macroeconomics and finance

This is the second part of Lecture 9 in Advanced Macro II, Spring 2019, at PIDE by Dr. Asad Zaman. The first part (L09A: Why Minsky Matters) covers the first 27m of the YouTube lecture linked below. The second part, L09B, starts 27:22m is about 1hr long:


A 1500 word summary/outline of the key points covered in L09B is given below:

Krugman fails to understand Minsky

On the one hand, Minsky has been transformed from an eclectic outcast to a darling of the mainstream after the crisis. On the other hand, Krugman and others have failed to appreciate the central insights of Minsky, just as they did with Keynes. While Keynes had completely rejected mainstream theories on solid grounds, Hicks and Samuelson constructed a neoclassical synthesis which conceded the short-run to Keynes on the basis of short run wage rigidities, but kept the fundamentals of mainstream theories intact. Similarly, today mainstream economists like Krugman admit to being at fault in not predicting the GFC, but blame it on external factors, rather than central weaknesses in mainstream theories. Three external factors which account for the failure of economists to “see it coming” are:

  1. The GFC was Black Swan Event. A period of stability led to under-estimation of risks and a discounting of the probabilities of crisis.
  2. The Fed kept interest rates low for too long. This allowed massive credit creation, which led to bubbles
  3. Rise of Shadow Banking Industry went un-noticed. The unregulated financial sector created a crisis by making high leverage gambles, using derivatives as insurance.

Accordingly, mainstream economists propose three solutions, none of which require re-thinking traditional Macroeconomics.

  1. We should pay more attention to the possibility of black swan events, and allow for distributions with fat tails in our stock market models.
  2. We should pay more attention to monetary policy
  3. We should do more regulation of shadow banking (Macro-Prudential Regulations)

In fact, this analysis fails to understand the central insights of Minsky. The mainstream, deluded by theories of intermediation, does not understand the central role of private sector credit creation in generating crises. Even more important, Minsky attacks the central religious belief in “equilibrium”. While Krugman believes that market forces are stabilizing, Minsky promotes the heresy that “equilibria” are inherently unstable. In modern financial economies, the very stability of the equilibria generates the forces which de-stabilize the economy.  Very briefly, stability encourages risk taking behavior, which increases until a crisis occurs. This view is truly deeply heretical because it attacks the founding pillars (optimization/equilibrium) of mainstream orthodoxy.

Mainstream Views on Money

The standard story of money, taught worldwide in conventional textbooks, is that the Central Bank controls the High Powered Reserves, and the total money supply is determined as a simple multiple – M = kR, where M is money supply, k is the money multiplier, and R is the High Powered Reserves. Monetarists argue that the Money supply has no effect on the real economy except for determining prices. Accordingly, Friedman recommended the simple monetary policy rule that the Central Bank should aim for 6% per annum growth in the money supply. Setting a fixed target, and achieving it would anchor expectations about future money and prices, allowing inter-temporal trade without frictions created by uncertainty. Attempt by Central Banks to follow this policy proved to be a complete failure. The reason is that the process of credit creation by private banks is not under the control of the Central Bank. This depends on the investment climate and business expectations. Central Banks would routinely fail to meet announced policy targets, since the money supply depended on factors outside their control. This failure would damage credibility of the central bank, further weakening the impact of monetary policy.

This failure of the Friedman rule led to the use of Minsky’s preferred and recommended policy: the use of the overnite discount rate (and not reserves) for monetary policy. In addition, Minsky recommended the elimination of the interbank borrowing of reserves. The theory behind the creation of the inter-bank market was that this allows extra liquidity to the banks. However, Minsky thought that reserves should only be borrowed from the Central Bank, because this will allow the Central Bank to monitor the quality of loans being offered as collateral. The inter-bank borrowing market allows a general decline in quality of loans, as occurred prior to the GFC. Had Minsky’s idea been implemented, it would have been possible for the Central Bank to forestall the crisis by refusing to accept high risk mortagages as collateral for borrowing of reserves. The Fed would have been aware of risky debt portfolios accumulating in the Private Banks, because that is used as collateral for reserves.

The Financial Instability Hypothesis

One of the key contributions of Minsky, which advances on Keynes, is the recognition that the Business Cycle is caused by Pro-cyclical Credit Creation. In booming economy, there is a huge demand for credit, and everybody is lending, substantially expanding the supply of credit to the economy. Financial assets are used as basis for loans, and easy availability of credit can lead to rise in the prices of these assets, creating a bubble. When all banks are lending, accepting high-risk assets as collateral, no one bank can afford to get left behind, because they would lose market shares. When the music is playing, everyone must dance. BUT, when music stops, you are caught holding assets no one wants. In more prosaic terms, pro-cyclical lending exacerbates the cycle.

To explain the business cycle, Minsky offers us a pair of related theories. The first is the Keynesian theory of Investment as the driver of the business cycle. The second is Minsky’s contribution, the Financial Theory of Investment. These are explained further below.

Keynesian Theory of Investment: What differentiates Keynesian views from modern macro is the idea that investment is driven by “animal spirits” – expectations about the future which are not ‘anchored’ by any past events (and hence not ‘rational’).  This corresponds to the Keynesian view that the future is DEEPLY and INHERENTLY uncertain. Because it is COMPLETELY unpredictable – rational expectations cannot exist. If all investors are optimistic, this will create a self-fulfilling prophecy, and similarly for pessimism. Random fluctuations in investor sentiments can lead to an upswing maintained for sufficiently long to lead to creation of extra credit. Now the pro-cyclical behavior of financial institutions further fuels the fire, providing extra credit with high leverage, high risk, weak collaterals. Then the Central Bank Responds to the increasing aggregate demand by raising interest rates. In the expansion phase, firms have short term debt which is to be rolled over. Now this becomes more costly than anticipated and creates losses, possibly bankruptcies. This leads to a minor downswing which is further exacerbated by financial response created by tightening credit, and reducing money supply.

Minsky’s Typology of Finance: In this context, it is useful to learn the Minsky Classification of financing:

  1. Hedge Finance (not related to Hedge Funds): earnings enough to repay interest and principal.
  2. Speculative Finance (earnings sufficient for interest payments, but not for principal)
  3. Ponzi Finance (earnings not even sufficient for interest – more borrowing to pay off interest)

Speculative Finance is based on the speculation that asset values will increase in the future, allowing repayment of the principal – for example, this could happen in market where property values are rising rapidly. However, if incomes decrease or interest rates increase, then speculative finance can turn into Ponzi finance, where one has to borrow to make interest payments. This is problematic because loans may not be available, leading to bankruptcies. Many households took Ponzi financing to purchase houses in 2000-2007, speculating that rising house prices would cover their costs. To some extent, Lenders lend to protect past loan, but they will cut losses at some point by going for loan default and collecting collateral.

Causes of Crisis: As the expansion continues, financial fragility continues to increase, as riskier loans are extended, with more leveraging. There are multiple sources which can create a crisis which bursts the bubble:

  • income flows turn out to be lower than expected,
  • interest rates rise,
  • lenders curtail lending,
  • prominent firm or bank defaults on payment commitments.

When leveraging is high, then one failed payment has a multiplied impact on contraction of credit, and this can rapidly multiply defaults throughout the system, leading to a financial crisis. A financial crisis collapses the economy via the following mechanisms:

  1. Debtors cut back spending to make payments
  2. This leads to fall in Aggregated Demand, hence fall in income, jobs, wages
  3. To make loan payments,Asset are sold, which leads to fall in asset prices.

In extreme cases, this can lead to the Debt-Deflation seen by Irving Fisher in the aftermath of the Great Depression. Because of asset price collapse, and defaults by financial institutions, wealth is wiped out. Inability to make payments leads to widespread bankruptcies. Output and employment collapse. Debt increases further from efforts to pay it off.

Minsky’s Policy Recommendation: It was thought that the development of the inter-bank Funds market would facilitate credit creation. Minsky argued AGAINST this. It is not true that banks first acquire reserves and then they make loans. Rather, Banks make loans and then borrow reserves to meet reserve requirements. The Inter-bank market weakens the REGULATORY capacity of the central bank, it does not create additional capacity for lending. If the Central Bank is the sole source for reserve funds, it can monitor the quality of assets being used for collateral throughout the system, and thereby control systemic risks much more efficiently.

Course Website: – contains lectures for both Adv Macro I and II.


Advanced Macroeconomics II – Spring 2019 – PIDE – Dr. Asad Zaman. Course Website: . Lecture 9 is provides an introduction to L Randall Wray “Why Minsky Matters”. This post [L09A] covers the first portion (00-27:22m) of the lecture linked in the YouTube Video Below:

AM2 L09A – first half of lecture 9 compares the Global Financial Crisis to the Great Depression, similarities in origins and differences in responses.

  1. Why did No One See It Coming?

We start by posing the question “Why did no one see it coming?” which the Queen of England asked at the London School of Economics. To answer, we must consider the evolution of macroeconomic thought. This involves the rejection of Keynes, the rise of monetarism of Friedman, the extremism of Lucas, New Monetary Consensus of Bernanke, Efficient Markets of Fama, Laissez-Faire approach to financial regulation. The book starts with a beautiful description of the problem, eminently worth adding to my collection of “Quotes Critical of Economics”:

What passed for macroeconomics on the verge of the global financial collapse had little to do with reality. The world modeled by mainstream economics bore no relation to our economy. It was based on rational expectations in which everyone bets right, at least within a random error, and maximizes anything and everything while living in a world without financial institutions. There are no bubbles, no speculation, no crashes, and no crises in these models. And everyone always pays all debts due on time.

In short, expecting the queen’s economists to foresee the crisis would be like putting flat-earthers in charge of navigation for NASA and expecting them to accurately predict points of reentry and landing of the space shuttle. The same can be said of the U.S. president’s Council of Economic Advisers (CEA)—who actually had served as little more than cheerleaders for the theory that so ill-served policy makers.

  1. Minsky: Stability is De-Stabilizing!

According to Minsky, the degree that the economy achieves what looks to be robust and stable growth, this is setting up the conditions in which a crash becomes ever more likely. It is the stability that changes behaviors, policy making, and business opportunities so that the instability results. Examining the history of financial crises furnishes empirical evidence for this thesis: Crashes are often preceded by long period of stability.

The Great Depression: Back in 1929, the most famous American economist, Irving Fisher, announced that the stock market had achieved a “permanent plateau,” having banished the possibility of a market crash. In the late 1960s, Keynesian economists such as Paul Samuelson announced that policy makers had learned how to “fine-tune” the economy so that neither inflation nor recession would ever again rear their ugly heads. In the mid-1990s, Chairman Greenspan argued that the “new economy” reflected in the NASDAQ equities boom had created conditions conducive to high growth without inflation. In 2004, Chairman Bernanke announced that the era of “the Great Moderation” had arrived so that recessions would be mild and financial fluctuations attenuated.

In every case, there was ample evidence to support the belief that the economy and financial markets were more stable, that the “good times” would continue indefinitely, and that economists had finally gotten it right. In every case, the prognostications were completely wrong. In every case, the “stability is destabilizing” view had it right. In every case, Minsky was vindicated.

Minsky not only saw it coming, but all along the way he warned that “it” (another Great Depression) could happen again. In retrospect, he had identified in “real time” those financial innovations that would eventually create the conditions that led to the GFC—such as securitization, rising debt ratios, layering debts on debts, and leveraged buyouts

  1. Financial Crisis Inquiry Report

The crisis was foreseeable and avoidable. It did not “just happen,” and it had nothing to do with “black swans with fat tails.” It was created by the biggest banks under the noses of our regulators.  This contrasts with what economists at LSE told the Queen – that these things just happen and no one can foresee them – like earthquakes.

According to the report, the GFC represents a dramatic failure of corporate governance and risk management, in large part a result of an unwarranted and unwise focus on trading (actually, gambling) and rapid growth (a good indication of fraud, as William Black argues). Indeed, the biggest banks were aided and abetted by government overseers who not only refused to do their jobs but also continually pushed for deregulation and de-supervision in favor of self-regulation and self-supervision

  1. Dynamite Prize: Friedman, Greenspan, Summers

Instead of helping, economists  (armed with defective economic theories), actually pushed for OPPOSITE policies to those required for stabilization. President Clinton’s Secretary of the Treasury Larry Summers—a nephew of Paul Samuelson and the most prominent Harvard Keynesian of today—famously pushed for deregulation of “derivatives” that played a critical enabling role in creating the financial tsunami that sank the economy. One of the key contributions of Minsky lies in identifying the sources which make the economic system prone to crises. This diagnosis permits the design of appropriate remedies.

  1. Response to GFC 2007 different from response to GD 1929

Monetary and Fiscal Stimulus: Both crises were created by similar kinds of irresponsible behavior by unregulated financial institutions. However, the response to both was dramatically different. A $29 Trillion package was used to bail-out bankrupt financial institutions, and a $1 Trillion government deficit was incurred to pursue expansionary fiscal and monetary policy. This change in response also led to a change in outcomes. Financial collapse of the system was avoided. Although huge numbers became homeless and hungry, the social security programs enacted in the New Deal prevented the worst scenarios of deep massive social misery which followed the Great Depression. HOWEVER, a terrible Recession did follow, where unemployment reached double digit figures, around 25 million.

Recovery? It is claimed that there has been a recovery. Although official unemployment rates came down, much of the improvement is illusory—millions of workers have given up all hope and left the labor force. Even after years of “recovery,” both the homeownership rate (percentage of Americans who own their homes) and the employment rate (percentage of the adult population with jobs) are stuck well below where they were before the GFC. Inequality has actually increased, and all of the gains in the recovery have gone to the very top of the income and wealth distribution.

No Post-Crisis Financial Reforms:  The federal government in Washington did not follow Roosevelt’s example in undertaking a thorough reform of the financial system after GD ’29. The biggest banks are actually even bigger and more dangerous than they were on the eve of the GFC. They’ve resumed many of the same practices that created the GFC. Our public stewards are again allowing this to happen. We didn’t seem to learn much from the GFC. Not only is it true that banking practices have not changed, but is also true that mainstream economics has not changed. Examination of syllabi of universities after the GFC does not reveal any significant changes in terms addition of readings on Minsky, Keynes, and others, who offer deeper insights into the crisis. The same ARCH/GARCH models that failed miserably to assess volatility in the GFC continue to be used. The same DSGE/RBS models in use to make monetary policy continue to be used all over the world.

It seems that we have not learned much from the Global Financial Crisis!

CONTINUED in L09B: Mainstream VS Minsky — goes from 27m to end of lecture (1 hr) — explains how the mainstream misunderstands Minsky, just like they misunderstook Keynes, whose work Minsky builds upon.

This post is the third part of lecture 8 of Advanced Macro L08C: Fisher’s Debt-Deflation Theory of the Great Depression. In previous segments of this lecture L08A: Micro-Foundations for Keynesian Economics, and L08B: Keynesian Explanation for Great Depression: Seriously Incomplete, we examined the Keynesian explanation for the Great Depression, and found serious deficiencies in it. L08A explains that many different kinds of outcomes, with and without unemployment, are possible depending on how we specify details of the micro-structure that Keynes failed to specify. L08B explains that a simple deficiency in aggregate demand created by savings does not suffice to create unemployment because savings of current period is income/wealth of the next. It is necessary to look at abnormal savings, together with fixed prices, to create surplus production which signals shortfall in aggregate demand to the producers. Thus, many elements – micro-structure, role of debt, and different sectors of the economy – must be added to the Keynesian model to achieve the outcome of unemployment due to shortfall in aggregate demand that is at the center of Keynesian analysis.

This post deals with the last segment of the lecture, which explains Fisher’s Debt-Deflation theory of inflation. The lecture goes through and explains the article: Fisher, Irving (1933), “The Debt-Deflation Theory of Great Depressions”, Econometrica – making only minor commentaries. The goal is to understand what Fisher was saying, before attempting analysis, critique, and extensions. Many elements of this explanation are crucial to understanding the Great Depression, but are not available in the standard Keynesian analysis. Recently, elements of this theory have been picked up and presented as “Fisher-Minsky-Koo approach: Debt, Deleveraging, And The Liquidity Trap: A Fisher-Minsky-Koo Approach”  Gauti B. Eggertsson and Paul Krugman: The Quarterly Journal of Economics,Vol. 127, No. 3 (August 2012), pp. 1469-1513. In this lecture, we only present Fisher’s original paper. Post covers portion of lecture from 37m to 1:15m.

Summary of Fisher’s Econometrica paper on Debt-Deflation.
Fisher starts with an insight which comes straight from the experience of living through the Great Depression. An economic system is complex, subject to numerous conflicting forces acting simultaneously and repeatedly through time. It is unlikely to ever be in equilibrium. It is unfortunate the modern economics rejects this fundamental insight.

Fisher starts by asking how we can study disequilibria? In theoretical terms, the answer is to look at the forces which are acting in a given economic situation. Instead of looking at the long run outcome of how these forces would be resolved to arrive at equilibrium, we should use historical experience to judge the relative speed and strength of these forces. This would be a radically different methodology from the one currently in use in economics today.

By using this methodology, Fisher comes to the conclusion that the Business Cycle is a myth. There are many different kinds of economic forces which create multiple cycles. The complex of of forces can acting in tandem or at cross purposes. There are three types of tendencies (forces) – both cyclical and non-cyclical: (1) Those which create growth; (2) Those which create random fluctuations; and (3) Those which create cycles – these cycles can be stable and unstable, and they can be due to  (or interact with) internal factors, or external shocks to the economy.

He compares the economic system to a boat, which can resist small waves, but will capsize in a major storm. The system can accommodate small cycles, but may fall into crisis in big ones. There are some economic variables which can systematically deviate from equilibrium values. He names Capital Stocks, Real Income, Prices. In particular, Say’s Law is regularly violated. The production of goods can be in excess, or deficient, both in stocks and in flows. Forces in temporary disequilibrium will determine what happens next. Overshooting or Undershooting targets for production is common. BUT – this is NOT the cause of BIG disequilibria. The CENTRAL diagnosis of Fisher is the following:

The biggest cause of economic crises is: Too little money (too high price) mistaken for excess of goods!!

NOTE: This resonates with Friedman’s insufficient money supply explanation. Also, the Keynesian explanation, both of which work with short run fixity of prices.

In arriving at this diagnosis, Fisher lists and considers many common factors which lead to disequilibrium, and rejects them as sources of major crises. He then focuses attention on the Big Bad Actors – Debts and Deflation – as the cause of crisis. H says that the Apparent Causes are Over-Investment & Over-Speculation – this was obvious to all in the aftermath of the Great Depression. But Fisher thinks that the real Harm is caused by UNDERLYING debt which is used to finance this activity.

The mechanism which Fisher outlines starts with excess debt taken in a booming economy. Since assets like land, stocks are booming, people are happy to take debt at low interest, planning repay from the gains they make due to rapidly rising prices of stocks and real estate. Banks are happy to lend because they have the valuable asset as collateral for the loan, so even if the lender cannot repay, they will be able to cover their costs by selling the asset. Since banks create the money they lend, there is no check on the process, and loans increase geometrically leading to a situation with excess debt.

At some point, the bubble bursts. This is generally caused by failure of nerve of some party – either the banks, or the lenders. As indebtedness increases, people take loans to repay interest on past loans, and eventually, a steady stream of failures to repay emerges to public notice. At this point some people panic and start selling their assets, which sets off a chain reaction. As people sell to pay off loans, money supply contracts, and loans become less available. Now people who were relying on borrowing to repay previous loans start defaulting, or start to sell assets to cover loans. As more and more people sell assets, asset prices collapse. The collapse of prices leads to DEFLATION. Deflation increases the value of money, so that the debt burden becomes heavier. Paradoxically, the attempt to pay off debt puts people deeper into debt.

Balance sheets of banks, and firms, contain assets which are priced according to their market prices (This is called Mark-to-Market in accounting terminology). When stock and real estate prices collapse, the net worth of banks and businesses can become negative. Similarly, mortgage loans go under-water; they have negative equity. In simpler terms, this means that the value of house you own is less than the amount of loan you must pay to the bank to get ownership of the house. In this situation, it pays for the homeowner to declare bankruptcy and walk away from the loan and the house. Similarly, businesses whose net worth has become negative can collapse. This leads to panic and loss of confidence about the future in the general public. As expectations about the future become negative, people stop investing, business stop producing and lay-off employees. Heavily indebted people lose incomes and ability to pay off loans. Negative expectations about the future become self-fulfilling prophecies.

In the “Fisher” Sequence of events which leads to major crisis, Fisher says that two diseases – excessive debt, and price deflation – act together to create crisis.The effort to pay off debt leads to falling asset prices, which leads to further increase in real debt, and decrease in ability to pay. This is a vicious cycle which leads to collapse. Either one of the two forces acting individually would tend to return the system to equilibrium. The system can take small shocks and return to equilibrium, but large shocks, acting in tandem, lead to collapse.

Some Comments on Fisher’s Debt-Deflation paper

Fisher attempts to define “over-indebtness” which would lead to crisis, but failed to do so satisfactorily. Here Hyman Minsky made a major contribution. Minsky identifies three stages of debt in the business cycle. In the first stage, people & firms borrow to invest, and their stream of earnings is enough to pay off the interest and the principal. In the second stage, earnings are not sufficient to pay the principal, but enough to pay interest. Now loans are re-financed when the principal is due. In the third stage, earnings streams are not even sufficient to repay interest, and borrowing is done to pay interest on the loan. This last stage is what Fisher wanted to define as “over-indebtedness”, but failed to do.

He attempts to quantify the size of loans relative to assets/income available to repay. He writes that debts in 1929 were at historically highest known levels. By 1933, debts reduced by 20%, Prices decreased by 55%. Value of dollar increased by 75% — real debt increase 40%. This provides support for his key hypothesis: As you pay off debt, you go deeper into debt

Fisher offers the solution as price reflation, breaking one of the two components of the vicious cycle. He thought that if we could take policy actions to prevent prices from falling, or to put them back up to pre-crisis levels, then the economic system would find its way back to equilibrium. However, subsequent authors have cast doubts on this, suggesting that the levels of debt are so high that they cannot be repaid, even if assets do not lose their value. Thus the only solution would be to require debt-forgiveness.

The Wikipedia entry on Debt-Deflation provides a good summary of key points of Fisher’s thesis, and also its influence on subsequent work, and later developments. In fact, Fisher’s theories were ignored and neglected in favor of Keynes for a long time, prior to revival of interest in the 1980s. One of the reasons for this neglect was the idea that debt did not matter. What is a debt of one person is an asset of the other, so debts cancel. This mirage – that debts do not matter – continues to mislead economists. It is the large-scale inability to repay debts which is ignored in this picture.

As debts mounted up, Fisher’s Debt-Deflation theory has enjoyed a resurgence in popularity. It seems clear from a lot of research that levels of debt play a very important role in leading to financial and economic crises. For example, Atif Mian and Amir Sufi in House of Debt, highlight the role of leveraged debt as a key factor in the Global Financial Crisis. “Deflation”, or a dramatic fall in inflated asset prices, also plays a major role, and when combined with leveraged debt, this creates the catastrophic combination that Fisher identified. In retrospect, it seems that the widely accepted Keynesian explanation for the Great Depression was seriously incomplete, and Fisher identified some key elements missing from Keynes. For an update on Fisher, see:   DEBT, DELEVERAGING, AND THE LIQUIDITY TRAP: A FISHER-MINSKY-KOO APPROACH  by Gauti B. Eggertsson and Paul Krugman, in The Quarterly Journal of Economics,Vol. 127, No. 3 (August 2012), pp. 1469-1513

Last Portion of Lecture 8 – from 1hr 15m onwards

The last portion of the lecture  L08D Friedman-Schwartz   discusses the Friedman-Schwartz book on the Monetary History of the United States, which puts forth yet another diagnosis for the reasons of the Great Depression. They argued that it was the sharp contraction in the money supply that was responsible. This diagnosis was the one that was actually followed by Bernanke during the Global Financial Crisis, who massively increased money supply via Quantitative Easing programs. This did prevent financial collapse, but could not prevent the Great Recession, invalidating the Friedman-Schwartz hypothesis about the causes of the Great Depression. Furthermore, as a result of Quantitative Easing, reflation of asset prices has also occurred, which was Fisher’s proposed remedy. This has not proven very satisfactory, in many different ways. Of the two problems, Fisher thought that taking care of Deflation would suffice, but it seems to be only half of the remedy. The other half is the “Debt”, which can be removed by various methods, such as debt-forgiveness.

In a rapidly changing world, ways of thinking which served us well in other eras, become obstacles to understanding, and reacting appropriately to change. Traditional economic theories, currently being taught all around the world,blinded economists to the possibility of the global financial crisis.The Queen of England went to London School of Economics to ask why “no one saw it coming?”.The US Congress appointed a committee to study why economic theories “dismissed the notion that a financial crisis was possible”. At the heart of this failure arewrong ideas about the role of money in the economy. All major schools of macroeconomics currently being taught around the globe teach that the quantity of money only affects the prices, and does not have any other effects on the real economy. Economists write that “money is a veil” – it hides the workings of the real economy, but does not play any role in it. Economists were blindsided by the crisis because models currently in use for policy making do not have a role for money, credit, banking, and debt, even though these were the factors responsible for the Global financial crisis.

The crisis made clear to all and sundry the vital role of money in the economy. Surprisingly, the mainstream economics profession has been extremely resistant to change. The same textbooks, theories and models which failed so drastically, continue to be used in teaching and policy making throughout the world. However, the space for unorthodoxy has expanded substantially, and a lot of new theories of money have emerged to challenge mainstream views. Among these, Modern Monetary Theory, which provides a radically different perspective on money, has emerged as a strong contender. This article aims to summarize some of the key insights of MMT, which creates new ways of looking at the world of fiat money that we live in today.

The starting point of MMT is that our thinking about money is conditioned by the view that money is based on gold, which leads us to ignore the radical differences between gold-backed money and “fiat” money, which comes into existence by government decree, and does not require any backing. With a gold-backed currency, the concept of a government deficit makes sense – the government must have gold, in order to spend it. However, with a fiat currency, a deficit must always be self-imposed; the government chooses not to print money in order to pay its obligations.The idea that the government does not have money to fund social welfare or investment is wrong, because the government creates money by sovereign fiat, and can always print as much money as it likes. MMT raises the question of why the government should impose taxes on citizens to generate revenue – why not just print the money instead? Readers who have been conditioned by economic theories will eagerly proffer the standard answer: because this will lead to inflation! But this answer is neither sufficient, nor satisfactory.

Based on his experiences as Governor of the New York Federal Reserve Bank, Daniel Tarullo has written that at present we do not have a working theory of inflation. Similarly, Joseph Stiglitz has written that the stable relationship between money and inflation broke down in the 1980’s, leaving us with no reliable guide to monetary policy. The Quantitative Easing program that was adopted in major world economies after the Global Financial Crisis involved printing huge amounts of money. However, to the surprise of economists, no inflation resulted, in conflict with standard theories of inflation. So, the idea that if the government prints money, inflation will necessarily result is not credible.

As experience of the past few decades has shown, there is no automatic relationship between printing money and inflation. A more sophisticated analysis is needed. MMT provides rather different answers to when and whether governments should print money, as well as the why of taxation. First let us consider the printing of money. Whether or not it is inflationary depends on how the printed money is used. For instance, if it is deposited in the accounts of billionaires and adds to their financial wealth, without being used for any other purpose, then it will not have any inflationary effect. If the money is used to purchase goods in a sector where the economy has excess capacity for production, then the demand stimulus will create an expansion, with increase in employment and in production. This is the Keynesian phenomenon – in a recession, where economy is below it peak production capacity, a monetary stimulus can create increases in employment without inflation. If the money is used to buy goods in sectors where economy is at peak productive capacity, then it will create inflation in the short run. What happens in the long run depends on whether the industry can expand to meet the excess demand.

Against this Keynesian possibility where printing money increases production and employment, there are many possible ways that money creation can harm the economy.If money is spent on land and stocks, this will lead to inflation in their prices. Money can also be used for purchase of luxury foreign goods, or transferred abroad in various forms. In such cases, increased demand for dollars would lead to depreciation of the exchange rates. Keynesian economists have suggested that dropping money from helicopters would be a useful policy to reduce unemployment in recessions. Modern Monetary Theory tells us that we need to be more discriminating in targeting the printing and distribution of money. If money goes to sectors of the economy where there is excess capacity, it will stimulate production and employment, without causing inflation. If it goes to domestic sectors operating at peak capacity, it will lead to domestic inflation. If it is exchanged for dollars and flows out of the country, it will lead to depreciation.

One of the key resulting insights is that the “deficit” numbers by themselves – whether in percentages of GNP or in absolute quantitative terms – are meaningless. The government can “sustain” any amount of deficit by printing money to pay its obligations. Of course, this is not a license for irresponsible spending. Creation of money, and its utilization in ways which do not enhance productive capacity of the domestic economy are sure to cause harm to the economy. Rather, MMT provides us with a license for responsible spending. If there are worthwhile projects which will utilize resources currently lying idle, then there is no need to be scared of the deficit numbers in spending on these projects. Viewed in this light, the project of building a million houses is not constrained by the budget of the government. Rather it is constrained by the availability of resources which are required for this purpose. If there is idle productive capacity in terms of labor, land, and materials, spending is this area will utilize them to the maximum. If the capacity does not exist, then a carefully balanced spending strategy, which builds capacity in a way coordinated with the increasing demand for utilization of this capacity, can be funded by deficit financing, without causing harm to the economy. Of course, it goes without saying that this requires skillful management and planning.

This is the second lecture on Understanding the Rise and Fall of the Gold Standard — shortlink: — we start with a  Summary of First Lecture 

The first lecture discusses the Keynesian theory that the exact level of money in an economy is critically important – too little leads to recessions, while too much leads to inflations. Furthermore, domestic business cycles, and international financial crises are caused by pro-cyclical behavior of current artificial systems of money creation and international trade. Standard macro theories make it impossible to understand the economy because they assert that money is neutral, and does not affect the real economy – exactly the opposite of the Keynesian idea that the quantity of money is all important. Standard macro model currently in use throughout the world have no explicit role of money, banks, and credit, even though these factors are of central importance in understanding the world. Once we understand the vital role and function of money within an economy, it becomes possible to understand historical events of the twentieth century – whereas this is impossible using conventional macro theories. The first lecture summarizes how the colonial system came into being, and the monetary arrangement for a hard currency at the core and soft currencies in the periphery. This system of fiat currencies works fine within one system of colonies, where the value of money is decreed by sovereign fiat. For trading between different countries, the gold backed currencies were used. As European countries prospered by exploiting resources throughout the globe within their colonies, inter-European trade increased. The optimal quantity of money required for the domestic economy is not the same as that required for stable international exchange rates. The pro-cyclical money creation which is characteristic of the system creates cycles, and large cycles lead to crises on a routine basis. World War I was partly caused by the breakdown of the colonial trading system due to the end of expansion possibilities after the completion of the conquest of the globe. Efforts to restore the gold standard after World War I failed. The second part of the lecture discusses the post World War I history, with reference to the international financial architecture that emerged in the post-Gold era after World War I.

3100 Word Summary of Second Lecture on Global Financial Architecture

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[] Lecture 1 on Rise and Fall of the Gold Standard, on Friday 4th May 2018 in AR Kemal Rm at PIDE, by Dr. Asad Zaman, VC PIDE. 1hr 20m Video Lecture. Shortlink for Lecture 2:

3100 word summary of lecture:

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This 1000 word article is the third in a series of posts on Re-Reading Keynes. It traces the impact of Keynesian theories on the 20th century, as necessary background knowledge for a contextual and historically situated study of Keynes. It was published in Express Tribune on 4 Nov 2016.

The Global Financial Crisis (GFC) has created awareness of the great gap between academic models and reality. IMF Chief Economist Olivier Blanchard said that modern DSGE macroeconomic models currently used for policy decisions are based on assumptions which are profoundly at odds with what we know about consumers and firms. More than seven different schools of macroeconomic thought contend with each other, without coming to agreement on any fundamental issue. This bears a striking resemblance to the post-Depression era when Keynes set out to resolve the “deep divergences of opinion between fellow economists which have for the time being almost destroyed the practical influence of economic theory.”

Likewise, today, the inability of mainstream economists to predict, understand, explain, or find remedies for the Global Financial Crisis, has deeply damaged the reputation of economists and economic theories. Recently, World Bank Chief Economist Paul Romer stated that for more than three decades, macroeconomics has gone backwards. Since modern macroeconomics bears a strong resemblance to pre-Keynesian theories, Keynesian theories have fresh relevance, as described below.

In the aftermath of the Great Depression, economic misery was a major factor which led to the Russian Revolution and the rise of Hitler in Germany. Conventional economic theory held that market forces would automatically and quickly correct the temporary disequilibrium of high unemployment and low production in Europe and USA. Keynes argued that high unemployment could persist, and government interventions in the form of active monetary and fiscal policy were required to correct the economic problems. Many have suggested that Keynes rescued Capitalism by providing governments with rationale to intervene on behalf of the workers, thereby preventing socialist or communist revolutions. There is no doubt that strong and powerful labor movements in Europe and USA derived strength from the economic misery of the masses, and also took inspiration from the pro-labor and anti-capitalist theories of Marx. While it is hard to be sure whether Keynes saved capitalism, we can be very sure that Keynes and Keynesian theories were extremely influential in shaping the economic landscapes of the 20th Century.

Keynes actually met Roosevelt (FDR) to try to persuade him of the necessity of an aggressive fiscal policy and of running budget deficits, in order to lift the US economy out of recession. He was only partially successful. FDR, like nearly all political leaders as well as economists of the time, was convinced of the necessity of balancing budgets: this is the same ‘austerity’ being touted today as the cure for economic problems. Leading economists like Lionel Robinson and Friedrich Hayek argued in favor of austerity, and said that Keynesian remedies were dangerously wrong. They held the view that the Great Depression had been caused by excessively easy monetary policies in the pre-Depression period, and Keynesian interventions in the form of further easy monetary and fiscal policies would only prolong the agony.

FDR was not quite convinced by Keynes, but was politically savvy enough to announce that he would not balance the budget on the backs of the American people. Accordingly, he did go against his personal convictions, as well as his campaign promises of balancing the budget, which he believed to be a sound and necessary economic policy. Keynes felt that the economic policies of FDR were timid and hesitant, and prolonged the recession un-necessarily. In light of contemporary experience of the tremendously aggressive expansionary monetary policy in the post-GFC era, we can see that bolder steps by FDR would not have caused the harms that he was afraid of. In fact, after the economy recovered somewhat, FDR went back to conventional wisdom and started reducing budget deficits in 1936. This created a mini-recession which has been labelled the “Roosevelt Recession of 1937”. Duly chastened, FDR embraced Keynesian policies with greater conviction, and increased deficit spending right up to the second World War. It was the effectiveness of Keynesian policies that led even arch-enemy Friedman to state that “We are all Keynesians now,” though he later recanted. Indeed, he master-minded the Monetarist counter-revolution in the 1970’s which eventually led to a rejection of Keynesian insights, and a return to the pre-Keynesian ideas of austerity as a cure for recessions.  Forgetting the hard-learned lessons of Keynes led to a recurrence of problems very similar to those faced by Keynes in the form of GFC 2007.

Following the GFC, there has been a resurgence of interest in Keynes and Keynesian Theories. In the “Return of Depression Economics”, Krugman argued for the continuing relevance of Keynes, and stated that we could end the Great Recession immediately by implementing Keynesian policies.  China implemented Keynesian policies, and used a fiscal stimulus of $586 billion spread over two years, to successfully combat the global recession created by the GFC.  Unlike countries forced to implement austerity, which further wrecked their economies, the Chinese economy was able to perform well in the aftermath of the GFC. The Shanghai index had been falling sharply since the September 2008 bankruptcy of Lehman Brothers, but the decline was halted when news of the planned stimulus leaked in late October. The day after the stimulus was officially announced, the Shanghai index immediately rose by 7.3%, followed by sustained growth. Speaking at the 2010 Summer Davos, Premier Wen Jiabao also credited the Keynesian fiscal stimulus for good performance of the Chinese economy over the two years following the GFC.

Meanwhile, even IMF acknowledged the failure of austerity, the anti-thesis of the Keynesian policy. Massive damage was caused to Greece, Ireland, Portugal and other economies which were forced to tighten budgets in response to the recession. In the see-saw battle between Keynesians and Monetarists, after three decades of darkness, the Keynesian star seems to be rising. Strange as it may seem, many fundamental insights of Keynes were never actually absorbed by conventional economists. Keynes himself said that he had the greatest difficulty in escaping the habits of thought created by an economics education. Mainstream economists never made this escape. As a result, Keynesian theories remain an undiscovered treasure offering deep insights into current economic conditions.

The website page has many links to related materials on L3: Impact of Keynes