Theory of financial institutions

* **The link from credit to physical production is psychological and credit has no effect whatsoever on physical production capacity**

## Central banks

### Money creation

* Whenever a bank makes a loan, it simultaneously creates a matching deposit in the borrower’s bank account, thereby creating new money.
* The households and companies who receive the money created by new lending may take actions that affect the stock of money — they could quickly ‘destroy’ money by using it to repay their existing debt - In fact, when households choose to save more money in bank accounts, those deposits come simply at the expense of deposits that would have otherwise gone to companies in payment for goods and services. Saving does not by itself increase the deposits or ‘funds available’ for banks to lend.
* In normal times, the Bank of England implements monetary policy by setting the interest rate on central bank reserves.
* A common misconception is that the central bank determines the quantity of loans and deposits in the economy by controlling the quantity of central bank money — the so-called ‘money multiplier’ approach. In that view, central banks implement monetary policy by choosing a quantity of reserves. And, because there is assumed to be a constant ratio of broad money/M3 (i.e. physical money+demand deposits+repos) to base money, these reserves are then ‘multiplied up’ to a much greater change in bank
* For the theory to hold, the amount of reserves must be a binding constraint on lending, and the central bank must directly determine the amount of reserves. Rather than controlling the quantity of reserves, central banks today typically implement monetary policy by setting the price of reserves — that is, interest rates.
* In fact, the relationship is reverse: Banks first decide how much to lend depending on the profitable lending opportunities available to them — which will, crucially, depend on the interest rate set by the Bank of England. It is these lending decisions that determine how many bank deposits are created by the banking system. The amount of bank deposits in turn influences how much central bank money banks want to hold in reserve
* Bank deposits are simply a record of how much the bank itself owes its customers. So they are a liability of the bank, not an asset that could be lent out.
* Banks are limited in their money creation by:
	+ Market forces: giving out loans to households by creating a deposit, which the household uses to buy the house (transfer of deposit to seller's bank) means that banks have to attract new liabilities against the outstanding loan/asset they hold, usually through offering good savings account rates
	+ Risk management: liquidity risk constraints (making sure that they attract relatively stable deposits to match their new loans, that is, deposits that are unlikely or unable to be withdrawn in large amounts) + credit risk constraints (lending to HH who are unable to repay - the average credit loss cost is usually priced into the interest rate)
	+ The behaviour of households and companies in response to money creation by the banking sector can also be important. As the households and companies who take out loans do so because they want to spend more, they will quickly pass that money on to others as they do so. How those households and companies then respond will determine the stock of money in the economy, and potentially have implications for spending and inflation - if they use it to repay debt, money is destroyed; alternatively, if they are already very liquid, they may decide to buy higher-yield assets or spending on goods/services ('hot potato effect')
	+ CB monetary behavior: set short-term interest rate by setting the interest rate paid on central bank reserves held by commercial banks. It is because there is demand for central bank money — the ultimate means of settlement for banks, the creators of broad money — that the price of reserves has a meaningful impact on other interest rates in the economy. Changes in interbank interest rates then feed through (i.e. transmission mechanism of monetary policy)to a wider range of interest rates in different markets and at different maturities, including the interest rates that banks charge borrowers for loans and offer savers for deposits
* However, all this pertained to individual banks. If all banks simultaneously decide to try to do more lending, money growth may not be limited in quite the same way. Although an individual bank may lose deposits to other banks, it would itself be likely to gain some deposits as a result of the other banks making loans.
* Demand for base money is therefore more likely to be a consequence rather than a cause of banks making loans and creating broad money - changes in quantities of reserves are unrelated to changes in quantities of loans in the United States
* Contrary to the money multiplier myth, reserve requirements are not an important aspect of monetary policy frameworks in most advanced economies today

### QE

* QE is intended to boost the amount of money in the economy directly by purchasing assets, mainly from non-bank financial companies.
* QE initially increases the amount of bank deposits those companies hold (in place of the assets they sell). Those companies will then wish to rebalance their portfolios of assets by buying higher-yielding assets, raising the price of those assets and stimulating spending in the economy.
* As a by-product of QE, new central bank reserves are created. But these are not an important part of the transmission mechanism.
* The CBpurchases a quantity of assets, financed by the creation of broad money and a corresponding increase in the amount of central bank reserves. The sellers of the assets will be left holding the newly created deposits in place of government bonds. Being overly liquid now, these companies will want to rebalance their portfolios, for example by using the new deposits to buy higher-yielding assets such as bonds and shares issued by companies, which raises their prices and lowers companies' funding costs
* QE leaves banks with both a new IOU from the central bank but also a new, equally sized IOU to consumers, and the interest rates on both of these depend on Bank Rate.
* The transmission mechanism of QE relies on the effects of the newly created broad — rather than base — money. The start of that transmission is the creation ofbank deposits on the asset holder’s balance sheet in the place of government debt
* Reserves with the CB are an IOU from the central bank to commercial banks. Those banks can use them to make payments to each other, but they cannot ‘lend’ them on to consumers in the economy, who do not hold reserves accounts.
* Major objectives of QE are to simultaneously i) inject liquidity so as to alleviate an expansion of private bank lending; ii) increase asset prices, inducing a higher stock market collateral valuation; and iii) act against deflation by increasing the money supply and hence inflationary expectations and the inflation rate in the long run.
* QE central banking targets restoring liquidity and not the quality of leverage and liability structures. QE central banking seems not to pay particular attention to the distinction between position-making operations that are collateral based and income based. In contrast, evolutionary central banking targets Ponzi finance in order to reduce the risk of financial fragility and of debt deflation from a flawed financial structure.
* The QE (govies) asset purchases were intended to reduce gilt yields and boost the price of a range of assets – such as equities and corporate bonds – via the so called ‘portfolio rebalancing channel’ of monetary policy. There is a broad range of evidence that suggests that QE did reduce gilt yields and boost other asset prices. This should boost spending for two reasons: 1)It increases the net wealth of asset holders, which encourages them to consume more, and 2) it lowers borrowing costs, particularly for firms, which encourages them to invest more
	+ In theory, it may have also led to an increase in banks’ willingness to lend, via a so called ‘bank lending channel’ (BLC). [1]

## From monetarism to inflation targeting

* 1980: expansive money supply but no inflation occuring
* 1990: exchange rate targeting is abandoned

* (page 4)

* After crises, CB care more about deflation than inflation
* In the UK, near-0 interest rates didn't increase inflation for years. Only wit Brexit affecting the exchange rate did inflation rise
* CB sets a money rate of interest (nominal) and not the prices (real)
* Since interbank market stopped working in 2007, cutting IR didn't work; banks funded long-term ABS with short-term borrowing (hence, having to roll over debt)
* CB in the interbank market means that it affects the pricing of risk
* If a commercial bank wants to raise its capital adequacy: issue shares or sell assets to get cash (which is = to reserves at the CB)

* The level of CB reserves turned out to be a poor predictor of inflation in the economy
* New-Wicksellian doctrine (up to GFC): what the CB does with its money supply doesn't matter, the interest rate counts! - in the past, r was controlled through open market operations

* If actual r < natural r = expansion
* If the yield curve flattens (i.e. long-term = short-term bonds): the interest rate spread is small (which is the main source of income for banks though) - banks are liquid but not making money
* So if you flatten the yield curve (and banks are still holding long-term assets):
* Who hold long-term assets? Pension funds, insurance and the CBs - they all lose since the price of the long-term asset declines (in the case of the CB - losses are only nominal though)
* Interest rate is only about the transfer/balance between debtor and creditor.
* Few central banks of major industrial nations still make much use of credit controls or other attempts to directly regulate the flow of funds through financial markets and institutions. Instead, banks restrict themselves to interventions that seek to control the overnight interest rate in an interbank market for central-bank balances (e.g., the federal funds rate in the United States).
* The effectiveness of changes in central-bank targets for overnight rates in affecting spending decisions (and hence ultimately pricing and employment decisions) is wholly dependent upon the impact of such actions upon other financial-market prices, such as longer-term interest rates, equity prices, and exchange rates.
* Taylor rule: the classic “Taylor rule” prescribes setting an interest-rate operating target at each decision point as a function of current

estimates of inflation and the output gap only

### CB open market operations

* As the history of open market operations reveals, context is everything in understanding what such operations do, what they can do, and how we understand what they are doing. Whatever their purpose, the context determines their scope and effectiveness and this justifies a consideration of those broader factors that affect such operations.
* Since the 1980s, the policy framework directing central bank operations has centred upon the central bank’s policy rate of interest as the key instrument of monetary policy. Initially it was thought that open markets needed to reinforce this.
* It was quickly realised that the official rate could be enforced more effectively simply by maintaining a narrow enough ‘corridor’ between the deposit and lending rates for reserves at the central bank\* If natural r < actual r = deflation process/economic activity goes down/infatlation goes down
* 'Standing facilities' at the ECB allow commercial banks to borrow reserves from the central bank, or to place excess reserves with it (i.e. they can affect the CB's balance sheet as they wish)
* In the GFC, open market operations come back big time: CBs buy the commercial banks' ABSs (replacing them with reserves of the commercial banks at the CB). The large scale purchases of long-term securities by central banks, or quantitative easing as it was dubbed, marked a return to open market operations by central banks
* Open market operations are done at discretion of CB, QE is preannounced target of # of securities bought (pushed up bond prices) - flattens the yield curve
* Open market operations mirror monetary policy doctrine
* If CB sells bonds this is a transfer from commercial bank to CB, which then cancels out → money supply is decreased. Put differently, the CB's sale of securities to a commercial bank would be paid for by a transfer from that bank’s reserve account at the central bank to the central bank, which would then cancel those reserves.
* If CB sells bonds to a non-bank, the process is the same (we pay with a check and the process of clearing it – through our bank – transfers the same amount - in CB reserves - from the commercial bank to the CB)
* Conversely: The CB's purchase of securities from commercial banks (or the 2ndary market more generaaly) would be paid for by the creation of reserves that are credited to the reserve account of the commercial bank that sells those securities
* Basically, if the CB buys govies, this raises their price (therefore, decreasing their yield) which reduces the market interest rate. At the same time, money is created
* CB buying and selling transfers CB reserves to/from commercial banks
* For Milton Friedman, open market operations were the way to regulate the money supply
* A repo: one bank buys a security, paying with CB's reserves that are transfered to the counterparty bank's CB reserve account. The agreement specifies a date of repurchase back to the original bank (formerly two weeks, now one week). The difference between the purchase and sale price is in effect the rate of interest on the temporary addition to its reserves that the counterparty bank now obtains
* This time-adjusted difference or rate of interest on repurchase agreements ('repos') became the official policy rate of the European Central Bank, the Bank of England and most European central banks during the 1990s. The repo rate is the interest rate for the period between near date and far date
* When done by the CB, repurchase agreements add reserves to the banking system and then after a specified period of time withdraw them. Under a repurchase agreement, the Federal Reserve (Fed) buys U.S. Treasury securities, U.S. agency securities, or mortgage-backed securities from a primary dealer who agrees to buy them back within typically one to seven days; a reverse repo is the opposite
* The other open market operation are outright purchases of securities. Outright purchases and sales of securities or foreign currency are undertaken with a view to changing the asset portfolio of the central bank
* In bank-based systems, commercial banks may be much more dependent on liquidity from the central bank because their loan book is much less liquid than are the loan books of banks in capital market-based systems.
* Henry Simons (advocate of 100% reserves Chicago Plan): abolish the Fed. This would allow the concentration of responsibility for monetary policy in the US Treasury which, through its open market operations in US government debt, effectively determines the quantity of money in the banking and financial system
* Keynes came to the conclusion that open market operations held the key to managing the liquidity of the market in long-term securities. This liquidity determines the long-term rate of interest, rather than the official central bank rate of interest. For Keynes, that long-term rate is the rate of interest that is relevant to the fixed capital investment which determines output and employment. This strategy, however, hinges on how high the proportion of medium- and long term government securities on the commercial banks' balance sheets is. If given, open market sales of such securities can squeeze the balance sheets of commercial banks more effectively than changes in the discount rate.

## Risk, uncertainty

* Theories of profit
	+ Marginal productivity
	+ Rent (income from production that is not for contribution to production) for scarce capital
	+ Marshall's 'normal' profit for capital to stay in (i.e. expected profit)
	+ Veblen: capital is scarce and firms make output scarce on purpose (monopoly)
	+ Hobson:
	+ Marx/Ricardian: interest as a deduction from gross profit
	+ The smart-ass entrepreneur (Knight, Schumpeter)

* Randomness
	+ Randomness is the lack of pattern or predictability in events. A random sequence of events, symbols or steps has no order and does not follow an intelligible pattern or combination. Individual random events are by definition unpredictable, but in many cases the frequency of different outcomes over a large number of events (or "trials") is predictable
	+ A random process is a sequence of random variables whose outcomes do not follow a deterministic pattern, but follow an evolution described by probability distributions
	+ Objective randomness (indeterminateness): random events that cannot be reduced, i.e. which are not governed by (hidden) causes but which are fundamentally indeterminate/unbestimmt and cannot be rationally explained (for mathematical proof of irreducibility see Neumann). However, the difficulty lies in finding out whether causes are only not known/hidden or truly absent (as much is in quantum mechanics)

### Risk

* Risk refers to situations where precise outcomes are unknown but the probability distribution is known
* In mainstream models, all uncertainty is exogenous and additive
* Risk: agents are assumed to know the future with at least probabilistic certainty
* Fisher: risk in finance is purely subjective
* At the heart of financial risk is the balance sheet of the firm (à la MMT)
* Knight: situation in which there are recognized procedures (or routines) for assigning probabilities across a known set of possible outcomes

#### Frequentist stats

* The frequentist view that past events do not influence future events holds in theory only if the probabilities are known a priori, as in teh case of a balanced coin
* Haavelmo's idea was that he relationship which existed between the population and the sample in probability theory provided a model for the correspondence relationship between economic theory and passive economic data. This method translated into seeing theory as the explanation (cause) of an event and economic data as the sample to gauge if the explanation was correct. With this approach, theory testing rather than theory building and modification became the main use of statistics in economics
* Given that the dice are fair, if we want to calculate the probability of throwing a certain number, we know the cause (the shape of the dice) but lack certainty about the effect (a certain number) - vs. the inverse method of Bayesian

### Uncertainty

* Keynes: In the presence of fundamental uncertainty, no stable probability function exists to forecast future ‘fundamentals’, which can then be used as a reliable guide to the ‘correct’ equilibrium price of financial assets over time, but convention – the assumption ‘that the existing state of affairs will continue indefinitely’ and the psychological confidence with which we hold this convention govern investment behaviour
* Fundamental uncertainty ≠ limited cognitive ability to make forecasts but a statement about the nature of social reality
* Black swan events: we pretend to have knowledge of all the risks; in other words, Knightian uncertainty is presumed to not exist in day-to-day affairs, often with disastrous consequences
* Bayesian: there is an objective probability but it is unknown. You learn about it through experiments
* Probability deals with predicting the likelihood of future events, while statistics involves the analysis of the frequency of past events
* Objective probability: where I know that if I toss a fair coin enough times, it’ll turn up heads 50% of the time; informed statement about a system; a constant number if we’ve done the calculations right
* Subjective probability:where I think there’s a 10% chance it’ll rain tomorrow, and I don’t care to repeat the event; our best guess about an event; number can change as our knowledge of the event increases
* Actually, the risk of default *increases* with income (for the US poor, not making the payments losing their only home)
* Reduce uncertainty: insurance, diffusing shareholdings (diversification/conglomeration), specialized speculation (i.e. learn all you can about the market)
* Kalecki: the basis of being an entrepreneur is the ownership of capital in cash form
* Shackle: uncertainty is a necessary condition for imagination
* The distribution of possible outcomes is unknown, i.e. randomness - metaphysically there is a huge difference between treating something as as stochastic process (there is a probability distributions but we don't know where we are on it) and as indeterminate
* The distinction between risk and uncertainty is generally interpreted as having to do with whether or not agents can be assumed to act as if they have in mind well-defined probabilities on possible outcomes. If so, the situation is one of risk; if not, it is one of uncertainty.
* Keynes: the probability of a proposition and the weight/value attached to a proposition (e.g. how crucial would it be if God existed; note, this is not the same as the 2nd order probability)
* Consider a division of uncertainty between two levels corresponding to first and second-order probability whereby second-order uncertainty = uncertainty about the (uncertain) probability function. With such a division it becomes possible to distinguish between on the one hand ignorance in the guise of a uniform probability distribution over the possible outcomes and on the other hand ignorance in the form of a uniform second-order distribution. In the first case we are sure of being uncertain but in the other we express uncertainty on a higher level.
	+ Where there are probability distributions there is uncertainty, with a second-order distribution there is then the uncertainty that comes with the second-order probabilities but also the uncertainty o f the first-order probabilities. Assume there are two stocks and you know one of them has a high cash flow, the other one a low one but you don't know which one is which. In this case there is no first-order uncertainty but maximum second-order uncertainty because both p(x1=1, x2=0)=0.5 and p(x1=0, x2=1)=0.5
	+ Distinguish being certain that I'm uncertain (ignorance on the first order level but there is no doubt about which first-order level is the proper one) vs. being uncertain that I'm certain (uncertainty is entirely 2nd-order) → for example certainty (2nd order) that a die is fair (1st order). Believers in fundamental randomness would assume that each side has

	p
	=

	1
	6

	{\displaystyle p=\frac{1}{6}}

#### Knight

* In an unchanging environment the knowledge required for intelligent choice could be supplanted by routine, but added that ‘it is doubtful whether intelligence itself would exist in such a situation’
* Knight's purpose in Risk, Uncertainty and Profit ( 1921) was to explain profit as the reward for bearing uncertainty: "It is this true uncertainty which gives the characteristic form of 'enterprise' to economic organization as a whole and accounts for the peculiar income of the entrepreneur" → the book is properly read as an analysis of the consequences of the fact that entrepreneurship is uninsurable
* For Knight, profit is the residual between revenue and those costs that are contractual or imputable (i.e., can be contractual if the entrepreneur chooses not to bear them himself). Knight excluded interest and wages of management from profit on the grounds that these, being contractual or imputable, are qualitatively different from profit even though in practice they may be paid to the same person (note: Rather than deny that salaried managers are managers, Knight would have done better to deny that they are salaried (in the sense of being paid at a rate that does not depend on performance): incentive contracts, stock options, and the like put the income of the salaried manager of a large firm in a position similar to that of the proprietor of a small firm.
	+ The reward for bearing insurable hazards should be excluded from profit for the same reason: insurance premia appear on the books as costs when contracted out, so they should be imputed to cost rather than considered a component of profit if entrepreneurs elect instead to self-insure. If profit is the reward for bearing uninsurable hazards and if it is uncertainty that gives rise to profit it follows that **uncertainty must be identified with uninsurable hazards. Risks, on the other hand, are insurable hazards** → Risks, according to Knight, arise from random sequences; so they can be covered, if there are enough of them, by insurance
	+ Knight interpreted objective probabilities as those everyone would agree to. This might be so either because these probabilities are deductive in nature or because there exist large enough samples of similar events that differences in priors are of negligible importance → the difficulty however lies in distinguishing the two: Nothing in the universe of experience is absolutely unique any more than any two things are absolutely alike. Consequently it is always possible to form classes if the bars are let down and a loose enough interpretation of similarity is accepted
	+ Read 'objective' in Knight as meaning 'publicly verifiable/measurable' → the connection between the existence or nonexistence of objective probabilities and that of insurance markets is immediate: insurance markets fail when there exists no public way to verify whether the event insured against has occurred or to evaluate the magnitude of the loss
	+ For Knight business decisions are uninsurable because there is no way to separate bad luck from bad decision making in order to insure the former → any attempt to insure the outcome of entrepreneurship would fail because of the impossibility of excluding entrepreneurial lemons, whose presence in the pool would necessitate raising the insurance premium to the point where successful entrepreneurs would drop out of the pool
* To Knight, economics had to be based on judgments about human behavior - hence he fits into behavioral economics.
* For Knight, in a certain world with perfect knowledge about supply and demand conditions, no profit would exist (although he talked mainly about entrepreneurial profit from running a business and not investment)
* By using standard theory Knight demonstrated that it is uncertainty which makes possible profit, entrepreneurship and the firm; it is uncertainty that requires intelligence.
* The world contains an infinite amount of knowledge → human mind uses its finite intelligence to deal with this by searching for uniformity in its classification of objects and constancy in patterns of behavior → ultimately, they would make decisions based on inferences that they drew from their perceptions of the world around them → these inferences become estimates of how the future will look → such estimates based on inferences from partial knowledge about the world are at the heart of statistical methods
* Differed from Fisher in postulating two judgments: the formation of an estimate and the estimate of its value. Thus, people may act only on their guess of how accurate their estimate of the chance of an event is (an estimate of the chance that my estimate of the change of event A occurring is correct). Subjective estimates of probability are 1) an estimate of the probability of an event and 2) an estimate of my ability to estimate that probability (reminiscent of Keynes confidence in beliefs)
	+ Hence, Knight's view was consistent with Bayesian subjective probability view but slightly different: for him, probability beliefs are often but not always subjective → the first task of decision makers is to determine whether you basis is probability theory or statistics
	+ While Bayes recommended the consideration of new information to counter unreasonable expectations about the constancy of recurring events (overconfidence), Knight raised the problem of unique events. In the business world, entrepreneurs create groupings of similar events through the consolidation of businesses → formation of the corporation reduces uncertainty by creating a statistically meaningful number of events (turn uncertainty into measurable risk by creating a large # of investment projects, i.e. generate sufficient data for statistical inference). This type of consolidation is limited only by the corporation's ability to sell stock → here lie the origins of Knight's theory of diversification based on probability theory: diversified portfolios turn uncertainty about future returns on stock into risk
	+ Investors might base their decisions on facts, but really they are taking a chance that their judgment of the future of those facts is accurate

* Knight's definitions of risk and uncertainty were based on his threefold classification of unknown outcomes (pp. 224-25 ff.). Knight identified risk with points 1 and 2 and uncertainty with 3.
	+ A priori probabilities, which are derived deductively, as in rolling dice
	+ Statistical probabilities, which are generated by empirical evaluation of relative frequencies, as in life insurance
	+ Estimates, in which "there is no valid basis of any kind for classifying instances"
* Contrary to the received reading, Knight was at pains both to emphasize the distinction between objective and subjective probability and to stress that subjective probabilities apply even in situations of uncertainty
* Since there is no basis for rational expectations in uncertainty, we must create an image of the future, and we cannot do so without assuming that the future will be somewhat like the past, even though the need for decision arises from the belief that it will be somewhat different from the past (Knight 1921: 313). Imagination requires an anchor.
* Knight repeatedly identified the risk-uncertainty distinction with that between objective and subjective probabilities
* Even when insisting on the inapplicability of objective probabilities in situations of uncertainty, Knight made it clear that he saw agents as always having subjective probabilities, which - confusingly - have the same *form* as a probability statement. Since subjective probabilities are always formed, the distinction between risk and uncertainty has to do with the existence or nonexistence of objective probabilities, not subjective probabilities

* A priori vs. statistical uncertainty:
	+ The practical difference between a priori and statistical probability seems to depend upon the accuracy of classification of the instances grouped together. In the case of the die, the successive throws are held to he "alike" in a degree and a sense which cannot be predicated of the different buildings exposed to fire hazard. There is, of course, a constant effort on the part of the actuary to make his classifications more exact, dividing groups into subgroups to secure the greatest possible homogeneity. Yet we can hardly conceive this process being carried so far as to make applicable the idea of real probability in a particular instance.
	+ Risk exists where the outcomes can be measured by a priori or statistical probability methods (i.e. the distribution of outcomes is known) and uncertainty holds where they cannot (because no group of instances can be formed - situations are highly unique)
	+ Statistics give but a probability as to what the true probability is
	+ A priori probability: "chances" can be computed on general principles
	+ Statistics: probability can only be determined empirically
	+ This contrasts to Venn and Edgeworth who reduce the a priori to the statistical on the basis of an empirical law of large numbers and accept practically the assumption of real indeterminateness
	+ The difference between the two relates to the accuracy of classification because instances/throws in the a priori form a homogeneous group in a higher sense than can be predicated from the statistical
	+ The possibility of prediction seems to rest upon the uniformity of nature.
	+ Contrast between knowledge as the scientist and the logician of science uses the term and the convictions or opinions upon which conduct is based outside of laboratory experiments
* The liability of opinion or estimate to error must be radically distinguished from probability or chance of either type, for there is no possibility of forming in any way groups of instances of sufficient homogeneity to make possible a quantitative determination of true probability.

* **A priori uncertainty**
	+ Absolutely homogeneous classification of instances completely identical except for really indeterminate factors. This judgment of probability is on the same logical plane as the propositions of mathematics (ultimately inductions from experience)
	+ You don't need to confirm this type with statistical experiments. Throwing the perfect dice hundreds of times is irrelevant for this. The mathematician can easily calculate the probability that any proposed distribution of results will come out of any given number of throws, and no finite number would give certainty as to the probable distribution.

* **Statistical**
	+ Empirical evaluation of the frequency of association between predicates (i.e. empirical generalization), not analyzable into varying combinations of equally probable alternatives. However, any high degree of confidence that the proportions found in the past will hold in the future is still based on an a priori judgment of indeterminateness (and it is impossible to eliminate all factors not really indeterminate). The main distinguishing characteristic of this type is that it rests on an empirical classification of instances
	+ Calculation is impossible and the result is reached by the empirical method of applying statistics to actual instances.
	+ Outcomes are unique and probability can be an estimate: the difficulty facing businesses is to determine when their probability calculations are an estimate and when they are not
	+ Statistical probability uses the empirical tests of frequency to establish probabilities that are then assumed to hold in the future.

* **Estimates**
	+ The distinction here is that there is no valid basis of any kind for classifying instances.

#### Bayesian stats

* Bayes stood traditional probability theory on its head by arguing from observed events to the probability of their causes
* For Bayesians, the objective of statistics is to enable individuals to make decisions with incomplete and uncertain information, and human judgment is a necessary condition of that objective
* Inverse method of probability: from the known character of certain events we may argue backwards to teh probability of a certain law governing those events
* Even though the starting point might be different (i.e. subjective) in the Bayesian approach, as new information is incorporated, the different views will converge
	+ If you initially flip the coin and get a couple of heads, the chance of heads is slightly higher but this perception of bias in the coin will only be temporary as further flips would change the probability
	+ The starting point is not as critical as frequentists suppose and is subjective anyways, including the belief that coins are usually fair. What matters is that the information gathered be objective and is analyzed in an objective way. Incomplete information means there is never a final judgment but only continuous revision of the initial subjective estimate

### Dealing with uncertainty

* Through insurance, diffused shareholding (diversification, conglomeration), or specialized speculation
* In so far as ignorance of the future is due to practical indeterminateness in nature itself we can only appeal to the law of large numbers to distribute the losses, and make them calculable, not to reduce them in amount, and this is only possible in so far as the contingencies to be dealt with admit of assimilation into homogeneous groups; i.e., in so far as they repeat themselves.
* Dealing with uncertainty and risk often means dealing with asymmetric information, limited information about borrowers → think of German capitalism where banks hold sometimes controlling shares, in the companies that borrow from them. This eliminates differences between the bank and the borrower over the credit-worthiness of the borrower by making the bank a co-manager of the company borrowing from it.
* Only over a period of time working with a client can a bank or financial institution **acquire reliable information** about that client’s creditworthiness
* **Rationing credit** is the banks’ way of limiting their commitment of funds to activities whose true risk is unknown
	+ Customers are selected according to the evaluation by the bank of the future profitability of the business or, secondarily, the liquidity of the assets it can offer as collateral. Moreover, the disposition to expand or contract credit depends on expectations about the performance of the whole economy.
	+ In the boom, financial institutions in such a context play their role of supporting this greater ambition of the private sector by expanding the supply of credit.
* Credit is frequently rationed **using collateral** values or the borrower’s liquidity as proxies for the ‘riskiness’ of the loan
	+ Uncertainty about future prospective yields may erode the safety margins, causing a contraction in the supply of loans. Banks, then, in order to avoid a devaluation of the market value of their assets, will try to recover their position, and a way of doing this is by refusing to provide new loans, either absolutely or, more likely, in relative terms, raising interest rates of safety margins requirements
* Establish routines because successful change requires a substantial element of predictability, the principal source of which, as Schumpeter recognized, is the prevalence of routine behaviour. Our cognitive limitations cause us to rely on our own routines to provide space for thinking, and other people’s routines to provide an empirical context for our thoughts.
	+ Keynes: when we do not know what to do we tend to follow the lead of others who we believe are better informed. Our readiness to accept guidance, and even instruction, from others is necessary to operate successfully in a complex modern society, and it is driven by emotion rather than by rational choice

#### Insurance

* Measurability depends on the possibility of assimilating a given situation to a group of similars and finding the proportions of the members of the group which may be expected to exhibit the various possible outcomes. The classification will be of all degrees of precision (i.e. might be of the *a priori* kind), but the asertainment of proportions must be empirical.
* Insurers must not only compute the premia by predicting losses accurately but also calculate even more exactly so as to be able to present that the premium is adequate for the insured party's real probability of loss, i.e., that he is bearing his fair share of the burden
* Contrast the near mathematical case of life insurance with the accident/fire insurance case
* At best there is a large field for the exercise of "judgment" even after literally thousands of classes of risks have been more or less accurately defined. The mere fact that judgment is being exercised in regard to the situations forms a fairly valid basis for assimilating them into groups
* On account of the "moral hazard" and practical difficulties, it is necessary to restrict the amount of insurance to the "direct loss or damage" → large margin of uncertainty remains because of impossibility of objectively homogeneous groupings and accurate measurement of the chance of loss → chance for profit
* The probabilities in the case of fire are, of course, complicated by the fact that risks are not entirely independent. A fire once started is likely to spread and there is a tendency for losses to occur in groups.
* Thus, the typical uninsurable (because unmeasurable and this because unclassifiable) business risk relates to the exercise of judgment in the making of decisions by the business man; second, although such estimates do tend to fall into groups within which fluctuations cancel out and hence to approach constancy and measurability, this happens only after the fact and, especially in view of the brevity of a man's active life, can only to a limited extent be made the basis of prediction. And classifications are problematic if not done by the person herself because of moral harard (which falls away with the corporation)
* The insurer's smaller risk compared to self-insured entrepreneurs is only due to assuming large numbers and not because he knows more about the venture

#### Conglomerization

* The individual entrepreneur simply bears to much risk for investors so that he cannot acquire the sufficient resources. Next, in the partnership, it's the problem of moral hazard that pushes for the corporate organizational form of business
* Corporations *reduce* and do not merely transfer risk according to Knight (whereas limited liability transfers losses simply from owners to creditors)
* Deal with uncertainty by consolidation such as through insurance or through the corporation → eliminate uncertainty by dealing with groups of cases instead of individual cases
* Knight's argument for the role of leverage: In so far as a single business man, by borrowing capital or otherwise, can extend the scope of his exercise of judgment over a greater number of decisions or estimates, there is a greater probability that bad guesses will be offset by good ones and that a degree of constancy and dependability in the total results will be achieved
* The reduction of risk to borrowed capital is the principal desideratum leading to the displacement of individual enterprise by the partnership and the substitution of corporate organization for the partnership - Conglomerates as better because of 1) extension of the scope of operations to include a larger number cases/instances/ventures and 2) more effective unification of interest
* Diffusion effect: the minute divisibility of ownership and tradeability of shares also facilitates risk-bearing from investors point of view
* As Marshall puts forward, a firm is a form of organisation that aids knowledge, that is, firms provide the institutional framework and co-ordination needed for ‘the generation and testing of new conjectures’. Firms thus undertake knowledge-creating activities, which are the underpinning of economic growth

#### Specialization

* Reducing uncertainty through spezialization of uncertainty-bearing: its conversion into a measured risk or elimination by grouping which is implied in the very fact of specialization. The typical illustration to show the advantage of organized speculation to business at large is the use of the hedging contract -eliminates the chance of loss or gain due to changes in the value of materials used in his operations during time of production, shifting risk to speculator
* Specialization implies concentration, and concentration involves consolidation; and no matter how heterogeneous the "cases" the gains and losses neutralize each other in the aggregate to an extent increasing as the number of cases thrown together is larger.
* Specialization itself is primarily an application of the insurance principle but helps because
* Venture capitalists (who withdraw as soon as regular business kicks in). The gain from arrangements of this sort arises largely from the consolidation of uncertainties, their conversion by grouping into measured risks which are for the group of cases not uncertainties at all. The venture capitalist does not "expect" to have his "expectations" verified by the results in every case; the expectations on which he really counts are based on an average, on an estimate of the long-run value of his estimates

## Debt deflation

* Generally speaking: overborrowing during the expansion → changes in the purchasing power of money that this expansion causes → collapse in credit → drop in price level; "the causes of all great depressions appear to be over-indebtedness to start with and deflation following soon after", with the rest as symptoms

### General and other background

* What should you add to your portfolio to hedge against inflation (apart from inflation-indexed bonds): hold company shares - if prices rise in the economy, company's sales are increasing
* Companies Act allowed limited liability much more easily
* Hilferding/Lenin: Classic capitalism financed with short-term debt whereas modern capitalist firms finance with long-term debt/equity
* Hilferding: the debt deflation effect pertains to SME, while some firms make profit through both boom and bust
* In the 19th century, the short-term financing was used for investment, whereas the kind of short-term borrowing in recent decades is used for long-term securities (borrow with bills to buy securities)
* Up to 1860s, when you had a crisis, it would be a bank credit squeeze since in the boom people were paying with coins/notes and this was driving down the banks' reserves. First, they would try to counter this by raising interest rates, which brought companies into a crisis (they'd stop producing and focus on repayment) - firms were faced with a maturity mismatch
* One effect of either a decline in prices or a decline in inflation is to transfer wealth from debtors to creditors
* The extent to which debtors' spending fell owing to lower real wealth would be balanced by increased spending on the part of creditors. Tobin, however, argued that debtors would be more likely to spend than creditors, and thus the Fisher effect would be stronger than the Pigou effect (whereby a rise in real balances of wealth due to deflation boosts consumption)
* When nominal prices and wages arc deflated, debt service is a higher proportion of debtors' incomes, and the reduction or elimination of their margins of equity disqualifies them from funher access to credit.
* Veblen's credit cycle theory===
	+ Theory of class: the non-productive classes live on the legal claims to the produce
	+ Capitalism changes by the type of money it uses. Commodity money facilitates barter, paper money facilitates a broader money circulation, credit money
	+ Firm issuing long-term bonds have a competitive advantage - expected future earnings feeds the boom
	+ Stock market crash 1907 (Knickerbocker crisis): JP Morgan runs out of gold reserves - Fed is set up in 1913
	+ In the run-up to the 1929 crisis, brokers (financed with commercial loans) were buying stocks to keep up prices until the Fed raised interest rates
* Keynesian (if the private debt decreases, public debt should increase (fiscal stimulus to offset private sector deflation)) vs. Monetarist (let the CB buy up bonds (simply make banks more liquid while not preventing the private non-bank sector from deleveraging))
* According to Bernanke, a small decline in the price level simply reallocates wealth from debtors to creditors without doing damage to the economy. But when the deflation is severe falling asset prices along with debtor bankruptcies lead to a decline in the nominal value of assets on bank balance sheets. Banks will react by tightening their credit conditions, that in turn leads to a credit crunch which does serious harm to the economy. A credit crunch lowers investment and consumption and results in declining aggregate demand which additionally contributes to the deflationary spiral.

### Fisher's debt deflation

* There are no regular business cycles because the economy is constantly in flux

#### Role of high debt

* In a credit system, if you lower your prices (in order to realize your glut of commodities in the recession), the real value of debt rises - firms focus on repayment of debt.
* Ignoring the foreign component, or looking at the world as a whole, the overall level of debt makes no difference to aggregate net worth—one person’s liability is another person’s asset. It follows that the level of debt matters only if the distribution of that debt matters, if highly indebted players face different constraints from players with low debt → this was the counterargument to Fisher at the time and the reason for his being marginalized, pure re-distributions should have no significant macroeconomic effects
* → Eggertson & Krugman, 2012: Debt overhang à la Richard Koo's 'Balance sheet recession' - firms use borrowed money to pay off debt; Richard Koo (2008) has long argued that both Japan’s ‘‘lost decade’’ and the Great Depression were essentially caused by balance sheet distress, with large parts of the economy unable to spend thanks to excessive debt. Eggertson & Krugman recommend temporary rise in government spending, arguing it will not crowd out private spending, it will lead to increased spending on the part of liquidity-constrained debtors (who are debt-constrained, i.e. Ricardian Equivalence broke down)
* For Fisher, credit cycles are not caused by the autonomous operations of the credit system, but by the limited outlook and perceptions of borrowers and lenders. This causes them to make future financial commitments without knowing what the future price level will be, with the result that the real value of debts can change. Such changes then cause fluctuations in investment as well as redistributing wealth between borrowers and lenders → such cycles can occur due to various variables, but crises are caused by the interaction between debt and the purchasing power of the

monetary unit

#### Role of high leverage

* During the Crash of 1929 preceding the Great Depression, margin requirements were only 10%. Banks began to fail as debtors defaulted on debt and depositors attempted to withdraw their deposits en masse, triggering multiple bank runs. Government guarantees and Federal Reserve banking regulations to prevent such panics were ineffective or not used. Bank failures led to the loss of billions of dollars in assets. Bank failures snowballed as desperate bankers called in loans which the borrowers did not have time or money to repay
* Outstanding debts became heavier, because prices and incomes fell by 20–50% but the debts remained at the same dollar amount. Debt deflation turned a 1930 recession into a 1933 great depression.

#### Role of (changes in PP of) money

* Repayment of debt means you give your deposit back to the bank. The bank cancels the debt

#### Deflation process

* In the Great Depression, the **liquidation of debt could not keep up with the fall of prices which it caused - liquidation defeats itself**
* Debts are fixed in nominal terms. Thus, when prices fall, so does the nominal income of firms for a given output level (which is not a problem becuase wages and other input costs are presumably also falling - but not debt service costs). Deflation is more dangerous, the more indebted the firm/economy
* Deleveraging shock affects output instead of, or as well as, prices.
* 'Displacements' cause a change in expectations of future profit (e.g. new technology)
* Greenspan warned that the yield curve inverts: costs of borrowing for long-term fell below the short-term interest

#### Price systems

* Relationship between 2 price systems can move the economy into a sustained boom/recession
	+ Prices of current production & exchange (prices equilibrate supply/demand)
	+ Prices of credit transactions with future financial commitments/claims (i.e. the yield curve - what are the financial commitments you have to make to get a certain type of borrowing)
* Price adjustments between systems: if credit shrinks, prices in the first system fall - the ratio between the two systems stays the same
* Fisher: Price determined by MS (including bank deposit money) - i.e. repayment shrinks MS, causing price fall. As prices fall, the more firms try to pay off debt, the more the real value of debt increases (Minsky's 'swelling dollar')

## Theory of interest

* Generally, nominal interest rates have to increase more than expected inflation for the real interest rates to go up
* Gross debt payments settled by net payments: giro system. In the case of Berlin banks, they wouldn't even settle/clear their balances but simply transfer them to the next day
* In the money theory of credit, velocity of money accelerated through credit
* The rate of profit is not a corridor for the rate of interest because we are in an economy of mutually indebteded agents
* The precondition for being an entrepreneur is not innovative ideas or MoP but having money capital (i.e. holding money claims on other capitalists through the financial markets)
* Liabilities management: banks filling up their deposits by borrowing them from other banks (interbank market) - distinguish this from asset management (mainstream savings as deposits theory)
* Up to the 1930s, assumed that there is a monetary business cycle - lower i to induce firms to invest. When the UK dropped the gold standard in 1931, they lowered i but without effect, then came Keynes
* Current monetary policy considers the rate of interest to be a key variable in determining the equality of saving and investment.
* Nominal interest rates rise and fall with prices (and not inversely, as is assumed by the monetary policy consensus today).
* An individual can save more, but not the entire economy since national income is determined by expenditure
	+ China: investment is done by the public sector through loans, which are matched by deposits of private sector companies - savings are driven by companies depositing in banks - fostering the development of a shadow banking sector;
* Real vs. monetary theory of the determination of interest rates:
	+ In real analysis it is presumed that the functioning of the economy can be sufficiently well understood in terms of real factors; money is simply a veil
	+ Monetary analysis focuses instead on the money flows that are the counterpart of all exchanges. “Money prices, money incomes, and saving and investment decisions bearing upon these money incomes… acquire a life and an importance of their own, and it has to be recognized that essential features of the capitalist process may depend upon the ‘veil’ and that the ‘face behind it’ is incomplete without it”
		- Monetary analysis comes alive in disequilibrium, when the market and natural rates (which is always in EQ) differ. In this analysis, when the market rate is below the natural rate, banks create additional credit, thereby adding to the money stock, in order to meet the additional investment demand (the “cumulative process”). If goods prices are fully flexible and output cannot expand, prices rise and “crowd out” household consumption, ie they generate disequilibrium → the balance between ex ante saving and investment is best thought of as affecting the natural, not the market, interest rate
		- Through the creation of deposits associated with credit expansion, banks can grant nominal purchasing power without reducing it for other agents in the economy (financial intermediaries do not just allocate real resources but generate purchasing power ex nihilo). The banking system can both expand total nominal purchasing power and allocate it at terms different from those associated with full-employment saving-investment equilibrium. In the process, the system is able to stabilise interest rates at an arbitrary level. The quantity of credit adjusts to accommodate the demand at the prevailing interest rate.
		- Critically, the existence of a demand for banks’ reserves, arising from the need to settle transactions, is essential for the central bank to be able to set interest rates, by exploiting its monopoly over their supply

### Classical theory of interest

* The classical theory of money applies to a very particular capitalist economy in which the monetary sector or banking are external to capitalist production
* Classical theory of interest:
	+ The rate of interest is governed by the return on investment undertaken using borrowed funds: a rate of interest higher than this would find no demand for loans, because no capitalist would be able to earn a profit from new investment
	+ The rate of interest determines the level of production, employment and investment because that rate marks the limit to which production and investment can profitably be pushed by profit-maximising capitalists.
	+ Shaikh: The loan interest rate directly regulates capitalist accumulation through its role as the benchmark against which the general rate of profit can be measured
* In the classical theory of interest, changes in the rate of interest are neutral with respect to income (determined by the real resources available for production and exchange), but non-neutral with respect to expenditure (affecting allocation of those resources between consumption and saving, and hence the volume of investment)
* In Ricardo and Shaikh, capitalists carry on investing in the real economy because they cannot earn any money on their bank deposits and other financial assets.
* Kalecki: A rise/fall in the rate of interest increases/decreases gross income, but does not change the overall composition of consumption or investment (i.e. non-neutral with respect to the effects on income, but neutral as regards expenditure)
* Toporowski: However, when credit is endogenous to capitalist production, the rate of interest is no longer governed by the rate of profit in the real economy, and the rate of profit of the banking sector does not depend on the actual rate of interest. In the modern capitalist economy, debt and interest have the function of redistributing income, but are unrelated to the rate of profit from production
* A key implication of the classic theory of interest is that all debt involves a transfer out of the (productive) economy.
* The problem with taking gross debt as the indicator of financial stress is that it does not distinguish situations of genuine financial stress, where households face rising debt payments without any increase in income or liquid assets, from situations where debt increases, but is hedged with liquid assets, so that the drain on income is just the margin between income from those assets and the cost of the debt.

### Loanable funds theory

* Articulated by Wicksell 1898: The basic idea here is that market interest rates are determined in the market for loanable funds, or credit more generally, where demanders of funds interact with providers of funds (financing). That is, the market rate is fundamentally a monetary phenomenon. But when the economy is in full equilibrium, the market rate coincides with the natural rate, which is fundamentally a real phenomenon, equating ex ante saving and ex ante investment at full employment
	+ In full equilibrium, the goods market and the credit market clear at full employment without price pressures. With investment demand being driven by the marginal product of capital and saving governed by households’ rate of time preference, it is possible to characterise investment and saving as functions of the real interest rate
	+ Wicksell: Wicksel held firmly to the basic 'real' analysis tenet that the rate of interest for money was not an independent force in the economy; In essence, the natural rate determines the money rate, which in turn determines the quantity of money (both cash and credit-money). But this hypothetical causal sequence is based entirely on the axioms of the theory of the 'real' economy, and is nowhere explained or, more importantly, described empirically. 'The money rate of interest ... is always tending to coincide with an ever changing natural rate'
	+ For Wicksell, the money rate of interest was a direct function the capacity of productive capital
* Rate of interest assumed to be inversely related to rate of investment (cost of finance, opportunity cost of investment) leading to
	+ Loanable funds theory of interest (Hayek, Schumpeter, Robertson etc.): supply of loanable funds comes from savings; demand for loanable funds comes from demand for investment. In PK, S (savings) does not represent the stock of loanable funds; the latter is a multiple of the former because bank loans create money

### Other theories of interest

* Marx's claim on surplus value
* Marshall: interest payable only on liquid capital (i.e. money)
* Ricardian theory of interest: i is determined by rate of profit; independent of MS
* Marx: interest rate equalizes rates of profit
* New Classical view (Lucas): loanable funds + rate of discount for future consumption in intertemporal optimisation
* In neo-classical theory, following Marshall, it is the rate of interest that causes capitalists to invest and vary production so that the marginal productivity of capital is brought into line with that rate of interest
* Liquidity theory of interest:
	+ In Keynes’ (and Post Keynesian) analysis, the fact of uncertainty changes the mechanism by which interest rates are determined
	+ In a world where the future is unknown, agents’ insatiable demand is for wealth (goods, services, and assets) and not just goods and services.
	+ Keynes referred to the bond rate of interest as the long-term i (determined by the bond market), and insisted that the long-term rate matters most
	+ Keynes emphasized the differences between the short-term rate of interest which is controlled, more or less, by the central bank, and the long-term rate of interest which is determined in the bond market
	+ The volume of savings does not respond to interest rate movements. What interest does do is determine the manner in which savings are held. Interest is inversely affected by the supply of liquidity, a supply that is partly exogenous (as governed by the central monetary authority) but largely endogenous
	+ Keynes: long-term interest rate is determined in secondary long-term bond market
	+ Keynes: credit cycles associated with I≠S. The balance between I and S is mediated by the interest rate
	+ What determines i is the (financial market) demand for money (as a hedge) and not any equilibrium between I and S
	+ Keynes: you cannot know the real return on assets, hence expectations count; Marginal Efficiency of Capital = expected return - i
	+ Keynes: “the predominant explanation of the crisis is, not primarily a rise in the rate of interest, but a sudden collapse in the marginal efficiency of capital”
	+ Speculative demand for money: buying bonds when they are cheap (corporate bond prices are high because CB have been buying them); the demand for money from holders of financial portfolios who will postpone buying bonds (and therefore hold more money) if they expect that long-term rate of interest to rise
	+ For Keynes, it is the long-term rather than the short-term rate of interest that, along with the ‘state of long-term expectations’, determines the level of investment.
* Hicks/Tobin monetary teory of interests: ;risk refers to the change of the money value of bonds

### Liquidity trap

* Liquidity trap: short-term nominal interest rate is at or near zero, causing a liquidity trap and limiting the capacity that the central bank has to stimulate economic growth
* Although the original idea of helicopter money describes CBs making payments directly to individuals, economists have used the term 'helicopter money' to refer to a wide range of different policy ideas, including the 'permanent' monetization of budget deficits – with the additional element of attempting to shock beliefs about future inflation or nominal GDP growth, in order to change expectations. Typically, helicopter drops have been interpreted as involving the central bank directly financing the budget deficit
* Falling asset prices leading to a negative return on real assets
* Current view of liquidity trap: falling value of consumer goods leads to positive real interest rates since the nominal i stays at 0

### Long & short-term interest rates

* Determination of long-term interest rate: in the (state & company) bond market; savings availability poses some limit; inflation and growth expectations
	+ Keynes: uncertainty and expectations can prevent the LT-rate from going down (and hence open market operations should be used to bring it down); determined in the credit market

* Determination of short-term interest rate: in the money market, i.e. by banks' short-term lending; liquidity needs of firms and the state; less limited because of money creation
	+ Kalecki: the short-term rate of interest is determined by the volume of transactions and the supply of cash by the banking system

* Effects of long-term rate: high LT-rates lead to underinvestment
* Effects of short-term rate
* The difference between ST & LT determination:
	+ Itoh & Lapavitsas: Yield of fixed income bonds is determined along the same lines as the total yield of shares, and incorporates the expectation of future bond price changes. The important difference with shares is that future interest payments on bonds are known with certainty whereas dividend payments are uncertain. The extent of difference between LT & ST rates of interest, however, cannot be theoretically determined a priori, and depends on the concrete historical and social circumstances of the country in question. The difference could also be reversed in favour of short-term rates during particularly critical phases of economic fluctuation; ceteris paribus, a rise in the money market interest rate leads to a fall in bond and share prices; the opposite holds for a fall
	+ Minsky: rising short- and long-term interest rates have opposite effects on the demand price for capital assets and the supply price of investment. The demand price for capital assets falls as long-term interest rates increase, and the supply price of investment output rises as short-term interest rates rise. This tends to lower the price gap that induces investment demand. If the rise in interest rates is extreme, the present value of the investment good as a capital asset can fall below the supply price of the investment good as current output. Such a present value reversal, if it occurs, will bring investment activity to a halt.
	+ Kalecki: the stimulus to keep bonds is the margin between the present long-term rate and the anticipated average short-term rate over a long period - if I expect the short-term rate to be (on average) = to the long-term rate, why should I buy bonds? Thus, the LT-rate must be > than the **expected** average of the ST rates. If I expect ST to be high for the foreseeable future, this will bring down LT bond prices

## Speculation and the financial markets

* Two types of return on assets: Income on assets (interest on bonds/dividend on shares) + increase in value
* One of the functions of short-term credit is to make long-term credit liquid
* Financial markets also have the effect of maturity transformation whereby investors such as shareholders and bondholders can sell their shares and bonds in the secondary market (i.e. the larger part of the stock market) at any time without affecting the company that issued the shares or bonds. Thus the company can be a long-term borrower from a market of short-term lenders
* In the GFC, firms tried to climb up the ladder by replacing expensive bank loans with cheaper equity. They got the loans but couldn't replace by equity and also couldn't roll over the debt in the money market. Then they had to do what all companies do when in crisis: cut investment
* Liquidity vs. solvency of companies: in the GFC Lehman was insolvent (liabilities > assets) because capital markets froze (i.e. they couldn't sell the ABSs)
* Prior to the GFC, companies were in debt not for fixed investment but for mergers etc. couldn't refinance their debt into the long-term securities market nor in the money market.
* In fact, consumption didn't fall much in the GFC, it was investment!
* The three attributes of asset demand specified by Keynes – q(yield) – c(carrying cost) + l(liquidity premium)

### Classical theory of speculation

* Speculation as a monetary phenomenon: arising out of the kind of money that was used
* Scotland's deficit vis-a-vis England led to a drain of money. John Law proposes paper money, backed by land.
* Gov sold shares in Mississipe company against gov debt (i.e. cancelling out the debt) - first privatization scheme (gov sells the shares but the money doesn't go into the company but to the gov to pay off the debt)
* Henry Thornton: speculation has sth. to do with the amount/type of money used
* Mill: the problem is paper money (which is unavoidable, though, but should be restricted); mercantile speculation (i.e. commodity speculation); elastic credit is problematic because in a credit system there is no limit to how much credit enters the financial system

### Speculative theory of investment

* Speculative because returns are uncertain (Knight)
* New technology = speculative vs. routine business as non-speculative
	+ Austrian theory of entrepreneurs as bold enough, arguing that it is the entrepreneur who takes the loss, no social loss

### Hedging theory of speculation

* Kaldor: you can't speculate in anything, only durable goods and ideally of inelastic supply
* Gold does not pay you interest (i.e. only price speculation) - it's much simpler to buy shares in a gold mining company, giving you a regular income and you have no carrying costs
* Veblen, MM etc.: Price of stock should be the discounted value of future income
* Holding money as a hedge
* Over-capitalization (issued more capital obligations/shares than justified by profits)
* Toporowski: If you overcapitalize, you don't just have too much capital but the excess are also bank deposits (which are financial assets), i.e. a way to hedge your balance sheet
	+ Google etc. overcapitalize to incorporate parts of the capital market into the company

### Refinancing theory of speculation

* Refinancing: provision of liquidity
* Most long-term securities are not issued for long-term investment but to repay debt
* Equity as a hedge against infation (if prices rise, so do equities)

### Toporowski

* The hallmark of any actual financial crisis is an inability to clear complex transactions between assets and liabilities that were previously settled in a routine way.
* Collateralized lending is vulnerable to asset inflation, leading to lending against prospective capital gains.
* Financial markets typically operate for extended periods of disequilibrium, itself the counterpart of the structural disequilibrium of the real economy that they are accommodating.
* Established companies try not to finance their fixed capital investment from the capital markets, with the notable exception of investments in buildings where the scarcity of land is thought to place a lower limit on the capital losses that may be sustained by a company. In practice,

companies prefer to finance their fixed capital investment out of their reserves (i.e., their accumulated undistributed income) and in Britain some 80 per cent of such investment is financed in this way

* Kalecki’s Principle of Increasing Risk: According to this, the key determinant of a firm’s ability to finance investment and growth is the size and liquidity of its reserves.
* The system whereby capital markets are used to replenish reserves after fixed capital investments have proven themselves suggests a corporate financial structure in which the nominal value of a company’s stocks and shares corresponds more or less to the book value of its fixed capital assets
* Because of the trade cycle, this cash flow fluctuates and therefore, to avoid default on their capital market obligations, fixed capital investment expenditures, together with changes in reserves, have to accommodate changes in cash flow. Even companies financing themselves ‘prudently’ by only re-financing proven fixed capital investments in the capital markets can be over-capitalized as a result of a recession. The degree to which they are embarrassed in this way depends on the ratio of their respective external financing to their own liquid reserves, and the relative fall in sales revenue.

#### Over-capitalization

* As a result of the excess demand for shares, corporations have issued capital in excess of what they need to finance their commercial and industrial operations. In the past, the overcapitalization of companies might have been avoided because it would have involved the ‘watering down’ of profits (sharing a given amount of profits among more shareholders), or loss of control by the directors of a company who could no longer control the majority of shares at a company general meeting. However, today’s shareholders are mostly institutions whose large diversified portfolios are subcontracted to professional fund managers and rated on financial returns, rather than on their interventions in the running of companies. Those financial returns include the appreciation of the value of stocks through financial inflation, a return that is paid by other participants in the market, rather than by the issuer of the securities.
* By and large fund managers have too many diverse holdings to take any other than a financial interest in a company.
* New techniques of senior management remuneration have tended to replace profit-related pay with share- price- related pay, through stock options.
* Excess capital has been used to replace bank borrowing with cheaper long- term capital. Where excess capital has not been used to reduce debt, it has been used to buy short- term financial assets. Alternatively, excess capital is committed to buying and selling companies.

## Minsky

### General outlook

* Role of finance in capitalism
	+ Positions in the existing stock of capital assets need to be financed
	+ Activities, that is, the production and distribution of consumption and investment goods, need to be financed
	+ Payment commitments, as stated on financial contracts, need to be met
* Minsky: Modern capitalism financial entrepreneurship and financial innovation and competition drive economic changes (i.e. leading to explosive business cycles that undermine the conditions necessary for orderly investment and financing decisions). (Protif-led) Financial innovation increases liquidity and hence the capacity of units to over-leverage → financial innovation and competition induce Schumpeterian processes of creation and destruction in financial markets that affect the financial structure of firms and banks, conditional on the initial state of their balance sheets and the monetary and macroeconomic conditions.
* Minsky: US economy has institutionally evolved through five stages of financial relations, flows and arrangements, namely, commercial capitalism, industrial capitalism, financial capitalism, managerial and welfare state capitalism and money manager capitalism
* Minsky’s argument heavily relies on Schumpeter’s insight that economic development requires credit creation (for Schumpeter, since entrepreneurs require credit, credit is a good thing vs. the Fisherian more pessimistic view of debt)
* For Minsky, the major cause of financial fragility and instability is the evolving institutional and structural characteristics of the financial system that change the terms and directions of the flow of liquidity.

### Financial Instability Hypothesis

* Building on Keynes financial theory of investment which also discussed the role of demand prices of capital assets, Minsky argued that Keynes' failure to theorize boom&bust was because he never explained how the liability structures of firms, banks and other financial institutions evolve - the present is linked to the past through these inherited assets and liabilities and to the future through expectations formed under uncertainty
* The FIH recognizes two intertwining features of modern capitalist economies: large, expensive, privately-owned capital assets that require financing to acquire and operate & systems of complex financial institutions and practices that are constantly evolving
* The theoretical core of the FIH is rooted in Minsky's financial theory of investment in an institutional structre that is subject to evolutionary change stemming from the effects of private sector (financial) innovations and from government policies initiated in reactions to previous periods of financial crisis and debt-deflation
* In a nutshell: endogenous financial fragility induced by the speculative financial positions that firms are obliged to take in the face of uncertain future returns
* The FIH studies how the role of finance in investment decisions can translate into business cycles.
* Instability in a capitalist framework comes mainly from the techniques that are used to finance investments and positions in the stock of capital assets. If the capitalist economy is to be investing then the banking mechanism needs finance investment demand even as the pricing system reacts to the financings of such demand by generating an offsetting surplus
* In periods of sanguine optimism, companies may and do issue stock in anticipation of the fruits of their investment. Such financing creates what
* Minsky calls fragile financial structures, in which capital market liabilities are assumed even before the revenue to pay them is secured
* Endogenous explanation of cycles (≠New Keynesian)
* Financial sphere not merely as a propagation mechanism but also as cause
* Hedge projects: The "hedge borrower" can make debt payments (covering interest and principal) from current cash flows from investments.
* Speculative projects: 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
* Ponzi projects: The "Ponzi borrower" 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; Ponzi units rely on their capacity to refinance loans, and/or to liquidate asset positions in order to meet debt commitments
* The switch to ever more debt/risk-taking comes partly to the ex post realization of firms that margins were unnecessarily big.
* The passage from a situation where hedge units dominate to a situation where speculative units dominate occurs because capitalists and bankers are seeking more profit opportunities to be exploited
* An unexpected shortfall of cash, an increase in the interest rate together with a change in the degree of confidence about the future behaviour of business will make speculative units review their desired degree of indebtedness.
* Minsky's financial cycle: increased investment leads to larger current profits, and larger current profits stimulate expectations of higher future profits; these, in turn, will trigger more investment → new investment projects are evaluated on the basis of more optimistic expectations (reducing liquidity preference/liquidity rises endogenously in boom and inducing greater risk-taking → risk-assessment and risk-preference are thus endogenous); there is more investment but also more speculative purchase of assets & borrowing;debt/equity and loan/deposit ratios rise, interest coverage ratios fall, and interest rates rise → an extended economic expansion eventually creates financial fragility → triggers a rise in market interest rates
* Once investment turns down in a financially fragile environment, financial markets accelerate the rate of descent. Lower investment than expected means lower aggregate demand, lower sales, and smaller profits than expected (i.e. as AD growth slows and UE rises, agents discover that their expectations were too optimistic and that security prices are too high relative to expected future cash flows→revise downward); the initial problem is then magnified by multiplier effects → forced fire sales → real investment even less attractive; declining investment and falling financial asset prices can combine to lead to debt deflation through reverse wealth effect; fear of higher default rates will cause interest rates to rise (higher risk aversion) further and credit for riskier agents to be eliminated; eventually even sound assets have to be sold which spreads the crisis across the market
* During the boom, firms are in the hedged position → investment boom; rising profits lead to systemic expectations confidence → boom euphoria; optimistic climate + cheap finance lead to appetite for more risk-taking; illiquidity in the system → interest rates go up, which triggers fire sales of assets (hence, their prices drops) → debt deflation spirals
* A period of prosperity may begin with hedge units being dominant, and so liquidity is plentiful as the asset structure is heavily weighted by money or liquid assets and the quasi-rents yields by current expenditure on capital assets are high. The degree of indebtedness is low, as the debt commitments are low in relation to the expected yields of capital assets. The interest rate structure is such that it encourages investment in fixed assets as ‘short-term interest rates on secure instruments will be significantly lower than the yields from owning capital’
* Monetary policy role: lender of last resort
* For Keynes, expectations follow conventions and norms
* Minsky and post-Keynesian theorists argue that over-optimistic expectations make investors and entrepreneurs commit themselves to excessive financial liabilities. In fact, it is the recession of the business cycle that makes otherwise quite realistic expectations over-optimistic.
* In the FIH, fragile financial structures and instability are created by the change in the composition of capital market liabilities: as the boom proceeds, the ratio of debt to equity is supposed to rise. Minsky’s financial crisis is essentially one of over-indebtedness
* Once over-indebtedness is in place, the ‘internal workings of the banking mechanism or Central Bank action’ will result in a rise in interest rates. Increases in short-term interest rates lead to a rise in long-term interest rates. This leads to a fall in the present value of gross profits → but under the ‘reflux’ principle of profits (which Minsky borrowed from Kalecki), as investment expenditures rise, there should also be a corresponding increase in internal funds, notably in the investment goods sector
	+ In fact, studies of corporate finance data indicate that, when an economic boom provides them with plentiful sales revenue, firms actually reduce their debt financing, and even replace it with equity (common stock) as the stock market flourishes. However, the Hypothesis may still be valid if equity is regarded like debt as a liability of firms. In effect, equity finance is not a substitute for internal finance because it is a capital market liability rather than a liquid asset
	+ In this analysis, as in Kalecki and Steindl, the key financial ratio is companies’ gross gearing (i.e., the ratio of their total capital market and bank liabilities to liquid assets), rather than their net gearing (the ratio of debt to liquid assets)
* Minsky’s Financial Instability Hypothesis only stands up to empirical scrutiny if debt and equity are regarded as liabilities of companies, in contrast to the legal fiction that equity is equivalent to entrepreneur’s capital.
* The realised cash flows of firms and banks and especially their expected and realised profits depend on the expected effective demand and are the centre around which financial fragility revolves
* The distribution of cash flows among firms-which can be viewed as the outcome of a competition among capitals for profits-depends upon the behavior examined in microeconomic analysis, but the macroeconomic state of the economy determines the totality of such cash flows.

### Prices, investment, money & financing

* Modern investment goods are expensive and long- lived, requiring complex financial instruments and relations. Investment-fueled economic growth will at the same time tend to produce growing private debt ratios that increase financial fragility. For this reason, Minsky always argued that government- spending- led growth is more sustainable because it allows private sector spending to grow based on income rather than private debt.
* The liability structures used to finance positions in capital assets reflect subjective views as to the acceptable chance of illiquidity occurring.
* Τhe maturity mismatch between assets and liabilities increases the reliance of organisations on refinancing sources and/or asset liquidation in order to meet debt commitments.
* An increase in liquidity preference, which typically occurs when quasi-rents fail to validate debt structures or financial markets fail to refinance positions, will force attempts to reduce near-term payment commitments relative to expected quasi-rents. This will lead to a fall in the money price of capital assets.
	+ A fall in the value of capital assets of a sufficient degree to overcome normal margins of safety will lead to a decline of confidence in the banks' liabilities, and eventually, to a collapse in their value represented by a bank panic and a collapse of the system (note that we speak here of real capital goods' prices and *financial liability prices*, rather than the price of current output). Which, in fact, occurred in 1932. The policy prescription is, clearly, to avoid the collapse of confidence in banks' liabilities by supporting the prices of capital assets (achieved through turning all bills into money at a very moderate rate of discount, i.e., supporting prices at par, thereby saving the discounters from capital losses, supporting the prices of their assets, and preventing a collapse in the price of their liabilities and a general collapse of confidence
	+ In conditions of crisis we must add another price duality. Above, it was noted that the role of monetary policy in affecting anticipations would have to deal with two separate sets of anticipations-of the public over financial liabilities (addressed in Keynes' liquidity preference), and of entrepreneurs over capital assets (addressed by Keynes' efficiency of capital)
* Credit and money allow to buy (invest) now and pay (produce) later
	+ Money for purchasing (minimizes transaction costs) and market power
	+ Money to avoid risk (speculative demand for money)
	+ The banking system will react to demand for money by supplying it, whenever it shares with borrowers the belief that positions in assets or a particular activity to be financed will generate sufficient future cash flows to repay the debt.
* The notion of position-making plays a fundamental role in Minsky’s system and implies the process that organizations make investment and financing decisions and in particular portfolio transactions to meet balance-sheet commitments.
* Capital development is a process of position-making in real and financial assets, which is structured as dated payment commitments. Position-making operations build leverage structures that in turn create liability structures (quality of which depends on the 3 types of solvency regimes(, which will be validated or repudiated by the subsequent operation of the economy and the flow of liquidity to organisations.

* **Dual price system**: There are really two systems of prices in a capitalist economy-one for current output and the other for capital assets.
	+ Prices for current output: determined by “cost plus mark-up”, set at a level that will generate profits; represents the 'carrier of profits' and the means for validation of debts; determined by investment expenditure (and Big Government expenditure)
	+ Asset prices: assets are expected to generate a stream of income and possibly capital gains; prospective income stream cannot be known with certainty, thus is subject to subjective expectations; Minsky argued that the amount one is willing to pay depends on the amount of external finance required—greater borrowing exposes the buyer to higher risk of insolvency; helps determine the first price set through its impact on investment
* When the price level of capital assets is high relative to the price level of current output, conditions are favorable for investment (i.e. a boom is triggered when the price of capital assets rises relative to the price of investment output); when the price level of capital assets is low relative to the price level of current output, then conditions are not favorable for investment, and a recession-or a depression-is indicated. Business cycles result from a dance of these two price levels, even as the price of a unit of money is fixed at one. One key problem of economic policy is to fix the economy so that the two price levels are such that there is an appropriate amount of investment: this requires that both realized and expected profit flows he high enough so that capital-asset prices exceed the supply prices of investment output (Minsky, 1986; p. 160)
	+ Since the decision to hold capital assets is also a decision concerning their financing, investment represents a decision about both assets and liabilities structures. The values attached to the capital assets have an impact on the value of the liabilities created to acquire them.
* Investment can proceed only if the demand price (which includes margins of safety, which are affected by entrepreneurs' expectations concerning unknowable outcomes) exceeds supply price of capital assets
* The increase in the weight of debt-financing/leverage raises the market price of capital assets. As this happens, the economy is transformed into a boom economy (transforming tranquil growth into speculative excess). The tendency to transform 'doing well' into a speculative investment boom is the basic instability of capitalism (i.e. the fundamental instability of capitalism is upward)
* The endogenous generation of instability is thus built around the linkage between current output prices and the demand for investment and capital goods prices. Expectations of increasing current output prices cause capital asset prices to rise relative to currently prevailing output prices. This, then, leads to an increase in borrowing to fund new investment. The increased borrowing leads to higher interest payments which can only be met if expectations of increased future returns are confirmed. Bankers must share the expectations of the firms if new lending is to be extended. The increased lending is reflected in the firms ' liabilities held as assets by the banking system to support its own liabilities, and acquired to fund the lending. The value of these liabilities also depends on the realization of expectations of future profit flows. A sufficiently large fall in capital asset prices may then have an impact on the value of bank liabilities. Uncertainty over the value of a bank's liabilities, i.e., its ability to meet its payments commitments, is the source of financial panic and crisis
	+ For Minsky, Big Government spending can partially offset the fall in profit flows which results from a fall-off in investment or overoptimistic expectations, and in this way, provides support for consumption goodc; prices. But it cannot directly support the foll in the value of a bank's assets which results from a fall in capital goods prices. This is why Big Government, by itself, is not enough to counter instability. A Big Bank must come in to stabilize the prices of capital assets by indirectly supporting the prices of these assets as they appear on the banks' balance sheets
	+ We thus have the fundamental point of difference between the two approaches: Is monetary policy (the Big Bank) to be assigned to control goods prices (monetarist). or aid fiscal policy to control quantities (neoclassical Keynesian); or should it, instead, be directed to stabilize capital asset prices? If the central bank is to support asset prices and the stability of the financial system in general, then is it clear that it will have to be both discretionary in its action and act as a direct participant in the financial markets where the prices of financial assets found on the banks' balance sheets are determined? Minsky's support of discount policy is an anempt to introduce monetary policy at the beginning, rather than at the end, of the process which determines capital asset prices, i.e., at the moment when banks and firms evaluate the future profitability of investment in drawing up lending agreements
* Any drop in the value of real capital assets relative to the price level of current output and money may induce changes in portfolio preferences that will reduce new positions in real assets and increase positions in portfolio and balance-sheet transactions
* To understand how coherence normally rules in a capitalist economy and why it sometimes breaks down, prices cannot be treated as though their only function is to allocate resources and distribute income
* Minsky’s fundamental criticism of Keynes was that Keynes did not take into account the price of capital assets in determining the demand for them. Minsky suggested that this should be done by calculating the present value future expected yields, or cash flows, using the current money market rate of interest to discount future incomes and costs.

#### Money

* If debts are to banks, then the payments which fulfill commitments on debts destroy "money." In a normally functioning capitalist economy, in which money is mainly debts to banks, money is constantly being created and destroyed
* Expected profits induce debt creation and the realized profits that lead to the validation of debt.

### Policy, regulation & intervention

* The CB can intervene through the discount window or/and open market operations.
	+ As the Federal Reserve was originally conceived and as it originally operated the discount window was a major source of bank reserves. Until the Great Depression of the 1930's the borrowings by member banks at the discount window were the source of a large proportion of nominal functioning bank reserves. From the Great Depression onwards, the discount window has ceased to be a normal functioning source of bank reserves. The normal Federal Reserve asset is now Treasury Securities and the Federal Reserve operates on bank reserves by buying and selling Treasury Securities on the open market. Open market operations central banking tends to emphasize the quantity of bank financing and thus the quantity of money, whereas discount window central banking tends to emphasize the terms upon which financing is available to the units of the economy.
	+ The fact that Minsky preferred the discount window is linked to his emphasis on the way in which financial prices are determined
	+ Note the following: "When the Federal Reserve acquires assets as a result of financing some activity, then the banking system acquires reserves or the public acquires currency. If the Federal Reserve mainly acquires Treasury debt, as it does when open-market operations are the source of bank reserves, it abets the financing of government activities. But when the Federal Reserve cquires private business debts through the discount window, it is mainly cofinancing business" (Minsky, 1986; p. 358). → This would situate the CB at the interface between firms' anticipations of future profits and banks' anticipations of ability to pay interest; the point at which the price of capital assets is determined. It would thus be directly influencing the process of determination of assets prices, and, thereby, investment expenditures. If we accept the "two level/two price" theory explanation, Minsky's proposal is that BG, as the sustainer of the overall level of investment and of current output prices, be joined by the BB, which is capable of supporting investment via the effect of its discounting policy on the price of capital assets
* In a complex and evolving financial structure, evolutionary central banking requires a ‘cash-flow’–based bank examination approach to detect Ponzi finance so as to continuously assess the creditworthiness, the credit risk and the margins of safety of organisations in terms of the quality of their balance sheets and debt commitments → such an approach views liquidity not as an innate attribute of an asset but as ‘a time related characteristic of an ongoing, continuing economic institution’
	+ The ‘cash-flow’ examination approach puts the distinction between position-making operations that are collateral based and income based at the epicentre of evolutionary central banking → evolutionary central banking must evaluate the cash flows that indebted organisations use to repay debts rather than their ability to repay per se
* Monetary policy could alleviate through LOLR and by lowering IR in the crisis - By reducing the servicing costs of corporate financial liabilities, lower interest rates could convert Ponzi financing structures into merely speculative ones, and speculative financing structures into hedge financing
* Minsky argued that macroeconomic policies should target full employment rather than growth. The distinction between growth and full employment is vital from the point of view of position-making operations that are collateral based or income based. Economic growth could be the result of collateralbased Ponzi finance. On the other hand, full employment can be achieved only as the result of position-making in real assets that is income based.
* In Minsky's system, a stable monetary and financial system that accommodates the funds that are needed for a full employment capital development must be the overriding objective of the central banks’ monetary policy → monetary policy must sustain flows of liquidity between the financial sector and the ‘real’ sector that would in turn sustain the level of the effective demand that promotes full employment with price stability.
* Evolutionary central banking can effectively manage financial fragility if the discount window is the major source of liquidity and of banks’ reserves
* Evolutionary central banking assumes discount window interventions before the collapse of market asset values so as to avoid serious depression and debt deflation.
* Central banking is effective in making a capitalist economy work better to the extent that it prevents both run away investment booms and inflations and deep debt deflations and depressions.

### Problems in Minsky

* The financial booms at the end of the twentieth century were characterised more by equity than debt finance, and even featured the issue of equity to pay off debt. From an orthodox finance point of view, such equity finance stabilises corporate cash flows because dividend payments are, in theory at least, at the discretion of the company. However, in fact with the financial booms of the last decades of the twentieth century, companies were increasingly using their equity capital to take speculative positions in the financial markets that required further refinancing to be profitable
* Wolfson proposes that a ‘surprise event’ precipitates financial crisis (a ‘surprise default’ by a major borrower, or a sudden tightening of credit by financial regulators, that exposes financial fragility in the system). He also invokes involuntary investment (i.e. investment projects that have already been started and need additional external financing in the future to complete) as a crucial mechanism for transmitting financial crisis to the economy at large. Because it involves expenditure without any immediate and corresponding sales revenue. The financing needs

of investment projects begun in an earlier period mean that, through investment, businesses submit themselves to financial risk.