Krugman would definitely subtitle a post like this “Wonkish”!

Click here for this post in PDF: Debtwatch; CfESI

This is a paper I’ve recently submitted by invitation to an Australian economics journal. I have been very quiet on the blog while finishing this in the last 2 weeks. I’m likely to remain quiet for the next fortnight, since I leave for the Fields Institute in Toronto on June 1^st, where I’ll be working for a month with the mathematicians there to analyze and refine my various models of financial instability. Grasselli and Costa Lima have already done a brilliant job analyzing my 1995 model in this paper.

Abstract

The “Global Financial Crisis” is widely acknowledged to be a tail event for neoclassical economics (Stevens 2008), but it was an expected outcome for a range of non-neoclassical economists from the Austrian and Post Keynesian schools. This article will provide a survey of the relevant Post Keynesian approaches for readers who are not familiar with this literature. Though it will cover the history of how Post Keynesian economics came to diverge so much from the neoclassical mainstream, the focus will be on the current state of Post Keynesian macroeconomics and its alternative indicators of macroeconomic turbulence, rather than historical exegesis.

1. A “Black Swan”?

   I do not know anyone who predicted this course of events. This should give us cause to reflect on how hard a job it is to make genuinely useful forecasts. What we have seen is truly a ‘tail’ outcome—the kind of outcome that the routine forecasting process never predicts. But it has occurred, it has implications, and so we must reflect on it.(Stevens 2008, p. 7)

RBA Governor Stevens’ remarks succinctly expressed the Neoclassical reaction to the “Global Financial Crisis” (GFC). It was not anticipated by any Neoclassical economic model—au contraire, in 2007 all conventional models predicted a continuance of “the Great Moderation” (Bernanke 2004; Bernanke 2004), with the OECD’s observation that “the current economic situation is in many ways better than what we have experienced in years” (OECD 2007, p. 7) being typical of official forecasts for 2008.

In the wake of that dramatically wrong forecast, the crisis that began in late 2007 and continues to this day is regarded as an inherently unpredictable event, due to the scale of unanticipated and unforeseeable exogenous shocks. Once shocks of the required magnitude and variability are injected into DSGE models, the behavior at the time of the crisis emerges (McKibbin and Stoeckel 2009; Ireland 2011) [but see Solow 2003, p. 1], but this behavior could not have been anticipated prior to the crisis.

Figure 1: The sudden transition from Great Moderation to Great Recession in the USA

On the other hand, a number of economists and market commentators claim to have anticipated the crisis (Bezemer 2009; see also Fullbrook 2010). Bezemer identified twelve individuals with a legitimate claim to having foreseen this crisis, on the basis of four selection criteria:

Only analysts were included who provide some account on how they arrived at their conclusions. Second, the analysts included went beyond predicting a real estate crisis, also making the link to real-sector recessionary implications, including an analytical account of those links. Third, the actual prediction must have been made by the analyst and available in the public domain, rather than being asserted by others. Finally, the prediction had to have some timing attached to it. (Bezemer 2009, p. 7)

However, only two of the twelve were guided by mathematical models: Wynne Godley (Godley and Wray 2000; Godley and Izurieta 2002; Godley and Izurieta 2004; Godley and Lavoie 2007) and myself (Keen 1995, 1996, 1997, 2000, 2007)—see Table 1, which is adapted from Bezemer (Bezemer 2009, p. 9). To evaluate whether this crisis could have been forecast, one has to compare like with like: are there mathematical models of the macroeconomy that did what Neoclassical models did not—anticipate the Global Financial Crisis?; and are there empirical indicators that are not included in Neoclassical macroeconomic models that did indicate that a crisis was approaching?

Table 1: Predictors of the Global Financial Crisis (adapted from Bezemer, 2009, Table 1)

On the record, there are only two contending mathematical approaches—the “Stock-Flow Consistent” framework developed by Godley, and the complex systems approach I use to model Minsky’s “Financial Instability Hypothesis” (Minsky 1977); and two key indicators—sectoral imbalances identified by Godley’s approach, and the ratio of private debt to GDP that plays a key role in my models.

Both Godley and I self-identify as Post-Keynesian, though there are large differences in our approaches. This survey article will introduce our models to an audience far more familiar with Neoclassical modelling. Some attention will be given to criticisms of Neoclassical macroeconomics, “What Keynes Really Meant” textual exegesis, and the development of our approaches in the context of earlier Post Keynesian research, but these are only preliminaries to describing our approaches to macroeconomic modeling to an audience that is not familiar with them. This paper is also not a history of Post Keynesian economics—for that, see (King 2003; King 2012). What history there is a “Whig history” of the evolution of my and Godley’s approaches to monetary macroeconomics.

1. Divergence: Equilibrium, Expectations, Microfoundations and Money

There are 5 key areas in which modern Post-Keynesian macroeconomics differs from Neoclassical macroeconomics: the role of equilibrium, the nature of expectations, the need for microfoundations, the model of production, the role of money, and the role of government. The reasons for these differences are set out below, not in an attempt to persuade Neoclassical readers on these issues, but to establish that the fact that Post Keynesian models do not conform to Neoclassical principles does not provide an a priori reason to reject these approaches to macroeconomic modeling.

1. Equilibrium

It is well-known that the IS-LM model was developed by Hicks rather than Keynes (Hicks 1937), but was accepted “as a convenient synopsis of Keynesian theory” (Hicks 1981, p. 139) by the vast majority of economists. The development of Post Keynesian macroeconomics began with economists like Joan Robinson in the UK (Robinson 1964) and Paul Davidson in the USA (Davidson 1969) who instead rejected ‘Mr Keynes & the “Classics”‘ (Hicks 1937) as “an article which … misses Keynes’ point completely” (Minsky 1969, p. 225).

What is less well known is that the elder Sir John Hicks agreed with the critics, and disowned the IS-LM model as an inadequate basis for macroeconomics. Whereas Neoclassical economics also rejected IS-LM, on the basis that the model did not have good microfoundations, Hicks rejected it because, he argued, it required the unacceptable assumption that the economy was in equilibrium at all times.

Reflecting on his creation in 1981, Hicks observed firstly that it was not a model of Keynes General Theory, since he had conceived of IS-LM “before I wrote even the first of my papers on Keynes” (Hicks 1981, p. 140), and secondly that it was Walrasian rather than Keynesian in origin (Hicks 1981, p. 141-142).

One essentially Walrasian foundation of IS-LM was the representation of a 3-market system as a 2 market model under the assumption that, if two of the markets were in equilibrium, then so was the third by Walras’ Law. Hicks therefore ignored the market for loanable funds (and also the labor market) in the IS-LM model:

‘One did not have to bother about the market for “loanable funds,” since it appeared, on the Walras analogy, that if these two “markets” were in equilibrium, the third must be also. So I concluded that the intersection of IS and LM determined the equilibrium of the system as a whole.’ (Hicks 1981, p. 142)

However, this Walrasian analogy applied in reverse in disequilibrium: if one of the two markets in IS-LM was out of equilibrium, then necessarily so was the other—and/or the other markets ignored in equilibrium had also to be considered. Consequently, the only point in the IS-LM diagram that “makes any claim to representing what actually happened” (Hicks 1981, p. 149) is the intersection of the IS and LM curves. This in turn requires assuming that the economy is always in equilibrium.

This had to be rejected, Hicks argued, because assuming continuous equilibrium also meant assuming that expectations were fulfilled at all times, whereas at crucial turning points in the economy “the system was not in equilibrium. There were plans which failed to be carried through as intended; there were surprises.” (Hicks 1981, p. 150). Macroeconomics therefore had to be about disequilibrium—which he described as “the traverse”

When one turns to questions of policy … the use of equilibrium methods is still more suspect. … There can be no change of policy if everything is to go on as expected—if the economy is to remain in what (however approximately) may be regarded as its existing equilibrium. It may be hoped that, after the change in policy, the economy will somehow, at some time in the future, settle into what may be regarded, in the same sense, as a new equilibrium; but there must necessarily be a stage before that equilibrium is reached. There must always be a problem of traverse. For the study of a traverse, one has to have recourse to sequential methods of one kind or another. (Hicks 1981, pp. 152-153)

This proposition that macroeconomics must be a study of disequilibrium states is a common theme in Post-Keynesian economics (Fisher 1933; Kaldor 1940; Kaldor 1951; Goodwin 1967; Kornai 1971; Robinson 1974; Goodwin 1986). Our macroeconomic models fit within this theme, with Godley’s model expressed in difference equations while I employ nonlinear differential equations.

1. Expectations

A long line of non-Neoclassical economists have emphasized the role of uncertainty in economics, and especially in Keynes’s analysis. Keynes once famously described economic theory prior to his work as “one of these pretty, polite techniques which tries to deal with the present by abstracting from the fact that we know very little about the future” (Keynes 1937, p. 215). To Post Keynesians, the “Rational Expectations Revolution” replaced this with an even prettier but less polite technique that assumed that the future could be predicted by agents endowed with “rational expectations”.

The transition from IS-LM to Rational Expectations macroeconomics began the Lucas Critique (Lucas 1976), and its well-founded objections to using historical relations in large scale macroeconomic models to predict behavior under future policy regimes. However, that paper continued a research agenda into the “Natural Rate Hypothesis” (NRH) in which Lucas had previously acknowledged that the NRH required the assumption that inflationary expectations are accurate, and that assuming “expectations are rational in the sense of Muth” was equivalent to adding the assumption that inflationary expectations were accurate “simply … as an additional axiom” (Lucas 1972, p. 55).

This was more than one axiom too far for Post Keynesian economists, who insisted that expectations formation under uncertainty was a crucial aspect of reality, and that this had to allow for investors on occasions making decisions that “in a more sober expectational climate, they would have rejected” (Minsky 1972; Minsky 1982, p. 117). Rational expectations, to coin a phrase, meant “never having to say you were drunk”. Godley’s models and mine allow for expectations to be based on inaccurate estimates of future outcomes, while still being derived from rational responses to current information, given the inherent uncertainty of the future (Blatt 1979; Blatt 1980).

1. Microfoundations

Lucas’s observation that “Nobody was satisfied with IS-LM as the end of macroeconomic theorizing” pithily summarizes the key motivation behind the evolution of Neoclassical macroeconomics from the time of Keynes: “The idea was we were going to tie it together with microeconomics and that was the job of our generation” (Lucas 2004, p. 20). The major argument in favor of a micro-founded macroeconomics was that micro analysis could provide the “deep parameters” that were invariant to policy changes (Estrella and Fuhrer 1999; Estrella and Fuhrer 2003; Ljungqvist and Sargent 2004, pp. xxvi-xxvii ), in contrast to the parameters of large-scale econometric models which would be subject to drift as policy changed (Lucas 1976, p. 39). This led initially to Real Business Cycle models in which the entire economy was modeled by a “representative agent” (Kydland and Prescott 1982), and ultimately to New Keynesian macroeconomics (Gordon 1982; Woodford 2009).

Post Keynesians rejected the argument that macroeconomics could be derived from microeconomics (Kregel 1985). Though this position is contrary to Neoclassical practice, it is in fact supported by well-known but poorly understood Neoclassical research: the Sonnenschein-Mantel-Debreu theorems (Shafer and Sonnenschein 1993). While these are portrayed in textbooks as arguing simply that “stringent conditions” are needed to ensure that a representative agent can be used to model aggregate behavior (Varian 1984, p. 268), their real import is that the “Law of Demand” does not apply at the level of a single market, even if all consumers in that market are rational utility maximizers:

Can an arbitrary continuous function … be an excess demand function for some commodity in a general equilibrium economy? … we prove that every polynomial … is an excess demand function for a specified commodity in some n commodity economy… every continuous real-valued function is approximately an excess demand function. (Sonnenschein 1972, pp. 549-550)

The fact that demand in a single market cannot be legitimately modeled as being derived from a representative agent (and thus subject to the Law of Demand) strongly implies that aggregate demand cannot be modeled that way either: microeconomic “deep parameters” are therefore lost in the interactions between agents. This is an instance of a common phenomenon arising from the interaction of multiple entities in a system, which physicists have dubbed “Emergent Properties”: the system itself cannot be understood from the properties of the entities themselves, since its behavior depends on nonlinear interactions between the entities. As Physics Nobel Laureate Philip Anderson put it:

The behavior of large and complex aggregates of elementary particles, it turns out, is not to be understood in terms of a simple extrapolation of the properties of a few particles. Instead, at each level of complexity entirely new properties appear, and the understanding of the new behaviors requires research which I think is as fundamental in its nature as any other… (Anderson 1972, p. 393)

Anderson continued that “Psychology is not applied biology, nor is biology applied chemistry” (Anderson 1972, p. 393), and Post Keynesians similarly assert that “Macroeconomics is not applied microeconomics”. Godley’s models work at the level of economic sectors—households, firms, the government and banks—while my models work at the level of social classes, in line with Andrew Kirman’s reaction to the SMD conditions that “we may well be forced to theories in terms of groups who have collectively coherent behavior…. The idea that we should start at the level of the isolated individual is one which we may well have to abandon.” (Kirman 1989, p. 138).

1. Production

Substitutability of inputs, rising marginal cost and diminishing marginal productivity are familiar elements of Neoclassical micro and macroeconomics. Post-Keynesian micro and macroeconomics instead assume fixed proportions between inputs, constant or even falling marginal costs, abjure the relevance of marginal productivity, and in particular reject the Cobb-Douglas production function (see section 7).

The Post Keynesian position is based on almost 80 years of empirical research—commencing with the Oxford Economists Research Group in 1934 in the UK (Hall and Hitch 1939; Lee 1981; Besomi 1998; Simon and Slater 1998) and Gardiner Means in the USA (Means 1936)—which has found that, despite its a priori appeal, diminishing marginal productivity and rising marginal cost are the exception rather than the rule for industrial companies.

The most recent work confirming this result was done by Alan Blinder, who after a careful survey of 200 firms that collectively accounted for 7.6% of US GDP {Blinder, 1998 #297, p. 68}, reported that:

The overwhelmingly bad news here (for economic theory) is that, apparently, only 11 percent of GDP is produced under conditions of rising marginal cost. .. (Blinder 1998, p. 102)… 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, p. 302)

Table 2: Blinder’s survey results on firm cost structures (pp. 100-106)

This result is consistent with inputs being used in fixed proportions, and Post Keynesian macroeconomic models treat production as linearly related to labor and intermediate good inputs (with variable utilization of fixed capital in some instances), a position first put logically by Sraffa (Sraffa 1926).

1. Money

Money neutrality—certainly in the long run and, under Rational Expectations, also in the short run—is an essential aspect of the Neoclassical approach, in which macroeconomic models abstract from the existence of money, private debt, and banks. To Neoclassicals, the argument that changes in monetary variables impact upon real economic variables smacks of the fallacy of money illusion, and the difficulty lies in reconciling this principle with the empirical record:

It is natural (to an economist) to view the cyclical correlation between real output and prices as arising from a volatile aggregate demand schedule that traces out a relatively stable, upward-sloping supply curve. This point of departure leads to something of a paradox, since the absence of money illusion on the part of firms and consumers appears to imply a vertical aggregate supply schedule, which in turn implies that aggregate demand fluctuations of a purely nominal nature should lead to price fluctuations only. (Lucas 1972, p. 51)

Post Keynesian economists initially rejected money neutrality on the basis of Keynes’s argument that a monetary economy “is essentially one in which changing views about the future are capable of influencing the quantity of employment and not merely its direction” (Keynes 1936, p. xxii), thus conflating money with uncertainty. They also rejected the applicability of the concept of money illusion in a credit-based economy with nominal debts, since even Friedman’s statement of it conceded that it was only strictly true if debts were denominated in real terms:

nothing is so unimportant as the quantity of money expressed in terms of the nominal monetary unit … let the number of dollars in existence be multiplied by 100; that, too, will have no other essential effect, provided that all other nominal magnitudes (prices of goods and services, and quantities of other assets and liabilities that are expressed in nominal terms) are also multiplied by 100. (Friedman 1969, p. 1; emphasis added)

Later work into the mechanics of money creation strengthened the case for distinguishing the macroeconomics of a monetary economy from a non-monetary one. Basil Moore (Moore 1979) argued that bank lending was not effectively constrained by the reserve-setting behavior of Central Banks, using both empirical analysis and the mechanics of Federal Reserve behavior. As Federal Reserve Bank of New York Vice President Alan Holmes put it in his arguments opposing Monetarism in 1969:

The idea of a regular injection of reserves … also suffers from 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… the reserves required to be maintained by the banking system are predetermined by the level of deposits existing two weeks earlier. (Holmes 1969, p. 73)

The relationship of loans and deposits leading and reserves lagging is more pronounced today, with the reserve lag now being 30 days (O’Brien 2007, Table 12, p. 52). The European Central Bank has also recently confirmed that the Post Keynesian position that “loans create deposits, and determine reserves with a lag” accurately describes private and Central Bank procedures:

In fact, the ECB’s reserve requirements are backward-looking, i.e. they depend on the stock of deposits (and other liabilities of credit institutions) subject to reserve requirements as it stood in the previous period, and thus after banks have extended the credit demanded by their customers. (ECB 2012, p. 21)

These operational perspectives on the endogenous creation of money by banks were confirmed by empirical work into the timing of economic variables by Kydland and Prescott, where they concluded that

the monetary base lags the cycle slightly… The difference of M2-M1 leads the cycle by … 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, pp. 4, 15)

More recently, the collapse in the ratio of broad money to base money during and after the crisis inspired an FRB Discussion Paper which concluded that:

the relationships implied by the money multiplier do not exist in the data for the most liquid and well-capitalized banks. Changes in reserves are unrelated to changes in lending, and open market operations do not have a direct impact on lending. We conclude that the textbook treatment of money in the transmission mechanism can be rejected. (Carpenter and Demiralp 2010, pp. 27-28)

However these empirical realities alone are not sufficient to support a critical role for banks, money and debt in macroeconomics: there must also be a link between change in monetary variables and change in real economic activity. The proposition that there is such a link was first put by Schumpeter, when he argued that the dominant source of funds for entrepreneurial investment was the creation of additional spending power by banks—not by transferring funds from savers to borrowers, but by the process of simultaneously creating both a deposit and a debt for a borrower without reducing the spending capacity of savers.

In Schumpeter’s model, entrepreneurs were individuals with concepts that could transform production or distribution in a discontinuous way—and thus yield “super-normal” profits to themselves—but no money with which to put these concepts into action. They therefore had to borrow:

the entrepreneur … can only become an entrepreneur by previously becoming a debtor… his becoming a debtor arises from the necessity of the case and is not something abnormal, an accidental event to be explained by particular circumstances. What he first wants is credit. Before he requires any goods whatever, he requires purchasing power. He is the typical debtor in capitalist society.’ (Schumpeter 1934, p. 102)

Schumpeter conceded that some of this finance could arise from saving—abstaining from consumption—but argued that this was minor compared to the endogenous creation of additional spending power by banks:

‘Even though the conventional answer to our question is not obviously absurd, yet there is another method of obtaining money for this purpose, which … does not presuppose the existence of accumulated results of previous development, and hence may be considered as the only one which is available in strict logic. This method of obtaining money is the creation of purchasing power by banks… It is always a question, not of transforming purchasing power which already exists in someone’s possession, but of the creation of new purchasing power out of nothing… (Schumpeter 1934, p. 73)

This theoretical argument received empirical support from research by Fama and French. Using the Compustat database of company reports from publicly-traded US non-financial corporations between 1951 & 1996, Fama and French calculated aggregate non-financial corporate investment, and correlated it with equity issue, retained earnings, and new debt (see Figure 2).

Figure 2: Correlations of investment to new equity, retained earnings and new debt (Fama & French 1999, p. 1954)

They concluded that “the source of financing most correlated with investment is long-term debt”:

Figure 3 shows investment and its financing year by year. The figure suggests that new net issues of stock do not move closely with investment. In fact, when the variables are measured relative to book capital … the correlation of investment, It, and new net issues of stock, dSt, is only 0.19… retained cash earnings move more closely with investment. The correlation between It and RCEt is indeed higher, 0.56, but far from perfect. The source of financing most correlated with investment is long-term debt. The correlation between It and dLTDt is 0.79. The correlation between It and new short-term debt is lower, 0.60, but nontrivial. These correlations confirm the impression from Figure 3 that debt plays a key role in accommodating year-by-year variation in investment. (Fama and French 1999, p. 1954)

There is thus a very important link between changes in monetary aggregates and real economic activity. This relationship is reflected in Godley’s and my models, with debt financing investment and liability structures arising from debt playing a key role in the predictions our models provide. The banking sector is also essential, since its financing of investment by the endogenous expansion of the money supply is a vital component of a growing economy. In both sets of models, money and debt are created simultaneously and endogenously by the bookkeeping operations of banks (Graziani 1989; Graziani 2003).

1. Government

With its view of a market economy as self-equilibrating, the Neoclassical school has had a tendency towards a critical perspective on the role of government, which culminated in the “Policy Inefffectiveness Proposition” that:

by virtue of the assumption that expectations are rational, there is no feedback rule that the authority can employ and expect to be able systematically to fool the public. This means that the authority cannot expect to exploit the Phillips Curve even for one period. (Sargent and Wallace 1976, p. 178)

Post Keynesian work has instead adhered to Keynes’s perspective that the market economy can generate insufficient aggregate demand to guarantee full employment (Keynes 1936, p. 25). This in turn leads Post Keynesians in general to argue that the government has both a responsibility and a capacity to boost aggregate demand during recessions, though there are differences in how effective such policies are expected to be.

Godley’s sectoral balance approach argues that a government surplus can force the private sector into a deficit, while government deficits are needed to enable the private sector to restore its balance sheet (Godley and Wray 2000, p. 204). My 1995 paper argued that counter-cyclical government spending could prevent a debt-induced recession by attenuating speculative euphoria during a boom and providing cash flows to service debts during a slump (Keen 1995, pp. 625-632).

1. Convergence: Structure, Dynamics and Minsky

That concludes an overview of the ways in which, in common with the broad Post-Keynesian tradition, Godley and I diverge from Neoclassical practice. The next topic is the positive themes in Post Keynesian economics that our approaches share.

1. Structure

Though the extent to which Post-Keynesian practice has lived up to its rhetoric can be disputed, Post-Keynesian theory has stressed the need to accurately model the institutions and structure of the economy that set the constraints on individual and collective behavior, in contrast to the Neoclassical emphasis upon methodological individualism (Krugman 1996). This emphasis can be dated to Sraffa’s empirically-oriented criticism of Marshall (Sraffa 1926; Robertson, Sraffa et al. 1930), which led to his input-output equilibrium critique of Neoclassical production theory (Sraffa 1960) and the development of an input-output oriented approach to macrodynamics (Pasinetti 1973; Pasinetti 1988; Salvadori and Steedman 1988; Kurz and Salvadori 1993; Pasinetti 1993; Salvadori 1998; Kurz and Salvadori 2006). This has caused conflict within the broad Post-Keynesian tradition akin to the Saltwater-Freshwater divide in Neoclassical economics between those who insist that input-output relations are a “brute fact about modern industrial economies” (Steedman 1992, p. 126) and those who develop “corn economy” models (Kriesler 1992; Sawyer 1992; Steedman 1993; but see Keen 1998). Though input-output dynamics are absent from Godley’s work, the emphasis upon modeling structure of the economy is common to both of us.

1. Dynamics

Post Keynesian models emphasize dynamics and disequilibrium rather than comparative statics and equilibrium, in a tradition that dates back to Kalecki (Kalecki 1935; Kalecki 1937) and Harrod (Harrod 1939; Harrod 1960). Post Keynesian macroeconomic models are iterative in nature and do not have a long-run equilibrium towards which the economy is assumed to converge (Arestis 1989; Sawyer 1995; Sawyer 1995).

Both Godley and I have developed not simply models (like, for example, Arestis 1989; Keen 2000, pp. 84-89), but modeling frameworks from which a wide variety of related models can be derived.

1. Minsky: Can “It” Happen Again?

Can “It”—a Great Depression—happen again? And if “It” can happen, why didn’t “It” occur in the years since World War II? These are questions that naturally follow from both the historical record and the comparative success of the past thirty-five years. To answer these questions it is necessary to have an economic theory which makes great depressions one of the possible states in which our type of capitalist economy can find itself. (Minsky 1982, p. 5)

In this “Chicago” view there exists a financial system … which would make serious financial disturbances impossible. It is the task of monetary analysis to design such a financial system, and of monetary policy to execute the design… The alternative polar view, which I call unreconstructed Keynesian, is that capitalism is inherently flawed, being prone to booms, crises, and depressions. This instability, in my view, is due to characteristics the financial system must possess if it is to be consistent with full-blown capitalism. Such a financial system will be capable of both generating signals that induce an accelerating desire to invest and of financing that accelerating investment. (Minsky 1969; Minsky 1982, p. 279)

Hyman Minsky’s “Financial Instability Hypothesis” has become a unifying vision in Post Keynesian economics, crystallizing the many differences between this school’s approach and the Neoclassical model. Since he is still unfamiliar to Neoclassical economists, it is important to set out his analysis at length here.

Minsky’s initial intellectual foundations were his PhD supervisor Schumpeter’s inherently cyclical and monetary vision of capitalism (Schumpeter 1928), and Irving Fisher’s “Debt-Deflation” explanation of the Great Depression (Fisher 1933). After reading Keynes 1937 essay “The General Theory of Employment” (Keynes 1937) in 1968, Minsky realized that IS-LM was not an accurate rendition of Keynes’s theory, and Keynes’s focus upon expectations formation under uncertainty in this paper (Keynes 1937, p. 214) provided the final component in his Hypothesis. This explains the puzzle that his first exposition of the Financial Instability Hypothesis was in a book whose title implied it was a biography of Keynes (Minsky 1975). It was instead an exposition of Minsky’s thesis in a book whose title paid homage to Keynes as an intellectual pioneer.

Minsky’s verbal model of a financial cycle begins at a time when the economy is doing well (the rate of economic growth equals or exceeds that needed to reduce unemployment), but firms are conservative in their portfolio management (debt to equity ratios are low and profit to interest cover is high), and this conservatism is shared by banks, who are only willing to fund cash-flow shortfalls or low-risk investments.

The cause of this high and universally practiced risk aversion is the memory of a not too distant system-wide financial failure, when many investment projects foundered, many firms could not finance their borrowings, and many banks had to write off bad debts. Because of this recent experience, both sides of the borrowing relationship prefer extremely conservative estimates of prospective cash flows: their risk premiums are very high.

However, the combination of a growing economy and conservatively financed investment means that most projects succeed. Two things gradually become evident to managers and bankers: “Existing debts are easily validated and units that were heavily in debt prospered: it pays to lever” (Minsky 1982, p. 65). As a result, both managers and bankers come to regard the previously accepted risk premium as excessive. Investment projects are evaluated using less conservative estimates of prospective cash flows, so that with these rising expectations go rising investment and asset prices. The general decline in risk aversion thus sets off both growth in investment and exponential growth in the price level of assets, which is the foundation of both the boom and its eventual collapse.

More external finance is needed to fund the increased level of investment and the speculative purchase of assets, and these external funds are forthcoming because the banking sector shares the increased optimism of investors (Minsky, 1980, p. 121). The accepted debt to equity ratio rises, liquidity decreases. and the growth of credit accelerates.

This marks the beginning of what Minsky calls “the euphoric economy” (Minsky 1982, pp. 120-124), where both lenders and borrowers believe that the future is assured, and therefore that most investments will succeed. Asset prices are revalued upward as previous valuations are perceived to be based on mistakenly conservative grounds. Highly liquid, low-yielding financial instruments are devalued, leading to a rise in the interest rates offered by them as their purveyors fight to retain market share.

Financial institutions now accept liability structures for both themselves and their customers “that, in a more sober expectational climate, they would have rejected” (Minsky 1980, p. 123). The liquidity of firms is simultaneously reduced by the rise in debt to equity ratios, making firms more susceptible to increased interest rates. The general decrease in liquidity and the rise in interest paid on highly liquid instruments triggers a market-based increase in the interest rate, even without any attempt by monetary authorities to control the boom. However, the increased cost of credit does little to temper the boom, since anticipated yields from speculative investments normally far exceed prevailing interest rates, leading to a decline in the elasticity of demand for credit with respect to interest rates.

The condition of euphoria also permits the development of an important actor in Minsky’s drama, the Ponzi financier (Minsky 1982, pp. 70, 115; Galbraith, 1954, pp. 4-5). These capitalists are inherently insolvent, but profit by trading assets on a rising market, and must incur significant debt in the process:

A Ponzi finance unit is a speculative financing unit for which the income component of the near term cash flows falls short of the near term interest payments on debt so that for some time in the future the outstanding debt will grow due to interest on existing debt… Ponzi units can fulfill their payment commitments on debts only by borrowing (or disposing of assets)… a Ponzi unit must increase its outstanding debts.’ (Minsky 1982, p. 24)

The servicing costs for Ponzi debtors exceed the cash flows of the businesses they own, but the capital appreciation they anticipate far exceeds their debt servicing costs. They therefore play an important role in pushing up the market interest rate, and an equally important role in increasing the fragility of the system to a reversal in the growth of asset values.

Rising interest rates and increasing debt to equity ratios eventually affect the viability of many business activities, reducing the interest rate cover, turning projects that were originally conservatively funded into speculative ones, and making ones that were speculative “Ponzi.” Such businesses will find themselves having to sell assets to finance their debt servicing—and this entry of new sellers into the market for assets pricks the exponential growth of asset prices. With the price boom checked, Ponzi financiers now find themselves with assets that can no longer be traded at a profit, and levels of debt that cannot be serviced from the cash flows of the businesses they now control. Banks that financed these assets purchases now find that their leading customers can no longer pay their debts—and this realization leads initially to a further bank-driven increase in interest rates. Liquidity is suddenly much more highly prized; holders of illiquid assets attempt to sell them in return for liquidity. The asset market becomes flooded and the euphoria becomes a panic, the boom becomes a slump.

As the boom collapses, the fundamental problem facing the economy is one of excessive divergence between the debts incurred to purchase assets, and the cash flows generated by them—with those cash flows depending upon both the level of investment and the rate of inflation.

The level of investment has collapsed in the aftermath of the boom, leaving only two forces that can bring asset prices and cash flows back into harmony: asset market deflation, or current goods inflation. This dilemma is the foundation of Minsky’s iconoclastic perception of the role of inflation, and his explanation for the stagflation of the 1970s and early 1980s.

Minsky argues that if the rate of inflation is high at the time of the crisis, then though the collapse of the boom causes investment to slump and economic growth to falter, rising cash flows rapidly enable the repayment of debt incurred during the boom. The economy can thus emerge from the crisis with diminished growth and high inflation, but few bankruptcies and a sustained decrease in liquidity. Thus, though this course involves the twin “bads” of inflation and initially low growth, it is a self-correcting mechanism in that a prolonged slump is avoided.

However, the conditions are soon reestablished for the cycle to repeat itself, and the avoidance of a true calamity is likely to lead to a secular decrease in liquidity preference.

If the rate of inflation is low at the time of the crisis, then cash flows will remain inadequate relative to the debt structures in place. Firms whose interest bills exceed their cash flows will be forced to undertake extreme measures: they will have to sell assets, attempt to increase their cash flows (at the expense of their competitors) by cutting their margins, or go bankrupt. In contrast to the inflationary course, all three classes of action tend to further depress the current price level, thus at least partially exacerbating the original imbalance. The asset price deflation route is, therefore, not self-correcting but rather self-reinforcing, and is Minsky’s explanation of a depression.

The above sketch basically describes Minsky’s perception of an economy in the absence of a government sector. With big government, the picture changes in two ways, because of fiscal deficits and Reserve Bank interventions. With a developed social security system, the collapse in cash flows that occurs when a boom becomes a panic will be at least partly ameliorated by a rise in government spending—the classic “automatic stabilizers,” though this time seen in a more monetary light. The collapse in credit can also be tempered or even reversed by rapid action by the Reserve Bank to increase liquidity.

Thus, though Minsky argued that financial instability was inevitable, he argued that Depressions could be avoided by a combination of deficits resulting from “Big Government” and “Lender of Last Resort” interventions by the Central Bank—so long as, in addition, we “establish and enforce a ‘good financial society’ in which the tendency by business and bankers to engage in speculative finance is constrained” (Minsky 1977; Minsky 1982, p. 69).

Minsky’s ambition in his PhD thesis (

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