Pre­dict­ing the “Global Finan­cial Cri­sis”: Post Key­ne­sian Macro­eco­nom­ics

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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.
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  • Krist­jan Andre

    Also notice that it’s a cycle, so if you start with the loan and end up with income in your cal­cu­la­tion, you won’t bal­ance, that’s your mis­take.”

    ok, please point out what I don’t bal­ance in the fol­low­ing exam­ple

    aggre­gate demand=income+change in debt

    a baker bor­rows money from bank 100 000, bank deposit is cre­ated. Baker makes sev­eral trans­fers until all of the 100 000 is trans­fered to contractor’s account. Con­trac­tor buys some of baker’s pro­duc­tion dur­ing this period, he trans­fers 5000 to baker’s account. 

    At the end of this period aggre­gate income of this econ­omy has been 105 000, do you agree?

    Change in bank debt is 100 000. Do you agree? Or did I not bal­ance some­thing because I started with a loan and ended up with income? Do you cal­cu­late aggre­gate income in some other way? If so, please demon­strate.

    So we end up with GDP being 105 000 and aggre­gate demand being 205 00.
    I didn’t put any banker’s inter­est charges here for sim­plic­ity. It doesn’t change the point I am try­ing to make.

  • Derek R

    Krist­jan, what about the loan con­tract doc­u­ment that the baker signed? This is an item worth 100 000 dol­lars which the bank now owns and could sell to a third party if it wished to. There is no change in the bank’s debt. It started out with zero debt and it ends up with zero debt. The party who ends up with the 100 000 debt is the baker. He owes this debt to the bank. The bank owns a signed doc­u­ment prov­ing it.

    The stan­dard def­i­n­i­tion of aggre­gate demand does not include this doc­u­ment. Nei­ther does the stan­dard def­i­n­i­tion of GDP. So if you are using the stan­dard def­i­n­i­tions, the aggre­gate demand is 105 000 and the GDP is 105 000. Aggre­gate income is also 105 000 since the stan­dard def­i­n­i­tion does not count the loan which the baker received as income.

    How­ever Steve is say­ing that in a mon­e­tary econ­omy, we need to change the def­i­n­i­tion of aggre­gate demand to include incomes from loans. The equa­tion that you quote is using the stan­dard def­i­n­i­tion of aggre­gate income and change in debt to cre­ate a new def­i­n­i­tion for aggre­gate demand: one that includes debt instru­ments.

    So Aggre­gate Demand (Steve’s def­i­n­i­tion) = Aggre­gate Income (stan­dard def­i­n­i­tion) + Change in Debt or in fig­ures, 205 000 = 105 000 + 100 000

  • math­ieu dufresne

    In your exam­ple, total income is 105 000 and total spend­ing is also 105 000. If you add the change in debt to income, aggre­gate demand doesn’t bal­ance with total spend­ing, that’s basi­cally why you think it’s dou­ble count­ing to add the change in debt with income. The mis­take isn’t that aggre­gate demand doesn’t bal­ance with total spend­ing, it is to think that the gap between the two comes from dou­ble count­ing. If I spend less than my income, the demand gen­er­ated by income will be less than income. That’s what hap­pen in your exam­ple, you have 95 000 (con­trac­tor) and 5000 (baker) of income which isn’t spent. That’s what I mean when I say you start from the loan and end up with income. Notice that you will get the same result if you replace the ini­tial loan by income, it all depends on where you start and stop in the cycle.

  • math­ieu dufresne

    Here’s an anal­ogy which I think (I hope) will make things clear enough.

    Imag­ine a pipe in which you pump water, it is a closed cir­cuit and the water just turns over in the pipe. Now, add a side pipe which leads to a tank. If you open the valve to allow some water to go into the tank, the inflow will be greater than the out­flow. Since the out­flow is the source of the inflow, the lat­ter will be reduced. It means that in any point in time, the inflow will bal­ance with out­flow only if the amount of water in the tank is con­stant (the rate of change of water in the tank is zero). If you cal­cu­late total inflow and total out­flow by start­ing from inflow and end­ing by inflow, it won’t bal­ance even if the the rate of change of water in the tank is zero, and it’s not because you’re dou­ble count­ing. Now, you can replace water by money, inflow by income, out­flow by spend­ing and the tank by sav­ings. The change in debt is the equiv­a­lent of adding or remov­ing water right from the inflow. Its means that when you say aggre­gate demand is income plus the change in debt, you’re talk­ing about an inflow. The only sit­u­a­tion where aggre­gate demand will bal­ance with total spend­ing is when the rate of change in sav­ings is zero. Since no one bor­rows money to save it, you can safely assume that bor­rowed money will auto­mat­i­cally be added to total spend­ing. This imply that when the change in debt is pos­i­tive and the rate of change of sav­ing is zero, total spend­ing will be greater than income alone.

  • Krist­jan Andre

    Math­ieu Dufresne: so by income Steve means not tra­di­tional income the way aggre­gate income is defined in macro­eco­nom­ics. It is just that the state­ment ‘aggre­gate demand= income + change in debt’ is prob­lem­atic IMO. For exam­ple if delever­ag­ing is going on then some of the income is used to pay debt. Let’s say next period in baker/contractor econ­omy con­trac­tor buys 95 000 worth of cakes from baker and baker buys smaller house from con­trac­tor 80 000 worth. Baker pays 20 000 debt.
    Now we have: aggre­gate demand= income +change in debt
    155 000=175 000+(-20 000) Income/GDP= 175 000, aggre­gate demand=155 000. Unspent income: baker= 15 000, con­trac­tor =-15 000

  • math­ieu dufresne

    Steve’s def­i­n­i­tion of aggre­gate demand is dif­fer­ent, not the def­i­n­i­tion of income (as far as I know). Be care­ful to not con­fuse your sim­ple exam­ple and my anal­ogy with real world econ­omy, those are toy mod­els we use to explore the logic of a sys­tem. In your exam­ple, all spend­ing ends up being income, that’s not nec­es­sar­ily true in real­ity. It all comes down on how you gather and treat empir­i­cal datas and this goes beyond my knowl­edge.

    In your last exam­ple, total income is 175 000 and total spend­ing is also 175 000. You started from spend­ing (out­flow) and ended up with income (inflow), if you do it this way, it will always bal­ance. I don’t know how you got this 15 000 and –15 000 but that’s wrong, you can’t have neg­a­tive income, it would mean the flow is going in the oppo­site direc­tion, which is the equiv­a­lent of say­ing time is going back­ward. Unspent income for that period is 95 000 ( 15 000 in baker’s account and 80 000 in contractor’s account) and total unspent income is 100 000 (u add the 5000 of baker’s sav­ings from last period). Now, if you repay 20 000 of debt, aggre­gate demand will be income (175 000) minus change in debt (20 000), so 155 000. It doesn’t mean that aggre­gate demand for the last period has been 155 000, you need to be care­ful about where you start and stop in the cycle. When you cal­cu­late aggre­gate demand from income, you project the demand gen­er­ated by that income in the future. In other words, you need to start from income and end up with spend­ing, and it will bal­ance only if the rate of change in sav­ings is zero. More­over, if you want to com­pare two peri­ods, you need to start and stop at the same point, if not, it becomes very con­fus­ing.

  • koonyeow

    Title: Steve — The Taleb of Aus­tralia

    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.

    Those grey swans of Extrem­is­tan.

  • Sim­ple ques­tion: If u is the wage share, 1- u is invest­ment demand, then the ratio (1 — u)/u is the real inter­est rate, is it not, being demand/circulation?

    I don’t see why these mod­els fail to relate basic terms math­e­mat­i­cally.

  • This is a detailed “wonk­ish”, but clear crit­i­cal com­men­tary on some vari­eties of eco­nomic thought.

    I think that a short intro­duc­tory non wonk­ish expla­na­tion and def­i­n­i­tion of the main char­ac­ter­is­tics of clas­si­cal, neo­clas­si­cal, Key­ne­sian, or Post-Key­ne­sian schools of thought or ori­en­ta­tions that appear in the chart list­ing eco­nomic observers who saw the col­lapse of the asset bub­bles and the onset of the cur­rent cri­sis would be highly use­ful.

    Why, for exam­ple does Michael Hud­son see him­self or is seen by oth­ers as a clas­si­cal econ­o­mist influ­enced by Marx. Where does Paul David­son fit into this pic­ture. Is he a post Key­ne­sian econ­o­mist who cri­tiques but con­tin­ues to espouse a neo­clas­si­cal syn­the­sis of Keynes as opposed to Paul Samuel­son or is he a gen­uine post-Key­ne­sian? What about Joseph Stiglitz and his writ­ings favor­ing indus­trial poli­cies for devel­op­ing coun­tries, but not for indus­tri­al­ized coun­tries? What are the cri­te­ria by which the school or ori­en­ta­tion of a par­tic­u­lar econ­o­mist or eco­nomic observer are defined? When do these cri­te­ria amount to some­thing crit­i­cal to pol­icy and insti­tu­tional design? When are they less impor­tant? To what extent are there sev­eral ways to skin a cat.

    You could have a debt jubilee or you might have the gov­ern­ment mon­e­tiz­ing the debt and pay­ing it off. Where do var­i­ous indi­vid­u­als pro­mot­ing MMT like Bill Mitchell fit into this pic­ture?

    These are some ques­tions that a syn­thetic or eclec­tic observer of facts first and doc­trines sec­ond might pose on these issues.

    My per­sonal pref­er­ence, partly influ­enced by some of the argu­ments pre­sented here would be for a care­fully con­ceived debt jubilee designed in such away as to avoid to pro­mote debt free or low debt eco­nomic expan­sion, full employ­ment, with con­sid­er­a­tion for the sur­vival of work­ing class pen­sion­ers whose pen­sion fund man­agers lost other people’s money in deriv­a­tive spec­u­la­tion. The case of Nestor Kirch­ner and Argentina’s debt jubilee, a few pro­vi­sions to pro­tect the inter­ests of any real work­ing class pen­sion­ers from Italy but not those of vul­ture cap­i­tal­ists might serve as an exam­ple. It may be nec­es­sary for work­ing peo­ple in Spain and Greece to revolt and impose a fair debt jubilee that pun­ishes prop­erty spec­u­la­tors and other par­a­sites, while pre­serv­ing real pub­lic ser­vices and pub­lic and pri­vate sec­tor employ­ment. I don’t know if these ideas are Marx­ist or Post Key­ne­sian, but I think they should be con­sid­ered.

  • My eye­sight isn’t too good so here are a cou­ple of cor­rec­tions to unclear sen­tences in the pre­vi­ous post.

    My per­sonal pref­er­ence, partly influ­enced by some of the argu­ments pre­sented here, would be for a care­fully con­ceived debt jubilee designed in such away as to fos­ter debt free or low debt eco­nomic expan­sion, and full employ­ment, with some spe­cial con­sid­er­a­tion for the sur­vival of work­ing class pen­sion­ers whose pen­sion fund man­agers lost there hard earned sav­ings (other people’s money) through deriv­a­tives spec­u­la­tion.

    Where does Paul David­son fit into the clas­si­fi­ca­tion pre­sented here? Is he a post Key­ne­sian econ­o­mist who cri­tiques but con­tin­ues to espouse a neo­clas­si­cal syn­the­sis of Keynes (sim­i­lar to that of Paul Samuel­son) or is he a gen­uine post-Key­ne­sian?

    A debt jubilee, like that insti­tuted by Nestor Kirch­ner in Argentina, with a few pro­vi­sions to pro­tect the inter­ests of any real work­ing class pen­sion­ers from Italy but not those of vul­ture cap­i­tal­ists might serve as a real world exam­ple.

  • Another cor­rec­tion:

    .….spe­cial con­sid­er­a­tion for the sur­vival of work­ing class pen­sion­ers whose pen­sion fund man­agers lost THEIR hard earned sav­ings .….

  • In answer to my own post con­cern­ing this dis­cus­sion of var­i­ous approaches or schools of thought influ­enc­ing our under­stand­ing of the cur­rent eco­nomic cri­sis, espe­cially the Post-Key­ne­sian per­spec­tive, I have found the Wikipedia arti­cles on this sub­ject use­ful. I still believe some­thing more con­cise and less detailed might be in order to inform the aver­age reader who needs a con­cise def­i­n­i­tion or expla­na­tion of some of the cat­e­gories of thought dis­cussed on this site.

    Here are the titles of some use­ful Wikipedia arti­cles on these sub­jects.

    Post-Key­ne­sian eco­nom­ics
    Neo­clas­si­cal eco­nom­ics
    Clas­si­cal eco­nom­ics
    Aus­trian School
    Ratio­nal expec­ta­tions
    Wash­ing­ton Con­sen­sus

    To access any of these arti­cles dis­cussing schools of eco­nomic and social thought one can sim­ply go to the main Wikipedia Eng­lish site and do a search using any of the above terms or key­words.

    Wikipedia may be imper­fect, but it is highly use­ful and may arti­cles are of excel­lent qual­ity.

    If you have time to plow through these arti­cles which also list promi­nent pro­po­nents of each school, you will find some use­ful dis­cus­sion of some of the key con­cepts that appear fre­quently in the dis­cus­sions on this site.

  • Ques­tion:

    I have just been look­ing at the Fed’s Flow of Funds Accounts for June 7, 2012


    They appear to show an increase in pri­vate debt out­stand­ing or cumu­la­tive pri­vate debt from 2007 to 2011, but a decrease in yearly debt. 

    What accounts for the increase in debt out­stand­ing for most sec­tors shown in the FED report? See page 9 of the Fed Report. The yearly stats for Credit Mar­ket Bor­row­ing by Sec­tor on page 8 show a higher level of de-lever­ag­ing than the cumu­la­tive stats. I won­der what accounts for the dif­fer­ence. Why wouldn’t a neg­a­tive yearly debt or actual sav­ing be reflected in a lower cumu­la­tive debt. Of course, if the lower bor­row­ing and debt lev­els are merely lower than the pre­vi­ous year but still pos­i­tive, this should be reg­is­tered in the cumu­la­tive debt. The raw stats on pages 8 and 9 don’t show inter­est charges on past debt in the pri­vate sec­tor, some­thing else that could go into play here.

    This is a prob­lem I find in inter­pret­ing what actu­ally is being mea­sured in offi­cial sta­tis­tics and I have quite a bit of expe­ri­ence in review­ing of such data.

    Are the BLS data any dif­fer­ent in this respect form the Fed stats?

    Any “wonk­ish” com­ments on the FED data or their method of report­ing?

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