Financial Markets Instability: Sources & Remedies A Minskian View Steve Keen University of Western Sydney www.debtdeflation.com/blogs A Primer on Minsky • Firstly ignored by Neoclassical economists: – “Minsky … argued for the inherent instability of the financial system but … departed from the assumption of rational economic behaviour… – I do not deny the possible importance of irrationality in economic life; however it seems that the best research strategy is to push the rationality postulate as far as it will go.” (Bernanke 2000, p. 43) • Now misinterpreted by them (Krugman & Eggertsson 2010) – “A Fisher-Minsky-Koo approach”? • Equilibrium DSGE model • Without endogenous money or banks • Where aggregate debt doesn’t matter (only distribution) A Primer on Minsky • In general rejection of Neoclassical model: – “The abstract model of the neoclassical synthesis cannot generate instability. – When the neoclassical synthesis is constructed, • capital assets, • financing arrangements that center around banks and money creation, • constraints imposed by liabilities, and • the problems associated with knowledge about uncertain futures – are all assumed away. – For economists and policy-makers to do better we have to abandon the neoclassical synthesis.” (Minsky 1982 , p. 5) A Primer on Minsky • In particular (from Fisher & Schumpeter as well as Minsky): – Disequilibrium • “Theoretically there must be over or under everything… • It is as absurd to assume that the variables in the economic organization, or any part of them, will "stay put," in perfect equilibrium, as to assume that the Atlantic Ocean can ever be without a wave.” (Fisher 1933, p. 339) • “Stable growth is inconsistent with an economy in which debt-financed ownership of capital assets exists. It follows that … • the fundamental instability of a capitalist economy is upward. • The tendency to transform doing well into a speculative investment boom is the basic instability in a capitalist economy.” (Minsky 1982) A Primer on Endogenous money • Endogenous money and banks (Schumpeter 1934, p. 73) – “the conventional answer is not obviously absurd, – yet there is another method of obtaining money… – the creation of purchasing power by banks… – It is not transforming purchasing power which already exists – but the creation of new purchasing power out of nothing.” • Debt—Investment link confirmed by Fama-French empirical work: – “These correlations confirm the impression that debt plays a key role in accommodating year-by-year variation in investment.” (Fama and French 1999, p. 1954) – “Debt seems to be the residual variable in financing decisions. Investment increases debt, higher earnings tend to reduce debt.” For Absent Friends… ”I’m all for including the banking sector in stories where it’s relevant; but why is it so crucial to a story about debt and leverage?” • New York Fed Senior VP Alan Holmes (1969): Monetarism makes… • “a naive assumption that the banking system only expands loans after the System or market factors have put reserves in the banking system. • In the real world, banks extend credit, creating deposits in the process, and look for the reserves later. • In any given statement week, the reserves required to be maintained by the banking system are predetermined by the level of deposits existing two weeks earlier. • Since excess reserves in the banking system normally run at frictional levels the level of total reserves in any given statement week is also pretty well determined in advance. • Since banks have to meet their reserve requirements each week … that total amount of reserves has to be available to the banking system.” For Absent Friends… • “There is no evidence that either the monetary base or M1 leads the cycle, although some economists still believe this monetary myth… • The difference of M2-M1 leads the cycle by even more than M2, with the lead being about three quarters… • The fact that the transaction component of real cash balances (M1) moves contemporaneously with the cycle while the much larger nontransaction component (M2) leads the cycle suggests that credit arrangements could play a significant role in future business cycle theory. • Introducing money and credit into growth theory in a way that accounts for the cyclical behavior of monetary as well as real aggregates is an important open problem in economics.” (Kydland and Prescott 1990) A Primer on Minsky continued • Minsky: growing aggregate private debt source of economic growth – “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 be greater than current received income and – that some market technique exist by which aggregate spending in excess of aggregate anticipated income can be financed. – 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 1982) • Rising debt also finances Ponzi behaviour & asset bubbles A Primer on Minsky • “Ponzi income falls short of interest payments on debt so that the outstanding debt will grow due to interest on existing debt… Ponzi units can fulfill their payment commitments on debts only by borrowing… a Ponzi unit must increase its outstanding debts.’ (Minsky 1982, p. 24) • Ponzi debt drives up asset prices: • “During a period of tranquility, there will be a decline in the value of the insurance that the holding of money bestows. • This will lead to a rise in the price of capital assets so that a larger admixture of Ponzi finance is accepted by bankers. • In this way the financial system endogenously generates at least part of the finance needed by the increased investment demand that follows a rise in the price of capital assets.” (Minsky 1982, p. 107) A strictly monetary view of aggregate demand • Two sources of monetary demand – Income (Wages + Profits) – Borrowing (Change in Debt) • Two categories of supply – Goods & Services (Consumer + Investment Goods/Services) – Net new financial assets • Schumpeter: – Incomes mainly spent on consumption – Change in debt main source of funds for investment • Minsky: Change in debt also finances Ponzi behavior Wages Profits d D Consumption Investment NetFIRE dt Walras-Schumpeter-Minsky Law • Aggregate Demand = Income + Change in Debt • Aggregate Supply = Good & Services + Net Asset Turnover d D GDP NetFIRE dt Implications for macro & finance: NetFIRE PA QA TA Y • – Change in debt a factor in level of employment, output – Debt acceleration drives change in GDP & asset prices d d2 d d Y 2 D GDP PA QA TA dt dt dt dt • Change in debt explains crisis (& “Great Moderation” before it) • Accelerating debt explains why asset bubbles must burst Aggregate debt overview • Private debt far more important than government debt: US Debt to GDP 320 300 280 • Only the Great Depression compares to now • & “Roaring Twenties” to “The Great Moderation” P rivate P ublic Percent of GDP 260 240 220 200 180 160 140 120 100 80 60 40 20 0 1920 1930 1940 1950 1960 1970 1980 1990 www.debtdeflation.com/blo gs 2000 2010 2020 Aggregate debt overview • Higher level of debt today than now • Different distribution part of why crisis less severe Percent of GDP Debt to GDP by Sector 170 160 150 140 130 120 110 100 90 80 70 60 50 40 30 20 10 0 1920 Business Finance Household 1930 1940 1950 1960 1970 1980 www.debtdeflation.com/blogs 1990 2000 2010 2020 • Dynamics of aggregate private debt explain both Depressions Change in Debt & Aggregate Demand • Great Depression: US $ million p.a. US Aggregate Demand 1920-1940 120000 115000 110000 105000 100000 95000 90000 85000 80000 75000 70000 65000 60000 55000 50000 45000 40000 35000 30000 1920 Nominal GDP +Change in P rivate Debt +Change in P ublic Debt 1922 1924 1926 1928 1930 1932 www.debtdeflation.com/blo gs 1934 1936 1938 1940 Change in Debt & Aggregate Demand • Today—compared to Then US USAggregate Aggregate Demand Demand 1920-1940 1980-2012 US $ million p.a. US $ million p.a. 7 1.9 120000 10 7 115000 1.8 10 7 110000 1.7 10 7 105000 1.6 10 1000007 1.510 950007 1.490000 10 7 1.385000 10 7 1.280000 10 7 1.175000 10 7 170000 10 6 965000 10 6 860000 10 550006 710 500006 610 450006 540000 10 6 435000 10 6 330000 10 1980 1920 Nom inal GDP +Change in P rivat e Debt +Change in P ublic Debt Nominal GDP +Change in P rivate Debt +Change in P ublic Debt 1982 1922 1984 1986 19241988 1990 1926 1992 1928 1994 199619301998 2000 1932 2002 1934 2004 www.debt www.debtdeflation.com/blo deflat ion.com /blogs gs 20061936 2008 2010 1938 2012 1940 2014 Acceleration in Debt & Change in Employment • Then… 20 10 15 7.5 10 5 5 2.5 0 0 0 -5 - 2.5 - 10 -5 - 15 - 7.5 - 20 - 10 - 25 - 30 1920 Credit Acceleration Employment Change 1922 1924 1926 1928 - 12.5 1930 1932 1934 www.debtdeflation.com/blogs 1936 1938 - 15 1940 Change in 100 minus unemployment rate p.a. Private Debt Acceleration p.a. as percent of GDP Credit Acceleration & Employment Change (Corr=0.76) Acceleration in Debt & Change in Employment • Now (compared to then) 20 15 10 3 15 10 7.5 2 10 5 5 1 5 0 2.5 0 0 0 0 -1 - 2.5 0 -5 -5 - 10 - 10 -2 -5 - 15 - 15 -3 - 7.5 - 20 - 20 -4 - 10 - 25 Credit Acceleration Employment Change 5 - 12.5 - 30 - 15 6 1920 1922 1924 192619921928 1930 193220021934 1936 1938 1980 1982 1984 1986 1988 1990 1994 1996 1998 2000 2004 2006 2008 2010 2012 1940 2014 www.debtdeflation.com/blogs Change in 100 minus unemployment rate p.a. Change in 100 minus unemployment rate p.a. Private Debt Acceleration p.a. as percent of GDP Credit Acceleration & Employment Change (Corr=0.76) (Corr=0.69) Share Prices—the long view • Dow Jones deflated by the CPI DJIA deflated by t he CPI 1200 1100 1000 Index (2012/02/01: 979) Mean 1915-1995 (245) T rend 1915-1995 (2012/02/0 1: 584) Index 1915 = 100 900 800 700 600 500 400 300 200 100 0 1910 1920 1930 1940 1950 1960 1970 1980 1990 2000 www.debt deflat ion.com /blogs 2010 2020 Share Prices—the long view • Deviation from trend Point deviation above or below trend, 1915=0 CPI-deflated DJIA minus 1915-1995 Trend 800 700 600 500 400 300 200 100 0 0 - 100 - 200 1910 1920 1930 1940 1950 1960 1970 1980 1990 2000 www.debt deflat ion.com /blogs 2010 2020 Acceleration in Debt & Change in Dow Jones • Then 20 200 15 150 10 100 5 50 0 0 0 -5 - 50 - 10 - 100 - 15 - 150 - 20 - 200 - 25 - 30 1920 Credit Accelerat ion DJIA Ch ange 1922 1924 1926 1928 - 250 1930 1932 1934 1936 www.debt deflat ion.com /blogs 1938 1940 - 300 1942 Annual Change Deviation from Trend DJIA Percent Credit Acceleration p.a. Percent of GDP (1 year lag) Credit Accelerator & DJIA Deviation from Trend (Corr=0.65) Acceleration in Debt & Change in Dow Jones • Now (compared to then) 20 200 100 15 150 75 10 100 50 5 50 25 0 0 0 -5 50 - 25 - 10 100 - 50 - 15 150 - 75 - 20 200 - 100 - 25 Credit Accelerat ion DJIA Ch ange - 30 1920 1988 19221990 1924 1928 1998 193020001932 1936 2008 1938 1986 1992 1926 1994 1996 2002 1934 2004 2006 2010 1940 2012 www.debt deflat ion.com /blogs 250 - 125 300 - 150 1942 2014 Annual Change Deviation from Trend DJIA Percent Acceleration p.a. Percent of GDP CreditCredit Acceleration p.a. Percent of GDP (1 year lag) (Corr=0.65) Credit Accelerator & DJIA Deviation from Trend (Corr=0.34) House Prices deflated by CPI—the long view • NO trend; long term average 98 Real House Price Index 300 275 250 Index 1890 = 100 225 200 175 150 Greenspan Index (2006/04: 262; 2012 /01: 173 ) Mean 1890-1997 (98) • “a "bubble" in home prices does not appear likely • home price declines, were they to occur, likely would not have substantial macroeconomic implications.” (Greenspan to Congress, August 2005) 125 100 75 50 25 0 1890 1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 www.debt deflat ion.com /blo gs; Case-Shiller In dex 2000 2010 2020 Acceleration in Mortgages & Change in House Prices 7 21 6 18 5 15 4 12 3 9 2 6 1 3 0 0 0 -1 -3 -2 -6 -3 -9 -4 - 12 -5 -6 -7 1986 - 15 Mortgage Accelerator Change in Real House Prices 1988 1990 1992 1994 1996 1998 - 18 2000 2002 2004 2006 www.debtdeflation.com/blogs 2008 2010 2012 - 21 2014 Percent change in real Case-Shiller Index p.a. Percent of GDP Mortgage Acceleration & House Price Movements (Corr=0.78) Sources & Remedies • Accelerating debt THE source of asset price bubbles • Breaking debt-asset price nexus essential to stop bubbles • Two modest but fundamental proposals – “Jubilee Shares” • Last forever when purchased from firm • Can be sold on secondary market 7 times • After 7th sale, last 50 years then expire – “The Pill” • Property Income Limited Leverage – Maximum mortgage (say) 1o times property income • NO reliance on regulators, fine tuning, etc. • Negative feedback loop between asset prices & change in debt • Debt reserved for beneficial investment, not Ponzi Schemes “Just one more thing…Remedy for today’s crisis” • “Modern Debt Jubilee” – “Quantitative easing for the public” • Cancel irresponsibly created debt without penalizing savers – Fiat money injection via private bank accounts • First usage must be debt reduction • Bank debt necessarily paid down – Solvency maintained, liquidity challenged • Bonds reduced in value • But non-debtor bond-holders receive cash injection – Minimal damage to aggregate demand, inflation/deflation