The ideas which are here expressed so laboriously are extremely simple and should be obvious. The difficulty lies, not in the new ideas, but in escaping from the old ones, which ramify, for those brought up as most of us have been, into every corner of our minds. (Keynes 1936, p. xxiii)

The concept of endogenous money has been integral to Post Keynesian economics ever since the pioneering empirical work of Basil Moore (Moore 1979; Moore 1983; Moore 1988; Moore 1988; Moore 1995; Moore 1997; Moore 2001; Moore 2006), and it is fundamental to Minsky’s Financial Instability Hypothesis (Minsky 1963; Minsky 1972; Minsky 1975; Minsky 1977; Minsky 1980; Minsky 1982). The concept can be traced back to Schumpeter (Schumpeter 1934), and even further ( though in not as explicit a form—see Newcomb 1886; Taussig 1911).

However, the ubiquity of the concept does not mean that its implications are fully understood—even by those who accept it is true—for the reason encapsulated in our opening quote from Keynes. Old ideas, even old ones from Keynes himself, can make it difficult to fully appreciate the consequences of a new idea. In this paper we prove that two key concepts from Keynes’s General Theory (Keynes 1936)—the equality of income and expenditure (and hence savings and investment)—must be modified for a model of capitalism with growth in which banks endogenously create money.

The starting point of the monetary macroeconomics of endogenous money is instead that effective demand is equal to income plus the change in debt. This is entirely consistent with sectoral balances summing to zero, as we prove below.

Antecedents

The proposition that effective demand exceeds income is not a new one: it can be found in both Schumpeter and Minsky (and arguably in Keynes’s writings after the General Theory, though not in as definitive form—see Keynes 1937, p. 247). A difference between income and expenditure, with the gap filled by the endogenous creation of money, was a foundation of Schumpeter’s vision of the entrepreneurial role in capitalism. Minsky’s attempt to reconcile endogenous money and sectoral balances is the closest antecedent to the argument we make, but we will start in chronological order with Schumpeter’s analysis.

Schumpeter: Endogenous money and the Entrepreneur

To Schumpeter, an entrepreneur was fundamentally someone with a good idea, but no money to put that idea into effect. Lacking money, he must either raise it or borrow it from a bank, and Schumpeter focused upon the latter route. The entrepreneur was therefore “the typical debtor in capitalist society” (Schumpeter 1934, p. 102). When the bank advanced the entrepreneur a loan, this was not “the transfer of existing purchasing power” but “the creation of new purchasing power out of nothing… which is added to the existing circulation.” (Schumpeter 1934, p. 106)

Total demand in the economy was therefore the sum of demand from incomes earned by the sale of existing goods and services (which Schumpeter described as “fully covered credit” in “the circular flow”) plus this debt-financed expenditure by entrepreneurs. Consequently total demand—which he describes as “total credit”—exceeds that from income alone:

From this it follows, therefore, that in real life total credit must be greater than it could be if there were only fully covered credit. The credit structure projects not only beyond the existing gold basis, but also beyond the existing commodity basis. (Schumpeter 1934, p. 101. Emphasis added)

Minsky: Sectoral balance and endogenous money

Minsky confronted the issue of reconciling sectoral balances with effective demand exceeding income in his most famously named paper (“Can “It” Happen Again?”–Minsky 1963), and his first book-length treatment of the Financial Instability Hypothesis (John Maynard Keynes–Minsky 1975). In both cases he described his work as tentative—heading the former “A Sketch of a Model” and describing the latter as “the bare bones of a model”. Since this issue remains contentious, with many Post Keynesian economists seeing an obvious double-counting error in the proposition that effective demand can exceed income (Berry, Harrison et al. 2007; Keister and McAndrews 2009; Benes and Kumhof 2012), we cite this passage from Minsky (1963) in its entirety, to show that the argument that expenditure exceeds income has a long but neglected pedigree:

Within a closed economy, for any period

(I – S ) = (T – G)

which can be written as:

(2)    (S – I) + (T – G) = 0

where (S – I) is the gross surplus of the private sectors and (T – G) is the gross surplus of the federal government. The surplus of each sector _j (j = 1 … n) is defined as the difference between its gross cash receipts minus its spending on consumption and gross real investment, including inventory accumulations. We therefore have:

(3)

Equation 3 is an ex post accounting identity. However, each _j is the result of the observed investing and saving behavior of the various sectors, and can be interpreted as the result of market processes by which not necessarily consistent sectoral ex ante saving and investment plans are reconciled. If income is to grow, the financial markets, where the various plans to save and invest are reconciled, must generate an aggregate demand that, aside from brief intervals, is ever rising. For real aggregate demand to be increasing, given that commodity and factor prices do not fall readily in the absence of substantial excess supply, it is necessary that current spending plans, summed over all sectors, be greater than current received income and that some market technique exist by which aggregate spending in excess of aggregate anticipated income can be financed. It follows that over a period during which economic growth takes place, at least some sectors finance a part of their spending by emitting debt or selling assets.

For such planned deficits to succeed in raising income it is necessary that the market processes which enable these plans to be carried out do not result in offsetting reductions in the spending plans of other units. Even though the ex post result will be that some sectors have larger surpluses than anticipated, on the whole these larger surpluses must be a result of the rise in sectoral income rather than a reduction of spending below the amount planned. For this to take place, it is necessary for some of the spending to be financed either by portfolio changes which draw money from idle balances into active circulation (that is, by an increase in velocity) or by the creation of new money. (Minsky 1963. Emphasis added; Minsky 1982, pp. 5-6)

Minsky thus appreciated that there were biconditional logical links between growing aggregate demand, demand exceeding income, and the endogenous creation of money, which at the same time had to be consistent with sectoral balances summing to zero—as we prove later in this paper.

He returned to this theme in John Maynard Keynes (Minsky 1975, pp. 131-134) and attempted to construct a mathematical proof. In a section entitled “The Economics of Budget Constraints”, Minsky defined the budget constraint for consumption (C) as wages (W) plus a fraction  of income from the ownership of capital (D—which included both distributed earning and interest payments on bonds) that was allocated to consumption spending. Ignoring debt-financed consumption or savings by workers for the sake of simplicity (“this assumption is not necessary—only convenient”), his equation for the consumption budget was:

Investment (I) he defined as being equal to retained earnings () times a leverage factor (:

where  could range from negative during a debt-deflation to very large during a boom. The total budget constraint (Y) was thus

Minsky reasoned that since of household income was not used for consumption, some fraction (u) of it would be available to finance investment. It therefore followed that if the leveraged portion of investment exceeded this fraction of savings, then part of investment had to be debt-financed:

If , then some of investment will have to be financed in a manner other than by the intermediation of household savings. This excess of investment financing demanded over the supply available from intermediation of savings can be satisfied by some combination of an increase in the money supply and of a decrease in the money holdings in portfolios, i.e., by an increase in velocity. (Minsky 1975, p. 132. Emphasis added)

Minsky then attempted to formalize the distinction between ex ante and ex post income, using a difference equation approach. He modelled planned or ex-ante expenditure as depending on income levels in the previous period, so that

Ex post income in period t-1 was

For ex ante income in period t to exceed ex post in period t-1, Minsky derived the condition that:

He observed that for income to grow, investment therefore had to exceed savings:

Thus for income to increase, the externally financed investment must exceed the savings of households. (Minsky 1975, p. 133)

For this to be possible, another source of finance had to exist: an increase in the money supply (ΔM) “where ΔM_t can be either money creation or a change in velocity.” Since a proportion u of household savings was “presumed to be made available for financing investment, we have that”:

Substituting that from equation , Minsky concluded that for ex-ante income in period t to exceed ex-post income in period t-1—in other words, for effective demand and income to grow over time—the creation of new money had to exceed the fraction of household income saved and not made available for investment:

Figure 1: Minsky’s equations from John Maynard Keynes, p. 133

Minsky’s principle thus transcends Keynes on both “income equals expenditure” and “savings equal investment”, with Keynes’s identities applying in the abstraction of equilibrium, but Minsky’s applying in the (normally) growing economy in which we actually live. Our analysis is thus consistent with Minsky, and formalizes the essential role of the endogenous creation of money by the banking sector in this analysis. But it still appears, to many Post Keynesians, to be contradicting Keynes himself.

Contradicting or extending Keynes?

Minsky’s insight that the endogenous creation of money by the banking sector is simultaneously an addition to demand that allows expenditure and income to grow over time supports Graziani’s assertion that the banking sector must be treated as separate from the firm sector:

Since in a monetary economy money payments go necessarily through a third agent, the third agent being one that specialises in the activity of producing means of payment (in modern times a bank), banks and firms must be considered as two distinct kinds of agents. Firms are present in the market as sellers or buyers of commodities and make recourse to banks in order to perform their payments; banks on the other hand produce means of payment, and act as clearing houses among firms. In any model of a monetary economy, banks and firms cannot be aggregated into one single sector. (Graziani 1989)

Keynes did not do this in the General Theory, arguing instead that “technical monetary detail falls into the background”:

whilst it is found that money enters into the economic scheme in an essential and peculiar manner, technical monetary detail falls into the background. A monetary economy, we shall find, is essentially one in which changing views about the future are capable of influencing the quantity of employment and not merely its direction. But our method of analysing the economic behaviour of the present under the influence of changing ideas about the future is one which depends on the interaction of supply and demand, and is in this way linked up with our fundamental theory of value. We are thus led to a more general theory, which includes the classical theory with which we are familiar, as a special case. (Keynes 1936, pp. xxii-xxiii)

However, in his debates with critics in 1937, Keynes began to appreciate the need to separate the banking sector from the firm sector when considering the “finance demand for money”. In this next passage, Keynes also reached the conclusion derived by Minsky above that investment exceeds savings—though when speaking in terms of an individual entrepreneur:

I proceed to the third possible source of confusion, due to the fact (which may deserve more emphasis than I have given it previously) that an investment decision (Prof. Ohlin’s investment ex-ante) may sometimes involve a temporary demand for money before it is carried out, quite distinct from the demand for active balances which will arise as a result of the investment activity whilst it is going on. This demand may arise in the following way. Planned investment—i.e. investment ex-ante—may have to secure its “financial provision” before the investment takes place; that is to say, before the corresponding saving has taken place. It is, so to speak, as though a particular piece of saving had to be earmarked against a particular piece of investment before either has occurred, before it is known who is going to do the particular piece of saving, and by someone who is not going to do the saving himself. There has, therefore, to be a technique to bridge this gap between the time when the decision to invest is taken and the time when the correlative investment and saving actually occur.

This service may be provided either by the new issue market or by the banks;—which it is, makes no difference. Even if the entrepreneur avails himself of the financial provision which he has arranged beforehand pari passu with his actual expenditure on the investment, either by calling up instalments in respect of his new market-issue exactly when he wants them or by arranging overdraft facilities with his bank, it will still be true that the market’s commitments will be in excess of actual saving to date and there is a limit to the extent of the commitments which the market will agree to enter into in advance. But if he accumulates a cash balance beforehand (which is more likely to occur if he is financing himself by a new market-issue than if he is depending on his bank), then an accumulation of unexecuted or incompletely executed investment-decisions may occasion for the time being an extra special demand for cash. To avoid confusion with Prof. Ohlin’s sense of the word, let us call this advance provision of cash the ‘finance ‘ required by the current decisions to invest. Investment finance in this sense is, of course, only a special case of the finance required by any productive process; but since it is subject to special fluctuations of its own, I should (I now think) have done well to have emphasised it when I analysed the various sources of the demand for money. (Keynes 1937, pp. 246-247. Bold and bold italic emphasis added)

Keynes’s comments here arguably reach the same conclusion that Minsky later established, that investment exceeds savings in a growing economy, and the gap is filled by a rise in debt, which also causes a rise in the stock of money.

Endogenous Money and Effective Demand

We now proceed to generalize Minsky’s closed economy argument in a continuous time framework, prior to proving that expenditure exceeding income (and investment exceeding saving) at a point in time is consistent with recorded expenditure equalling recorded income over an accounting period (see Werner 2012 for similar arguments).

We start by defining income (Y_I) as wages (W) plus profits (), where profits are either distributed to households (_D) or retained by firms (_R):

Expenditure (Y_E) is the sum of money spent purchasing either consumer goods (C) or investment goods (I):

Consumption by workers (C_W) is the sum of wages plus the change in workers debt used for consumption (D_WC); and consumption by capitalists (C_) is the sum of distributed profits plus the change in capitalists’ debt used to finance consumption (D_C—in all cases, the change in debt is debt to the banking sector):

Investment is the sum of retained earnings plus the change in the debt of the firm sector (D_FI):

Expenditure minus income is thus equal to the change in total debt to the banking sector:

As Minsky emphasized, for this to be possible there must either be an increase in the stock of money equivalent to the increase in debt, or an increase in the rate of circulation of money. The latter can emanate from changes in the behaviour of either lenders or borrowers—an increased willingness to invest can accelerate the rate of turnover of the existing stock of money. But for the former to occur, there must be a mechanism by which the physical stock of money is increased by a change in debt.

Mechanism of Endogenous Money Creation

The creation of a loan by any entity to any other increases assets and liabilities identically and simultaneously, and this accounting truism misleads Neoclassical economists into believing that therefore the aggregate level of debt does not matter—only its distribution can have economic significance:

Ignoring the foreign component, or looking at the world as a whole, we see that the overall level of debt makes no difference to aggregate net worth—one person’s liability is another person’s asset. It follows that the level of debt matters only if the distribution of net worth matters, if highly indebted players face different constraints from players with low debt.    (Krugman 2012, p. 146)

However, as the Circuit School emphasizes, money is fundamentally a liability of the banking sector which other agents in the economy accept as complete payment in a transaction:

The only way to satisfy those three conditions is to have payments made by means of promises of a third agent, the typical third agent being nowadays a bank. When an agent makes a payment by means of a cheque, he satisfies his partner by the promise of the bank to pay the amount due. Once the payment is made, no debt and credit relationships are left between the two agents. But one of them is now a creditor of the bank, while the second is a debtor of the same bank. (Graziani 1989, p. 3)

Since the total stock of money in existence is the sum of the liabilities of the banking sector to the non-bank sectors of the economy, it follows that an increase in assets and liabilities of the banking sector increases the money stock. In contrast, a loan from one non-bank entity to another does not change the stock of money in existence. Therefore changes in the aggregate liabilities of the banking sector do matter, because they directly change the supply of money—and, as we argue, they add to demand as well at the point of expenditure of the new money the debt creates.

The distinction between non-bank debt and bank debt is crucial in this argument. Table 1 illustrates the difference between banking sector loans and non-banking sector loans by comparing the sale of a bond by the Firm Sector to the Household Sector—which does not create money—with a loan by the Banking Sector to the Firm Sector, which does create money by creating a bank liability.

Table 1: Parsimonious comparison of bond issue versus new loan

While the actual process of lending can be very complicated, at a parsimonious level the mechanism of endogenous money creation is extremely simple: the simultaneous creation of an asset and a liability by the banking sector. We illustrate this with an example that also shows the link between money creation and an increase in demand— as well as the actual role of reserves as the means by which banks transfer liabilities.

There are five entities in the model: three banks—Buyer Bank, Seller Bank, and the Central Bank; and two non-bank agents—Buyer and Seller. The account interactions between the three banks are shown in Table 2 to Table 4, along with the impact on the amount of bank liabilities (and hence the amount of money in circulation) at each step in the process.

Two sources of demand are modelled: a purchase from existing deposits (“Cash”); and a purchase financed by accessing debt (such as a line of credit or a credit card—”Card”). The Cash purchase uses funds generated from income; the Card purchase is obviously funded by an increase in debt.

The cash purchase reduces the Buyer’s deposit by the amount “Cash” (shown as a decrease in the Buyer Bank’s liabilities in Table 2), thus reducing the Buyer Bank’s assets and liabilities by the same amount. At this step in the process, the amount of money in circulation has fallen by Cash. However the purchase increases the Seller’s Deposit at the Seller Bank, and also increases the Seller Bank’s Reserves by the same amount (shown on the first row of Table 3). The net effect, of course, is no change in the money supply.

Table 2: Account operations at Buyer’s bank

The credit-financed purchase is shown in two stages: firstly the Buyer accesses his line of credit, increasing his Deposit and his Loans from the Buyer Bank by the same amount “Card”. This creates new money by increasing the Buyer Bank’s liabilities. Then the purchase is executed, which reduces the Buyer’s Deposit by the same amount, and also reduces Buyer Bank’s Reserves. The fall in Buyer Bank’s liabilities reverses the money creation of the previous operation, so there is no net money creation at this point.

However the transfer of the funds to the Seller’s Deposit at Seller Bank increases the assets and liabilities of Seller Bank by the amount Card. There is therefore an increase of the money supply by the amount Card. Since this was used to fund a purchase, the increase in the money supply is identical to the increase in transactions funded by the loan: the creation of new money is also an increase in demand.

Table 3: Account operations at Seller’s Bank

The impacts of these transactions on the accounts of the Central Bank are shown in Table 4. Since both Cash and Card operations involve transfers between liability accounts at the Central Bank, no new Reserves are created by either operation; reserves are simply transferred from Buyer Bank to Seller Bank in both cases.

Table 4: Account operations at Central Bank

Endogenous Money and Reserves

Of course, if reserve requirement rules are in operation, then the Buyer Bank might need to acquire additional reserves to fulfil the requirements. Does this then limit private credit creation, as Neoclassical economists claim (Krugman 2012)?

Two aspects of reality answer in the negative. Firstly, as the European Central Bank stressed as recently as May 2012, reserve requirements are backward-looking: reserve requirements today are based on levels of loans and deposits typically one month earlier. Secondly, the Central Bank in practice must meet demands for Reserves from private banks, since if they did not the system of interbank transfers would break down. Our credit example illustrates this.

A Buyer with unused credit (in a negotiated line of credit, overdraft or credit card) has the right to access that unused credit at any time. If at that time, the Buyer Bank was already on its Reserve limit (so that the transfer of Card would take it below its Reserve limit) and the Central Bank therefore refused to transfer reserves of Card from Buyer Bank to Seller Bank, then the Buyer’s purchase would be voided—even though the Buyer had the necessary unused credit on his own contract with Buyer Bank. The impact of the Central Bank behaving this way would be catastrophic for Buyer Bank, and the interbank payments system in general.

This example puts flesh of New York Federal Reserve Vice-President Alan Holmes’s discussion of the relationship between reserves and lending, when he attempted to block the push for the Fed to adopt Monetarist money growth targeting:

The idea of a regular injection of reserves—in some approaches at least—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 question then becomes one of whether and how the Federal Reserve will accommodate the demand for reserves. In the very short run, the Federal Reserve has little or no choice about accommodating that demand; over time, its influence can obviously be felt.

In any given statement week, 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. Emphasis added; The lag is now 30 days—see O’Brien 2007, p. 53)

Given the widespread ignorance of these issues within the economics profession itself, the ECB’s very similar recent statement is worth quoting at length to show that the considerations which applied in Holmes’s day continue to apply today:

The occurrence of significant excess central bank liquidity does not, in itself, necessarily imply an accelerated expansion of MFI credit to the private sector. If credit institutions were constrained in their capacity to lend by their holdings of central bank reserves, then the easing of this constraint would result mechanically in an increase in the supply of credit. The Eurosystem, however, as the monopoly supplier of central bank reserves in the euro area, always provides the banking system with the liquidity required to meet the aggregate reserve requirement. 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…

In the case of normally functioning interbank markets, the Eurosystem always provides the central bank reserves needed on aggregate, which are then traded among banks and therefore redistributed within the banking system as necessary. The Eurosystem thus effectively accommodates the aggregate demand for central bank reserves at all times and seeks to influence financing conditions in the economy by steering short-term interest rates. (ECB 2012, pp. 21-22. Emphasis added)

If transfers between banks leave one bank in need of reserves, there are two sources: loans from another bank, or direct borrowing from the Central Bank. The Central Bank has an obvious motivation to want to provide such loans—the desire to keep the payments system functioning. In practice, private banks prefer to borrow reserves from each other when needed, and private banks with excess reserves banks face the motivation to lend of a higher return than from holding excess reserves themselves.

In our example, if Seller Bank began with no excess reserves before the transactions, it had excess reserves after them, because the transfer of funds from Buyer Bank increased Seller Bank’s Reserves by precisely as much as Seller’s Deposit account rose. Since the Reserve Requirement is a fraction of deposits (10% of household deposits only in the USA—there is no reserve requirement for corporate deposits. See O’Brien 2007, p. 53), it now has more Reserves than it needs. Better to lend them at the interbank rate to Buyer Bank than to get no return (or a very low return) on the Reserves themselves. We model these two sources of required reserves in Tables 5-7.

On the Buyer Bank’s accounts, both operations increase its assets, and give it matching liabilities, not to the non-bank public, but to the banking sector itself—therefore no new money is created.

Table 5: Reserve operations from Buyer Bank’s perspective

Seller Bank’s liabilities are unchanged, but its Reserve assets fall and its income-earning asset of loans to Buyer Bank increases.

Table 6: Reserve operations from Seller Bank’s perspective

The Central Bank records the loan by Seller Bank as a fall in Seller Bank’s liabilities to it and a rise in Buyer Bank’s, with no change in the level of reserves. Only the direct loan to Buyer Bank creates new reserves.

Table 7: Reserve operations from the Central Bank’s perspective

Reserves therefore do not constrain lending, and causation runs not from Reserves to private lending, but in the opposite direction: though the Central Bank can inject excess reserves, the level of required reserves is determined by the lending practices of banking sector.

We now return to the topic of effective demand and the change in debt.

Including Speculation in Expenditure

As we detail in subsequent papers, contra Schumpeter’s venture capitalist vision of finance, by far the major use of credit creation today is to buy assets and finance “financial engineering” activity in the FIRE sector, rather than to enable entrepreneurial investment. A truly monetary macroeconomics therefore must incorporate the FIRE sector in its analysis. The first step in doing this is to acknowledge that monetary expenditure is on both goods and services and assets (A):

Making a similarly convenient assumption to that made by Minsky with regard to workers’ consumption, we focus solely on speculation by capitalists. Distributed earnings are now used for both consumption and speculation _S:

Asset purchases are funded both by distributed profits and new debt for speculation D_S:

The gap between expenditure and income now includes the change in debt used to finance speculation:

Including Government in Expenditure

When the government sector is explicitly included, expenditure includes net government spending (G-T), where the difference between G and T causes a change in government debt D_G. There are many additional nuances that complicate the analysis (government generation of wages & profits, what the Central Bank does in response to a deficit), but the parsimonious outcome is as shown in Equation :

International trade and capital flows add substantial complications to both income and expenditure that we will consider in a later paper, but they do not alter the conclusion that effective demand is income plus the change in debt. We will now address the apparent paradox that this is consistent with recorded income being identical to recorded expenditure.

Identity of ex-post income and expenditure

Absent new debt, expenditure is financed by incomes generated by the turnover of the existing stock of money, and the flow of expenditure can expand and contract as behaviour changes while the volume of money in existence remains constant. However, when an agent finances some expenditure by debt, there is a simultaneous injection of additional money and debt-financed expenditure into the turnover of the pre-existing stock of money and the expenditure it finances. After the debt is expended, that expenditure has become another agent’s income, but at the point of the creation of new money, there is a discontinuity, as illustrated by Figure 2.

Figure 2: Debt-financed expenditure and a discontinuity in income

The discontinuity means that there is a difference between income at time t (Y_I(t))—income ex-ante, prior to the debt injection—and income as it will be recorded by an accountant after the event for time t (Y_I(t⁺))—income ex-post, after the debt injection. Expenditure at time t (Y_E(t)) is therefore equal to income at time t, before the debt injection (Y_I(t)), plus the debt injection (D(t))—on the assumption that the money created by the new debt is immediately spent.

The measurement of income and expenditure between any two points in time (t₁ and t₂) corresponds to integration of the flows of income and expenditure over time. Since income and expenditure are identical to each other at all times except where there is a debt-financed addition to expenditure, and since debt is a discontinuous injection into the circular flow of existing income and expenditure, measurement will find that these two quantities are identical because this is akin to a property of integration that functions differing only at finitely many discontinuities must have identical integrals:

A numerical example should make this clearer. Suppose the economy is humming along in a state of constant flow of income equal to $1B/year, so the curve Y_I is a horizontal line at $1B/year, which when integrated over a given period (say 6 months) gives the total income for that period (in this case $500M). We are asserting that the effect of a loan of say $100M granted at time t is to bump this income flow up instantaneously by an amount exactly equal to $100M/year (assuming the newly created money is instantly spent, and ignoring—for the sake of illustration—any feedback between new credit in the economy and the level of output), so that from t+ onwards Y_I is a new horizontal line at $1.1B/year. In other words, we are saying that Y_I(s) is equal to $1B/year for s<=t, and equal to $1.1B/year for s>t. On the other hand, Y_E(s) is equal to $1B/year for s<t and equal to $1.1B/year for s>=t. That is, Y_I = Y_E(s)
for all s except s=t, so their integrals are exactly the same. For example, if you integrate them from 3 months before the debt injection to 3 month after the debt injection you get total income = total expenditure = $250M + $275M = $525M. Of course this is more than the $500M that you would get for a 6-month period without a debt injection, so the debt injection changed the value of the integral, but it changed it by the same amount ($25M=$100M/year * 3 months) for both income and expenditure.

There is thus no conflict between the statements “Recorded income equals recorded expenditure” and “Expenditure equals income plus the change in debt”. But there is a very big difference between a macroeconomic theory which begins from the proposition that “Aggregate demand equals aggregate income” and one that commences from “Aggregate demand equals income plus the change in debt”. The former is only true in a Loanable Funds model of lending; the latter is true in the endogenous money world in which we actually live—as Schumpeter, Minsky, and (arguably) Keynes have asserted before us.

Effective Demand and Effective Expenditure

Nonetheless, since the expression “Aggregate Demand” has been so linked to Aggregate Supply via the “habitual modes of thought and expression” (Keynes 1936, p. xxiii) of the last seventy five years, we propose resurrecting another of Keynes’s terms that has fallen into disuse, “Effective Demand”, to state our starting point for macroeconomics that “Effective Demand equals income plus the change in debt”:

Acknowledging that effective demand is income plus the change in debt also requires acknowledging that money is expended not just on goods and services but also on buying existing assets—and therefore that finance and macroeconomics have to be integrated, rather than treated as separate fields as they are by Neoclassical theory. Effective expenditure is therefore expenditure on output of goods and services plus net new expenditure on existing assets. Defining the latter as “Net Asset Turnover” (NAT), this can be decomposed into the price index for assets (P_A), times the quantity index (Q_A), times the proportion of that quantity that turns over in any given time period (T_A):

In subsequent papers we explore the implications of this approach for a new, monetary macroeconomics. In this paper we will conclude with two brief empirical examples of the importance of this approach for macroeconomics and finance. More empirical analysis will be provided in subsequent papers.

Empirical data on debt and aggregate demand

Equation , which focuses upon the role of change in the level of private debt in financing investment and consumption expenditure, can be summarized as asserting that private sector aggregate expenditure on goods and services will equal GDP plus the change in private sector debt. This in turn implies a relationship between change in debt and employment—amongst many other macroeconomic variables. The Neoclassical case, well captured in Bernanke’s explanation of why Neoclassical economists ignored Fisher’s debt-deflation theory of great depressions (Fisher 1933), is that any relationship between changes in the aggregate level of debt and macroeconomic variables will be slight:

Fisher’s idea was less influential in academic circles, though, because of the counterargument that debt-deflation represented no more than a redistribution from one group (debtors) to another (creditors). Absent implausibly large differences in marginal spending propensities among the groups, it was suggested, pure redistributions should have no significant macro-economic effects… (Bernanke 2000, p. 24. Emphasis added.)

The Neoclassical “null hypothesis” is clearly rejected by the data: the correlation of the annual change in private debt (measured as a percentage of GDP) with the current unemployment rate over the 23 years from 1990 till 2013 is -0.92.

Figure 3: Correlation between change in debt and unemployment

Our second empirical example applies a concept first developed by Biggs, Mayer and Pick (Biggs and Mayer 2010; Biggs, Mayer et al. 2010). Equating equations and yields:

The first derivative of implies that the acceleration of debt will be related to change in the components of expenditure in both goods and assets markets.

Biggs, Mayer & Pick reached this same conclusion independently, and to apply it econometrically they defined the “Credit Impulse” as the acceleration in debt divided by the level of GDP. We prefer to call this the “Credit Accelerator”, since “Impulse” implies a transient and exogenous phenomenon, when in fact this is a permanent and endogenous feature of a market economy.

For empirical purposes, we approximate the Credit Accelerator as the change in the change in debt over a year, divided by GDP at the midpoint of that year. This measure’s correlation with change in employment over the almost six decades from 1955 till 2013 is 0. 64.

Figure 4: Credit acceleration and change in the employment to population ratio

As well as the general Credit Accelerator for all private debt, specific Credit Accelerators can be defined for specific asset markets. The correlation between the Mortgage Accelerator and change in Shiller’s real house price index over the same time period is 0.74 (see Figure 5).

Figure 5: Mortgage acceleration and Change in CPI-deflated House Prices

Conclusion

Endogenous money is a reality of the monetary economy in which we live, and at the same time it is a revolutionary concept that has not yet been properly integrated into macroeconomics—even within the Post Keynesian School where it is an accepted concept. Its proper integration requires transcending the definitions of aggregate demand and aggregate supply that emanated from macroeconomic theory in which banks and credit creation played no role.

In this paper we have outlined the foundations of that revolution. In future papers we will explore its ramifications in economic policy, the analysis of the FIRE sector, and macroeconomic modelling.

Benes, J. and M. Kumhof (2012). The Chicago Plan Revisited. IMF Working Paper. Washington, IMF.

Bernanke, B. S. (2000). Essays on the Great Depression. Princeton, Princeton University Press.

Berry, S., R. Harrison, et al. (2007). “Interpreting Movements in Broad Money.” Bank of England Quarterly Bulletin
Q3, 47(3): 376-388.

Biggs, M. and T. Mayer (2010). “The Output Gap Conundrum.” Intereconomics/Review of European Economic Policy
45(1): 11-16.

Biggs, M., T. Mayer, et al. (2010). “Credit and Economic Recovery: Demystifying Phoenix Miracles.” SSRN eLibrary.

ECB (2012). Monetary and Financial Developments. Monthly Bulletin May 2012. Brussels, European Central Bank.

Fisher, I. (1933). “The Debt-Deflation Theory of Great Depressions.” Econometrica
1(4): 337-357.

Graziani, A. (1989). “The Theory of the Monetary Circuit.” Thames Papers in Political Economy
Spring: 1-26.

Holmes, A. R. (1969). Operational Constraints on the Stabilization of Money Supply Growth. Controlling Monetary Aggregates. F. E. Morris. Nantucket Island, The Federal Reserve Bank of Boston: 65-77.

Keister, T. and J. McAndrews (2009). Why Are Banks Holding So Many Excess Reserves? New York, Federal Reserve Bank of New York.

Keynes, J. M. (1936). The general theory of employment, interest and money. London, Macmillan.

Keynes, J. M. (1937). “Alternative theories of the rate of interest.” Economic Journal
47: 241-252.

Krugman, P. (2012). “Banking Mysticism, Continued.” The Conscience of a Liberal
http://krugman.blogs.nytimes.com/2012/03/30/banking-mysticism-continued/.

Krugman, P. (2012). End this Depression Now! New York, W.W. Norton.

Minsky, H. (1963). Can “It” Happen Again? Banking and Monetary Studies. D. Carson. Homewood, Richard D Irwin: 101-111.

Minsky, H. P. (1963). Can “It” Happen Again? Banking and Monetary Studies. D. Carson. Homewood, Illinois, Richard D. Irwin: 101-111.

Minsky, H. P. (1972). Financial instability revisited: the economics of disaster. Reappraisal of the Federal Reserve Discount Mechanism. B. o. G. o. t. F. R. System. Washington, D.C., Board of Governors of the Federal Reserve System: pp. 95-136.

Minsky, H. P. (1975). John Maynard Keynes. New York, Columbia University Press.

Minsky, H. P. (1977). “The Financial Instability Hypothesis: An Interpretation of Keynes and an Alternative to ‘Standard’ Theory.” Nebraska Journal of Economics and Business
16(1): 5-16.

Minsky, H. P. (1980). “Capitalist Financial Processes and the Instability of Capitalism.” Journal of Economic Issues
14(2): 505-523.

Minsky, H. P. (1982). Can “it” happen again? : essays on instability and finance. Armonk, N.Y., M.E. Sharpe.

Moore, B. J. (1979). “The Endogenous Money Stock.” Journal of Post Keynesian Economics
2(1): 49-70.

Moore, B. J. (1983). “Unpacking the Post Keynesian Black Box: Bank Lending and the Money Supply.” Journal of Post Keynesian Economics
5(4): 537-556.

Moore, B. J. (1988). “The Endogenous Money Supply.” Journal of Post Keynesian Economics
10(3): 372-385.

Moore, B. J. (1988). Horizontalists and Verticalists: The Macroeconomics of Credit Money. Cambridge, Cambridge University Press.

Moore, B. J. (1995). The Endogenous Money Supply. The money supply in the economic process: A post Keynesian perspective. M. Musella and C. Panico. Aldershot, U.K., Edward Elgar Publishers: 459-472.

Moore, B. J. (1997). “Reconciliation of the Supply and Demand for Endogenous Money.” Journal of Post Keynesian Economics
19(3): 423-428.

Moore, B. J. (2001). Some Reflections on Endogenous Money. Credit, interest rates and the open economy: Essays on horizontalism. L.-P. Rochon and M. Vernengo. Edward Elgar, Cheltenham: 11-30.

Moore, B. J. (2006). Shaking the Invisible Hand: Complexity, Endogenous Money and Exogenous Interest Rates, Houndmills, U.K. and New York: Palgrave Macmillan.

Newcomb, S. (1886). Principles of Political Economy. New York, Harper & Row.

O’Brien, Y.-Y. J. C. (2007). “Reserve Requirement Systems in OECD Countries.” SSRN eLibrary.

Schumpeter, J. A. (1934). The theory of economic development : an inquiry into profits, capital, credit, interest and the business cycle. Cambridge, Massachusetts, Harvard University Press.

Taussig, F. W. (1911). Principles of Economics. New York, Macmillan.

Werner, R. (2012). “Towards a New Research Programme on ‘Banking and the Economy’ – Implications of the Quantity Theory of Credit for the Prevention and Resolution of Banking and Debt Crises.” International Review of Financial Analysis
In Press.

Venue: Seattle Town Hall
Date: May 23rd
Time: 6PM

If you’d like to attend, click on this link.

I’ll also be speaking with Gerard Fitzpatrick (Russell Investments strategic bond fund manager) on “Money, Monetary Policy and Financial Repression” at a daytime event (11:30 – 1:30) at the Town Hall.

This is the start of what can only be described as a truly ridiculous speaking and seminar tour (if I had any control over the sequence, it would be entirely different):

• May 22-25
  • Seattle  Economics Council ”The Great Financial Crisis and the Great Recession: How we got here and the way out“
• May 30th-June 1
  • University of Pula (Croatia) “Economic in Crisis – The Crisis of Economics“
• June 5-7
  • Harvard University Law School Institute for Global Law and Policy (Boston) Pro-seminar on “Re-Theorizing Liquidity” (an invitation-only event to scholars in the field of monetary macroeconomics)
• June 10-11
  • Central Bank of Malaysia (Kuala Lumpur) Conference on “Monetary Policy in the New Normal“
• June 20-21
  • A tentative proposal for talks in Frankfurt
• June 25-26
  • KEDGE Business School, Bordeaux France “Rethinking Financial and Economic Models for a Post-Crisis Era“
• July 1-2
  • Newcastle University (NSW Australia) ATEC 2013: “The future of Economics Education in Australasia: Challenges and Opportunities“

I’d be pleased to see Debunking Economics readers at the above events. Of course, while doing all that travelling, I will be less able to respond to emails (and tweets) than usual.

But last week’s ABS House Price Index was surprising even to a bona fide Housing Bear like myself: nominal house prices rose a whole 0.1 per cent over the March Quarter. In inflation-adjusted terms, it appears that the recent house price rise ran out of steam in January, and resulted in prices being a whole 1.8 per cent higher, in real terms, than at the nadir in September. They are now just 1.6% higher.

Table 1: House Prices and Consumer Prices

Some boom. That’s not even a Sucker’s Rally—it’s a Claytons’ Sucker’s Rally (for non-Australian readers, a “Claytons” is “the drink you have when you’re not having a drink”).

My mortgage accelerator indicator gave an inkling that this could happen, since it peaked out at a mere 0.23 percent of GDP in January (versus 5 times than during the First Home Vendors Boost), and then fell to below 0.2 percent.

Figure 1: House Price Change and Mortgage Debt Acceleration

But since there are many cooks at work in baking the Australian house price cake—from meddling Federal and State governments and allegedly rigid councils on the government side, to unregulated and unmonitored overseas buyers in a wide-open domestic real estate market on the private side—I didn’t want to stick my neck out and say that the price rise was over now, since any of those factors could have outweighed mortgage debt acceleration.

I still think this mini-rally could revive a bit (and the most recent figures may well be revised upwards, as the previous quarter’s were with more data), but it is clearly on the edge of deflating after a truly anaemic rise.

This data hasn’t yet dented the enthusiasm of the bulls—my fellow Spectator Stephen Kouloulas stuck with his call for a 8-12% rise in nominal house prices, and Stephen Nicholas (and interviewees) in the Sydney Morning Herald managed to wax lyrical about how last Tuesday’s RBA interest rate cut would “generate house price growth”, without once mentioning the flat ABS figures that came out the same day (“Agents welcome surprise rate cut“, SMH May 7^th 2013).

Figure 2: The Kouk’s affirmation of his call for an 8-12% rise in Australian house prices in 2013

Nor did their mention of “flying” clearance rates of 78.1 per cent in Sydney last week note that this is more terrain-hugging than high-flying, since the volume of sales is now 27 per cent lower than during the FHVB-inspired boom in 2009, and 40 per cent below the peak level of sales back in 2003 (see Figure 3).

Figure 3: A Booming Market?

Since the housing stock has grown over time, the current “booming market” involves almost the lowest level of sales volume compared to housing stock since the ABS began collecting the data in 2002 (see Figure 4). This is almost certainly a factor in why the current rise petered out so quickly—and why any house future price revival is likely to be short-lived: any apparent revival in prices is likely to bring out an increased supply from would-be vendors awaiting such a price rise. Since the volume of sales is so depressed compared to the boom times of 2002-2008, any temporary revival in prices can easily be snuffed out by an increase in sellers.

Figure 4: Housing sales as percentage of housing stock

With the supply of existing houses for sale so flexible, the only salve for the market could emanate from equally flexible demand. That’s somewhat the case in the USA now, since mortgage debt has dropped so much there—and since with lower prices, rental yields are now attractive to genuine investors (i.e., people who plan to profit from being landlords rather than making a tax-deducting loss as in Australia).

In part, this reflects the pain the USA has already been through with substantial deleveraging and even larger price falls. Australia avoided this pain, with the First Home Vendors Boost pushing prices up at the same time as floating mortgage rates reduced the cost of carrying mortgages. But the downside of “no pain” is “no gain”: whereas the Global Financial Crisis led to actual falls in mortgage debt (and all other categories of private debt) in the USA, all it did in Australia was slow down its rate of growth to slightly lower than that of nominal GDP. Consequently mortgage debt is now little different to what it was at the house price peak in June 2010—and therefore the room for it to rise is also limited.

Figure 5: The USA delevered, Australia did not

Of course further interest rate cuts might well entice more people into mortage debt—and as Peter Martin pointed out, just because the RBA’s cash rate is the lowest it has been since Elvis was in the Army (as opposed to in the House), that doesn’t mean that mortgage rates are as low as they can go. They are still above the lows they set during the GFC, and another 3 cuts in the cash rate would be needed to take them below that level (“How low will the RBA go?“, SMH May 8^th 2013).

Figure 6: Mortgage rates still high after all these cuts

So we may well see mortgage rates that low, or even lower. But while mortgage debt remains as high as it is, we will never see mortgage servicing costing as little as it did before the most recent Australian house price bubble began in 1997—let alone as low as it was in the 1970s—even if the RBA dropped the cash rate to zero, and mortgage rates fell to just 3%.

Figure 7: Mortgage interest payments as a percentage of GDP

That isn’t factoring in the repayment of mortgages either. Before the price boom, this wasn’t a major issue: mortgage debt was relatively small compared to GDP, and a large variation in how long people took to repay loans had a minor effect on debt servicing costs as a percentage of total income. During the price boom, this wasn’t a major issue: you could struggle with repayments for a while and then repay by selling your property into the rising market seven years after you bought it. But after the boom, repaying mortgages as fast as Australians have done in the past will be prohibitively expensive. Mortgage durations are therefore likely to blow out, which will make the thought of taking out mortgage debt that much less attractive.

Figure 8: Mortgage payments given different repayment periods

So demand is anything but flexible up, and the trend to falling mortgage debt growth rates is likely to continue.

Figure 9: New mortgages per annum

With that trend, any period of accelerating debt—and therefore rising prices—is likely to be short-lived, as appears to be the case in this Clayton’s Sucker’s Rally.

Figure 10: Australian Mortgage accelerators

The ABS publishes its house price index data today. My leading indicator for this is the Mortgage Accelerator, and it implies another increase in prices—and the first sign of rising real prices on an annual basis since early 2011. But there’s also a turnaround developing in mortgage acceleration which implies that the rate of increase will top out at a much lower level than the 2008 and 2010 booms.

Figure 1: Before the release of ABS data on May 7 2013

Some house price bubble! Up 0.1 in nominal terms over the quarter, meaning a fall in real terms. Here’s my mortgage acceleration and house price change chart after the data.

Figure 1: Before the release of ABS data on May 7 2013

And I have proof! After all, we have 40 years of data showing the ratio of the budget deficit (and sometimes surplus) to GDP. Let’s see how the current deficit compares to other years since 1975. And look, it’s one of the worst ever!

Figure 1: Budget position as percent of GDP since 1975

OK, now that I’ve done my bit for hysteria, let’s take another look at that same data. It covers an almost 40 year history of the Australian economy, mixed with a 40 year history of the bluster of Australian politicians, with each side praising its budget management skills and rubbishing those of its opponents.

What if the truth, as opposed to the bluster, is that the economy controls the politicians far more than they control the economy—despite their competitive “my surplus is bigger than your surplus” rhetoric?

After all, the revenue side of the government’s balance sheet reflects current taxes as applied to current incomes, and the ups and downs of the latter act with far more speed than the government changes gears (let alone drivers). So revenue is largely out of government control.

Ditto the expenditure side. The government can do things like slash spending on universities by $3 billion this year, but it can’t abolish universities completely (though it might feel that way sometimes) to balance the budget. Equally it can fiddle pensions, Medicare levies and unemployment benefits, but it’s still tinkering at the edges: the vast majority of government spending is locked in, and influenced again primarily by the ups and downs of the economy.

That’s not to say that discretionary government policy can’t have an impact on economic performance. Clearly it can, as the tragic situation in Europe shows: the single-minded obsession with reducing government deficits via savage austerity has made Europe’s downturn worse that what it experienced during the Great Depression. What I’m considering here is the average impact of government policy over the very long term, including periods of booms, bust, and the occasional period of tranquillity.

The one thing that the government can do over that longer term perspective is bias the direction of spending one way or the other against the trend that the economy pushes back onto it. For the last 40 years, with the sole exception of the Rudd Government during the GFC (Global Financial Crisis for non-Australian readers), the shared fetish of our political parties has been with achieving surpluses, not deficits (the opposite could be said to have applied in the post-WWII years till the early 70s, with the Whitlam government being its last gasp).

The probable aggregate causation is thus something like 90% or more of the budget position reflects the economy’s impact on the government, while 10% of less represents the impact of the government’s deliberate decisions to attempt to achieve a surplus.

This gives us a way to interpret the average budget deficit over the last 40 years: it irons out both political parties (now there’s an attractive thought), and pretty much tells us what the economy needs the government to do—not vice versa (apart from the impact of the single-minded emphasis upon running surpluses since the “Dark Days” of the Whitlam era).

Secondly, even critics like me have to admit that the last 40 years have on average delivered good outcomes in the Australian economy–nowhere near as good as in the 50s and 60s mind you, but better than most of the OECD.

So since the economy drives the budget rather than vice versa, what does the data tell us is the economy’s “preferred” level of the budget deficit?

It’s 2.7 per cent: for the last 38 years, the average budget deficit has been 2.7 per cent of GDP.

Figure 2: Actual and average budget position since 1975

Has the sky fallen in as a result—or rather has inflation skyrocketed, since that’s one of the alleged impacts of a government that continually runs budget deficits?

Figure 3: Australian Inflation Rate Since 1975

Whoops… Apparently not. And obviously we can reject the “budget deficits will cause your currency to depreciate” argument in Australia’s case. So at best a deficit of the order of that currently being contemplated by the Gillard Government of about 1.5 to 2 per cent of GDP is No Big Deal.

Now let’s put hysteria to one side for the moment and think: why might an economy function very well with a deficit that, on average, equals almost 3% of GDP?

This data goes against the mantra that dominates both political parties in Australia—and most of their counterparts in the rest of the world for that matter—that a government should “balance its books, just like a household”. But can this really be true, given that the country that portrays itself—and is currently seen—as the best-managed fiscally in the world can’t achieve balance?

For a start, the “governments should be as responsible as households” mantra is a farce: if governments really did that, we’d now be embarking on the biggest debt-financed spending spree ever. Australian households in particular have resorted to debt finance far more so than its government. Even after the Rudd stimulus and subsequent deficits, Australian government debt has only just exceeded household non-mortgage debt, and it is only slightly more than 10 per cent of total household debt.

Figure 4: Australian household debt far exceeds government debt

So let’s forget the “the government should balance its books like a household” nonsense. This data instead suggests that the average target for government shouldn’t be a deficit of zero, but a deficit of about 3 per cent of GDP—roughly equal to the average rate of economic growth for the post-WWII period. The deficit would be smaller when the economy was booming—and would possibly be a surplus during extreme booms—and larger when it was growing well below trend.

That would not result in a household-sector-like blowout in debt, but in a level of government debt which was relatively constant compared to GDP—versus the obsession both parties have with getting that debt to zero.

If 3% is the proper goal for a government deficit during times of tranquil growth, then the current expected deficit in the order of $25 billion—or roughly 1.7% of GDP—is the sort of target you’d set during a boom, when you were trying to restrain private demand.

Not even the bulls believe we’re in a boom anymore, so the current level of the government deficit is probably less than the economy is currently ordering. Its impact is likely to put a further drag on growth—and, if the usual post-election farce occurs, sharp “the deficit is worse than we thought” cuts may well amplify the downturn. Welcome to political anorexia, brought to you by bad, anti-empirical economics.

Keen 2013 Eric Aarons Festschrift

I’m still waiting on the end of this month before posting a letter to subscribers as well–by that stage I will know just how much I have to say about this site and its future.

A defining feature of mainstream economic modeling is the belief that the economy is stable: given any disturbance, it will ultimately return to a state of tranquil growth. Mainstreamers argue over how fast this will happen—Chicago/Freshwater /New Classicals argue it adjusts instantly, while Saltwalter/New Keynesians say it will take time because of “frictions” in the economy’s adjustment processes. But they both take the innate stability of the economy for granted, and this belief is hard-coded into their mathematical models.

This stability is also seen as a good thing—so much so that anything which obstructs it being achieved should be removed. They argue over policy in a crisis like our today, with New Classicals falling firmly into the “Austerians” camp while New Keynesians favour fiscal stimulus, but they speak almost as one in favour of eliminating monopolies, reducing union power, deregulating finance—or they did before the financial crisis came along.

One would think that after as disturbing an event as the Great Recession—and let’s call it as it is now, the Second (or perhaps Third) Great Depression in Europe—that this belief in the innate stability of capitalism might be at least reconsidered by the mainstream. But though they’re willing to tinker at the edges, their core vision of the economy as being either in or near a stable equilibrium remains an unchallenged mantra.

I come from a different tradition that sees the economy as inherently unstable, and which regards this instability as both creative and destructive. Schumpeter famously gave us the phrase “creative destruction” to describe the process by which capitalism develops new products and new institutions, and my work builds on his and that of his most famous pupil, Hyman Minsky.

Here there is also a bit of a “Freshwater vs Saltwater” divide, since Schumpeter focused on the industrial and entrepreneurial process—what you might call Main Street Capitalism—while Minsky focused on Wall Street Capitalism. In the latter case, the instability can be purely destructive, as inventive financiers find ways to portray what are innately Ponzi Schemes as good investments, and end up fleecing the public while conjuring financial crises into existence.

Minsky’s most famous phrase on this front is often paraphrased to 3 words: “Stability is Destabilizing” (the full sentence was “Stability—or tranquility—in a world with a cyclical past and capitalist financial institutions is destabilizing”). But I think there is a better (if longer) passage that gives the true flavor of Minsky’s perspective. He noted that in the “Chicago view” of capitalism, “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…

He then stated his alternative view—and I’ve highlighted the key propositions in it below:

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 1982, p. 279)

That’s a strong statement: capitalism is inherently flawed, and this is because of characteristics the financial system must have: the causes of instability are not an “optional extra” that careful regulation or institutional design might eliminate. An eloquent supporter of this view is venture capitalist and INET co-sponsor Bill Janeway, who argues in his book Doing Capitalism in the Innovation Economy that “the Innovation Economy is driven by financial speculation”, and this is part of the creative process of capitalism:

Occasionally, decisively, the object of speculation is the financial representation of one of those fundamental technological innovations—canals, railroads, electrification, automobiles, airplanes, computers, the internet—the deployment of which at scale transforms the market economy, indeed creates a “new economy” from the wreckage of the financial bubble that attended its birth. (Janeway 2012, p. 2)

Consistent with Keynes’s much derided phrase “animal spirits”, Janeway argues that the innovation and scale of investment would be much less if the giddy prospects of enormous financial gain was not there to dazzle the minds of both innovators and their financiers. Stifle this folly and you might stifle capitalism itself.

This was the essence of Keynes’s comments on animal spirits as well: businessmen, both entrepreneurs and financiers, embark on projects and gamble fortunes on hopes that well exceed rational calculation. But because they do, society advances—irregularly and unstably to be sure, but it advances all the same:

Even apart from the instability due to speculation, there is the instability due to the characteristic of human nature that a large proportion of our positive activities depend on spontaneous optimism rather than on a mathematical expectation, whether moral or hedonistic or economic. Most, probably, of our decisions to do something positive, the full consequences of which will be drawn out over many days to come, can only be taken as a result of animal spirits—of a spontaneous urge to action rather than inaction, and not as the outcome of a weighted average of quantitative benefits multiplied by quantitative probabilities.

Enterprise only pretends to itself to be mainly actuated by the statements in its own prospectus, however candid and sincere. Only a little more than an expedition to the South Pole, is it based on an exact calculation of benefits to come. Thus if the animal spirits are dimmed and the spontaneous optimism falters, leaving us to depend on nothing but a mathematical expectation, enterprise will fade and die; though fears of loss may have a basis no more reasonable than hopes of profit had before.

It is safe to say that enterprise which depends on hopes stretching into the future benefits the community as a whole. But individual initiative will only be adequate when reasonable calculation is supplemented and supported by animal spirits, so that the thought of ultimate loss which often overtakes pioneers, as experience undoubtedly tells us and them, is put aside as a healthy man puts aside the expectation of death. (Keynes 1936, pp. 161-162. Emphasis added)

I’ve tended to underplay the importance of this in my own reactions to the economic crisis, and in my suggestions for reform as well. I’ve argued that we can tame the tendency for finance to generate speculative bubbles, without paying sufficient attention to whether those bubbles, sometimes, may actually leave behind a worthwhile residue when the froth has subsided. Certainly that was the case with the Internet Bubble of the 1990s to early 2000s: numerous futile ventures were undertaken (remember Pets.com?) and far too much debt was generated. But the aftermath was the development of an “information superhighway” that few of us could imagine doing without today.

I still believe that capitalism would keep its dynamism even if we developed an institutional framework for banking that stopped it financing Ponzi Schemes in real estate. But I’m now rather more inclined to treat bubbles in finance markets as perhaps a necessary price for innovation.

Part of this shift in sentiment is the result of recent modeling that I did as part of making a presentation to a staff seminar at the Australian Treasury last week. I’ll discuss that in my second installment on this topic.

Janeway, W. H. (2012). Doing Capitalism in the Innovation Economy: Markets, Speculation and the State. Cambridge, Cambridge University Press.

Keynes, J. M. (1936). The general theory of employment, interest and money. London, Macmillan.

Minsky, H. P. (1982). Can “it” happen again? : essays on instability and finance. Armonk, N.Y., M.E. Sharpe.

Eric Aarons, now 94 years old, has been a significant figure in left and progressive politics for over sixty years.

For the last forty years he has also been a successful sculptor in wood, marble, granite, concrete, steel and other materials. Most of Eric’s more than 200 sculptures reflect his commitments to social justice and human rights, within and between nations and peoples, and to the importance of emotions and values in human life.

Over the last 20 years he has written several books and many articles reflecting on his life and experiences in politics, and the need for new thinking for the left. Central to this new thinking is our common need to preserve the environment, alongside shaping a just society which values and respects all people.

Born just after World War I, Eric’s life was shaped by the aftermath of the slaughter of that Great War and the Great Depression of his early teens. He joined the Communist Party while studying science at university, and later worked for it in many capacities, including as a national secretary in the late 1970s.

The CPA condemned the 1968 Soviet invasion of Czechoslovakia, which ended the Prague Spring and “socialism with a human face”, and the failures of the repressive Soviet system as a whole. Eric began a long process of rethinking his earlier commitments to orthodox Marxism and the Soviet model of socialism. In the 1990s and 2000s he published five books, including a detailed consideration of the philosophies of Friedrich Hayek and Karl Marx, the two thinkers who most influenced the politics and history of the 20^th Century.

The Casula Powerhouse Art Centre is hosting an event to honour Eric’s wide-ranging contributions to art, politics and political philosophy.

MC and Introduction:

Kon Gouriotis, Director, Australian Centre of Photography and former Director of Casula Powerhouse Art Centre

Speakers:

• Meredith Burgmann – ALP and progressive left activist, and former President of the NSW Legislative Council
• Professor Steve Keen – author of Debunking Economics
• Drew Hutton – President of the “Lock the Gate Alliance” fighting irresponsible mining, longtime environmental campaigner, and a co-founder of the Australian Greens
• Margaret West – artist, poet and essayist

Join us – and Eric – for an afternoon of discussion and celebration.

Refreshments provided.