Predicting the “Global Financial Crisis”: Post Keynesian Macroeconomics

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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 1st, 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.


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)

Ana­lyst Aca­d­e­m­ic Affil­i­a­tion School Ori­en­ta­tion Mod­el
Dean Bak­er Yes Cen­ter for Eco­nom­ic and Pol­i­cy Research Neo­clas­si­cal Key­ne­sian No
Wynne God­ley Yes Levy Insti­tute; Deceased 2010 Post Key­ne­sian Lern­er Yes
Fred Har­ri­son No UK Media Geor­gist No
Michael Hud­son Yes Uni­ver­si­ty of Mis­souri, Kansas City Clas­si­cal Marx No
Eric Jan­szen No US Web­site Eclec­tic Aus­tri­an No
Stephen Keen Yes Uni­ver­si­ty of West­ern Syd­ney Post Key­ne­sian Min­sky Yes
Jakob Brøch­n­er Mad­sen & Jens Kjaer Sørensen Yes Copen­hagen Uni­ver­si­ty (Monash Uni­ver­si­ty since 2006) Neo­clas­si­cal Key­ne­sian No
Kurt Richebäch­er No Deceased 2007 Aus­tri­an No
Nouriel Roubi­ni Yes New York Uni­ver­si­ty Neo­clas­si­cal Key­ne­sian No
Peter Schiff No Euro Pacif­ic Cap­i­tal Aus­tri­an No
Robert Shiller Yes Yale Uni­ver­si­ty Neo­clas­si­cal Behav­iour­al No

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)

Prop­er­ty of Mar­gin­al Costs Per­cent of firms
Increas­ing 11%
Con­stant 48%
Decreas­ing 41%

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 (Min­sky and Papadim­itri­ou 2004) was to pro­vide a math­e­mat­i­cal mod­el of a finance-dri­ven trade cycle by which finan­cial cycles could lead to a Depres­sion, and this result­ed in only AER pub­li­ca­tion (Min­sky 1957). After his PhD, he large­ly aban­doned math­e­mat­i­cal meth­ods (apart from a flir­ta­tion with Kaleck­i’s macro­eco­nom­ic iden­ti­ties Kalec­ki 1942; Kalec­ki 1971) and devel­oped the ver­bal account giv­en above of how debt-financed invest­ment and spec­u­la­tion, in a world with an cycli­cal past and an uncer­tain future, could lead to a Great Depres­sion caused, not by bad mon­e­tary pol­i­cy, but by the inher­ent nature of cap­i­tal­ism.

Min­sky’s deci­sion not to pur­sue a math­e­mat­i­cal treat­ment of his hypoth­e­sis reflect­ed part­ly the less advanced state of dynam­ic mod­el­ling at the time he learnt math­e­mat­ics, and part­ly the fun­da­men­tal flaws of the “Hicks-Hansen-Samuel­son” sec­ond order dif­fer­ence equa­tion mod­el of the trade cycle on which he attempt­ed to build his mod­el. With the advan­tage of hav­ing learnt math­e­mat­ics after the devel­op­ment of com­plex­i­ty the­o­ry, I saw Min­sky’s mod­el as emi­nent­ly suit­ed to a com­plex sys­tems treat­ment, and under­took to build such a mod­el in my own PhD.

  1. Anticipating the Black Swan I—Debt-Deflation and Complexity

An essen­tial aspect of Schum­peter and Min­sky’s shared vision of cap­i­tal­ism is that it is inher­ent­ly cycli­cal, rather than a sys­tem that tends to equi­lib­ri­um. Schum­peter saw this as a strength of cap­i­tal­ism, and essen­tial to its vital­i­ty (Schum­peter 1928). Min­sky was rather less san­guine:

Sta­ble growth is incon­sis­tent with the man­ner in which invest­ment is deter­mined in an econ­o­my in which debt-financed own­er­ship of cap­i­tal assets exists, and the extent to which such debt financ­ing can be car­ried is mar­ket deter­mined. 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 1977; Min­sky 1982, p. 67)

A cycli­cal mod­el was thus required to under­pin Min­sky’s Hypoth­e­sis. I used Good­win’s growth cycle mod­el for this pur­pose (Good­win 1967), fol­low­ing Blat­t’s advice that, from the per­spec­tive of an applied math­e­mati­cian, it was the “most hope­ful”, and that its flaw “of an equi­lib­ri­um which is not unsta­ble” could be reme­died by the “intro­duc­tion of a finan­cial sec­tor, includ­ing mon­ey and cred­it as well as some index of busi­ness con­fi­dence” (Blatt 1983, pp. 210–211; Harvie 2000; Harvie, Kel­man­son et al. 2007; Keen 2009).

  1. Goodwin’s Growth Cycle

Good­win’s mod­el can eas­i­ly be laid out in a causal chain:

  • The lev­el of cap­i­tal K deter­mines out­put Y via the accel­er­a­tor rela­tion v:
  • Out­put deter­mines employ­ment L via labour pro­duc­tiv­i­ty a:
  • Employ­ment deter­mines the rate of employ­ment ? giv­en pop­u­la­tion N:
  • The employ­ment rate deter­mines the rate of change of the wage rate w—a Phillips curve rela­tion:
  • Out­put minus the wage bill deter­mines prof­its ?:
  • All prof­its are invest­ed, so that where invest­ment I is of course the rate of change of cap­i­tal:
  • Good­win assumed con­stant growth in labor pro­duc­tiv­i­ty and con­stant pop­u­la­tion growth .

The mod­el reduces to two sys­tem states in the employ­ment rate and the wages share of out­put (for a sim­ple expo­si­tion of the deriva­tion see Blatt 1983, pp. 211–216):

Though Phillips insist­ed the employ­ment-rate-wage-change rela­tion­ship was non­lin­ear (and that the rate of change of employ­ment and infla­tion were also fac­tors in wage deter­mi­na­tion– see Phillips 1958, pp. 283–284), Good­win used a lin­ear form for his mod­el:

Blatt employed a non­lin­ear form:

As Good­win illus­trat­ed, this mod­el has a non-triv­ial equi­lib­ri­um which is neu­tral, result­ing in the mod­el gen­er­at­ing a closed curve in space for any non-equi­lib­ri­um ini­tial con­di­tions, what­ev­er form is assumed for the Phillips curve. The mod­el’s sus­tained cycles occur even if the mod­el’s behav­ioral form is lin­ear, because the cycles emanate from inher­ent non­lin­ear­i­ties, such as mul­ti­ply­ing the two vari­ables w and L togeth­er to derive prof­its (and hence the lev­el of invest­ment). Non­lin­ear behav­ioral rela­tions are used, not to cause cycles, but to add realism—in Blat­t’s case, to ensure that the employ­ment rate could not exceed 100%.

As a pre­lude to mod­el­ing Min­sky, I added a sim­i­lar non­lin­ear func­tion for invest­ment, replac­ing the unre­al­is­tic assump­tion that cap­i­tal­ists invest all their prof­its with an invest­ment func­tion where the lev­el of invest­ment as a per­cent­age of GDP depend­ed on the rate of prof­it (which equals , where is the prof­it share of income:):

With depre­ci­a­tion intro­duced as well, Good­win’s equa­tions are now:

The dynam­ics of the three ver­sions of the Good­win mod­el are illus­trat­ed in Fig­ure 3 (para­me­ter val­ues and ini­tial con­di­tions are giv­en in Appen­dix 3: Para­me­ter val­ues for Good­win Mod­el,).

Fig­ure 3: Closed cycle in the orig­i­nal Good­win mod­el

  1. Modelling Minsky

I extend­ed Good­win’s mod­el to rep­re­sent the core of MIn­sky’s Hypoth­e­sis by adding the rela­tion­ship lat­er empir­i­cal­ly con­firmed by Fama and French, that “debt plays a key role in accom­mo­dat­ing year-by-year vari­a­tion in invest­ment” (Fama and French 1999, p. 1954). They put this even more clear­ly in an ear­li­er work­ing paper ver­sion of this paper: “More invest­ment tends to gen­er­ate more debt, while high­er earn­ings are used to reduce debt.” (Fama and French 1999, p. 9). In dynam­ic terms, this says that the rate of change of debt D is invest­ment minus prof­its (where prof­its are now net of inter­est pay­ments, which equal the inter­est rate r times the debt lev­el):

This intro­duced a third sys­tem state into the mod­el: the ratio of debt to out­put, d. The basic Min­sky mod­el is thus:

This third dimen­sion intro­duces the pos­si­bil­i­ty of com­plex behav­ior and sen­si­tive depen­dence upon ini­tial con­di­tions: an equi­lib­ri­um that is tech­ni­cal­ly sta­ble can nonethe­less be a repeller rather than an attrac­tor for some ini­tial con­di­tions (Li and Yorke 1975; May and Oster 1976). The many equi­lib­ria of this sys­tem depend on inverse func­tions of the non­lin­ear Phillips and Invest­ment func­tions:

The mod­el’s gen­er­al math­e­mat­i­cal prop­er­ties are ful­ly explored in (Gras­sel­li and Cos­ta Lima), where they iden­ti­fy two non-triv­ial equi­lib­ria: one with pos­i­tive val­ues for the first two sys­tem states and a finite val­ue for , and the oth­er with zero val­ues for and but an infi­nite val­ue for : this is the debt-defla­tion­ary ter­mi­nal point of a Depres­sion (though sans defla­tion in this non-price mod­el). On the lat­ter equi­lib­ri­um, Gras­sel­li and Cos­ta Lima observe that what appears to be a desir­able sit­u­a­tion from a Neo­clas­si­cal point of view—in that it is a con­di­tion that guar­an­tees the absence of ratio­nal bubbles—leads to Depres­sion in this dynam­ic mod­el:

a suf­fi­cient con­di­tion for (?2, ?2, u2) = (0, 0, 0) to be a local­ly sta­ble equi­lib­ri­um … is that the real inter­est rate r exceeds the growth rate of the econ­o­my at the equi­lib­ri­um (?1, ?1, d1), which resem­bles the con­di­tion derived by Tirole for the absence of ratio­nal bub­bles in an over­lap­ping gen­er­a­tion mod­el, cor­re­spond­ing to an “effi­cient” econ­o­my. (Gras­sel­li and Cos­ta Lima, p. 11)

My own sim­u­la­tions in Keen 1995 illus­trat­ed this pos­si­bil­i­ty of a debt-induced col­lapse if the rate of inter­est was too high. For a low rate, a con­ver­gence to equi­lib­ri­um occurred:




Fig­ure 4: Con­ver­gence to equi­lib­ri­um with a low real inter­est rate (Keen 1995, Fig­ure 6, p. 622)

At a high­er rate, the sys­tem approached the infi­nite debt to out­put ratio equi­lib­ri­um, but in a curi­ous way: the cycles in employ­ment and income dis­tri­b­u­tion dimin­ished as the cri­sis approached. An eco­nom­ic the­o­ry which ignored the role of pri­vate debt could there­fore inter­pret this process as indi­cat­ing a trend towards sta­bil­i­ty rather than break­down.

Fig­ure 5: Appar­ent sta­bil­i­ty and then break­down with a high real inter­est rate (Keen 1995, Fig­ure 8, p. 624)

The con­clu­sion of my 1995 paper focused on this strik­ing char­ac­ter­is­tic of the 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, p. 634)

Unfor­tu­nate­ly, the declin­ing volatil­i­ty in infla­tion and unem­ploy­ment from 1980 till mid-2007 shown in Fig­ure 1 (and repro­duced in smoothed form in Fig­ure 6) was inter­pret­ed as “the Great Mod­er­a­tion” by many Neo­clas­si­cal macro­econ­o­mists, with Bernanke in par­tic­u­lar eulo­giz­ing it as “this wel­come change in the econ­o­my” (Bernanke 2004).

Fig­ure 6: US Infla­tion & Unem­ploy­ment trends from 1980

From the point of view of my Min­sky mod­el, where the debt ratio is a cru­cial vari­able omit­ted by Neo­clas­si­cal macro­eco­nom­ics, this peri­od was real­ly the “lull before the storm” (see Fig­ure 7). The tran­si­tion from the Great Mod­er­a­tion to what was orig­i­nal­ly dubbed the “Great Reces­sion” was inex­plic­a­ble from a Neo­clas­si­cal point of view, but could be inferred from my Min­sky mod­el.

Fig­ure 7: Infla­tion, Unem­ploy­ment and Debt till June 2007

How­ev­er this was still only an infer­ence, since the 1995 mod­el lacked price dynam­ics. I have since devel­oped a strict­ly mon­e­tary ver­sion of Min­sky’s mod­el so that price dynam­ics could also be explored (Keen).

  1. Monetary Macroeconomics

The mon­e­tary flows in a sim­ple mod­el econ­o­my can be derived from the flows between bank accounts in a styl­ized finan­cial sys­tem. The sim­plest pos­si­ble mon­e­tary mod­el of Min­sky’s Hypothesis—which abstracts from the insti­tu­tion­al fea­tures of and reg­u­la­to­ry attempts to con­trol banks today, and there­fore resem­bles the 19th cen­tu­ry exper­i­ment with “Free Bank­ing” (Rock­off 1974; Rol­nick and Weber 1986; Sechrest 1991; White 1991; Dow and Smithin 1992; Dwyer 1996; Hick­son and Turn­er 2002; Lako­maa 2007)—has a sin­gle bank­ing sec­tor with accounts for the firm sec­tor, work­ers, and the bank­ing sec­tor itself:

  • A “Bank Vault” in which bank notes are stored while not in cir­cu­la­tion;
  • A “Firm Loan” account, a ledger that records the loans cur­rent­ly extant to the firm sec­tor;
  • A “Firm Deposit” account, where mon­ey lent to firms is stored;
  • A “Work­er Deposit” account into which wages are paid; and
  • A “Bank Safe” account, through which inter­est pay­ments pass.

Table 3 shows the basic flows in this econ­o­my, including—on rows 12 and 13—the financ­ing of invest­ment by the endoge­nous expan­sion of the mon­ey sup­ply. The table does not fol­low the Flow of Funds con­ven­tion (which is employed by God­ley) but a sys­tems engi­neer­ing one, in which out­flows from a sys­tem state have a neg­a­tive sign, and inflows to a sys­tem state have a pos­i­tive sign.

Table 3: Mon­e­tary flows in a styl­ized pure cred­it econ­o­my

Assets Lia­bil­i­ties Equi­ty
Account name Vault Loans Firms Work­ers Safe
Sym­bol BV FL FD WD BS
Row Trans­ac­tion Type
1 Loan MT -Loan Loan
2 Record Loan LE Loan
3 Com­pound Debt LE Com­pound
4 Pay Inter­est MT -Com­pound Com­pound
5 Record Pay­ment LE -Com­pound
6 Deposit Inter­est MT DepF -DepF
7 Wages MT -Wages Wages
8 Deposit Inter­est MT DepW -DepW
9 Con­sump­tion MT ConsW + ConsB -ConsW -ConsB
10 Repay Loan MT Repay -Repay
11 Record Repay­ment LR -Repay
12 Invest­ment Finance MT Invest
13 Record Finance LE Invest


Since the entries in each row rep­re­sent the flows into and out of the bank accounts, the sym­bol­ic sum of each col­umn describes the rate of change of each bank account—see Equa­tion .

The “place­hold­er” entries in equa­tion are replaced by non­lin­ear behav­iour­al rela­tions for lend­ing, debt repay­ment and invest­ment based on the rate of prof­it, and, for sim­plic­i­ty, lin­ear con­sump­tion func­tions.

Behav­ioral rela­tions, a wage-set­ting rela­tion, a dynam­ic price-set­ting equa­tion, and a mon­e­tary invest­ment func­tion link these finan­cial equa­tions to a Good­win mod­el of the phys­i­cal econ­o­my.

The wage set­ting equa­tion includes all 3 ele­ments not­ed by Phillips: a non­lin­ear reac­tion to the lev­el of employ­ment, plus reac­tions to the rate of change of employ­ment and the rate of infla­tion:

The price equa­tion was derived by equat­ing the equi­lib­ri­um rate of flows of demand and sup­ply in a steady state econ­o­my, and then express­ing the rate of change of prices as a lagged con­ver­gence to this equi­lib­ri­um price (Keen 2010, pp. 18–19). In an unex­pect­ed result, this equa­tion cor­re­spond­ed to the Kaleck­ian markup-pric­ing equa­tion. This implies the Neo­clas­si­cal-Post Key­ne­sian dis­pute over “sup­ply & demand equi­li­brat­ing” ver­sus “cost plus mark-up” pric­ing may be a “sham fight” rather than a sub­stan­tive one (Lan­glois 1989), since the for­mer yields the lat­ter in equi­lib­ri­um:

The com­plete mod­el is shown in Equa­tion :

The behav­ior of this mod­el under a rea­son­able but uncal­i­brat­ed set of para­me­ter val­ues con­firms the intu­ition from both Min­sky’s ver­bal Hypoth­e­sis and the ear­li­er non-price mod­el: a peri­od of a falling trend of dimin­ish­ing cycles in unem­ploy­ment and infla­tion can be the pre­lude to a debt-defla­tion (see Fig­ure 8).

Fig­ure 8: Debt-defla­tion in a mon­e­tary Min­sky mod­el

The mod­el­ing frame­work, which I call “Mon­e­tary Cir­cuit The­o­ry”, can be tak­en much fur­ther than shown here, and in par­tic­u­lar can be extend­ed to mul­ti­ple sec­tors with non-equi­lib­ri­um input-out­put dynam­ics (Schan­dl, Alexan­der et al. 2011, pp. 153–180. See Fig­ure 9), but a dis­cus­sion of this mod­el is beyond the scope of this paper.

Fig­ure 9: A mul­ti-sec­toral Min­sky mod­el with sus­tain­able cycles (Schan­dl et al., 2011, Fig­ure 7.2 (b), p. 159)

  1. Alternative Macroeconomic Indicators: Debt to GDP

The key indi­ca­tor that Min­sky’s Hypoth­e­sis adds to the eco­nom­ic Panop­ti­con is the ratio of pri­vate debt to GDP, and in par­tic­u­lar its first and sec­ond deriv­a­tives with respect to time. The ratio of debt to GDP alone is an indi­ca­tor of the degree of finan­cial stress on an econ­o­my, while its ser­vic­ing cost can depress both invest­ment (as indi­cat­ed by the equa­tions for the rate of prof­it and invest­ment in equa­tions and ) and con­sump­tion (when debt is owed by house­holds as well as firms, as is heav­i­ly the case today). Though an opti­mum ratio of debt to GDP can­not be defined, a strong diver­gence from his­toric norms is a use­ful indi­ca­tor of macro­eco­nom­ic trou­bles to come.

On this basis alone, the poten­tial for a severe eco­nom­ic cri­sis was implied by the lev­el of pri­vate debt (the aggre­gate of house­hold, non-finan­cial busi­ness and finance sec­tor debt) com­pared to GDP, which by ear­ly 2000 had exceed­ed the peak reached dur­ing the severe defla­tion of 1932 (see Fig­ure 10). On this basis, I pub­lished my expec­ta­tion that a finan­cial cri­sis would occur in the near future in (Keen 2001, p. 254–257, 311–12; Keen 2011, pp. 1–6), and I began to warn of an immi­nent debt-induced cri­sis on the basis of both Aus­tralian and US pri­vate debt data from April 2005 (Keen 2005; Keen 2005; Keen 2006; Keen 2007; Keen 2007).

Fig­ure 10: US debt lev­els 1920–2012

Since that cor­rect pre­dic­tion, I have attempt­ed to devel­op improved indi­ca­tors that can actu­al­ly iso­late debt-induced turn­ing points in the eco­nom­ic cycle. These began from Schum­peter and Min­sky’s argu­ments that the change in debt adds to aggre­gate demand from income alone—financing both invest­ment (Schum­peter 1934, p. 73) and spec­u­la­tion on asset prices (Min­sky, Okun et al. 1963; Min­sky 1982, p. 6)—which implied the need to gen­er­alise Wal­ras’ Law for a cred­it-based econ­o­my. Where­as aggre­gate sup­ply is aggre­gate demand in a non-mon­e­tary econ­o­my, aggre­gate demand is income plus the change in debt in a mon­e­tary econ­o­my. Income is pri­mar­i­ly expend­ed on con­sump­tion goods, while the change in debt pri­mar­i­ly financ­ing both invest­ment goods pur­chas­es and net spec­u­la­tion on asset markets—where this depends on the lev­el of asset prices , the quan­ti­ty of assets , and the annu­al turnover of assets . This implies rela­tion of the form shown in equa­tion —though this ignores feed­back effects between the change in debt and the growth of income:

A sud­den decline in the rate of growth of debt will there­fore mean a sud­den decline in the lev­el of aggre­gate demand. As Fig­ure 1 indi­cates, such a decline did occur in 2008, and it reduced aggre­gate demand from the pri­vate sec­tor alone from $18 tril­lion p.a. in 2008 to under $12 tril­lion in 2010 (see Fig­ure 11)

Fig­ure 11: The plunge in debt-financed demand in 2008

The time deriv­a­tive of indi­cates that the accel­er­a­tion of debt is a major fac­tor in caus­ing changes in the lev­el of output—and hence employment—and the rate of change of asset prices:

This is relat­ed to the “Finan­cial Accel­er­a­tor” (Bernanke, Gertler et al. 1996) but far more pow­er­ful because it involves not mere­ly a change in the veloc­i­ty of mon­ey, but a change in the rate of growth of the vol­ume of mon­ey. Big­gs, May­er and Pick pro­posed the ratio of the accel­er­a­tion of debt to GDP as an indi­ca­tor of this effect, and dubbed it “The Cred­it Impulse” (Big­gs and May­er 2010; Big­gs, May­er et al. 2010). I pre­fer the term “Cred­it Accel­er­a­tor”, since impulse implies a tran­sient phe­nom­e­non. The cor­re­la­tions of this indi­ca­tor with both change in employ­ment and change in asset prices are strik­ing.

Fig­ure 12: USA Cred­it Accel­er­a­tion and Unem­ploy­ment Change 1990–2012

Fig­ure 13:Mortgage accel­er­a­tion and real house price change


  1. Anticipating the Black Swan II—Stock-Flow Consistent Macroeconomics

God­ley’s pre­dic­tion of an impend­ing cri­sis (God­ley and Wray 2000; God­ley 2001; God­ley and Izuri­eta 2002; God­ley and Izuri­eta 2004) was derived from mod­els of the macro­econ­o­my that were devel­oped using an account­ing frame­work which he chris­tened Stock-Flow Con­sis­tent (SFC) dynam­ic mod­el­ing (Cripps and God­ley 1976; God­ley 1999; God­ley 1999; God­ley 2004; God­ley 2004; God­ley and Lavoie 2005; God­ley and Lavoie 2007; God­ley and Lavoie 2007; God­ley and Lavoie 2007; Tay­lor 2008). Inter­na­tion­al, pub­lic and pri­vate sec­tor imbal­ances iden­ti­fied using this approach led God­ley to antic­i­pate a severe reces­sion from ear­ly 2000 (God­ley and Wray 2000; God­ley 2001; God­ley and Izuri­eta 2002; God­ley and Izuri­eta 2004; God­ley, Izuri­eta et al. 2005).

God­ley’s approach to macro­eco­nom­ic mod­el­ing was influ­enced by his peri­od in the British Trea­sury (1956–1970) which he described as “they hey­day of ‘stop-go’ poli­cies when we tried to fore­cast what would hap­pen dur­ing the fol­low­ing 18 months and then design a bud­get which would rec­ti­fy any­thing like­ly to go wrong”. His Dam­a­scene moment occurred when he real­ized that “mea­sured at cur­rent prices, the gov­ern­men­t’s bud­get deficit less the cur­rent account deficit is equal, by def­i­n­i­tion, to pri­vate sav­ing net of invest­ment” (God­ley and Lavoie 2007, p. xxxvi). This real­iza­tion that the bal­ance of pay­ments could be deduced from the bud­get deficit and pri­vate net sav­ing inspired him to cre­ate the Stock-Flow Con­sis­tent approach to con­struct­ing macro­eco­nom­ic mod­els, in which a frame­work of con­sis­tent accounts between sec­tors had to be set out before behav­iour­al rela­tions were intro­duced into the mod­el.

God­ley and Lavoie con­trast their empha­sis upon sec­toral bal­ances with pre-DSGE macro­eco­nom­ics by con­sid­er­ing what a stan­dard nation­al income equa­tion looks like when por­trayed in terms of trans­ac­tions between sec­tors. They start from equa­tion in which GDP (Y) is bro­ken down into con­sump­tion (C) plus invest­ment (I) plus gov­ern­ment expen­di­ture (G), and also equat­ed to the sum of wages (WB) plus prof­its (F):

Table 4 sets out equa­tion in terms of trans­ac­tions between sec­tors, where, for exam­ple, con­sump­tion expen­di­ture C involves a trans­fer of mon­ey from house­holds to firms. The table is con­struct­ed accord­ing to the con­ven­tions of the Flow of Funds:

Note that all sources of funds in a sec­toral account take a plus sign, while the uses of these funds take a minus sign. Any trans­ac­tion involv­ing an incom­ing flow, the pro­ceeds of a sale or the receipts of some mon­e­tary flow, thus takes a pos­i­tive sign; a trans­ac­tion involv­ing an out­go­ing flow must take a neg­a­tive sign. (God­ley and Lavoie 2007, p. 40)

Table 4: Equa­tion laid out as a trans­ac­tions matrix











Gov­ern­ment expen­di­ture








[GDP (memo)]










Tax net of trans­fers











God­ley and Lavoie point out that, expressed in this man­ner, defi­cien­cies in equa­tion become obvi­ous: for exam­ple, if there is an excess of income over expen­di­ture, where does it go and how does it affect the rest of the econ­o­my, “where does the finance for invest­ment come from? And how are bud­get deficits financed?” Their revised table pro­vides answers to these omis­sions by includ­ing a bank­ing sec­tor, and “show­ing a rel­a­tive­ly sim­ple com­pre­hen­sive sys­tem of accounts which describes all the inter­sec­toral trans­ac­tions implied … but not shown” by Table 4 (God­ley and Lavoie 2007, p. 6).

Table 5: A sim­ple trans­ac­tions matrix implied by equa­tion (God­ley & Lavoie 2007, Table 1.2, p. 7)

Pro­duc­tion Firms















Gov­ern­ment expen­di­tures

















Change in Loans




Change in Cash





Change in Deposits




Change in Bills





Change in Equi­ties












As well as indi­cat­ing that a com­pli­cat­ed dynam­ic sys­tem is need­ed to prop­er­ly express equa­tion , Table 5 also show­cas­es God­ley’s guid­ing prin­ci­ple that in a mon­e­tary econ­o­my “every­thing comes from some­where and goes some­where”, so that in his tables “all rows and all columns sum to zero” (God­ley and Lavoie 2007, p. 6).

God­ley and Lavoie and the com­mu­ni­ty of Stock-Flow Con­sis­tent mod­el­ers that has devel­oped around them derive sys­tems of dif­fer­ence equa­tions from tables like these, which range from sim­ple mod­els that abstract from pri­vate cred­it cre­ation, to com­pli­cat­ed ones that incor­po­rate gov­ern­ment and bank mon­ey cre­ation and inter­na­tion­al trade.(Zez­za and Dos San­tos 2004; Berglund 2005; Dos San­tos 2005; God­ley and Lavoie 2007; San­tos and Zez­za 2007).

God­ley and Lavoie pro­vide a sim­ple exam­ple of the pro­ce­dure need­ed to derive a sim­u­la­tion mod­el from a SFC table with the abstrac­tion of a pure fiat mon­ey econ­o­my in which the gov­ern­ment finances deficits by issu­ing cur­ren­cy only, and where firms make no prof­its (God­ley and Lavoie 2007, pp. 57–98).

Table 6: The account­ing matrix for the SIM mod­el (God­ley & Lavoie 2007, p. 62, Table 3.3)









Gov­ern­ment Expen­di­tures















Mon­ey stock changes










The dis­crete time mod­el derived from this table makes behav­ioral assump­tions about tax­es (a con­stant ? times the wage bill) and con­sump­tion (a con­stant ?1 times net income plus ?2 times house­hold wealth—which is entire­ly in the form of cash Hh—in the pre­vi­ous year) to derive a set of 11 equa­tions:

They sim­u­late this mod­el with gov­ern­ment expen­di­ture of $20 p.a. (Gd=$20), tax rate of 20% (?=0.2), a wage rate of $1 p.a. (W=1), con­sump­tion out of income of 0.4 (?1=0.6) and out of wealth of 0.4 (?2=0.4)—see Table 7.

Table 7: Sim­u­la­tion of SIM mod­el




































This extreme­ly sim­ple mod­el is fol­lowed by oth­ers that include banks and pri­vate cred­it cre­ation as well as gov­ern­ment mon­ey, bonds, oth­er secu­ri­ties and port­fo­lio issues, the impact of expec­ta­tions fail­ing to be real­ized, pro­duc­tion and inter­na­tion­al trade.

  1. Alternative Macroeconomic Indicators: Sectoral Imbalances

The Stock-Flow-Con­sis­tent empha­sis upon sec­toral bal­ances enabled God­ley to pre­dict the Glob­al Finan­cial Cri­sis from as long ago as 2000 (God­ley and Wray 2000; God­ley 2001; God­ley and Izuri­eta 2002; God­ley and Izuri­eta 2004; God­ley, Izuri­eta et al. 2005). The prin­ci­pal insight that enabled God­ley to pre­dict an immi­nent cri­sis was that, when the gov­ern­ment sec­tor, the pri­vate sec­tor and the inter­na­tion­al econ­o­my are treat­ed as aggre­gates, the sec­toral bal­ances must sum to zero:

By def­i­n­i­tion, the pri­vate sec­tor sur­plus must equal the pub­lic sec­tor deficit plus the trade account sur­plus. Thus, the pub­lic sec­tor could run a sur­plus, which if more than off­set by a trade account sur­plus, could still be asso­ci­at­ed with a pri­vate sec­tor sur­plus. On the oth­er hand, if the pub­lic sec­tor runs a sur­plus and the trade account is neg­a­tive, the pri­vate sec­tor, by def­i­n­i­tion, must be in deficit. (God­ley and Wray 2000, p. 202)

The US sec­toral posi­tion at the end of the 1990s and begin­ning of the 2000s was pre­cise­ly that case: a pub­lic sec­tor sur­plus and trade sec­tor deficit along with a pri­vate sec­tor deficit. They not­ed that the pri­vate sec­tor deficit was 5.3% of GDP in 2000, while the gov­ern­ment sur­plus was 2.2% of GDP and the bal­ance of pay­ments deficit was 3.1%. The US econ­o­my was, they argued:

in unchart­ed ter­ri­to­ry, with a pri­vate sec­tor deficit that is five times greater than any­thing achieved in the past (rel­a­tive to GDP) and that has already per­sist­ed for twice as long as any past deficits. (God­ley and Wray 2000, p. 204)

Using the CBO’s pro­jec­tions of GDP growth rates and grow­ing gov­ern­ment sur­plus­es, and “rea­son­able assump­tions about con­tin­ued dete­ri­o­ra­tion of the U.S. trade account”, they argued that these trends implied a pri­vate sec­tor deficit “equal to 8 per­cent of GDP with­in five years”. This made a reces­sion inevitable:

We has­ten to add that we do not believe this pro­jec­tion. The econ­o­my will not con­tin­ue to grow; the pro­ject­ed bud­get sur­plus­es will not be achieved; pri­vate sec­tor spend­ing will not con­tin­ue to out­strip income; and growth of pri­vate sec­tor indebt­ed­ness will not accel­er­ate. We present these pro­jec­tions only to show what would have to hap­pen to the finan­cial sit­u­a­tion of the pri­vate sec­tor in order for the CBO’s pro­jec­tions to unfold. As soon as pri­vate sec­tor spend­ing stops grow­ing faster than pri­vate sec­tor income, GDP will stop grow­ing. When the reces­sion hits, the pub­lic sec­tor bud­get will move from sur­plus to deficit, and our trade account will improve (because imports will fall). Togeth­er, these will gen­er­ate pri­vate sec­tor sur­plus­es. (God­ley and Wray 2000, p. 204)

Fig­ure 14: Pre­dic­tion of unsus­tain­able pri­vate sec­tor deficits giv­en CBO expec­ta­tions of sus­tained gov­ern­ment sur­plus­es (God­ley & Wray 2000, Fig­ure 1, p. 203)

  1. Conclusion: A New Macroeconomics?

What was a “tail event” for Neo­clas­si­cal macro­eco­nom­ic mod­els (Stevens 2008, p. 7) was thus a core pre­dic­tion of two Post Key­ne­sian approach­es to macro­eco­nom­ic mod­el­ing. While Neo­clas­si­cal macro­econ­o­mists have felt com­pelled to pub­lish arti­cles with titles like “How Did Econ­o­mists Get It So Wrong?” (Krug­man 2009), Post Key­ne­sian econ­o­mists have been embold­ened by their suc­cess. They take no joy from the con­tin­ued gloom in the glob­al econ­o­my, but their research agen­da is vibrant, with both “Mon­e­tary Cir­cuit The­o­ry” and Stock-Flow Con­sis­tent mod­el­ing under­go­ing rapid devel­op­ment today (Gras­sel­li and Cos­ta Lima ; Keen ; Dos San­tos 2003; Zez­za and Dos San­tos 2004; Zez­za and Dos San­tos 2006; Lavoie 2008; Le Heron 2008; van Treeck 2009; San­tos and Mace­do e Sil­va 2010; Dallery and van Treeck 2011; Keen 2011; Lavoie and Daigle 2011; Le Heron 2011).

The con­fi­dence that Neo­clas­si­cal econ­o­mists had in the state of macro­eco­nom­ic mod­el­ing pri­or to the GFC (Bernanke 2004; Blan­chard 2009) was char­ac­ter­ized by “sep­a­rate devel­op­ment”, with Neo­clas­si­cal the­o­ry pay­ing no atten­tion to the work of Post Key­ne­sian econ­o­mists, though as shown here, the Post Key­ne­sian approach devel­oped in part in reac­tion to Neo­clas­si­cal thought. Per­haps after the GFC, and as the “Less­er Depres­sion” con­tin­ues, it is time for rap­proche­ment to occur.

  1. Appendix 1: The Cobb-Douglas Production Function

Take the nation­al income iden­ti­ty that income equals wages plus prof­its:

Intro­duce uni­form real wage and prof­it rates, and the quan­ti­ty of labour and cap­i­tal:

Dif­fer­en­ti­ate with respect to time:

Divide by Y to derive the per­cent­age rate of change of income:

Con­vert all terms to per­cent­age rates of change:

All terms on the right hand side now include income shares. Define :

Since income shares change slow­ly over time, treat ? as approx­i­mate­ly a con­stant and inte­grate:

Take expo­nen­tials and rearrange:

This is the “Cobb-Dou­glas Pro­duc­tion Func­tion” under con­stant returns, with the tech­nol­o­gy term replaced by a trans­for­ma­tion of the real wage times a trans­for­ma­tion of the real rate of prof­it. So the “Cobb-Dou­glas Pro­duc­tion Func­tion” can be derived from the true-by-def­i­n­i­tion account­ing iden­ti­ty using only one rea­son­ably valid assump­tion (the rel­a­tive con­stan­cy of income shares over time). There­fore the high cor­re­la­tion between a Cobb-Dou­glas Pro­duc­tion Func­tion and actu­al data is to be expect­ed, and does not pro­vide empir­i­cal sup­port for the valid­i­ty of the Neo­clas­si­cal mod­el of pro­duc­tion (Shaikh 1974; McCom­bie 2000; Shaikh 2005).

  1. Appendix 2: The invalidity of the Hicks-Hansen-Samuelson trade cycle model

Min­sky’s used a stan­dard Hicks-Hansen-Samuel­son mul­ti­pli­er-accel­er­a­tor mod­el (Samuel­son 1939) as the foun­da­tion of his attempt to devel­op a math­e­mat­i­cal mod­el of a finan­cial­ly-dri­ven trade cycle. His basic equa­tion was:

This class of mod­els should nev­er have been giv­en cre­dence, since it is eas­i­ly shown that the only solu­tion is the triv­ial solu­tion. A con­di­tion for a dif­fer­ence equa­tion to have a non-triv­ial solu­tion is that the matrix form of the equa­tion is non-invert­ible. The matrix form of is:

This matrix is invert­ible:

There­fore the only solu­tion to is , and the “cycles” gen­er­at­ed by this mod­el are mere­ly fluc­tu­a­tions on the con­ver­gent path to this triv­ial solu­tion.

The mod­el is invalid because it is derived by equat­ing an equa­tion for actu­al sav­ings (as a lagged func­tion of income) to desired invest­ment (as a lagged func­tion of income), and there is no school of thought—Keynesian or otherwise—that argues these two are equal to each oth­er. See {Keen, 2000 #141, pp. 84–89} for more detail and a prop­er­ly derived mod­el with a non-triv­ial solu­tion and growth.

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About Steve Keen

I am Professor of Economics and Head of Economics, History and Politics at Kingston University London, and a long time critic of conventional economic thought. As well as attacking mainstream thought in Debunking Economics, I am also developing an alternative dynamic approach to economic modelling. The key issue I am tackling here is the prospect for a debt-deflation on the back of the enormous private debts accumulated globally, and our very low rate of inflation.