Caverzasi and Godin (2014) build a model to investigate the role financialisation and inequality played in the 2007 subprime mortgage crisis, drawing on aspects of Hyman Minsky’s Financial Instability Hypothesis (Minsky, 1992) and Jan Toporowski’s Theory of Capital Market Inflation (Toporowski, 2000). The authors present a model with two household sectors (workers and rentiers), a firm sector and a banking sector. The model captures the process of financialisation by extending the firm sector’s investment decision to encompass financial assets, so that both firms and households can make portfolio allocation decisions. Household lending can lead to either property bubbles (when the lending is for house purchases) or growth (when households borrow to realise capital gains). Financial instability also enters the model via a ‘keeping up with the Jones’ term in the consumption function, which causes workers to imitate rentiers’ consumption patterns, with this spending financed via borrowing.
The authors find that an increase in firms’ demand for financial assets (over investment goods) leads to a fall in investment and a continual decline in GDP. A second simulation looks at the role of inequality in the 2007 - 2008 crisis. An attempt by workers to imitate rentiers’ consumption patterns financed by borrowing initially leads to an increase in investment, GDP and an asset price boom. However, over time, workers’ debts increase (as does financial fragility), and this leads to lower consumption and an economic downturn. This finding is similar to the warnings issued by the empirical SFC literature (e.g. Papadimitriou et al. 2014, 2015, 2016).
Dafermos (2012) investigates the role of liquidity preference and uncertainty in causing recessions. As in Caverzasi and Godin (2014), portfolio allocation decisions are extended beyond the household sector to include both firms and banks. However, the main innovation in the paper is the inclusion of a ‘perceived degree of uncertainty’ term in a number of the model’s behavioural equations.
Simulations are then conducted in which the value of the perceived degree of uncertainty term is increased. This is found to lead to an increase in the household sector’s liquidity preference (and so
an increase in the demand for assets with a higher ‘liquidity premium’) and a reduction in target levels of debt/lending. The shift into more liquid assets and away from equities leads to an increase in interest rates, a reduction in target debt levels, credit rationing by banks and lower equity prices. Taken together, these effects cause the economy to enter a recessionary phase.
Zezza (2008) investigates the fall in the U.S. saving rate since 1985, in light of the shift in the distribution of income towards the top 5% of income earners. Zezza’s model, which extends the model found in Dos Santos and Zezza (2006), explores how an increase in house prices might affect the savings rate. The model is able to replicate a number of the economic processes that
characterised the run-up to the 2007 - 2008 financial crisis, such as a housing boom, higher
inequality, and lower savings rates. However, despite the additional complexity, Zezza’s model does not endogenously generate an economic downturn (as does Caverzasi and Godin [2014] and Ryoo [2010]).
Le Heron (2011) investigates the possible transmission mechanisms from the 2007 - 2008 financial crisis to the French economy. He notes that while there is a clear transmission mechanism to several European countries28, the links to others are less clear-cut. For example, he points out that most
European banks were not overly involved in U.S. subprime markets, that European household savings/pensions were not overly linked to the stock market, that the private sector had low debt levels in relation to the U.S., and that the U.S. was not a major export market for many European countries. Consequently, Le Heron (2011) postulates that the transmission mechanism from the U.S. financial crisis to the French economy must have been via changes in expectations. In order to test this hypothesis, he builds a model that is partially calibrated to the French economy. While the model is relatively complex (with nine assets and five sectors), there is no foreign sector. Instead, the effect of the financial crisis enters the model via the firm, household and banking sector’s
expectations. The values for the expectations parameters are derived from a series of surveys that investigate French household and firm confidence between 2005 and 2009. The model shows that the majority of the variation in French GDP over the period 2005 - 2009 can be explained by changes in firms’ expectations (which affect investment and therefore output), with changes to bank and household expectations relatively unimportant in comparison.
Le Heron (2012) utilises a similar model to that presented in Le Heron (2011) in order to explore two alternative policy responses to the recession that followed the 2007 - 2008 financial crisis. The first
28 Britain and Iceland have large banking sectors, Spain, Ireland and the U.K. were experiencing a property boom, Ireland relies heavily on U.S. investment and Greece has serious structural problems.
policy response is broadly Keynesian, and assumes the government’s fiscal policy includes automatic stabilisers alongside a monetary policy that targets inflation and growth (so that monetary policy supports the government’s fiscal policy). The second policy response is meant to imitate the European Union’s fiscal and monetary arrangements, so that fiscal policy targets a balanced budget while monetary policy targets inflation.
In order to replicate the effect of the sub-prime crisis, Le Heron simulates a drop in confidence and an increase in the liquidity preference of all private sectors. He finds that the recession is around half as big under the ‘Keynesian’ policy mix as it is under the ‘European’ policy mix. In the European policy mix, lower government spending affects output growth via the firm sector’s cash flows, which lower the supply of credit from banks. In the Keynesian policy mix, the increase in cash flows allows firms to finance their investment expenditures internally rather than through banks loans.
Consequently, in this simulation government debt increases as firm debts fall.
Ryoo (2010) presents a continuous time model without a steady state. Instead, the model exhibits a short-run cycle that fluctuates around a longer wave. The short-run cycle is based on Harrod’s ‘instability principle’, while the long waves are based on Minsky’s Financial Instability Hypothesis (Minsky, 1992). The short cycles result from changes in demand relative to capacity utilisation, and are constrained by labour market dynamics, while the long waves depend on the interaction between two stable subsystems – one that determines firms’ debt structures, and another that determines households’ expectations of equity prices (and hence their portfolio allocation decisions). The upswing of the long wave is caused by steady increases in firms’ debt-capital and equity-deposit ratios, fuelled by positive expectations resulting from a stable economic
environment. These expectations modify the acceptable leverage ratio of firms over time (so that tranquil economic periods result in increases in acceptable leverage ratios). However, increases in the debt-to-capital ratio ultimately reduce the profit-interest ratio. When the profit-interest ratio stabilises, expectations shift, and this leads firms to reduce their debt accumulation, resulting in a long downturn. The model, therefore, generates a business cycle within a long-term financial crisis cycle. Interestingly, in contrast, the majority of SFC models, equities are the flexible element in firm financing, rather than bank loans.
Tymoigne (2006) models a ‘Minskyian’ system with one financial asset (demand deposits) and one real asset (capital). Two models are presented. The first contains firms, banks and households, while the second adds a central bank. The first model is only able to generate constant expansions or contractions (unless the model is shocked). This model is used to illustrate a number of insights from Minsky’s work, including the importance of matching the maturity of assets and liabilities on firms’ balance sheets, the role that the removal of debt from bank and firm balance sheets plays in
economic recoveries, and the asymmetric effect of changes in interest rates in economic expansions versus contractions. The second model (with a central bank sector) generates a cycle rather than a steady state. However, unlike in Ryoo (2010), this cycle is a result of the central bank attempting to stabilise the economy via monetary policy.