Tag Archives: stock flow coherent models

RIP, Lance Taylor

Lance Taylor has passed away.

Among other things, he promoted stock-flow consistent modeling. He had a book Reconstructing Macroeconomics.

I hold dear the review of Lance Taylor of Wynne Godley’s work, titled: A Foxy Hedgehog: Wynne Godley And Macroeconomic Modelling.

The article starts:

The fox knows many things, but the hedgehog knows one big thing (Archilochus, seventh century BCE).

Lance Taylor clearly understood the importance of accounting. In the paper A Simple Model Of Three Economies With Two Currencies, Wynne Godley and Marc Lavoie quote him:

As pointed out by Taylor (2004, p. 206), ‘the best way to attack a problem in economics is to make sure the accounting is right’.

Bibliography

Taylor, L. 2004. Exchange rate interderminacy in portfolio balance, Mundell–Fleming and
uncovered interest rate parity models, Cambridge Journal of Economics, vol. 28, no. 2, 205–27

Here’s the link to that Lance Taylor paper.

OECD’s ‘Understanding Financial Accounts’ On The Importance Of Stock-Flow Coherent Models

International organisations such as the UN, IMF, OECD etc., publish some good guides on national accounts and the flow of funds. I just noticed that the 2017 edition of OECD’s book ‘Understanding Financial Accounts’ has a section in appreciation of stock-flow coherent (SFC) models with a history starting with the work of Morris Copeland.

From page 407-409:

  1. Uses of financial accounts and balance sheets in economic research

Financial accounts were first modelled by Morris A. Copeland …

The fall of financial accounts and balance sheets and the work of Godley

In the 1960s and the 1970s financial accounts were at the centre of economic analysis. From the mid-1980s until the 2007-09 economic and financial crisis, interest in financial accounts and balance sheets more or less vanished, for a number of reasons: a growing focus on the micro-economic foundations of macroeconomics; the increasing role of monetary and credit aggregates for the conduct of monetary policy that implied a lower focus on the entire financial system; trust in the self-correcting market mechanism through price adjustments, while considering quantities – both flows and stocks – less important; the rational expectation critique of Keynesian models; a growing inclination among economists to separate monetary and real phenomena; and the problems of achieving full international harmonisation of statistics until the introduction of the 1993 System of National Accounts (SNA93).

In contrast, Wynne Godley never abandoned the idea that economic models should be founded on flows and stocks, and developed consistent models of the US economy and other countries. In his approach, modern economies have an institutional structure comprising (non-financial) enterprises, banks, governments and households. The evolution of economies through time is dependent on the way these agents take decisions and interact with one another (Godley and Lavoie [2007]) …

References

Godley, W. and M. Lavoie (2007), Monetary Economics: An Integrated Approach to Money, Credit, Income, Production and Wealth, Palgrave MacMillan, Basingstoke.

Appreciation Of Wynne Godley’s Work In Adam Tooze’s Crashed And Its Reviews

Adam Tooze’s book Crashed seems popular. The book and two reviews have some good appreciation of Wynne Godley’s work used in the book to explain why the crisis happened. The two reviews, both published in New Left Review:

  1. In The Crisis Cockpit, by Cédric Durand,
  2. Situationism À L’envers? by Perry Anderson.


In the acknowledgments section of his book Adam Tooze writes:

Wynne Godley was a mentor and teacher of a very different kind. Spontaneously warm and generous in spirit, he took me under his cape in my first year at King’s and introduced me, and a group of my contemporaries, to what was, at the time, a highly idiosyncratic brand of economics. In so doing he provided a model of intellectual warmth and vitality. He also confirmed doubts that had been gestating in me about the IS-LM model that was my first great love in economics. Wynne introduced me to the importance of looking “beyond the flows” and insisting on stock-flow consistency in macro models. I don’t think this book, written almost thirty years later would have been the same without his early influence.

Cédric Durand says:

What, then, are the conceptual underpinnings of Tooze’s work? In Crashed, none are made explicit. Nevertheless, in his emphasis on balancesheet vulnerabilities he implicitly follows the lead of post-Keynesian research, one of the more creative currents in contemporary economics, deriving from a synthesis of Keynes with a specific form of Marxian macroeconomics pioneered in the 1940s by Michał Kalecki. Tooze appears to draw in part upon the post-Keynesian ‘stock-flow consistency’ model, an approach that seeks to combine the ‘real’ and financial spheres of the economy. The term ‘stockflow’ implies attentiveness to the build-up of vulnerabilities in the ‘stock’ of financial assets and liabilities, beyond the financial ‘flows’ themselves: for example, when a sector’s prolonged deficit results in an unsustainable stock of debt. This approach has become increasingly popular since the crash, and was incorporated in the Bank of England’s policy-making toolkit in 2016. Initially developed by Nicholas Kaldor in the 1940s, the methodology was transformed in the 1960s and 70s by the work of James Tobin and Wynne Godley, Tooze’s teacher at Cambridge. Godley is credited by Tooze here with introducing him to ‘the importance of looking “beyond the flows” and insisting on stock-flow consistency’.

At the heart of this approach is the idea that macroeconomic dynamics hinge on a three-way interaction between the financial balances of public, private and foreign sectors. This ‘three balances’ perspective arguably supplies the unstated backbone of Tooze’s general argument. His achievement is to dress the dryness of this technical skeleton with the dense and complex sensitivity of historical flesh. If this framework were to be made explicit, it would suggest that the adventures of the private-sector balance drove a spectacular upward distribution of wealth that ultimately backfired in the political arena as resurgent nationalism and xenophobia. Public-sector balances were the scene of dramatic deliberations about crisis-containment strategy, with central bankers standing far above the other actors in the hierarchy of policy-making. Finally, the international balance-sheet perspective sheds light on a multipolar world where monetary policy, currency reserves and financial sanctions can be as effective as military force in deciding geopolitical outcomes and national fates.

Tooze’s mentor Wynne Godley observed in 1992 that the establishment of a single currency on the Maastricht model ‘would bring to an end the sovereignty of its component nations’, leaving them with the economic autonomy of ‘a local authority or colony’, while no central government could emerge with sufficient fiscal muscle to take decisive economic action. As a result, in the case of a major macroeconomic shock, the populations of countries deprived of the power to devalue, and not benefiting from a system of fiscal equalization, will see ‘emigration as the only alternative to poverty’. This sounds like an impressive, prescient account of the role of macro-institutional systems—and not just bad policy-making, as Tooze would have it—in the fates the Greek, Portuguese and Spanish people have had to suffer. Political, geopolitical and economic dimensions are structurally intertwined via institutions in the process of crisis making and management. While Tooze perfectly demonstrates the latter, in particular in his magnificent account of the balance-sheet intricacy at the heart of the 2008 crisis, he doesn’t account for the former.

Perry Anderson:

Durand observes, its narrative is no simple—or rather in this case, of course, highly complex and intricate—empirical tracking of the crisis and its outcomes. It possesses definite ‘conceptual underpinnings’, suggested by Tooze himself in acknowledging his debt to Wynne Godley’s use of ‘stock-flow consistency’ modelling of the financial interactions between public, private and foreign sectors. This in Durand’s view supplies ‘the unstated backbone’ of Tooze’s general argument.

Both judgements appear sound. But in Durand’s exposition a paradox attaches to each of them, since by the end of his review, somewhat different notes are struck. For Godley, one of the key advantages of the stock-flow consistency approach was that it integrated the financial with the real economy, as alternative models did not. Durand, however, remarks that Crashed ‘does not discuss the concrete intertwining of the financial and productive sectors in the global economy at all’, and so ‘fails to set the financial crisis in the context of the structural crisis tendencies within contemporary capitalist economies.’ This observation in turn generates another, which might seem to put in question Durand’s overall tribute to the book. For there he writes of ‘Tooze’s unwillingness to investigate the relations between the political and the economic’, a reluctance that ‘ultimately undermines his account of the crisis decade.’ Logically, the question then arises: do these two apparent contradictions lie in Tooze’s work, or in Durand’s review of it? Or can both be coherent in their own terms?

So Adam Tooze is appreciated in using the correct mathematical formulation but not paying much attention to political economy. Of course Wynne Godley’s work is based with a background in Kaldorian/Post-Keynesian economics, so the critique doesn’t apply to him. Tooze has a preface to his response to Anderson which will appear soon.

What Is Equilibrium?

The new paper by Gennaro Zezza and Michalis Nikiforos for the Levy Institute, surveying the literature on stock-flow consistent models has a discussion on the concept of equilibrium:

In the short run, “equilibrium” is reached through price adjustments in financial markets, while output adjustments guarantee that overall saving is equal to investment. However, such “equilibrium” is not a state of rest, since the expectations that drive expenditure and portfolio decisions may not be fulfilled, and/or the end-of-period level for at least one stock in the economy is not at its target level, so that such discrepancies influence decisions in the next period.

In theoretical SFC models, the long-run equilibrium is defined as the state where the stock-flow ratios are stable. In other words, the stocks and the flows grow at the same rate. The system converges towards that equilibrium with a sequence of short-run equilibria, and thus follows the Kaleckian dictum that “the long-run trend is but a slowly changing component of a chain of short-run situations; it has no independent entity” (Kalecki 1971: 165). The adjustment takes place because stocks and stock-flow ratios are relevant for the decisions of the agents of the economy. If stocks did not feed back into flows, the model may generate ever-increasing (or decreasing) stock-flow ratios: a result that might be stock-flow consistent, but at the same time unendurable. The convergence towards the long-run equilibrium also depends on more conventional hypotheses regarding the parameters of the model.

So equilibrium is a state where stock-flow ratios are stable.

Of course equilibrium just means that and doesn’t automatically translate to full employment, for example. One can imagine stock-flow ratios such as public debt/gdp, private debt/gdp may converge to some level such as 80%, 50% respectively but with unemployment at, say, 5%.

Also, it’s worth mentioning—especially in open economies—there is in general no automatic/market mechanism which guarantees that stock-flow norms are converging to some stable ratios.

Let me offer an alternative viewpoint for the short run.

In the short run, there’s really no concept of equilibrium because there is no heavenly Walrasian auctioneer in most markets. As pointed out by Nicholas Kaldor, there are dealers who are both buyers and sellers simultaneously. Dealers quote bid/ask prices and the quantities they are willing to buy or sell. Since there is a mismatch in demand and supply of “outside buyers” and “outside sellers”, dealers accumulate inventories or stocks. Dealers make a business out of the bid-ask spread. In non-financial markets, the terminology is slightly different. You won’t find a board with bid/ask prices at a car dealer, but the concept is similar. Here even the producer has inventories in the goods market. In the services market, whatever is demanded is supplied (or put in queue or refused if capacity is reached).

So there’s no equilibrium to be reached in the short-run. It’s always in disequilibrium. Sometimes neoclassical authors make it look like accounting identities are violated in disequilibrium and satisfied in equilibrium arranged by the Walrasian auctioneer. But in SFC models, it’s illogical to have such a thing. Accounting identities must always be respected. At all times, between all time periods, even infinitesimally small.

In real life, especially because of complications of the open economy, there is no such thing as an equilibrium or a tendency to move toward any equilibrium via market forces.

Still, the concept of equilibrium is useful even in SFC models. One can start with a state with a stable stock-flow ratios and then study what happens if some parameter or some exogenous variable is changed or a set of them are changed simultaneously. The dynamics may or may not reach equilibrium in the long run but we can study what happens in the traverse.

Link

Stock-Flow Consistent Models: A Survey

There’s a new paper by Gennaro Zezza and Michalis Nikiforos for the Levy Institute.

Abstract:

The stock-flow consistent (SFC) modeling approach, grounded in the pioneering work of Wynne Godley and James Tobin in the 1970s, has been adopted by a growing number of researchers in macroeconomics, especially after the publication of Godley and Lavoie (2007), which provided a general framework for the analysis of whole economic systems, and the recognition that macroeconomic models integrating real markets with flow-of-funds analysis had been particularly successful in predicting the Great Recession of 2007–9. We introduce the general features of the SFC approach for a closed economy, showing how the core model has been extended to address issues such as financialization and income distribution. We next discuss the implications of the approach for models of open economies and compare the methodologies adopted in developing SFC empirical models for whole countries. We review the contributions where the SFC approach is being adopted as the macroeconomic closure of microeconomic agent-based models, and how the SFC approach is at the core of new research in ecological macroeconomics. Finally, we discuss the appropriateness of the name “stock-flow consistent” for the class of models we survey.

[The title is the link]

Link

https://criticalfinance.org/2016/09/08/consistent-modelling-and-inconsistent-terminology/

Jo Michell has a nice reply to Simon-Wren Lewis’ critique of stock-flow coherent models.

[the title of this post is the link]

Look for links to models around the world which use the SFC methodology.

DSGE, SFC And Behaviour

This is a continuation of my post Simon Wren-Lewis On Wynne Godley’s Models. I was comparing stock-flow coherent models to DSGE models implicitly (didn’t mention the ‘DSGE’).

One of the things I spoke of was behaviour: firms deciding how much to produce. In stock-flow consistent models, it is decided by trends in sales. So if entrepreneurs see a fall in their inventory-to-sales ratio, they’ll produce more typically. This can be made more accurate. See Wynne Godley and Marc Lavoie’s text Monetary Economics for more details.

Here I want to concentrate on models such as DSGE or any other model used by institutions such as the UK Treasury for the case of production. In these models, there is a production function describing how much firms will produce. This is incorrect to begin with. It says nothing about behaviour. If households start borrowing a lot, in DSGE models, producers are still producing the same because production is governed by the production function. In stock-flow consistent models, simple modeling assumptions about how much firms produce are far superior. So in this case, in SFC, more borrowing leads to more sales and a change in sales trends, inventory/sales ratio and hence affecting how much will be produced.

The DSGE production function is thus inconsistent with the Keynesian principle of effective demand. DSGE is not even Keynesian. It’s thus ridiculous how economists defending DSGE models and its ancestors accuse SFC modelers of not paying attention to behaviour.