Finance and Economic Breakdown: Modeling Minsky's "Financial Instability Hypothesis"

Author(s): Steve Keen

Source: Journal of Post Keynesian Economics, Vol. 17, No. 4 (Summer, 1995), pp. 607-635
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STEVE KEEN

Finance and economic breakdown:

modeling Minsky's "financial
instability hypothesis"

Fromas long ago as 1957,Minskyhasarguedthatanadvancedcapitalist

economy with developed financialinstitutionsis fundamentallyunsta-
ble, and liable to fall into a depressionin the aftermathof a period of
debt-financed"euphoria."His strictureswere comfortablyneglected
duringthe long boom of the 1960s, and even duringthe oil and Third
World debt shocks of the 1970s. However, this hypothesis cannot be
ignoredafterthe long periodof economic instabilityusheredin by the
crash of 1987. The late 1980s were manifestly a period of euphoria,
financialinnovationsupportedthe boom, andthe desire of both corpo-
rationsand banksto recoverfromexcessive debt is, to lay observersat
least,a majorfactorin the "joblessrecovery"of the early 1990s. Clearly,
currenteconomic circumstanceswarranta more consideredevaluation
of Minsky's theories.
This paper models four basic insights of the "financial instability
hypothesis"on the foundationof Goodwin's limit cycle model: the
tendency of capitaliststo incurdebt on the basis of euphoricexpecta-
tions; the importanceof long-term debt; the destabilizing impact of
income inequality;andthe stabilizingeffect of government.The intro-
ductionof these conceptsintoGoodwin'sframeworkconvertshis stable
butcyclical system into a chaoticone, with the possibilityof a divergent
breakdown-the simulationequivalentof a depression.

Keynesian foundations

Minsky's financial instabilityhypothesis derives from his distinctive

readingof Keynes, which is basedlargelyon chapter17 of TheGeneral
The authoris in the Departmentof Economicsat the Universityof New South
Wales, Kensington,NSW, Australia.He would like to thankCarolynCurrie,Geoff
Fishburn,CraigFreedman,Bill Junor,PeterKrieslerand two anonymousrefereesfor
commentson this paper.
Journalof Post KeynesianEconomics/ Summer 1995, Vol. 17, No. 4 607

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608 JOURNALOF POST KEYNESIAN
ECONOMICS

Theoryof Employment,Interest and Money (Keynes, 1936), and the

1937 papers,"The GeneralTheory of Employment"(Keynes, 1937a)
and "AlternativeTheories of the Rate of Interest"(Keynes, 1937b).
Minsky arguesthatin these papersKeynes developeda perspectiveon
the motive for investment that differs radically from the "marginal
efficiency of capital"argumentthatwas the basis for the conventional
analysis of investment after Keynes. There are three key facets to
Keynes' distinctly expectations-basedexplanation of investment in
these three works: a dualprice level; a volatile basis for the formation
of expectations,which determinesthe desire to invest; and a finance-
based demandfor money, in additionto the traditionaltriadof transac-
tions, precautionaryand speculativedemand.
Inchapter17,Keynes arguedthatinvestmentis motivatedby the desire
to produce"those assets of which the normalsupply-priceis less than
the demandprice"(Keynes, 1936, p. 228), wherethe demandprice was
determinedby the influences of prospectiveyields, depreciation,and
liquiditypreference.This insight was furtherrefined in "The General
Theory of Employment,"where Keynes talks of the progresstoward
equilibrium between different prospective investments leading to
"shifts in the money-prices of capital assets relative to the prices of
money-loans." The concept of two price levels and the focus on
capital appreciation as the motive for investment are even more
evident in the observationthatthe scale of productionof capitalassets
"depends,of course, on the relationbetween their costs of production
and the prices whichthey areexpectedto realisein the market"(Keynes
1937a,p. 217).
Keynes' discussionof uncertaintyin this articleis alliedto anincreased
use of the concept of asset prices, and a muchdiminishedstatusfor the
marginalefficiency of capital.Keynesassociatesthe latterwiththe view
thatuncertaintycan be reduced"tothe same calculablestatusas thatof
certainty itself' via a "Benthamitecalculus," whereas the kind of
uncertaintythat mattersin investmentis that aboutwhich "thereis no
scientific basis on which to form any calculableprobabilitywhatever.
We simply do not know"(Keynes, 1937a,pp. 213, 214). Keynes argues
thatin the midst of this incalculableuncertainty,investorsform fragile
expectationsabout the future,which are crystalizedin the prices they
placeuponcapitalassets,andthesepricesarethereforesubjectto sudden
andviolent change-with equallysuddenandviolent consequencesfor
the propensityto invest. Seen in this light, the marginalefficiency of
capitalis simplythe ratioof the yield froman assetto its currentdemand

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 FINANCEAND ECONOMICBREAKDOWN 609

price, andthereforethereis a different"marginalefficiency of capital"

for every differentlevel of asset prices (Keynes, 1937a, p. 222).
Keynes' explanation for the formation of expectations under true
uncertaintyhas threecomponents:a presumptionthat"thepresentis a
muchmoreserviceableguideto the futurethana candidexaminationof
pastexperiencewould show it to havebeen hitherto";thebelief that"the
existing state of opinion as expressed in prices and the characterof
existing outputis based on a correctsummingup of futureprospects";
and a reliance on mass sentiment:"we endeavourto fall back on the
judgment of the rest of the world which is perhapsbetter informed"
(Keynes 1936, p. 214). The fundamentaleffect of shifts in expectations
is to change the importanceattributedto liquidity, thus shifting the
apportionmentof funds between assets embodyingvaryingdegrees of
liquidity, with volatile consequencesfor the level and composition of
investment.
Keynes strengthensthis increasinglyfinancialfocus with the observa-
tion that there exists a finance demand for money, which must be
exercised and fulfilled before investment is undertaken.Having ne-
glected this conceptin the GeneralTheory,he arguesherethat"it is, to
an importantextent,the 'financial'facilities which regulatethe pace of
new investment."It is therefore not a lack of savings that inhibits
investment,but a lack of financeconsequentupon "too greata press of
uncompletedinvestment"(Keynes, 1937b, p. 247).
Potentthoughthese observationsof Keynes' may be, they are not as
systematicas those in the GeneralTheoryon the marginalefficiency of
capital, let alone as structuredas the model in "Mr. Keynes and the
Classics" (Hicks, 1937), which led to IS-LM analysis with its static
treatmentof expectations(Hicks, 1982). Since Keynes adheredto the
concept of diminishingreturnsin the shortrun,it was difficult for him
to explain how the two price levels could diverge;therewas no expla-
nationfor the stateof expectationsat any given time, nor for why shifts
might occur; there was no integrationof the question of expectations
with the question of supply of finance, and the notion of an endoge-
nously variablesupplyof financesits uneasilywith the exogenousview
of the supplyof money presentedin the GeneralTheory.It is therefore
little wonderthatthese insightshave not been developedin the conven-
tional literature.
Minsky's contributionhas been to codify these insights,with the aim
of developing a theoryof investmentconsistentwith the occurrenceof
periodic economic disturbancesof the kind experiencedin the 1930s

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610 JOURNALOF POST KEYNESIAN
ECONOMICS

and,arguably,in the 1980s. He has filled the gaps in Keynes' pictureby

consideringthe developmentof expectationsover time, within an ex-
plicitly monetaryframework.

PostKeynesianessentials
Two factorsareneededto providea foundationfor Minsky's model-a
theoryof prices thatallows for two price levels andthe developmentof
noncorrectingdivergence between them in the medium term; and a
perspectiveon the supplyof money thatis consistentwith variationsin
finance affectingthe level of investment.
As a Post Keynesian,Minskyarguesthatthe prices of most (end-con-
sumer)commoditiesare set by a markupon primecost (see Reynolds,
1987, pp. 53-62). The largely independentprice level of assets-
broadly defined as items whose ownershipgives rise to claims to a
stream of future cash flows-is based, not on the original cost of
productionof the assets, buton the net presentvalue of anticipatedcash
flows. These in turndependon the generalstateof expectations,which
vary systematically over the financial cycle, lagging behind current
prices in a slump, runningahead of them in a recovery and boom.
Though asset prices must eventuallyreturnto some kind of harmony
with currentprices over the very long term,this perspectiveallows for
significantdivergencebetweenthe two pricelevels as expectationsrise
and fall over the mediumterm.
Minsky arguesthat the supply of money is essentially endogenously
determined,and provides two reasonswhy the controlsof a regulated
system do not makeit strictlyexogenous.First,if the currentregulatory
regime limits the supply of finance for investment to less than that
desiredby the privatesector, then intermediationwill occur and inno-
vativefinancialproductswill be developed,increasingvelocity. Second,
if a financial institutiongets into difficulties, the authoritieswill nor-
mally guaranteeits deposits to preventa "run";in this case, eitherthe
money base will be expandedor the creditmultiplierwill be increased.
In other words, in times of potentialfinancialcrisis, the conventional
money equationworksbackwards,fromthe supplyof moneyto thebase
and multiplier.The resultingendogenousincreasein the money stock
then persiststhroughtime.
Ina deregulatedsystem,wherethecentralbankhasinfluenceoveronly
the monetarybase and the rediscountrate, expansion of the money
supplycan occurmuchmoreeasily, throughbothincreasedwillingness

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 FINANCEAND ECONOMICBREAKDOWN 611

of banks to lend-which increasesthe creditmultiplier-and through

financialinnovation.The moredifficultand slowerpathof intermedia-
tion is no longerrequired(thoughit can still be practised).

The basic Minsky model

Minsky's analysis of a financial cycle begins at a time when the

economy is doing well (the rateof economic growthequals or exceeds
thatneededto reduceunemployment),butfirmsareconservativein their
portfoliomanagement(debtto equityratiosarelow andprofitto interest
cover is high), and this conservatismis sharedby banks,who are only
willing to fundcash-flow shortfallsor low-riskinvestments.The cause
of this high and universallypractisedrisk aversionis the memoryof a
not too distant systemwide financial failure, when many investment
projectsfoundered,manyfirmscould not financetheirborrowings,and
many bankshad to write off bad debts. Because of this recent experi-
ence, both sides of the borrowingrelationshippreferextremelyconser-
vative estimatesof prospectivecash flows: theirriskpremiumsarevery
high.
However, the combinationof a growingeconomy andconservatively
financed investment means that most projects succeed. Two things
graduallybecome evidentto managersandbankers:"Existingdebtsare
easily validatedandunitsthatwere heavily in debtprospered:it pavs to
lever" (Minsky, 1982, p. 65). As a result,both managersand bankers
come to regard the previously accepted risk premium as excessive.
Investmentprojectsare evaluatedusing less conservativeestimatesof
prospectivecash flows, so thatwith these rising expectationsgo rising
investmentand asset prices. The general decline in risk aversionthus
sets off both growthin investmentand exponentialgrowthin the price
level of assets, which is the foundationof boththe boom andits eventual
collapse.
More externalfinance is needed to fundthe increasedlevel of invest-
ment and the speculativepurchaseof assets, and these externalfunds
are forthcomingbecause the bankingsector sharesthe increasedopti-
mism of investors(Minsky, 1980, p. 121). The accepteddebt to equity
ratiorises, liquiditydecreases,andthe growthof creditaccelerates.
This marksthe beginning of what Minsky calls "the euphoricecon-
omy" (Minsky, 1980, pp. 120-124), whereboth lendersandborrowers
believe that the futureis assured,and thereforethat most investments
will succeed. Asset prices are revaluedupwardas previous valuations

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612 JOURNALOF POST KEYNESIAN
ECONOMICS

are perceivedto be based on mistakenlyconservativegrounds.Highly

liquid,low-yieldingfinancialinstrumentsaredevalued,leadingto a rise
in the interestrates offered by them as their purveyorsfight to retain
marketshare.
Financial institutionsnow accept liability structuresfor both them-
selves andtheircustomers"that,in a more soberexpectationalclimate,
they would haverejected"(Minsky, 1980,p. 123).Theliquidityof firms
is simultaneouslyreducedby the rise in debt to equity ratios, making
firmsmore susceptibleto increasedinterestrates.The generaldecrease
in liquidity and the rise in interestpaid on highly liquid instruments
triggersa market-basedincreasein the interestrate, even without any
attempt by monetary authoritiesto control the boom. However, the
increasedcost o1 creditdoes littleto temperthe boom, since anticipated
yields from speculative investments normally far exceed prevailing
interestrates,leadingto a decline in the elasticity of demandfor credit
with respectto interestrates.
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 profit
by tradingassets on a rising market,and incur significant debt in the
process. The servicing costs for Ponzi debtorsexceed the cash flows
of the businesses they own, but the capital appreciationthey antici-
pate far exceeds the interest bill. They therefore play an important
role in pushing up the marketinterestrate, and an equally important
role in increasingthe fragility of the system to a reversalin the growth
of asset values.
Rising interestrates and increasingdebt to equity ratios eventually
affectthe viabilityof manybusinessactivities,reducingthe interestrate
cover, turningprojectsthatwere originallyconservativelyfundedinto
speculativeones, andmakingones thatwere speculative"Ponzi."Such
businesseswill findthemselveshavingto sell assetsto financetheirdebt
servicing-and this entryof new sellersintothe marketfor assetspricks
the exponentialgrowth of asset prices. With the price boom checked,
Ponzi financiersnow find themselveswith assets thatcan no longerbe
tradedat a profit, and levels of debt that cannotbe serviced from the
cash flows of the businessestheynow control.Banksthatfinancedthese
assetspurchasesnow findthattheirleadingcustomerscanno longerpay
theirdebts-and this realizationleads initiallyto a furtherbank-driven
increasein interestrates.Liquidityis suddenlymuchmorehighlyprized;
holdersof illiquidassets attemptto sell themin returnfor liquidity.The

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 FINANCEAND ECONOMICBREAKDOWN 613

asset marketbecomes flooded and the euphoriabecomes a panic, the

boom becomes a slump.
As the boom collapses, the fundamentalproblemfacing the economy
is one of excessive divergencebetween the debts incurredto purchase
assets, and the cash flows generatedby them-with those cash flows
dependingupon both the level of investmentand the rate of inflation.
The level of investment has collapsed in the aftermathof the boom,
leaving only two forces thatcan bringasset prices andcash flows back
into harmony: asset price deflation, or currentprice inflation. This
dilemma is the foundationof Minsky's iconoclastic perceptionof the
role of inflation,andhis explanationfor the stagflationof the 1970s and
early 1980s.
Minsky argues that if the rate of inflation is high at the time of the
crisis, thenthoughthe collapse of the boom causes investmentto slump
and economic growth to falter, rising cash flows rapidly enable the
repaymentof debt incurredduringthe boom. The economy can thus
emerge from the crisis with diminishedgrowthand high inflation, but
few bankruptciesanda sustaineddecreasein liquidity.Thus,thoughthis
course involves the twin "bads"of inflationandinitiallylow growth,it
is a self-correctingmechanismin that a prolonged slump is avoided.
However, the conditionsare soon reestablishedfor the cycle to repeat
itself, and the avoidanceof a truecalamityis likely to lead to a secular
decreasein liquiditypreference.
If the rate of inflationis low at the time of the crisis, then cash flows
will remain inadequaterelative to the debt structuresin place. Firms
whose interestbills exceed theircash flows will be forcedto undertake
extrememeasures:they will haveto sell assets, attemptto increasetheir
cash flows (atthe expense of theircompetitors)by cuttingtheirmargins,
or go bankrupt.In contrastto the inflationarycourse,all threeclasses of
action tend to furtherdepress the currentprice level, thus at least
partiallyexacerbatingthe originalimbalance.The asset price deflation
routeis, therefore,not self-correctingbutratherself-reinforcing,and is
Minsky's explanationof a depression.
The above sketchbasicallydescribesMinsky'sperceptionof an econ-
omy in the absence of a governmentsector. With big government,the
picturechangesin two ways, becauseof fiscal deficitsandReserveBank
interventions.With a developed social securitysystem, the collapse in
cash flows that occurs when a boom becomes a panic will be at least
partlyamelioratedby a rise in governmentspending-4he classic "au-
tomaticstabilizers,"thoughthis time seen in a moremonetarylight. The

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614 JOURNALOF POST KEYNESIAN
ECONOMICS

collapse in creditcan also be temperedor even reversedby rapidaction

by the Reserve Bank to increase liquidity. With both these forces
operatingin all Westerneconomies since World War II,Minsky ex-
pected the conventionalcycle to be markedby "chronicand . . . accel-
erating inflation"(Minsky, 1982, p. 85). However, by the end of the
1980s, the cost pressuresthat coincided with the slump of the early
1970s had long since been eliminated,by fifteen years of high unem-
ploymentandthe diminutionof OPEC'scartelpower. The crisis of the
late 1980s thus occurredin a milieu of low inflation,raisingthe specter
of a debt deflation.

Modeling Minsky
A completemodelingof Minsky's hypothesiswould requirea model of
considerablecomplexity.However,the essence of Minsky's analysis-
the propositionthat in a capitalisteconomy with finance, an endemic
tendency towardeuphoricexpectationswill generateboth cycles and
a secular trend of rising debt, leading ultimately to a debt-induced
crash-can easily be modeled by introducing a prototypal "real"
finance sector and two "stylized facts" into Goodwin's 1967 model
of the tradecycle (Goodwin, 1982).
Goodwin's model is drivenby the single stylized fact thatworkersare
morelikely to demandrealwage rises duringtimes of high employment
than during times of high unemployment-a "Phillips curve." The
adaptationthatfollows introducesa similarstylized fact for capitalists,
thatthey are more willing to invest duringbooms thanduringslumps.
When a banking sector is introduced,the interest rate is treated as
consisting of a base rate determinedby external fiat, and a variable
componentreflectingan increasingrisk premiumas the debt to output
ratiorises. This tempersthe extreme"horizontalist"(see Moore, 1988)
position of the model, in thatotherwisethe finance sector is treatedas
having an unlimitedcapacityto finance capitalistinvestment.'
I A more completemodel would have bankfinancialreservesbeing relatedto past
andpresentcapitalistprofits,with a variablemoney multiplierexpandingand con-
tractingthe financethese profitscan generate.However,the model as specified al-
lows us to focus on the basic antinomybetween profits,investment,and long-term
debt. Its openness only becomes an issue when the system approachesbreakdown-
at which time it indicatesthatcapitalistscan affordto financeexponentiallyincreas-
ing debt, when in fact they would go bankrupt.The modeling of bankers'income
also abstractsfromthe fact thatbankersmaketheirprofiton the spreadbetween de-
posit and loan interestrates.

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 FINANCEAND ECONOMICBREAKDOWN 615

The following equations define the basic Goodwin model and the
finance extension2:

a = ao x e at = Exponentialgrowthof disembodiedlabour
productivity;

N = No x ept = growthof thelabourforce;

Exponential
Y= a xL = Outputdecisions of capitalistsdetermine
employment,given productivity;

K = v XY = A fixed acceleratorrelation;
L
k= N = The employedfractionof the work force;

dw = w [X] x w = The rateof changeof real wages is a nonlinear

functionof the rateof employment;
_dK_ FH
I - k LK x Y- 1 x K = Net investment
is a functionof profit
times the level of outputminus depreciation.
A functional form is needed for the wage change and investment
functionsfor the subsequentnumericalsimulations.The equationused
is generalizedfrom that first suggestedby Blatt (1983, p. 213). It has
the desiredcharacteristicsof nonlinearity,fallingto a nearconstantlevel
at low levels of the triggeringvariable,andrisingasymptoticallyat high
levels.
Forthe wage changefunction,the equationis w(X)= (Al[(B- C x X)2)-
D, which given the parametervaluesused (A = 0.0000641;B = 1; C = 1;
D = 0.0400641), resultsin workersacceptinga constantreal wage at an
unemploymentrate of 3.6 percent,acceptingreal wage cuts at higher
levels of unemployment(to a maximumof 4 percentper period), and
demandingreal wage rises at lower rates (rising asymptoticallyat full
employment).
Capitalistinvestmentis modeledusing the same functionalform,

2
In the following numericalsimulations,the parameterand initialvalues used are:
a= 1,N= lOO,a=0.015,.= 0.035,y=0.02,v=3, X=0.9,o=0.96.

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616 JOURNALOF POST KEYNESIAN
ECONOMICS

k7Z2
k ~ ~ E~~-H, -7> 7t> 0
Yj (F-Gx)2
V

With the parameter values used (E = 0.0175; F = 0.53; G = 6; H=

0.065), investmentis zeroat andbelow zeroprofit,risingto equalprofits
when the profit share is 10 percent,and exceeding profits for higher
profit shares(figure 1).
Continuingwith the definitions:

K = vxY =- = The rate of profit equals profit share over

K vx Y v
the accelerator;
t = 1 -o - b = Profit share is a residual after workers and
bankersincome;

c3 = W _ wxL _ = The wages share of national income;

Y Lxa a

B r xD
b =-= = =Bankers income is the interest rate times
y
outstandingdebt;

- = r x D + I - n = Capitalistsuse debt solely to finance

investment;

r = 4 + (px - = The interest rate is a linear function of the

y
debtto outputratio.

The derivationis as follows:

K v
dt dt xYJx Y =The rate of change of output;

dL dY l(dY~
ad Y=J x d-a x
-Y= =The rateof change of
employment;

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 FINANCEAND ECONOMICBREAKDOWN 617

dt dtN v a- =Therate of change of the

employmentrate;

d(c da =X) x (w(k) - a) = The rateof changeof workers'

dt dt a
shareof output;

dd d(Dv
dt dtvi b - T- (v - d) x < - = Therateof changeof
the debtratio;

rx
dt dt ((pxd+r) x -b--(v-d)xj2- j= The
dit- dt Y ( x+)
rateof c~hange
of bankersshare.

Simulations

Basic Goodwinlimit cycle

In the basic Goodwin system, where k [i/v] = 1 - 0), the equations

for dXldt and doldt are sufficient to describe the behavior of the
system. With capitalists passively investing all their profits, the
driving force in the model is the reaction of workers to the level of
employment, as expressed in the rate of change of the wages share
of output, 0o. An initially above-equilibriumlevel of wages share
results in less investment than is needed to sustain the rate of output
growth above the growth of the work force, and hence employment
falls. Workers accept wage cuts, resulting in a higher profit share,
increasing investment and faster output growth, which eventually
reverses the decline in employment. However, workers' share of
output continues to fall for a while since employment is still
below the level at which workers demand a constant real wage,
leading to still higher investment, growth, and eventually extreme
demands for higher real wages. The initial conditions are thus re-
stored andthe cycle repeats.The same fundamentalcondition applies

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618 JOURNAL OF POST KEYNESIAN ECONOMICS

Figure1 Behavioralfunctionsforworkersandcapitalists
Real wage change Investment/Output

0.64-0.8 _ ,_

0.4_ _ _ _ _ _ _ _ . 4_ _

0.31
0.2-- XiI - 0.2
0 .2 =+ _ _

o o

0.9 0.92 0.94 0.96 0.98 -0.1 -0.05 0 0.05 0.1 0.15 0.2

Employment Rate Profit/Output

when the propensityto invest functionreplacesthe presumptionthatall
profits are invested. The major change is that the cycles are more
frequent(figure 2)?.
The essentially stable natureof this model can be seen in the phase
diagramin figure 3, which shows the time paths in employment and
wages shareemanatingfromfourdifferentsets of initialconditions,two
of whichgenerateequilibriumoutcomes,andtwo of whichgenerate
cycles.

Finance and instability

The introduction of a financesectormeansthatcapitalistscanborrow

to financetheirinvestment plans,andhenceaccumulate long-tenndebt.
Thispossibilityfundamentally altersthe natureof the model:a stable
limitcycleis replacedby eitherof twopossibilities,giventhevaluesof
keyparameters: a systemthattendsto stability,ora systemthat"breaks
down,"by achievingan unsustainabledebt to outputratio. In the
followingsimulations,the key parameter whosevalueis variedis the
interestrate.Twokindsof variationsareconsidered:anincreasein the
base rate(correspondingto conventionalgovernmentalactionto control
3 While time in this model is clearly historic (in thatdte time path of the system is
crucial), it is in no way intendedto match actualtime. The objective of the modeling
is to captureaspects of the cyclical behaviorand stabilitypropertiesof an actualecon-
omy, but not to accuratelyquantifythis behavior.One of the lessons of nonlineardy-
narnicsis thatsuch accuratequantificationis in fact impossible. The emphasisof
modeling thereforeshifts frompredictionto simulation.

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 FINANCEAND ECONOMICBREAKDOWN 619

Figure2 Wageshareandemployment,
basicGoodwinmodel

1 I.A t i t ,

0.9 1

0.8 ---

0.7a

0.6 a__

0 20 40 60 80 100

Periods
Figure3 Cyclicalandequilibrium
timepaths

0.975 f Rac CToodwin TInvestmeont

0.975~~~~~~
Equil brium Equ librium
0.95

0.925 Basic Goo win InvestmentFunction

E \ Cycle Cycle
o 0.9-
,0.875 -

0.85 -

0.825 - . _

0.8
0.6 0.7 0.8 0.9 1
WageShare

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620 JOURNALOF POT KEYNESIAN
ECONOMICS

an overheatedeconomy using monetarypolicy), given zero banksensi-

tivity to the debt to outputratio;and differentlevels of bank sensitivity
to the debt to outputratio,given a constantbase rate.

Base rate variations

Stability
With the parametervalues used in these simulations,a base rateof less
than4.6 percentresultsin a systemwhich,overtime, approachesa stable
equilibrium.At this level of the rate of interest,the interestpayments
occasioned by the growth in debt (which results from capitalistsbor-
rowing to finance investment during booms) gradually attenuatethe
level the booms reach. This results in capitalistinvestment cyclically
taperingdown to a level at which the ratioof debt to outputstabilizes.
Constantincome sharesthenensueforthethree"classes"in the model-
workers,capitalists,andbankers-and the system thereaftergrows at a
steady pace (see figures 4-6).
A phase space diagram (figure 6) with three dimensions (workers'
shareof output,bankers'share,andthe employmentrate)now replaces
the workers' income/employmentphase space of the basic Goodwin
system. The dynamics of the above route to stability are graphically
apparentin the figure.
Instability-rising debtwith a wages blowout:At a base interestrateof
4.6 percentor above, a differentdynamicemerges.An initiallylow level
of workers'shareand zero bankers'shareleads to high investnent and
rapidgrowthof employment.The investmentis financedby borrowing,
resultingin a rise in bankers'share.The increasedemploymenteventu-
ally resultsin sharplyrising workers'share,which, coming on top of a
rise in bankers'share, reducesprofit and results in a fall-off in invest-
ment. The reducedinvestmentleads to lower employment,which ini-
tially tempers and then reverses the increase in workers' share. In the
early stage of the cycle, profits then exceed investment, resulting in
some bank debt being repaidand hence a falling bankers' share. The
decline in bankers' and workers' share restores capitalistprofits, but
since bank debt has not been completely repaid, the cycle is not as
extreme when it next repeats.
However, ratherthanthe cycle being dampedaway, the higherrateof
interest leads to the fonnation of a wage-employmentvortex, where
bankers'share continuesto grow ratherthan reachinga plateau.From

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 FINANCEAND ECONOMICBREAKDOWN 621

Figure4 andwageshareatlow interest

Employment

0.95 rmployment
0.95

0.875
0.85
0.825 i ffi Share
lage t <
N

0 50 100 150 200

Periods
Figure5 Profit,investment,andbankshareat low interest

0.4 _ _ _ _ _

0 .3 5 - _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _

0.3 -_ _ _ _ _ _ _ _ _ _

0.25 -
n-vestment

0.15
0.1 t 1Slll .
1111IlV+ i
Profit Share
~ VImt [ gl lb;XV

0.05 -f

0 :ankShare
0 50 100 150 200

Periods

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622 JOURNALOF POST KEYNESIAN
ECONOMICS

Figure 6 Income and employmentstabilityat low interest

Employment 0.95/i \

a
n 0.01 /~~0
k
S.0

a 0.85
r
e

0.85

Wages 0.9

0.95

this point on, the rise in bankers' share causes a fall in investment,
leading to a drop in employmentand hence a (slightly sharper)fall in
workers'share.This causes an increasein profitsandhence investment,
leading to furtherdebt and a rise in bankers' share again. Ratherthan
attenuating,the cycles now become more intense, with the strongfall in
workers'sharecausing a big growthin profits,a commensuratelylarger
surge in investment(given the nonlinearinvestmentfunction),a further
increase in debt, then the increase in workers' share due to increased
employment (and the nonlinearwage change function), and a renewal
of the cycle at a higherpitch. Eventuallythe boom is so extremethatthe
extra debt incurredresultsin profits falling and remainingbelow zero,
given the level of debt that has been accumulated.The system then
collapses toward zero employment,wages, and profits, with bankers'
share spiraling ever upward. It is now in a debt-inducedbreakdown,

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 FINANCEAND ECONOMICBREAKDOWN 623

Figure7 Instabilityat"high"interest

0.95
Employmen.
0.9 . . . . . .

0.85

0.8 =

0.5
0.75 aWges Shar.

0 200 400 600 800

Periods

fromwhich-without a changein therules,suchas a debtmoratorium-

it cannotescape (figures 7 and 8).

Debt sensitivityvariations
At a low level of sensitivityto debt and a base ratethatof itself leads to
stability, a variableinterestrate causes the model to stabilize rapidly.
Higher levels of debt sensitivity lead to a quite different form of
breakdownthan results from increases in the base rate (figures 9 and
10). Whereasa high base rateof interestset in trainforces thatled to an
extreme investmentboom, followed by an extremewages blowout and
then a collapse, the collapse with high debt sensitivityis precipitatedby
a very low key investment"boom"and only a temporaryreversalof a
seculartrendto a falling wages share.
The fallingworkers'sharesustainsprofitsat a level at whichthe excess
of investment over profits causes the debt to outputratio to rise over
time. This leads to a rising rateof interestand a rising bankersshareof
output,whose dampeningeffects on capitalistinvestmentare, for some
time, balancedby the falling workers'share.An increasein the pace of
decline in workers'shareprovidesan additionalboost to profits,hence

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624 JOURNALOF POST KEYNESIAN
ECONOMICS

Figure8 Instabilityat"high"interest

Employmn

B
a
n
k

h
a
r

0.
Wage Share

causing a minor investment boom (which causes a minor boost to

employmentand momentarilychecks the fall in the workers' shareof
output).The combinationof a momentarypause in the fall of workers'
shareof outputwith an investment-inducedrise in the growthof the debt
ratioandan accelerationof therateof growthof the rateof interest,leads
to the rate of growthof bankersshareexceeding the rate of decline of
workersshare.The residual,the rateof profit,dropsbelow zero andthe
model breaksdown.
The phase diagramshows the more muted dynamics of this system
(figure 10). The initial behavioris similarto the high base rate case;
however,the dualforceof the rise in the debtratio(whichitselfdrivesthe
interestratehigher)andthe risinginterestrate,resultsin a greaterrate of

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 FINANCE AND ECONOMIC BREAKDOWN 625

Figure9 Debtsensitivitydrivencrisis
1

0.9 -

0.8

0.7

0.6

0 50 100 150 200

Periods
accelerationof bankers'share,with little variationin the cyclical
behavior of wages and employment.Eventually, the interestpayable
on outstandingdebt exceeds the profits of capitalists, leading to zero
investment and a final collapse of wages, employment, and output.

Minksiangovernment:stabilizingan unstableeconomy
From a Minskianperspective, the essential role of governmentis to
stabilize the economy by (a) preventingcapitalistexpectations from
going into euphoriaduringbooms,and(b) boostingcashflows to enable
capitaliststo repaydebtsduringslumps.This notionof governmentcan
be introducedwith two furthernonlinearfunctions,one relatingthe rate
of changeof governmentspendingto unemployment,the otherrelating
the rateof changeof taxation(of capitalistsonly) to the level of profitS.4
This extension to the model requires some redefinitions,as well as
severalnew equations:

7t = 1-m = Grossprofittermrevertsto its prebankingform;

4 The same functionalform is used as

before, with ij,k,l and m,n,o,p,respectively,
takingthe place of a,b,c,din the real wage change function.In these simulations,i=
0.05,j = l.2,k =4, 1 =0.05,m =0.0175, n =0.83,o =5,p =0.039.

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 ECONOMICS
626 JOURNALOF POST KEYNESIAN

Figure10 Debtsensitivitycrisis
Employment
o0;9

BankShare
0. 5~~~~~~.

0~~~~~~~~~~~~~~~~~
0.2 07

Wages 09~

nk= 1--t + g x dk = Profitnet of governmentand interestpay-

ments is the basis for capitalistinvestment
decisions;

ddt =g l1- 7)x Y = The rateof change of governmentspendingis

a functionof unemployment;

dT The rateof change of taxationis a functionof

t (it) x Y =

the rateof profit.

The impactof governmentdebt on the rate of growthof overall debt is

instructive:it does not alterthe expression,but instead "Credistributes"
debt between privateandpublic sectors:

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 FINANCEAND ECONOMICBREAKDOWN 627

Figure11 Government
behavioral
functions
Governmentspendingchange Tax change

0.25 { 0.06=-
0.2 T 0.04-
0.15 0.02_/
0.1 t _
O --
0.05
o ___________ ~~~ -0.01 ~_ _

0.8 0.85 0.9 0.95 1 -0.2 -0.1 0 0.1 0.2

Employment Profit/Output

Figure12 cycleswithgovernment
Persistent

0.9 ;mp y t

0.8 .________ %Base Rate,.5% D bt Sensitivity

0.7

Waes Sh e S
0.6 \ V
i

0 50 100 150 200 250 300

dD dDk dD
dt dt dt
= (rxDk+I-n+ T-G)+(rxDg+G- T)=rxD+I-Ifl.
Privateinvestmentdecisions, however, are now based on significantly
attenuatedprofits and losses, so thatthe time path of the simulationis
significantlydifferent.
The final system consists of six differentialequations:the original

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628 JOURNALOF POST KEYNESIAN
ECONOMICS

equations for employment and workers' share of output (with the

investmentfunctionnow dependinguponnetprofit),plusnew equations
for the ratesof change of governmentspending,taxation,government,
and capitalistdebt (which has replacedbankers'share of outputas a
determinantof net profits):

dt dt y g - k) - g x v y- The rateof change of

govemmentspening as a proportionof
output;

dt dt =
tcitY -X- = The rateof change of
'xation as a proportionof output;

ddk=
dt
dDky
ciY
= rxdk+(v-dk)x L-Yj (7- t+g) =The
dt = h
rateof change of capitalistdebt;

dx r V + (g-t) =Therateof
dt dt Y cg~cfnefo]
dt
~
change of gov e~nment debt.

The governmentsectorplays the role of a countercyclicalstabilizerto

the profit-driven investment behavior of capitalists. When falling
worker and/orbankersharescause profit to approachlevels that pre-
viously induced"euphoric"levels of investment,rapidlyrisingtaxation
and rapidly falling governmentexpenditurereduce net profit; when
risingworkerand/orbankersharesinducean investmentslump,dimin-
ished taxation and increasedgovernmentexpenditureboost capitalist
net income, enablingdebtsto be serviced.
Governmentinterventiongreatly diminishes the possibility of com-
plete breakdown,but it does not eliminatecycles. Instead,the system
displays apparentlyrandom,irregularcycles (figure 12).
The economic interpretationof this apparentlybizarrebehavioris that
the objectives of the various economic actors are not consistent. In
particular,in this simulation,the governmentspendingfunction(which

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 FINANCEAND ECONOMICBREAKDOWN 629

is directedat alleviatingunemployment)does not have the same stable

point as the taxationfunction(whichis directedat preventingexcessive
investment levels). The product of countercyclicalbehavior-taxes
rising and subsidies falling when profits (and hence investment) are
rising, vice versa when employmentis falling-is cyclical stability,as
the system passes endlessly and ever more regularly from near the
employment to near the investmenttarget. The truly countercyclical
operationbehavior of the governmentsector can be seen in the pub-
lic/privatesectorplots in figure 13.
Fromthe perspectiveof chaotic dynamics,the introductionof a gov-
ernmentsectorconvertsthe system froma three-dimensionalsystem-
which had a stable fixed point attractoronly while the interestratewas
below the critical level, and which above this level, necessarily pro-
gressed towardbreakdown-to a six-dimensionalsystem. This intro-
ducesthe likelihoodof complexattractorbehavior,with interactionswe
can no longer visualize (since we can only "see" three dimensions)
causing a phase plot to move from one orbit around an apparent
equilibriumpoint to anotherdistinct orbit, and then back again. Sus-
tainedirregularcyclical behavioris therefore,somewhatparadoxically,
a probableconsequenceof successful stabilizationpolicy. However, as
is crucialfrom the point of view of the financialinstabilityhypothesis,
this preventeda debt-inducedbreakdownat levels of the rateof interest
thatpreviouslycauseda breakdown(figure 14).
The final outcome, for a wide range of interest rates and initial
conditions, was a cyclical attractor(see Lorenz, 1993, p. 35) between
wage share and employment.Unlike the rigid two-dimensionallimit
cycle of the basic Goodwin model, this is in fact the consequenceof a
complex balance between the opposing forces underlyingthe simula-
tion-the procyclicalbehaviorof workersandcapitalists,the "memory"
function of banks and long-termdebt, and the two-dimensionalcoun-
tercyclical behavior of government(with taxation based on income
shares, and spending based on employment) (figure 15). The cata-
strophicsimulationsof the previoussection can be seen, in contrast,as
indicatingthe behaviorof an economy lackingthe crucialhomeostatic
inputof governmentintervention.

Actualgovernment?

The above simulationsestablish that a govemment that behaves as a

countercyclicalforcecangreatlydiminishthepossibilitythata capitalist

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630 JOURNALOF POST KEYNESIAN
ECONOMICS

Figure13 Thestabilizingeffectof countercyclical

policy

PrivateSector

0.9

0.8

30.7

0.6

0.5 L LL1
0.88 0.9 0.92 0.94 0.96 0.98

PublicSector

-0.1

t-0.2

-0.3

0.88 0.9 0.92 0.94 0.96 0.98

Employment
economy with sophisticatedfinancewill experiencea depression.How-
ever, actualgovernmentsdo not necessarilybehavein this fashion:over
the last thirtyyears, Westerngovernmentshave adoptedpolicies anti-
thetical to the countercyclicalrole they largely followed in the 1950s
and 1960s. In particular,they have lessened the progressiveness of
income tax scales, so that in contrastto the model explored above, the
rate of change of the tax rate to income [(d/dt) (T/Y)]is roughly zero.

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 FINANCEAND ECONOMIC'BREAKDOWN
631

Figure14 Complexitywithgovernment,
butno breakdown

Employmen

B
a0
ne .~~~~~09

While discretionaryspendinghas also been reduced,the existence of

social securit;ysystems has meantthat there is still a positive relation
between the level of unemployment and the rate of change of the
governmentspendingto outputratio.
Space does not allow these issues to be fully explored in this paper.
But it does appearthat such a form of interventionwould not attenuate
the investmentbehaviorof capitalists,with the consequencethatbooms
would be as markedas in the nongovemnment simulation.Debt-induced
breakdownswould thus still occur. Inicreasedgovernment spending
duringslumpswould enable recoveryin the aftermathto lesser booms;

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632 JOURNAL OF POST KEYNESIAN ECONOMICS

Figure15 Cyclicalstabilitywithgovernment

Oto 100 100 to 150

0.9-i -
0.8
0.7
0.6 -
0.5
0.8 0.85 0.9 0.95 0.94 0.95 0.96 0.97 0.98 0.99

150 to 200 200 to 250

0.64
0.6
- -
, -
0.564-- I7
0.58
0.56-

0.52-
0.5
0.94 0.95 0.96 0.97 0.98 0.99 0.94 0.95 0.96 0.97 0.98 0.99

250 to 300 300 to 350

0.64- 0.64
0.62 - 0.62-
0.6 - 0.6
0.58 0.58- C -
0.56 0.56 -
0.54 0.54
0.52 - 0.52
0.5 0.5
0.94 0.95 0.96 0.97 0.98 0.99 0.94 0.95 0.96 0.97 0.98 0.99

Employment

largerbooms,however,couldresultin therateof growthof accumulated

private debt exceeding net profits for some time, thus leading to a
prolongedslump. It also appearsprobablethat a governmentbehaving
in this fashion would over time accumulatea deficit, ratherthan the
surplusaccumulatedin the above Minskiansimulations.

Conclusion

Minsky's ambitionin constructingthe financial instabilityhypothesis

was to build a theorythat"makesgreatdepressionsone of the possible
states in which ourtype of capitalisteconomy can find itself' (Minsky,
1982, p. xi). His purposewas to find "an apt economic theory for our

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 FINANCEAND ECONOMICBREAKDOWN 633

economy"(p. 68), since it was a manifestfact thatcapitalisteconomies

periodicallyfind themselves in such a state.
Thisvery simplifiedmodelof a capitalisteconomywith finance,which
hasbeen constructedvia "stylizedfact"extensionsto Goodwin'sgrowth
cycle model, is able to demonstratethis key predictionof Minsky's
hypothesis. Using plausible values for real interest rates, capitalist
expectationsof profit duringbooms can lead them to incurmore debt
than the system is capableof financing.The breakdownthat occurs is
analogous to a debt-induceddepressionin an actual economy. When
such an event occurs,the model indicatesa forever-increasinglevel of
capitalistindebtedness.Intherealworld,however,the systemcontinues
but with some formof breakdown:some capitalistsgo bankrupt,many
lenderswrite off bad debts and suffercapitallosses.
The two types of breakdownfollow pathspredictedby Minsky.In the
high base rate case, booms, which were unproblematicearly in the
simulation,become destabilizinglaterbecause of the increaseddebt to
outputratios that develop over time. This correspondswith Minsky's
predictionsof a seculartrendtowardrising debt to equity ratios as the
memoryof the previousmajorcrisis recedes, which makes the system
more fragile.
In the high debt sensitivity case, falling workers' share and rising
bankersshare(ata slightlyslowerrate)leadto a minorspeculativeboom
which, occurringat a time of greatlyincreaseddebt,leads to a runaway
blowout in debt.In effect, a rise in income inequality(betweenworkers
and capitalists) leads to a period of instability and then collapse, a
concept exploredin Minsky (1986).
In both cases, a long periodof apparentstabilityis in fact illusory, and
the crisis,when it hits, is sudden-occurring too quicklyto be reversible
by changes to discretionarypolicy at the time. As is evident from the
phase diagrams,the conventionalpolicy responseof governmentsto an
overheatedeconomy-increasing the interestratewith the intentionof
dampeninginvestment and thus temperingthe boom-acts not only
uponthe incentiveto invest,butalso uponthe level of outstandingdebt.
If this level is alreadyhigh, then increasingthe interestrate may turn
boom into crisis. The subsequentattemptto revive the economy by
reducinginterestrates-and thus stimulatinginvestment,accordingto
IS-LM analysis--amounts to trying to force the economy back down
into the stable section of the vortex, when it has alreadypassed into its
catastrophicregion. However, the centripetalforces that exist in that
region-the weight of accumulateddebtupon a depressedeconomy-

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634 JOURNALOF POST KEYNESIAN
ECONOMICS

are so great that any governmentaction at that time may be too little,
too late. This emphasizesthe essentialpolicy message of the financial
instabilityhypothesis,thatwe shouldavoid crises in the first place, by
developing and maintaininginstitutionsand policies that enforce "a
'good financialsociety' in which the tendencyby businesses andbank-
ers to engage in speculativefinance is constrained"(Minsky, 1982, p.
69). These institutionalarrangementsinclude close and discretionary
supervisionof financialinstitutionsand financialarrangements,and a
bias towardincome equityratherthaninequality.
The importanceof governmentis emphasizedby the resultsof incor-
poratinga stylized governmentintothe model:its interventionsconvert
situations that previously led to breakdowninto ones that generate
irregularcycles, of a kind reminiscentof those experiencedduringthe
long postwar boom. These simulations provide strong support for
Minsky'spropositionthatthe institutionalarrangementsinstitutedin the
aftermathof the GreatDepression "worked,"since though cycles oc-
curred,breakdowndidnot. The objectiveof stabilizationpolicy was not
to avoid cycles-which are endemic to any complex system-but to
preventthe possibilityof economiccollapse.Thereare,however,severe
doubtsas to whetherthe kind of governmentthathas been constructed
over the last thirtyyearsis a sufficientlypowerfulor balancedstabilizer
to capitalistinvestmentbehavior.
From the perspectiveof economic theory and policy, this vision of a
capitalisteconomy with finance requiresus to go beyond that habitof
mind that Keynes described so well, the excessive reliance on the
(stable) recent past as a guide to the future. The chaotic dynamics
explored in this paper should warn us against accepting a period of
relativetranquilityin a capitalisteconomy as anythingotherthana lull
before the storm.

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