From the Great Moderation to the Lesser Depression
• Sudden decay of economic conditions in 2007-08:
10
9
8
7
6
5
4
3
2
15
14
13
12
11
1
0



1
2
3
1980
Unemployment
Inflation
1985 1990 1995 2000 2005
2008
2010
0
2015
Year; Source BLS, Federal Reserve Flow of Funds

From the Great Moderation to the Lesser Depression
• Crisis not anticipated by DSGE models:
– OECD Economic Outlook June 2007
– “the current economic situation is in many ways better than what
we have experienced in years…
– Our central forecast remains indeed quite benign:
• a soft landing in the United States, a strong and sustained recovery in Europe,… In line with recent trends,
• sustained growth in OECD economies would be underpinned by
strong job creation and falling unemployment.” (Cotis 2007)
• Great Moderation & Depression anticipated by Minsky-oriented model
– “From the perspective of economic theory and policy, this vision of a capitalist economy with finance requires us to go beyond that habit of mind which Keynes described so well, the excessive reliance on the (stable) recent past as a guide to the future.
– The chaotic dynamics explored in this paper should warn us against accepting a period of relative tranquility in a capitalist
economy as anything other than a lull before the storm.” (Keen
1995)

From the Great Moderation to the Lesser Depression
• Key empirical difference: focus on role of private debt…
20
2008
15
300
280
10
5
0

5

10

15

20

25

30
1980
Unemployment
Inflation
Debt Change
Debt Ratio
1985 1990 1995 2000 2005 2010
160
140
120
100
2015
260
240
0 220
200
180
Year; Source BLS, Federal Reserve Flow of Funds

Minsky approach compared to DGSE approach
• Non-equilibrium & instability rather than equilibrium dynamics
– “Stability—or tranquility—in a world with a cyclical past and capitalist financial institutions is destabilizing” (Minsky 1978)
• Euphoric rather than Rational Expectations
– “Once euphoria sets in … Financial institutions … accept liability structures … that, in a more sober expectational climate, they would have rejected” (Minsky 1972)
• Complexity & Emergent Properties rather than Microfoundations
– “every polynomial … is an excess demand function for a specified commodity in some n commodity economy…”
(Sonnenschein 1972)
• Linear production rather than diminishing marginal productivity
– “Firms … rarely report the upward-sloping marginal cost curves that are ubiquitous in economic theory. Indeed, downward-sloping marginal cost curves are more common.”
(Blinder 1998)

Minsky approach compared to DGSE approach
• Endogenous money rather than money neutrality
– “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)
– “Debt plays a key role in accommodating year-by-year variation in investment.” (Fama and French 1999)
• Government homeostatic stabilizer rather than “Policy Ineffectiveness”
– “Big government prevents the collapse of profits which is a necessary condition for a deep and long depression…” (Minsky 1982)
• Non-equilibrium methods needed to model Fisher/Minsky processes
– “Theoretically … there must be over-or under-production, …overor under-investment … and over or under everything else.
– It is as absurd to assume that, for any long period of time, the variables in the economic organization … will "stay put," in perfect equilibrium, as to assume that the Atlantic Ocean can ever be without a wave.” (Fisher 1933)

The Financial Instability Hypothesis
• Economy in historical time
• Debt-induced recession in recent past
• Firms and banks conservative re debt/equity, assets
• Only conservative projects are funded
– Recovery means most projects succeed
• Firms and banks revise risk premiums
– Accepted debt/equity ratio rises
– Assets revalued upwards…
• “Stability is destabilising”
– Period of tranquility causes expectations to rise…
• Self-fulfilling expectations
– Decline in risk aversion causes increase in investment
– Investment expansion causes economy to grow faster
• Rising expectations leads to “The Euphoric Economy”…

The Financial Instability Hypothesis
• Asset prices rise: speculation on assets profitable
• Increased willingness to lend increases money supply
– Money supply endogenous, not controlled by CB
• Riskier investments enabled, asset speculation rises
• The emergence of “Ponzi” financiers
– Cash flow less than debt servicing costs
– Profit by selling assets on rising market
– Interest-rate insensitive demand for finance
• Rising debt levels & interest rates lead to crisis
– Rising rates make conservative projects speculative
– Non-Ponzi investors sell assets to service debts
– Entry of new sellers floods asset markets
– Rising trend of asset prices falters or reverses

The Financial Instability Hypothesis
• Boom turns to bust
• Ponzi financiers first to go bankrupt
– Can no longer sell assets for a profit
– Debt servicing on assets far exceeds cash flows
• Asset prices collapse, increasing debt/equity ratios
• Endogenous expansion of money supply reverses
• Investment evaporates; economic growth slows
• Economy enters a debt-induced recession
– Back where we started...
• Process repeats once debt levels fall
– But starts from higher debt to GDP level
• Final crisis where debt burden overwhelms economy
• Turning verbal argument into a model…

Cyclical foundations of Minsky model
• Goodwin’s cyclical growth model (1967)
– Capital K determines output Y via accelerator v:
– Y determines employment L via labour productivity a:
– L determines employment rate
 given population N:
–
 determines rate of change of the wage rate w:
– Output minus the wage bill determines profits

:
L Y a
 
L N
1 w
  dw d
    t
 
P h
 
– All profits are invested:
• As a reduced system of ODEs (in

& w
= w/a): d

1
 w dt d w w dt
 

P h v
 
    

• As dynamic flowchart
• Cycles even with linear Phillips curve…
• Generalized for nonlinear investment function & depreciation: d dt



I
   v
    



• System has neutral equilibrium
– (Dominant eigenvalue has zero real part) d w w dt

P h
  

Cyclical foundations of Minsky model
• System inherently cyclical—structural nonlinearity that wage bill = w.L
• Nonlinear functions add realism, not cycles themselves
• Additional realism to introduce Minsky
– Nonlinear investment function: investment exceeds profits during boom, below profits during slump
• No structural change to model, but more realistic simulated values:
105
100
95
90
Goodwin model: closed curves in phase space
85
40 60 80
Wages share of output %
Linear Phillips Curve
Nonlinear Phillips Curve
Nonlinear Phillips & Investment
100 120

Minsky model: introducing debt
• Next element of realism: debt-financed investment:
– “More investment tends to generate more debt, while higher earnings are used to reduce debt.” (Fama and French 1999)
• In equations:
– Rate of change of debt equals investment minus profits
– Profit net of interest payments on debt dD dt
Y w L r D
• Significant structural change to model
• Now 3 dimensions:
– Rate of employment
– Wages share of output
– Debt to output ratio

Minsky (without government)
• As system of ODEs: d dt


I

1 w v d dt w d dt d
 w 

P h
 
 d r
 
I (1 w v

 
   


)
 




I

1 w r d
 
1 w 
• Li and Yorke (1975), “Period Three Implies Chaos”
– Stability now dependent on initial conditions, parameters
– “Inverse tangent route to chaos” (Pomeau and Manneville 1980)
• Equilibrium convergence for some initial conditions
• Divergence for others
– Apparent convergence to stability followed by breakdown

Finance & Economic Breakdown
• Stability for some initial conditions & parameter values…

Finance & Economic Breakdown
• Apparent stability followed by instability for others
– “Great Moderation” followed by “Great Depression”…

Finance & Economic Breakdown
• Model has 2 equilibria:
– “Good equilibrium”:
• Positive incomes, positive employment, & finite debt
– “Bad equilibrium”:
• Zero wage & profit income, zero employment, & infinite debt
• Size of basin of attraction of good equilibrium a negative function of debt to output ratio…
• Outside this basin, convergence to bad equilibrium likely
• Stability of good equilibrium
– Eliminated by “Ponzi” behavior
• Debt-financed speculation on asset prices
– Expanded by government counter-cyclical spending
• Cash flow to private sector enables debts to be serviced, repaid
• Role of private debt in economy crucial…

Finance & Economic Breakdown
• Higher debt ratio gives lower range of stable initial conditions…

Destabilizing a bad stable equilibrium
• Bad equilibrium similar to astronomical Black Hole
– Escape once economy enters its “Event Horizon” impossible unless
• Debt is reduced by bankruptcy, debt jubilees
– Like “ Hawkins Radiation ”: reduce mass of Black Hole
• Reduce real interest rate
– Like reducing gravitational constant
• Non-discretionary government spending can destabilize this bad stable equilibrium
– Government spending rises when unemployment rises;
– Government tax revenues fall when unemployment rises
– Spending gives business cash flow to service/repay debt
• Modelled by introducing government net spending as a function of the employment rate: dG
 g

  
Y dt
Y w L r D G

Destabilizing a bad stable equilibrium
• Results in 4-dimensional system: d dt


I

1 w v
 
   

 d dt w w

P h
    d dt

 r

I (1 w
 d dt g
 g

I (1 v w v
)
 




I

1 w r d g
 
1 w 
)
 
• Counter-cyclical government spending
– Destabilizes bad equilibrium
• Basin of attraction substantially reduced
• Economy can be moved from bad equilibrium with large stimulus
– Makes good equilibrium stable but cyclical…

Destabilizing a bad stable equilibrium
• Cyclical stability around good equilibrium
– Stability not absence of cycles but absence of breakdown…
Minsky model with Government
110
105
100
95
90
85
80
75
70
65
60
55
50
0
Wages Share
Employment
50 100 150 200 250
Years

A strictly monetary macroeconomic model
• Preceding model implicitly monetary
– Debt finances investment in excess of retained earnings
• Explicitly monetary model needed to
– Consider impact of inflation, deflation
– Properly incorporate banking sector into macroeconomics
• Innovation: using accounting tables to build financial flow models
– Explicitly include bank accounts in macroeconomic model
• Firm Debt, Household Debt, Government Debt, etc.
• Deposit accounts of Firms, Households, Government too
• Model endogenous money creation process…

A strictly monetary macroeconomic model
• Monetary foundation enables explicit inflation modeling
– Price dynamics derived from lagged demand-supply convergence dP dt
 

1


 P

P a

W s



– Monetary wages with employment, rate of change of employment, and inflation-compensation dynamics d d t
W

W


P h
1

 d d t

P d dt
P ,0 1
– Simple model with
• Bank lending to Firms only
• Deposit and wage income to households
• Generates stylized facts of Great Moderation/Depression
– Decline in employment & inflation volatility
– Then sudden collapse into deflation & rising unemployment

A strictly monetary macroeconomic model
• Model equations:
Finance Sector d B
V dt dF
L dt

R
F
L
 

L
B
V
 

L
B
V
 

R
F
L
 

I
 
Y dF
D dt dW
D dt dB
S dt

L
B
V
 

R
F
L
 

I

Y r F
L r F W L
W

D
W


B
S
B
   
D

W
D

W r F
L

 r F r W
D


B
S
B

 dP
 dt
Prices an d Wage s

1
P


P
 a
W
  s )

 dW dt

W

P h w

1 d

1 d dt P dt
P
Production
 
R
Y
R
L

K
R
 v
Y
R a dK dt

R

L
N

K
R




I v
 r


P
 



 r
L

K
R
F
L r F
D

Productivity & Population da a dt dN
  
N d t


8
0
7

5
4
4



2
8
1
13
11
4
10
Monetary Macroeconomic Model & Economic Data
• Uncalibrated model output…
• Smoothed actual US data…
Inflation
Unemployment
Debt to GDP
280
260
350
250
0
230
250
220
1995
30
2000
200
150
190
Inflation
Unemployment
Debt to GDP
40
2005
170
50
160
0 0
60
150
2015 1990
20
Year; Source BLS

Monetary Macroeconomic Model & Economic Data
• Income distribution dynamics matter
– Profit share behavior gives no warning of impending crisis
– Rising bank income a sign of danger…
10
9
8
Profit
Bank Income
3
2
1
0
0
7
6
5
4
5 10 15 20 25 30 35 40 45 50 55 60
Years

Extending Monetary Macroeconomic Modelling
• Monetary modelling clearly adds to our understanding of the economy
• Preceding model still very simple & incomplete
• New research agenda: building a platform for monetary modelling
• Extend existing “system dynamics” technology to handle money flows
• Innovation: accounting double-entry creates stock-flow consistent monetary dynamics
– Bank accounts in columns
– Transactions between accounts in rows
– Multiple banks—including Central Bank—easily modelled
– Double-entry to ensure stock-flow consistency
– Complex system of financial flow ODEs built with ease…

Extending Monetary Macroeconomic Modelling
• Enter flows in double entry table:
• Define flows visually:

Extending Monetary Macroeconomic Modelling
• Simulate numerically:

Extending Monetary Macroeconomic Modelling
• Generate stock-flow consistent system of ODEs automatically: d
 dt d
 dt
 d
 
B dt d
dt

 
W
B

W

• Easily linked to physical production system
• Extensible to multiple banks, multiple sectors, input-output dynamics, international trade and financial flows…

Extending Monetary Macroeconomic Modelling
• Multiple banks with Central Bank as clearing house…

Extending Monetary Macroeconomic Modelling
• Multiple sectors, input-output dynamics can be modelled…
15
The Rate of Profit in a Monetary Multisectoral Model of Production
10
5
0

5
0 20 40 t
Years
60
Capital Goods
Consumer Goods
Agriculture
Energy
80 100

Conclusion
• Economic crisis shows need for macro models to incorporate financial sector, debt & money dynamics
• Minsky’s Hypothesis provides insights missing in DSGE models
• Monetary macro models should be added to toolkit of Treasuries,
Central Banks
• Technology to make monetary modelling straightforward now exists
– http://sourceforge.net/p/minsky/home/Home/
• Let’s jointly develop the technology & the models…