Evaluating Macro-Prudential Instruments:
From Minsky towards a new Framework?
Student: Jonas Schlegel Student number: 10604995
Master of Science in Economics: Monetary Policy and Banking Faculty of Economics and Business
University of Amsterdam
First supervisor: Professor L.H. Hoogduin Second Supervisor: Dr. W.E. Romp
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Abstract
While macro-prudential instruments have been seen as unnecessary in mainstream theory, this view has changed rapidly since the financial crisis. Nevertheless, most of economic research on the evaluation of macro-prudential instruments is still based on mainstream theory, namely the DSGE framework, which abandons financial instability by assumption. Hyman Minsky has criticized specific features about mainstream theory whenever financial instability takes place. It is shown that these critiques are still applicable for DSGE models and lead therefore to inevitable failures in the evaluation of macro-prudential instruments. Minsky has offered the financial instability hypothesis as an alternative to mainstream theory. Based on this hypothesis, Minsky has called for instruments to sustain financial stability since the 1960s, and therefore 50 years earlier than “mainstream” economists. While Minsky was not able to model his ideas, Steve Keen is the only economist, who developed a holistic Minsky model. This thesis is to my knowledge the first paper, which critical verifies Keen’s model in two ways: Firstly, if it is in line with Minsky’s ideas and secondly, if it is empirically valid. This analysis is a necessary task to answer the question whether macro-prudential instruments will be able to be evaluated within this given model. This thesis concludes that Keen’s model reflects the main requirements requested by Minsky. In addition, the baseline story of the financial instability hypothesis is implemented. On the other hand, in more detail, the model shows missing features of the financial instability hypothesis. Additionally, the underlying Goodwin cycle and a fixed and exogenous determined interest rate appear as unpromising features from a real world perspective. As a final conclusion, the thesis argues that while an introduction of macro-prudential instruments to stabilize an otherwise unstable system will not offer difficulties, the way towards a more realistic and empirically more valid model will appear as the more challenging part in the future.
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Table of Content
1. Introduction ... 3
2. The need for macro-prudential instruments ... 4
2.1 Macro-prudential instruments before the crisis ... 4
2.2 Macro-prudential instruments after the crisis ... 6
2.3 Types of instruments ... 6
3. Mainstream theory and financial instability ... 7
3.1 Minsky’s criticism on mainstream theory ... 7
3.2 A validity check towards today’s mainstream theory ... 10
3.3 Minsky’s views about how financial instability should be modelled ... 12
4. Minsky’s analysis about financial instability ... 13
4.1 Financial instability hypothesis – the baseline story ... 13
4.2 Detecting financial instability – The three types of financing ... 15
4.3 Stabilization factors of the economy ... 17
4.4 Macro-prudential instruments from a Minsky perspective ... 18
5. A Minsky Model ... 21
5.1 Goodwin’s growth and business cycle ... 21
5.2 Keen’s “Minsky Model” ... 22
5.2.1 Adjustments of the Goodwin cycle ... 22
5.2.2 First attempts of introducing Minsky ... 22
5.3 The Minsky model with endogenous money ... 23
6. A critical verification of Keen’s “Minsky Model” ... 27
6.1 The model from a Minsky perspective ... 27
6.2 A verification check of the model ... 30
6.2.1 The Goodwin model ... 30
6.2.2 The monetary part of the model ... 34
6.3 The final step: Evaluating macro-prudential instruments? ... 35
7. Conclusion ... 36
References ... 39
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“For an economic theory to be relevant what happens in the world must be a possible event in the theory. On that score alone, standard economic theory is a failure; the instability so evident in our system cannot happen if the core of standard theory is to be believed.” (Minsky 2008b, p. 323)
"Once it is accepted that the neoclassical synthesis 'won't do', the question becomes: 'What will do?' - 'What is an apt economic theory for our economy?'" (Minsky 1982e,
p. 68)
1. Introduction
The evaluation of macro-prudential instruments has appeared as one of the most important macroeconomic research questions since the financial crisis. While researchers and policy makers use Minsky’s ideas as an explanation of the crisis (for instance see (Yellen 2009)), they totally oversee his additional work about how a framework, which wants to capture financial instability, should be modelled. If Minsky developed meaningful insights for a better understanding of financial crises, his critique about mainstream theory should be considered as serious as his other analysis. In conclusion, an evaluation of macro-prudential instruments, which goes hand in hand with financial stability, can only take place in a framework, which allows for financial instability because “simulation cannot be better than the model, and the econometric model cannot be closer to reality than the economic theory of the model builder” (Minsky 2008b, p. 143). Steve Keen (1995, 2009a, 2009b, 2010, 2013a, 2013b) is the first economists who implements Minsky’s ideas and critique in a holistic macroeconomic model so that there are promising features for an evaluation of macro-prudential instruments in the future. This thesis is therefore to my knowledge the first paper, which critical verifies Keen’s model in two ways: Firstly, if it is in line with Minsky’s ideas and secondly, if it is empirically valid. This analysis is a necessary task to answer the question whether macro-prudential instruments will be able to be evaluated within this given model.
The thesis is therefore structured as follows: The second chapter explains why macro-prudential instruments have been seen as unnecessary tools for financial stability until the crisis and shows that this view has changed. Additionally it explains that it is difficult to evaluate macro-prudential instruments and that the common framework in which they are evaluated is mainly the DSGE approach. The third chapter explains Minsky’s critique on mainstream theory, how financial instability should be modelled instead and shows that his critique is still applicable for current mainstream theory, namely for DSGE models. The fourth chapter presents Minsky’s analysis about financial instability, which is called the financial instability hypothesis. Keen’s model is explained in the fifth chapter, while the
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mathematical derivations can be found in the appendix. The sixth chapter shows that Keen was able to implement Minsky’s critique on mainstream theory. On the other side, important aspects of the financial instability hypothesis are not implemented in the current model. Additionally, empirical validation shows serious problems because, besides other difficulties, the underlying Goodwin model appears as problematic. In a last step, the thesis presents that the style of the model provides perfect conditions for an introduction of macro-prudential instruments so that the way towards a more realistic and empirically more valid model will appear as the more challenging part in the future. Finally, the seventh chapter concludes and gives a brief guidance on what aspects future research should focus on.
2. The need for macro-prudential instruments
The financial crisis in 2007-2009 has occurred unexpectedly for governments, central bankers and regulators. Especially financial regulators, whose main job it is to reduce negative side effects and tail risks of the financial system and reveal financial fragility, have failed to foresee it coming. The upcoming questions are: Why did regulators not use tools to prevent the crisis? What are the tools they should have used? Why models used by regulators did not help to see it coming?1 This chapter will therefore focus on frameworks and instruments used until the crisis and on the debate about useful tools – called macro-prudential instruments – after the crisis.
2.1 Macro-prudential instruments before the crisis
Prior to the crisis, objectives and instruments have been well-organized among institutions and were based on a coherent theoretical framework. Independent central banks guaranteed price stability by setting the short-term interest rate. It followed that monetary and fiscal policy are separated so that the objective for governments was to keep public debt levels sustainable. This resulted in independent public debt management. “In that case government assets are risk free and public debt management does not influence the interest rate on long-term government debt, which is delong-termined by expectations about future monetary policy” (Hoogduin, Wierts 2012, p. 87). Additionally, money is neutral in the long run. The financial system is assumed to be passive and therefore, macroeconomic stability directly assures financial stability (Hoogduin, Wierts 2012, p. 87). According to Elliott et al. (2013, p. 2),
1 Although the aim of this thesis is not to discuss how to foresee financial crises, the theoretical framework
becomes highly important whenever instruments to prevent breakdowns need to be tested. As it will be discussed later, varying assumptions and axioms about the financial markets will make tremendous differences about the usefulness of certain instruments.
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standard economic models suggested that finance was a "veil" and not an independent source of risk. Moreover, it was commonly thought that monetary policy should react to asset bubbles only insofar as they affected the real economy (Elliott et al. 2013, p. 2).
On the other side, financial risks were not overseen, but considered from a different perspective. Policy regulators were well aware of individual banking risks. Main difference is that it was commonly accepted that these risks could be highly limited at an individual level, making use of micro-prudential instruments. A micro-prudential perspective is hereby clearly separated from a macro perspective. The objectives of the micro-prudential perspective are mainly the protection of investors and depositors, while from a macro-prudential perspective it would be to avoid output costs. Additionally, correlations and common exposures across institutions are considered as irrelevant from a micro-prudential perspective (Borio 2003, p. 2). The minimum capital requirements defined in Basel 2, Pillar 1 can be seen as a good example for this perspective.
Nevertheless, it is important to mention that contrary to a common misperception, policymakers took actions in the past, which “would be considered as cyclical macro-prudential actions under today’s framework” (Elliott et al. 2013, p. 49). Policy makers hereby targeted growing asset price speculations, which should be moderated by slowing credit growth. In more detail, the U.S. used loan-to-value ratios and restrictions on loan maturities in the 1940s and 1950s, margin requirements from 1934 till 1974, tax policy and incentives from the 1950s till the 1981, capital requirements in the 1980s, portfolio restrictions from the 1940s till the 1980s (Elliott et al. 2013, p. 50). Interestingly, these actions stopped at the end of the 1980s because policymakers thought that they were not useful or not necessary anymore. Additionally, according to Clement (2010, p. 59), the term macro-prudential was used first in June 1979 at a meeting of the Cooke Committee, the forerunner of the present Basel Committee on Banking Supervision.
This shows that the discussed instruments as well as the term macro-prudential cannot be seen as an innovation which has its origins in the financial crisis. It is rather the case that the decision if macro-prudential instruments are necessary or not depends highly on political and economic opinions about financial markets. As already indicated and more specified in the third chapter, this opinion is in turn strongly formed by a superior theoretical framework during a specific time.
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While there were some reasons to believe that the financial system has only worked as an intermediate for the real economy, this believe broke down after the financial crisis. The need for additional instruments from a macro perspective – macro-prudential instruments - to sustain financial sustainability appeared therefore rapidly after the crisis:
“In terms of policy, the recent financial crisis has highlighted the need to go beyond a purely micro-based approach to financial regulation and supervision. In recent months, the number of policy speeches, research papers and conferences that discuss a macro perspective on financial regulation has grown considerably. There is a growing consensus among policymakers that a macroprudential approach to regulation and supervision should be adopted.” (Galati, Moessner 2011, p. 2)
"There is a growing support for the view that policymakers should use a variety of tools to minimize the frequency and severity of asset bubbles fuelled by excessive credit growth and ultimately to limit their potential to damage the wider economy."
(Elliott et al. 2013, p. 2)
"Prudential authorities converged on frameworks that concentrated too much on the safety and soundness of individual institutions and too little on that of the system as a whole – frameworks in which the macroeconomy and the financial cycle hardly figured. They focused too much on individual trees and too little on the wood. In current jargon, they had too much of a “microprudential” focus, as opposed to a “macroprudential” one. Monetary authorities, still burnt by the Great Inflation experience, focused narrowly on stabilising near-term inflation. They could not justify raising interest rates if inflation was low and stable, let alone falling, even if financial imbalances were building up. As a result, the imbalances proceeded to grow unchecked.” (Borio 2012, p. 8)
The need for macro-prudential instruments implies that it “is now clear that the achievement of price stability does not guarantee financial stability” (Goodhart 2010, p. 4). This insight leads to the fact that central banks face two targets, namely price and financial stability, but are still left with a single instrument of targeting the short-term interest rate. The general framework, where institutions are able to work independently and capture one objective with specific instruments is therefore not possible to maintain anymore. This raises questions, which have not been necessary to ask until the crisis.
2.3 Types of instruments
If macro-prudential instruments need to be used, they have to be operational, which means that a clear objective needs to be addressed, whereby the overall aim of a sustained financial system is too broad to work as a sufficient objective. There are three reasons why the search
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for a specific objective is a difficult task. Firstly, there are no unique definitions for financial stability, systemic risks and macro-prudential instruments. Secondly, one faces timing problems, which makes it hard to distinguish between prevention policy and crises management (Houben et al. 2012, pp. 15–16). Finally, macro-prudential instruments need to be subdivided into structural and cyclical policies: “structural policies mitigate threats to financial stability that are present at all times while cyclical policies mitigate to the financial system that wax and wane over time” (Elliott et al. 2013, p. 3). The most common instruments in the current debate are hereby capital based tools, which are firstly risk-weighted assets (RWA) and secondly countercyclical capital buffers (CCB), reserve requirements (RR), Loan-to-Value (LTV), Debt-to-Income Requirements (DTI) and dynamic provisioning (Arregui et al. 2013, pp. 22–24).
From this analysis, four subsequent questions arise. If policy makers want to make use of a specific tool, they firstly need to know when to act. This means that early warning indicators are needed. Secondly, policy makers need a conceptual framework, which is able to provide sufficient information about policy effectiveness. Additionally, long-term costs and benefits as well transitional costs and benefits need to be estimated to make an evaluation between different instruments possible. Moreover, macro-prudential instruments could lead to leakages with unintended side effects, which need to be detected and estimated (Arregui et al. 2013, p. 5).
Taking into account the current level of research, outcomes are widespread and none of these issues can be answered with certainty. Additionally, outcomes depend highly on the theoretical framework, its assumptions and its axioms. Besides empirically papers, most of the theoretical papers, which try to develop interactions between macro-prudential instruments and macroeconomics outcomes, are based on the DSGE approach (for instance see (Angeloni, Faia 2013), (Quin, Rabanal 2013) or (Mendoza, Bianchi 2011)).
3. Mainstream theory and financial instability
3.1 Minsky’s criticism on mainstream theoryAs it has been mentioned already, the theoretical framework can be seen as the most important aspect for the evaluation of macro-prudential instruments. Dependent on assumptions and axioms, benefits, costs, effectiveness and undesirable side effects can vary a lot. Minsky was well aware of this circumstance, which let him conclude that economic theory can be seen as the main reason, why policy makers did not pay attention to financial
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instability. His main criticisms about mainstream theory were that a second great depression is not even a possible state in the model but that the economy always tends towards equilibria, that the financial sector is assumed to be neutral for the real economy and not explicitly modelled, that money is not endogenous but totally controlled by the central bank and that it is assumed that banking sector faces risks instead of uncertainty, which leads to dramatically differences in the view about the banking sector.
Minsky demands that two questions need to be asked: “Can ‘It’ - a Great Depression - happen again? And if ‘It’ can happen, why didn’t ‘It’ occur in the years since World War II?” (Minsky 1982a, p. xi) He concludes that “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” (Minsky 1982a, p. xi). Therefore he follows that “within today's standard economic theory, which is commonly called the neoclassical synthesis, the question ‘Why is our economy so unstable?’ is just a nonsense question. Standard economic theory not only does not lead to an explanation of instability as a system attribute, it really does not recognize that endogenous instability is a problem that a satisfactory theory must explain” (Minsky 2008b, pp. 109–110).
Current economic theory, in which the economy always tends towards equilibrium, cannot be taken seriously if one takes the banking sector into account. According to Minsky, “the endogenously determined value of liquidity means that each possible equilibrium of the economy contains disequilibrium forces. Even if the neoclassical proposition that the endogenous workings of the market mechanism will lead an economy from less employment to full employment is valid, the process that brings this about will not stop with full employment, but will carry the economy to a speculative boom” (Minsky 2008b, p. 205). This endogenous behaviour takes place in every capitalistic economy with a banking system and is directly caused by the financial instability hypothesis, which shows the inherent mismatch between financial contracts today and investment outcomes in the future.
Moreover, “money, banking, and finance cannot be understood unless allowance is made for financial evolution and innovation: money, in truth, is an endogenously determined variable – the supply is responsive to demand and not something mechanically controlled by the Federal Reserve” (Minsky 2008b, pp. 252–253). This leads to the fact that the “banker’s activism affects not just the volume and the distribution of finance but also the cyclical behavior of prices, incomes, and employment” (Minsky 2008b, p. 252).
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Additionally, as long as uncertainties in investment decisions remains, which will be the case as long as investments need to be financed, have longer durations, instability within the financial system stays inherently. “Today’s appropriate liability structure for holding any capital asset can be determined only on the basis of history and conventions. In the course of history there have been significant swings in the mix of internal and external financing of investment and much innovation in liability structures. Liability structures (and asset holdings by intermediaries) that were deemed safe when entered upon may turn out to be highly risky as history unfolds” (Minsky 2008b, p. 207). The differentiation between uncertainty and risk is based on Keynes ideas. While risks have probabilities, which allow measurements and the possibilities of insurances, there will be no protection against uncertainty due to the fact that there are no scientific bases.2
Economic theory is hereby the cornerstone, on which perceptions about the economy and objectives depend. “Simulation cannot be better than the model, and the econometric model cannot be closer to reality than the economic theory of the model builder. In particular, instability generated from within the workings of the economy is not caught by models that do not include strong links with the financial structure.” (Minsky 2008b, p. 143) It follows that “policy decisions on the basis of simulations with such models, therefore, reflect the explicit assumption that financial instability cannot occur or is not relevant. Consequently, such decisions ignore a major part of reality and will often result on the economy missing the policy objectives” (Minsky 2008b, p. 144).3
2 “By ‘uncertain’ knowledge, let me explain, I do not mean merely to distinguish what is known for certain from
what is only probable. The game of roulette is not subject, in this sense, to uncertainty; nor is the prospect of a Victory bond being drawn. Or, again, the expectation of life is only slightly uncertain. Even the weather is only moderately uncertain. The sense in which I am using the term is that in which the prospect of a European war is uncertain, or the price of copper and the rate of interest twenty years hence, or the obsolescence of a new invention, or the position of private wealth-owners in the social system in 1970. About these matters there is no scientific basis on which to form any calculable probability whatever.” (J. M. Keynes 1937, pp. 213–214)
3 It needs to be mentioned, that Minsky did not criticize the paradigm as a whole, but only the specific failures
within the theory:
“Economists who offer policy advices are neither fools nor knaves. Knowing instability exists, they nevertheless base their analysis and advice upon a theory that cannot explain instability, because this theory does provide answers to deep and serious questions and has had some success as a basis for policy. Before abandoning or radically revising neoclassical theory, therefore, it is necessary to understand the significance of the deep and serious questions that this theory does answer and why any alternative economic theory must come to grips with the questions that neoclassical theory addresses.” (Minsky 2008b, p. 110)
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3.2 A validity check towards today’s mainstream theory
Minsky formulated his work mainly in the 1970s and1980s, which raises the question, if his criticism is still up to date. Mainstream theory during this time was called the Neoclassical Synthesis. This theory is a consensus in macroeconomics between traditional neoclassical theory and new aspects provided by Keynes. The consensus can be seen as an agreement that markets are largely rational and “that prices and wages did not adjust very quickly to clear markets” (Blanchard 2006, p. 2). Therefore, markets do not provide efficient outcomes under laissez-faire, but only under the use of monetary and fiscal policy, “the old classical truths would come back into relevance” (Blanchard 2006, p. 1). This theory showed first failures in the 1970s, when it was not able to explain events like stagflation. Additionally, Lucas criticized that macroeconomic models are not based on a micro-founded optimisation approach but derived from statistical evidence. The Phillips curve can be used as a good example how anticipation progresses lead to a lack in economic theory, although there has been empirical evidence for it. After discovering the Phillips curve, Market participants took advantage of it and adjusted for the expected inflation so that finally, the original Phillips curve did not hold anymore. ”In short, it appears that policy makers, if they wish to forecast the response of citizens, must take the latter into their confidence” (Lucas 1976, p. 45).
Nowadays, mainstream theory is called the New Neoclassical Synthesis and is grounded in the dynamic stochastic general equilibrium (DSGE) model (Goodfriend, King 1997), which is still a symbiosis of the real business cycle approach and elements of the New Keynesian approach like wage rigidities. It is undeniable that macroeconomic models have improved a lot since the 1980s and are able to capture real-world data for specific economic events (Galí, Gertler 2007, pp. 25–28). Nevertheless, the critique Minsky pointed out 30 years ago is still inherent.4
DSGE models are derived from first principals. This means that “they describe the general equilibrium allocations and prices of the economy in which all agents dynamically maximize their objectives (utility, profits, ect) subject to budget or resource constraints” (Tovar 2008, p. 9). The general equilibrium approach leads to the circumstance that only external shocks like supply side shocks (productivity and labour supply shocks), demand side shocks (preference and government spending shocks), cost-push or mark-up shocks are able to deviate the model from its equilibrium. Additionally, the shocks are assumed to follow a
4 The task of this subchapter is not to provide a comprehensive analysis of DSGE models, but does only focus on
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order autoregressive process, which guaranties a self-stabilizing effect of the model. Minsky’s criticism that financial breakdowns need to be a possible outcome is therefore not only not given but excluded by assumption. In more detail, deviations from equilibrium are calculated with the help of the principle of log-linearization, which again makes use of a first-order Taylor expansion. It therefore assumes linear relations. This may be applicable for small deviations from equilibrium. A financial breakdown like the Great Depression cannot be seen as a small deviation, which makes it very difficult to agree with the assumption of linear relations.
Besides short-term interest rates determined by the central bank, financial markets did not appear in the general models until the crises. It needs to be recognized that a lot of effort has put into research concerning this topic since the crisis. Nowadays, financial frictions are modelled due to a financial accelerator introduced by Bernanke et al. (1999). Although the financial accelerator is a helpful improvement, the addition of one specific financial friction is still far away from capturing a complex financial system (Tovar 2008, p. 5). Although one can expect further improvements in the future, it is uncertain if the model will be ever able to cover a complex and innovative financial market. The reason is that financial markets in DSGE models can only be modelled implicitly because the model is derived from first principals. This means that a banking sector can only affect the representative agent, which again changes the rational decisions and therefore the outcomes of the agent but that a banking sector will never have direct effects within DSGE models.
In DSGE models, central banks determine the short-term interest rate (depending on an interest rate feedback rule), which is able to control the amount of money. This means that money is assumed to be exogenous which contradicts Minsky’s believes that money is created endogenously by the banking sector.5
Rational expectations are one of the main features of DSGE models. This stands in sharp contrast to uncertainty, which is one of the key features of Minsky’ financial instability hypothesis. Additionally, in general models, the long term interest rate is determined by a
5 This thesis gives no room for an extended discussion about exogenous and endogenous money. Nevertheless,
to back up Minsky’s position, Kydland, Prescott (1990, p. 14) stated that “there is no evidence that either the monetary base or M1 leads the cycle, although some economists still believe this monetary myth”. Additionally, according to the Bank of England, namely McLeay et al. (2014), there are two misconceptions about money creation. One is “that banks act simply as intermediaries, lending out the deposits that savers place with them” and the second is that the central bank determines the quantity of loans and deposits in the economy by controlling the quantity of central money – the so-called ‘money-multiplier’ approach” (McLeay et al. 2014, p. 15).
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forward looking IS curve, so that the long term interest rate is the expected path of the short-term interest rate. “As a result shifts in the short-term premium of interest rates play no role in determining output” (Tovar 2008, p. 6). Recalling Minsky, the term premium - highly dependent on the view about the shape of the economy in the future – determines the speed of the economy.
Therefore, it can be summarized that current mainstream theory has not improved the failures Minsky detected. This leads to the results that mainstream macroeconomic theory, namely DSGE models, cannot be used as a tool to evaluate macro-prudential instruments.
3.3 Minsky’s views about how financial instability should be modelled
According to Minsky, the financial instability hypothesis does not have these failures. In his view “the fundamental difference between that viewpoint (Neoclassical Synthesis, author’s note) and the financial instability hypothesis […] centers on the notion of disequilibria and how they are generated. From the neoclassical synthesis, deviations from a full employment-stable price level equilibrium have to be explained by shocks;[…]. Thus, in the neoclassical view "outside" disturbances are responsible whenever the performance of the economy is unsatisfactory.” (Minsky 2008b, p. 127) It follows that “the view that instability is the result of the internal processes of a capitalist economy stands in sharp contrast to neoclassical theory, whether Keynesian or monetarist” (Minsky 2008b, p. 114).
Although Minsky had some attempts modelling his ideas, he was not able to set up a useful model. Nevertheless, a model, which reflects an unstable financial system, is highly necessary in Minsky’s view. The reasons are that “the lender-of-last-resort interventions and the massive government deficits that have succeeded in preventing the sky from falling are strong medicine. Strong medicine often has side effects. Furthermore, we know that the system can evolve so that medicine that was effective in one regime or one set of structures may not be effective in another. In order to examine these issues we need a theory of why our system is susceptible to threats of the sky falling and how particular policy interventions may be successful at one time and ineffective at others” (Minsky 2008b, p. 75).
Additionally, it is possible to identify guidelines how the model should look like and cluster them into five different aspects. Firstly, "it is self-evident that if a theory is to explain an event, the event must be possible." (Minsky 1982a, p. 16) Secondly, "to understand the behaviour of our economy it is necessary to integrate financial relations into an explanation of employment, income and prices. The performance of our economy at any date is closely related to the current success of debtors in fulfilling their commitments and to current views
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of the ability of today's borrowers to fulfill commitments." (Minsky 1982a, p. 17) Thirdly, “to understand how coherence normally rules in a capitalist economy and why it sometimes breaks down, prices cannot be treated as though their only function is to allocate resources and distribute income. Prices also must be related to the need for cash flows to validate the capital assets, financial structure, and business style of the economy. The cash flows that prices carry enable debts to be paid, induce and partially finance investment, and enable new financial obligations to be accepted” (Minsky 2008b, p. 159). It follows that “there are really two systems of prices in a capitalist economy – one for current output and the other for capital assets. […] Business cycles result from a dance of these two price levels, even as the price of a unit of money is fixed at one” (Minsky 2008b, p. 160). Fourthly, “the stability of the economy depends upon the way investment and positions in capital assets are financed. It will be argued that instability is determined by mechanisms within the system, not outside it; our economy is not unstable because it is shocked by oil, wars, or monetary surprises, but because of its nature. The fundamentals of a theory of financial instability can be derived from Keynes’s General Theory, Irving Fisher’s description of a debt deflation, and the writings of Henry Simons.” (Minsky 2008b, p. 198) Fifthly, most important and strongly different from the mainstream paradigm, Minsky argues that “to analyse how financial commitments affect the economy it is necessary to look at economic units in terms of their cash flows. The cash-flow approach looks at all units - be they households, corporations, state and municipal governments, or even national governments - as if they were banks” (Minsky 2008b, p. 221).
4. Minsky’s analysis about financial instability
Hyman Minsky started developing his ideas in the 60s, when financial markets showed first signs of instability since the great depression. Minsky’s work should be famous for two important remarks. Firstly, for his financial instability hypothesis, which showed that stability is destabilizing (also known as the paradox of instability) and secondly, for his call for instruments – derived from the financial instability hypothesis – to sustain financial stability, which would be named macro-prudential instruments nowadays. Interestingly, researchers and policy makers needed a financial crisis to finally listen to the insights Minsky discovered. 4.1 Financial instability hypothesis – the baseline story
"There is, in the financial instability hypothesis, a theory of how a capitalist economy endogenously generates a financial structure which is susceptible to financial crises, and how the normal functioning of financial markets in the resulting boom economy will trigger a financial crisis." (Minsky 1982e, pp. 67–68)
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Minsky started his description of the economy at a time, where firms and banks behave conservatively so that firms have low debt to equity ratios and banks are restrictive in their lending behavior. Restrictive lending implies hereby that banks only fund safe investments and afford high risk premiums for their loans. This makes it additionally unattractive for firms to increase their debt. The reason for this conservative behavior lies in a crisis which happened in the past and is still in the memory of bankers and firm owners.
Due to the fact that the participants of the economy behave conservatively, investment projects succeed which makes bankers and manager realize that they could have taken more risks in the past. Firms are now willing to increase their debt to equity ratio and bankers reduce their risk premiums. This new behavior leads to more investments, which results in higher growth rates and higher asset prices due to higher leverage and a more positive view about the future. “It paid to lever” (Minsky 1982e, p. 65).
The state of an euphoric economy leads to an appearance of the Ponzi financier. The Ponzi financier has recognized that asset prices increased continuously in the past and wants to have a part of the pie. To increase his profits, the Ponzi financier agrees to such a high leverage, that only rising markets will make him able to repay the interest rates for the debt. The appearance of the Ponzi financiers has therefore two effects. Firstly, they help to increase asset prices even faster and secondly, due to the high amount of additional debt, their behavior lead to an increase in interest rates.
The increase in interest rates marks the turning point of the economy. Investments by the firms do not look safe anymore because of higher discounting factors in the future. Given that firms are highly in debt during this state, firms have to sell some of their assets to service their debt costs. The stock market stagnates or decreases which results in severe financing problems for the Ponzi financiers. Banks start realizing that their loans are in danger or see that loans had already turned bad, which leads to a bank-driven increase in interests rates. Additionally, due to an increase in market risks, market participants try to trade liquid assets for their illiquid ones, which decrease stock markets even further (Minsky 2008a, pp. 122– 125).
“Quite suddenly a panic can develop as pressure to lower debt ratios increases” (Minsky 1982e, p. 67). Investments collapse, the economy is not growing anymore, which reduces cash flows dramatically. On the other hand firms are still highly in debt and banks face risks they cannot cover.
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For Minsky there is only one combination, how the economy could escape from a dilemma: asset price deflation combined with current price inflation. If the economy faces high inflation rates during the crisis, the increasing cash flows in comparison to constant debt burdens help firms to finance their debt services. This additional stabilizes the banks’ balance sheets so that the economy can recover quickly.
On the other side, if the rate of inflation stays low, cash flows will stay stable in comparison to the debt levels of the firms. Firms will not be able to finance their service costs, which force them to sell even more of their assets, which again results in a lower debt to equity ratio and in bankruptcy. Whatever the outcome will be, this behavior depresses price levels even further, which again increases the debt to equity ratio and debt to cash flow ratio. Instead of a self-correcting mechanism of the economy, this mechanism is self-reinforcing and will finally result in a depression like it did in 1933, which is perfectly explained by Fisher (1933).6
4.2 Detecting financial instability – The three types of financing
"A capitalist economy with sophisticated financial institutions is capable of a number of modes of behaviour and the mode that actually rules at any time depends upon institutional relations, the structure of financial linkages and the history of the economy." (Minsky 1982d, p. 92)
Minsky starts his description of different types of financing from the basics. At the end, he characterized three different types of financing: Hedge, Speculative and Ponzi financing. The final solution thereby seems simple: The more an economy tends to use speculative and Ponzi financing, the more fragile the financial system and the more likely a financial crisis.7
Three sources of financing can be distinguished: Firstly, cash and equivalent assets, secondly, gross profits after dividends and taxes and thirdly external funds (Minsky 2008b, pp.211-213). Firms in a capitalistic economy have two different types for external funding. First issuing equities, which demands dividends and second going into debt, which demands interests (Minsky 2008, p.205). The second position has hereby important characteristics on the economy. The reason is that the “the debt structure is a legacy of past financing conditions and decisions. The question this analysis raises is whether the future profitability of the business sector can support the financial decisions that were made as the current capital-asset structure of the economy was put into place” (Minsky 1982b, pp. 24–25).
6 This story is based on Minsky (1982c, 1982d, 2008a, pp. 115–127) and Keen (1995, pp. 611–614).
7 The term unit will be used instead of the particular borrower due to the fact that the three different types of
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Minsky specifies gross capital income as the key receipts variable to distinguish between different types of financing, whereby gross capital income can be defined in two ways: firstly, it is the total receipts from operations minus the current labor and material costs, and secondly it is the principal and interest due in debts plus the income taxes plus the owners income. Hedge financing takes place when the expected gross capital income exceeds the payment commitments due to debts in every period. The most important aspect hereby is that “the capitalized value of the flow of gross capital income will exceed the capitalized value of payment commitments at every interest rate (Minsky 1982b, p. 25).This leads to the fact, that hedge financing units cannot become insolvent due to an increase in interest rates. The only way insolvency will be possible if the firm’s revenues decrease so that labor and material costs exceed total receipts from operations.
Speculative financing appears when for some periods the cash payment commitments on debts exceed the expected gross capital income. The speculation symbolizes the belief that refinancing in these periods will be possible. Main reason for this appearance is short term financing, which makes it impossible to repay because the project faces near term cash deficits and cash surpluses in later terms. In opposite to hedge financing, speculative financing is affected by changes in interest rates in three different ways. Firstly, “cash flows which yield a positive excess of asset values over the value of debts at low interest rates may yield a negative excess at high interest rates” (Minsky 1982b, p. 27). Secondly, if assets are of longer term than liabilities, a rise in both “will lead to a greater fall in the market value of their assets than of their liabilities” (Minsky 1982e, p. 67). Thirdly, the view about the liability structure is subjective so that during a roll-over of credit a revaluation may take place (Minsky 1982e, p. 67).
Ponzi financing happens when “units must borrow in order to pay the interest on their outstanding debt: their outstanding debt grows even if no new income yielding assets are acquired” (Minsky 1982b, p. 28). Without doubts, both, units and bankers, still believe that the sum of all future expected cash receipts and payments is positive. Otherwise, Ponzi financing would not happen in the first place. A typical Ponzi finance behavior is to go into debt and buy capital assets - although the interest rates exceed the cash flows from the assets - in the expectation that in the future an increase in the market value will offset the payments for interests. Ponzi financing is the final step and it “cannot carry on too long” (Minsky 1982e, p. 67).
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Minsky concludes that “the mixture of hedge, speculative, and Ponzi finance in an economy is a major determinant of its stability. The existence of a large component of positions financed in a speculative or a Ponzi manner is necessary for financial instability” (Minsky 2008b, p. 232). The overall argument therefore is that speculative and Ponzi financing imply smaller margins of safety, which leads directly to a greater fragility of the financial system. Additionally, financing units are not fixed, but highly depended on the interest rates. “High and rising interest rates can force hedge financing units into speculative financing and speculative financing into Ponzi financing” (Minsky 1982e, p. 67).
4.3 Stabilization factors of the economy
Minsky presents two factors, which explain the circumstance that a second great depression did not happen till the 1980s, namely the importance of big government and the central bank in its function as a lender-of-last-resort.
Big government
An influential government is able to stabilize the economy through 3 different transmission channels: “the income and employment effect, which operates through government demand for goods, services and labor; the budget effect, which operates through generating sectorial surpluses and deficits; and the portfolio effect, which exists because the financial instruments put out to finance a deficit must appear in some portfolio” (Minsky 2008b, p.24). The important factor here is that even if the economy is in the state of panic, the government keeps its cash flows stable. As long as government debt stays sustainable, the additional deficits during recessions improve the balance sheets of corporations and banks. Corporations profit from the income and employment effect as well as from the budget effect. The banking sector profits firstly from the risk-free cash flows provided by the government in the form of interest rates, secondly from an increasing proportion of hedge financing in their balance sheets and thirdly from the improvements of the corporations, which makes their loans more secure (Minsky 2008b, pp.15-41).
Central bank as a lender of last resort
The central bank as a lender of last resort is able to provide the financial system with liquidity, which reduces the need to sell illiquid assets. “The Federal Reserve makes it unnecessary for firms and financial institutions that cannot refinance their positions to try to raise cash by selling assets or borrowing at highly penal rates. Federal Reserve lender-of-last-resort actions, directly or indirectly, set floors under the prices of assets or ceilings on
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financial terms, thus socializing some of the risks involved in speculative finance” (Minsky 2008b, pp. 49-50).
Both stabilization factors are not possible without any costs or upcoming risks. While big government can lead to inflation, the behavior of central banks as a lender of last resort shows banks that liquidity provisions are not necessary which increases financial instability in the future.
4.4 Macro-prudential instruments from a Minsky perspective
"The financial instability hypothesis has policy implications that go beyond the simple rules for monetary and fiscal policy that are derived from the neo-classical synthesis."
(Minsky 1982d, p. 92)
Although Minsky developed his ideas about financial market instability during a time, where the term macro-prudential has not been introduced in economic jargon, Minsky discovered ideas how to stabilize the financial system and the overall economy, which would be called macro-prudential nowadays. Hereby, Minsky was aware of two important things in his analysis, which every policy maker should have had in mind. Firstly, that “it is easy to list objectives, but much more difficult to deliver – to establish institutions and to start processes that will achieve those objectives” (Minsky 2008, p. 319) and secondly that “there is no possibility that we can ever set things right once and for all; instability, put to rest by one set of reforms will, after time, emerge in a new guise” (Minsky 2008, p. 370 (additional see p. 81, p. 199, p. 245, p. 261, p. 264)). Therefore he concluded that “the policy suggestions that have been put forward here are best interpreted as an agenda for discussion rather than a nonnegotiable program. The analysis argues for a system of changes, not for isolated changes” (Minsky 2008b, p. 370).
Capital requirements
Minsky called for a minimum equity-asset ratio of 5 percent. Firstly, this would make additional risk-taking more expensive and secondly, the profit-gaining effect for growing banks would be lowered, which would strengthen decentralized banking. Additionally, “the Federal Reserve should have the right to vary the ratio if aggregate bank capital is compromised” (Minsky 2008b, p. 356). To make sure that banks follow that target, “a penalty constraint upon dividends should be assessed for significant shortfalls of capital” (Minsky 2008b, p. 356). Minsky concluded that the “control over the capital-asset ratio and the pay-out ratio for banks are powerful weapons for guiding the development of banking. Once set, the uniform capital-asset ratio should not be changed routinely, but the authorities regulating
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banking should be granted the power to vary the pay-out ratio if the growth of bank equity is too fast or too slow” (Minsky 2008b, p. 357). The capital requirements should therefore be used as instruments, which strengthen financial stability in the long run.
Central banking in periods of financial fragility
In general, Minsky argued that central banks need to rethink their principal role in the economy: “The Federal Reserve has to be concerned with the effect upon stability of the changing structure of financial relations. This definition of responsibility stands in sharp contrast to the hands-off policy with respect to financial usages and institutions that the Federal Reserve has typically followed” (Minsky 2008b, p. 349).
In more detail, Minsky demanded that central banks should make usage of the discount window instead of open market operations in times of crisis. Open market operations in treasury securities are well-working instruments in times when the financial system is robust, which is presented by small portions of speculative, and Ponzi finance, and businesses, holding a sufficient amount of money and other liquid assets. Generally speaking, bank assets consist of a large amount of government debt and private debt, which reflect hedge financing. In these situations, changes in the interest rates lead to changes in the level of banking activity but not to changes in the stability of the financial system. Every time an increase in the interest rate takes place, “banks will simply substitute business debt for government debt in their portfolios” (Minsky 2008b, p. 360), which will only affect the interest rates on Treasury debt and future financial assets. When the financial system is fragile this separation is not given anymore. Increasing favours for speculative, and Ponzi financing leads to a reduction of the proportion of treasury debt in the balance sheet of banks. Therefore, “no direct business contact exists between commercial banks and the central banks” (Minsky 2008b, p. 360). The shock absorber in robust times – Treasury debt – does not work because banks are now constrained by the rate of growth of bank loans needed to keep speculative and Ponzi financing sustainable. It follows that an increase in the interest rate has a direct effect on available financing and therefore on the stability of the financial system. Minsky therefore argues that “the Federal Reserve should stop relying upon open-market operations to determine reserves of the banking system. As an alternative to open-market operations, the Federal Reserve could furnish bank reserves by discounting bank assets. In the discount technique, bank reserves are furnished when the central bank buys or lends on specified, eligible types of paper that are a result of financing business” (Minsky 2008b, p. 361). This instrument gives the central bank the power to differentiate between different types of assets
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so that interest rates on saver assets (hedge units) are lower than on unsecure assets (Speculative and Ponzi units). It is indispensable that a central bank makes usage of this power every time it intervenes. “Central bank lender-of-last-resort interventions must lead to legislated or administered changes that favour hedge financing” (Minsky 2008b, p. 364). Otherwise, banks recognize that taking too many risks is a secondary issue and central banks assure that there will be a more severe crisis in the future by calming down the current crisis (Minsky 2008b, p. 357-365).
Structural policies
Minsky mentions a set of additional guidelines to sustain financial stability. Short-term financing tends to make the financial system even more fragile and should be scaled back as much as possible (Minsky 2008b, p. 87). Authorities should incentivize banks to prefer to-the-asset financing of inventories again, which means that every loan is directly linked to a specific investment. This finance behavior reflects hedge financing, which – as explained -stabilizes the financial systems and additionally, makes the banking system more transparent (Minsky 2008b, pp. 356-358). Corporate income tax should be removed because of two reasons: Firstly, it rewards debt-financing, which is the root cause of financial instability and secondly it incentivize market power and therefore inefficiencies (Minsky 2008b, p. 340, p. 354). In general, a decentralized banking system with small banks has its advantages because it helps to cut ties between big banks and big corporations and therefore equalizes finance condition between large and small businesses, which again increases competition. Additional to the already mentioned instrument of asset-equity ratios, entry barriers should be lowered and small banks should have the right to act as investment banks (Minsky 2008b, pp. 356-357, p. 367).8
8 It is interesting that some of Minsky’s requirements are currently in the implementation phase, introduced by
Basel III, while some are not even in discussion. For instance, “common equity Tier 1 must be at least 4.5% of risk-weighted assets at all times” (Bank for International Settlements 2011, p. 12).This seems to be close to the asset-to-equity ratio of 5% demanded by Minsky, but risk-weighted assets is by far lower than total assets so that there is still a huge discrepancy between these two requirements. The countercyclical and therefore the additional requirements should be between 0% and 2.5% of Common Equity Tier 1 and depend on the credit-to-GDP gap Bank for International Settlements 2011, which is in line with Minsky. On the other side, a change in the task of Central Banks towards price and financial stability instead of a single focus on price stability is currently not part of the debate.
21 5. A Minsky Model
As shown, Minsky developed a theory, which is able to explain financial crises endogenously. Additionally, he was able to show the need for macro-prudential instruments 30 years earlier than “mainstream” economists. Nevertheless, economists try to evaluate macro-prudential instruments within a framework, which is not able to reflect a "capitalist economy with sophisticated financial institutions" (Minsky 1982d, p. 92). In contrary, Keen (1995, 2009a, 2009b, 2010, 2013a, 2013b) developed a model, which is by far the model most in line with Minsky and therefore shows promising features to evaluate macro-prudential instruments in the future. The developments and mechanisms of this model will be explained in this chapter. Mathematical derivations can be found in the appendix.
5.1 Goodwin’s growth and business cycle
Goodwin (1967) developed a dynamic, non-linear and endogenous growth and business cycle model, which is based on a predator-prey-model, which again is described by Lotka-Volterra-Equations. The model focuses on the interdependencies between capital accumulation and the distribution of income between capital and labor. Thereby, workers’ share of national income takes the place of the predator, whereas the employment rate symbolizes the prey. The cycle reflects a distribution conflict which is in line with Marx ideas and based on Marx’s general law of capitalist accumulation. According to Goodwin (1972, p. 443), the distribution conflict reflects “the most essential dynamic aspects of capitalism”. The system appears simple: Higher investments lead to an increase in the employment rate. A higher employment rate generates higher wages due to a real Philipps curve, which again goes hand in hand with lower earnings. Lower earnings reduce investments so that the employment rate decreases which puts pressure on labour wages. The reduction in the wage share, increases earning, which again increase investments so that the cycle continues.
The economy shows exponential growth rates, which are based on technical progress. A real Philipps curve provides a link between the business and the growth cycle, so that in combination, the business cycle fluctuates around the exponential growth trend.
Money does not exist in this simple model, so that every variable is expressed in real terms. The system shows prevailing constraints which lead to the circumstance that agents always behave in the same way so that the economy fluctuates around a center forever. Additionally,
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the system is structurally unstable, which means that depending on its parameters, the model is able to produce stable and unstable outcomes.9
5.2 Keen’s “Minsky Model”
5.2.1 Adjustments of the Goodwin cycle
Before Keen (1995) introduced Minsky’s ideas into the Goodwin cycle, he had improved three assumptions. Firstly, Keen (1995) replaced the unrealistic assumption that capitalist invest all their profits. Investments now depend on a non-linear relationship of the profit share of income and the inverse of the acceleration relation between capital and output. Secondly, Keen (1995) introduced a non-linear Phillips Curve instead of a linear one. This invention of the Goodwin cycle was firstly presented by (Blatt 1983, pp. 211–216) and is additionally in line with Phillips (1958). Thirdly, a constant depreciating rate was introduced.10
5.2.2 First attempts of introducing Minsky
So far, the Goodwin model is a model without money and debt, where workers’ reactions to the level of unemployment are the driving force. Keen maintains the simplicity of the model but relaxes the assumption that all wages are consumed and all profits saved are invested due to the introduction of the possibility of debt. Keen (1995) adds the simple relationship that the rate of change of debt is investment minus profits. Given that firms now hold debt, profits are not only reduced by wages from output, but additionally by the amount of debt times the interest rate.
The dynamic function for debt is therefore the investment function minus the profit share of income minus the net profit rate (profit rate minus the depreciation rate) times the level of current debt. The possible equilibria and therefore also the possibility of instability within the system depends on the parameters of the non-linear Phillips curve and the non-linear investment function.
Grasselli and Costa Lima (2012, p. 208) show mathematically that at this stage, there exist “two distinct equilibria, a good one with finite debt and strictly positive employment and wage share, and a bad one with infinite debt and zero employment and wage share”. Keen (1995, pp. 620-623) shows by using reasonable parameter values that ceteris paribus, an
9 A detailed mathematical derivation of the model “The mathematical derivations of the Goodwin model” can be
found in the appendix.
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interest rate of less than 4.6 percent will lead to stable equilibrium, whereas interest rates above 4.6 result in a breakdown.
In (Keen 2009a), Ponzi speculations are introduced in the model via a non-linear Ponzi investment function that depends on the rate of economic growth and that is financed entirely by debt. Hereby, Ponzi speculation “does not add to the economy’s productive capacity” (Keen 2009a, p. 352) and is defined as an increasing function of the growth rate of the economy which again is a function of the level of debt and the wage rate times the output level. The model is therefore now 4 dimensional. Grasselli and Costa Lima (2012, p. 204) show that Ponzi financing could become negative in the model, which is not plausible from an economic standpoint. To avoid this, the authors propose to replace the function and use the existing Ponzi funding instead of the output level. On this basis, Grasselli and Costa Lima (2012, pp. 204–208) proof that Ponzi finance is able to “destabilize an otherwise stable equilibrium” (Grasselli, Costa Lima 2012, p. 207), meaning in the absence of Ponzi speculation. This outcome takes place whenever Ponzi financing grows faster than the growth rate of the economy.11
5.3 The Minsky model with endogenous money
At this point, the model is able to generate debt-induced financial breakdowns, which means that “It” can actually happen in this model. Additionally, the model is endogenously determined so that no external shocks are needed, which is in line with Minsky as well. On the other hand, the model does still not explicitly model the financial sector and the model does not make use of cash flows, which is necessary to model money explicitly and endogenously. Minsky pointed out that “to analyse how financial commitments affect the economy it is necessary to look at economic units in terms of their cash flows. The cash-flow approach looks at all units - be they households, corporations, state and municipal governments, or even national governments - as if they were banks.” (Minsky 2008b, p. 221).12
11 The mathematical expressions “Introducing Minsky” can be found in the appendix.
12 This requested approach, called the stock-flow consistent macroeconomics approach, was introduced in the
1970s and has developed and improved since then. This approach has gained more and more interest in the last year. It is well known that there are only a few economists, who saw the financial crisis coming. Bezemer (2010) analyses that most of the economists, who were able to foresee the crisis, took advantage of accounting models. Among others, Wynne Godley, who is one of the founders of this approach, warned a number of times with the help of the stock-flow consistent macroeconomics approach (for instance see (Godley et al. 2007) and (Godley, Zezza 2006)).
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Additionally, the model misses basic requirements for a holistic macroeconomic model, namely that it is not able to explain price dynamics.
Stock-Flow Consistent Macroeconomics
The stock-flow consistent macroeconomic approach is “grounded in double entry systems of accounts […] in which every entry describing an income or expenditure is invariably seen as a transaction between two sectors, with every outlay by one sector having an identical counterpart in the form of a receipt by another” (Godley, Lavoie 2012, p. xlv). This approach therefore offers two highly important features, which other approaches are not able to cover in such an explicit manner: Firstly, an explicit modelled financial sector with all its specific characteristics for firms, households and the government will be available and secondly, the flows of money between the banking system, firms, households and the government will be traceable for each period, which gives the money stock more explanation power than in common models. This approach may be become clearer in the next subchapter.
Keen (2009b, p. 163) makes some substantive deviations from the stock-flow consistent approach. Firstly, time is modelled continuously instead of discretely. According to Keen, this has the advantage that aggregate economic processes are better captured because “time dependencies in discrete-time models often force compromises on the modeller” (Keen 2009b, p. 163). Additionally, in continuous-time models, all entries are flows, while in discrete models some entries have to be stocks. In a continuous time, the stock is therefore just the integral of the flows, which avoids confusions during modelling.
Secondly, the model focuses more on bank transactions accounts via the banking system instead of economic entities like households. The advantage hereby is that financial transactions can be shown explicitly and separately from physical transfers. This will make it easier to model the endogenous creation of money.
Thirdly, a household sector, where “profits from firms, net interest income from financial transactions and wages are aggregated” (Keen 2009b, p. 164) does not exist. This makes it possible to model different behaviours between different social classes.
Finally, the model has fewer restrictions than the stock-flow consistent approach. Firstly, due to the fact of endogenous money, it is no longer compulsory that every row sums to zero. While “transactions between deposit accounts necessarily sum to zero” (Keen 2009b, p. 165) the introduction of the concept of endogenous money growth leads to the fact that entries in the credit account of firms do not find matches from any other account. Secondly, the nth
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equation rule is not required because the differential-equation model “is fully specified by its flows and a set of initial conditions – of which there is one per system state (or stock)” (Keen 2009b, p. 165).
A Minsky model with endogenous money
Keen makes usage of five sectorial accounts. A Bank Vault ( ) that represents the banking sector’s monetary assets; the Bank Saving Account ( ) through which all expenditure and interest payment pass, which can be interpreted as bank equity; a Firm Loan ledger ( ), which records the amount of outstanding debt owed by the firm sector to the banking sector; a Firm Deposit Account ( ) into which the borrowed money is deposited and finally a Worker Deposit Account ( ) into which wages are paid (Keen 2013a, pp. 229–230, 2013b, pp. 240– 242).
Operations within these five accounts can be subdivided into money transfers, accounting operations and money creation, which sum up into fourteen transactions per period.13
Altogether, eight money transfers appear per period.
1. Lending of existing money stock, which is not in circulation from to , defined as a function of the rate of profit ( ( )).
2. Payment of interest on the loan ( ) by to 3. Payment of interest on deposits ( ) by to . 4. Wage payments ( ( ) ( )) by to .
5. Payment of interest on deposits ( ) by to .
6. Payment for consumption with a time constant ( ( )) by to
7. Payment for consumption with a time constant ( ( )) by to .
8. Repayment of loans defined as a nonlinear function of the rate of profit ( ( )) by to .
9. The endogenous creation of new money takes place in due to investment finance, which is defined as a nonlinear function of the rate of profit ( ( )).
13 The table “Table of variables” provides short explanations for every variable and can be found in the
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Additional there are five ledger entries, whose task it is to record the level of debt and which solely takes place in :
10. Recording the loans of the existing money stock ( ( )) from 1. 11. Compounding the debt at the rate of interest on loans ( ). 12. Recording the payment of interest on loans ( ) from 2. 13. Recording the repayment of loans ( ( )) from 8.
14. Recording the endogenous creation of new money ( ( )) from 9 (Keen 2013a, pp. 227–233, 2013b, pp. 240–242).
These 14 operations result in one dynamic equation for each account, whereas 10.-14. solely take place in as a record for the level of debt:
( ) ( ) ( )
( ) ( )
( ) ( ) ( ) ( )
( ) ( ) ( ( ) ( )) ( ) ( )
( )
In a last step, “the financial system is coupled to the physical production model via prices” (Keen 2013a, p. 232). Recalling Goodwin, every variable is expressed in real terms. So far, the Phillips-Curve was also noted in real terms. (Keen 2010) therefore changes this feature to a common Phillips-Curve as follows: Firstly, the monetary value of demand is determined by the sum of wages and profits and in equilibrium, physical output equals physical demand. A combination of these two equations can be solved for an equilibrium price level. Assuming that it takes time ( ) for firms to revise prices out of equilibrium, “it is reasonable to postulate a first-order convergence to this level” (Keen 2010, p. 19) which gives the final dynamic disequilibrium price equation.
Finally, with the help of the dynamic disequilibrium price equation Keen (2013a, p. 232) makes usage of Phillips (1958) to extend the money wage setting relation. The relation
