Towards a post- Keynesian consensus in macroeconomics: Reconciling the Cambridge and Wall Street views Marc Lavoie University of Ottawa

Towards a post-Keynesian consensus in

macroeconomics:Reconciling the

Cambridge and Wall Street views

Marc Lavoie

University of Ottawa

Problem statement

• The current financial crisis, which started to unfold in August 2007, is a reminder that macroeconomics cannot ignore financial relations, otherwise financial crises cannot be explained.

• It was not always clear how Cambridge economists did integrate financial relations in their real models.

American PK vs Cambridge PK

• American PK: Money, debt, liquidity, interest rates, cash flows– Fundamentalist PK– Financial Keynesianism– Wall Street Keynesianism

• Cambridge PK: Real economy, actual and normal profit rates, pricing, rates of utilization – Robinsonians/Kaleckians– Kaldorians– Sraffians

Purpose of paper

• Recall frustrations of American PK strand with regards to the apparent absence of monetary factors

• Go over standard Robinsonian/Kaleckian real growth models• Recall early efforts to remedy to the problem in 1950s and

1960s• Discuss efforts in the mid 1980s and early 1990s• Discuss stock-flow consistent models as means to reconciliation

and provide some sort of consensus method

Cambridge macroeconomics without money• Davidson (1968, 1972) notes that in Kaldor’s famous

neo-Pasinetti theorem, where the propensity to save out of wages has no impact on the rate of profit, as in the Pasinetti 1962 model, there is no money.

• All saving is done in the form of stock-market shares.• The theorem does not hold up when money as a

second asset is introduced.

Click View then Header and Footer to change this footer

Cambridge macroeconomics without money II• Jan Kregel (1985, p. 133):

– “Money plays no more than a perfunctory role in the Cambridge theories of growth, capital and distribution developed after Keynes”.

• Cambridge macroeconomics without money is like Hamlet without the Prince.

• Kregel (1986) calls for the introduction of Bulls and Bears into heterodox Keynesian analysis, and for a generalization of liquidity preference theory.

• The partial failure of the Trieste PK Summer school (1980s) to integrate the Wall Street and the Cambridge views is an exemplar of the growing frustration of members of both strands .

CAMBRIDGE-KALECKIAN MODELS WITHOUT MONEY


Effective demand and growth

• 1. The Old Cambridge growth models– Robinson and Kaldor models– Keynes’s paradox of thrift applied to the long run

• 2. The New Kaleckian growth models– Paradox of costs– Variants of the model

rb* rh*ra r0 r

g

gb*

g0

gh*

B

H

gs

Stability in the Robinsonian model

gs = sp.r

gi = + .re

gi

r1* r

g

g1*H

H’gs

gi

gs(sc2)

The paradox of thrift in the Robinsonian model:A lower propensity to save leads to faster growth

gs = sp.r

gi = + .re

r2*

g2*

g

u

u

r PCED

gs

gi

u0*

r0*

g0*

The Kaleckian growth model

gs = sp.rgi = + (u-us )r = f.u/v (PC)

f =profit share

ED obtained by equating both g’s

- .us

us

rs

g

u

u

r PCED

gs

gi

u0* u1*u1

r0*

r1*

g0*

g1*

rmic

The Kaleckian paradox of costs: effect of a reduction in

costing margins

gs =sp.rgi = + .(u-us )

r = f.u/vp = (1+)(w/pr)w/p = pr/(1+)

f = / (1+)

Limits to the paradox of costs

• The investment equation may be positively related to the profit share f or to the target rate of return rs

(Bhaduri and Marglin 1990; Kurz 1990)

• In an open economy, rising real wages achieved by rising wages may be detrimental to competiveness.

Limits to the paradoxes of costs and of thrift• There must be some mechanism that will bring back

the actual rate of utilization towards the normal rate of utilization (Skott, Shaikh, Committeri)

• Here is one mechanism, based on inflation:• What if higher rates of growth and/or higher rates of

capacity utilization are conducive to faster growth rates?

• What if the central bank reacts to higher inflation rates by raising real interest rates?

• What if real interest rates reduce investment?• This is the Marxist story (Duménil and Lévy)

g

u

u

r PCED

gs

gi

u1*us

r1*

g2*

g1*

The Marxist story: return to the standard rate of capacity utilization

gs =sp.rgi = + .(u-us )

= (u-us)d/dt = -

r = f.u/vp = (1+)(w/pr)w/p = pr/(1+)

f = / (1+)

r2= rs

g0

Questioning the necessity of any adjustment of u towards un

• Provisional equilibrium; everything moves anyway (Chick and Caserta 1997)

• Other stock-flow norms in growth models are not realized, even when agents try to achieve them – wealth/income targets (Godley)

• There is a large range of acceptable “desired” or “normal” rates of capacity utilization (Hicks, Dutt 1990).

• A firm may operate each running plant at optimal capacity (cost-minimizing), while being unable to to run all plants (idle capacity) (Caserta 1990).

An acceptable range of rates of capacity utilization around the normal rate

• ‘The stock adjustment principle, with its particular desired level of stocks, is itself a simplification. It would be more realistic to suppose that there is a range or interval, within which the level of stock is “comfortable”, so that no special measures seem called for to change it. Only if the actual level goes outside that range will there be a reaction.’ (Hicks 1974, p. 19)

Even Sraffians accept that firms usually have idle capacity

• ‘It is virtually impossible for the investment-saving mechanism … to result in an optimal degree of capacity utilization…. It is, rather, expected, that the economy will generally exhibit smaller or larger margins of unutilized capacity over and above the difference between full and optimal capacity’. (Kurz 1994)

• ‘One must keep in mind that although each entrepreneur might know the optimal degree of capacity utilization, this is not enough to insure that each of them will be able to realize this optimal rate’. (Kurz 1993)

Still, we do not wish to sweep the problem under the carpet

• There are mechanisms that can bring together the actual and the normal rates of capacity utilization, by making the normal rate endogenous to the values taken by the actual rate (Lavoie 1992, 1996, 2003; Cassetti 2006, Commendatore 2006).

• So normal rates adjust to the actual rates.• With some specifications, these path-dependent models

safeguard both the paradoxes of thrift and of costs.• A critique of these has been: why would firms modify the

normal rate of utilization just because it has not been achieved recently (Skott 2008)?

BRINGING IN MONETARY FACTORS IN CAMBRIDGE MODELS


A few efforts by Cambridge authors to insert monetary factors

• Pasinetti (1974) distinguishes between the interest rate and the rate of return of capitalists.

• Kaldor’s (1966) neo-Pasinetti model inserts stock market shares, as does Moore (1975), with growth depending on the q-ratio, but they both money deposits, as already pointed out.

• Several chapters on money and credit in Robinson’s (1956) The Accumulation of Capital. – the loaned amounts depend on the interest covering ratio, that

is, the ratio of (profit) income to due interest payments. – the borrowing power of entrepreneurs will depend on “the

strictness of the banks’ standards of creditworthiness” and the state of mind of individual investors, as well as “the subjective attitude of potential lenders” .

• Joseph Steindl (1952) pays attention to the debt ratio of firms, and the possible contradiction in the evolution of the target and the actual debt ratios, but his book falls into oblivion.

The Sraffian contribution

• Garegnani (1979), Pivetti (1985) and Panico (1988) argue that the trend rate of interest and the normal profit rate are linked one on one.– Wray (1988) and Robinson (1979) unconvinced, despite

Robinson (1952) having a similar mechanism• There is a link with target return pricing and normal-cost pricing,

where the interest rate determines the target rate of return that will help to set the markup.

• Raising interest rates to slow down the economy can have inflationary consequences.

• This approach has been extended within a Kaleckian model by Dutt (1992), Lavoie (1993), Hein (2006, 2008), and more recently by Setterfield and Tadeu Lima (ROPE 2010). – Investment function takes interest payments into account – Saving function also does– But no stock market

Minsky-Cambridge models

• The Taylor and O’Connell (1985) model• The Semmler and Franke (1991) model

– Both have portfolio choice (deposits, equities)– Both have an investment function that depends on

confidence– Both have a differential equation determining

confidence (spread profit-interest rates, leverage ratio) and producing cycles.

Minsky-Cambridge models II

• The Delli Gatti and Gallegati (1990s) models.– Investment is a function of q ratio and a multiple of

retained earnings, this multiple changing pro-cyclically (Minsky 2-price diagram).

• The Jarsulic 1988, early 1990s models• Charles (2006, 2008)

– Ad hoc non-linearities, effect of debt ratios, chaos, bifurcations


Minsky-Cambridge models III

• Palley (1991, 1994) models– Introduce loans to consumers.– An extension of Minky’s FIH to the consumer

sector.– initially, the higher debt taken on by borrowers

leads to higher economic activity; but then, as more interest payments must be made, this slows down economic activity.

• Skott’s models (1981, 1988, 1989)– An earlier forgotten effort at synthesis, which is

stock-flow consistent


Drawbacks of previous models: Sometimes ….• Models are not fully stock-flow consistent• Models do not incorporate growth• Money is exogenous, or set by the

government deficit• The leverage ratio is not considered explicity• There is no stock market, or, • The stock market value of equities is

determined by fundamentals, and not by the market supply and demand

Stock-flow consistent models

• The main claim of the present paper is that stock-flow consistent models (SFC models), inspired in particular by the work of Wynne Godley, are the likely locus of some form of post-Keynesian consensus in macroeconomics, as it allows to entertain both monetary and real issues within a single model.

SFC models and Minsky• It is interesting to note that the possible links between

flow-of-funds analysis and balance sheet accounts on the one hand, and the Minskyan view of Wall Street economics on the other hand, were already underlined by Alan Roe (1973).

• Roe argued that that individuals and institutions generally follow stock-flow norms, but that during expansion they may agree to let standards deteriorate. He was also concerned with sudden shifts in portfolio holdings.

• Roe explicitly refers to the work of Minsky on financial fragility, showing that a stock-flow consistent framework is certainly an ideal method to analyze the merits and the possible consequences of Minsky’s financial fragility hypothesis.

Minsky and SFC models• “The structure of an economic model that is

relevant for a capitalist economy needs to include the interrelated balance sheets and income statements of the units of the economy” (Minsky 1996, p. 77).

• Thus starting out with an appropriate balance sheet matrix insures that economists “analyze how financial commitments affect the economy” (Minsky 1986, p. 221), by taking into account all the interrelated cash flows of the various sectors.

• Still, different behavioural equations will lead to different results.

A complete balance sheet

The simple Lavoie and Godley (2001-02) balance sheet

Split households, add loans to consumers

Add government and the central bank

Focus instead on the porfolio of banks

Add housing and mortgages (Zezza 2008)Rich Households

Other Households

Firms Banks Govt Central Bank

∑

Productive capital

+ pk.kf + Kf

Homes + ph.hrh + ph.hoh + Kh

Bills + Brh + Bf + Bb − B + Bcb 0

Cash + HPMrh + HPMoh + HPMb − HPM 0

Advances − A + A 0

Deposits + Drh + Doh − D 0

Loans − Lf + L 0

Mortgages − Moh + M

Equities + pf.efrh - pf.ef 0

Net worth − NWh − NWh − NWf 0 − NWg 0 −K

∑ 0 0 0 0 0 0

How about mortgage-backed financial assets?

Click View then Header and Footer to change this text

Simulating current changes in financial flows


Effect on the stock of personal loans of a one-time increase in the

flow of gross household loans to personal income


Effect of a one-time increase in the flow of gross household loans to personal income


Effect of a one-time decrease in the flow of gross household loans to personal income ratio, with a decrease in the propensity to consume out of personal income


Effect of a one-time decrease in the flow of gross household loans to personal income ratio, with a decrease in the propensity to consume out of personal income

Conclusion

• This tour should dispel the notion that Cambridge economics was impervious to the challenge posed by the earlier fundamentalist Post Keynesians, who were very much concerned with a monetary production economy.

• The SFC approach, despite its complexities, is far superior to the New consensus approach (new neoclassical synthesis), which however extended, cannot take into account the financial commitments of banks and other agents of the economy – a constraint that has turned up to be so important for our banking and financial system during the recent financial crisis.

Documents

Towards a post- Keynesian consensus in macroeconomics: Reconciling the Cambridge and Wall Street views Marc Lavoie University of Ottawa