a fundamental transformation of macroeconomics.
(4) Moore Tables will be added to Minsky as an analytic feature.
Each row in a Moore Table shows expenditure by one sector on the others in an economy. Expenditure is shown as a negative entry on the diagonal of the table, and a positive entry on the off-diagonal, with the two necessarily summing to zero on each row and the overall table. Flows are denominated in $/Year. The negative sum of the diagonal of the table is aggregate demand (AD), while the sum of the off-diagonal elements is aggregate income (AY). The two are necessarily equal.
Figure 3 shows a monetary economy in which neither lending nor borrowing can occur. The flows A to F represent the turnover of an existing and constant money stock, and in this sense are comparable to Friedman’s mythical “Optimum Quantity of Money” economy (minus the helicopters dispensing money (Friedman 1969)). The sum of these monetary flows can thus be substituted by the velocity of money V times the stock of money M, as in Equation (1.3).
Figure 3: Moore Table for a monetary economy with no lending
Figure 4 shows the mythical Neoclassical model of Loanable Funds, in which lending is between one non-bank agent and another. Lending is shown as a flow across the diagonal of the Moore Table 6 (in a later part of this paper).
Without loss of generality, I show Sector 2 lending Credit dollars per year to Sector 1, which Sector 1 then spends buying the output of Sector 3; Sector 1 also has to pay Interest $/year to Sector 1, to service the outstanding stock of debt.
The flow of lending affects the spending power of the lender as well as the borrower: the flow of Credit $/Year from Sector 2 to Sector 1 reduces the amount that Sector 2 can spend on Sector 3.7
Figure 4: Moore Table for Loanable Funds
Figure 4 confirms the belief of Neoclassical economists, that if banks were just intermediaries, then credit would be a pure redistribution, and it would play no role in aggregate demand and income. However, one interesting result is that (gross) interest payments are part of aggregate demand and aggregate income – see Equation [Field].
Figure 5 shows the real-world situation that Credit money (a flow of $/Year) is created by bank lending. The Table is now expanded to show the Assets, Liabilities and Equity of the Banking Sector, and monetary flows now include the matching increase of Assets and Liabilities when a new loan (Credit, denominated in $/Year) is made, as well as transfers between Liabilities (predominantly deposit accounts), and also Bank Equity. The Credit money created by the loan is used by Sector 1 to buy goods from Sector 3, and Sector 1 is obliged to service the stock of outstanding loans by paying the flow of Interest $/Year to the Bank (which is recorded in its Equity account).
Figure 5: Moore Table for Endogenous Money (“Bank Originated Money and Debt”)
The crucial result here is that Credit is part of aggregate demand and aggregate income, in the real world of Endogenous Money (8) in which bank lending creates money:
This realisation strengthens the underlying Post Keynesian and MMT methodologies. Not only is “Endogenous Money/BOMD” a more realistic description of banking than “Loanable Funds”, it has an enormous impact on macroeconomics as well.
(8) I prefer to describe “Endiogenius Money” as “Bank Originated Money and Debt”, since it is more meaningful to non-specialists-and it has a great acronym (BOMD).
Macroeconomic models that omit banks, debt, money – and therefore the role of credit in aggregate demand and income – omit the “causa causans, that factor which is most prone to sudden and wide fluctuation” (Keynes 1936, p. 221), and are utterly misleading models of the macroeconomy. This judgment applies to the entire corpus of Neoclassical economics, bar the work of Michael Kumhof (Kumhof and Jakab 2015; Kumhof, Ranciere et al. 2015).
See Part 2: Simulating Loanable Funds and BOMD
.
include(“/home/aleta/public_html/files/ad_openx.htm”); ?>
