This project thus integrates two research paradigms. The first is the Keynes-Minsky vision that puts effective demand front and center of economic analysis, and the second is the Schumpeter-Minsky vision that focuses on innovation and competition. We will bring the two visions together to provide rigorous and critical analysis of competition in the financial sphere and how it interacts with competition in the industrial sphere. This will enable us to make policy recommendations to reform finance to promote the capital development of the economy. Finance which helps to create value rather than just extract it: finance for creative destruction, not destructive creation.
We will use this synthesis to understand the current state of the global financial system and to assess its weaknesses. As discussed above, while the economy has become “financialized”, in many important areas projects cannot get financed. This is particularly true in the more innovative sectors of our economy. As a consequence we have poverty (underfunding) in the midst of plenty (tens of trillions of dollars of wealth in search of high returns). The policy problem, then, is to explore alternative ways to redirect existing finance, and to create new funding methods, to finance the innovation that we will need for the 21st century.
The first tradition is concerned with finding the point of effective demand in conditions of uncertainty. Expectations and what Keynes called monetary production in early drafts of the General Theory are the critical determinants. Disappointment is possible, which can change expectations and result in a different equilibrium. Macroeconomic identities and particular causal implications allow us to avoid fallacies of composition as the identities serve as a check on what is possible for individual behaviour. Kalecki augmented Keynes’s framework by distinguishing the capital- and consumer-goods sectors, and showing how investment generates profits at the macro-economic level, competitive firms’ pricing (and profit) can be a function of their internally-financed investment target, and innovation can determine the growth rate of capital through its impact on profits. Minsky followed Kalecki but formulated his financial theory of investment to introduce financial decisions and conditions into determination of the point of effective demand. All of this can be put in the context of growth, although the efforts to date are not satisfactory. At best, the Keynes-Minsky vision provides reason to believe that growth will not be steady and that it will normally be demand-constrained.
The second is concerned with evolution of the structure of the economy over time—those factors that disturb equilibrium, and can spur growth. Schumpeter introduced innovation into the analysis of competition, allowing the feedback between innovation and industry structure to cause the linear structure-conduct-performance (SCP) approach of industrial organization to fall apart. The Schumpeterian approach to competition is thus centred on understanding the co-evolution of those mechanisms that create differences between firms and the mechanisms of competitive selection that winnow in on the differences allowing only some firms to survive and grow. Innovation, births and deaths of firms are engines of growth and structural change. While some innovations allow incumbents to maintain their lead, radical innovations tend to destroy it. This is the essence of Schumpeter’s famous term creative destruction.
The banker, Schumpeter’s “ephor of capitalism”, plays an important role in helping to get innovations financed, and Minsky extended Schumpeter’s innovation to the financial sector itself. Like any other firm, a bank continually seeks to reduce costs and increase revenues, with innovations helping to do both while also changing the structure of the financial system and hence the structure of the nonfinancial system whose behaviour is heavily influenced by the structure of finance. As is well-known, he developed the “investment theory of the cycle and the financial theory of investment” to put the Keynesian model in the context of the business cycle. The first part of this is Keynesian, the second brings in Schumpeter’s ephor. Over the cycle, the structure of the economy and most importantly the structure of its finance changes in a manner that makes it fragile.
There are structures that are conducive to what Minsky called the “capital development” of the economy—which is broadly defined to go beyond privately owned capital equipment to include technology, labor productivity, and public infrastructure. Minsky believed that a high wage, high employment, “big government” economy would be more stable and would tend to channel finance in the direction of capital development. Further, finance needs constraints because of the inevitable thrust to innovation; that, in turn, is a problem because the “market” forces that direct finance toward capital development of the economy are not always operative, so the innovations in finance can actually hinder capital development. This appeared especially true in the Anglo-Saxon economies from the mid-1990s, when low capital costs linked to falling equity risk premiums led to a ‘search for yield’ in financial rather than real-sector innovation, so that strong corporate profitability did not translate into strong investment outside the financial sector, whose GDP share and indebtedness consequently grew.
What is relatively lacking in the Schumpeter-Minsky approach is the innovation and dynamism in the nonfinancial sector. However, there is an emerging literature that does build on Schumpeter’s work to examine innovation and structural transformation of the “real” sector: the new Evolutionary economics. The work of Richard Nelson and Sydney Winter (among others) is increasingly recognized as providing the possibility of a new theory of the firm, as well as a more dynamic treatment of market structure. While Schumpeterian-evolutionary analysis provides insights on the dynamics of structural/technological change in the real economy, Minsky’s insights can provide a theory of money and financial fragility, which is virtually lacking in Schumpeterian models. Indeed many of these do not include money and finance at all. Our synthesis seeks to fill this lacuna: we will link the real with the monetary as well as provide a theory of competition in both the financial and non-financial sectors.