Tag Archives: stock flow coherent models

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]

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.

Link

New Bank Of England Paper On The Financial Balances Model For The United Kingdom

Stephen Kinsella is out with a new paper with co-authors Stephen Burgess, Oliver Burrows, Antoine Godin, and Stephen Millard published by the Bank of England.

From the paper:

Our paper makes two contributions to the literature. First, we develop, estimate, and calibrate the model itself from first principles as well as describing the stock-flow consistent database we construct to validate the model; as far as we know, we are the first to develop such a sophisticated SFC model of the UK economy in recent years.4 And second, we impose several scenarios on the model to test its usefulness as a medium-term scenario analysis tool. The approach we propose to use links decisions about real variables to credit creation in the financial sector and decisions about asset allocation among investors. It was developed in the 1980s and 1990s by James Tobin on the one hand, and Wynne Godley and co-authors on the other, and is known as the ‘stock-flow consistent’ (SFC) approach. The approach is best described in Godley and Lavoie (2012) and Caverzasi and Godin (2015) and underpins the models of Barwell and Burrows (2011), Greiff et al. (2011), and Caiani et al. (2014a,b). Dos Santos (2006) describes how SFC models incorporate detailed accounting constraints typically found in systems of national accounts. SFC models allow us to build a framework for the model where every flow comes from somewhere in the economy and goes somewhere, and sectoral savings/borrowings and capital gains/losses add or subtract from stocks of wealth/debt, following Copeland (1949). Accounting constraints allow us to identify relationships between sectoral transactions in the short and long run. The addition of accounting constraints is crucial, as one aspect of the economy we would like to model is the way it might react differently when policies such as fiscal consolidations are imposed slowly or quickly

4 Such models were popular in the past; for example Davis (1987a, 1987b) developed a rudimentary stock flow consistent model of the UK economy.

[The title of this page is the link]

Simon Wren-Lewis On Wynne Godley’s Models

Simon Wren-Lewis has an article on his blog on stock-flow consistent/coherent models by Wynne Godley. Unlike other articles, this has a more engaging tone and isn’t dismissive.

This is a  good thing but it has the tone “Oh, there’s hardly anything new” about stock-flow consistent modeling and the sectoral balances approach. 🤦. To me this is highly inaccurate, to say the least. None of the models outside SFC models —with one exception—come anywhere close to the important question about what money is and how money is created. Even in the Post-Keynesian literature, while there are various non-mathematical approaches, there’s hardly anything that comes close. That important exception is the work of James Tobin as is summarized in his Nobel Prize lecture Money and Finance in the Macroeconomic Process. Except that Wynne Godley’s model greatly improve upon the deficiencies of Tobin’s approach.

The sectoral balances approach is a mini-version of stock-flow coherent modeling. Wren-Lewis seems to say there’s hardly anything great and don’t tell much. First, almost nobody was making a cri de coeur as much as Wynne Godley. Second, the approach makes it clear why a huge recession was coming. This is because US private expenditure was rising faster than private income and the US private sector was in deficit for long and the private sector was accumulating debt on a huge scale relative to income. It’s difficult to say when this would have reversed pre-2007, but had to reverse. Once this is reversed, i.e., when private expenditure slows relative to private income, so that the private sector goes into a surplus, output will fall as a result of a slowdown of private expenditure.

Moreover, the US economy had a critical imbalance in its trade with its current account balance of payments touching almost 6.5% at the end of 2005, hemorrhaging the circular flow of national income at a massive scale.

Wynne Godley’s argument was that because of the external imbalance, the US fiscal policy will be unable to expand output to full employment easily, once the US enters a recession. Hence, he proposed import controls for the United States.

None of anybody outside Wynne Godley’s circle came anywhere close to saying anything of this sort.

But these empirical analysis is a much more complicated discussion. At a simpler level, nobody has come closer to what stock-flow coherent models achieve. All we see is economists struggling with basic questions on how money is created, what role it plays and so on.

Wren-Lewis also criticises SFC models saying they have minimal behavioural hypothesis. Now, this is far from the truth. If you write stock-flow consistent models, which are more realistic, you’ll end up with having a lot of equations and parameters. Behaviour of each “sector” is articulated in these models. How money is created by the act of loan making by banks, to how households and firms accumulate assets and liabilities, to how firms making pricing decisions and how much they produce and how much households consume. In addition, the importance of fiscal policy is articulated: how governments make spending decisions, whether government expenditure can be thought of as exogenous and how in normal times—when politicians pay attention to how much the government’s deficit and debt it has—governement’s fiscal policy can be thought of as endogenous. And crucially, the supreme importance of the government’s finance in the financial assets/liabities creation process. While most economists stop at one time-step for the expenditure process, using stock-flow consistent models, you can see the full process. Moreover, the analysis highlights the correct direction of causalities. A good example is the direction of causation from prices to money.

I want to however highlight another important point. A lot about how the economy works can be understood without going too much into behaviour. Just national accounts, flow of funds and a minimal set of behavioural assumptions would be a great progress. The rest of the profession however struggles to even understand basic flow of funds. A lot can be understood because most of the times, economists are erring on basic accounting. Hence their story doesn’t add up and produces something completely unrelated to the real world. If only economists understood this, that’ll be a lot of progress. Stock-flow consistent models are rich in behavioral analysis but even without it, understanding flow of funds with a minimal set of assumptions is the right direction.

Economics Without Mathematics?

Recently, Noah Smith wrote an article for Bloomberg View, titled Economics Without Math Is Trendy, But It Doesn’t Add Up.

Smith’s attitude is the following:

  1. Heterodox economics is vague and neoclassical economists are mathematical geniuses.
  2. Heterodox authors somehow manage to sneak in some model of the economy.

How about something opposite? That stock flow consistent/coherent models come close to describing the real world and neoclassical models don’t even start in the right foot? The usage of mathematics in neoclassical economics looks silly to me to say the least. Heterodox authors on the other hand have made important breakthroughs with stock-flow consistent models. In these models, the description of how stocks and flows affect each other leading to macrodynamics describing the real world is obtained.

Neoclassical models (which the phrase I use for the “new consensus”) not only doesn’t have anything as mathematical as this but it fails in the first place to identify the correct tools to describe economic behaviour.

Morris Copeland writing in Social Accounting For Moneyflows in Flow-of-Funds Analysis: A Handbook for Practitioners (1996) [article originally published in 1949] said:

The subject of money, credit and moneyflows is a highly technical one, but it is also one that has a wide popular appeal. For centuries it has attracted quacks as well as serious students, and there has too often been difficulty in distinguishing a widely held popular belief from a completely formulated and tested scientific hypothesis.

I have said that the subject of money and moneyflows lends itself to a social accounting approach. Let me go one step farther. I am convinced that only with such an approach will economists be able to rid this subject of the quackery and misconceptions that have hitherto been prevalent in it.

Morris Copeland’s work is what led the U.S. flow of funds which is published by the Federal Reserve every quarter. National accounts have also improved since their first version to incorporate Copeland’s ideas. See the 2008 SNA and the Balance of Payments And International Investment Position Manual, Sixth Edition for example.

Apart from stock-flow consistent/coherent models, models of the economy don’t even come close to describing the economy, because they miss the most important aspect: flow of funds.

So Goldman Sachs’ chief economist, Jan Hatzius for example uses this approach. See his paper The Private Sector Deficit Meets The GSFCI : A Financial Balances Model Of The US Economy, Global Economics Paper No. 98, Goldman Sachs, Sep 18, 2003.

So it is not that neoclassical economists have great mathematical tools. It’s that by failing to incorporate the framework of flow of funds, they are showing their incompetence in mathematical reasoning.

A Short Note On George Soros’ Principle Of Reflexivity

There’s a nice paper by George Soros from 2014, titled Fallibility, Reflexivity, And The Human Uncertainty Principle in which he gives a good alternative description of financial markets. It’s a kind of a review article of his own ideas he has developed over the years. This is in sharp contrast to the “efficient market hypothesis”.

Here I wanted to discuss just one aspect. In section 4.1 of the paper, Soros says:

Let me state the three key concepts of my approach, fallibility, reflexivity, and the human uncertainty principle as they apply to the financial markets …

Second, reflexivity. Instead of playing a purely passive role in reflecting an underlying reality, financial markets also have an active role: they can affect the future earnings flows they are supposed to reflect. That is the point that behavioral economists have missed. Behavioral economics focuses on only half of the reflexive process: cognitive fallibility leading to the mispricing of assets; they do not concern themselves with the effects that mispricing can have on the fundamentals.

Although, in neoclassical economics, it is difficult to see how this is the case, it is easy in stock-flow coherent macro models. Without writing equations, let’s see how this works.

  1. A rise in expectations of equity prices will lead to a rise in the actual value of equity prices.
  2. Higher equity prices implies holding gains (capital gains) for the holders ultimately households.
  3. This raises consumption (and purchases of houses) as households are richer.
  4. This rise in domestic demand raises output as producers will produce more to meet the demand.
  5. Higher production means higher profits.
  6. A boom in financial markets also leads to a rise in firms’ capital formation (“investment”). Investment is self-financing as investment expenditure for one firm is a source of revenue for another.

Of course, there are feedback effects as well and this may become a bubble which goes bust, but this is the basic mechanism by which reflexivity works.

Although this appears simple, this cannot happen in neoclassical economics because the “production function” is at the heart of it.

Back to Soros. In the paper, he has a nice chart with an explanation of it.

George Soros - Stock Prices Affecting Fundamentals

Soros explains:

A typical market boom– bust. In the initial stage (AB), a new positive earning trend is not yet recognized. Then comes a period of acceleration (BC) when the trend is recognized and reinforced by expectations. A period of testing may intervene when either earnings or expectations waiver (CD). If the positive trend and bias survive the testing, both emerge stronger. Conviction develops and is no longer shaken by a setback in earnings (DE). The gap between expectations and reality becomes wider (EF) until the moment of truth arrives when reality can no longer sustain the exaggerated expectations and the bias is recognized as such (F). A twilight period ensues when people continue to play the game although they no longer believe in it (FG). Eventually a crossover point (G) is reached when the trend turns down and prices lose their last prop. This leads to a catastrophic downward acceleration (GH) commonly known as the crash. The pessimism becomes over done, earnings stabilize, and prices recover somewhat (HI).

Of course, it’s more complicated. There can be other factors leading to the fall of both equities and earnings. But importantly, the fall in equity prices can—via the wealth effect and a fall in firms’ capital formation (“investment”)—lead to a fall in earnings.

George Soros’ criticism of neoclassical economics is great and he’s quite correct in getting an important causality. His description however lacks a mechanism. This can be provided with a demand-led stock-flow coherent behavioural model without any production function.

Marc Lavoie Lectures On Post-Keynesian Economics And Stock-Flow Consistent Modeling

There are two wonderful lectures by Marc Lavoie given at the UMKC two years ago. I had seen them that time but forgot to post it on my blog.

Likely you might have seen it, but if not, here they are.

Lecture 1: Essentials of Heterodox And Post-Keynesian Economics

Slides

Marc Lavoie - Essentials Of Heterodox And Post-Keynesian Economics

Click picture to view the video on YouTube.

Lecture 2: Workshop on stock-flow consistent modeling

Slides

Marc Lavoie - Workshop On Stock-Flow Consistent Modeling

Click picture to view the video on YouTube.

UK Poorer?

The commentary after the EU Referendum has moved into a consensus from economists claiming that “Brexit” will make the UK poorer. So we hear it from Paul Krugman:

Yes, Brexit will make Britain poorer

Krugman’s thoughts are also echoed by Simon-Wren Lewis. First SWL claims that:

Calculating the size of this effect is an exercise in trade economics not macroeconomics

I don’t understand this. Calculation is both an exercise in trade economics and macroeconomics. So in stock-flow consistent models of the open economy, you see such a thing. It’s both macroeconomics and trade. Trade is automatically incorporated in a macroeconomic model.

This is not just a minor point in semantics. In stock-flow-consistent models, one cannot avoid some parts and talk of the rest. One is forced to incorporate trade, not just in goods and services but also financial assets. Something which models which SWL uses isn’t sophisticated enough to handle.

Moving on, SWL claims that the UK’s exit from the EU makes the UK poorer. He says:

This decline in trade leads to a loss in productivity which makes UK citizens poorer over the medium term. It also means that the real value of sterling has to fall to make up for the fall in net exports. Other things being equal, this fall in sterling will happen immediately, as indeed it already has. This will make people poorer immediately, because imported goods cost more. But here the macroeconomics gets complicated. The hit to trade from leaving the single market will evolve gradually, but the fall in sterling is immediate. (The reason is something economists call UIP.) That means that trading firms might get a short term competitiveness boost, even though this will evaporate in the medium term. This may or may not be enough to compensate for the short term impact of rising prices on consumption spending.

Unfortunately that is not all that happens in the short term. Uncertainty about future arrangements will hold back investment, and it may also add to the depreciation in sterling. For this and other reasons the short term impact on aggregate demand is likely to be negative, although measuring its size is difficult. We then need to think about whether the MPC will raise or cut interest rates. The National Institute’s analysis is very readable on all this.

[underlying: mine]

So the claim that it will make the UK poorer. In effect, SWL’s model is telling him that real GDP will fall as well as real wealth as well fall in real household expenditure. There are several ways in which it happens. Productivity falls. Fall in productivity leads to a less than rapid increase in production. Consumer prices rising means lower real expenditure and so on.

Now, in Kaldorian story the causalities in the real story of actual economic dynamics are almost reverse than the ones presented above. Faced will less free trade, the UK government is less constrained to expand domestic demand and output. It can protect its manufacturing industry. Rising production leads to rising productivity, reverse of what is implied by SWL’s model. True, imported goods will be costlier, but it also reduces import penetration which allows domestic demand to be expanded and hence output and hence real national income and household income so that consumers are more than compensated for imports being made more expensive.

Of course, all this depends on whether the UK government reduces austerity and expands domestic demand. But some effects can be seen, although uncertain. This is because the foreign trade multiplier is improving and the fiscal policy multiplier improves, even if the fiscal stance is not changed. Higher wages if immigration is controlled also provides a boost to demand.

At any rate, the important point in this post is that the remain campaign’s economics is a model which is completely erroneous about causalities and how economies work.