#macro 2

"Structural Contradictions of Current Capitalism: A Keynes-Marx-Schumpeter Analysis", Crotty 2001

http://people.umass.edu/crotty/india-rev-May25.pdf

"Government regulation of aggregate demand is a necessary, but not a sufficient, condition for healthy, egalitarian growth. "

Schumpeterian versus Neoliberal Micro Theory and the Globalization Debate

Does competition really lead to maximimum efficiency? Well no, because if firms actually perfectly competed, they would self-destruct. Therefore corespective competition (monopolistic, oligopolistic) as shown by Schumpeter. Firms can also threaten new entrants with a price-war, to deter entry, but continues to intensify the profit squeeze. So we have corespective competition or natural oligopolies, which is necessary for fast-pace capital accumulation and rapid innovation (especially due to fixed costs). But, globalization destroyed this symbiotic relationship between state and firms, and between micro and macro. Corespective competition in the Golden Age, is no longer possible in globalized markets.

"However, when productive assets are substantially irreversible, the neoclassical defense of allocative efficiency in unregulated markets is dramatically weakened because exit is not free, but entails a major capital loss for the firm."

Keynes-Minsky Theory of Uncertainty and Fragility follows logically from the capitalist dynamics described by Marx, stemming from the dialectical relationship between competition and investment. 

"Some aspects of these shifts in strategy fit comfortably in traditional theory. Others, especially increased debt-financed, cost-cutting investment in the face of battered profits and rather severe financial fragility, do not. In neoclassical theories such as Tobin's theory "q" and in Minsky's theory of financial fragility, a lower profit rate and higher leverage are associated with less investment, not more. However, the description of firms investing in response to severe competitive pressure reminded me of Marx's references in Capital to "coerced" investment and his explanation of how competitive pressure "compelled" firms to "Accumulate, Accumulate!".

The theoretical grounding for the General Theory is based on uncertainty and the role of expectations, and in doing so Keynes creates a distinctive approach to behavior and rationality. Keynes has the following expectations dependent concepts:

1. Effective demand- because expectations are not always realized. Keynes writes that "effective demand always reflects the current expectation of actual demand." and "effective demand corresponds to the income of the expectation of which has set production moving, not to the actually realized income." So it's' a mix between expected income of consumers, expectations of the profit maximizing firm to determine employment/out, and expectations of investors.

2. The Propensity to Consume- Keynes describes how this is determined by both objective and subjective factors, but uncertainty and expectations figure prominently in the subjective factors saying "Propensity to consumer is determined solely by a psychological composite of actual and expected income."

3. The Marginal Efficiency of Capital- the chronological series of expected yields (expected profits, almost)

4. Liquidity Preference and the Rate of Interest- the rate of interest equilibrates the total demand and supply of money. Motives for liquidity include transactions, precautionary, and speculative.

5. Monetary Theory of Economics- "a monetary economy is essentially one in which changing views about the future are capable of influencing the quantity of employment." Money is the indispensable characteristic of an economy in which activity depends on expectations prone to variation.

Short & Long Run Expectations

Short: concerned with decisions to produce using existing capital

Long: concerned with investment 

JMK's Political Philosophy

"lion's share of investment"....

"the political problem of mankind is to combine three things: economic efficiency, social justice, and individual liberty.."

Doesn't argue that market forces are sufficient for optimal social states 

Critique of laissez-faire, private and social interests do not always coincide 

State as agent of social rationality, but also to preserve liberty

Regulation of casino stock market

Remove involuntary unemployment

"uneconomic" activities deserving of public monies (health, recreation, natural beauty)

Notes on Keynes's 1937 QJE article "The General Theory of Employment". 

(212-3) "But these more recent writers like their predecessors were still dealing with a system in which the amount of the factors employed was given and the other relevant facts were known more or less for certain. This does not mean that they were dealing with a system in which change was ruled out, or even one in which the disappointment of expectation was ruled out. But at any given time factors and expectations were assumed to be given in a definite and calculable form; and risks, of which,though admitted, not much  notice was taken, were supposed to be capable of an exact actuarial computation."

(214) "About these matters there is no scientific basis on which to form any calculable probability whatever. We simply do not know."

Techniques for Dealing with Uncertainty for the Rational, Economic Man

1. We assume that the present is a much more servicable guide to the future than a candid examination of past experience....in other words we largely ignore the prospect of future changes about the actual character of which we know nothing

2. We assume that the existing state of opinion as expressed in prices and the character of existing output is based on a correct summing up of future prospectus, so that we can accept it as such unless and until something new and relevant comes into the picture

3. Knowing that our own individual judgement is worthless, we endeavor to fall back on the judgement of the rest of the world which is perhaps better informed....The psychology of a society of individuals each of whom is endeavoring to copy the others lead to what we may strictly term a conventional judgement. 

Main Grounds of Keynes's Departure

1. Uncertainty

a.) What were the main causes within the financial system of the financial crisis that erupted in the US in 2008 and quickly spread around the globe?

New Financial Architecture

deregulation

special investment vehicles and financial innovation (including MBS and CDOs)

merge of investment and commercial banking

leverage ratios

too big to fail institutions, lender of last resort policies 

assumptions of NFA: efficient market hypothesis, risk is price accurately, risk is distributed to those who can best bear it, government intervention is unnecessary and harmful 

Perverse Incentives and "Rainmakers"

Shareholder revolution

Bonus-pay structure for "rainmakers" 

Asymmetric and perverse incentives 

Marc Jarsulic argues that at least one reason for the 2007/8 meltdown had to do with bank size, leverage, and the rise of shadow banking. He also argues that the rise of brokers, who are intermediaries in these financial relationships but themselves do not supply the loan, also contributed to the crisis because they were lightly supervised, and had asymmetric risk due to the fact that they were not the originators. He highlights that leading up to the crisis saw a mass concentration of mortgage originators. These mortgages, concentrated mainly in just 10 banks with 60% of the market share, were then packaged (and repackaged) into securities such as Mortgage Backed Securities (and then Collatoralized Debt Obligations). This mass availability of credit, funded through shadow banks, sold by brokers, and repackaged by investment banks, fed into the housing price bubble. Upon the housing markets collapse, the collapse of credit triggered the greater financial crisis  (especially due to the role of expectations). For Jarsulic, the origins of the crisis starts, in part, with sophisticated new financial market intermediaries, such as shadow banks and brokers, who funneled money for credit to credulous homebuyers and in doing so created a credit bubble. He understands their willingness to do so is due to the asymmetric risk and short-term financial gain associated with the structure of many of these relationships. 

b.) A major financial crisis cannot be endogenously generated in mainstream financial market theory or in the dominant mainstream macro theory, but endogenous financial crises are almost inevitable in Keynes-Minsky financial market theory. Which of the causes of the crisis discussed in your answer to part a.) are adequately theorized in Keynes-Minsky theory and which are not, Explain your answer. 

Because mainstream theory relies on the efficient market hypothesis, the theory does not allow for endogenously generated financial crises. It assumes that risk is accurately priced and distributed to those who can best bear it. If that were the case though, financial institutions would not have been interested in receiving bailouts or having those troubled assets removed from their balance sheets. 

That considered, Keynes-Minsky theory does allow for crises to be endogenously generated stemming from the structure of the economy and financial system itself. Both Keynes and Minsky argued that instead of reliance on neoclassical/classical theory and the efficient market hypothesis, a realistic set of assumptions and theories about the economy and financial markets should be derived. Crotty shows in his 2011 paper "The Realism of Assumptions Does Matter" that Keynes-Minsky theory would embody the assumptions that:

1. The future in inherently unknowable. The world is characterized by uncertainty rather than calculable risk.

2. Expectations are endogenous and pro-cyclical. They become more optimistic in booms, and more pessimistic in downturns, and wildly unstable in panics.

3. The degree of agent risk aversion is endogenous. Agents become less risk-averse in a bubble and more risk-averse in a downturn.

4. Agents are heterogenous: they have different expectations, degrees of aversion. This is why there's massive daily and hourly trading on security markets.

5. Financial market decisions affect real-sector outcomes and conversely in an interactive, dynamic, and path-dependent process. Future cash flows impact agent decisions.

6. There is no stable financial market equilibrium, though there are periods of relative stasis. Financial market centers of gravity are always being altered by endogenous change in expectations and risk aversion, as well as by the creation and spread of real and financial innovations.

7. The degree of liquidity changes over time. There is excessive liquidity in the boom that pushes security prices to unsustainable levels, but liquidity evaporates in a crisis, making the crisis worse.

8. Agents cannot borrow without limit at a risk free interest rate. 

9. Defaults (and therefore counter party risk) exist and are important. Defaults are highly counter-cyclical. Fear of default is a major source of downward price pressure in a collapse.

10. Financial institutions strongly affect the performance of financial markets. They are complex agents whose incentives, information sets, objectives and constraints different from individual agents. 

That said, Keynes-Minsky theory adequately addresses the following issues that led to the financial crisis:

1. The Role of Expectations: both Keynes and Minsky theorized the role of expectations in creating bubble/bust cycles. Keynes first wrote that our expectations are merely heuristic guesses based on information about the present, while the future is actually fundamentally uncertain. That considered, Keynes and Minsky apply the nature of expectations, which are pessimistic in downturns and optimistic in upturns, to how this creates and amplifies the massive swings in a capitalist economy. These expectations, rather than certain and calculable knowledge about the future, are what lead to the development of overly optimistic and complex securities, the overextension of credit (credit bubble), and fed into the price bubble for the housing market. 

2. Credit boom/crunch and the role of liquidity: Keynes's theory of liquidity accurately understood that liquidity preference changes over time. In the pre-2008 boom, there was excessive liquidity and credit that pushed security prices and housing prices to unsustainable levels. After the "Minsky moment", or the sudden collapse in asset prices associated with increasing financial fragility, then liquidity evaporates and credit dried up, worsening the crisis especially for individuals and the real-sector.

3. Creation of special investment vehicles and complex derivatives: Keynes and Minsky's theory show that the basis for these complex securities is virtually non-sense. MBS, CDO, CMBS, and other types of securities, in order to accurately package, require knowledge of known, and certain, risk probability distributions. But, under conditions of fundamental uncertainty, this is impossible. 

4. Fragility & Instability: Keynes-Minsky theory also theorizes that the growth and concentration of the financial sector necessarily leads to increasing financial fragility and instability, leading to crises. For both, capitalist economies are inherently unstable, so the 2008 financial crisis would have been no surprise. For Minsky, part of this is due to the fact that in a capitalist market system, prices are unstable. 

Minsky argued that a key mechanism that pushes an economy towards a crisis is the accumulation of debt by the non-government sector. He identified three types of borrowers that contribute to the accumulation of insolvent debt: hedge borrowers, speculative borrowers, and Ponzi borrowers.

The "hedge borrower" can make debt payments (covering interest and principal) from current cash flows from investments. For the "speculative borrower", the cash flow from investments can service the debt, i.e., cover the interest due, but the borrower must regularly roll over, or re-borrow, the principal. The "Ponzi borrower" (named for Charles Ponzi, see also Ponzi scheme) borrows based on the belief that the appreciation of the value of the asset will be sufficient to refinance the debt but could not make sufficient payments on interest or principal with the cash flow from investments; only the appreciating asset value can keep the Ponzi borrower afloat.

Domain of Fundamental Uncertainty

Agent choice for crucial decisions

not for day-to-day, non-crucial decisions

Crucial

Time, dependent on future to realize the results

Irreversibility (changing mind poses high cost)

Centrality/Cruciality (is important to agent's well-being, not trivial)

Nonrepeatability (unique environment, decision alters the environment)

Example: capital investment is a crucial decision subject to fundamental uncertainty 

Keynes introduces the concept of fundamental uncertainty in Chapter 12 of the GT 

Neoclassical/classical economic theory requires perfect foresight of the agent, with known probability distributions of future events, in order for the rational expectations model to work. This distribution must be known and stationary in order for the agent to optimize. Optimization is NOT POSSIBLE under conditions of fundamental uncertainty. There would be only two ways this is possible:

if the agent knows the general mechanism for future outcomes is definitely stationary, with enough observations then the agent can know for certain the model

But this requires a KNOWN, STATIONARY, and OBJECTIVE probability distribution, and reality is NOT stationary

Real Assumptions

there's no guaranteed learning process of the agent

the probability distribution is always changing, i.e. a moving target

learning process then is also unstable 

So then why do economists, neoclassical and classical, make the assumption of stationary probability distribution and perfect knowledge of agents? Because it's tractable? And to show that free markets produce optimal incomes? 

QJE 1937 "we simply do not know"...this is an "awkward fact"

So what we do have are expectations and confidence in those expectations, which are based on the present, emotions, etc. For Keynes, confidence does not equal optimism, it is the weight of belief in your expectations. Neoclassicals on the other hand, assume 100% confidence in expectations. 

Question 1: It has been argued that the General Theory initiated a methodological "revolution" in economic theory. The assumption set adopted and the methods of analysis used in this book constituted a sharp break with those associated with Classical theory, Neoclassical theory, New classical theory, or New Keynesian theory. These innovations led to a qualitatively different vision of the laws of motion of modern capitalism, a fact perhaps easiest to appreciate when reading his essay on the GT in the QJE 1937 article. 

Keynes presents his theory of the determination of investment spending, the cornerstone of his theory of macro dynamics, in chapters 11-15 of the GT. Chapters 11 and 12 analyze the demand for capital goods holding the cost of capital- here the long-term rate of interest- constant. Chapters 13-15 constitute a uniquely Keynesian theory of financial markets. They contain a sharp attack on the mainstream theory of financial markets and the determination of interest rates, and present an alternative theory. Keynes's theory helped explain the extreme volatility of financial markets in the late 1920s and early 1930s and the collapse of investment spending after the 1920s boom. In your answers show how chapters 11-15 reflect Keynes's methodological revolution:

a.) Present the main arguments used by Keynesian in Chapters 11 and 12 to discredit the received theory of investment demand. Be specific. Then show precisely how this alternative approach leads to a theory of investment demand with dramatically different static and dynamic properties than mainstream theory.

In Chapter 11 of the GT, Keynes reject the dominant theory of investment demand by asserting that investment decisions (and all decisions) are made under conditions of fundamental uncertainty- a dramatic departure from Classical and neoclassical theory- and the related concepts of expectations and confidence. 

Keynes explains that classical and neoclassical theories of investment rely on assuming that the present is a stationary state and that the future is assumed to look like the present. He explains that the neoclassical assumptions rely on the assumption that there are known and certain probability distributions associated with the investment decision, over which the rational investor maximizes given a certain marginal product of capital calculated by a production function, and a fixed amount of labor and output (the market clearing level guaranteed by Says's Law). With this in aggregate, the value of the MP of capital is a declining function of K, and the firm and the whole economy, select the value of K for which the MP of K equals the price of user cost of capital- also known as optimization. 

But Keynes notes, very seriously, that these assumptions are unrealistic. In fact, the future is unknown and it is uncertain whether or not it will at all resemble the present. 

He proposes instead, in light of uncertainty, that we need to instead calculate the value of a variable he calls the "marginal efficiency of capital" (MEC or m), which as Crotty describes:

The MEC is that value of m for which the following equation holds: ∑ QtE /(1 + m)t = PS, where t is a time index from 1 to T that represents the T periods in the future that cover the expected life of the investment good, QtE is the net cash flow expected to be generated by this investment in future period t, and PS is the cost (or supply price) of the investment good. The MEC is clearly a profit rate of some kind since it will be higher the larger the expected QtEs, the more the total expected cash flow is front-loaded, and the lower PS. 

Basically, the MEC is the risk adjusted cost of capital based on expectations rather than certain optimization. For Keynes, the future does not exist yet and it is impossible to know the present. Therefore, expectations about the future are formed, even though the MEC is essentially unknown and unknowable at the time of investment. This departs from the mainstream assumption that the probability distribution of the QtEs(the expected net cash flow to be generated by the investment in the future period t). These expectations are loosely based on heuristics (rules of thumb), and investors may have varying levels of confidence in those expectations themselves.

This acceptance of uncertainty is Keynes's methodological breakthrough.As he says in the QJE 1937 article --“about such matters [as the state of the economy in the future], we simply do not know”. 

Keynes links expectations to the present, since investors form their expectations about the unknowable future from the conditions of the present. For Keynes, this means that the trajectory of the economy is path dependent and linked to the present. In this way, Keynes links both the passage of time and uncertainty of the future to economic methodology.

b.) Present the main argument used by Keynes in chapters 13-15 to discredit the received theory of financial markets and the role this theory plays in sustaining the conclusion that free markets always remain at or near full employment. Be specific. 

In these chapters, Keynes extends his methodological intervention regarding uncertainty to the theory of financial markets. Keynes again attacks the mainstream theory of financial markets, their self-correcting mechanism of AD shocks responded to with swift changes in the interest rate to restore AD to the level needs to keep AS moving too far away from full-employment or market clearing levels. He rejects also the implication that this accepts Say's law. 

JMK instead proposes that long-term interest rates are based on a uncertainty, with a psychologically complex agent and the use of conventions to form expectations and confidence. 

The theory of liquidity preference is based on this idea. He also asserts that bond prices are inherently restless (Shackle), highly psychological, and highly conventional variables. For Keynes, investment decisions, interest rates, and then prices are dependent on the conventions, expectations, and confidence of capitalist investors rather than intrinsic prices or calculable probability distributions. In fact, because the financial markets face fundamental uncertainty about the future, Keynes concludes then that this uncertainty leads to volatility and instability. For JMK, financial markets might initiative instability, magnify instability in the real sector, or reduce it. It all depends. 

Upon introducing uncertainty, Keynes shows that uncertainty in relation to the future rate of interest is necessary to explain the existence of liquidity preference for holding wealth. 

Keynes has a two-pronged attack on the classical theory of financial markets. He insists that AS depends on and quickly reacts to AD, and when AD falls so does AS, therefore Say's law does not hold. For Keynes then, AS is endogenous as it moves with AD, which is a complete departure from classical financial market theory. On example of this should be in the IS-LM model where S= S(r, Y) and Y is endogenously determined by AD. A negative shock to investment shifts the I function down, and to the left, and also lowers AD and therefore Y. Since Y has fallen, so has S (because it's not exogenous!!, unlike classical models). How far Y shifts down depends on expectations. The new equilibrium S and I have fallen by the same amount, but C (r,Y) has declined because r is the same as before and Y is smaller. Now AD and Y are below Y full employment! The fall in C gives a multiplier impact to the initial negative I shock (if expectations are endogenous), i.e. collapsing income and rising unemployment. All due to a shock in investment, from unstable financial markets. 

Therefore, in Keynes's new theory, fundamental uncertainty leads to instability in financial markets. This instability may lead to shocks in investment. With AD and Y endogenous, this means that the shocks to I can result in a downward spiral in the economy of declining AD, Y, C, and Y under full employment. Unless there is intervention in financial markets and planning of investment. 

Then show precisely how his alternative approach leads to a theory of financial markets and capital investment with dramatically different static and dynamic properties than mainstream theory. 

By developing a theory of financial markets and capital investment based on the realistic assumption of fundamental uncertainty, Keynes concludes that these markets are inherently unstable, the interest rate is inherently restless, and this instability necessarily leads to unfavorable outcomes (crises). For Keynes, the static present impacts the unknowable only in that expectations and confidence are informed by the present state, but the dynamic time variable component of this means that negative feedback loops may occur when expectations are inconsistent with what actually happens.