The crisis in economics & economic theory - PowerPoint Presentation

Slide1

The crisis in economics & economic theory

Steve KeenUniversity of Western SydneyDebunking Economicswww.debtdeflation.com/blogswww.debunkingeconomics.comSlide2

Macroeconomics Before the Crisis: Triumphalism“Macroeconomics was born as a distinct field in the 1940's, as a part of the intellectual response to the Great Depression.

The term then referred to the body of knowledge and expertise that we hoped would prevent the recurrence of that economic disaster.My thesis in this lecture is that macroeconomics in this original sense has succeeded:Its central problem of depression prevention has been solved, for all practical purposes, and has in fact been solved for many decades.”(Lucas

2003)Slide3

Macroeconomics Before the Crisis: Triumphalism“As it turned out, the low-inflation era of the past two decades has seen not only significant improvements in economic growth and productivity

but also a marked reduction in economic volatility, both in the United States and abroad, a phenomenon that has been dubbed “the Great Moderation”.Recessions have become less frequent and milder, and quarter-to-quarter volatility in output and employment has declined significantly as well.The sources of the Great Moderation remain somewhat controversial, but as I have argued elsewhere, there is evidence for the view that improved control of inflation has contributed in important measure to this welcome change in the economy.” (Bernanke 2004)Slide4

Macroeconomics Before the Crisis: Triumphalism“there has been enormous progress and substantial convergence…Facts have a way of eventually forcing irrelevant theory out (

one wishes it happened faster), and good theory also has a way of eventually forcing bad theory out.The new tools developed by the New-Classicals came to dominate.The facts emphasized by the New-Keynesians forced imperfections back in the benchmark model. A largely common vision has

emerged…The state of macro is good…” (Blanchard 2008, 2009)Published as working paper 1 year after crisis began!Slide5

And then there was an exogenous shock…From “The Great Moderation”…

To “The Great Contraction”

& “The Jobless Recovery”Slide6

Macroeconomics After the Crisis: Evasion“These models were designed to describe aggregate

economic fluctuations during normal times when markets can bring borrowers and lenders together in orderly ways, not during financial crises and market breakdowns.” (Sargent in Rolnick 2010)“Are … standard macroeconomic models … significantly

flawed? I think the answer is a qualified no…Most of the time, including during recessions, serious financial instability is not an issue. The standard models were designed for these non-crisis periods, and they have proven quite useful in that context.” (Bernanke 2010)“It

is important to start by stating the obvious, namely, that the baby should not be thrown out with the bathwater.” (Blanchard, Dell'Ariccia and Mauro 2010)Slide7

Macroeconomics After the Crisis: EvasionPermanently negative random exogenous shocks?…“the

Great Recession began in late 2007 and early 2008 with a series of adverse preference and technology shocks in roughly the same mix and of roughly the same magnitude as those that hit the United States at the onset of the previous two recessions…The string of adverse preference and technology shocks continued, however, throughout 2008 and into 2009. Moreover, these shocks grew larger in magnitude, adding substantially not just to the length but also to the severity of the great recession…” (Ireland 2011;

see also McKibbin and Stoeckel 2009)Slide8

Monetary Macroeconomic RealismNon-neoclassical economic realism:Endogenous crisis, not exogenous shockGrowth of private debt caused “Great Moderation”

Slowdown in growth of debt caused “Great Recession”Crisis will continue until deleveraging endsNeoclassical macro incapable of analysing these factorsKey problem: blindsided by “exogenous money” fallacy…Slide9

The exogenous money fallacyIndividuals/companies have two sources of spending:IncomeIncrease in debtNeoclassical theory counts the first, ignores the second

Debt transfers money from saver to borrowerOnly distribution of debt matters, not aggregate levelFisher's “Debt Deflation” theory ignored:“because of the counterargument that debt-deflation represented no more than a redistribution from one group (debtors) to another (creditors).Absent implausibly large differences in marginal spending propensities among the groups … pure redistributions should have no significant macro-economic effects

…” (Bernanke 2000)Slide10

The exogenous money fallacy“Ignoring the foreign component, or looking at the world as a whole, the overall level of debt makes no difference to aggregate net worth—one person's liability is another person's asset…In what follows, we begin by setting out a flexible-price endowment model in which “impatient” agents borrow from “patient” agents, but are subject to a debt limit.” (

Krugman and Eggertsson 2010)“the debt we create is basically money we owe to ourselves, and the burden it imposes does not involve a real transfer of resources.That’s not to say that high debt can’t cause problems — it certainly can. But these are problems of distribution and incentives, not the burden of debt as is commonly understood.” (

Krugman 2011)Slide11

The exogenous money fallacyPatient lends to Impatient

Patient’s spending power goes down

Impatient’s

spending power goes up

No change in aggregate demand

Banks mere intermediaries (ignored in analysis)Slide12

The endogenous money realityLogically & Empirically falseLending is not “transfer from saver to borrower”But money creation “out of nothing”“Even though the conventional answer to our question is not obviously absurd, yet there is another method of obtaining money for this purpose, which … does not presuppose the existence of accumulated results of previous development…

This method of obtaining money is the creation of purchasing power by banks…It is always a question, not of transforming purchasing power which already exists in someone's possession, but of the creation of new purchasing power out of nothing…” (Schumpeter, 1934)New debt net source of new investment & speculationSlide13

Actual “endogenous money” processEntrepreneur approaches bank for loan

Assets

Liabilities

Bank grants loan & creates deposit

simultaneously

Alan Holmes, Senior V-P, New York Fed

“In the real world, banks extend credit, creating deposits in the process, and look for the reserves later.” (1969)

New loan puts additional spending power into circulation

Aggregate demand

exceeds

demand from income alone

Neoclassical macro

wrong to ignore change in debtSlide14

“Endogenous money” changes everythingExplains why dynamics of debt caused boom and bustAggregate demand = Income + Change in DebtIncome (mainly) finances consumptionChange in debt (mainly) finances:

Investment (new factories, innovation)Speculation (gambling on asset prices)Spent onNew goods and services (the real economy)Financial claims on existing assets (the FIRE economy)Call this Net Asset Turnover:Price of assets (DJIA, Case-Shiller

Index)Times quantity (Number of shares, houses)Annual turnover (% sold each year)Slide15

“Endogenous money” changes everythingAggregate accounting balance is not “Walras’ Law”“Aggregate Demand is

Aggregate Supply”But “Walras-Schumpeter-Minsky Law”Income + Change in Debt = GDP + NATGrowth accounting balance isChange in Income;Plus Acceleration in Debt (Change in the change…)EqualsChange in GDP plus

Change in NATMost of which is Change in Share & House PricesSlide16

“Endogenous money” changes everythingBasic Logic:

Debt

acceleration

drives

change in

asset pricesSlide17

“Endogenous money” changes everythingSince accelerating debt causes asset price bubblesBubbles must burst, because acceleration must endJust like a car can’t accelerate forever

At maximum velocity, acceleration is zeroApplying this to:Why the economy boomed from 1993-2007Why it crashed in 2007Why asset markets crashed as wellSlide18

Boom & Bust: debt-charged growth & collapseRising private debt boosted demand by $4 trillion at peakFalling debt cut demand by $2.8 trillion at troughFrom $18.3 to $11.5 trillion in just 2 yearsSlide19

Partial Government RescueGovernment debt also creates money“Fiat” rather than CreditGovernment deficit partially offset private

deleveragingFrom $18.7 to $13 trillion in 2 yearsWithout government deficit, aggregate demand would be$1 trillion lower$300 billion less than GDPPoliticians obsess on government debt, but…Slide20

Partial Government RescueRise in government debt 30% GDPDwarfed by 47% fall in private debtSlide21

“The Great Recession”Fall in debt-financed demand drove unemploymentSlide22

“The Great Recession”Acceleration drives change in unemploymentSlide23

Stock market boom and bustDebt acceleration drives asset prices—up and downSlide24

Housing bubble and bustMore obvious for mortgage debt & house prices:Slide25

From facts to theory…Neoclassical failure to foresee crisis inevitable:“The preferred model has a single representative consumer optimizing over infinite time with perfect

foresight or rational expectations, in an environment that realizes the resulting plans more or less flawlessly through perfectly competitive forward-looking markets for goods and labor, and perfectly flexible prices and wages.How could anyone expect a sensible short-to-medium-run macroeconomics to come out of that set-up?...I start from the presumption that we want macroeconomics to account for the occasional aggregative pathologies that beset modern capitalist

economies…A model that rules out pathologies by definition is unlikely to help.’” (Solow [Nobel Prize Winner!] in 2003)Slide26

Towards a monetary macroeconomicsAll methodological choices of neoclassical macro wrong:Disequilibrium & dynamics, not equilibrium & staticsSocial classes, not isolated individuals

Money not barterFoundations: Marx, Schumpeter, Sraffa, Keynes, Fisher, Kalecki, Minsky, Goodwin, GrazianiIntegrated in Minsky’s Financial Instability HypothesisFocus: a

model that can generate a Great Depression:Anything else isn’t a model of capitalismSlide27

The Financial Instability HypothesisHyman Minsky, 1982:“Can “It”—a Great Depression—happen again?

And if “It” can happen, why didn’t “It” occur in the years since World War II?These are questions that naturally follow from both the historical record and the comparative success of the past thirty-five years.To answer these questions it is necessary to have an economic theory which makes great depressions one of the possible states in which our type of capitalist economy can find itself.”Slide28

The Financial Instability Hypothesis

Economy in historical timeDebt-induced recession in recent pastFirms and banks conservative re debt/equity, assetsOnly conservative projects are fundedRecovery means most projects succeed

Firms and banks revise risk premiumsAccepted debt/equity ratio risesAssets revalued upwards…“Stability is destabilising”Period of tranquility causes expectations to rise…Self-fulfilling expectations

Decline in risk aversion causes increase in investmentInvestment expansion causes economy to grow fasterRising expectations leads to “The Euphoric Economy”…Slide29

The Financial Instability Hypothesis

Asset prices rise: speculation on assets profitableIncreased willingness to lend increases money supplyMoney supply endogenous, not controlled by CBRiskier investments enabled, asset speculation risesThe emergence of “Ponzi” financiersCash flow less than debt servicing costsProfit by selling assets on rising marketInterest-rate insensitive demand for financeRising debt levels & interest rates lead to crisis

Rising rates make conservative projects speculativeNon-Ponzi investors sell assets to service debtsEntry of new sellers floods asset marketsRising trend of asset prices falters or reversesSlide30

The Financial Instability Hypothesis

Boom turns to bustPonzi financiers first to go bankruptCan no longer sell assets for a profitDebt servicing on assets far exceeds cash flowsAsset prices collapse, increasing debt/equity ratiosEndogenous expansion of money supply reversesInvestment evaporates; economic growth slowsEconomy enters a debt-induced recession

Back where we started...Process repeats once debt levels fallBut starts from higher debt to GDP levelFinal crisis where debt burden overwhelms economyModeling Minsky…Slide31

Keen 1995 Model Foundations: Nonlinear dynamicsGrowth Cycle model (Goodwin 1967, Blatt 1983)

Closes the loop:

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 Phillips Curve

Integral of w determines W (given initial value)

Y-W determines profits P and thus Investment I…Slide32

Modelling Minsky & Endogenous Money…Goodwin model:

Debt essential element to introduce Minsky

For debt, essential that 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)Slide33

Modelling Minsky & Endogenous Money…Results in 3-dimensional system:

Wages share of output

Employment ratio

Debt to output ratio

Equilibrium of system locally stable but globally unstable

“Inverse tangent” route to chaosSlide34

Sensitive dependence on initial conditions..Outcome depends on initial conditions:Close to equilibrium, convergence;Far from equilibrium, divergence into debt-induced depression:Slide35

Sensitive dependence on initial conditions..Debt dynamics behind very different outcomes:

1995 model included Government as “homeostatic stabilizer”

Current work—converting to strictly monetary modelSlide36

Theoretical dynamics of debt: Minsky + CircuitMonetary model of capitalism built from combination of:Goodwin’s growth cycleMinsky’s Financial Instability Hypothesis

Circuit theory of endogenous money creationProduct: “Monetary Circuit Theory”—MCTGraziani, Circuit Theory“any monetary payment must therefore be a triangular transaction, involving at least three agents, the payer, the payee, and the bank. Real money is therefore credit money.” (Graziani, 1989, p. 3)Strictly monetary model developed from double-entry bookkeepingSlide37

Explicitly Monetary Minsky ModelInput financial relations in Table:

AssetsLiabilities

EquityReserveLoan

Firm DepositWorker DepositBank EquityLend-A

A

Record Loan

A

Interest

B

Pay Interest

-B

B

Record

-B

Wages

-C

C

Consumption

D+E

-D-ERepay LoanF

-FRecord-F

New MoneyGRecord

G

System of dynamic equations derived automatically:

Illustrating this in Mathcad…Slide38

Explicit Money Minsky ModelStrictly monetary macro model developedLinked to production vianonlinear investment, lending & debt repayment functionsDynamic pricing equation

Generalized (3 factor) “Phillips curve”As in original Phillips papers but ignored by neoclassicalsComplex nonlinear dynamic system results…

Full 11-equation ODE system in Mathcad…Slide39

Explicitly Monetary Minsky ModelNew monetary macroeconomics can explain the crisisSlide40

Multi-sectoral extensionExtended to multiple sectors withInput-output relations in financial flows tableReplicated “Goodwin” cycle model of productionCurrently implemented as multiple columns in 2D matrix

Objective: represent as multidimensional “hypercube”Slide41

Multi-sectoral extensionGenerates multi-sectoral limit cycleSlide42

Multi-sectoral extensionFinancial and income distribution dynamics:

Reforming economics

Accessible monetary macroeconomics with

MinskySlide43

A new tool for dynamic macroeconomicsEconomists still practicing “comparative statics”“[We] were doing comparative statics… there are a variety of problems in economics … where you want to understand how some kind of shock will affect

some equilibrating variable…It’s often helpful to do the analysis in two stages. First, you ask how some desired quantities would change holding the equilibrating variable constant; then you ask how that variable has to change to restore equilibrium…” (Paul Krugman 2012)

Useless technique for non-equilibrating real worldNeed to get new students to do dynamics insteadBut current tools unsuitable for economics…Slide44

Minsky: dynamic monetary modellingE.g., monetary flow model in Vissim:

Same model in bookkeeping format:

Enter “

Minsky

”

Melding systems dynamics with accountingSlide45

Minsky: dynamic monetary modellingVery early prototype (Tcl/Tk

)But can do flowchart modelling…

And accounting…

Ambition: economic equivalent of meteorological modelling…Slide46

Minsky: dynamic monetary modellingTable becomes HypercubeTwist one way—multiple sectorsTwist the other—multiple banks

Multiple tables: trade & finance flows between national economiesThere’s just one more thing…

We need help!!!Slide47

Minsky: dynamic monetary modellingFirst INET Grant ($128K) runs out July 2012Were going to apply for ARC Linkage Grant $500KINET agreed to pay $40K p.a. to thisLast year 2 rounds, 1st round funding by August

Jan 10th 2012 ARC says 1 round only funding July 2013!We need $ to keep single programmer going till thenINET will provide $40K if we get additional fundingCoding assistance in GPL projectAssistance in both respects neededSlide48

Deleveraging for … 2 decades?At current rate, get to 1970 debt level by 2025

It won’t be a smooth ride down…Slide49

Volatility rulesIt hasn’t been—and won’t be—a smooth ride down…Slide50

Acceleration DynamicsWhy asset markets lead…

Peak Acceleration

Peak Velocity

Why they’re weird…

Acceleration rises

As velocity falls

Velocity: addition to aggregate demand

Acceleration

Change in aggregate demand

Change in asset pricesSlide51

What about Australia?Same basic story: debt-driven boom/bust cycle

Higher level than ever before

But lower than USASlide52

Australia: Crisis? What Crisis?We avoided crisis by delaying deleveraging:Slide53

Australia: Crisis? What Crisis?We avoided crisis by delaying deleveraging:

Plus Government stimulus…Slide54

ConclusionWe are in a different Great DepressionHigher level of private debt, larger deleveraging

Different debt distribution—less deflation

“Turning Japanese” rather than 1930 rerunSlide55

ConclusionLarger Government significant reason for shallower crisisSlide56

ConclusionPolicyReduce private debt to reduce scale of crisisTheoryConsign neoclassical economics to dustbin of history