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Towards a Theory of Endogenous Financial Instability and Debt-Deflation
Abstract
Post-keynesian and heterodox critiques have challenged the Monetarist assumptions of an exogenous money supply and the doctrine of monetary neutrality in the long run. Within these heterodox currents, there has emerged a widespread consensus that the money supply is endogenous—governed by the demand for credit and by the keynesian notion of liquidity preferences. These heterodox theories also reinstate the original insights by keynes over the critical issue of uncertainty in the behavior of investors, which contradicts the assumptions of rational expectations. This article will examine some of these intellectual currents in order to develop a more rigorous interpretation of the root causes of financial turbulence.
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This upward revision of future profits resembles Keynes's famous “widow's curse of profits.” To quote Joan Robinson: “Mr Keynes's analysis may be summarised thus: When prices are in excess of costs windfall profits are earned by entrepreneurs, and however much of these profits the entrepreneurs spend the total profits remain unchanged, since spending by one entrepreneur only serves to increase the windfall profits of others” (Robinson 1933: 24).
According to Kalecki: “We shall call the rate e at which the series of returns must be discounted in order to obtain the amount invested k —the efficiency of investment, whilst by prospective profit p we denote the product k.e. Now we assume that with the given amount invested k the entrepreneur chooses such a method of production as would maximise the efficiency of investment or what amounts to the same ( k being given) the prospective profit pm : Pm = f(k) ” (Kalecki 1937: 440).
A more coherent treatment of Kalecki's principle of increasing risk was formulated by Steindl (1945). According to Steindl: “Let us call the entrepreneur's capital C and the amount of capital invested I ; the rate of profit earned in the latter e , and the rate of profit earned in the entrepreneur's capital (after deduction of interest paid) p ; and the rate of interest, r . Then we can say that: P = I/c(e-r) + r i.e., the rate of profit on the entrepreneur's capital increases if he borrows more. To induce the entrepreneur to invest, the rate of profit must cover not only interest but also a certain risk premium. We can define this risk premium as the excess of the rate of profit over the rate of interest which induces the entrepreneur to invest, at a given cost of the equipment” (Steindl 1945: 21–22).
To quote from Sawyer (1985): “Kalecki expressed his approach in terms of circulation V being an increasing function of the short rate of interest r so that T/M = V(rs) , where T is the nominal value of transactions and M is the supply of money which is determined by banking policy, i.e. the interaction between the Central Bank's monetary policy and decisions taken by banks. He further argued that when the velocity of circulation is high (and so money holding small relative to turnover), it requires relatively large increases in the short-term rate of interest to reduce money holding further. Thus the first and second derivation of V(rs) are positive. The equation T/M = V(rs) was interpreted by Kalecki as indicating the determination of the short-term rate of interest by the value of transactions and the supply of money” (Sawyer 1985: 99).