It's only been three days, but Facebook's time on the public markets has been rocky. As you can see in this chart, the stock has dropped 18% from its IPO price, losing over $15 billion in market cap.

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Frank Holmes recently gave a monster presentation that included over 70 charts supporting his bullish call on gold.

Here's one of the more informal charts that captures the idea that gold is loved across cultures.

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There’s been a lot of chatter in recent days about Japan and their debt issue.  John Carney and Joe Weisenthal both wrote good pieces on their sites and then today Bloomberg reported the Fitch downgrade of Japanese debt citing:

“A lack of new fiscal policy measures aimed at stabilising public finances amid continued rises in government debt ratios could lead to a further downgrade. A shock to Japan’s sovereign funding conditions such as a steep and sustained rise in yields would be strongly negative for the ratings, although Fitch does not consider this likely.”

I would say that I do not consider this “likely” either.  Now, I don’t know if I’d go as far as Joe goes in saying that Japan won’t ever default.  They could very well choose to default much like Russia did in the 90′s.  And I certainly wouldn’t make big bets on the political intelligence of Japanese officials (in either direction).  After all, there are a lot of politicians in this world who simply don’t know how the monetary system works and they might even conclude that a default would be good.  Who knows?  The Euro crisis that never ends hasn’t yet convinced some people that austerity is crushing these economies, but sometimes evidence in front of your face just isn’t enough.

But the more important point is that Japan is like the USA in being an autonomous currency issuer.  In essence, the US Treasury would never run into trouble procuring funds to pay bondholders because of its unique relationship with the Federal Reserve.  Bondholders know this so US bonds are seen as a save haven.  As an act of Congress and the lender of last resort the Fed can always be counted on to supply fund to the US government so bond holders can be paid and remain whole.  In this regard, the US government is a currency issuer because of its explicit political unity between its central bank and treasury (the exact thing missing in Europe).  The same relationship exists in Japan.  So, unless you think central bankers are bad at “printing money” for their governments then it’s rather silly to assume that Japan or the USA can’t obtain the funds to remain “solvent”.   Of course, Japan could suffer hyperinflation at some point, but as I’ve previously explained, this is quite a different phenomenon than “running out of money”.

With the Los Angeles Lakers losing last night, Kobe Bryant will end the season without an MVP award or a championship trophy for the second year in a row.

That leaves Kobe with six trophies combined (5 championships, 1 MVP), tied with three other players, but still behind the top five, which is led by Bill Russell (16), Kareem Abdul-Jabbar (12), and Michael Jordan (11).

Here is a look at all the players with a minimum of three combined trophies (min. 1 MVP award)...

data via Basketball-Reference.com

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Greed has quickly turned to fear as our manic friend, Mr. Market, resumes his generally bi-polar behavior.   The note below is a fear barometer courtesy of Morgan Stanley (via Business Insider).   It is consistent with levels also seen in the AAII readings of late:

“Panic” resurfaces. Admittedly, markets rarely get that “cataclysmic crescendo of capitulation” to call for buying stocks, but proprietary measures such as the Panic/Euphoria Model now are intimating that upside opportunity has re-emerged. Meetings with institutional investors do not anecdotally demonstrate that people are “freaked out,” but the sharp decline over the past six weeks has caused significant deterioration of sentiment (even amongst credit investors). Other metrics still are not providing the requisite buy inflection such that a more positive view for stocks is appropriate but that nuance does not imply a willingness to grow long bull horns yet.”

1.  The National Review continues to edge in the direction of market monetarism.  Veronique de Rugy quotes me and then comments:

The whole thing is here. In my view, monetary policy in Europe, or in the U.S. for that matter, would increase the effectiveness of spending cuts and structural reforms (kind of like the water you drink to help the medicine go down). There may even be a good case that it would be useful independently of other reforms. But it is mistake to oversell it and it certainly won’t achieve our long term goals without serious reductions is government spending.

I completely agree.  NGDP targeting won’t even come close to addressing all the structural problems that hold Europe back.  BTW, lower spending is desirable, but the Nordic countries show that neoliberal reforms are even more important.

2.  Jon Hilsenrath of the WSJ discussed how the current recession discredited two views of inflation:

After the financial crisis erupted in 2008, two narratives about inflation dominated economic airwaves and financial-market worry lists.

One was that consumer prices would tumble in a replay of Depression-era deflation because the recession was so deep and unemployment so high. The other was that inflation would soar because the Federal Reserve responded so aggressively to the crisis by pumping trillions of dollars into the financial system.

It turns out that both sets of predictions were wrong.

Those are roughly the views of old-style Keynesianism and old-style monetarism.  He concludes as follows:

Minutes of the last two Fed meetings show Fed staff have been revising up their inflation forecasts because slack hasn’t been as great as they thought.

So inflation since mid-2008 has been the lowest since the mid-1950s, and the Fed staff was expecting even lower?  I.e. they set their policy levers in a position expected to produce even lower inflation than we’ve had, which ipso facto means lower NGDP growth (since monetary policy affects inflation from the demand-side.)

3.  A few weeks back James Hamilton replied to my criticism.  I agree with much of what he has to say, but would quibble slightly with one comment:

I suggested that the current policy, which I read as not allowing inflation to fall below 2%, works well for both objectives.

It seems to me that policy is closer to a ceiling of 2% inflation, even if you assume the Fed puts zero weight on jobs.  Inflation has averaged well under 2% since mid-2008, and at the most recent Fed meeting they declined to offer any additional stimulus, despite a forecast that inflation would average below 2% over the next few years.  That’s too tight even if they had a single mandate to control inflation, as the ultra-conservatives in Congress have proposed.

4.  Paul Krugman did a recent piece where he argued that the PIIGS need deep currency depreciation.  I think he’s right, but differ slightly in my reasoning.  One of Krugman’s arguments is:

Second, Munchau’s argument that Germany was badly overvalued in 1999. But it had a roughly balanced current account; I think it’s hard to make the case that it was a really big overvaluation.

I’m kind of shocked by this.  Krugman is a first rate international economist; he knows that the correct exchange rate is not the one that balances the current account.  Japan’s currency has been overvalued for 20 years, and yet they’ve run consistent CA surpluses.  Some might argue that the standard model doesn’t apply in liquidity traps.  I don’t agree, but the liquidity trap model has no applicability to Germany circa 1999.  The CA surplus reflects relative saving and investment propensities.  You decide whether a currency is under or overvalued by looking at whether aggregate demand is at an appropriate level.

5.  On a lighter note, here’s Krugman again, in a post entitled “None So Blind“:

Eddie Lazear has an op-ed in the WSJ on the fiscal cliff that, among other things, pooh-poohs any concerns that sudden cuts in spending might hurt the economy. He weasels a bit, but basically conveys the impression that there’s no evidence for Keynesian effects.

What this signifies to me is the politicization and corruption overtaking the economics profession. I’ll give Eddie the benefit of the doubt; he is probably just going by what his friends say.

And here’s Matt Yglesias:

Conventional wisdom in DC is that not only would the full expiration of the Bush tax cuts make people grumpy as they find themselves needing to pay more taxes, it would also provide the macroeconomy a job-killing dose of fiscal drag. The chart above from Goldman Sachs illustrates the idea clearly.

I don’t buy it.

The problem is that this chart ignores what I think we’re now going to call the Sumner Critique.

I hope Krugman also gives Matt the benefit of the doubt . . .

HT:  Tyler Cowen, dwb.

By Walter Kurtz, Sober Look

A sobering article from Reuters points to potential credit problems with commodity buyers in China. It seems some middlemen have in the past been taking speculative inventory with the goal of earning more than the usual spread. As demand slowed, these buyers are having trouble raising cash to meet their obligations. They typically relied on rapid sales to their customers to purchase new inventory – but that does not seem as easy these days.

Reuters: – Chinese buyers are deferring or have defaulted on coal and iron ore deliveries following a drop in prices, traders said, providing more evidence that a slowdown in the world’s second-largest economy is hitting its appetite for commodities.

China is the world’s biggest consumer of iron ore, coal and other base metals, but recent data has shown the economy cooling more quickly than expected, with industrial output growth slowing sharply in April and fixed asset investment, a key driver of the economy, hitting its lowest in nearly a decade.

Coal and iron ore prices could fall further before recovering towards the tail end of the second quarter, traders say, sparking more defaults or deferred deliveries.

“There are a few distressed cargoes but no one is gung-ho enough to take them. Chinese utilities aren’t buying because they have a lot of coal and traders are also afraid of getting burnt. It’s very bearish now,” said a trader.

The defaults come on the heels of a slump in global thermal coal benchmark prices to two-year lows and increases the prospect of an even steeper fall unless China revives buying to absorb the global coal surplus as exporters ramp up production.

Anecdotal evidence also suggests that wholesalers are cutting coal inventories in a number of ports. Spot prices for coking coal have indeed been dropping.

China Foundry Coke Domestic Spot Price Shanghai (Bloomberg)

These events may be an indication of a demand slowdown in China that is far sharper than anticipated – driven primarily by reduced infrastructure investment (discussed here). A more aggressive stimulus program from the government may be on the way shortly.

Jeff Saut of Raymond James says his indicators are pointing to historical buying points:

“the recent downside dive from May 1st’s 1415 level into last Friday’s close of 1295.22 has caused many of my indicators to register readings not seen in a long time. For example, the McClellan Oscillator is now at oversold readings not seen since the recent April 10th trading bottom (see chart on page 3). Then there is the CBOE Equity Put/Call Ratio, which is flashing a “buy signal” that has proven profitable at every downside inflection point since 1994; or, as the astute folks at Bespoke write:

“Following today’s 0.44% decline (5/16/12) in the S&P 500, the 10-day Advance/Decline line for the S&P 500 has now dropped down to –1,930. This is an extreme oversold reading based on historical standards. For those unfamiliar with the indicator, the 10-Day A/D line is simply a rolling 10-day total of the daily net number (of similar readings) shows that equities have historically rebounded after hitting such extreme oversold levels. Over the next week, the S&P 500 averages a gain of 1.21% with positive returns two-thirds of the time. Over the next month, the S&P 500 averages a gain of 5.58% with positive returns 83% of the time. Going out three months, the S&P 500 averages a gain of 7.68%, and over the next six months the index averages a gain of 13.35%.”

Adding to the litany of downside inflection-point indicators is the AAII (American Association of Individual Investors) survey that recorded its lowest bullish reading (23.6% bulls) since August 2010. Moreover, my parade of short/intermediate-term indicators shows a composite reading that is at historic levels. To wit, there have only been only four other times when my indicators have combined to show such negative inclinations. More than seventy percent of the time, given such readings, the major market averages have been higher a week later, while 92% of the time they have been higher a month later. “

Soource: Raymond James

By Lance Roberts, CEO, StreetTalk Advisors

In this past weekend’s missive we stated that: “There is very little doubt that the confirming sell signal will occur by the end of this week, or, early next week at the latest. Enough deterioration has occurred within the market at this point that it is now just a function of time.” As of this morning the recent initial sell signalwas confirmed by a crossover in our longer term indicator as shown in the first chart.

Also, the expected oversold bounce is now officially engaged.This is NOT a buying opportunity — this rally should be used to sell and reduce exposure to portfolio equity risk. Our short term moving average has now turned down, and like last summer, will cross below our long term moving average by July. Last summer the market correction made a full 2-standard deviation correction (black box). In the current market environment a similar 2-standard deviation reversion would take the market to 1175ish today. However, I suspect that the lower band will be closer to 1200 by the time this correction cycle is complete.

The next chart details the correction process in a little more detail. Last summer after the “confirmed sell signal” was issued the market proceeded to reach “oversold conditions” in a brutal 6 week sell off. The current magnitude of the selloff has likewise gotten the markets to an oversold state which is why, like last summer, we expected a fairly strong countertrend bounce. Currently, using Fibonacci retracement analysis, we can find three potential areas that the bounce could obtain: 1337, 1351, and 1364.

It is important not to become hung up on exact numbers. These are general areas to begin reducing equity exposure during the rally. Begin reducing exposure to equities as the market approaches the first level and continue to do so as the market rally ensues.

As stated this past weekend the guidelines to implement in your portfolio, based on your current position, are as follows:

Situation A) I Am Overweight Equities

1. Reduce equity exposure on any rally to align with model.

2. Sell losers/laggards and rebalance winning positions back to original allocation weightings.

3. Hold cash raised from the liquidation until correction is complete.

4. Raise fixed income allocation to 35% of portfolio.

Situation B) I Am Underweight Equities

1. Keep equity exposure at current levels.

2. On a rally sell losers/laggards completely. Rebalance winning trades back to original allocation weightings.

3. Hold cash until correction is complete.

4. Adjust bonds to 35% of portfolio.

Situation B) I’m All Cash

1. When correction is complete, and the next buy signal is generated, align equity exposure with model.

2. Raise bonds to 35% of portfolio.

The currently rally can fizzle out at any moment. We are walking along a very thin tightrope with Europe with any misstep a potential to rout the financial markets. The easiest path currently for the market is down. Until that changes, which will be indicated by our current“sell” signal reversing, our job is to “sell rallies” and be patient.

Patience is the basis of successful long term investing because in order to be truly successful with your investments in the long term you must have a strong investment discipline to mitigate risks, rational expectations of performance and the patience to wait for the right opportunities to present themselves.

Finally, always remember Warren Buffet’s investment rules.

1) Never lose money

2) Refer to rule #1

By Walter Kurtz, Sober Look

Source: Capital Economics

Capital Economics: – A lower exchange rate would also prompt domestic residents to substitute away from foreign goods to cheaper domestically produced products. After the plunge in the krona in 2008, Icelandic import volumes fell by 45%, far sharper than the fall in domestic demand. In Argentina imports fell almost as sharply after the substantial devaluation in 2002. What’s more, a sharp devaluation may boost business sentiment and asset prices.

…once the dust settles and growth prospects in Europe begin to improve, markets are likely to rebound, particularly in those economies that exit the euro-zone. The euro could strengthen too.

This analysis obviously assumes stable global growth that helped Argentina recover quickly – which would not necessarily be the case going forward. But it does demonstrate that there maybe “life after the euro”.

By Mark Lynas, author of The God Species: How the Planet Can Survive the Age of Humans. Originally published at the Guardian.

The traffic lights are still blinking in Odaka town, north-western Japan, but few cars pass through these deserted intersections. Frozen in time after being hit by the triple disaster of earthquake, tsunami and meltdowns in the nearby Fukushima Dai'ichi nuclear plant, tables are still laid in partially-collapsed restaurants and cars are stacked up against railings where they were deposited by the retreating wave. When I visited last week, a deathly silence reigned, the only noise the chirruping of frogs in uncultivated rice paddies on the edge of town, and the bleeping of my dosimeter.

Radiation readings in Odaka are well below anything that could be considered a health risk, but people are still not coming back. Indeed, the long shadow cast by Fukushima has extended over a much wider area than any scientific assessment of radiological hazard would argue is necessary. In Minamisoma, 20km north of the stricken reactor, a community centre above the town is decked out for indoor play because no one wants to let their children venture out of doors. The parents refuse to believe that radiation readings are low enough - barely above normal background, on my dosimeter - that their children's health would be improved by letting them play outside in the fresh air. Watching the kids cooped up in a big wooden hall, I could only conclude that unnecessary fear of radiation is just as much a hazard as the real thing.

On a wider scale still, unnecessary fear of radiation now presents a serious hazard to the world's climate. Japan's precipitous exit from nuclear power generation - the day I arrived in Tokyo was the first non-nuclear day in Japan for 42 years - has pushed the country's fossil fuel demand through the roof, with imports of oil and gas up by more than 100% since last year, their ballooning cost driving a record trade deficit of $32bn. As carbon emissions rise in lockstep, Japan's leaders are now backing off from their international climate change commitments, which the country has no chance of meeting. Given that wind, solar and geothermal account for less than 1% of Japan's electricity generation, the country will be massively dependent on fossil fuels for decades to come if the reactors stay switched off. The only alternative is blackout.

Given the trauma of the March 2011 tsunami disaster, Japan's nuclear shutdown is understandable - if regrettable from a global warming perspective. But a flight across the Sea of Japan to its neighbour South Korea shows a very different model in evidence.

In the same week that Japan mothballed its very last reactor, Korea broke ground on two new-build nuclear power stations - a pair of APR-1400 units now being constructed at Shin Ulchin, on the east coast. They are two of eight new stations planned to add to the country's existing nuclear fleet of 23, currently supplying 45% of the nation's electricity. To mark the occasion the country's president, Lee Myung-bak, paid a visit to the site, praising a "huge milestone" for South Korea's engineers, who had helped the country achieve "the dream of independent nuclear technology".

It is not that South Korea is not green. In fact the mantra of "green growth" has been a central component of President Lee's policy platform since 2008, and this month - even as Japan backed away from its own climate commitments - Korea's legislature unanimously passed a new climate act which will enforce carbon caps and an emissions trading scheme among its heavy industry and electricity sector. The country's international carbon emissions target is for a 30% cut below "business as usual" emissions by 2020, a commitment its leaders say they intend to deliver on. It also spent a higher proportion of its post-economic crash stimulus package on environmental initiatives than any other country.

South Korea is anxious to export its green growth model to other countries. Last week President Lee spoke at a landmark summit held by the Seoul-based Global Green Growth Institute, reiterating his view that there need be no automatic trade-off between rapid economic growth and environmental sustainability. In respect of Japanese sensitivities, he refrained from addressing the centrality of nuclear to Korea's green growth plans, but tension between the competing visions for what counts as "green" were evident throughout the two-day meeting. The president was immediately followed by the Japanese telecoms billionaire Masayoshi Son, who - having reinvented himself as head of the new Japan Renewable Energy Foundation - dramatically declared that there should be "no nuclear for mankind anywhere in the world, for the sake of the future, for the sake of our children, for the Earth".

The Korean hosts clapped politely, but did not appear convinced - hardly surprising given that Masayoshi Son's only proposed alternative to nuclear generation was a scheme for a pan-Asian supergrid linking Japanese cities with thousands of solar and wind plants supposedly to be built across the Gobi desert in faraway Mongolia. The plan would cost trillions and take decades to implement - and would leave Japan dependent on power lines crossing its energy-hungry and often less-than-friendly neighbour China. Koreans know that their economic miracle has been built on practical engineering success, not magical thinking.

The chair of the Green Growth Institute, Dr Han Seung-soo, himself a former prime minister of Korea, told me later: "Once the safety aspect is guaranteed there is no cleaner source than nuclear. It is clean energy because the amount of emissions created is almost nil." When I asked if Korea had a target for wind and solar deployment, he shook his head. Looking out of the window, from the centre of an Asian megacity with impressive skyscrapers in every direction as far as the eye could see, the idea of powering Seoul with renewables did seem nonsensical.

The truth is that, as in Japan, the proportion of solar and wind on the Korean grid is tiny, about 0.25% - most of the country's power comes from coal, and the only way to reduce its carbon emissions significantly is to continue to replace coal plants with nuclear. Yet as the post-Fukushima anti-nuclear hysteria continues to drag many countries - from Japan to Germany to Switzerland - back towards the fossil fuels age, South Korea is quietly getting on with reducing its carbon emissions while continuing its growth miracle.

Krugman would definitely subtitle a post like this “Wonkish”!

Click here for this post in PDF: Debtwatch; CfESI

This is a paper I’ve recently submitted by invitation to an Australian economics journal. I have been very quiet on the blog while finishing this in the last 2 weeks. I’m likely to remain quiet for the next fortnight, since I leave for the Fields Institute in Toronto on June 1^st, where I’ll be working for a month with the mathematicians there to analyze and refine my various models of financial instability. Grasselli and Costa Lima have already done a brilliant job analyzing my 1995 model in this paper.

Abstract

The “Global Financial Crisis” is widely acknowledged to be a tail event for neoclassical economics (Stevens 2008), but it was an expected outcome for a range of non-neoclassical economists from the Austrian and Post Keynesian schools. This article will provide a survey of the relevant Post Keynesian approaches for readers who are not familiar with this literature. Though it will cover the history of how Post Keynesian economics came to diverge so much from the neoclassical mainstream, the focus will be on the current state of Post Keynesian macroeconomics and its alternative indicators of macroeconomic turbulence, rather than historical exegesis.

1. A “Black Swan”?

   I do not know anyone who predicted this course of events. This should give us cause to reflect on how hard a job it is to make genuinely useful forecasts. What we have seen is truly a ‘tail’ outcome—the kind of outcome that the routine forecasting process never predicts. But it has occurred, it has implications, and so we must reflect on it.(Stevens 2008, p. 7)

RBA Governor Stevens’ remarks succinctly expressed the Neoclassical reaction to the “Global Financial Crisis” (GFC). It was not anticipated by any Neoclassical economic model—au contraire, in 2007 all conventional models predicted a continuance of “the Great Moderation” (Bernanke 2004; Bernanke 2004), with the OECD’s observation that “the current economic situation is in many ways better than what we have experienced in years” (OECD 2007, p. 7) being typical of official forecasts for 2008.

In the wake of that dramatically wrong forecast, the crisis that began in late 2007 and continues to this day is regarded as an inherently unpredictable event, due to the scale of unanticipated and unforeseeable exogenous shocks. Once shocks of the required magnitude and variability are injected into DSGE models, the behavior at the time of the crisis emerges (McKibbin and Stoeckel 2009; Ireland 2011) [but see Solow 2003, p. 1], but this behavior could not have been anticipated prior to the crisis.

Figure 1: The sudden transition from Great Moderation to Great Recession in the USA

On the other hand, a number of economists and market commentators claim to have anticipated the crisis (Bezemer 2009; see also Fullbrook 2010). Bezemer identified twelve individuals with a legitimate claim to having foreseen this crisis, on the basis of four selection criteria:

Only analysts were included who provide some account on how they arrived at their conclusions. Second, the analysts included went beyond predicting a real estate crisis, also making the link to real-sector recessionary implications, including an analytical account of those links. Third, the actual prediction must have been made by the analyst and available in the public domain, rather than being asserted by others. Finally, the prediction had to have some timing attached to it. (Bezemer 2009, p. 7)

However, only two of the twelve were guided by mathematical models: Wynne Godley (Godley and Wray 2000; Godley and Izurieta 2002; Godley and Izurieta 2004; Godley and Lavoie 2007) and myself (Keen 1995, 1996, 1997, 2000, 2007)—see Table 1, which is adapted from Bezemer (Bezemer 2009, p. 9). To evaluate whether this crisis could have been forecast, one has to compare like with like: are there mathematical models of the macroeconomy that did what Neoclassical models did not—anticipate the Global Financial Crisis?; and are there empirical indicators that are not included in Neoclassical macroeconomic models that did indicate that a crisis was approaching?

Table 1: Predictors of the Global Financial Crisis (adapted from Bezemer, 2009, Table 1)

On the record, there are only two contending mathematical approaches—the “Stock-Flow Consistent” framework developed by Godley, and the complex systems approach I use to model Minsky’s “Financial Instability Hypothesis” (Minsky 1977); and two key indicators—sectoral imbalances identified by Godley’s approach, and the ratio of private debt to GDP that plays a key role in my models.

Both Godley and I self-identify as Post-Keynesian, though there are large differences in our approaches. This survey article will introduce our models to an audience far more familiar with Neoclassical modelling. Some attention will be given to criticisms of Neoclassical macroeconomics, “What Keynes Really Meant” textual exegesis, and the development of our approaches in the context of earlier Post Keynesian research, but these are only preliminaries to describing our approaches to macroeconomic modeling to an audience that is not familiar with them. This paper is also not a history of Post Keynesian economics—for that, see (King 2003; King 2012). What history there is a “Whig history” of the evolution of my and Godley’s approaches to monetary macroeconomics.

1. Divergence: Equilibrium, Expectations, Microfoundations and Money

There are 5 key areas in which modern Post-Keynesian macroeconomics differs from Neoclassical macroeconomics: the role of equilibrium, the nature of expectations, the need for microfoundations, the model of production, the role of money, and the role of government. The reasons for these differences are set out below, not in an attempt to persuade Neoclassical readers on these issues, but to establish that the fact that Post Keynesian models do not conform to Neoclassical principles does not provide an a priori reason to reject these approaches to macroeconomic modeling.

1. Equilibrium

It is well-known that the IS-LM model was developed by Hicks rather than Keynes (Hicks 1937), but was accepted “as a convenient synopsis of Keynesian theory” (Hicks 1981, p. 139) by the vast majority of economists. The development of Post Keynesian macroeconomics began with economists like Joan Robinson in the UK (Robinson 1964) and Paul Davidson in the USA (Davidson 1969) who instead rejected ‘Mr Keynes & the “Classics”‘ (Hicks 1937) as “an article which … misses Keynes’ point completely” (Minsky 1969, p. 225).

What is less well known is that the elder Sir John Hicks agreed with the critics, and disowned the IS-LM model as an inadequate basis for macroeconomics. Whereas Neoclassical economics also rejected IS-LM, on the basis that the model did not have good microfoundations, Hicks rejected it because, he argued, it required the unacceptable assumption that the economy was in equilibrium at all times.

Reflecting on his creation in 1981, Hicks observed firstly that it was not a model of Keynes General Theory, since he had conceived of IS-LM “before I wrote even the first of my papers on Keynes” (Hicks 1981, p. 140), and secondly that it was Walrasian rather than Keynesian in origin (Hicks 1981, p. 141-142).

One essentially Walrasian foundation of IS-LM was the representation of a 3-market system as a 2 market model under the assumption that, if two of the markets were in equilibrium, then so was the third by Walras’ Law. Hicks therefore ignored the market for loanable funds (and also the labor market) in the IS-LM model:

‘One did not have to bother about the market for “loanable funds,” since it appeared, on the Walras analogy, that if these two “markets” were in equilibrium, the third must be also. So I concluded that the intersection of IS and LM determined the equilibrium of the system as a whole.’ (Hicks 1981, p. 142)

However, this Walrasian analogy applied in reverse in disequilibrium: if one of the two markets in IS-LM was out of equilibrium, then necessarily so was the other—and/or the other markets ignored in equilibrium had also to be considered. Consequently, the only point in the IS-LM diagram that “makes any claim to representing what actually happened” (Hicks 1981, p. 149) is the intersection of the IS and LM curves. This in turn requires assuming that the economy is always in equilibrium.

This had to be rejected, Hicks argued, because assuming continuous equilibrium also meant assuming that expectations were fulfilled at all times, whereas at crucial turning points in the economy “the system was not in equilibrium. There were plans which failed to be carried through as intended; there were surprises.” (Hicks 1981, p. 150). Macroeconomics therefore had to be about disequilibrium—which he described as “the traverse”

When one turns to questions of policy … the use of equilibrium methods is still more suspect. … There can be no change of policy if everything is to go on as expected—if the economy is to remain in what (however approximately) may be regarded as its existing equilibrium. It may be hoped that, after the change in policy, the economy will somehow, at some time in the future, settle into what may be regarded, in the same sense, as a new equilibrium; but there must necessarily be a stage before that equilibrium is reached. There must always be a problem of traverse. For the study of a traverse, one has to have recourse to sequential methods of one kind or another. (Hicks 1981, pp. 152-153)

This proposition that macroeconomics must be a study of disequilibrium states is a common theme in Post-Keynesian economics (Fisher 1933; Kaldor 1940; Kaldor 1951; Goodwin 1967; Kornai 1971; Robinson 1974; Goodwin 1986). Our macroeconomic models fit within this theme, with Godley’s model expressed in difference equations while I employ nonlinear differential equations.

1. Expectations

A long line of non-Neoclassical economists have emphasized the role of uncertainty in economics, and especially in Keynes’s analysis. Keynes once famously described economic theory prior to his work as “one of these pretty, polite techniques which tries to deal with the present by abstracting from the fact that we know very little about the future” (Keynes 1937, p. 215). To Post Keynesians, the “Rational Expectations Revolution” replaced this with an even prettier but less polite technique that assumed that the future could be predicted by agents endowed with “rational expectations”.

The transition from IS-LM to Rational Expectations macroeconomics began the Lucas Critique (Lucas 1976), and its well-founded objections to using historical relations in large scale macroeconomic models to predict behavior under future policy regimes. However, that paper continued a research agenda into the “Natural Rate Hypothesis” (NRH) in which Lucas had previously acknowledged that the NRH required the assumption that inflationary expectations are accurate, and that assuming “expectations are rational in the sense of Muth” was equivalent to adding the assumption that inflationary expectations were accurate “simply … as an additional axiom” (Lucas 1972, p. 55).

This was more than one axiom too far for Post Keynesian economists, who insisted that expectations formation under uncertainty was a crucial aspect of reality, and that this had to allow for investors on occasions making decisions that “in a more sober expectational climate, they would have rejected” (Minsky 1972; Minsky 1982, p. 117). Rational expectations, to coin a phrase, meant “never having to say you were drunk”. Godley’s models and mine allow for expectations to be based on inaccurate estimates of future outcomes, while still being derived from rational responses to current information, given the inherent uncertainty of the future (Blatt 1979; Blatt 1980).

1. Microfoundations

Lucas’s observation that “Nobody was satisfied with IS-LM as the end of macroeconomic theorizing” pithily summarizes the key motivation behind the evolution of Neoclassical macroeconomics from the time of Keynes: “The idea was we were going to tie it together with microeconomics and that was the job of our generation” (Lucas 2004, p. 20). The major argument in favor of a micro-founded macroeconomics was that micro analysis could provide the “deep parameters” that were invariant to policy changes (Estrella and Fuhrer 1999; Estrella and Fuhrer 2003; Ljungqvist and Sargent 2004, pp. xxvi-xxvii ), in contrast to the parameters of large-scale econometric models which would be subject to drift as policy changed (Lucas 1976, p. 39). This led initially to Real Business Cycle models in which the entire economy was modeled by a “representative agent” (Kydland and Prescott 1982), and ultimately to New Keynesian macroeconomics (Gordon 1982; Woodford 2009).

Post Keynesians rejected the argument that macroeconomics could be derived from microeconomics (Kregel 1985). Though this position is contrary to Neoclassical practice, it is in fact supported by well-known but poorly understood Neoclassical research: the Sonnenschein-Mantel-Debreu theorems (Shafer and Sonnenschein 1993). While these are portrayed in textbooks as arguing simply that “stringent conditions” are needed to ensure that a representative agent can be used to model aggregate behavior (Varian 1984, p. 268), their real import is that the “Law of Demand” does not apply at the level of a single market, even if all consumers in that market are rational utility maximizers:

Can an arbitrary continuous function … be an excess demand function for some commodity in a general equilibrium economy? … we prove that every polynomial … is an excess demand function for a specified commodity in some n commodity economy… every continuous real-valued function is approximately an excess demand function. (Sonnenschein 1972, pp. 549-550)

The fact that demand in a single market cannot be legitimately modeled as being derived from a representative agent (and thus subject to the Law of Demand) strongly implies that aggregate demand cannot be modeled that way either: microeconomic “deep parameters” are therefore lost in the interactions between agents. This is an instance of a common phenomenon arising from the interaction of multiple entities in a system, which physicists have dubbed “Emergent Properties”: the system itself cannot be understood from the properties of the entities themselves, since its behavior depends on nonlinear interactions between the entities. As Physics Nobel Laureate Philip Anderson put it:

The behavior of large and complex aggregates of elementary particles, it turns out, is not to be understood in terms of a simple extrapolation of the properties of a few particles. Instead, at each level of complexity entirely new properties appear, and the understanding of the new behaviors requires research which I think is as fundamental in its nature as any other… (Anderson 1972, p. 393)

Anderson continued that “Psychology is not applied biology, nor is biology applied chemistry” (Anderson 1972, p. 393), and Post Keynesians similarly assert that “Macroeconomics is not applied microeconomics”. Godley’s models work at the level of economic sectors—households, firms, the government and banks—while my models work at the level of social classes, in line with Andrew Kirman’s reaction to the SMD conditions that “we may well be forced to theories in terms of groups who have collectively coherent behavior…. The idea that we should start at the level of the isolated individual is one which we may well have to abandon.” (Kirman 1989, p. 138).

1. Production

Substitutability of inputs, rising marginal cost and diminishing marginal productivity are familiar elements of Neoclassical micro and macroeconomics. Post-Keynesian micro and macroeconomics instead assume fixed proportions between inputs, constant or even falling marginal costs, abjure the relevance of marginal productivity, and in particular reject the Cobb-Douglas production function (see section 7).

The Post Keynesian position is based on almost 80 years of empirical research—commencing with the Oxford Economists Research Group in 1934 in the UK (Hall and Hitch 1939; Lee 1981; Besomi 1998; Simon and Slater 1998) and Gardiner Means in the USA (Means 1936)—which has found that, despite its a priori appeal, diminishing marginal productivity and rising marginal cost are the exception rather than the rule for industrial companies.

The most recent work confirming this result was done by Alan Blinder, who after a careful survey of 200 firms that collectively accounted for 7.6% of US GDP {Blinder, 1998 #297, p. 68}, reported that:

The overwhelmingly bad news here (for economic theory) is that, apparently, only 11 percent of GDP is produced under conditions of rising marginal cost. .. (Blinder 1998, p. 102)… Firms … rarely report the upward-sloping marginal cost curves that are ubiquitous in economic theory. Indeed, downward-sloping marginal cost curves are more common. (Blinder 1998, p. 302)

Table 2: Blinder’s survey results on firm cost structures (pp. 100-106)

This result is consistent with inputs being used in fixed proportions, and Post Keynesian macroeconomic models treat production as linearly related to labor and intermediate good inputs (with variable utilization of fixed capital in some instances), a position first put logically by Sraffa (Sraffa 1926).

1. Money

Money neutrality—certainly in the long run and, under Rational Expectations, also in the short run—is an essential aspect of the Neoclassical approach, in which macroeconomic models abstract from the existence of money, private debt, and banks. To Neoclassicals, the argument that changes in monetary variables impact upon real economic variables smacks of the fallacy of money illusion, and the difficulty lies in reconciling this principle with the empirical record:

It is natural (to an economist) to view the cyclical correlation between real output and prices as arising from a volatile aggregate demand schedule that traces out a relatively stable, upward-sloping supply curve. This point of departure leads to something of a paradox, since the absence of money illusion on the part of firms and consumers appears to imply a vertical aggregate supply schedule, which in turn implies that aggregate demand fluctuations of a purely nominal nature should lead to price fluctuations only. (Lucas 1972, p. 51)

Post Keynesian economists initially rejected money neutrality on the basis of Keynes’s argument that a monetary economy “is essentially one in which changing views about the future are capable of influencing the quantity of employment and not merely its direction” (Keynes 1936, p. xxii), thus conflating money with uncertainty. They also rejected the applicability of the concept of money illusion in a credit-based economy with nominal debts, since even Friedman’s statement of it conceded that it was only strictly true if debts were denominated in real terms:

nothing is so unimportant as the quantity of money expressed in terms of the nominal monetary unit … let the number of dollars in existence be multiplied by 100; that, too, will have no other essential effect, provided that all other nominal magnitudes (prices of goods and services, and quantities of other assets and liabilities that are expressed in nominal terms) are also multiplied by 100. (Friedman 1969, p. 1; emphasis added)

Later work into the mechanics of money creation strengthened the case for distinguishing the macroeconomics of a monetary economy from a non-monetary one. Basil Moore (Moore 1979) argued that bank lending was not effectively constrained by the reserve-setting behavior of Central Banks, using both empirical analysis and the mechanics of Federal Reserve behavior. As Federal Reserve Bank of New York Vice President Alan Holmes put it in his arguments opposing Monetarism in 1969:

The idea of a regular injection of reserves … also suffers from a naive assumption that the banking system only expands loans after the System (or market factors) have put reserves in the banking system. In the real world, banks extend credit, creating deposits in the process, and look for the reserves later… the reserves required to be maintained by the banking system are predetermined by the level of deposits existing two weeks earlier. (Holmes 1969, p. 73)

The relationship of loans and deposits leading and reserves lagging is more pronounced today, with the reserve lag now being 30 days (O’Brien 2007, Table 12, p. 52). The European Central Bank has also recently confirmed that the Post Keynesian position that “loans create deposits, and determine reserves with a lag” accurately describes private and Central Bank procedures:

In fact, the ECB’s reserve requirements are backward-looking, i.e. they depend on the stock of deposits (and other liabilities of credit institutions) subject to reserve requirements as it stood in the previous period, and thus after banks have extended the credit demanded by their customers. (ECB 2012, p. 21)

These operational perspectives on the endogenous creation of money by banks were confirmed by empirical work into the timing of economic variables by Kydland and Prescott, where they concluded that

the monetary base lags the cycle slightly… The difference of M2-M1 leads the cycle by … about three quarters… The fact that the transaction component of real cash balances (M1) moves contemporaneously with the cycle while the much larger nontransaction component (M2) leads the cycle suggests that credit arrangements could play a significant role in future business cycle theory. Introducing money and credit into growth theory in a way that accounts for the cyclical behavior of monetary as well as real aggregates is an important open problem in economics. (Kydland and Prescott 1990, pp. 4, 15)

More recently, the collapse in the ratio of broad money to base money during and after the crisis inspired an FRB Discussion Paper which concluded that:

the relationships implied by the money multiplier do not exist in the data for the most liquid and well-capitalized banks. Changes in reserves are unrelated to changes in lending, and open market operations do not have a direct impact on lending. We conclude that the textbook treatment of money in the transmission mechanism can be rejected. (Carpenter and Demiralp 2010, pp. 27-28)

However these empirical realities alone are not sufficient to support a critical role for banks, money and debt in macroeconomics: there must also be a link between change in monetary variables and change in real economic activity. The proposition that there is such a link was first put by Schumpeter, when he argued that the dominant source of funds for entrepreneurial investment was the creation of additional spending power by banks—not by transferring funds from savers to borrowers, but by the process of simultaneously creating both a deposit and a debt for a borrower without reducing the spending capacity of savers.

In Schumpeter’s model, entrepreneurs were individuals with concepts that could transform production or distribution in a discontinuous way—and thus yield “super-normal” profits to themselves—but no money with which to put these concepts into action. They therefore had to borrow:

the entrepreneur … can only become an entrepreneur by previously becoming a debtor… his becoming a debtor arises from the necessity of the case and is not something abnormal, an accidental event to be explained by particular circumstances. What he first wants is credit. Before he requires any goods whatever, he requires purchasing power. He is the typical debtor in capitalist society.’ (Schumpeter 1934, p. 102)

Schumpeter conceded that some of this finance could arise from saving—abstaining from consumption—but argued that this was minor compared to the endogenous creation of additional spending power by banks:

‘Even though the conventional answer to our question is not obviously absurd, yet there is another method of obtaining money for this purpose, which … does not presuppose the existence of accumulated results of previous development, and hence may be considered as the only one which is available in strict logic. This method of obtaining money is the creation of purchasing power by banks… It is always a question, not of transforming purchasing power which already exists in someone’s possession, but of the creation of new purchasing power out of nothing… (Schumpeter 1934, p. 73)

This theoretical argument received empirical support from research by Fama and French. Using the Compustat database of company reports from publicly-traded US non-financial corporations between 1951 & 1996, Fama and French calculated aggregate non-financial corporate investment, and correlated it with equity issue, retained earnings, and new debt (see Figure 2).

Figure 2: Correlations of investment to new equity, retained earnings and new debt (Fama & French 1999, p. 1954)

They concluded that “the source of financing most correlated with investment is long-term debt”:

Figure 3 shows investment and its financing year by year. The figure suggests that new net issues of stock do not move closely with investment. In fact, when the variables are measured relative to book capital … the correlation of investment, It, and new net issues of stock, dSt, is only 0.19… retained cash earnings move more closely with investment. The correlation between It and RCEt is indeed higher, 0.56, but far from perfect. The source of financing most correlated with investment is long-term debt. The correlation between It and dLTDt is 0.79. The correlation between It and new short-term debt is lower, 0.60, but nontrivial. These correlations confirm the impression from Figure 3 that debt plays a key role in accommodating year-by-year variation in investment. (Fama and French 1999, p. 1954)

There is thus a very important link between changes in monetary aggregates and real economic activity. This relationship is reflected in Godley’s and my models, with debt financing investment and liability structures arising from debt playing a key role in the predictions our models provide. The banking sector is also essential, since its financing of investment by the endogenous expansion of the money supply is a vital component of a growing economy. In both sets of models, money and debt are created simultaneously and endogenously by the bookkeeping operations of banks (Graziani 1989; Graziani 2003).

1. Government

With its view of a market economy as self-equilibrating, the Neoclassical school has had a tendency towards a critical perspective on the role of government, which culminated in the “Policy Inefffectiveness Proposition” that:

by virtue of the assumption that expectations are rational, there is no feedback rule that the authority can employ and expect to be able systematically to fool the public. This means that the authority cannot expect to exploit the Phillips Curve even for one period. (Sargent and Wallace 1976, p. 178)

Post Keynesian work has instead adhered to Keynes’s perspective that the market economy can generate insufficient aggregate demand to guarantee full employment (Keynes 1936, p. 25). This in turn leads Post Keynesians in general to argue that the government has both a responsibility and a capacity to boost aggregate demand during recessions, though there are differences in how effective such policies are expected to be.

Godley’s sectoral balance approach argues that a government surplus can force the private sector into a deficit, while government deficits are needed to enable the private sector to restore its balance sheet (Godley and Wray 2000, p. 204). My 1995 paper argued that counter-cyclical government spending could prevent a debt-induced recession by attenuating speculative euphoria during a boom and providing cash flows to service debts during a slump (Keen 1995, pp. 625-632).

1. Convergence: Structure, Dynamics and Minsky

That concludes an overview of the ways in which, in common with the broad Post-Keynesian tradition, Godley and I diverge from Neoclassical practice. The next topic is the positive themes in Post Keynesian economics that our approaches share.

1. Structure

Though the extent to which Post-Keynesian practice has lived up to its rhetoric can be disputed, Post-Keynesian theory has stressed the need to accurately model the institutions and structure of the economy that set the constraints on individual and collective behavior, in contrast to the Neoclassical emphasis upon methodological individualism (Krugman 1996). This emphasis can be dated to Sraffa’s empirically-oriented criticism of Marshall (Sraffa 1926; Robertson, Sraffa et al. 1930), which led to his input-output equilibrium critique of Neoclassical production theory (Sraffa 1960) and the development of an input-output oriented approach to macrodynamics (Pasinetti 1973; Pasinetti 1988; Salvadori and Steedman 1988; Kurz and Salvadori 1993; Pasinetti 1993; Salvadori 1998; Kurz and Salvadori 2006). This has caused conflict within the broad Post-Keynesian tradition akin to the Saltwater-Freshwater divide in Neoclassical economics between those who insist that input-output relations are a “brute fact about modern industrial economies” (Steedman 1992, p. 126) and those who develop “corn economy” models (Kriesler 1992; Sawyer 1992; Steedman 1993; but see Keen 1998). Though input-output dynamics are absent from Godley’s work, the emphasis upon modeling structure of the economy is common to both of us.

1. Dynamics

Post Keynesian models emphasize dynamics and disequilibrium rather than comparative statics and equilibrium, in a tradition that dates back to Kalecki (Kalecki 1935; Kalecki 1937) and Harrod (Harrod 1939; Harrod 1960). Post Keynesian macroeconomic models are iterative in nature and do not have a long-run equilibrium towards which the economy is assumed to converge (Arestis 1989; Sawyer 1995; Sawyer 1995).

Both Godley and I have developed not simply models (like, for example, Arestis 1989; Keen 2000, pp. 84-89), but modeling frameworks from which a wide variety of related models can be derived.

1. Minsky: Can “It” Happen Again?

Can “It”—a Great Depression—happen again? And if “It” can happen, why didn’t “It” occur in the years since World War II? These are questions that naturally follow from both the historical record and the comparative success of the past thirty-five years. To answer these questions it is necessary to have an economic theory which makes great depressions one of the possible states in which our type of capitalist economy can find itself. (Minsky 1982, p. 5)

In this “Chicago” view there exists a financial system … which would make serious financial disturbances impossible. It is the task of monetary analysis to design such a financial system, and of monetary policy to execute the design… The alternative polar view, which I call unreconstructed Keynesian, is that capitalism is inherently flawed, being prone to booms, crises, and depressions. This instability, in my view, is due to characteristics the financial system must possess if it is to be consistent with full-blown capitalism. Such a financial system will be capable of both generating signals that induce an accelerating desire to invest and of financing that accelerating investment. (Minsky 1969; Minsky 1982, p. 279)

Hyman Minsky’s “Financial Instability Hypothesis” has become a unifying vision in Post Keynesian economics, crystallizing the many differences between this school’s approach and the Neoclassical model. Since he is still unfamiliar to Neoclassical economists, it is important to set out his analysis at length here.

Minsky’s initial intellectual foundations were his PhD supervisor Schumpeter’s inherently cyclical and monetary vision of capitalism (Schumpeter 1928), and Irving Fisher’s “Debt-Deflation” explanation of the Great Depression (Fisher 1933). After reading Keynes 1937 essay “The General Theory of Employment” (Keynes 1937) in 1968, Minsky realized that IS-LM was not an accurate rendition of Keynes’s theory, and Keynes’s focus upon expectations formation under uncertainty in this paper (Keynes 1937, p. 214) provided the final component in his Hypothesis. This explains the puzzle that his first exposition of the Financial Instability Hypothesis was in a book whose title implied it was a biography of Keynes (Minsky 1975). It was instead an exposition of Minsky’s thesis in a book whose title paid homage to Keynes as an intellectual pioneer.

Minsky’s verbal model of a financial cycle begins at a time when the economy is doing well (the rate of economic growth equals or exceeds that needed to reduce unemployment), but firms are conservative in their portfolio management (debt to equity ratios are low and profit to interest cover is high), and this conservatism is shared by banks, who are only willing to fund cash-flow shortfalls or low-risk investments.

The cause of this high and universally practiced risk aversion is the memory of a not too distant system-wide financial failure, when many investment projects foundered, many firms could not finance their borrowings, and many banks had to write off bad debts. Because of this recent experience, both sides of the borrowing relationship prefer extremely conservative estimates of prospective cash flows: their risk premiums are very high.

However, the combination of a growing economy and conservatively financed investment means that most projects succeed. Two things gradually become evident to managers and bankers: “Existing debts are easily validated and units that were heavily in debt prospered: it pays to lever” (Minsky 1982, p. 65). As a result, both managers and bankers come to regard the previously accepted risk premium as excessive. Investment projects are evaluated using less conservative estimates of prospective cash flows, so that with these rising expectations go rising investment and asset prices. The general decline in risk aversion thus sets off both growth in investment and exponential growth in the price level of assets, which is the foundation of both the boom and its eventual collapse.

More external finance is needed to fund the increased level of investment and the speculative purchase of assets, and these external funds are forthcoming because the banking sector shares the increased optimism of investors (Minsky, 1980, p. 121). The accepted debt to equity ratio rises, liquidity decreases. and the growth of credit accelerates.

This marks the beginning of what Minsky calls “the euphoric economy” (Minsky 1982, pp. 120-124), where both lenders and borrowers believe that the future is assured, and therefore that most investments will succeed. Asset prices are revalued upward as previous valuations are perceived to be based on mistakenly conservative grounds. Highly liquid, low-yielding financial instruments are devalued, leading to a rise in the interest rates offered by them as their purveyors fight to retain market share.

Financial institutions now accept liability structures for both themselves and their customers “that, in a more sober expectational climate, they would have rejected” (Minsky 1980, p. 123). The liquidity of firms is simultaneously reduced by the rise in debt to equity ratios, making firms more susceptible to increased interest rates. The general decrease in liquidity and the rise in interest paid on highly liquid instruments triggers a market-based increase in the interest rate, even without any attempt by monetary authorities to control the boom. However, the increased cost of credit does little to temper the boom, since anticipated yields from speculative investments normally far exceed prevailing interest rates, leading to a decline in the elasticity of demand for credit with respect to interest rates.

The condition of euphoria also permits the development of an important actor in Minsky’s drama, the Ponzi financier (Minsky 1982, pp. 70, 115; Galbraith, 1954, pp. 4-5). These capitalists are inherently insolvent, but profit by trading assets on a rising market, and must incur significant debt in the process:

A Ponzi finance unit is a speculative financing unit for which the income component of the near term cash flows falls short of the near term interest payments on debt so that for some time in the future the outstanding debt will grow due to interest on existing debt… Ponzi units can fulfill their payment commitments on debts only by borrowing (or disposing of assets)… a Ponzi unit must increase its outstanding debts.’ (Minsky 1982, p. 24)

The servicing costs for Ponzi debtors exceed the cash flows of the businesses they own, but the capital appreciation they anticipate far exceeds their debt servicing costs. They therefore play an important role in pushing up the market interest rate, and an equally important role in increasing the fragility of the system to a reversal in the growth of asset values.

Rising interest rates and increasing debt to equity ratios eventually affect the viability of many business activities, reducing the interest rate cover, turning projects that were originally conservatively funded into speculative ones, and making ones that were speculative “Ponzi.” Such businesses will find themselves having to sell assets to finance their debt servicing—and this entry of new sellers into the market for assets pricks the exponential growth of asset prices. With the price boom checked, Ponzi financiers now find themselves with assets that can no longer be traded at a profit, and levels of debt that cannot be serviced from the cash flows of the businesses they now control. Banks that financed these assets purchases now find that their leading customers can no longer pay their debts—and this realization leads initially to a further bank-driven increase in interest rates. Liquidity is suddenly much more highly prized; holders of illiquid assets attempt to sell them in return for liquidity. The asset market becomes flooded and the euphoria becomes a panic, the boom becomes a slump.

As the boom collapses, the fundamental problem facing the economy is one of excessive divergence between the debts incurred to purchase assets, and the cash flows generated by them—with those cash flows depending upon both the level of investment and the rate of inflation.

The level of investment has collapsed in the aftermath of the boom, leaving only two forces that can bring asset prices and cash flows back into harmony: asset market deflation, or current goods inflation. This dilemma is the foundation of Minsky’s iconoclastic perception of the role of inflation, and his explanation for the stagflation of the 1970s and early 1980s.

Minsky argues that if the rate of inflation is high at the time of the crisis, then though the collapse of the boom causes investment to slump and economic growth to falter, rising cash flows rapidly enable the repayment of debt incurred during the boom. The economy can thus emerge from the crisis with diminished growth and high inflation, but few bankruptcies and a sustained decrease in liquidity. Thus, though this course involves the twin “bads” of inflation and initially low growth, it is a self-correcting mechanism in that a prolonged slump is avoided.

However, the conditions are soon reestablished for the cycle to repeat itself, and the avoidance of a true calamity is likely to lead to a secular decrease in liquidity preference.

If the rate of inflation is low at the time of the crisis, then cash flows will remain inadequate relative to the debt structures in place. Firms whose interest bills exceed their cash flows will be forced to undertake extreme measures: they will have to sell assets, attempt to increase their cash flows (at the expense of their competitors) by cutting their margins, or go bankrupt. In contrast to the inflationary course, all three classes of action tend to further depress the current price level, thus at least partially exacerbating the original imbalance. The asset price deflation route is, therefore, not self-correcting but rather self-reinforcing, and is Minsky’s explanation of a depression.

The above sketch basically describes Minsky’s perception of an economy in the absence of a government sector. With big government, the picture changes in two ways, because of fiscal deficits and Reserve Bank interventions. With a developed social security system, the collapse in cash flows that occurs when a boom becomes a panic will be at least partly ameliorated by a rise in government spending—the classic “automatic stabilizers,” though this time seen in a more monetary light. The collapse in credit can also be tempered or even reversed by rapid action by the Reserve Bank to increase liquidity.

Thus, though Minsky argued that financial instability was inevitable, he argued that Depressions could be avoided by a combination of deficits resulting from “Big Government” and “Lender of Last Resort” interventions by the Central Bank—so long as, in addition, we “establish and enforce a ‘good financial society’ in which the tendency by business and bankers to engage in speculative finance is constrained” (Minsky 1977; Minsky 1982, p. 69).

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

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

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

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

Stable growth is inconsistent with the manner in which investment is determined in an economy in which debt-financed ownership of capital assets exists, and the extent to which such debt financing can be carried is market determined. It follows that the fundamental instability of a capitalist economy is upward. The tendency to transform doing well into a speculative investment boom is the basic instability in a capitalist economy. (Minsky 1977; Minsky 1982, p. 67)

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

1. Goodwin’s Growth Cycle

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

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

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

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

Blatt employed a nonlinear form:

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

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

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

Most of the major European indexes closed modestly higher today, the first day of a week that includes a highly anticipated EU summit, and a day after Gavyn Davies featured a sobering chart in his FT commentary, The Anatomy of the Eurozone Bank Run. The EURO STOXX 50 index gained a quarter of a percent, and the Bloomberg table of European Stocks, which includes the STOXX 50 and the eight largest country indexes, showed only two declines for the day. More...

Michael Platt, the founder of the $30 billion dollar BlueCrest Capital Management joined Bloomberg to provide his outlook on Europe and other major macro events.   Earlier this year he made it clear that Europe’s crisis was far from over and would likely lead to a renewed wave of crisis.   The big rumor I’ve been hearing today is that Greece might leave, but authorities are planning to “ring fence” the event with a massive intervention of some type.  Platt says Eurobonds would be needed.  I agree.   Here’s more via Bloomberg:

Michael Platt of BlueCrest Capital Management spoke with Bloomberg Television’s Stephanie Ruhle and Erik Schatzker today and said that “Greece will never give back” money that has been lent to it by Europe.  He also said that a Greek exit from the euro would prompt more departures and that Spanish banks are probably “evergreening” their mortgage books.

On JPMorgan’s $2 billion trading loss, Platt said, “I think it’s a trading loss. They deliberately put the positions on” and “they’re not out of those positions.”

On Europe’s crisis and whether the euro is a failed experiment:

“I think we need to look at the situation country by country. If you take the situation of Greece, in the opinion of the markets, Greece should have should never have been allowed into the euro in the first place. They have already defaulted on their debts. They nearly defaulted again on a whole currency bond last week. They are not in a position to pay their bills. They have a primary deficit still. They will continue to be excluded from the funding markets. I think at this point in time, as the market increasingly calls into credibility the Troika, they are continuing to put money into a situation which has clearly become hopeless. “

On why the Troika continues to put money in:

“Greece will never give it back. We’re got some pretty clear evidence that this is the case. They are not in a position to pay the money back. The situation in Greece has gone from mainstream politics to now communism being the likely dominant party at the next round. The communist party has promised chocolate cake with no calories to the population – they can stay in the euro but abandon the  program of austerity, which will not be the case. The market now is openly speculating that Greece will exit the euro. “

On when Greece will exit the euro:

“I think it revolves around what happens to the Greek banks. We have seeing a gradual movement of money out of Greek banks. The deposit base has reduced from about 240 billion euros to 140 billion euros. We saw the pace of that stepping up recently. The big worry would be a stampede out of Greek banks, which precipitates an earlier crisis while the country has no government. That could move that way. If we go to a world where there’s an election and Switzer gets a 30% share in the votes, and then forms a coalition, I think they will leave almost immediately. “

On the total financial impact of a Greek exit:

“I think the order of events would be Greece exits, shock wave across Europe, massive stress in banks, Spain turns into the battleground for the euro because of distresses in their own banking system, and then we either get a very swift and strong European solution or we get a hugely disorderly meltdown in Europe. “

On what a swift and orderly solution would look like:

“Let’s look at the problem. In Spain at the moment, the estimate of the amount of money required to take Spanish banks to a proper 10% tier 1 capital ratio is around 90 billion euros. There is no effective federal deposit insurance scheme in Spain. It used to be eight billion euros, now it’s at 300 million euros. It has forward losses of between 15 and 20 billion euros as a result of two caja deals. So the risk is that people focus on the Spanish banking sector and we witness strong outflows or runs out of Spanish banks.”

On whether Spanish banks are acknowledging their real estate positions:

“No, they are not. In a country with 24% unemployment, they have a 3% provision against their mortgage book…The mortgage book of Ireland has a 10% provision. What is going on in Spain is that 22% of Spanish mortgages have been reworked, half of them more than twice. In other words, there’s evidence that the banks have been evergreening loans.  In which case, 7% of it, you have to take another allowance of 7% to get it to Irish levels against 650 billion euros. That’s another 50 billion euros there. And the same is going on in the loans to small and medium enterprises.”

On who has enough money to backstop Europe from a disorderly meltdown:

“On the day that Greece leaves, in order to circumvent bank runs and market mayhem, there would need to be an enormous announcement from the EU, there are two things that could be effective. I think we can rule an enormous money printing operation by the ECB. But I think the announcement of a eurobond for Europe would be something that would buy an enormous amount of time. It would have to be massive. The problem is, issuing a eurobond, I do not see that a hasty and ill-conceived monetary union can be solved by a hasty and ill-conceived fiscal union. Governments would need to cede sovereignty over their domestic spending to a central European entity, and I just can’t see that happening.”

“ I think that there’s a misconception also in the markets that Germany can ultimately pay for everything. The truth is that the European area is an economy as big as the United States. And Germany is 78% smaller than the United States.”

On whether Germany would exit the euro if the country doesn’t have the money to support the rest of Europe:

“I think an elegant solution, and I know it’s not politically acceptable, will be for Germany to manage an exit for itself from the euro, control its currency versus the euro, and then the remaining euro region could then print money, buy bonds, and instantiate a Fed mandate for the ECB, which have a mandate to minimize the loss of the economy versus inflation and unemployment.”

On how he’s trading Europe right now:

“The problem is you can make a pretty sensible argument for almost any outcome in Europe. It could be a run on the banks very quickly. The Greeks could end up staying in for a little bit longer. They could vote to take themselves out. There could be a eurobond. The whole situation could be overtaken by events. We could have bank runs in Spain. We could have LTRO. We could have a concerted bond-buying action from the ECB. You can make a sensible argument for almost any outcome it’s in such a state of flux right now. I think that when you get into these sorts of situations, the first thing you want to do is you want to ensure that your money is in a place where you like the credit so that if there is a major banking problem you’re not going to lose money on credit…The reason why the treasury market’s doing so well. Treasuries, and the short end of Europe with German government bonds, for two years now yield being essentially zero.”

On France and Italy:

“I think Spain is the battleground. I think that [France and Italy] come after. I think it will all be resolved

in terms of where we end up with Spain, honestly. If Spain leaves, I think if Spain comes to a position where it has to leave, I think you’ll end up in a situation where either Spain leaves or Germany leaves.”

On whether a run on banks has already begun:

“I think that it’s been a crawling, slow run for a long period of time. 650 billion euros via the target two system has found its way into Germany, and that has come from the deposit base elsewhere in

Europe. And as the stress has increased and we go towards a situation where Greece might actually – you’ve come to the realization that a euro in a Spanish bank and a euro in a Portuguese bank are not worth as much as a euro in a German bank.”

On JPMorgan’s 2 billion trading losses:

“I think JPMorgan – it’s well known in the Street – and I want to be very kind to JPMorgan as my biggest trader and former employer… My first job was at JPMorgan on Wall Street when I was 23. So I’ve got a very good disposition towards that bank. But I would say that if a bank in its normal course of its business has exposure to mortgage markets, has exposure to corporate accounts parties and the activities that they undertook in their chief investment office just increased them. So I don’t think they could be described in any way as a hedge. They’re not out of those positions. And if we end up with a catastrophe in Europe in the short run, they’re probably not positions that anyone would want to have.”

On whether the loss is broader than a trading loss:

“I think it’s a trading loss. They deliberately put the positions on. The London whale, who has subsequently been harpooned, put positions on and yeah, other people in the Street – BlueCrest and our credit fund, in the normal course of our business in a small way, not in any way looking to try and cause them any problems, we found some anomalies in the market. And I think that a number of credit funds found anomalies caused by these very large transactions, and possibly have taken the other side to provide market liquidity.”

On whether there’s any way for JPMorgan to elegantly extract itself from the situation:

“There’s always a price. There’s always a price to get out of anything. It might not be a price you like, but there’s always a price. So that’s true. It is in very high grade credit in the United States, so I think that they would ultimately be able to exit this position, yes.”

On whether he’d do the same thing as Jamie Dimon, maximizing the economic value of the trade over the long-term even if it’s going to come with some serious mark-to-market pain:

“Absolutely I would. There are other hedges. If corporate American credit really blows out, it’s likely that there are much bigger problems elsewhere. There are other instruments to hedge in. So yeah, I would be looking, if I was in that position, creatively at finding other avenues to reduce the value of risk of the book.”

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The ongoing shale gas boom has expanded domestic energy production, pushed wholesale electricity prices to record lows, and accelerated the closure of America's aging coal plant fleet, lowering national power-sector carbon emissions. This revolution in natural gas -- unleashed by a flood of recently accessible shale gas reserves, once thought to be unrecoverable -- is the product of over 25 years of federal agencies and programs driving technology development in collaboration with private gas companies.

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The history of shale gas fracking in the United States was punctuated by the successive developments of massive hydraulic fracturing (MHF), microseismic imaging, horizontal drilling, and other key innovations that when combined made the once unreachable energy resource technically recoverable (see infographic below for details). Along each stage of the innovation pipeline -- from basic research to applied R&D to cost-sharing on demonstration projects to tax policy support for deployment -- public-private partnerships and federal investments helped push hydraulic fracturing in shale into full commercial competitiveness.

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CLICK ON CHART TO ENLARGE

Shared the sentiment chart (lower left) with Premium Members last week, reflecting a good deal of stock market bears are at hand, at the same time the Dollar continues to deal with strong overhead resistance.

 This set up increases the odds of a short-term rally as it has in the past in the lower left chart.