The finan cial instabil ity hypo thesis is a variant of postKeynesian econom ics.
The inter pret a tion of Keynes that has descen ded from the form al iz a tions by Hicks, Hansen, Modigliani, and Patinkin of the General Theory has always been of ques tion able legit im acy.2 The inter pret a tion of Keynes that is devel op ing under the rather unfor tu nate label of postKeynesian econom ics emphas izes the import ance of time and uncer tainty, espe cially as they relate to capital
asset pricing, invest ment, and the liab il ity asset struc tures of house holds, busi ness, and finan cial insti tu tions, to an under stand ing of Keynes. One focal point of the emer ging postKeynesian theory is the propos i tion that the liquid ity pref er ence func tion of the neoclassical synthesis is both a poor repres ent a tion of Keynes’ thought and an inept way to examine how money and finance affect the beha vior of a capit al ist economy.3
In the inter pret a tion of Keynes used in the neoclassic synthesis the liquid ity pref er ence func tion is inter preted as a demand for money func
tion. In the rebut tal to Viner’s outstand ing review of the General Theory, Keynes denied the valid ity of such an inter pret a tion.4 Keynes argued that with a given set of long run expect a tions (and with given insti tu tional arrange
ments and conven tions in finance) the supply and demand for money affects the price level of capital assets. In partic u lar Keynes argued against any view that the effect of the quant ity of money was mainly on the price level of output or even the money value of output. Keynes argued that the supply and demand for money determ ines the price level of capital assets. This objec tion by Keynes has been ignored and the neoclassical model build ers continue to inter pret liquid ity pref er ence as a demand equa tion for money.
The revival of the quant ity theory by Professor Friedman rests upon a stable demand for money func tion which permits the money supply to be the main determ in ant of the money value of total output.5 It is but a small step from Friedman’s construct to the preKeynesian view that the supply and demand for labor yields output and the quant ity of money yields the price level.
The current domin ant thrust in economic theory, which holds that the Walrasian theor et ical scheme of a system of inter de pend ent equa tions in
which relat ive prices are the only argu ment, is valid and that the main propos i tion of this theory, which is that the economy will follow a full employ ment growth path, is valid, has taken economic theory full circle back to the 1920s and 30s. This time however, the neoclassical theory is buttressed against the objec tions raised by Keynes by what special ists in the philo sophy of science char ac ter ize as degen er at ive and ad hoc assump tions.
In the light of the current state of capital theory it is known that the proposi
tion that an invest ing economy with money and capital assets gener ates a growth equi lib rium rests upon a prior assump tion that invest ment goods and capitalasset prices are always equal.6 This equal ity assump tion is equiva
l ent to assum ing that the economy is now and always will be in equi lib
rium. Assuming the “result” that a theory is “designed” to prove is clearly not admiss ible. The buttress ing of neoclassical theory by the assump tion that capitalasset prices are equal to invest ment goods prices reduces neoclas sical theory to a tauto logy.
The view that Keynes advanced in his rebut tal to Viner (a view which appears in the General Theory) is that money, along with liab il ity struc ture pref
er ences, the mix of avail able capital assets, and the supply of finan cial assets, gener ates the prices of capital assets. In Keynes’ view, each capital and finan
cial asset is a combin a tion of quick cash and future income. Furthermore, each liab il ity is a dated demand or contin gent commit ment to pay cash. As a result of the nature of debts and contracts there will always be a subject ive return from holding quick cash. The quant ity of money determ ines the amount of quick cash that will be held and thus the subject ive returns from holding money. The money prices of those assets which can be exchanged or pledged for quick cash only at a cost and with varying degrees of certainty but which yield cash income streams will have prices that adjust to the stand ard set by the subject ive return on money. In contrast to the way in which the price system for capitalassets is set the price system of current output (both consump tion and invest ment output) is set by the short run profit expect a tions of firms, demand condi tions, and the cost of produ cing output.
In the aggreg ate, and in a closed economy, the costs of using capital assets to produce current output are mainly labor costs. The price system of current output is keyed to the money wage rate as the main determ in ant of relat ive unit costs of differ ent outputs.
A capit al ist economy, there fore, is char ac ter ized by two sets of relat ive prices, one of current output and the other of capital assets. Prices of capital
assets depend upon current views of future profit (quasirent) flows and the current subject ive value placed upon the insur ance against uncer tainty embod ied in money or quick cash: these current views depend upon the expect a tions that are held about the longer run devel op ment of the economy.
The prices of current output are based upon current views of near term demand condi tions and current know ledge of money wage rates. Thus the prices of current output—and the employ ment offered in produ cing output—depend upon shorter run expect a tions. Capitalasset and current output prices are based upon expect a tions over quite differ ent time hori
zons: capital asset prices reflect long run expect a tions and current output prices reflect short run expect a tions.
The align ment of these two sets of prices, which are based upon quite differ ent time hori zons and quite differ ent prox im ate vari ables, along with finan cing condi tions, determ ines invest ment. Furthermore current invest
ment demand, along with other factors, such as consump tion out of profit income, savings out of wages income, the way govern ment taxes and spend ing respond to income, and the foreign trade balance yields aggreg ate effect ive demand. The aggreg ate effect ive demand for consump tion, invest
ment, govern ment, and export output yields employ ment.
The finan cial instabil ity hypo thesis starts with the determ in ants of each period’s effect ive demand. It takes into account the finan cial residue or legacy from past finan cing activ ity and how this legacy both imposes require ments upon the current func tion ing of the economy and condi tions the future beha vior of the economy. The finan cial instabil ity hypo thesis forces us to look beyond the simple account ing rela tions of the Gross National Product tables to the flows of funds in a capit al ist economy where cash payment commit ments exist because they are a legacy from past finan cing decisions.
The finan cial instabil ity hypo thesis which is rooted in Keynes differs from what is expli cit in Keynes and other postKeynesian econom ists in that finan cial insti tu tions and usages are integ rated into the analysis. Furthermore, because of the emphasis upon finance and the way in which changes in relat ive prices of current output and capital assets are brought about the finan cial instabil ity hypo thesis is more clearly a theory of the cyclical beha vior of a capit al ist economy than the economic theory of other postKeynesian econom ists. That is, the finan cial instabil ity hypo thesis leads to an invest ment theory of the busi ness cycle and a finan cial theory of invest ment.
III. INvESTMENT, CONSUMP TION, AND THE THEORY OF EFFECT IvE DEMAND7
The distinc tion between invest ment and consump tion demand and the differ ences in the vari ables, markets, and consid er a tions that affect these demands are crucial to an under stand ing of:
1. Why a theory of effect ive demand is neces sary,
2. The concept of equi lib rium that is relev ant for the under stand ing of an invest ing capit al ist economy and how the relev ant concept differs from the concept as used in stand ard economic theory, i.e., the differ ence between Keynesian and Walrasian ideas of equi lib rium, and
3. The beha vior of a capit al ist economy that uses expens ive capital assets in produc tion and which has complex, soph ist ic ated, and evolving finan cial insti tu tions and prac tices.
In recent years a consid er able liter at ure on the inter pret a tion and true meaning of Keynes has been produced.8 Part of this liter at ure consists of inter pret ing “Keynesian Economics” as a “disequi lib rium state” within the frame work provided by static Walrasian general equi lib rium theory. In these inter pret a tions assump tions about market beha vior, in the form of sticky prices, are intro duced so that “short side” sales or “ration ing” char ac ter izes the equi lib rium. The “short side outcome” or “ration ing” of jobs yields unem ploy ment as an equi lib rium of a constrained system. In these models wage, price, and interest rate rigid it ies are constraints which lead to the unem ploy ment result. The unem ploy ment result is taken to char ac ter ize Keynesian analysis.9
This disequi lib rium approach completely misses the central problem that was iden ti fied by Keynes, which is that in a capit al ist economy the vari ables and markets which determ ine invest ment demand are differ ent from the vari ables and markets that determ ine the extent to which labor is applied to exist ing capital assets to produce “current output.” Keynes worked with inter de pend ent markets, but the inter de pend ence stretched back and forth through time and the vari ables and markets that are relev ant to one set of time depend ent decisions are not the same as those that affect other sets. In these inter de pend ent markets the signals from current util iz a tion rates to invest ment demand can be apt, nonexistent, weak, or perverse depend ing upon rela tions and insti tu tions that reflect the history of the economy.
The main issue in the contro versy about what Keynes really meant is not the discov ery of the true meaning of the “Master’s” text. The main issue is how to construct a theory that enables us to under stand the beha vior of a capit al ist economy. Hopefully under stand ing how a capit al ist economy behaves will give us know ledge that will enable us to control and change it so that its most perverse char ac ter ist ics are either elim in ated or atten u ated.
In this quest Keynes provides us with the “shoulders of a giant” on which we can stand as we do our little bit. Therefore an attempt to under stand Keynes is a valid scientific endeavor.
To under stand Keynes it is neces sary to recog nize that Keynes’ analysis was not solely given to explain ing unem ploy ment. True the massive and continu ing unem ploy ment of the 1930s was a “crit ical exper i ment” thrown up by history which forced a recon sid er a tion of the valid ity of the inher ited economic theory. However, Keynes, while allow ing for and explain ing the time to time appear ance of deep and persist ent unem ploy ment, did not hold that deep depres sions are the usual, normal, or ever last ing state of a capit al ist economy. The collapse of the world’s finan cial order over 1929–1933 was another “crit ical exper i ment” that forced a recon sid er a tion of inher ited economic theory. Keynes’ special theory argued that in a partic
u lar conjunc tion, where a finan cial crisis and a debt defla tion process had just occurred, endo gen ous market processes were both inef fi cient and quite likely perverse, in that they would tend to make matters worse with regard to elim in at ing unem ploy ment. This state of things would not last forever, but would last long enough to be polit ic ally and socially relev ant.
Keynes’ General Theory viewed the progress of the economy as a cyclical process; his theory allowed for trans it ory states of moder ate unem ploy ment and minor infla tions as well as serious infla tions and deep depres sions.
Although cyclical beha vior is the rule for capit al ist econom ies, Keynes clearly differ en ti ated between normal and trau matic cycles. In a foot note Keynes noted that “it is in the trans ition that we actu ally have our being.”10 This remark succinctly catches the inher ently dynamic char ac ter ist ics of the economy being studied.
Disequilibrium theor ists such as Malinvaud persist in forcing the analysis of inher ently dynamic prob lems into their static general equi lib rium frame
work. In this frame work constraints and rigid it ies are intro duced to determ ine the char ac ter ist ics of the “equi lib rium.” In doing this Malinvaud hides the inter est ing and relev ant econom ics in the market and social processes that determ ine the constraints. The disequi lib rium theor ists may
construct logic ally sound models that enable them to demon strate some degree of theor et ical virtu os ity, but at the price of making their econom ics trivial.
Keynes’ novelty and relat ively quick accept ance as a guide to policy were not due to his advocacy of debt financed public expendit ures and easy money as apt policies to reverse the down ward move ment and speed recov ery during a depres sion. Such programs were strongly advoc ated by various econom ists through out the world. Part of Keynes’ exas per a tion with his colleagues and contem por ar ies was that the policies they advoc ated did not follow from their theory. In the United States econom ists such as Professor Paul Douglas, Henry Simon, and even Jacob Viner, all of whom were at the University of Chicago, advoc ated what would now be called expan sion ary fiscal policies well before the General Theory appeared. Before Herbert Hoover was pres id ent of the United States he was Secretary of Commerce. As such he sponsored commis sions and reports which advo cated a budget that was balanced over the busi ness cycle rather than annu
ally, i.e., under his auspices contracyclical fiscal policies were advoc ated.
However these econom ists and politi cians did not have and hold a theory of the beha vior of capit al ist econom ies which gave credence to their policies:
their policy advice was divorced from their theory. Keynes’ contri bu tion can be inter preted as provid ing a theory that made activ ist expan sion ary policy a “logical infer ence from a tightly knit theory.”11
The concept of “effect ive” or aggreg ate demand and the market processes that determ ine each trans it ory equi lib rium of effect ive demand and supply are central to Keynesian theory and central to an under stand ing of the dynamic processes that determ ine the beha vior of the economy. Significant and serious market fail ures occur because market processes do not assure that effect ive demand will be suffi cient to achieve full employ ment.
Furthermore when effect ive demand is suffi cient, so that full employ ment is first achieved and then sustained, market processes will take place which lead to a “spec u lat ive” invest ment and finan cial boom that cannot be sustained.
Effective or aggreg ate demand is the sum of two demands: consump tion demand and invest ment demand. (Government and the rest of the world are ignored for now.) Businesses offer employ ment and thus produce output on the basis of the profits they expect to earn by using labor and the exist ing capital assets to produce and distrib ute consump tion and invest ment output.
In produc tion and distri bu tion demand for labor to use with exist ing capital
assets depends upon what Keynes iden ti fied as “short run expect a tions.” In determ in ing the price at which shoes will be offered to American and German distrib ut ors for the “next” season, Italian produ cers need to estim ate their labor and mater ial costs over this relat ively short horizon. The American and German whole sale and retail firms have to estim ate next summer’s market for shoes in their country—which mainly depends upon their expect a tions of income, employ ment, and price devel op ments. Similar short run consid er a tions center ing around invest ment projects under way, author
iz a tions to spend on invest ment approved by busi ness, and finan cing arrange ments being made affect the employ ment and output decisions of the produ cers of goods used in invest ment. Employment offered in the construc tion industry, where projects are under taken on the basis of “orders in hand,” also relates to short run expect a tions. Thus it is short run expect a
tions that lead to the produc tion of consumer and invest ment goods.
Standard gross national product stat ist ics measure the result over a period of time of a set of short run expect a tions.
In addi tion to decid ing how to use exist ing capa city busi ness has to decide whether and how to expand capa city. Whereas the util iz a tion of exist ing capa city is determ ined by price, cost, and there fore profit expect a
tions over a relat ively short run (six months, one or two years) the decision to expand capa city is determ ined by profit expect a tions over a much longer time horizon: ten, twenty, and even forty years. Thus uncer tainty, in the sense that there is a need to decide and act on the basis of conjec tures about future economic and polit ical situ ations which in no way can be encom
passed by prob ab il ity calcu la tions, enters in an essen tial way into the determ in a tion of that part of today’s effect ive demand that is derived from invest ment beha vior.
Investment demand is financed in a differ ent manner than consump tion demand. It is true that in a world with consumer credit, banks and finan cial rela tions affect consump tion demand, but consumer demand mainly depends upon income plus the demand for capital assets, while invest ment truly depends upon the condi tions under which short and long term external finance are avail able. Thus the demand for invest ment output is affected by the long run expect a tions not only of busi ness men but also of the finan cial community. Finance and finan cial markets enter in an essen tial way in gener at ing the effect ive demand for invest ment output.
The distinc tion between the external finan cing of house hold demand—
consumer finan cing and the finan cing of home owner ship—and of