Australian Debt & monetary model of financial instability…

Steve KeenUniversity of Western Sydney

Conventional Finance Theory

• Finance and Economics completely independent• Finance markets

– In equilibrium– Efficient…

• The data according to CAPM founder Eugene Fama?– “the failure of the CAPM in empirical tests implies

that most applications of the model are invalid.” (Fama & French 2004: 25)

• New model needed to explain empirical data– Most striking feature: growth of debt relative to

GDP• E.g., Australia 1964-2008:

Australia’s debt driven economy…

• Australia’s private debt to GDP ratio has risen exponentially at 4.2% p.a. for over 43 years:

• Not an isolated phenomenon:– 15 other

OECD nations have similar debt to GDP data:

1950 1960 1970 1980 1990 2000 20100

20

40

60

80

100

120

140

160RatioExponential Fit

Australia's Debt to GDP Ratio

Per

cen

t

The global debt-driven economy

• 3 decades of growing debt to GDP across OECD:

• Empirical questions– Where would

Romania fall on this continuum?

– Why is France an exception?

• Theoretical question:– How to explain

phenomenon?• An alternative

theory:

Minsky’s Financial Instability Hypothesis

• A non-neoclassical vision of capitalism:– “capitalism is inherently flawed, being prone to

booms, crises and depressions.– This instability, in my view, is due to

characteristics the financial system must possess if it is to be consistent with full-blown capitalism.

– Such a financial system will be capable of both generating signals that induce an accelerating desire to invest and of financing that accelerating investment.” (1969: 224; emphasis added)

• Foundations in Marx, Schumpeter, Fisher, & Keynes

Skip QuotesSkip Quotes

Marx

• Theoretical: a “dialectical” theory of prices– “What ... is … the price of the loaned capital?...

What the buyer of an ordinary commodity buys is its use-value; what he pays for is its value. What the borrower of money buys is likewise its use-value as capital; but what does he pay for? Surely not its price, or value, as in the case of ordinary commodities.” (Marx 1894: 352)

• Colourful: a sceptical view of banking:– “...The credit system … gives this class of parasites

the fabulous power, not only to periodically despoil industrial capitalists, but also to interfere in actual production in a most dangerous manner—and this gang knows nothing about production and has nothing to do with it." (Marx 1894: 544-45)

Schumpeter

• Well-known cyclical view of capitalism– Creative destruction, clusters of innovations, etc.

• Less well-known endogenous view of credit:– “[I]n so far as credit cannot be given out of the

results of past enterprise … it can only consist of credit means of payment created ad hoc, which can be backed neither by money in the strict sense nor by products already in existence... (Schumpeter 1934: 106)

– “this again leads us to … the heresy that money, and … other means of payment, perform an essential function…” (95)

Fisher

• Debt-deflation theory of Great Depressions:– Non-equilibrium analysis:

• “New disturbances are, humanly speaking, sure to occur, so that, in actual fact, any variable is almost always above or below the ideal equilibrium” (1933: 339)

– “two dominant factors” are “over-indebtedness to start with and deflation following soon after”• “Thus over-investment and over-speculation are

often important; but they would have far less serious results were they not conducted with borrowed money…

• I fancy that over-confidence seldom does any great harm except when, as, and if, it beguiles its victims into debt.” (Fisher 1933: 340-341)

Keynes

• Well-known (if neglected) views on uncertainty– Formalised in Kalecki’s “principle of increasing

risk” (Kalecki 1937, 1990: 285-293)• Investment limited not by declining marginal

efficiency of capital but increasing financial risk• Also post-General Theory “two-price level” analysis

– The scale of production of capital assets• “depends, of course, on the relation between

their costs of production and the prices which they are expected to realise in the market.” (Keynes 1937a: 217)

• All blended by Minsky to produce “Financial Instability Hypothesis”:

Financial Instability Hypothesis

• Economy in historical time• Debt-induced recession in recent past• Firms and banks conservative re debt/equity ratios,

asset valuation• Only conservative projects are funded• Recovery means conservative projects succeed• Firms and banks revise risk premiums

– Accepted debt/equity ratio rises– Assets revalued upwards

The Euphoric Economy

• Self-fulfilling expectations– Decline in risk aversion causes increase in

investment• Investment causes economy to grow faster

– Asset prices rise• Speculation on assets becomes profitable

– Increased willingness to lend increases money supply• Credit money endogenous

– Riskier investments enabled, more asset speculation• Emergence of “Ponzi” financiers

– Cash flow always less than debt servicing costs– Profits made by selling assets on a rising market– Interest-rate insensitive demand for finance

The Assets Boom and Bust

• Initial profitability of asset speculation:– reduces debt and interest rate sensitivity– drives up supply of and demand for finance– market interest rates rise

• But eventually:– rising interest rates make many once conservative

projects speculative– forces non-Ponzi investors to attempt to sell assets

to service debts– entry of new sellers floods asset markets– rising trend of asset prices falters or reverses

Crisis and Aftermath

• Ponzi financiers go bankrupt:– can no longer sell assets for a profit– debt servicing on assets far exceeds cash flows

• Asset prices collapse, drastically increasing debt/equity ratios

• Endogenous expansion of money supply reverses• Investment evaporates; economic growth slows or

reverses• Economy enters a debt-induced recession ...• High Inflation?

– Debts repaid by rising price level– Economic growth remains low: Stagflation– Renewal of cycle once debt levels reduced

Crisis and Aftermath

• Low Inflation?– Debts cannot be repaid– Chain of bankruptcy affects even non-speculative

businesses– Economic activity remains suppressed: a

Depression• Big Government?

– Anti-cyclical spending and taxation of government enables debts to be repaid

– Renewal of cycle once debt levels reduced• Persuasive verbal model; but no successful

mathematical rendition– My research objective

Employment rateEmployment rate

Workers share of outputWorkers share of output

Mathematical Foundations

• Goodwin’s “predator-prey” growth cycle model:– Verbal truisms:

• “Workers share of output will rise if (real) wage demands exceed sum of population growth and labour productivity”

• “Employment will rise if the rate of economic growth exceeds the rate of population growth”

– In mathematical form, two coupled differential equations: Phillips Phillips

CurveCurve

Investment FunctionInvestment Function

Depreciation, Depreciation, Productivity & Productivity &

Population Population growth ratesgrowth rates

t t( )

d

d t( ) PCg t( )( )

t t( )

d

d t( )

Ig1 t( )

v

v

td t( )

d

dIk

1 t( ) r d t( )v

1 t( ) r d t( )( )

d t( )

Ik1 t( ) r d t( )

v

v

Mathematical Foundations

• Generates closed cycle:

0.2 0.4 0.6 0.8 10.7

0.8

0.9

LinearNonlinear

Goodwin Growth Cycle

Wages Share

Em

ploy

men

t

• Add financial truisms:– “Banks finance investment

and charge interest”• Generates 3rd order system

– Debt to output ratio added:

Net real Net real interest rateinterest rate

Profit now net of Profit now net of interest paymentsinterest payments

The beginnings of chaos

• Two classes of outcome– Convergence to equilibrium…

• If capitalists accumulate “negative debt”

• But if they don’t…

0.6 0.7 0.8 0.90.92

0.94

0.96

0.98

1Nonlinear GoodwinStable Minsky

Goodwin & Minsky Cycles

Wages Share

Em

plo

ymen

t

This stability was dependent, however, upon initial conditions that generated a "negative"equilibrium ratio of debt to GDP--or in other words, capitalists accumulating net positivefinancial assets.

0 20 40 60 80 1004

3

2

1

0

Debt to GDP Ratio

The beginnings of chaos

• An unstable cycle… • And debt that “ratchets up” over time to a debt-crisis…

• How well does this simple model match empirical data?– Not very…

• Because the empirical data is much worse!Because the empirical data is much worse!

0.4 0.6 0.8 1 1.2 1.40.7

0.8

0.9

1

1.1

StableUnstable

Stable and Unstable Minsky Cycles

Wages Share

Em

plo

ymen

t

0 20 40 604

2

0

2

4

6StableUnstable

Debt to GDP Ratio

The Ponzi Economy

• Australia’s private debt to GDP ratio has risen exponentially at 4.2% p.a. for over 43 years:

• Not for the first time in our history either

• Long term RBA data shows three bubbles in Australia’s financial history– Current

bubble is the biggest by far!

1950 1960 1970 1980 1990 2000 20100

20

40

60

80

100

120

140

160RatioExponential Fit

Australia's Debt to GDP Ratio

Per

cen

t

The Ponzi Economy

1880 1890 1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 2000 20100

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160Debt RatioTrend 1964-NowTrend 1880-1892Trend 1925-1932

Debt to GDP: The Long Term View

Per

cen

t of

nom

inal

GD

P

The Ponzi Economy

• Correlation isn’t causation, but…

T

0 1 2 3

0

1

2

3

4

5

6

7

8

9

10

"Variable" "Credit" "Credit" "Credit"

"Compared to" "GDP" "GDP" "GDP"

"Start Date" 1880 1925 1964.5

"End Date" 1892.5 1932 2007.7

"Growth Rate" 9.2 9.5 4.2

"Correlation %" 97.9 97.6 99.1

"Doubling Period" 7.5 7.3 16.6

"Duration" 12.5 7 43.2

"Initial Value" 33.9 40.3 24.7

"Final Value" 103.9 76.2 159.5

"Increase %" 206.5 88.8 546.9

Clearly exponential processClearly exponential process

Biggest bubble in our historyBiggest bubble in our history

• There is a macroeconomic link:– Aggregate demand = GDP + change in debt– As debt rises, dependence on change in debt has risen

• Now accounts for 18% of aggregate demand– Unemployment increasingly linked to change in debt…

The Ponzi Economy

• Correlation debt’s contribution to aggregate demand of to unemployment initially trivial

• Exceeds -0.9 by early 1980s

• Formation of debt also increasingly dominated by speculation rather than investment:

1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 20102

0

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14

16

18

20

0

1

2

3

4

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7

8

9

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11Debt ChangeWhitlam 72-75Fraser 75-83Hawke 83-96HewsonHoward 96-07?Unemployment

Change in Debt, Politics, & Unemployment

Per

cen

tage

Con

trib

uti

on t

o A

ggre

gate

Dem

and

Un

emp

loym

ent

1960 1965 1970 1975 1980 1985 1990 1995 2000100

90

80

70

60

50

40

30

20

10

0

10

20

CorrelationWhitlamFraserHawke

Unemployment & Debt Contribution to Demand

Per

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Ponzi Households

• Lending for housing rises from 5-25% of GDP:

• Proportion that financed housing construction falls from 30% to under 10%:

1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 20080

5

10

15

20

25

Aggregate New Lending for Housing

Per

cen

t of

GD

P

• Back to modelling:– Clear omissions from

basic Minsky model are

– Endogenous money– Speculative lending…

1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 20080

10

20

30

40

50

60

70Owner OccupiersInvestors

Housing Construction

Per

cen

t of

Tot

al L

end

ing

Endogenous Money

• Exponential growth in credit despite regulatory regime implies endogenous (market-determined) money

• Common belief in non-neoclassical schools of thought• Empirically supported by Kydland & Prescott:

• But no accepted mathematical model of process• One can be derived from double-entry book-keeping:

Skip Systems NoteSkip Systems Note

A simple approach to dynamic systems

• Each column represents a stock (system state)• Each row entry represents a flow between stocks• Specify relations between system states across rows…

Dynamic System

“System States”Stock A Stock B … Stock Z Accounting

Flows

 + Flow 1 - Flow 1 … … Sum

… … + Flow 2 - Flow 2 Sum

• To generate the model, add up each column– Sum of column is “differential equation” for stock

ddt A t d

dt B t ddt Z t

Money creation in a pure credit economy

• Stylized linear model with three (classes of) agents:– Banks:

• lend money to firms• record all transactions

– Firms:• own factories that produce output; and

– Workers:• work in factories.

• Model starts with loan $L from bank to firm– Created “out of thin air”—simply simultaneous

recording of asset (debt) and liability (deposit) in bank’s double-entry book-keeping system:

“Money from nothing, but your cheques ain’t free”• Loan an asset of bank• Simultaneously creates liability of money in firm’s

deposit account:

• Sets off series of obligations:

– Interest charged on loan at rL% p.a.

– Interest paid on deposit at rD% p.a. where rL > rD

– Third account needed to record this: Bank Deposit BD

“Money from nothing, but your cheques ain’t free”• Full system is:

Interest flows: bank<―>firmInterest flows: bank<―>firm

Wage flows: firm―>workersWage flows: firm―>workersInterest flows: bank―>workersInterest flows: bank―>workers

Consumption flows: bank & workers―>firmsConsumption flows: bank & workers―>firms

0L

D D D L L D D D

D L L D D D D D

D D D D D

dF

dtdF r F r F w F B W

dtdB r F r F r W B

dtdW w F r W W

dt

• System of coupled differential equations:

• System conservative:• Amount of money

– (& debt)• remains constant

Ad

d u

p

Ad

d u

p

term

ste

rms

Get equationGet equation

“Money from nothing, but your cheques ain’t free”• System stable but no growth:

0 0.5 1 1.5 20

50

100

0

5

10

15

20

Firm LoanFirm DepositBank DepositWorkers Deposit

Account Balances, No New Money

FL t( )

FD t( )

BD t( )

WD t( )

t

• Growth in output requires new money to– Hire more workers– Pay for

intermediate inputs

• Simultaneous creation of new debt and new money:

• Violates “Walras’ ‘Law’”• Supports Schumpeter & Minsky on credit

New money flows: bank―>firmNew money flows: bank―>firm

Skip QuotesSkip Quotes

“Money from nothing, but your cheques ain’t free”• Schumpeter

– “in so far as credit cannot be given out of the results of past enterprise … it can only consist of credit means of payment created ad hoc, which can be backed neither by money in the strict sense nor by products already in existence...” (Schumpeter 1934: 106)

• Minsky– “If income is to grow, the financial markets … must

generate an aggregate demand that … is ever rising. For real aggregate demand to be increasing, . . . it is necessary that current spending plans, summed over all sectors, be greater than current received income…

– It follows that over a period during which economic growth takes place, at least some sectors finance a part of their spending by emitting debt or selling assets.” (Minsky 1963 [1982]: 6)

“Money from nothing, but your cheques ain’t free”• Money and debt now grow over time:

0 2 4 6 8 100

100

200

0

10

20

Firm LoanFirm DepositBank DepositWorkers Deposit

Account Balances, New Money Creation

FL t( )

FD t( )

BD t( )

WD t( )

t

L M D

D D D L L D D D M D

D L L D D D D D

D D D D D

dF n F

dtdF r F r F w F B W n F

dtdB r F r F r W B

dtdW w F r W W

dt

• System dissipative:• Rate of growth of money• = rate of growth of debt

Repayment and Re-lending of Principal

• Model so far omits loan repayment• Easily added by including “seignorage free” bank

“Vault”– Repaid loans have to go somewhere– If into bank deposit account, bank can pay for goods

using its money as “IOU”s• NOT the same as re-lending deposited “fiat”

money– Pure credit money system requires “quarantining” of

bank asset accounts from income (deposit) accounts• Bank assets now sum of

– Outstanding Loans– Loan Repayments

Repayment and Re-lending of Principal

• Repayments of Loans; and• Recycling of Loans

– Transfer money from income to asset accounts:

Repayment flows: firm―>bankRepayment flows: firm―>bank

Relending flows: bank―>firmRelending flows: bank―>firm

Wages flow shown as share of production surplusWages flow shown as share of production surplus

• Surplus from production drives all net income

• P is turnover period

• s is share going to firms

• (1-s) goes to workers

“Would you like a credit card with that?”

• Can now see what happens to bank income as– New Money is created– Loans are repaid– Repaid money is re-lent

0 2 4 6 8 102

4

6

8

10

12

StandardNew MoneyLoan RepaymentRecycling Loans

Bank Net Income and Bank Parameters

• Surprise surprise!• Bank income rises if

– Loans are repaid slowly (or not at all)

– Repaid money is recycled more quickly; and

– More new money is created

• Bank profits by extending more credit…

• Structural explanation for real world phenomenon of rising debt to GDP ratio

“Would you like a credit card with that?”

• Surprise surprise!• Bank income rises if

– Loans are repaid slowly (or not at all)

– Repaid money is recycled more quickly; and

– More new money is created

0 2 4 6 8 102

4

6

8

10

12

StandardNew MoneyLoan RepaymentRecycling Loans

Bank Net Income and Bank Parameters

• Lenders profits by extending more credit…– Structural reason for lenders creating rising debt

• What if they decide to change direction?– Impact of “credit crunch”…

“I’m sorry, you can’t have a credit card with that!”• US Economy now experiencing a “Credit Crunch”

– New money created less quickly– Loans repaid more quickly– Reserves re-lent more slowly?

• Key relation is link between creation of bank assets and liabilities– In growing economy, growth of bank liabilities

(active deposit accounts) positive;– In a credit crunch, growth of liabilities turns

negative

0L RM D

D M

F BdL n F

dt

“Dude, Who Moved My Economy?”

• “Credit Crunch”: rate of money creation drops– & repayment of loans increases– & relending drops…

0 5 10 150

100

200

300

0

5

10

15

Firm LoanBank ReserveFirm DepositWorker DepositBank Deposit

0 5 10 150

100

200

300

AssetsBank ReservesFirm Loan

0 5 10 150

100

200

300

0

5

10

15

Firm LoanBank ReserveFirm DepositWorker DepositBank Deposit

0 5 10 150

100

200

300

AssetsBank ReservesFirm Loan

• Loans (Assets in circulation) fall even without bankruptcy• Economy falls into recession:

– Credit-driven economic reversal…

For future research

• Combine two models to produce monetary Minsky model

• Speculative investment motivated by increase in asset price index– Adds to debt; does not add to productive capacity

• First stage: a monetary Goodwin model– Also includes Phillips’s “full Monty”

• Wage change related to– Rate of employment– Rate of change of employment– Lagged response to inflation:

Skip ModelSkip Model

For future research

• Combine two models to produce monetary Minsky model

• Speculative investment motivated by increase in asset price index– Adds to debt; does not add to productive capacity

• First stage: a monetary Goodwin model– Also includes Phillips’s “full Monty”

• Wage change related to– Rate of employment– Rate of change of employment– Lagged response to inflation:

Skip ModelSkip Model

A monetary Goodwin model

• Now six system states• But remarkably simple model t

Krd

dKr I

K

K

tWd

dW Ph

td

d dWdp

tPC

d

d

1P

PC 1 ( )W

a

tdWdp

d

d

1W

dWdp1

P1 1 ( ) [ ]

ta t( )d

d a t( )

tN t( )d

d N t( )

Physical CapitalPhysical Capital

Money WageMoney Wage

InflationInflation

Lagged wage responseLagged wage response

Technical changeTechnical change&&

Population growthPopulation growth

• Generates open cyclical model

20 40 60 80 10070

80

90

100

LinearNonlinearWith Prices

Goodwin Growth Cycle

Wages Share Percent

Em

ploy

men

t Rat

e P

erce

nt

0 2 4 6 8 10 120

10

20

30

Cycles in prices and unemployment

Unemployment Rate

Infl

atio

n R

ate

• With “Phillips surface” rather than Phillips curve inflation and unemployment dynamics

Meanwhile, in the real world…

• Combination of record Debt/GDP, high nominal interest rates and low inflation means huge real interest burden:

• Debt burden;• Aggregate

demand effect of debt reduction

• Serious downturn inevitable

• Counter forces– China boom– Possible global

warming/peak oil inflation

1880 1890 1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 2000 201010

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Inflation-adjusted interest payment burden

Per

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P

Selected References

• Joseph Schumpeter (1934), The Theory of Economic Development: An Inquiry into Profits, Capital, Credit, Interest, and the Business Cycle (republished 2004 by Transaction Publishers, New Brunswick)

• Charles Whalen, “The U.S. Credit Crunch of 2007: A Minsky Moment”, http://ideas.repec.org/p/lev/levppb/ppb_92.html

• Some web-accessible references on Minsky’s work:– http://www.debunkingeconomics.com/FinancialInstability.htm

• A Google Scholar search on Minsky– http://scholar.google.com.au/scholar?q=hyman+minsky&hl=en&lr=

• Some web-accessible references on endogenous money– http://www.debunkingeconomics.com/Lectures/Index.htm#FE