Institute for Dynamic Economic Analysis (IDEA Economics)

Ideas

Economics is broken. Conventional economics has missed badly in its forecasts, provided an incoherent explanation of economic events and failed to produce effective policy. There is another way. An economics that incorporates debt and money. An economics that is proven by history and practice, statistics and theoretical consistency.

Prosperity, real growth and full employment are not myths or suddenly unattainable in the "new normal." They are necessary conditions hidden behind a regime of bad policy and bad practices. An economics that acknowledges that money is created through the credit process is not forever waiting for baffled central bankers to make a difference. We would not be stuck in neutral with our foot on the accelerator, creating enormous action in financial markets, but going nowhere in the real economy, where real people and businesses are struggling.

An economics that realizes a return to normal is not guaranteed in a dynamic system like the economy, but is a hope based on faith in disproven theory and unrealistic assumptions. We would be rapidly installing the alternative. Instead TINA rules. There is No Alternative.
An economics that realizes the centrality of debt devotes its attention to resolving this problem, no matter the difficulty. Instead, orthodox economics largely -- believe it or not -- ignores debt unless it is on the public balance sheets. But it is the enormous private debt that created the crisis and continues to burden it. That debt is not shrinking, but growing. Absent a direct confrontation with this debt, there is no recovery. In the way are interests of an enormously powerful financial sector protecting huge and fragile banks.

Tools

Minsky,  We will offer interface and instruction in this revolutionary free open-source computer program for building and simulating dynamic, monetary economic models. A vital tool for a new approach to economics, optimized for accounting-based, flow-of-funds analysis.
The book: Finance and Economic Breakdown. A comprehensive, foundational book that develops an explicitly monetary, dynamic approach to the analysis of capitalism and its periodic financial crises.
Data collection and management. IDEA will work to form partnerships with organizations to gather, validate and normalize economic data, particularly that relating to credit and debt, and make it available online.
IDEA is dedicated to an economics that works for investors, business leaders, policy makers and, most importantly, everyday people who have been denied proper insight into the forces shaping their real lives. Our approach builds on a long tradition of classical, Keynesian and Post-Keynesian thought. We will develop, support and promote the economics that makes sense, partnering with others to establish a definitive and functional alternative to the orthodoxy that has failed.
In this work, the appropriate appeal is to the evidence as judge, not to political visions nor academic speculation. History and data are the test of explanations and predictions. If the explanations are valid, the predictions will be valid. If not, they need to be revised. It is the scientific method, and it needs to return to economics. IDEA intends to be a destination source for relevant data, as well as for valid assumptions.


Blog Ref Link http://www.p2pfoundation.net/Transfinancial_Economics

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http://www.ideaeconomics.org/about/

A real model of Minsky

Monday, February 18, 2013

Physics of Finance Blog / Mark Buchanan 

Noah Smith has a wonderfully informative post on the business cycle in economics. He's looking at the question of whether standard macroeconomic theories view the episodic ups and downs of the economy as the consequence of a real cycle, something arising from positive feed backs that drive persisting oscillations all on their own, or if they instead view these fluctuations as the consequence of external shocks to the system. As he notes, the tendency in macroeconomics has very much been the latter:

When things like this [cycles] happen in nature - like the Earth going around the Sun, or a ball bouncing on a spring, or water undulating up and down - it comes from some sort of restorative force. With a restorative force, being up high is what makes you more likely to come back down, and being low is what makes you more likely to go back up. Just imagine a ball on a spring; when the spring is really stretched out, all the force is pulling the ball in the direction opposite to the stretch. This causes cycles.

It's natural to think of business cycles this way. We see a recession come on the heels of a boom - like the 2008 crash after the 2006-7 boom, or the 2001 crash after the late-90s boom - and we can easily conclude that booms cause busts.

So you might be surprised to learn that very, very few macroeconomists think this! And very, very few macroeconomic models actually have this property.

In modern macro models, business "cycles" are nothing like waves. A boom does not make a bust more likely, nor vice versa. Modern macro models assume that what looks like a "cycle" is actually something called a "trend-stationary stochastic process" (like an AR(1)). This is a system where random disturbances ("shocks") are temporary, because they decay over time. After a shock, the system reverts to the mean (i.e., to the "trend"). This is very different from harmonic motion - a boom need not be followed by a bust - but it can end up looking like waves when you graph it...

I think this is interesting and deserves some further discussion. Take an ordinary pendulum. Give such a system a kick and it will swing for a time but eventually the motion will damp away. For a while, high now does portend low in the near future, and vice versa. But this pendulum won't start start swinging this way on its own, nor will it persist in swinging over long periods of time unless repeatedly kicked by some external force.

This is in fact a system of just the kind Noah is describing. Such a pendulum (taken in the linear regime) is akin to the AR(1) autoregressive process entering into macroeconomic models and it acts essentially as a filter on the source of shocks. The response of the system to a stream of random shocks can have a harmonic component, which can make the output look roughly like cycles as Noah mentioned. For an analogy, think of a big brass bell. This is a pendulum in the abstract, as it has internal vibratory modes that, once excited, damp way over time. Hang this bell in a storm and, as it receives a barrage of shocks, you'll hear a ringing that tells you more about the bell than it does the storm.

Still, to get really interesting cycles you need to go beyond the ordinary pendulum. You need a system capable of creating oscillatory behavior all on its own. In dynamical systems theory, this means a system with a limit cycle in its dynamics, which settles down in the absence of persisting perturbation to a cyclic behavior rather than to a fixed point. The existence of such a limit cycle generally implies that the system will have an unstable fixed point -- a state that seems superficially like an equilibrium, but which in fact will always dissolve away into cyclic behavior over time. Mathematically, this is the kind of situation one ought to think about when considering the possibility that natural instabilities drive oscillations in economics. Perhaps the equilibrium of the market is simply unstable, and the highs and lows of the business cycle reflect some natural limit cycle?

Noah mentions the work of Steve Keen, who has developed models along such lines. As far as I understand, these are generally low-dimensional models with limit cycle behavior and I expect they may be very instructive. But Noah also makes a good point that the data on the business cycle really doesn't show a clear harmonic signal at any one specific frequency. The real world is messier. An alternative to low dimensional models written in terms of aggregate economic variables is to build agent based models (of much higher dimension) to explore how natural human behavior such as trend following might lead to instabilities at least qualitatively like those we see.

For some recent work along these lines, take a look at this paper by Blake LeBaron which attempts to flesh out Hyman Minsky's well known story of inherent market instability in an agent based model. Here's the basic idea, as LeBaron describes it:

Minksy conjectures that financial markets begin to build up bubbles as investors become increasingly overconfident about markets. They begin to take more aggressive positions, and can often start to increase their leverage as financial prices rise. Prices eventually reach levels which cannot be sustained either by correct, or any reasonable forecast of future income streams on assets. Markets reach a point of instability, and the over extended investors must now begin to sell, and are forced to quickly deleverage in a fire sale like situation. As prices fall market volatility increases, and investors further reduce risky positions. The story that Minsky tells seems compelling, but we have no agreed on approach for how to model this, or whether all the pieces of the story will actually fit together. The model presented in this paper tries to bridge this gap.

The model is in crude terms like many I've described earlier on this blog. The agents are adaptive and try to learn the most profitable ways to behave. They are also heterogeneous in their behavior -- some rely more on perceived fundamentals to make their investment decisions, while others follow trends. The agents respond to what has recently happened in the market, and then the market reality emerges out of their collective behavior. That reality, in some of the runs LeBaron explores, shows natural, irregular cycles of bubbles and subsequent crashes of the sort Minsky envisioned. The figure below, for example, shows data for the stock price, weekly returns and trading volume as they fluctuate over a 10 year period of the model:

Now, it is not surprising at all that one can make a computational model to generate dynamics of this kind. But if you read the paper, LeBaron has tried hard to choose the various parameters to fit realistically with what is known about human learning dynamics and the behavior of different kinds of market players. The model also does a good job in reproducing many of the key statistical features of financial time series including long range fundamental deviations, volatility persistence, and fat tailed return distributions. So it generates Minsky-like fluctuations in what is arguably a plausible setting (although I'm sure experts will quibble with some details).

To my mind, one particularly interesting point to emerge from this model is the limited ability of fundamentalist investors to control the unstable behavior of speculators. One nice feature of agent based models is that it's possible to look inside and examine all manner of details. For example, during these bubble phases, which kind of investor controls most of the wealth? As LeBaron notes,

The large amount of wealth in the adaptive strategy relative to the fundamental is important. The fundamental traders will be a stabilizing force in a falling market. If there is not enough wealth in that strategy, then it will be unable to hold back sharp market declines. This is similar to a limits to arbitrage argument. In this market without borrowing the fundamental strategy will not have sufficient wealth to hold back a wave of self-reinforcing selling coming from the adaptive strategies.

Another important point, which LeBaron mentions in the paragraph above, is that there's no leverage in this model. People can't borrow to amplify investments they feel especially confident of. Leverage of course plays a central role in the instability mechanism described by Minsky, but it doesn't seem to be absolutely necessary to get this kind of instability. It can come solely from the interaction of different agents following distinct strategies.

I certainly don't mean to imply that these kinds of agent based models are superior to the low-dimensional modelling of Steve Keen and others. I think these are both useful approaches, and they ought to be complementary. Here's LeBaron's summing up at the end of the paper:

The dynamics are dominated by somewhat irregular swings around fundamentals, that show up as long persistent changes in the price/dividend ratio. Prices tend to rise slowly, and then crash fast and dramatically with high volatility and high trading volume. During the slow steady price rise, agents using similar volatility forecast models begin to lower their assessment of market risk. This drives them to be more aggressive in the market, and sets up a crash. All of this is reminiscent of the Minksy market instability dynamic, and other more modern approaches to financial instability.

Instability in this market is driven by agents steadily moving to more extreme portfolio positions. Much, but not all, of this movement is driven by risk assessments made by the traders. Many of them continue to use models with relatively short horizons for judging market volatility. These beliefs appear to be evolutionarily stable in the market. When short term volatility falls they extend their positions into the risky asset, and this eventually destabilizes the market. Portfolio composition varying from all cash to all equity yields very different dynamics in terms of forced sales in a falling market. As one moves more into cash, a market fall generates natural rebalancing and stabilizing purchases of the risky asset in a falling market. This disappears as agents move more of their wealth into the risky asset. It would reverse if they began to leverage this position with borrowed money. Here, a market fall will generate the typical destabilizing fire sale behavior shown in many models, and part of the classic Minsky story. Leverage can be added to this market in the future, but for now it is important that leverage per se is not necessary for market instability, and it is part of a continuum of destabilizing dynamics.

Time to read some Minsky

Time to read some Minsky

by Steve Keen on March 10th, 2008 at 11:13 am

The current turmoil on the Stock Market—and especially the sudden collapse of many once high-flyers—has taken a lot of people by surprise.
One person who, were he alive today, wouldn’t be the least bit surprised, is Hyman Minsky, who predicted that events like this would be a regular feature of a deregulated financial system.
He developed what he called “The Financial Instability Hypothesis”, and anyone who wants to understand today’s events needs to know about it.
The following is an extract from an article by Minsky in Challenge in 1977—well before even the 1987 Stock Market Crash—that provides a nutshell-sized precis of his theory.

Minsky on Financial Instability

The natural starting place for analyzing the relation between debt and income is to take an economy with a cyclical past that is now doing well. The inherited debt reflects the history of the economy, which includes a period in the not too distant past in which the economy did not do well. Acceptable liability structures are based upon some margin of safety so that expected cash flows, even, in periods when the economy is not doing well, will cover contractual debt payments.
As the period over which the economy does well lengthens, two things become evident in board rooms. Existing debts are easily validated and units that were heavily in debt prospered; it paid to lever. After the event, it becomes apparent that the margins of safety built into debt structures were too great, As a result, over a period in which the economy does well, views about acceptable debt structure change.
In the deal-making that goes on between banks, investment bankers, and businessmen, the acceptable amount of debt to use in financing various types of activity and positions increases. This increase in the weight of debt financing raises the market price of capital-assets and increases investment. As this continues the economy is transformed into a boom economy.
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 in which the extent to which such debtfinancing can be carried is determined by the market. It follows that the fundamental instability of a capitalist economy is upward. The tendency to transform doing well into a speculative investmcnt boom is the basic instability in a capitalist economy.
Innovations in financial practices are a feature of our economy, especially when things go well. New institutions, such as Real Estate Investment Trusts (REITs), and new instrunient, such as negotiable Certificates of Deposit, are developed; old instruments, such as commercial paper, increase in volume and find new uses. But each new instrument and expanded use of old instruments increases the amount of financing that is available and that can be used for financing activity and taking positions in inherited assets.
Increased availability of finance bids up the prices of assets relative to the prices of current output and this leads to increases in investment. The quantity of relevant money, in an economy in which money conforms to Keynes’ definition, is endogenously determined, The money of standard theory— be it the reserve base, demand deposits and currency, or a concept that includes time and savings deposits—does not catch the monetary phenomena that are relevant to the behavior of our economy.
In our economy it is useful to distinguish between hedge and speculative finance. Hedge finance takes place when the cash flows from operations are expected to be large enough to meet the payment commitments on debts. Speculative finance takes place when the cash flows from operations are not expected to be large enough to meet payment commitments, even though the present value of expected cash receipts is greater than the present value of payment commitments. Speculating units expect to fulfill obligations by raising funds by new debts.
By this definition a “bank” with demand and short-term deposits normally engages in speculative finance. The RET, airlines, and New York City engaged in speculative finance in 1970-73. Their difficulties in 1974-75 were due to a reversal in present values (the present value of debt commitments exceeding the present value of expected receipts), due to both increases in interest rates and a shortfall of realized over previously anticipated cash flows.
During a period of successful functioning of the economy, private debts and speculative financial practices are validated. However, whereas units that engage in hedge finance depend only upon the normal functioning of factor and product markets, units which engage in speculative finance also depend upon the normal functioning of financial markets. In particular, speculative units must continuously refinance their positions. Higher interest rates will raise their costs of money even as the returns on assets may not increase.
Whereas a money supply rule may be a valid guide to policy in a regime dominated by hedge finanee, such a rule loses its validity as the proportion of speculative finance increases. The Federal Reserve must pay more attention to credit market conditions whenever the importance of speculative financing increases, for the continued workability of units that engage in speculative finance depends upon interest rates remaining within rather narrow bounds.
Units that engage in speculative finance are vulnerable on “three fronts.’ First, they must meet the market as they refinance debt. A rise in interest rates can cause their cash payment commitments relative to cash receipts to rise. Second, as their assets are of longer term than their liabilities, a rise in both long- and short-term interest rates will lead to a greater fall in the market value of their assets than of their liabilities. The market value of assets can become smaller than the value of their debts. The third front of vulnerability is that the views as to acceptable liability structures are subjective, and a shortfall of cash receipts relative to cash payment commitments anywhere in the economy can lead to quick and wide revaluations of desired and acceptable financial structures.
Whereas experimentation with extending debt structures can go on for years and is a process of gradual testing of the limits of the market, the revaluation of acceptable debt structures, when anything goes wrong, can be quite sudden and quick.
In addition to hedge and speculative finance we can distinguish Ponzi finance—a situation in which cash payments commitments on debt are met by increasing the amount of debt outstanding. High and rising interest rates can force hedge financing units into speculative financing and speculative fiwincing units into Ponzi financing.
Poni financing units cannot carry on too long. Feedbacks from revealed financial weakness of some units affects the willingness of bankers and businessmen to debt finance a wide variety of organizations. Unless offset by government spending, the decline in investment that follows from a reluctance to finance leads to a decline in profits and in the ability to sustain debt. Quite suddenly a panic can develop as pressure to lower debt ratios increases.
What we have in the financial instability hypothesis is a theory of how a capitalist economy endogenously generates a financial structure which is susceptible to financial crises and how the normal functioning of financial markets in the resulting boom economy will trigger a financial crisis.
Excerpts from “The Financial Instability Hypothesis: An Interpretation of Keynes and an Alternative to “Standard” Theory, Challenge, March-April 1977, pp. 20-27. For copyright reasons, I can’t forward the entire article, but anyone who wants a copy who doesn’t have Web access to Challenge is welcome to send me an email requesting it.
I have also linked a lecture of mine which gives an overview of his theory, with quotes from other papers.