The objective of this book is not minor at all. Acknowledging the existence of a complex institutional structure that includes households, firms, banks and governments (sometimes separated from the Central Bank), "our aspiration is to introduce a new way in which an understanding can be gained as to how these very complicated systems work as a whole" (preface, p. xxxiv). However, the authors recognize that this is just a beginning, leaving everything to play for, in their own words.
Using a clear and pleasant style, the "new way" referred above is currently known as Stock-Flow Consistent modelling (SFC). The origin of this method can be traced at least to Tobin and Brainard (1968). It was developed by two groups, originally: The one of Tobin in Yale (the so called New Haven School or the Pitfalls Approach), and the other one in Cambridge (the New Cambridge School, led by Godley). The main bid of Godley and Lavoie (G&L, from now on) is to show (successfully, one could note) that the SFC models make it necessary to fully articulate an accounting structure, avoiding "black holes", gaining in consistency, accuracy, and providing a common framework for the comparison of different models.
The authors use the SFC framework to support a shift to the Post-Keynesian paradigm, also known as 'structuralist'.1 This approach tries to follow Keynes’s call for the development of a monetary theory of production, one that assigns a place for real-world features, such as incertitude, the existence and importance of institutions (broadly understood, to cover not only government but also firms, banks, even the conventions that rule the behaviour of agents, etc.), the role of time, and money, not merely as a numeraire, but as a key to the understanding of the behaviour of the economy, for its mitigating effect on factors mentioned above such as uncertainty and time. I apologise for not giving a comprehensive view of that paradigm, but matters of space forbid me of doing that, and G&L made a good case in their favour.
Although this kind of modelling has its limitations, acknowledged by Godley and Lavoie (quite similar to those of models that postulate a stationary or steady state), as one reads further one gets really convinced that it is the type of approach that makes it possible to analyse a great number of elements and complexities of the real world, as much as one wishes! (obviously, with the indispensable and invaluable help of the computer). One interesting point to mention is that the models deployed in the book are available on the internet for anyone who wants to reproduce the simulations, try out alternative parameters, or even change the models, with relatively limited skill.
Since we have talked about the method, let’s start to describe it. G&L adopt an institutional classification (households, firms, banks, government and the central bank). All the models presented in the book start with a "balance sheet" matrix, where all the assets and liabilities of each sector are described. These demonstrate that the assets of each sector (such as the holding of bonds and money by households) are necessarily the liabilities of another sector, so that every row must sum zero (except in the case of the stock of tangible capital, inventories, and gold reserves of the central bank). This key principle is also reflected in the fact that every transaction implies a "quadruple entry" in the matrix, two by each sector involved. As for the columns, one must add at the end a row that represents the net wealth of the sectors, with a sign opposite to the difference between assets and liabilities.
Godley and Lavoie also always present a transaction-flow matrix. A revaluation matrix can also be considered, taking into account capital gains, so as to explain the evolution of wealth from period to period. The transaction-flow matrix is certainly the most important of the matrices, because, as the authors say, "the transactions flow matrix, which ties together real decisions and monetary and financial consequences, is the backbone of the monetary production economy that Keynes and his followers, the post-Keynesians, wish to describe and to model" (p. 47). All this is presented in a clear and precise manner in Chapter 2. To finish the construction of a model, you need behavioural hypotheses. Given the coherence of the accounting system that characterizes the model, there will always be a redundant equation, because of a quasi "Walras’s Law": the nth equation is always implied by the others n-1 equations.
From Chapter 3 on, G&L present different models, the first ones being very simple, gradually adding complexities by introducing more sectors, enlarging the number of financial assets, opening the economy, etc. In a sense, one can say that they apply the deductive method of successive approximation of Ricardo, though they do not stick to the Marshallian ceteris paribus method, because they analyze the entire system, and never change a variable while leaving the others constant. G&L say that their model is grounded in historic time, since they explicitly describe the changes in the stock variables through time, thus explaining and describing what happens during the traverse between two stationary states when the first is subject to a disturbance. One must note that this method has more to do with Kaldor (1934) than with Joan Robinson (1997), though in the last chapter they get close to the latter, by not postulating any inherent tendency towards a new stationary state. Last but not least, the authors talk of two different meanings of the word "equilibrium". G&L speak of a temporary equilibrium when the relation between the flow variables remains constant, while the stationary long term equilibrium is the one in which not only the relation between flow variables but also between stocks remains constant.
As we said, the model of Chapter 3 is very simple (in fact, it is called SIM, for simple). One element that recurs is the chosen consumption function, à la Modigliani, where current consumption depends on disposable income (in many cases expected disposable income) and past accumulated wealth. That’s why in certain simulations the results could contradict some Keynesian results, such as the paradox of thrift.
Chapter 4 introduces the Central Bank, Treasury bills and interest payments, and in the following chapter they introduce long term government securities. Households assign their savings, after having decided how much to consume, among an array of financial assets along the lines of a portfolio choice à la Tobin. In this model, money is fully incorporated, not only as a medium of payment, but also as reserve of value. The authors go one step further, showing that money acts as a buffer when agents have mistaken expectations, which should be the norm in a world of uncertainty as the one we live in. The authors stay firmly in the horizontalist tradition (they postulate that the Central Bank and the Treasury, with some caveats, can set interest rates, whether they be short term or long term, nominal or real), although they also explore other possibilities.. Among the inferences one can extract from these models, one can mention the lack of control of government over its budget position. Also, public deficits, far from being a burden for the economy (to some extent, at least), can be a requirement for long term growth. Finally, the integration and interrelations between different sectors might lead to paradoxical results: for example, the interest rate has the well-known negative effects on investment, but it also determines the flow of payments of debt servicing, and as long as the creditors are local residents, it might exert a positive effect on effective demand. One must highlight also the considerations about certain restrictions faced by fiscal policy and government debt, according to the different simulations.
In Chapter 6, G&L open the economy. They start with two regions within one single country, but later they assume two different countries, each with its own policies. One can often deduce conclusions opposite to those of the standard neoclassical recommendations and postulates, such as the Mundell-Fleming model (one of the favourite targets of G&L): the authors contend that, even in fixed exchange rates regimes, countries have the capability of imposing interest rates of their choices; they also highlight the defensive character of sterilization. These conclusions, in line with the "cambist" view of the determination of exchange rate, will be repeated in Chapter 12 with a more complex model, more exchange rate regimes, and different means by which the Central Bank and the Treasury defend the parity of the home currency. In a sense, these models show two characteristics: first, there is a certain similitude with Kalecki (for example, with respect to the effect of a surplus in the current account on domestic demand), which should not take anyone by surprise; secondly, the achieved results are very similar to those of Thirlwall and McCombie, among others (see the interview). Given that G&L’s models cover a good part of the realities of international finance, the implications one can derive are very interesting, for example in relation to the accumulation of foreign reserves by the Central Bank (which in the model, can occur without any objective boundary), and even about Cavallo’s zero deficit policy!2
The book has many descriptions of historical episodes which are convenient for the illustrations of the results at hand. It also includes several appendixes or sections of great interest for the Argentinian economy, such as the discussion of monetary policy under a currency board. Later chapters introduce further complexities: banks, investment, profits, pricing (and inflation with it), etc. The authors postulate a conflicting-claims inflation theory, in the tradition of Kalecki. The model questions, obviously, the mere existence of a NAIRU, because there the Phillips curve has a flat segment. However, one could ask for a more thorough treatment of the features of the inflation theory defended, expressed mainly in the chosen real wage function. For instance, the choice of the level of the employment rate instead of the rate of change of employment could be questioned. But one must recognise that the non-linearity in the real wage targeted by trade unions, according to the level of employment, is certainly an innovation in these kinds of models.
By the tenth chapter the heavy artillery of the book comes out. The model, of eighty (80) equations, combines government-issued money (high-powered money or monetary base) with endogenous money, assuming that investment is limited to inventories. One of the most attractive features of the model is the array of financial assets available to households: money, checking deposits, time deposits, bills and Treasury bonds. As already mentioned, the allocation of saving between each of them is made according to a portfolio choice, with the usual adding-up requirements. Another interesting element is the realism introduced in the behaviour and constraints of banks (their holdings of government debt, the compulsory reserve requirements on deposits, the possibility of obtaining advances from the Central Bank, etc.).
The model presented in Chapter 11 is simply amazing, enormous, even as a closed-economy model. The complexities introduced are many, and care has been taken to register the interactions between apparently such diverse elements as productivity changes and profits including those of banks!. Although the model is complex and requires a great amount of attention from the reader, it is a pleasure to move along its descriptions of different sectors, their restrictions, and particularly their behaviour (those of firms and banks are incredible because of their realism), as well as their complications (credit rationing, a Phillips curve with flat segments, capital requirements for banks as established by the BIS, dividend distribution policies of banks and firms, etc.). Regretfully, the model does not seem to generate non-linear endogenous business cycles, a feature of the real world, but this may be asking too much! The results obtained are very interesting, with deep implications for the design and implemenation of economic policies, and at the same time they demystify many claims, often heard nowadays. Take for example the postulated effects of interest rate changes. One is tempted to say that the "bonds festival" of Lavagna motivated the construction and automobile sectors! Well, not that much, but it certainly gives us a warning about keeping in mind the different effects of a measure, according to the variables it influences, however bizarre it might seem. Remembering the authors’ emphasis on the government’s ability to impose the interest rates of its choice, one could affirm that the sector most damaged by high interest rates is the government sector itself, because of the debt service it must face. Another example refers to the inconsistent claims of politicians and economists who that argue for a budget surplus even when the private sector runs a net surplus, such as normally is the case with an economy operating near full employment.
The last chapter underlines some characteristics of the modelling methods used, emphasizing their differences with Tobin’s work. The book ends with a summary of the requirements for an alternative monetary theory.
After all that has been said, one can only congratulate Godley and Lavoie for this book, which is compulsory reading, because of its scope, its holistic view, and because it obliges the reader (including this reviewer, of course) always to have in mind all the aspects that are simultaneously involved when analyzing the behaviour of an economy.
Footnotes
References
Pablo
Gabriel Bortz
University
of Luján and
Ministry of Economy and Production,
Argentina