Academic journal article World Review of Political Economy

Towards a Theory of Endogenous Financial Instability and Debt-Deflation

Academic journal article World Review of Political Economy

Towards a Theory of Endogenous Financial Instability and Debt-Deflation

Article excerpt

Abstract: Post-Keynesian and heterodox critiques have challenged the Monetarist assumptions of an exogenous money supply and the doctrine of monetary neutrality in the long run. Within these heterodox currents, there has emerged a widespread consensus that the money supply is endogenous-governed by the demand for credit and by the Keynesian notion of liquidity preferences. These heterodox theories also reinstate the original insights by Keynes over the critical issue of uncertainty in the behavior of investors, which contradicts the assumptions of rational expectations. This article will examine some of these intellectual currents in order to develop a more rigorous interpretation of the root causes of financial turbulence.

Key words: money; speculation; financial; labor; capital

(ProQuest: ... denotes formulae omitted.)

Speculators may do no harm as bubbles on a steady stream of enterprise. But the position is serious when enterprise becomes a bubble on a whirlwind of speculation. When the capital development of a country becomes a by-product of the activities of a casino, the job is likely to be ill-done. (Keynes 1936: 159)

Those involved with the speculation are experiencing an increase in wealth-getting richer or being further enriched. No one wishes to believe that this is fortuitous or undeserved; all wish to think that it is the result of their own superior insight or intuition. The very increase in values thus captures the thoughts and minds of those being rewarded. Speculation buys up, in a very practical way, the intelligence of those involved. (Galbraith 1990: 5)


It will be argued that there is a coherent theoretical lineage between Kalecki and Minsky in their treatment of endogenous money and the causes of financial instability. The original debt-deflation theory of economic depressions, first formulated by Veblen and later refined by Irving Fisher, appears to augment these post-Keynesian theories of endogenous money. It is thus possible to construct a basic theoretical synthesis and to argue that these episodes of financial instability are not merely random, exogenous shocks, but constitute an inherent feature of the dynamics of capital accumulation. The boom itself therefore generates endogenously destabilizing forces, which could induce a speculative euphoria and its eventual crash.

Kalecki's Finance-Investment Nexus

The Kaleckian theory of investment provides a coherent approach by linking investment decisions to the accumulation of past profits and expected future profits. Kalecki's profit-investment relation can be simply denoted as:

... (1)

where P is aggregate profits, I denotes investment, Y is the level of income, and sw, sp are the marginal propensities to save out of wages and profits respectively (Arestis and Karakitsos 2004: 74). Investment would therefore need to be greater than swY if profits are to be realized. Kalecki assumes that the chain of causation runs from investment to profits; thus investment tends to "finance itself" in the short run. In other words, the propensity to invest is determined by the realization of past profits. The decision to invest is positively related to profits and negatively to the capital stock. Consequently, a larger volume of investment leads to a higher level of profits. During an expansionary phase, profits will tend to rise disproportionately and stimulate the rate of investment, which outstrips the level of effective demand and ultimately leads to problems of chronic excess productive capacity. Investment is curtailed as prices fall and a period of cumulative decline ensues (Eichner 1991: 435).

At the same time, however, since realized profits are only one source of finance, firms can also resort to external finance in order to activate future investment. Expected profits are assumed to be positively related to the current rate of profit, which allows firms to validate existing debt and attract new loans. …

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