Hoyt, Minsky and the Asset Price/Credit Cycle

Hyman Minsky has become much more widely known since his death in 1996 because his ideas seemed to offer a framework for understanding the great financial crisis – the phrase ‘minsky moment’ has entered the language.

Homer Hoyt, who died in 1984, on the other hand is almost unknown outside the urban geography, urban planning, real estate economics field.  However, where by contrast, and only in America (and in my house) he is somewhat of a revered figure in the small circle that still read his work, having made several major theoretical contributions.

Yet the ideas of each of them enormously enrich the ideas of the other – and offer an insight into what might be termed a Hoyt/Minsky process on how asset prices and credit, the physical economy and the monetary economy interact to drive financial stability/instability.  Though Hoyt’s focus was on land/real estate, with adjustments these concepts are adaptable to a broader categoryof physical assets.

You can read lots about Minksy on the web, a good starting point are Randy Wray’s and Steve Keen’s recent primers, and I guess people would’t be coming to this page unless they knew a little of Minksy’s ideas.

John Monroe Illustrating the Hoyt real estate boom bust cycle

Hoyt’s personal story is like many of those (like Fisher) who were personally burnt by the Great Depression.   During the 1920s Hoyt moved to Chicago, we has a realtor’s and had taught law and wanted to get in on the Chicago real estate boom of the 1920s.  Following the crash of 29 and subsequent depression as well as being personally stung his mind turned to how real esate values are related to economic cycles.  He became interested in land economics and became a doctoral student at the University of Chicago during its golden age.   His doctoral thesis published in 1933 ‘ One Hundred Years of Land Values in Chicago‘ is of interest in this post.

This informed Hoyt’s later much more famous work on how cities grow, both physically and economically.  I think these ideas, combined with modern non-neoclassical economic theory,  have the potential for a ‘Cantillon‘ like understanding of the relationship between the physical economiy, geography and economic growth, only for the modern capitalist economy, rather than the pre-industrial capitalist one.  Bold claim -and one to expand on in future – but to begin to understand this connection we have to go back to the genesis of Hoyt’s ideas.

A dissertation with the title of ‘ One Hundred Years of Land Values in Chicago’  would sound rather dull and institutionalist, but dull it is not and although institutionalist it is combined with theory and is a classic in how the two can and must inform each other.

The thesis had an immediate impact in puncturing the idea that property prices must always rise, as it outlined a series of five major booms and busts between 1830 and 1933.  As Hoyt in his characteristic modesty put it.

The reader may wonder whether a consideration of the unique combination of events that produced Chicago will lead to the formulation of any principles of universal validity…In the history of a city there are elements similar to that found in the biography of a man. An extraordinary combination of hereditary factors, likely never again to be exactly repeated, placed in a historical situation that is also a unique complex of men and events, produces a type of human behavior which may not be duplicated. …A study of an entire city during the whole period of its growth, however, discloses a vision that might escape the glance of one whose horizon was limited by his precinct. The broad sweep of the events of a century reveals recurring cycles in the growth of Chicago in which general moods or similar historical situations are to a certain extent repeated.It is possible that this long-run study of one city will lead to the discovery of factors that are characteristic of real estate activity in other cities, if allowances are made for inevitable differences in local histories and local environments (Authors Preface)

In chapter 5 – page 368 on – he drew together his 5 case studies and looked for common themes.  And before you leap on a high horse and say – hey he’s talking about population and not about credit, he goes on to talk about the interrelation of population and credit – and as I go on to look at Hoyt’s ideas need modification outside of the context of a city’s physical expansion being driven mainly by in-migration.

The causes of land booms in American urban sites in the past century could usually be traced to factors which led speculators to expect an extraordinary increase in the population of the locality within a relatively short time, or the expectation of its development for commercial and industrial purposes. The anticipated population growth was itself due to deep-seated forces, operating over the entire area of Western industrial civilization….

necessary to the population growth of an urban center is the growth of its factories, transportation lines, banks, wholesale houses, and stores, which in turn depend upon the extent of its trading hinterland and its advantages for manufacturing plants, that land speculators seldom fail to stress these factors in describing the possibilities of further growth and the rise of land values of any city….

This increase in the rate of population growth was one of the factors that led to an increase in rents, building activity, and subdivision activity, each of which in turn was carried to speculative excess, and each of which interacted upon the other and upon land values to generate and maintain the boom psychology. (p368 -369)

He called this the ‘real estate cycle

In four of these cycles population increases led land prices – though of course the study preceded by half a century modern methods of analysing leads and lags.  The one exception was the cycle ending 1879 where severe agricultural depression led to an influx from the countryside to Chicago, by contrast during the Great Depression the flow was to the West Coast.

Today we are more likely to consider wider issues of household growth rather than just population growth.  The Chicago model works best for cities on virgin land or formed from agricultural inmigration (such as China).  For more mature cities, as in America, Europe and Australasia today we also have to consider issues that lead to household formation in addition to population immigration, such as ageing (reducing turnover of properties), ups and downs in birth rates and deferred cohabitation,  and divorce (increasing turnover and increasing household formation) .  For example increased lifespan alone will require cities to grow to service the same population (in theory without any net  inmigration) as properties will be occupied across their lifespan by fewer households.  We also have to acknowledge that household formation is driven by economic growth as it requires sufficient income to form a home and sufficient taxes or expectations of profits to build them.  Allowing for this consider Hoyt’s conclusion.

All five movements, Figure 90 shows, were characterized on their upswing by rapid increases in population, feverish building operations, and a hectic land boom in which land values increased from twofold to tenfold in a few years and their downswing by widespread declines in rents and foreclosures on a large scale which reduced land values 50 per cent or more from the peak levels and which brought building operations almost to a standstill. (p372)

He fleshed this out in the rest of this chapter into a theory of the real estate cycle – a summary of the chapter is set out below.  I have highlighted the key sections where there is a supply shortage or oversupply  and reaction in the monetary economy.

A Case History of Five Major Booms and Busts 1830-1933

1. Machine techniques, production methods improved
2. Population begins to spurt up
3. Shortage of housing, office & commercial space first felt
4. Rents begin to rise.
5. Selling prices of old buildings begin to advance
6. Vacant lot purchases begin to rise
7. Rate of new construction begins to rise sharply
8. Credit eases to stimulate volume of new building
9. Rapid growth of population projected far into the future
10. Prices of tracts near settled areas advance rapidly to peak.
11. Large tracts subdivided beyond needs of immediate development
12. Lavish public expenditures
13. Rate of population growth falls off
14. Vacancies reappear
15. Rise in rents slackens
16. Volume of building construction at peak.
17. Asking prices of land advance in face of fewer land sales
18. Financial institutions continue loans on peak values in face of lessened construction
19. Holders of 2nd mortgages begin to foreclose with faith in 1st mortgages
20. Stock market crash
21. Unemployment mounts to peak; wages down
22. Increased movement of population to small city or farm; doubling up in city
23. Vacancies mount to peak in houses, apartments, offices, stores; industrial rents down
24. Interest charges high in proportion to net rents
25. Taxes high in proportion to net rents
26. Second mortgage holders wiped out in flood of first mortgage foreclosures
27. Bank failures mount; loaded with real-estate “frozen assets.”
28. Volume of new building at bottom
29. Subdividing stopped; most vacant land not salable at any price
30. Construction costs at lowest point

source: Homer Hoyt: One Hundred Years of Land Values in Chicago, Copyright University of Chicago Press, 1933

In a key passage Hoyt expanded on a key insight on Henry George nearly 40 years earlier

The supply of houses cannot be immediately increased. The new arrivals ..required housing facilities. They could not ship their old homes to their new abode as they could transport food and furniture. A mere shift in population from one place to another therefore increases the aggregate demand for new residential buildings, because the vacant space left behind cannot be transferred to the city to which the people are flocking. (p376)

In more modern terms we would talk about an increase in aggregate demand within a housing market area, caused by the interrelationship of economic growth in that market area, with effects on household formation, net turnover of properties in that market area and effects on inward and outward migration.  However the fact that ‘the supply of houses cannot be immediately increased’ is the same.  Land, and the property built on it, have a number of unique aspects of a factor of production, I will focus on just two for the preasent argument:

  • Firstly it is in its virgin state, like water and air it is a free good.  It is only when it becomes scarce, from the combination of property enclosure, population density and the advantages of resources/geographical location that that land enjoys that it has a scarcity, and hence a price at all.
  • Secondly property development takes time – it cannot be immediately expanded – you have to buy it, get consent, build it and sell it to a market which will require time to get credit and where there is a chain sell their own properties.

And if there are any New Keynsians out there this is not an issue of price ‘stickiness’ it is a matter of the maths of dynamic disequilbrium- time alone is enough.  By the time the property is bought and sold the market has moved on.  It is a matter of the mismatch of the monetary circuit and the physical circuit of the economy.

When the monetary cicuit and physical curcuit are aligned it is like the San Andreas fault in calm times, pricing decisions based on cost plus pricing is easy, the friction between the two circuits prevents a sharp change in relative prices, when the pressure builds however, such as from a lag in housing supply, then pressure builds and creates the setting for market catasrophe.Key readings on this interaction from Benassy and Laidler [Nick Rowe btw is largely Laidler’s ideas in blog form].

On the rise in disproportionate rise in credit that the disproportionate increase on asset prices causes Hoyt says:

The building boom is stimulated and sustained by a liberal supply of capital made available by the expansion of credit institutions and attracted into new construction by the high profits made in such projects and by the high net yields of existing buildings. Financial institutions play an important role in this mania for building. …almost the whole amount required to erect the building and even to buy the lot could be secured in the heyday of these booms by loans on first and second mortgages (‘shoestring mortgages’ – as Hoyt calls them). (p 383 & 386))

At this phase of the real estate cycle, the rapid rate of increase…that has recently taken place is projected far into the future in the rosy calculations that are broadcast by real estate men. A city that will surpass in size any metropolis the world has ever known before is erected in these speculative dreams, and facts and figures are collected by business men of the community and by “distinguished scholars” to buttress these “castles in Spain” and to make them seem tangible to the lay mind (p388)

For Hoyt the market falls off because the financial speculation outpaces the physical market, population growth falls off as house prices outpace earnings, and, after the delay discussed abov,e a flood of new properties come on stream forcing prices down.

The holders of heavily mortgaged properties, who find themselves called upon to meet prepayments upon both first and second mortgages as well as the interest charges, begin to get into difficulties with the holders of the junior incumberances as soon as the peak income declines slightly or heavy prepayment falls…Up to this time there has been no major recession in general business activity.  The end of the general period of prosperity in all lines is approaching, however, and on some red letter day…a crash on the Stock Market shatters the dream of never ending profits. ..The general slackening of industrial activity which continues after the stock-market crash, however, begins to wear down land values by a process of attrition. Within a year after the onset of the depression, increasing unemployment and reduced wages have sapped the public buying power….The reduction in the margin between income and operating expenses has now proceeded to the point where there is not even enough left to pay the interest charges on the first mortgages. The second mortgage holders, who were the first to foreclose, are themselves wiped out in the flood of foreclosures of first mortgages…All the factors now operate to depress real estate values as they operated to elevate them before….In this situation the financial institutions reverse their liberal lending policy of the earlier period. In most cases the banking power is badly crippled…

From this account it might be inferred that the real estate cycle automatically repeats itself. Such is by no means the case. According to the view presented, the cycle has been generated largely by a sudden and unexpected increase in population which was in turn due to a rush to take advantage of economic opportunities. If this theory is correct, then the recurrence of land booms in Chicago in the future will depend on the expansion of industrial opportunities which attract a sudden accession of population. (p398-401)

The sharp eyed may see this as a fleshing out of the thesis of set out by Simon Kuznets in 1930 in Kuznets S. Secular Movements in Production and Prices. Their Nature and their Bearing upon Cyclical Fluctuations. Boston: Houghton Mifflin, 1930. A kuznets cycle as we call it today –  of 15-25 years.  Kunzets is not mention in the references of Hoyt’s thesis – which doesn’t extend much beyond Chicago.  Also Kuznets work was not known for many years, and it was not publicised in Schumpeter’s work on business cycles because of the considerable rivarly between Schumpter andKuznets.  So to be fair we might call this an independent discovery and talk of a Kuznets/Hoyt cycle. (note Kuznets remarked dryly that the whole  ofSchumpeter’s story of economic growth  story boils down to the assumption that Schumpeter’s heroes (and heroines), entrepreneurs, are getting tired about every fifty years, whilst Schumpeter is a hero of mine as well, Kuznets was right that entrepreneurs are endogenous to cycles not exogenous).

It is here that the links to Minsky should become obvious, and his distinction between hedge, speculative and ponzi positions.

  • In a Hedge position, expected positive cash flow from the investment is sufficient to make all debt payments as they are due, including both interest and principle on the loan.
  • A Speculative position is one in which the expected cash flow from the investment is sufficient to make interest payments, but the principle has to be rolled-over. It is speculative as the positive cash flows must increase, or an asset must be sold on to cover the principle payment
  • a  Ponzi position  is one in which even interest payments cannot be met, so the debtor must borrow more to pay interest  (the outstanding loan balance on the creditors books grows by the interest due each period). Speculative positions will turn into Ponzi positions if positive cash flow falls, or if interest rates rise.  It is a gamble on rising asset prices. Ponzi positions are fragile and risky as default is avoided as long as the creditor allows the loan balance sheet entry to keep growing, and the debtor will keep borrowing, at almost any interest rate, if their only concern is to stay above water. At some point beyond forbearance the creditor will cut losses by forcing foreclosure.

In Minksys famous thesis stability creates the climate for instability  the mirage of stability, moderation and rising profits/asset prices, leads an in increase in speculative and ponzi positions – why innovate when there are lots of easy money and easy outlets for that money?

Specifically in terms of real estates and other assets that attract economic rent the valuation of that rent or imputed rent forms the basis of the valuation of the ‘fundamentals’  on a property loan, and whether the loan is ‘beyond fumandentals’.

Of course asset price driven booms and busts can be driven by any asset, such as in the dotcom and tulip booms, but in all such booms real estate plays a considerable part and in many provides a leading role.  (see Fred Harrisson’s books for a detailed overview of the Hoyt/Kuznets cycle in history and in the 2008 crash, Mason Gaffney has also covered the continuing relevance of Hoyts ideas in some detail.  )

Minskys ideas can be enriched by Hoyt/Kuznets as they help explain specifically what it is about physical asset prices and associated credit which drives the value/money mismatches that Minky talks about.  Also Hoyt/Kuznets can be expanded by an appreciation of Minksy’s ideas on credit and disequilbrium and the broader plug-in he provides to both the disequilbrium economics of Keynes and Fishers ideas of debt-deflation.  It also helps enlighten a debate between Randall Wray and holders of the monetary circuit theory (Sorry the next few paras on this are wonkish)

As summarised by Da Costa

As liquidity preference increases [that is the preference for holding assets as opposed to money], asset prices fall, causing a decline in physical asset output and, consequently, a decrease in the ex post spendings and income flows. In the opinion of [post keynsian critics of circuitism] authors, the divergence is basically because the circuit theory followers have their focus on the money flow created by credit, whereas [others] stress money as a balance that has to be held, because the future is uncertain.

The money balance view being essentially the same as Laidler’s concept of money as a ‘buffer stock’.  The buffer stock theory is a good one however as asset prices rise we get the reverse process a decline in preference for holding idle money stocks and balances and an increased demand for credit to fund physical expansion.  We need to make a distinction between the short run decisions made by entrepreneurs seeing opportunities in monetary/physical disequilibrium prices, and how medium term decisions which effect the price of money and sectoral balances by governments and central banks set the context for those entrepreneurial decisions – one is not reducible to the other nor even to the conventional and rather dated micro/macro distinction.

Of course both Minksy and Hoyt presented verbal models, systems models,  and the big breakthrough of the last 15 years has been the development of mathematical stock-flow consistent (SFC) models.  Will this extend to city modelling – overthrowing the general equilibrium Muth/MIlls/Alonso types models (ironically given the events of the last couple of weeks  it was for work within this framework that Krugman got his noble prize – not macroeconomics – all at once ‘I can tell’  – and even more ironically these equilibrium models are assuma ptoltolemaic land surface of perfects circles and even expansion – one which Hoyt famously criticised), in a way that explains polycentric uneven urbanisation, Hoyt like corridor expansion, fringe belts, and the effects of the economics of agglomeration (increasing’/constant returns – a non neoclassical assumption – see my Why a City Scales Like an Elephant– which these old school models can’t).

This would be not trivial but fairly easy if we could use Python to plug in the outputs from SFC modelling programmes such as the emerging Minsky to the new wave of agent based models such as CitySim, Metronamica, Slueth and ArcGis ( with approaches such as LUCIS), but we cant because the SFC end lacks of a python interface or base as far as I can see, and lack of input/outputs of RDMS arrays stored in common XML formats for modelling cities like CityGML (or any arbitrary format using a web ont0logy language).  With the right funding streams however this is well within the realms of possibility, and is an area where USGS, Erasmus, and the likes and IBM and Siemens have been very keen to fund urban modelling research proposals.  This is back again to Hoyt’s follow up work on city growth economically and physically.

What we are talking here is a firm understand of physical assets undermining economic SFC modelling, and conversly this being used to model economic and geographic growth – the same parameter’s as Cantillon’s work .

Reserves Don’t Constrain Lending – But cash flow, cost of capital and credit risk does – John Carney

John Carney offers important insights as a former banker on the issue of whether reserves constrain lending – worth reading in full. The argument being one made over a century ago – even with endogenous money there will be a cash flow constraint on further lending and this is influenced by the setting of interest rates – but this is a weak means of controlling the money supply.

The idea that banks are not constrained by reserve levels—because they can always borrow required reserves should they fall short—shouldn’t leave anyone with the impression that banks do not face serious constraints on their lending.

The biggest constraint on lending is the basic business model of banking.

When I was a banking lawyer, we usually referred to this as “cost plus lending.” The idea was that the bank’s source of profit was charging more for loans than it cost the bank to make the loan.

This sounds pretty simple until you start thinking about the source of the costs to make a loan. The first cost, of course, is what’s known as “the cost of funding”—the amount the bank must pay to borrow the reserves required to make loans.

But there are a host of non-funding costs as well. The bank must also somehow acquire the regulatory capital to back the loan, and capital can be expensive. The bank faces administrative costs in making the loan. Bankers must be paid. There may also be various taxes and government fees that apply.

Banks also face interest rate risk that they attempt to hedge by either borrowing funds at durations that match the term of the loan they are making—which raises the bank’s cost of funding—or making floating rate loans. But with very large loans, banks will often require floating rate borrowers to hedge against interest rate risk themselves—since you don’t want your borrower defaulting just because rates have increased. The price of interest rate hedging also has to be figured into the borrowers ability to pay the loan.

These aren’t trivial costs. The best estimate is that these add up to almost 300 basis points—the spread between the Fed Funds rate and the Prime Rate.

This means that even if banks can make loans out of thin air, there are plenty of loans that a bank cannot make. Or, to put it differently, if a bank makes too many of these loans it will lose money and eventually fail. A person or business whose free cash flow is too light to support the costs of the loan, for example, is not credit worthy—that is, not eligible to receive a loan under most circumstances.

This is one way that monetary policy works to encourage more lending. When monetary policy brings down the price of banks borrowing reserves—that is, reduces the Feds Funds rate—it brings down the cost of making loans. This means some borrowers will be credit worthy at lower rates that wouldn’t make the cut at higher rates.

The flip side of this is that potential borrowers must also see opportunities to put bank loans to work. If they view potential for future profit as weak, the demand for new loans shrinks. Of course, monetary policy plays a role here too. Low rates can make otherwise uneconomic projects work and, as the Austrians put it, may send a signal that there is more saving in the economy available for future spending. (Although, I would add, that under our current system of Fed manipulated interest rates and endogenous money creation by banks, this is almost certain to be a false signal.)

Banks also must price in the “credit risk” of making a loan—the risk that the borrowers may default, either because the collateral for the loan becomes so undervalued that the borrower “walks away” or because cash flow fall short of what is needed to make the loan.

Credit risk depends both on the individual character of each borrower and the general economic prospects. Rising unemployment, fall in consumer demand, the plausibility of management’s business plans all feed into credit risk.

Evidence indicates that credit risk, interest rate risk and other costs of lending exercise very strong influences over lending. The stuff the Fed tends to influence most directly—the cost of funding—can be overwhelmed by the credit risk and cost of capital.

As Christina and David Romer showed in this 1994 paper, banks have shown that they can maintain high lending levels even when policy is tightening. And, as we’ve seen recently, banks can maintain low lending levels (relative to reserves) even when policy is loosening.

To put it differently, banks are not free to create money willy-nilly. They are subject to restraints imposed by both the markets and regulators. But under current procedures, these restraints do not arise from a hard limit on the amount of reserves in the system. They arise from the costs of lending, which is conditioned by (a) the interest rate targeted by the Fed, (b) regulatory and market capital requirements and the market price for bank capital, (c) by back-office administrative and hedging costs of lending, and (d) the credit-worthiness and credit-hungriness of borrowers.

Is this banking mysticism then – imagining as Krugman asserts that different rules apply to banks than the rest of the economy. No Carneys ‘Cost plus lending’ model is exactly the same ‘cost plus’ balance sheet model of profits that Post-Keynesians have always asserted.  Banks are firms whose product is money – they follow the same rules as any other firm – firms produce physical goods, banks and other financial intermediaries produce money.

C-M

 M-M’

What is more you will spot we have a missing piece to the jigsaw – a theory of interest rates, cost plus=risk adjusted NPV of loan over period (very similar to Fisher).

Blog Brawl Bests Nobel Prize Winning Economist – and ‘gulp’ i’m dragged into Brawl

Lauren Lyster’s Capital Account covers probably what has been the biggest economists bust up since Hayek v Keynes and has caused something of an internet sensation.

The argument is between Professor Paul Krugman, Noble Prize Winner and undoubtedly the worlds most famous economist through his outspoken NYT column and blog, and Professor Steve Keen – who until recently was a marginalised and little known figure based in Australia.  Keen had one major claim to fame though, he was only one of a tiny handful of economists who predicted the great financial crisis of 2007 to today (and Krugman didnt) and the only one to do so with a mathematical model.

Now both figures are progressives and critics of the neo-conservative austerity ‘consensus’ that somehow we will get out of this great depression by austerity which is and will make matters worse.  So why have daggers been drawn? Well the reason is that Krugman and some of his more conservative colleagues such as Greg Mankiw and Robert Lucas all share the same underlying theory of economics – the neoclassical synthesis.  This approach of course failed to predict the crisis and is used to justify austerity economics.  However over a number of years the dissatisfaction with this approach has been growing.  Because progressive Neo-Classicals – the so called New Keynesians, have been unable to lend a clear blow on austerity economics, either to show why we had the great depression, to prove that it does not work and present a clear policy alternative, many have concluded that they are an active impediment to a change in thinking about economics.  But the austerians can point to progressives supporting the foundations of their own economic theory it must be right mustn’t it.  The New Keynsians have become the ideological prop to the status quo.  A potemkin village to be pointed at by neo-cons to critics of economics.  YankeeFrank on Naked capitalism sums it up

Actually, I would argue that Krugman and his Rubinite sponsors are our worst enemies. They provide many of the theoretical underpinnings for our current lemon socialist/crony capitalist system. Krugman, as far as I recall, has still refused to utter the words “fraud” or “crime” in relation to the misdeeds of our bankster overlords.

To say that debt can be “modeled out”, or banks can be ignored, in our understanding of the financial system is exactly how the devil gets in….

Krugman’s answer to our problems is the typical limousine liberal response, and it amounts to pretty much the same thing as the republican response: charity for the “losers” in our economy. The main difference is who should provide it, the government or private donors.

Sure Krugman wants “money drops”, but insists the current system is sustainable if we just do that. He in no way calls for real reform of finance, banking or industrial policy. But that is because he’s spent his career pushing the policies we now live under. …So yes, Krugman is the enemy. The idea that he is an ally just shows us how far from any real solutions this nation is; which is why we’re going to have another, much more massive and destructive, collapse before the ideas discussed on … truly progressive sites get the airing and support they deserve.

The alternative school has emerged from the ‘post Keynesian’ school.  This school grew out of Keynes closest associates and was based on the idea that the key issue in economics is that of disequilibrium.  That is when different markets are out of sync with excess/under supply, such as of course lack of demand for labour – unemployment, or excess demand for money, inflation. This group held that what was important about Keynes was that it was a disequilibrium theory.  Whereas in America the synthesis in the neoclassical synthesis squeezed Keynes into a more conventional ‘equilibrium’ box where economies are stable and markets stabilising and things tend to settle down except where there are external ‘shocks’, or where prices are ‘sticky’ – like – heaven forfend – when people don’t automatically drop their wages if their is a bad week.  The Post Keynsians attacked the foundations of this view, but for many years were a small group.  They achieved a few notable victories, notably from economist Piero Sraffa who for a time seemed to shake the whole foundations of economics with results neo-classicism couldn’t explain and which even the giants of the time such as Paul Samuelson admitted defeat on.  But it didn’t go anywhere.  It was a Pyrrhic victory.  The results were dismissed as being abstract and of no practical importance.

Have the heirs of Wyne Godley and Hyman Minsky begun to defeat neoclassical economics?

Everything carried on as before and heterodox figures were confined to a small club.  There was a reason for this – money – or rather lack of a theory and model of money and banking.  In the last 20-30 years however to fill that that huge gap, a theory of money, credit and banking, developed.  It was known as the French circuitist school.  Its ideas were actually very similar to ideas which were dominant before the second world war, that an expansion of money is based on credit, which is founded on profits in the future funding loans and creating monetary expansion today, through profits funding interest on loans, as opposed to investments created through savings, which is not monetary expansion as it is simply spending deferred until the future –  the monetary stock does not change.     A second breakthrough came with the work of Wyne Godley,  who incidentally is the model for the St Michael defeating the Devil on the side of Coventry Cathedral.  He took this approach toward money and modelled how it flowed between bank accounts and the economy.  This approach became known as stock-flow consistent economics.  The other key figure was Hyman Minsky – again a fairly marginal figure in his lifetime but a cult figure now –  since who set out a model of financial instability – how a boom in credit could create a financial crash and recession.  Steve Keen was the figure who brought these ideas together and more importantly created a dynamic computer economic model – which he used to predict the 2007 crash, and further more the risk of a further ‘double dip’ which we have actually now begun to see.

Although Steve Keen launched frequent attacks on the neo-classical citadel Krugman seemed to ignore Keen.  Until last week, and then it all kicked off.  Exactly what the issues were and how they were argued will have to wait till another day as it deserves a more through treatment in terms people can understand without jargon and maths.  In short though Krugman attacked a paper of Keen’seven though he professed not to really understand the ideas behind it.  The reaction on the internet was instant, the comments on Krugman’s blog made it clear that Krugman should learn this stuff and moreover most felt Keen was right.  The reaction of Krugman was to lash out accusing Keen and his critics of mysticism.  This simply unleashed a torrent of criticisms on the web, which to my eyes were about 20:1 in favour of Keen.  The problem was that Krugman seem to express some very naive and out of date ideas on how money works.  If you want to follow the arguments here is  Krugmans follow up and a third post. To which Keen replied here, and then  here.

Keen responded by calling Krugman’s economics ‘ptolomiac’ as outdated as assuming the sun revolved around the earth.  I chipped in a short piece explaining how Krugman’s economics weren’t even ptolomiac – as it was timeless so the earth didnt even spin.  The piece went through Krugman’s ideas on how investment is funded and how money is created and tried to show some flaws in his approach.  To my surprise Keen to whom I am just an acquaintance of and occasional correspondent with posted my piece in support and retweeted some of my more abtuse theoretical points.  From his blog.

I’m rather lucky with the calibre of my blog members, and that’s been in evidence in the discussion over Krugman here in the last few days. One comment by Andrew Lainton simply has to be shared more widely…

Gulp.  Krugman responding to the Ptolomiac criticism lashed out – but made a critical error, he quoted Keen selectively in order to make him look like some kind of unknowledgeable idiot.  The blogoshere spotted this instantly and came down on Krugman like a tonne of bricks, the argument became for a time intemperate.  Scott Fullweiller made a slam dunk intervention.  Until suddenly, Krugman, seeing that many had considered he had made an idiot of himself withdrew from the field saying im right, the rest of you are wrong and im not taking part in the debate any more – he took his ball home.  Though he did come back with the rather limp defence that the New Keynesian theories  were somehow different and not the kind of ‘DGSE’ models that Keen has attacked and.

I’m all for listening to heretics when they offer insights I can use, but I’m not finding that at all in this conversation, just word games and continual insistence that the members of the sect have insights denied to us lesser mortals. Time to move on.

Which the blogosophere immediately picked up on as hypocracy as New Kenynsian models are built on the mathematical foundation on DGSE and it was Krugman who was playing word games and refusing to engage with the criticisms of why they were wrong.

Ana -Berlin summed it up

What this latest Krugman post shows is a bad faith, not superior knowledge. I’ve read Keen’s blog and Krugman’s original posts along with all the readers comments and seems to me that 1) Krugman tried to debunk an opposing theory with a couple of coffee table talk remarks which is in itself a massive display of petulance. 2) Krugman constantly appealed to “authority” to disguise is inability to engage the opposing theory on scientific grounds (e.g. cannot go to Berlin due to more important engagements). 3) When hounded by readers who, correctly, point out that his arguments are fallacious and that he fundamentally misunderstands the role of banking, Krugman resorts to some third party opinion who, conveniently, misrepresents Keen’s points completely. 4) it all ends in a nasty tone, with Krugman insulting Keen, and here, one should note, that this is not a symmetric battle, you are talking about a Nobel prize winner, world wide known economist trying to diss and belittle a much lesser known professor out of spite.  On a final note i would advise everybody to get acquainted with Keen, Krugman is not going to write economical history

In terms of the argument the overwhelming view of the internet was the Krugman had lost the debate and this was one for the history books – perhaps even a turning point in the dominance of neolassical economics – or neo-con economics as I call it.  As I said a few days ago ‘this week will be remembered as the end of the beginning of the end of neo-classical economics’.

Interestingly many of the key theoreticians in this new approach come from a non economics background, such a historians, traders, and engineers, so why should not even a town planner join in.  Neo-classical economics had become so degraded that it needed to be torn down from the outside.

Neo-classical economics now has its wagons circled because there have been a number of attacks recently even from outside and inside the corral, from figures such as Eggertson and Kocherlakota which imply that disequilibrium is the norm and that you get this even when prices are fully flexible – so the defence that New Keynsianism is somehow immune to criticisms for its inclusion of ‘stickiness’ falls apart.  These results if followed through imply that the foundational principles of neo-classical economics are incoherent and must be replaced by a dynamic disequilibrium alternatives on broadly the lines that Keen and others have suggested.

As Keen Said on Capital Account last night – video at top

Hey, your models didn’t predict the financial crisis, we can ignore your models….

[Y]ou can’t model the economy without including the role of banks, debt, and money. And Krugman’s part of the economic establishment, which for thirty or forty years has got away with arguing that you can model a capitalist economy as if it had no banks in it, no money, and no debt… You just don’t have a model of capitalism if you don’t include those components.

Investment Volatility and the Business Cycle – Post Keynesian Approaches

Just a brief introductory note on matter which will require much deeper treatment with equations and models in due course.

Marx’s view that volatility in investment is the primary driver of the business cycle and periodic crisis is no longer a fringe idea only held by Marxian economists.  It is central to all of the explanations being offered to the financial crisis, post-Keynesian, even Austrian.  Neo-classicism almost by definition has no real explanation other than a voodoo reference to exogenous ‘shocks’.

However what the metronome like ‘driver’ of the cycle in dynamic terms is not agreed.  There is broad agreement in post-keynsian approaches that  once a disequilibrium process is initiated then Minsky type financial instability mechanisms can create a crash – that is if you accept the broad principle of the non-neutrality of money when out of equilibrium.

There is less agreement however over what that ticking metronome is.

Models based on Goodwins (1967) work assumed that a higher wage share leads to lower profits, then lower investment and thus a general economic slowdown, which then squeezes the wage share – and the cycle repeats.

The alternative approach is models based on Kaleckis (1933) approach & argues that a higher wage share has an expansionary, not a contractionary, effect because the propensity to consume out of wage income is higher than that out of profit income – retained capitalist profits.

“The approach…applied in the theory of business cycles….consists of establishing two relations: one based on the impact of the effective demand generated by investment upon profits and the national income; and the other showing the determination of investment by, broadly speaking, the level and the rate of change of economic activity. The first relation does not involve now particularly intricate question. The second, to my mind, remains the pièce de resistance of economics” (M. Kalecki, 1968: 435)

“Marx did not develop such a theory [i.e. a theory of the determinants of investment], but neither has this been accomplished in modern economics”. Kalecki (1968: 464)

During booms, firms enjoy increases in profits, leading to increased investment. However, the increase in orders for capital investment increases the stock of capital, until it proves unprofitable to make more investments.

Investment considered as capitalist‟s spending is the source of prosperity, and every increase of it improves business and stimulates a further rise of spending for investment. But at the same time investment is an addition to the capital equipment and right from birth it competes with the older generation of this equipment. (Kalecki 1937)

The causes of growth are easy to understand from this approach, but the causes of inflexion and the downswing is much more subtle – and insightful.  There are two effects here, one effect is due to time delay from investment.  For a period it assumes that capitalist spending is taken out of the system until the capital stock is ready to produce – but as here he may have made a partial error which I will explain in a moment.  Secondly as new capital comes on stream it competes with older capital which may not be able to compete at the same price, hence profits are squeezed.  A process of creative destruction of capital.

Why have not Kalecki’s models been used more widely in dynamic modelling? In 1933 Kalecki presented (1935 in English) a fully dynamic model, but following Frisch’s devastating criticisms of such models he abandoned it for an equilibrium model with exogenous shocks.  Also his 1933 model did not explicitly treat monetary flows – profits are only a signal to invest not a stock to invest from.  His models from 1937 did treat profits in this way but abandoned the earlier fully dynamic approach.  Hence Kalecki, despite his insights, never had a fully dynamic monetary model of investment.

Frisch’s influence may not have been benign, neither on Kalecki or on economics as the first joint Nobel prize winner.  He replaced dynamic disequilibrium processes with the mathematics of the pendulum, breaking down all times series into damped equilibrium processes oscillating to zero overlain by external shocks.  This approach strongly influenced Samueleson’s approach of treating all phenomenon in a comparative statics framework (see Weintraub 1991).   With more modern systems dynamics mathematics we can account for cycles that are stable but dont occilate to zero.  We can also see that Frisch’s criticism, that dynamic models which show breakdown were flawed, as dangerous.

Steve Keen’s systems dynamics approach is the most promising way of modelling the economy expanding on the transaction flow approach of Godelyand Lavoie, it uses explicit modelling of exogenous money with a Goodwin ‘predator prey’ model as its pulse feeding in to a Minsky type investment model.  The model in its various – still early – forms seems to match empirical data fairly well as well as passing the critical test of being able to model the boom and bust of the recent crisis.

However it is the treatment of the Goodwin process that may be problematic.  It is an approach which is good for an individual firm but weak for the overall economy, for the reasons concerning effective demand Kalecki expounded.  In generating a business cycle it generates good results but in doing so it might simply be simulating a profits cycle for the economy as a whole cause by other factors in the real economy.

This distinction between driver of the business cycle has been brought to the fore by  Stockhammer and Stehrer’s recent work – which seems to indicate that a Kalecki ‘profits led’ driver of the cycle fits the empirical data better than Goodwin’s (1967) based ‘wages led’ driver of the business cycle.  Also Goodwin’s 1989 work seemed to acknowledge that once unemployment and flexible capacity utilization is allowed for, an increase in the wage share need not lead to a decrease in effective demand – Kalecki’s position.  Goodwins 1967 model assumes full capacity utilisation and no unemployment.

Professor Keen seems to have rejected a Kalecki investment driven cycle because Kalecki’s model is non-monetary, this is true of his 1933 fully dynamic model, but from 1937 his models were monetary, influenced in part by Keynes and Kaldor.  Sadly they returned to an equilibrium framework using Frisch’s mathematical approach.  The challenge is to place Kalecki’s later models in a fully dynamic monetary framework and that is the task of a number of researchers worldwide.

But I don’t think the Goodwin and Kalecki approaches are mutually exclusive – though the insight for uniting them comes from an unlikely source. The key is to integrate wages fluctuations within an investment framework.

Kalecki’s assumption that ‘delays’ in investment lead to money being ‘paused’ and not entering into either cash-flow or effective demand is flawed.  The insight here comes from an austrian economist Strigl (1934 Capital and Production). his ideas, though clouded by its Austrian language of ’roundabout methods’  made him the only Austrian of his period to take production, liquidity and debt seriously and allow for endogenous money.  He had a fully worked out, though flawed, model of the business cycle (the key flaw being zero future consumer expectations of interest rates driving the cycle).

His insight is then when investment in capital goods is made until that capital good is complete funding is required for the wages of those constructing the capital good.  Therefore funding for wages limits the length of time to realise investment, and for entrepreneurs funding for wages during the period before sales begin would likely come from credit expansion. So the size of investment is limited both by the wages share and amount of anticipated profits and the availability of credit. Until a positive cash flow from production from a capital good is realised all intermediate good and set up investment is a diversion from capitalist consumption to workers consumption – the money is not delayed – it adds to effective demand, but constricts profits, the delay is important because of its distributional effects.  What is more it is a diversion to expenditure on what Strigl called consumer goods and what Sraffa would call ‘basics’. The higher the price, in terms of the real wage, for these basics the less money is available for investment.  A very classical insight  harking right back to Cantillon.  The price of food regulates profits and investment – a phenomenon we can now see very starkly in China and the Arab Spring.  What we have here is effectively a reproduction schema between consumer and capital goods.

My hope is that by explicitly modelling this schema, within a transaction flow system, we can enhance the Keen model, as well as providing for an endogenous treatment of both the interest rate and inflation – though these are beyond the scope of this article.  The hope also is that by modelling inflation and having a stock of unemployed labour we can generate a dynamic Phillips curve, and its breakdown,  rather than assuming a Phillips curve relationship.  Again a matter for another day.

There is much more that could be said here, especially about the heterogeneous nature of the capital stock and the creative destruction of it.  These are also  beyond the immediate scope of this article.

Frisch, R., (1933), “Propagation Problems and Impulses problems in Dynamic Economics”,in: Economic essays in Honour of Gustav Cassel, Londres: Georges Allen & Unwin, p. 171-205. Reprinted in Robert A. Gordon and Laurence R. Klein (eds.), Readings in Business Cycles,Homewood,Ill.: Irwin 1965.

Frisch, R. and Holme, H. (1935), “The Characteristic Solutions of a Mixed Difference and Differential Equation in Economic Dynamics. Reprinted in M. Kalecki, Collected Works, vol. I,Oxford: Clarendon Press, 1990.

Godley W. and Lavoie M. 2007. Monetary Economics: An Integrated Approach to Credit, Money, Income, Production and Wealth, Palgrave MacMillan.

Goodwin, R. (1964), “Econometrics in Business Cycle Analysis”, in: A.H. Hansen, Business Cycles and National Income, expanded edition,New York: W.W. Norton and Compagny Inc.

— (1989), “Kalecki’s Economic Dynamics: A Personal View”. Reprinted in M. Sebastiani, Kalecki’s Relevance Today, Macmillan, 1989.

-Essays in Nonlinear Dyanamics (1989)

Kalecki, M. (1990), Collected Works, vol. I,Oxford: Clarendon Press.

— (1990), Collected Works, vol. II,Oxford: Clarendon Press.

Keen. S (2011) Debunking Econonics Zed. London.
Keen, Steve. 1995. “Finance and Economic Breakdown: Modeling Minsky’s ‘Financial Instability Hypothesis.’.” Journal of Post Keynesian Economics, 17(4), 607-35.
-(2011)A Monetary Minsky Model of the Great Moderation and the Great Recession

Stockhammer, E, Stehrer, R (2011). Goodwin or Kalecki in demand? Functional income distribution and aggregate demand in the short run. Review of Radical Political Economics forthcoming

Stockhammer, Engelbert, Onaran, Ozlem and Ederer, Stefan (2009). Functional income distribution and aggregate demand in the Euro area. Cambridge Journal of Economics, 33(1), pp. 139-159. ISSN (print) 0309-166X

Strigl (1934) Capital and Production – English Translation Mises Instite 2000.

Goodwin or Kalecki in demand? Functional income distribution and aggregate demand in the short run Engelbert Stockhammer and Robert Stehrer http://www.peri.umass.edu/fileadmin/pdf/working_papers/working_papers_201-250/WP203.pdf

Weintraub w. (1991) Stabilizing Dynamics, Constricting Economic Kanowledge