Behavioural and Post-Keynesian Foundations for a new Macroeconomics Steven Hail A thesis submitted to Flinders University in fulfilment of the requirements for the degree of Doctor of Philosophy Flinders Business School March 2016 TABLE OF CONTENTS List of Tables and Figures v Abstract viii Declaration xi Acknowledgements xii Chapter 1 Introduction 1 1.1 Orthodox macroeconomics – ‘a steadfast refusal to face 1 facts’ 1.2 ‘The game of policy making is rigged’ 11 1.3 ‘Hard’ theories – not ‘soft’ theories 13 1.4 General equilibrium as ‘soft’ theory 22 1.5 Keynesian economics as ‘hard’ theory 28 1.6 ‘Hard’ Behavioural and Post-Keynesian economics 30 Chapter 2 Orthodox (Neoclassical) Macroeconomics 41 2.1 ‘Improvements’ in Monetary Policy 41 2.2 ‘Real analysis’ as ‘soft’ economics 45 2.3 Softening up ‘Keynesian economics’ 52 2.4 From ‘soft’ to ‘supersoft’ economics 58 2.5 The Second Neoclassical Synthesis 67 2.6 In My End is My Beginning 79 Chapter 3 Post-Keynesian Fundamentals: Escaping 84 Neoclassical Orthodoxy 3.1 A Long Struggle for a ‘Hard’ Economics 84 3.2 Keynes and Post-Keynesian Economics 87 3.3 Paul Davidson, Uncertainty and Liquidity Preference 94 3.4 Minsky and Financial Instability 120 3.5 Kalecki and Distribution 158 ii Chapter 4 Behavioural Fundamentals 169 4.1 People as They Are 169 4.2 People as They Are Not 172 4.3 Different Notions of Rationality 175 4.4 Procedural Rationality and Post Keynesian Economics 180 4.5 Cognitive Systems 186 4.6 Orthodox Utility Theory 190 4.7 Anomalies with Orthodoxy 203 4.8 Expected Utility Theory as Non-Science 215 4.9 The Heuristics Approach to Decision Making 223 4.10 Prospect Theory as a Descriptive Theory of Subjective Value 227 and Choice 4.11 Framing and Perceptions of Fairness and Inequality 244 Chapter 5 Monetary Fundamentals 259 5.1 What Mitchell Innes Called ‘Adam Smith’s Error’ 259 5.2 Coins have never been essential to monetary systems 275 5.3 Modern Money 280 Chapter 6 Modern Monetary Theory and Macroeconomic 287 Policy 6.1 Modern Monetary Theory and Functional Finance 287 6.2 Post Keynesian Critics - Palley’s Misunderstanding of Modern 293 Monetary Theory 6.3 Core and Supplementary Axioms of Modern Monetary 297 Theory 6.4 Further Criticisms 303 6.5 Importance of Monetary Sovereignty 313 6.6 Orthodox Views of Fiscal Sustainability 320 6.7 Government and Non-Government Financial Balances 344 6.8 Fullwiler’s Ten Principles of Modern Central Banking 353 Operations 6.9 Monetary Policy in the Text Books and in Reality 367 6.10 Fiscal Implications of the Decoupling Principle 390 Appendix Framing ‘Hard’ Monetary Theory 395 Chapter 7 Stock-Flow Consistent Macroeconomics 408 7.1 The Importance of Correctly Accounting for Flows and Stocks 408 iii 7.2 Godley and Lavoie’s Stock-Flow Consistent, Post-Keynesian 416 Models 7.3 Godley and Lavoie’s PCEX2 Model 425 7.4 Consolidating the Central Bank into the Government Sector 435 7.5 Equations of PCEX 437 7.6 Simulation of a Fiscal Tightening with Interest Rate Cuts in 452 PCEX2 7.7 A Fiscal ‘Taylor Rule’ and Fiscal Sustainability in a SFC Model 459 with a NAIRU Appendix Model 7A and Simulations 466 Chapter 8 An Employer of Last Resort: A Job Guarantee 508 8.1 Involuntary Unemployment Always and Everywhere Reduces 508 Subjective Well-Being 8.2 Inflation and Unemployment 518 8.3 A Three Part Non-Accelerationist Phillips Curve 528 8.4 A New Institutional Framework – Job Guarantees and 540 Mitchell’s NAIBER 8.5 Framing a Job Guarantee 544 8.6 What Makes Workers Happy? 552 Chapter 9 Conclusion 557 References 561 iv LIST OF TABLES AND FIGURES Tables Table 2.1: Australian Average Real GDP Growth; Average CPI Inflation; 44 Average Official Unemployment; by decades; 1960-1915 Table 2.2: Average Annual Real GDP Growth by decades; 1960s-2015 44 Table 3.1: Private Balance Sheets in Minsky’s Financial Instability 135 Hypothesis Table 4.1: Two Cognitive Systems 186 Table 4.2: Data from Quattrone and Tversky’s Experiment 209 Table 4.3: The Four-Fold Pattern of Common Attitudes to Risky Prospects 219 Table 4.4: Lowenstein, Thompson and Bazerman’s Experimental Results 248 Table 6.1: A Simplified Central Bank Balance Sheet 358 Table 7.1: Balance Sheet of Model PC 428 Table 7.2: Transactions-flow matrix of Model PC 433 Table 7.3: Simplified Balance Sheet of Model PC, with consolidated 435 Government Sector Table 7.4: Simplified Transactions-flow matrix of Model PC, with 436 consolidated Government Sector Table 7A.1: Model 7A; Balance Sheet 468 Table 7A.2: Model 7A; Balance Sheet; ‘Year 2000’ Values 470 Table 7A.3: Model 7A; Transactions Matrix 471 Table 7A.4: Model 7A; Balance Sheet; ‘Year 2000’ Values 473 Figures Figure 1.1: Australian Commonwealth Budget Balance (to 1996); General 2 Government Fiscal Balance (from 1996); % of GDP Figure 1.2: The Case-Shiller 20 City Composite Index; S&P 500 Share 6 Index; and US Nominal Personal Disposable Income; % of Jan 2000 values; 2000-15 Figure 1.3: US Household Debt Service Costs as a Percentage of Personal 8 Disposable Income; 1992-2015 Figure 3.1: Minsky’s Keynesian Two-Price Model of Investment 126 Figure 3.2: Investment during a Period of Euphoria in The Two-Price 133 Model Figure 3.3: Collapsing Investment Demand in a Great Recession 136 Figure 3.4: Australian Household Debt to Disposable Income Ratios; Total 157 Debt; Total Mortgage Debt; Owner-Occupier Mortgage Debt; and Investment Mortgage Debt; 1988-2015; per cent. v Figure 3.5: Share of Labour Income in US Gross Domestic Product; 1970- 165 2014; per cent Figure 4.1: Pascal’s Wager 192 Figure 4.2: Bernoulli’s Utility Function 196 Figure 4.3: Allais’ Paradox – Certainty versus Risk 205 Figure 4.4: Allais’ Paradox – The Common Ratio Effect 206 Figure 4.5: Kahneman and Tversky’s Two-Part Subjective Value Function, 235 with 휆 = 2.3, and 훼 = 훽 = 0.6. Figure 4.6: Decision Weighting Function, Over-weighting Rare Events 237 Figure 4.7: Decision Weighting Function, during a ‘Radical Suspension of 240 Disbelief’, when past occurrences of rare events have faded from memory. Figure 4.8: Value Functions for disadvantageous inequality; advantageous 249 inequality (business dispute; negative relationship); and advantageous inequality (social dispute; positive relationship) Figure 5.1: The Pyramid of Money 283 Figure 6.1: Three Sector Financial Balances – Australia, 1994-2014 345 Figure 6.2: Five Sector Financial Balances – Australia, 1994-2014 346 Figure 6.3: Fiscal Space and Financial Fragility: the Parenteau Chart 350 Figure 6.4: Australia’s Parenteau Chart: Pre- and Post-GFC 352 Figure 6.5: The Liquidity Preference Schedule of The General Theory 368 Figure 6.6: The Orthodox Money Market Equilibrium Diagram 370 Figure 6.7: Central Bank Accommodation of an increase in the Demand for 373 Base Money, in the Orthodox Diagram Figure 6.8: The Horizontalist View of Monetary Policy 374 Figure 6.9: Perfectly Interest Inelastic and Shifting Daily Demand for 377 Reserve Balances Figure 6.10: Interest Rate Targets with Reserve Ratio Requirements and 379 Averaging Periods Figure 6.11: An Interest Rate Corridor with a Zero Floor Rate 381 Figure 6.12: A Corridor with a Zero Floor and Reserve Averaging 382 Figure 6.13: A Corridor with a Non-Zero Floor Rate 384 Figure 6.14: Combining a Corridor with a Non-Zero Floor with Reserve 385 Averaging Figure 6.15: A Zero Corridor 386 Figure 6.16: The Provision of ‘Excess Reserves’ 389 Figure 6.17: The conservative economic construction 399 Figure 6.18: The economy is ‘Us’ 401 Figure 7.1: Simulation of a 2% Fiscal Tightening, with an Interest Rate Cut 455 from 2.5% to 1% in Model PCEX 2, with an assumed 50% marginal tax rate Figure 7.2: Evolution of Fiscal Balances in the Simulated Tight Fiscal/Loose 457 Monetary Policy Mix in PCEX2 Figure 7A.1: Nominal GDP. Model 7A - Base Case; 2000-60 489 Figure 7A.2: Unemployment Rate. Model 7A - Base Case; 2000-60 489 Figure 7A.3: Real GDP Growth Rate. Model 7A - Base Case; 2000-60 490 vi Figure 7A.4: Primary and Fiscal Balances to GDP. Model 7A- Base Case; 490 2000-60 Figure 7A.5: Domestic Expenditure Shares in GDP. Model 7A - Base Case; 491 2000-60 Figure 7A.6: 3-Sector Financial Balances to GDP. Model 7A -Base Case; 491 2000-60 Figure 7A.7: 3-Sector Financial Balances to GDP. Model 7A - Base Case; 492 2000-60 Figure 7A.8: Government ‘Debt’ Ratio. Model 7A- Base Case; 2000-60 492 Figure 7A.9: External Debt Ratio. Model 7A - Base Case; 2000-60 493 Figure 7A.10: Wage Share in GDP. Model 7A - Base Case; 2000-60 493 Figure 7A.11: Household Debt Ratio. Model 7A - Base Case; 2000-60 494 Figure 7A.12: Price Level and Wage Rate. Model 7A - Base Case; 2000-60 494 Figure 7A.13: One-Off Reduction in Rate of Growth of G from 4% to 1.92% in 497 2020. Model 7A - Impact on GDP relative to Base Case; 2015- 50 Figure 7A.14: One-Off Reduction in Rate of Growth of G from 4% to 1.92% in 498 2020, combined with a permanent cut in the ‘Cash Rate’ from 2% to 0%. Model 7A - Impact on GDP relative to Base Case; 2015-50 Figure 7A.15: ZIRP versus No-ZIRP; 2015-50 499 Figure 7A.16: A Mild Fiscal Rule for Eventual Full Employment; 2015-50 501 Figure 7A.17: GDP Growth under the Mild Fiscal Rule; 2015-50 502 Figure 7A.18: Unemployment with a Rising Degree of Monopoly; No Fiscal 503 Response; 2020-40 Figure 7A.19: Unemployment with a Rising Degree of Monopoly; 505 Aggressive Fiscal Response; 2020-40 Figure 8.1: Australian Underutilisation Rate for Workers Aged 16-24, per 518 cent Figure 8.2: Australian Inflation and Unemployment, 1960-2015 523 Figure 8.3: Australian Three-Part Phillips Curve, 1976-1990 529 Figure 8.4: Australian Horizontal Phillips Curve, 2002-12 530 Figure 8.5: The Three-Part Phillips Curve 534 Figure 8.6: The 1970s and the Three-Part Phillips Curve 536 Figure 8.7: Rising ‘Structural Unemployment’ and the Three-Part Phillips 539 Curve vii Behavioural and Post-Keynesian Foundations for a new Macroeconomics ABSTRACT Orthodox macroeconomics, as it is taught in the majority of universities around the world, and practised in governments, central banks, and international agencies, limits the range of economic policy proposals which can be given serious consideration, and consequently biases policy outcomes.