Introduction to the Cambridge Journal of Virtual Special Issue

Stock-flow consistent macroeconomics –

the foundations

Alan Shipman

The usefulness of taking a stock-flow consistent (SFC) approach to medium- and long-term analysis of the economy, and assessment of policy impacts, is now gaining recognition well beyond the small post- Keynesian circle that first developed them. New SFC contributions appear regularly in a range of heterodox journals, with the approach also finding important applications in the natural sciences. But for its first three decades, SFC theorising and empirical investigation were a minority pursuit, carried largely by the CJE. This virtual special issue traces its emergence from unresolved Keynesian debates, by drawing together some of the pioneering contributions.

In contrast to innovations that start with a single paper or debate, the quest for SFC took shape gradually, its origins remaining hard to pinpoint. The problem of conventional macro models (and representations of Keynes) yielding potentially misleading results, because they did not follow through all flows into -stock changes and credit flows into debt-stock changes, or include the effect of changed stocks on subsequent expenditure flows, was occasionally noted by mainstream authors (notably Patinkin 1965 and Christ 1968). Philip Davis (1987a, b), then at the Bank of England, set out the groundwork for SFC macro modelling and assessed its main challenges, in a year when stock-market crashes highlighted its usefulness. But it was those working in the Keynesian and Kaleckian tradition, and seeking to link short-term national- income determination to longer-term growth and distribution, who became most aware of the unanswered questions from analyses that were not SFC. This drove them to build an alternative framework that could take full account of stock changes, and their balance sheet impact, in a trade-exposed monetary economy with large, deregulated financial markets.

Stuck (without stock) in the short run, 1937-1983

Keynes’ (1936) emphasis on investment generating , via its multiplier effect on aggregate income, opened up a route into the long run via the capacity-building and income-generating effects, promptly followed up by Roy Harrod (1939). It also left room for the wage/profit distribution to influence the channelling of income into saving, an exploration pioneered by Pasinetti (1962) and Kaldor (1966). Kalecki’s (1933) introduction of a financial circuit, through which capitalists’ investment and consumption can collectively generate their profits, offered a way to reconnect Keynes’ ideas to classical theory and dynamic structural change beyond Harrod’s one-commodity world. But Kaleckian and Keynesian approaches depend on there being a financial system that can fully finance expenditures in advance of the income they generate.

In the combined ‘real’ and ‘monetary’ equilibrium approach presented by Hicks (1937), distilled into ‘IS- LM’ by Hansen (1953:143-53), the long-term consequences of investment spending and fiscal imbalances largely disappeared. Keynes’ was confined to a short-run analysis in which could take place without adding to capacity, and firms could invest more than their income (and governments spend more than their tax revenue) without any reference to the financing of these deficits. There were no changes to the private or public capital stock, and no counterpart changes in private or public debt.

Hicks personally found his eponymous cross too heavy to bear, admitting the inadequacy of mixing goods- market flow and financial-market stock equilibria in his final published work (Hicks 1980). But IS-LM’s usefulness in reducing Keynesian ‘aggregate demand failure’ to a wage rigidity or liquidity trap, and ascribing monetary policy at least comparable in power to fiscal policy, gave it an enduring pre-eminence in undergraduate textbooks. The attention drawn in Cambridge to the problem of aggregating , in real or monetary terms (Cohen & Harcourt 2003), did little to correct the imbalance. For those focused on longer-term growth and change in the real economy, the easiest escape was often to analyse it – even in the long term - as a system of flows, in which capital was used-up and re-created in each period (Pasinetti 1980). Ironically, when (in 1952) the US began publishing a full set of flow-of-funds tables, showing all the financial flows implied by changes in balance-sheets between years, the ‘Keynesian’ heirs to those who had devised them in the 1940s no longer knew what to do with them (dos Santos 2006: 546). National income – heavily shaped by Sir Richard Stone’s group, and its early decision to ignore capital gains as a source of income – became focused on the annual income flow, with no regular assessment of balance sheets, and no need to assess the pattern of flows that that served to reconcile the two.

Re-connecting stocks and flows, 1983-1999

Keynes and Kalecki both recognised that production takes time, requiring investment (in working people and working capital) even when there are no fixed-capital purchases. Even if they have , employees’ wages must be paid in advance, as must raw materials whose costs are only recovered when outputs are sold. So during the production process firms’ balance sheets will deteriorate, through running-down or taking out new debts. The financing of production and investment was not fully explored in early versions of their models, and left open the possibility that capitalists’ initial outlay could still be constrained by lack of liquidity. This missing element in post-Keynesian analysis was brought back to attention by Tom Asimakopulos (1983) in his first CJE contribution. His review examined the investment and saving flows in Kalecki’s models, and their impact on private-sector and central-bank balance sheets, in a way that anticipates the matrices now standard in SFC analysis. Investment might be held back by the objective constraint of finance being unavailable, or the subjective constraint of downbeat expectations deterring firms from making use of it. When the multiplier takes time to unfold, there may be moments when firms lack the revenue to finance all their planned investment (or when, in effect, this is forcibly deflected from intended fixed investment into unintended investment in unsold stocks). Asimakopulos’ article coincided with the attempt by Wynne Godley and Francis Cripps (1983), after a decade leading the Cambridge Economic Policy Group at the Department of Applied Economics (DAE), to rebuild macroeconomics in a way that paid full attention to the financing of working capital when goods could only be sold at the end of the production period.

There were numerous responses to Asimakopulos’ challenge, but five years later Peter Skott (1988) addressed it by putting some existing Kalecki-inspired models into a fuller SFC framework. The starting- point was Kaldor’s (1966) Pasinetti-inspired framework in which households and firms saving at different rates. But there was now a wider range of financial assets through which households could save and firms finance investment; and the consequent saving and investment flows were fully traced through to assess the pattern and impact of changes in the respective stocks. Investment, treated as exogenous, could lead to a flow of dividends to households if it fell below the level of profits or a flow of bank lending to firms if it moved above this. The model featured monopolistic firms that maintain excess capacity to deter entry, allowing for examination of Josef Steindl’s (1955) arguments about stagnation arising from growing oligopoly and declining wage share; and banks that met all credit demand rather than restricting it for their own profit, making the supply endogenous. It also featured households that receive a combination of wage and investment income - allowing underconsumption to be checked if profit distributions offset the effects of a falling wage share (but opening the way to its exacerbation if firms raise prices ahead of wages and do not distribute the resultant higher profits, forcing households to borrow for consumption and thereafter pay back interest). The model is open to various types of investment behaviour by firms, of which Skott investigated two: expansion when expected returns on invested capital exceeds its costs (and Tobin’s q exceeds 1), with a fixed mark-up, or use of a discretionary mark-up to generate the profits required for target investment (similar to the theory developed Adrian Wood (1975) along lines inspired by Kaldor and Robin Marris). Skott’s model could be solved algebraically, and used to analyse the medium term, when short-term changes in investment or saving decisions have had time to impact on real and financial stocks, and expenditures have fully adjusted to income changes. It contributed to the immediate debate by showing that any savings constraint on investment acted only in the very short term, but also had implications for wider debates - including a demonstration that the neoclassical transmission of higher saving to higher investment could in principle occur through the revaluation of financial capital stocks in a multi- model, and that firms’ tendency to respond to increased output with increased investment (to preserve their capacity margin) could counter any instability in Harrod’s warranted rate of growth.

Marcello Messori (1991) returned to the unsatisfactory treatment of corporate finance in Kaleckian models, probing Kalecki’s (1939) suggestion that business investment will always generate matching rises in saving and bank lending. A more thorough analysis of the ‘technical monetary factors’, in a model with a composite consumption good that can only be sold after workers are paid their wages, highlights the importance of commercial banks (and central banks as their lender of last resort) in ensuring sufficient availability of credit to stop it constraining the financing of production. This assessment showed how Kalecki’s account could be resilient to the charges of Asimakopulos (1983) that investment could be constrained by insufficient saving, and of Patinkin (1982) that savings had to equal investment ex ante rather than ex post. But it highlighted the importance of endogenous money creation, and the extent to which banks would meet any increase in firms’ demand for investment finance without starting to ration it by raising interest rates.

In the same CJE issue, Paul Dalziel (1991) extended the search for neglected flows (arising from deficits or surpluses, including profit) into the analysis of the Pasinetti Theorem. Pasinetti (1962) had shown that, in a model where capitalists save out of profits and workers out of wages (and both receive the same return), capitalists’ saving determined the rate of profit while workers’ saving had no impact. Capitalists ‘get what they spend’, even if workers don’t have to spend all they get. The original Theorem assumed a balanced budget, and earlier analyses suggested it broke down if governments moved into fiscal deficit. Pasinetti (1989) had already responded by showing how an adjusted version still held if there were a steady-state budget deficit. Dalziel expanded the macroeconomic picture further, taking account of capitalists’ and workers’ holdings of public debt, and the channelling of the resultant interest income into spending, saving or tax. Pasinetti’s result emerged intact, even without ‘Ricardian equivalence’ to ensure the repayment of debt from future taxes. If governments in deficit refused to issue debt and printed money instead, a real- terms version of the Theorem emerged after adjustment for the consequent inflation-tax.

The question of investment financing and aggregate demand in Kaleckian models was re-opened by Thomas Palley (1996), who showed that the introduction of inside debt could alter the Pasinetti theorem by causing workers’ saving decisions to affect the profit share and profit rate – eroding capitalists’ interest income if they saved or paid back debt, and boosting it if they borrowed more. A lively debate ensued, with Pasquale Commendatore (2002) defending Pasinetti’s result with a different specification of steady-growth equilibrium, followed by defences of the critique by Palley (2002), and Man-Seop Park (2006). But before that controversy unfolded, Palley (1997) probed deeper into the effect of stock changes on Cambridge distribution and growth theory, arguing that Dalziel (1991) had not really moved any further than Pasinetti (1962) in modelling the economy as truly monetary, rather than just having selected financial instruments as borrowing and saving devices. Palley introduced a treatment of the financing of fiscal deficits that traced the impacts on inflation and income distribution as well as on real output, when capitalists received income via interest on government debt as well as profits. Pasinetti’s result was once again relegated to a special case of inflation-free steady growth, since inflation forced capitalists to divert part of their investment into repairing their balance sheets after succumbing to the ‘inflation tax’.

The endogeneity of money, once commercial banks were licensed to create it through their lending, had long been obvious in the streets of Cambridge despite protests to the contrary from the City of London, becoming a central argument against the 1970s efforts rise of monetarism, as expressed by Kaldor (1986) in his Radcliffe lectures (and conveyed to UK policymakers via the House of Lords). But the process and consequences of private-sector money creation still raised a number of puzzles - notably how (in aggregate) banks’ loans would generate equivalent deposits through income generation and private-sector saving. A ‘horizontal’ credit supply not restricted by the high-powered base (Moore 1988) appeared important for achieving Kalecki’s results. Allowing any amount of credit growth without a rise in interest rates seemed unconvincing to those who studied banks more closely, and saw them tending to raise rates when uncertain about the quality of borrowers or strength of aggregate demand. The critique was summarised by Sheila Dow (1996) and extended by Philip Arestis and Peter Howells (1996), who saw in the ‘horizontal’ curve an illegitimate assumption that the flow of deposits would create its own demand. Building on Howells’ (1995) earlier work, they identified four possible mechanisms to ensure that deposits were re-lent. Of these, their preferred one – changes in the differential between bond interest rates and deposit rates – still looked ‘neoclassical’ to some post-Keynesians.

Seeking to resolve the debate on how an ex ante mismatch between total loans and deposits would be overcome, Marc Lavoie (1999) applied a fuller stock-flow analysis to an economy in which households save when their wage incomer exceeds their buying plans, and can do so via bonds as well as bank deposits. This highlighted the importance of the ‘reflux’ through which above-target savings lead to the automatic repayment of overdrafts and other household debt, reducing its stock independently of banks’ lending decisions. First drawn to attention by Robinson (1956 Ch 23) and Kaldor and Trevithick (1981), ‘reflux’ had been dismissed by some earlier post-Keynesians as unimportant or even fallacious, but re-emerged in Lavoie’s analysis as increasingly powerful in a world where households borrow as well as save, with the effect that the stock of loans and deposits could be raised or lowered by private-sector saving decisions even if the flow of loans depended on firms’ demand for them. Arestis and Howells (1999) in reply acknowledged the existence and importance of the ‘reflux’ process, while still identifying a need for interest rates to rise when meeting higher credit demand.

Endogenous money as a contributor to economic cycles, and fiscal deficits as a key means to counter them, were both in evidence when Martin Wolfson (1996) revisited ’s “debt-deflation” theory, developing arguments rehearsed at the Levy Economics Institute. Wolfson’s suggestion that the violent contractionary process encountered in the Great Depression could recur, despite the growth of big government and seemingly permanent price inflation, jarred with the optimism of the time, when strong GDP growth had moved the US budget into surplus and even sparked mild panic about the impending shortage of Treasury Bonds. But the deflationary impact of debt repayment was precisely the point he aimed to revive. Pointing out that Fisher (1933) had focused on a monetary contraction caused by households and firms having to liquidate assets so as to repay debts, and made only passing mention of banks, Wolfson sought to enrich the debt-deflation account by linking it to the work of Minsky (1982) on the financial sector and its tendency to over-indebtedness; and to the insight that an unanticipated slowdown of inflation could be as damaging to borrowers’ repayment and refinancing plans as an episode of falling prices, through its promotion of liquidity preference and shifting of from debtors to creditors.

Highlighting also the relevance of Keynes (1932) in explaining how a debt deflation can start as banks become unable or unwilling to continue lending (for production or investment), Wolfson showed how the 1987 stock market crash could be traced to the sudden correction of an unsustainable rise in debt-income ratios, especially of non-financial corporations. He also echoed the optimism of Minsky (1986) in arguing that the automatic fiscal stabilisation provided by big government, allied to accommodating monetary policy, had averted a serious downturn. But his analysis of the way financial asset-price drops (when credit tightens) can implosively feed back into forced debt repayment anticipated the depth and severity of the ‘balance-sheet recession’, as Koo (2003) was later to rename it. Households and banks could now eclipse other corporates as the vortex of over-indebtedness, with results that only the biggest of big governments might be able to contain.

The consonance of post-Keynesian monetary economics with Minsky’s financial fragility hypothesis revealed by SFC analysis became even clearer when Gilberto Tadeu Lima and Antonio Meirelles (2007) explicitly added banks to the model developed by Palley and Wolfson, linking their interest rate mark-up to firms’ demand for credit as indicated by capacity utilisation. Instability arose as predicted when borrowers’ repayments began to depend on future capital gain (as in Minsky’s ‘speculative’ and ‘Ponzi’ modes), with some revealing correctives (notably pro-cyclical movement of the banking mark-up) which anticipated the steps financial regulators were to take after the 2008 Global Financial Crisis (GFC). While debate continued around the impact on his theorem of more complex monetary conditions, Luigi Pasinetti (1998) was concerned by a macroeconomic problem whose seriousness grew when flows’ effect on stock changes and ratios were fully considered. The European Monetary System of fixed exchange rates was about to be transmuted into the Eurozone, with the membership of just two applicants – Belgium and Italy – in doubt because their public debt-to-GDP ratio greatly exceeded the Maastricht Treaty ceiling, 60% of GDP. Observing that the orthodox analysis of public debt sustainability (Blanchard et al 1990) never explained how it derived the ‘satisfactory’ public debt-GDP ratio (D/Y) or the acceptable time-interval for converging to it, Pasinetti’s commentary suggests that D/Y can be defined as on a sustainable path if it is no greater at the end of the year than the beginning in real terms. It points out that a fully balanced budget (with revenue matching public spending plus debt service costs) will shrink the ratio over time when GDP is growing, whereas a primary balance (with revenue just matching spending) can still lead to a rising ratio if the interest rate on debt exceeds the GDP growth rate.

Because the Maastricht rules refer only to full (not primary) deficits, they could (with a given interest rate) permit faster-growing member states to achieve a falling debt ratio despite exceeding the permitted fiscal- deficit ratio, while slower-growing members suffered a rising debt ratio despite keeping their deficits below the ceiling. Pasinetti was neatly anticipating the fate that Italy was about to encounter within the Eurozone, which has suffered rising debt despite years of fiscal austerity because of the slow GDP growth associated with this (Ehmer 2016). He was also highlighting the importance of incorporating debt dynamics, for the public and private sectors, in to any assessment of medium-term macroeconomic prospects (and the design of any fiscal rules that would affect these). Pasinetti concluded that it is absurd for the Maastricht Treaty to insist on a rigid deficit-to-GDP ratio (3%) while allowing flexibility over the debt—to-GDP ratio. Sustainability of the Soren debt-income ratio did not equate to its stability, as pointed out in the follow-up comment by Soren Harck (2000). But Pasinetti’s concern about slow growth landing taxpayers with an ever increasing debt and interest bill, despite attempts at budget restriction, was not allayed, as his reply (Pasinetti 2000) made clear. The ‘sustainability area’ concept has lived on as a retort to conventional wisdom on public debt, receiving an application to low-income countries and their debt-forgiveness case from Gianni Viaggi and Annalisa Prizzon (2013). It is notable that Pasinetti had, fifteen years earlier, given Godley and Cripps (1983) one of their most sympathetic reviews, pointing out that the whole book was premised on two stock-flow ratios (of to sales and money-balances to income), with the macroeconomy rendered ‘Keynesian’ by the plausible assumption that firms must borrow to finance their inventories.

Securing stock-flow consistency 1999-2010

Wynne Godley had switched attention to other economies – in Copenhagen and at the Levy Institute - after relinquishing the DAE directorship in 1988, subdued by the indifference (even among fellow Keynesians) towards his and Cripps’s Macroeconomics, and by the withdrawal of Research Council funds that disbanded the Cambridge Economic Policy Group soon after its publication in 1983. But he had been working intensely behind the scenes to link the stock-flow elements of his earlier book to a richer monetary analysis, especially with insights from post-Keynesians, from the pre-Keynesian analyses of Wicksell (1936), and from Tobin (1982). An early indication of this radical rethink appeared in Godley (1999a), which divides the economy into four sectors (firms, banks, government and households), whose savings and can be channelled via money, loans, short-term bills or longer-term bonds. This paper features one of the first published appearances of the now-standard SFC matrices, showing the flow of funds among the sectors when these financial instruments come into existence, and the corresponding stocks as assets and liabilities on each sector’s balance sheets. The matrices show the accounting identities, budget constraints and behavioural relations which set up a system of simultaneous equations (60 in this case), which yield a steady-state solution when stocks or stock-flow ratios are stable. This can then be used to analyse the impact of demand- or supply-side shocks, tracing the full range of flow and stock-change effects running through the financial system as well as ‘real’ production, income and expenditures.

In the transaction matrix the sums across each row (containing income and expenditure flows corresponding to the national flow-of-funds account) and down each column (showing income and expenditure for each sector) sum to zero, fulfilling the accounting necessity that every item originates somewhere and flows somewhere else. Adding together of the sums for each column, during which financial flows (with equal and opposite effects on assets and liabilities) cancel out, yields the familiar macroeconomic balance identity, in which the public sector deficit (government spending minus tax revenue) plus the private sector deficit (Investment minus saving) exactly match the current-account deficit, or the required international financing. In the stock matrix, each row shows that financial assets and liabilities again sum to zero (one sector’s assets being another’s liabilities), leaving only the stock of fixed assets and net foreign assets as a country’s net wealth; and each column sums to the sector’s net wealth.

Although models of this size defied algebraic solution, cheaper and faster computers were by now facilitating their analysis in ways unavailable to Godley and Cripps before 1983. So Godley’s paper also presents simulations for (among others) a rise in interest rates and in the -to-output ratio. These show the adjustment paths of the various stocks until they regain stability. The “fully-articulated stock-flow model” (Godley 1999:409) still contained numerous simplifying assumptions (including the absence of discretionary fiscal policy, international trade and owner-occupied homes as household wealth). But by making these visible, and clearly distinguishing among behavioural assumptions, accounting identities and empirically identifiable ‘target’ stock-flow ratios, it gave an open invitation to explore the implications of stock-flow consistency through additional simulations on – and developments of – this type of model. Despite its presentational newness, Godley presented his approach as a development of monetary and distributional ideas from his long-time mentor Kaldor – perhaps wary of some earlier tensions which had developed during the Cambridge years when his engagement with Tobin’s portfolio approach, and assertion that a stable private-sector saving-to-income ratio could cause a fiscal deficit to dissipate into a current- account deficit, led some critics to mislabel Godley and Cripps as closet monetarists (Dixon 1982-3). Godley also acknowledges other Keynesian influences including Levy Institute colleagues Lavoie, George McCarthy and Randall Wray, plus Charles Goodhart, Augusto Graziani, Basil Moore and Paul Davidson.

Unpublished drafts from the mid-1980s and early 1990s also reveal decisive contributions to the refinement of Godley’s SFC framework from Ken Coutts in Cambridge, and from former Treasury colleague Sir Bryan Hopkin, then based in Cardiff. Examining Treasury papers released under the 30-year rule, John Maloney (2012) showed how Godley and Cripps’ approach to macroeconomics was shaped by the intensive 1970s policy debates to which they became central (often jousting with Cambridge colleagues as well as monetarist critics elsewhere). Early empirical work by the Cambridge Economic Policy Group (CEPG) suggested that the ratio of private-sector financial assets to income was stable, and that increases in private- sector income (of firms plus households) generating proportionate increases in private expenditure within one year. Applied to the macroeconomic accounting identity, under which any public-sector deficit not offset by a private-sector surplus will transmit to a current-account deficit, this implied that fiscal expansion would quickly worsen the external balance and put downward pressure on the exchange rate. That conclusion made Cripps and Godley (whose Treasury past had included secretly designing the 1967 devaluation) inveterate advocates of import controls - blunting their influence on policymakers who soon found financing an external deficit (through IMF loans or deregulated capital inflows) easier than closing it. Their fears of balance-of-payments constraint also led Cambridge critics (notably Richard Kahn and Michael Posner) to identify the CEPG with monetarist ‘fiscal policy ineffectiveness’. Even when his expanded SFC framework yielded clearly Keynesian results, Godley found a warmer reception for his ideas when he took them on tour.

A presentation of his CJE paper at the University of Ottawa in December 1999 drew an audience that included Marc Lavoie, whose discovery of a mistake in one of the equations (corrected in Godley 2004) sparked a correspondence that led quickly to co-authorship on extensions and additional applications of the framework. In the same year as a sequence of their SFC models (Godley & Lavoie 2007a) was published as Monetary Economics, Godley & Lavoie (2007b) returned to CJE to present one of its more notable policy implications. The matrices were now expanded to include an international sector and a central bank, yielding almost 80 equations, despite subsuming commercial banks (and re-combining firms’ capital and current accounts) for simplicity. The range of financial instruments was also widened, and with sectors in one country allowed to invest or borrow abroad with assets issued by others. By depicting a situation in which two countries submit to a common currency and central bank, while maintaining independent fiscal policies, Godley and Lavoie constructed a framework somewhat similar to that of a Eurozone member (which they arbitrarily called Italy) that merged its monetary arrangements with Germany while maintaining trade and capital flows with the rest of the world. The model’s simulation results were painful: a weaker Eurozone member that suffers a negative external shock (such as a rise in import propensity) suffers a downturn in GDP and a worsening current account balance, while the stronger Eurozone member gets an export boost from the depreciating common currency, with its budget moving into surplus to prevent inflation on reaching full employment. The weaker member’s crisis could widen to engulf the whole zone if the (common) central bank ceased to buy the debt resulting from its cyclical budget deficit, or if financial markets panicked at the inexorable rise in its debt-to-income ratio.

Like Pasinetti on the eve of the Euro’s launch, Godley and Lavoie had used the SFC framework on the eve of the global financial crisis to identify the dire fate awaiting Italy (and other weaker Eurozone members) when hit by an external shock, after a deceptive first decade in which the single currency area was unusually free of them. Godley’s Levy Institute reports (notably on the ‘Seven Unsustainable Processes’ (Godley 1999b) had anticipated the GFC by identifying various stock-flow ratios rising far above historic norms. ‘Three economies with two currencies’ laid bare the Eurozone’s design flaws, and the likelihood of ongoing misery of Eurozone members that were banned from sufficiently expansionary fiscal policy when the common monetary policy proved too tight. The less economically damaging ways out – fiscal transfers from stronger to weaker members via a larger EU budget or an ‘anti-Maastricht’ stricture against fiscal surpluses – were not obviously politically viable.

The models developed by Godley and Lavoie made clear that ‘Keynesian’ effects resulted from particular behavioural assumptions introduced to match equations to unknowns, leaving scope to test the results of different assumptions, as well as of different ways to break-down the economy’s sectors and financial instruments. Claudio dos Santos (2006) explored the effect of different behavioural ‘closures’, in a paper that also popularised the ‘SFC’ term for this approach to macro modelling. Dos Santos presents SFC as the ‘natural outcome’ of Keynesians’ model development in the 1960s and 70s. Because the accounting framework is neutral in regard to the origins and direction of causation, until structural and behavioural assumptions are added, different economic theories can provide different ‘closures’ for the system.

By presenting a set of aggregate balance sheets, transactions-flow and social accounting matrices that are compatible with them all, dos Santos showed how the analyses of Godley, Tobin, Hyman Minsky and Paul Davidson can be understood as alternative closures. Godley assumes a stable long-run ratio of household income to wealth, retaining the ‘stable net acquisition of financial assets’ assumption that appeared empirically confirmed by 1960s UK data despite its apparent breakdown in the high-inflation 1970s. Tobin endogenises this ratio, leaving room for households to make their consumption and saving decisions simultaneously, responding to interest-rate incentives, in a way more compatible with long-term ‘lifecycle’ financial planning (Modigliani & Brumberg 1954). Davidson (1972) inserts his Keynesian twist via an investment function that includes the accelerator effect of rising sales and profit margins, and (in common with Minsky and Godley) the level of retained profit, while Tobin emphasises its link to firms’ ‘q’ ratio of market value to book (replacement) value. Dos Santos also demonstrated how these four authors model the role of commercial banks in different ways, while broadly agreeing on central banks’ ability (with sovereign money) to finance any government bond issues that the private sector does not take up.

Genie out of the bottle 2007-present

In 2006, Dos Santos was still troubled by “the failure of the SFC approach to be widely accepted by Keynesians” (2006:541). He also raised the question of whether SFC analysis (whichever way it was linked to Keynesian and Kaleckian theories) would simply be dismissed as outdated - because it dispensed with the utility-maximising ‘representative agent’, with which Keynesians might now feel forced to engage because the mainstream had been reformulated on it. Mainstream models with ‘microfoundations’ could also be rendered SFC, provided they kept to a relatively simple world of one commodity, one (producing- consuming) agent and one liquid financial asset. So post-Keynesianism’s fate might rest on whether a more realistic macro-world (with many products, a modern financial sector, and firms acting separately from households) merited the sacrifice of a seamless link to microeconomics. Dos Santos (2006) also noted that, while the SFC approach clarified the static situation with increasingly right institutional detail, its dynamic properties were still relatively unexplored. His case for ‘institutionally rich’ SFC models reflecting the economies’ durable financial and production structures, as a way to study the medium-term implications of Keynesian models, was developed in a follow-up paper by dos Santos and Antonio Macedo e Silva in 2011.

This deficit was substantially addressed by the first edition of Godley and Lavoie’s (2007a) Monetary Economics, which updated several of the SFC modelling exercises that had been published or circulated earlier, and unveiled many others that had not been presented before. Godley and Lavoie’s simulations, revisiting (and extending) those of Godley and Cripps (1983) with the benefit of two decades’ advances in theory and computing power, achieved new levels of detail with the specification of SFC and the exploration of its ‘Keynesian’ closure through simulation. Reviewing Monetary Economics for the CJE, Lance Taylor (2008) started by conceding that its “quite complicated computerised models, set out in loving detail with hundreds of equations and dozens of simulation plots” was not a methodological direction widely favoured in Cambridge, and that the signature accounting matrices are a version of those developed by Sir Richard Stone (1966). Stone’s successor as director of the DAE, Brian Reddaway, had broadened its research agenda from econometrics to the applied policy research preferred by many Keynesians, but the Growth Project directed by Stone continued alongside the Economic Policy Group until the early 1980s. Illustrating the construction of Godley’s matrices to indicate how shared roots give way to divergent routes, Taylor pointed out the SFC’s long lineage from Keynes (1930) and Kaldor (1956), and close affinity with the Keynesian financial-cycle analysis of Minsky (1975), which Godley had helped to synthesise while at the Levy Institute. He also showed how easily the SFC approach can incorporate past work (by Coutts, Godley & Nordhaus (1978) among many others) on mark-up pricing, shedding light on the interactions between changes in mark-ups, income distribution, aggregate output and capacity utilisation.

Taylor highlighted another presentational innovation popularised by Godley’s Levy work, the superimposed time series of public, private and international sector surpluses and deficits expressed as percentages of GDP. These instantly highlight the way that the swing of the US economy into fiscal surplus in the 1990s was mirrored by a slide into private-sector deficit, an inevitability of macroeconomic accounting whose unsustainable impact (on the private debt ratio) went almost unnoticed at the time. The equally inevitable reversal, when forced pay-down of private-sector debt pushed the budgets back into deficit as governments battled the Global Financial Crisis, brought SFC modellers’ foresight to mainstream attention just after Taylor’s article appeared. Even without belated recognition of Godley and Minsky as economists who defied consensus and foresaw the GFC, the appearance of Monetary Economics widened the audience for the SFC approach and encouraged a new generation to explore its applications. Their quest was promoted by the online availability of its underlying programs, translated from Godley’s archaic software by Gennaro Zezza.

The SFC approach is now being widely used to re-examine theoretical debates and refine medium-term economic analysis. Its detailed representation of the financial sector has proved particularly useful for examining the implications of financial deregulation, credit expansion and rising international capital flow. At the same time, its comprehensive capture of income flows between macroeconomic sectors (including the rest of the world) has promoted further development of models which analyse longer-run interactions between growth and income distribution, and trace the impact of changing market power in price- and wage- setting. The macroeconomic effects of financialisation, including increased ‘shareholder value’ pressure and the pro-cyclical bank landing highlighted by Minsky, have been probed by (among others) Peter Skott and Soon Ryoo (2008), Till van Treeck (2009) and Soon Ryoo (2013), with Dirk Bezemer (2016) highlighting importance of a macro accounting approach in understanding financial turbulence once tradable debt becomes money. Post-crisis policy assessments using the technique include a study of the impact of rising inequality in triggering the GFC and slowing the recovery from it by Barry Cynamon and Steve Fazzari (2016), and of the interaction between private-sector stock-flow norms and public sector ‘fiscal rules’ by Yannis Dafermos (2018). Internationalised SFC models have thrown light on, among other topics, the link between rising household debt linked, slow real-wage growth and current-account imbalances (Christian Belabed, Thomas Theobald and van Treeck (2018)), and the effectiveness of monetary and fiscal policies when countries deal separately with different types of inflationary shock (Matthew Greenwood-Nimmo (2014)). Reviewing the state of SFC in 2015, Eugenio Caversazi and Antoine Godin (2015) noted the ongoing debate whether SFC systems are best assessed analytically or by simulation, and the growing interest in adding behavioural ‘microfoundations’, whose absence may be one factor still steering policymakers towards mainstream dynamic stochastic general equilibrium (DSGE) models. While Caversazi and Godin suggest agent-based modelling as a likely way forward, others view the characterisation of sector-level norms and ‘macro’ behaviour as a lasting advantage of the Godley-Lavoie SFC approach; and there is equal interest (led by Pasinettians) in integrating the SFC approach with input-output analysis. The pursuit of SFC has ‘natural’ extensions into the analysis over time of interactions in the biosphere and atmosphere, with researchers into ecosystems and climate change finding particular usefulness in its comprehensive book- keeping and capacity to capture complex causal feedback. Models that combine SFC macroeconomic flows with the pioneering environmental analysis of Nicholas Georgescu-Roegen (Dafermos et al 2017), incorporate the sustainability of assets into balance sheets (Jackson et al 2016), and can thus analyse the two-way interaction of economic shocks and environmental shocks (Berg et al 2015) may offer an alternative to the grafting of environmental flows and ‘natural capital’ stock onto neoclassical growth models, whose pursuit by William Nordhaus (2017) gained a share of the Nobel award in 2018. As its applications and developments spread beyond those envisaged by its pioneers, the origins and early motivations of the stock-flow consistency approach deserve to be kept in view.

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