Understanding Modelling Financial Instability and Global Crisis

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Explore the intricate model of financial instability with empirical data analysis in the context of the global financial crisis. Follow the financial instability hypothesis to comprehend the dynamics of capitalism through a comprehensive monetary system model, integrating concepts of Ponzi finance, Minsky, and the Circuit. Delve into differential equations, algebraic relations, and cyclical growth patterns to simulate the impact of variables like output, wages, employment rate, and debt on the economic system.

  • Financial Instability
  • Global Crisis
  • Empirical Data
  • Modelling
  • Capitalism
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  1. Behavioural Finance Lecture 12 Part 2 The Global Financial Crisis Empirical Data & Modelling

  2. Modelling financial instability Financial Instability Hypothesis only theory that makes sense of this data Model in previous lecture Had only implicit money Omitted Ponzi Finance Omitted role of deflation This lecture Model with Ponzi finance Combining Minsky and the Circuit Full monetary model of capitalism

  3. Modelling financial instability Firstly: last week s Goodwin model in equations Causal chain: capital determines output K v Y a Y Output determines employment L Employment rate determines rate of change of wage (Phillips curve PH) L N 1 w dt d P w H Wages (w.L) determine profit w L Y d dt ( ) Profit determines investment = rate of change of capital Population growth & technical change drive the system: I K K 1 a dt d 1 N dt d = = a ; N

  4. Modelling financial instability dY dt dw dt da dt dN dt I System has 4 differential equations : Some calculus needed to work out other terms: = g Y Growth rate: ( ) = Wage level: P w H = Productivity: a = Population: N ( ) 1 Y dt d 1 K v d K dt v 1 K dt d 1 K ( ) ( ) r = = = = = g Y K I Y K r v Full system is

  5. Modelling financial instability 4 differential equations & 7 algebraic relations System States Real growth rate Algebraic Relations d d d d g t ( ) Y t ( ) t ( ) 0 ( ) 0 Y t ( ) Y 0 ( ) Y0 Y t ( ) W t ( ) t PH t ( ) ) w t ( ) w t ( ) L t ( ) Real wage w t ( ) ( w 0 ( ) w0 W t ( ) W 0 ( ) W0 t Y t ( ) a t ( ) L t ( ) N t ( ) w t ( ) a t ( ) Productivity Population d d d d a t ( ) a t ( ) a 0 ( ) a0 L t ( ) L 0 ( ) L0 t N t ( ) t ( ) 0 ( ) 0 N t ( ) N 0 ( ) N0 t t ( ) 0 ( ) 0 t ( ) v Y t ( ) ( rt ( ) r0 ( ) r0 ) I rt ( ) v g t ( ) g 0 ( ) g0 Simulating this, gives same cyclical pattern as last week s systems engineering model

  6. Modelling financial instability Cyclical growth Output Limit cycle in wages & employment Cycles in employment and wages 6000 110 100 4000 Real output 90 80 2000 70 Employment Rate % Wages share % 0 0 20 40 60 80 100 60 Income & Employment Limit Cycle 0 20 40 60 80 100 Year 1.1 Years Then add in debt Wages Share of Output 1 0.9 0.8 0.7 0.6 0.8 0.85 0.9 0.95 1 1.05 Employment Rate

  7. Modelling financial instability Firms borrow when desired investment exceeds profits: Change in debt: dD dt Profit now net of interest payments Y W r D = A new system state: debt to GDP ratio Very different dynamics but stable system 110 = I D Y = d Employment vs wages share 110 100 100 Wages share % 90 90 80 80 70 70 60 80 85 90 95 100 105 60 0 20 40 60 80 100 Employment Rate % Employment % Wages share %

  8. Modelling financial instability Now add in Ponzi Finance Borrowing $ to speculate on rising asset prices Adds to debt without adding to productive capital Modelled as a function of rate of economic growth Higher rate of growth, higher level of speculation 1 Ponzi Finance: Y dt dP ( ) g = Aggregate debt now includes Ponzi Finance Change in debt: dD = + I P dt

  9. Modelling financial instability Now a six-dimensional model: System States Algebraic Relations d d d d g t ( ) Y t ( ) t ( ) r t ( ) D t ( ) ( 0 ( ) 0 Y t ( ) Y 0 ( ) Y0 Y t ( ) W t ( ) ) t PH t ( ) ) w t ( ) w t ( ) L t ( ) w t ( ) ( w 0 ( ) w0 W t ( ) ( ) W 0 ( ) W0 t Y t ( ) a t ( ) L t ( ) L 0 ( ) L0 d d a t ( ) a t ( ) a 0 ( ) a0 t L t ( ) N t ( ) t ( ) 0 ( ) 0 d d N t ( ) N t ( ) N 0 ( ) N0 t W t ( ) Y t ( ) Debt dynamics t ( ) 0 ( ) 0 ( )Y t ( ) d d I rt ( ) t ( ) + D t ( ) P t ( ) D 0 ( ) D0 t t ( ) v Y t ( ) ( D t ( ) Y t ( ) rt ( ) r0 ( ) r0 Ponzi finance d d Ponzi g t ( ) P t ( ) ( ) Y t ( ) P 0 ( ) P 0 t ) g 0 ( ) g0 I rt ( ) v g t ( ) Very different dynamics With Ponzi switch set to zero, same as before With Ponzi on d t ( ) d 0 ( ) d0

  10. Modelling financial instability Dynamics Borrow money to finance investment during a boom Repay some of it during a slump Debt/ Income ratio rises in series of booms/busts Eventually one boom where debt accumulation passes point of no return Real Output Employment Rate 1500 No Speculation Ponzi Finance 100 1000 Per cent 90 500 80 No Speculation Ponzi Finance 70 0 10 20 30 40 50 0 0 10 20 30 40 50 Years Employment & Income Distribution 120 No Speculation Ponzi Finance Wages per cent of Output 100 80 60 40 70 80 90 100 Employment Rate per cent

  11. Modelling financial instability Driving force is debt to GDP ratio Debt to GDP Ratio 20 1200 No Speculation (LHS) Ponzi Finance (RHS) 0 1000 20 800 Per cent of GDP Per cent of GDP 40 600 60 400 80 200 100 0 120 200 0 10 20 30 40 50

  12. Are We It Yet? Can summarise model s equations in 4 stylised facts Employment rises if growth exceeds productivity + population increase Wages share grows if wage rises exceed productivity Bank lend money to finance investment & speculation Speculation rises when growth rises Same model in flowchart form (with different parameters)

  13. Are We It Yet? + + + + Investment Capital Output Plot Minsky: Ponzi finance extension to Keen 1995 Speculative to Productive Debt Output 6 Cyclical Growth 5 2000 4 1000 3 2 0 0 10 20 30 40 50 60 70 1 Time (Years) 0 0 10 20 30 40 50 60 70 WageShare Output Click here to download Vissim viewer program Time (Years) Click here to download Vissim viewer program Cyclical Growth Wages share of output Employment Rate On DebtInModel Debt Ratios 1.0 On Off Ponzi InitialBoom .5 Plot Click on icon to run simulation after installing Vissim Viewer Debt to Output Ratios Total Debt Productive Speculative 0 0 10 20 30 40 50 60 70 6 Time (Years) 5 Cyclical Growth 4 1.1 Employment 3 .9 2 .7 1 .5 .3 .5 .7 .9 1.1 0 0 10 20 30 40 50 60 70 Time (Years) EmploymentRate + + Wages Employment InterestRate TotalDebt Profit Productive Debt Speculative Debt Profit + + Investment RateOfGrowth *

  14. Are We It Yet? Weakness of previous model Implicit money only deflationary process ignored No explicit treatment of aggregate demand Overcome by blending Minsky with the Circuit Lay out basic macro operations in accounts table See Roving Cavaliers of Credit for basic approach Also Circuit Theory & Post Keynesian Economics Generate financial flows dynamics Couple with Goodwin cycle model

  15. Are We It Yet? The financial flows table: "Type" Nonlinear functions for placemarkers C, I and J: 0 0 1 1 1 "Account" "Bank Capital" "Bank P/L (B.PL)" "Firm Loan (FL)" "Firm Deposit (FD)" "Worker Deposit (WD)" "Symbol" B.C B.Ct ( ) B.PLt ( ) F.Lt ( ) F.Dt ( ) W.Dt ( ) "Compound Debt" 0 0 A 0 0 "Pay Debt" 0 B 0 B 0 "Record Payment" 0 0 B 0 0 "Debt-financed Investment" 0 0 C C 0 = M.1 "Wages" 0 0 + 0 D D "Interest" 0 ( E F ) 0 E + I F "Consumption" 0 G 0 G H H "Debt repayment" I 0 0 0 I "Record repayment" 0 0 0 0 "Lend from capital" J 0 0 J 0 "Record Loan" 0 0 J 0 0 ( )PCt ( ) = Inv Inv rt ( ) FLt ( ) RL rt ( ) C Yrt ( ) FL = I ( ) BCt ( ) LC rt ( ) BC = J ( )

  16. Are We It Yet? Fully specified Phillips function for wage setting: Employment Rate of change of employment Rate of inflation adjustments Inv rt ( ) Wages and Employment Rate ( ) Phillips Pc 1 v 1 W t ( ) d d Rate of change of employment Inflation ) Ph t ( ) Curve + + + W t ( ) W t ( ) ( ( ) v ( ) 1 v a t ( ) 1 ( s ) PCt ( ) t 20 Percent change in money wages 15 10 100 Ph 100 5 0 5 90 92 94 96 98 100 Employment Rate

  17. Are We It Yet? Investment, debt repayment and money relending functions: Investment & Profit Rate Loan Repayment and Money relending 50 20 Loan repayment Money relending 40 15 Percent of GDP x RL 30 r 100 Years 100 Inv 10 100 x LC 20 100 5 10 0 0 5 0 5 10 10 5 0 5 10 r x Profit Rate % Rate of Profit

  18. Are We It Yet? Financial Sector Overall model: 14 equations (11 ODEs, 3 algebraic) 5 equations for financial sector 1 for prices 1 for wages 7 for physical economy FLt ( ) ( BCt ( ) LC rt ( ) d d BCt ( ) ) ( ) RL rt ( ) t BPLt ( ) B d d BPLt ( ) rLFLt ( ) rDFDt ( ) rDWDt ( ) t BCt ( ) LC rt ( ) FLt ( ) ( ( ) d d + Inv rt ( ) FLt ( ) PCt ( ) Yrt ( ) ( ) ) RL rt ( ) t BCt ( ) LC rt ( ) FLt ( ) ( BPLt ( ) B WDt ( ) W W t ( ) Yrt ( ) a t ( ) ( ) d d + + + + Inv rt ( ) FDt ( ) rDFDt ( ) rLFLt ( ) PCt ( ) Yrt ( ) ( ) ) RL rt ( ) t WDt ( ) W W t ( ) Yrt ( ) a t ( ) d d + WDt ( ) rDWDt ( ) t Physical output, labour and price systems Krt ( ) v Level of output Yrt ( ) Yrt ( ) a t ( ) Yrt ( ) PCt ( ) Yrt ( ) W t ( ) rLFLt ( ) Rate of Profit rt ( ) v PCt ( ) ( ) Rate of employment ) Inv rt ( ) v 1 v d d t ( ) t ( ) + v ( ) t ( Inv rt ( ) v Rate of real economic growth g t ( ) ( ) Inv rt ( ) v Pc 1 v 1 W t ( ) d d ) Ph t ( ) + + + W t ( ) W t ( ) ( ( ) v ( ) 1 Rate of change of wages a t ( ) 1 ( s ) PCt ( ) t Pc Rate of change of prices 1 W t ( ) ( d d PCt ( ) PCt ( ) a t ( ) 1 s ) t d d d d Rate of change of capital stock Krt ( ) Krt ( ) g t ( ) t d d Rates of growth of population and productivity a t ( ) N t ( ) a t ( ) N t ( ) t t

  19. Are We It Yet? Same system in QED:

  20. Are We It Yet? Integrating Minsky & the Circuit Debt-deflationary dynamics in strictly monetary Minsky-Circuit model The Great Moderation , then The Great Crash Bank Accounts Debt to Output Ratio 1 105 5 1 104 4 Years to repay debt 3 1000 $ 2 100 Bank Equity Bank Transactions Firm Loan Firm Deposit Worker Deposit 1 10 0 0 10 20 30 40 50 1 0 10 20 30 40 50 Year Year

  21. Are We It Yet? Stability is destabilizing... Rate of employment and rate of profit Real growth rate 110 10 20 15 Percent of workforce 100 Percent p.a. 5 Percent p.a. 10 90 5 100 ( + ) 0 0 80 Employment Profit 5 0 10 20 30 40 50 70 5 0 10 20 30 40 50 Employment and wage share dynamics Year 120 Inflation Rate 60 100 Worker share of GDP 40 Percent p.a. 80 20 0 0 60 20 40 0.7 0.8 0.9 1 1.1 40 0 10 20 30 40 50 Employment rate a t ( ) t

  22. Are We It Yet? Income inequality Not worker vs capitalist but worker vs banker Income Distribution 110 Workers Capitalists Bankers 100 90 80 70 Percent of GDP 60 50 40 30 20 10 0 10 0 10 20 30 40 50 Year

  23. Are We It Yet? l r Bank Assets Bank Liabilities (Deposits) Can government policy save us? Simple model with fiat injection implies can succeed against credit crunch alone: 1500 Loans Unlent Reserves 1500 Firms Households Banks 1250 1250 1000 1000 750 750 500 500 250 250 0 0 0 10 20 30 40 50 60 0 10 20 30 40 50 60 Time (Years) Time (Years) H_D URate InfRate B_D F_D Unemployment Inflation 25 No Stimulus Bank Injection Borrowers Injection 10.0 No Stimulus Bank Injection Borrowers Injection 7.5 20 5.0 2.5 15 0 10 -2.5 -5.0 5 -7.5 0 -10.0 0 10 20 30 40 50 60 0 10 20 30 40 50 60 Time (Years) Time (Years) Parameters & Initial Conditions 3 Debt to Output Ratio Financial System 25 No Stimulus Bank Injection Borrowers Injection Magnitude of Crunch NoStimulus 20 Production System C_size tCC StimBank 0 25 15 StimFirm 10 StimFirm 1. l r 5 F_L D:0 S:1 / 100 Y 0 60. 0 10 20 30 40 50 60 Time (Years)

  24. Are We It Yet? My expectation: best outcome of government policy alone will be Japanese Stalemate Government monetary injections neutralise private sector deleveraging Outcome Turning Japanese : Long-term stagnation and borderline deflation Need debt abolition & real financial reform Cancel debts that should never have been issued Cauterise financial sector in the process Reform assets to minimise chance of future bubbles Shares on secondary market expire in 30 years Property leverage limited to 10 times annual rental

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