Stock-Flow-Consistency versus General Equilibrium

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In his PhD thesis, Steve Hail explains in nuce the difference between Post-Keynesian and Neoclassical/"Modern" Mainstream Macroeconomics. The former is looking for consistency in taking acccount of all the flows and changes in stocks that characterise the overall economy. The effort at consistency is not biased by an ambition to prove a ceratin outcome, notably a state of equilibrium and optimality. 

Mainstream Macroeconomics is based on a paradigm ("general equilibrium economics") that aims to construct and thereby prove equilibrium and optimality by introducing categories and procedures that are not consistency-oriented but "proof"-oriented, condoning to that purpose assumptions that violate consistency but suggest confirmation of the desired outcome. 

The below quote is taken from here (pages 32pp):

Godley and Lavoie provide, for the first time, a general framework for Post-Keynesian macroeconomic analysis – a world of interlocking balance sheets; of time moving from an unchangeable past to a fundamentally uncertain future; of production processes taking place over time; of realistic and endogenous financial and monetary processes; of safety margins, such as inventories, access to credit, the need for liquidity, excess production capacity; and the use of norms, conventions and non-optimising decision-making in a world where equilibrium outcomes are rare, and economic activity is generally determined by Keynesian effective demand and only ultimately constrained by supply and biophysical realities.

This balance sheet perspective, inspired by earlier Post Keynesians and most obviously by Minsky, addresses what have always been the principal intellectual weaknesses of a critical realistic approach to macroeconomics in general and Post Keynesian economics in particular, which is the lack of a generally accepted over-arching framework for analysis.

Whereas orthodoxy has always, implicitly if not explicitly, had the Walrasian general equilibrium system of simultaneous equations as a centre of gravity, heterodox economics has enjoyed no such common general framework. Post Keynesians have relied on partial equilibrium for comparative statics, which is strongly advocated by Keynes in the General Theory, and can be defended robustly as superior to Walrasian analysis (as in Rogers, 1989). However, it is incomplete, and not a basis for a generally accepted common analytical framework. Nor is it suited for discussions of dynamic out-of-equilibrium processes.

As Harcourt has said (2001, quoted in Godley & Lavoie, p 3), the partial equilibrium method involves ‘looking at parts of the economy in sequence, holding constant or abstracting from what is going on, or at least the effects of what is going on elsewhere, for the moment’, hoping by doing so in the end ‘to bring all our results together to give a full, overall picture’. The method cannot provide a unifying framework for a body of ideas, and is bound to be less attractive as a vehicle of analysis to mathematically inclined economists.

What Godley and Lavoie have done is to build on Godley’s earlier work by constructing a viable alternative framework to general equilibrium, where equilibrium is confined to financial markets, and where decision making reflects the informational and cognitive limitations or entrepreneurs and households. There is even a quasi-Walrasian principle in Godley and Lavoie - not an equilibrium principle, but a simple accounting rule used to close models where financial assets and liabilities are in balance across the system, where all financial flows come from somewhere and go to somewhere, and where to put it simply the numbers have to add up (as in accounting). There are no ‘black holes’ in Godley and Lavoie, and, hence, there is a greater likelihood of identifying unsustainable developments in balance sheets and the development of growing financial fragility over time.

“Our method guarantees that we will always be learning to live in a logically coherent world. And we are prepared to conjecture that, given that there are limits to the extent to which stock-flow ratios can change, the system dynamics of whole economies will pin down their overall behaviour in a way that can override the findings of econometrics as to the putative behaviour of the bits and pieces.”

(Godley & Lavoie 2012, p11)

The quote highlights a very important characteristic of the Godley and Lavoie models, and of stock-flow consistent macroeconomic models generally. As we shall see, it implies that apparent econometric relationships, even if they have appeared to be stable over long periods of time, cannot be sustainable indefinitely if they imply an evolution of balance sheets which is infeasible. This is consistent with what Minsky used to call ‘turning the Lucas critique on its head’. Parameters shift not due to the impact of anticipated government policies on private sector rational expectations (as in Lucas), but due to the growing financial fragility of a system of private sector balance sheets which are evolving in ways that cannot ultimately be sustainable.

The development of stock-flow consistent macroeconomic models allowed Godley to identify the fragilities of the euro-zone with great clarity well before its inception (Godley 1992). It also and allowed economists at the Levy Economics Institute to warn repeatedly of the potential for a major US financial crisis prior to 2007-8, using a model built by Godley and others.