Handbook of Critical Issues in Finance 1849803706, 9781849803700
This vital new Handbook is an authoritative volume presenting key issues in finance that have been widely discussed in t
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English Pages 336 [338] Year 2012
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JOBNAME: Toporowski PAGE: 1 SESS: 4 OUTPUT: Mon Oct 1 09:59:10 2012
HANDBOOK OF CRITICAL ISSUES IN FINANCE
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Handbook of Critical Issues in Finance
Edited by
Jan Toporowski Professor of Economics and Finance and Chair, Economics Department, School of Oriental and African Studies, University of London, UK
Jo Michell Researcher, Economics Department, School of Oriental and African Studies, University of London, UK
Edward Elgar Cheltenham, UK + Northampton, MA, USA
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© Jan Toporowski and Jo Michell 2012 All rights reserved. No part of this publication may be reproduced, stored in a retrieval system or transmitted in any form or by any means, electronic, mechanical or photocopying, recording, or otherwise without the prior permission of the publisher. Published by Edward Elgar Publishing Limited The Lypiatts 15 Lansdown Road Cheltenham Glos GL50 2JA UK Edward Elgar Publishing, Inc. William Pratt House 9 Dewey Court Northampton Massachusetts 01060 USA
A catalogue record for this book is available from the British Library
Library of Congress Control Number: 2012935278
ISBN 978 1 84980 370 0 Typeset by Columns Design XML Ltd, Reading Printed and bound by MPG Books Group, UK
01
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Contents
List of figures and tables List of contributors
viii ix
Introduction Jan Toporowski and Jo Michell
1
1 Asian monetary union Wei Song
4
2 Bad banks David G. Mayes
13
3 Bank regulation Geoffrey Wood
19
4 Capital controls Giovanni Cozzi
26
5 Capital market inflation Henryk Braun
33
6 Central bank policy Juan Pablo Painceira
38
7 Central banks Tim Congdon
43
8 Commodity markets Luigi Ventimiglia
49
9 Cooperative banking Panu Kalmi
56
10 Credit cycles Dirk Bezemer
66
11 Emerging markets Kobil Ruziev
77
12 The exchange rate Annina Kaltenbrunner
85
v
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Contents
13 Financial crises Martin H. Wolfson
93
14 Financial fragility Eric Tymoigne
98
15 Financial Keynesianism Riccardo Bellofiore
105
16 Financial markets in developing countries Noemi Levy Orlik
113
17 Financialization Engelbert Stockhammer
121
18 The flow of funds Jo Michell
127
19 The Franc Zone Jan Toporowski
135
20 Globalization Jonathan Perraton
139
21 Hedge funds Photis Lysandrou
145
22 The Iceland crisis Robert H. Wade and Silla Sigurgeirsdóttir
151
23 International banking Trevor Evans
165
24 International finance Jeff Powell
172
25 Islamic banking Ewa Karwowski
180
26 John Maynard Keynes Michael S. Lawlor
187
27 Limited liability Stephanie Blankenburg
193
28 Liquidity Anastasia Nesvetailova
201
29 Karl Marx Andrew Trigg
211
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Contents vii 30 The methodology of finance Sheila C. Dow
218
31 Microfinance Judith Tyson
225
32 Hyman P. Minsky Jan Kregel
237
33 Money in finance L. Randall Wray
243
34 Money manager capitalism Charles J. Whalen
254
35 Option pricing models Paulo L. dos Santos
263
36 Overcapitalization Jan Toporowski
270
37 Private equity funds Jan Toporowski
274
38 Quantitative easing Shujoya Venugopalan
279
39 Risk Tracy Mott
283
40 Securitization Sanjay Krishnan
289
41 Tax havens Ronen Palan
296
42 Transnational companies and finance Grazia Ietto-Gillies
301
43 Thorstein Veblen Charles G. Leathers and J. Patrick Raines
308
Index
317
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Figures and tables
FIGURES 1.1
Chronology of economic and monetary integration in Asia
6
TABLES 11.1 Resolution costs of bank crises in selected emerging economies 18.1 Simplified system of flow of funds accounts 24.1 A snapshot of the thicket of international finance 29.1 Money and crisis under simple circulation 31.1 Growth of microfinance, 1997–2008 31.2 Changes in the types of institutions, 2003–08 31.3 Types of lending practices, 2003–08 31.4 ‘Microfinance Banana Skins’ ranking of management and operating risks amongst the top 25 ‘biggest risks’ 31.5 ‘Microfinance Banana Skins’ ranking of risk categories amongst the top 25 ‘biggest risks’ 31.6 Average net profit margins by different categories for 2003 to 2008
81 129 174 213 227 228 229 230 231 232
viii
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Contributors
Riccardo Bellofiore, Professor in Political Economy, University of Bergamo, Italy Dirk Bezemer, Associate Professor, University of Groningen, the Netherlands Stephanie Blankenburg, Lecturer in International Political Economy, Economics Department, SOAS, University of London, UK Henryk Braun, retired banker Tim Congdon, Chief Executive of International Monetary Research Ltd and Chairman of the Freedom Association, UK Giovanni Cozzi, Researcher, Centre for Development Policy and Research, SOAS, University of London, UK Paulo L. dos Santos, Lecturer in Economics, SOAS, University of London, UK Sheila C. Dow, Emeritus Professor of Economics, University of Stirling, UK and Adjunct Professor of Economics, University of Victoria, Canada Trevor Evans, Professor of Economics, Berlin School of Economics and Law, Germany Grazia Ietto-Gillies, Emeritus Professor of Applied Economics, London South Bank University and Visiting Professor, Birkbeck, University of London, UK Panu Kalmi, Professor of Economics, University of Vaasa, Finland Annina Kaltenbrunner, Lecturer, Leeds University Business School, University of Leeds, UK Ewa Karwowski, Researcher, SOAS, University of London, UK Jan Kregel, Senior Scholar, Levy Economics Institute of Bard College, USA Sanjay Krishnan, Lewtan Technologies Michael S. Lawlor, Professor of Economics, Wake Forest University, USA ix
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Contributors
Charles G. Leathers, Professor Emeritus of Economics, University of Alabama, USA Noemi Levy Orlik, Professor of Economics, Universidad Nacional Autónoma de México, Mexico Photis Lysandrou, Professor of Global Political Economy, London Metropolitan Business School, London Metropolitan University, UK David G. Mayes, BNZ Professor of Finance, University of Auckland, New Zealand Jo Michell, Researcher, SOAS, University of London, UK Tracy Mott, Associate Professor of Economics, University of Denver, USA Anastasia Nesvetailova, Reader in International Political Economy, City University, London, UK Juan Pablo Painceira, Banco Central do Brasil, Brazil and Researcher, SOAS, University of London, UK Ronen Palan, Professor of International Political Economy, City University, London, UK Jonathan Perraton, Senior Lecturer in Economics, University of Sheffield, UK Jeff Powell, Researcher, SOAS, University of London, UK J. Patrick Raines, Dean of the College of Business and Professor of Economics, Belmont University, USA Kobil Ruziev, Lecturer in Economics, Aberystwyth University, UK Silla Sigurgeirsdóttir, Lecturer in Public Governance, University of Iceland Wei Song, Senior Lecturer in Economics, Coventry Business School, Coventry University, UK Engelbert Stockhammer, Professor of Economics, Kingston University, UK Jan Toporowski, Professor of Economics and Finance, SOAS, University of London, UK Andrew Trigg, Senior Lecturer in Economics, The Open University, UK Eric Tymoigne, Assistant Professor of Economics, Lewis and Clark College, USA
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Contributors xi Judith Tyson, Researcher, SOAS, University of London, UK Luigi Ventimiglia, Researcher, SOAS, University of London, UK Shujoya Venugopalan, Researcher, SOAS, University of London, UK Robert H. Wade, Professor of Political Economy, London School of Economics, UK Charles J. Whalen, Principal Analyst (Macroeconomics), Congressional Budget Office, US Congress, USA Martin H. Wolfson, Director of the Higgins Labor Studies Program, University of Notre Dame, USA Geoffrey Wood, Professor Emeritus of Economics, Cass Business School, London and Professor Emeritus of Economics, University of Buckingham, UK L. Randall Wray, Professor of Economics, University of Missouri – Kansas City and Senior Scholar, Levy Economics Institute of Bard College, USA
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Introduction Jan Toporowski and Jo Michell
When we were asked some years ago by Edward Elgar to consider preparing a ‘handbook of alternative finance’ our initial response was to turn down such a proposal on two grounds. The first was that such a handbook might sell too well among wealthy individuals, only to disappoint them when they realized that it was about alternative theories and approaches to finance, rather than about investing in Stradivarius violins, the paintings of the Camden Town Group, or the guano market of the South Pacific. But this objection might have been overcome by a more informative title indicating the scholarly rather than accounting character of the volume. A more serious objection to the whole enterprise is the very small amount of what might be called ‘alternative’ theory relating to finance. There are, of course, any number of obscure investment strategies that might be called ‘alternative’, whose purveyors promise higher returns than with more conventional finance. Indeed, there is now a whole new sub-set of investment funds, called hedge funds, that specialize in finding such alternative investment strategies and securing those higher returns. But these strategies, and the financial instruments that are combined to obtain those returns, are as ephemeral as the market conjunctures that they arbitrage. Related to such alternative investment strategies is ‘behavioural’ finance. This purports to explain various ‘anomalies’ in observed security prices and returns by reference to the limited understanding and rationality of individuals and hence their resort to rules of thumb, conventions and delegation of financial responsibility. Such research now has some purchase in universities. But the observation that individuals cannot manage their financial resources with the sophistication that North American university professors of finance apply to their study of finance is not a revelation and may not even flatter those professors. By studying merely ‘investment behaviour’, behavioural finance places itself too much in the craft of marketing, rather than the discipline of systematic economic investigation. Readers wishing to learn about this approach can satisfy their curiosity in textbooks and publications of key authors in this strand of academic finance. Other alternative approaches are provided by a different class of writers who may be called ‘agitators’. (In the penultimate sentence of his General Theory Keynes accused them, along with civil servants and politicians, of 1
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Handbook of critical issues in finance
applying old ideas to ‘current events’.) This is not necessarily a pejorative term since, in all situations of stress, it is to be expected that individuals will come forward articulating the ideas that the mass of participants would have thought if they had the time to think in such situations. But precisely because they appeal in particular situations, in changing conjunctures, the ideas of agitators are frequently as lacking in consistency and systematic analysis as are the instant reflections of those operating in the financial markets. Nevertheless, with the growing wealth of the middle classes over the last 100 years, and the dependence of the developing countries on commercial international credit since the 1970s, finance has reached a social significance that it did not have before. Its higher social and political profile has attracted criticism and blame when finance is associated with social and political catastrophes. Such associations inevitably attract agitators, so that blame for disasters and social pathologies is liberally apportioned to financiers. The origin of such agitation in modern times lies in popular agitation around usury in pre-capitalist times when, as Jeremy Bentham remarked in his Letters on Usury, it was associated with anti-Semitism and other notions that we would today regard as irrational. There is therefore, in particular after the financial crash of 2008, a rich seam of such ‘alternative’ views of finance. It ranges from systematic criticism, such as may be found in the works of J.A. Hobson, John Maynard Keynes and Hyman P. Minsky,1 intended to change common ideas on finance, to more populist agitation intended to associate finance with disasters, pathologies and political conspiracies that could fill up and discredit more than one handbook. As a matter of editorial policy we have chosen in this handbook to focus on the systematic analysis of two sets of issues. The first are topics that tend to be discussed in a rather uncritical way in standard finance textbooks, or in the conventional discussions of financial economics, pointing out some of the flaws in the conventional understanding of those topics. Examples of this in our handbook are the entries on exchange rates, by Annina Kaltenbrunner; options pricing, by Paulo dos Santos; risk, by Tracy Mott; hedge funds, by Photis Lysandrou; securitization, by Sanjay Krishnan; transnational companies, by Grazia Ietto-Gillies; central banks, by Tim Congdon; microfinance, by Judith Tyson; finance in developing countries, by Noemi Levy Orlik; financial crises, by Martin Wolfson; money, by L. Randall Wray; globalization, by Jonathan Perraton; emerging markets, by Kobil Ruziev; international banking, by Trevor Evans; and bank regulation, by Geoffrey Wood. A second large group of topics includes entries that are of increasing importance in finance and financial economics, but are largely ignored in
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Introduction 3 standard considerations of finance. Examples of such entries are the entries on limited liability, by Stephanie Blankenburg; the methodology of finance, by Sheila Dow; cooperative banking, by Panu Kalmi; Islamic banking, by Ewa Karwowski; financial Keynesianism, by Riccardo Bellofiore, flow of funds, by Jo Michell; bad banks, by David Mayes; liquidity, by Anastasia Nesvetailova; credit cycles by Dirk Bezemer; financialization, by Engelbert Stockhammer; the Icelandic crisis, by Robert Wade and Silla Sigurgeirsdóttir; capital controls, by Giovanni Cozzi; commodities, by Luigi Ventimiglia; tax havens, by Ronen Palan; the Asian monetary union, by Wei Song; and financial fragility, by Eric Tymoigne. There is a third, much smaller group of entries on Keynes, Marx, Veblen and Minsky from Michael Lawlor, Andrew Trigg, Charles G. Leathers and Pat Raines, Jan Kregel and Charles Whalen, illuminating systematic analyses that give finance a central role in the organization of economic activity. This volume is therefore intended to complement standard textbooks and the specialist critical literature on particular topics in finance. Further reading or references may be found at the end of each entry. Finally, we would like to thank all our contributors for gamely extending our knowledge and putting up with our editorial process. We ask them and our readers to enjoy the result and indulge our ‘ignorance unconquered’ as editors.
NOTE 1.
Much of this literature is surveyed in Jan Toporowski (2005), Theories of Financial Disturbance, Cheltenham, UK and Northampton, MA, USA: Edward Elgar.
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1 Asian monetary union Wei Song
An Asian monetary union has been proposed by a number of policy-makers and researchers, in particular since the 1997 Asian financial crisis. The financial crisis led countries affected to reconsider their banking systems and exchange rate regimes in order to control exchange rate fluctuation and to preserve a relatively stable macroeconomic environment and financial market in the region. Growing economic integration in recent years has strengthened macroeconomic links across East Asia, which suggests that it is increasingly important for the region’s economies to achieve intraregional exchange rate stability. Currency union (i.e., monetary union) can be viewed as the extension of a fixed exchange rate regime. A monetary union is believed to bring some benefits to the whole region as well as the individual country, including reduced transaction costs, reduced economic uncertainty, enhanced policy discipline and credibility and improved functioning of the monetary mechanism. The successful experience of the European Economic and Monetary Union (EMU) has attracted other regions in the world, including Asia, to emulate the euro’s success. In fact, Asia has made some efforts towards regional integration since 1967 with the creation of the Association of Southeast Asian Nations (ASEAN). More frequent economic, financial and monetary cooperation discussions among the ASEAN plus China, Japan and South Korea (ASEAN+3) since 1997 also show Asia’s aim towards deeper monetary integration in the region and possibly a future Asian monetary union. This chapter reviews some background, including the exchange rate regimes of Asian countries and the roadmap towards an Asian monetary union. The optimum currency area (OCA) theory provides a theoretical framework for analysing monetary union. Some debates on OCA theory are also discussed. The chapter concludes by discussing some practical issues for Asian monetary union, for example, the leaderships of China and Japan, and the impact on the international role of the US dollar.
BACKGROUND OF ASIAN MONETARY UNION There has been a popular view among economists and policy-makers since the 1997 financial crisis that developing countries with open capital 4
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Asian monetary union 5 accounts have only two options in their exchange rate regimes: either float the exchange rate freely or fix it hard. Some researchers claim that the 1997 crisis was partly caused by dollar-based arrangements, and ‘fear of floating’ caused the crisis-affected economies of East Asia to revert to their pre-crisis dollar peg regimes once the crisis had passed. With regard to a remedy against financial crises, some researchers suggest dollarization, and some others suggest that those East Asian countries should move away from dollar-based arrangements towards currency basket systems or creating a currency union like the EMU in Europe. The EMU provides valuable experience for Asia in exchange rate regime arrangements, in particular after 1999 when the EMU was created successfully. This allows researchers and policy-makers to consider whether Asian countries could emulate Europe’s approach to regional monetary integration. In fact, many developing countries with open capital accounts, in particular developing countries with thin capital markets and weak central banking institutions, have constraints on the effective conduct of an independent monetary policy. Therefore these countries may have less economic loss from giving up an independent monetary policy when joining a monetary union. Over the last decade, Asian countries have been looking for better exchange rate regimes to avoid financial crisis in the region. More researchers and policy-makers have suggested an Asian monetary union and argued that such a monetary union can bring more benefit for Asian countries. It took a long time for European countries to establish the EMU. What efforts have been made in Asia over the last few decades towards regional integration (and possibly a future monetary union)? Asia has already made some considerable efforts since the creation of the ASEAN in 1967, in order to increase economic, financial and monetary integration and stabilize exchange rates throughout the region. The ASEAN+3 has had more frequent cooperation discussions since the 1997 Asian financial crisis. The roadmap over the last four decades is shown in Figure 1.1. The ASEAN was established on 8 August 1967 with five initial member countries (i.e., Indonesia, Malaysia, Philippines, Singapore and Thailand), and later another five member countries joined (i.e., Brunei, Cambodia, Laos, Myanmar and Vietnam). The financial and monetary integration of the ASEAN focuses on four areas: capital market development, capital account liberalization, liberalization of financial services and currency cooperation. In 1992, the ASEAN Free Trade Area (AFTA) was launched, aiming to promote the region’s competitive advantage as a single production unit. The elimination of tariff and non-tariff barriers among member countries is expected to promote greater economic efficiency, productivity and competitiveness.
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Handbook of critical issues in finance 1967 Association of Southeast Asian Nations (ASEAN) established 8 August 1967 in Bangkok by five original Member Countries, namely Indonesia, Malaysia, Philippines, Singapore and Thailand. Brunei Darussalam joined 8 January 1984, Vietnam 28 July 1995, Laos PDR and Myanmar 23 July 1997 and Cambodia 30 April 1999
1992 ASEAN Free Trade Area (AFTA) launched
1997 The idea of an Asian Monetary Fund (AMF), which was first proposed by Japan in 1997 as a framework for promoting financial cooperation and policy coordination in the region
2000 AMF culminated in an agreement among the Finance Ministers of ASEAN plus China, Japan and Korea (ASEAN+3) to establish a system of swap arrangements among their countries in what is known as the Chiang Mai Initiative (CMI) on 6 May 2000
2003 Based on the proposal made by Japan, Korea and Thailand, the ASEAN+3 Finance Ministers embarked on the Asian Bond Markets Initiative to develop the regional bond markets in August 2003
2006 Plan to launch an Asian Currency Unit (ACU) to help develop regional bond markets and promote monetary cooperation. The ACU will be based on the ten members of the ASEAN together with Japan, China and South Korea – ASEAN+3
Figure 1.1 Chronology of economic and monetary integration in Asia The idea of setting up an Asian Monetary Fund (AMF) was first proposed by Japan in 1997 as a framework for promoting financial cooperation and policy coordination in the region. The AMF is considered a useful hedge against future financial crises in East Asia. The proposed AMF culminated in an agreement among the Finance Ministers of the ASEAN+3 to establish a system of swap arrangements among these countries, known as the Chiang Mai Initiative (CMI), on 6 May 2000. The CMI swap arrangements
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Asian monetary union 7 are designed to provide liquidity support for the member countries experiencing short-run balance of payment deficits to prevent an extreme crisis or systemic failure in a country and subsequent regional contagion as occurred in 1997. Based on the proposal made by Japan, South Korea and Thailand, the ASEAN+3 Finance Ministers embarked on the Asian Bond Markets Initiative to develop the regional bond markets in August 2003. Since then, several working groups were established to further discuss a range of key issues, such as securitization, credit guarantees, promotion of local currency-denominated bonds, credit rating and foreign exchange transactions and settlements. The Asian Currency Unit (ACU) is proposed based on the ASEAN+3 economic circle. The ACU takes its inspiration from the now defunct European Currency Unit. It is not intended to be a real currency, but rather a currency basket, that is, a weighted index of East Asian currencies functioning as a benchmark for regional currency movements. ACU aims to help develop regional bond markets and promote monetary cooperation. However, plans to launch the ACU have been delayed by political and technical arguments over which currencies to include and how the weighting system would work. Haruhiko Kuroda, Japanese president of the Asian Development Bank (ADB), indicates that the ACU could facilitate the development of an Asian multi-currency bond market and a deepening of capital markets, which would help reduce exposure to external shocks. He strongly supports increased financial cooperation in Asia and an eventual monetary union. The above roadmap has presented the efforts made by the ASEAN+3 over the last 40 years. In terms of the development of regional integration in Asia in recent years, some achievements can be summarized as follows. (1) Economic interdependence in East Asia has been deepening through the market-driven forces of cross-border trade, FDI and finance. (2) Trade in goods and services and FDI activities have expanded rapidly over the past 20 years. (3) Removal of various types of cross-border barriers and the geographical proximity of East Asian economies have created natural economic linkages among them. Although Asian countries have achieved much, integration needs to be further enhanced, and intra-regional exchange rate stability will become increasingly necessary. In recent years East Asia has seen rapid advances in market-driven economic integration through international trade, investment and finance. East Asia – comprising mainly the ASEAN+3 countries – is expected to become the world’s largest economic bloc by 2020; it is natural to expect this region to eventually have its own globally accepted, international currency.
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DEBATES ON OPTIMUM CURRENCY AREA (OCA) THEORY OCA theory provides a framework for analysis of benefits and costs of creating a monetary union across a group of countries. Creating a monetary union/sharing a single currency brings countries not only benefits but also costs. Countries have to give up their own independent monetary policy when joining a monetary union, which means they cannot use exchange rate adjustments when facing asymmetric shocks in international trade. OCA theory offers a number of OCA criteria, for example, factor mobility, openness, product diversification, fiscal federalism, policy integration, similarity of inflation, business cycles. These criteria are considered as the channels to accommodate the asymmetric shocks and therefore to reduce the pressure of exchange rate adjustments. The development of OCA criteria accelerates the development of OCA theory, and it can generally be noted that OCA theory developed from stressing economic aspects to realizing the importance of political aspects. This implies that political cooperation also plays a crucial role in deciding to engage in economic and monetary integration within any potential currency area. Later on, researchers came to the modern endogenous view. Frankel and Rose (1998) argue that the higher the trade integration, the higher the correlation of business cycles among countries. However, this endogenous view is in direct contrast with another popular argument from Krugman (1993) who uses evidence from North America and concludes that increased economic integration does not guarantee convergence and can lead to divergence, thus increasing the costs of monetary union. Fidrmuc (2004) uses an explicit test of endogeneity to confirm Frankel and Rose’s hypothesis, and concludes that the intensity of intra-industry trade has a positive impact on the synchronization of business cycles. Apart from the theoretical arguments on OCA criteria, some researchers also argue that the theory lacks a unifying framework and is less applicable in practice. It is pointed out that several criteria are difficult to measure unambiguously and evaluate against each other. One could still end up drawing different borders for a currency area by referring to different OCA criteria. This is called the ‘problem of inconclusiveness’ as OCA criteria may point in different directions: for example, an economy might be open, indicating the preferability of a fixed exchange rate, or even monetary integration, with its main partners, but the same economy might display low factors of production and labour mobility with respect to the same partners, suggesting the undesirability of a fixed exchange rate. In fact, OCA theory has been developing for 50 years. In the first 30 years researchers focused more on theoretical development and over the last 20 years they focused on
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Asian monetary union 9 its application in practice. After realizing the practical shortcomings of the theory, researchers have been looking for better research methods in evaluating a currency area in the light of OCA theory. There are generally four methods applied by researchers to investigate the suitability of a monetary union for countries. The most common method is to examine a number of single criteria initiated in OCA theory. This helps to investigate which criterion has not been fulfilled and therefore needs to be further enhanced in this aspect. However, the conclusion might not be clear when using this method. For example, if countries meet some of the OCA criteria but do not meet the rest, how can we judge whether the group of countries can gain more benefit from creating a monetary union? Another method is the OCA index approach, which is constructed by Bayoumi and Eichengreen (1997). This popular method focuses on the determinants of nominal exchange rate variability, involving the key economic OCA criteria (trade openness, product diversification and business cycles) in the analysis equation. This approach represents a good attempt to put traditional OCA theory into practice and has been applied by many researchers in examining the currency areas of Europe, Asia and Africa. The third approach is cluster analysis, which has been applied by some researchers. It seeks to assess the similarity of a broad range of OCA criteria within a group of countries in order to find clusters of countries sharing similar characteristics and may therefore be more suitable for monetary union. Cluster analysis appears to be a relatively appealing methodology and the flexibility of criteria allows adjustments to be made to the method. The fourth approach to examining currency areas is the vector autoregression (VAR) approach. This popular method relies on examining the macroeconomic disturbances (i.e., output shocks). However, this method looks at a different aspect to assess a currency area, and is not mainly based on OCA theory. In other words, good research methods, such as the OCA index approach and cluster analysis, although they might not be perfect methods, can make theory more applicable. Although OCA theory remains controversial, it has guided the creation of EMU and it helps in practice. The theory itself might need a general framework, connecting all OCA criteria, economic criteria and political criteria. With regard to the research methods, how to develop a benchmark for creating/joining a monetary union is very important and significant for the practice. However, most of the economic OCA criteria are measurable but some political criteria are not, which makes the benchmark more difficult to set if it involves all OCA criteria in the analysis.
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SOME PRACTICAL ISSUES IN ASIAN MONETARY UNION The sub-region of Asia (i.e., ASEAN+3), which counts amongst the most dynamically growing economies in the world, has long been considered a possible candidate for a regional monetary union. It is believed that a monetary union will bring great benefit to the whole region and individual countries. In fact, the ASEAN+3 has relatively met the economic preconditions for a monetary union. Considerable bilateral trade, more diversified export production, synchronized business cycles and increasingly mobility of capital in recent decades indicate that these economic mechanisms in the region have facilitated the pressure of exchange rate adjustments very well and economic integration has already reached a considerable level. Moreover, more frequent economic and financial cooperation among the ASEAN+3 countries also show their aim towards monetary integration. However, in view of this, why has such a monetary union not yet been established in Asia? There are two main reasons. First, a certain level of fiscal transfer and policy integration will also be needed to accommodate the asymmetric shocks in the region. This indicates that deepening monetary integration does not only need a certain level of economic integration, but also progress towards regional political integration. Current fiscal problems faced by the euro area remind Asia that a fiscal transfer system is also very important for a monetary union. In Asia, political integration is not currently an agenda in the region. As a consequence of this absence of convergence at political level, Asia is still not well prepared for a monetary union at the moment although it has demonstrated considerable progress towards economic integration. It took 40 years for European countries, from Free Trade Area, to Customs Union, to Single Market, to reach EMU. However, Asia remains in the early stage of regional integration, that is, between Free Trade Area and Customs Union. Therefore, it might have a long way to go towards a monetary union. Second, there is the issue of leadership. In the context of Europe, Germany and France played the leadership role in creating EMU. However, in Asia, there are currently no leaders within the region who show much interest in bringing impetus to institution building, although the Chiang Mai Initiative (CMI) could serve as an institution managing a mechanism of cooperation of exchange rate policies at the region level during a transition period and the proposed Asian Monetary Unit implies their interest in promoting monetary integration among the ASEAN+3. Which countries are best suited to take on a similar leadership role in developing an Asian currency area? Will China and Japan take this role? China is one of the
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Asian monetary union 11 largest economies in East Asia. With the Chinese economy growing rapidly, the Chinese currency, the renminbi, becoming more important in the world, and most of the ASEAN+3 countries increasingly converged with China, China is believed to be the most suitable leader in Asia’s monetary integration process. Apart from China, Japan is also one of the largest economies in Asia, and its currency, the yen, was previously the third important foreign currency in the world, just behind US dollar and euro. China and Japan, as the largest and most important economic entities in Asia, have more advantages than other Asian countries to take the leadership role towards creating Asian monetary union. Their past history of conflict and rivalries could be a serious handicap, but it could also be a decisive advantage. Indeed, two strong economic and political powers willing to set aside a long-standing historical antagonism in order to cooperate effectively are more likely to be followed by other nations in their attempts to enhance regional integration, as demonstrated by the role played by Franco-German cooperation in the process of European integration and in paving the way towards EMU. Moreover, whether the policy integration (e.g., harmonized economic policy) can be reached among countries, in particular between leader countries, is also very important for a successful monetary union. The US dollar has been gradually losing weight as a share of international reserves since the launch of euro, although this process is more likely to be slow due to lingering doubts about the future of the euro following fiscal problems in several euro area countries. Will the creation of an Asian Monetary Union impact upon the international role of US dollar? If Asian countries create a new currency or adopt an existing currency (e.g., Chinese renminbi or Japanese yen), it will be another challenge for the US dollar after the euro. In recent years, the US dollar continues to face growing competition from other currencies, such as the euro, the renminbi, and probably the supranational currency SDR. Eichengreen (2010) also indicates that the multiple reserve currency system is coming, and we need to prepare for one in which the dollar, the euro and the renminbi will be consequential international and reserve currencies.
REFERENCES Bayoumi, Tamim and Barry Eichengreen (1997), ‘Ever closer to heaven? An optimumcurrency-area index for European countries’, European Economic Review, 41(3–5), 761– 70. Eichengreen, B. (2010), ‘Managing a multiple reserve currency world’, in J.D. Sachs, M. Kawai, J. Lee and W.T. Woo (eds), The Future Global Reserve System – An Asian Perspective, ADB report, available at http://aric.adb.org/grs/; accessed 31 March 2012. Fidrmuc, J. (2004), ‘The endogeneity of the optimum currency area criteria, intra-industry trade, and EMU enlargement’, Contemporary Economic Policy, 22(1), 1–12.
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Frankel, J. and A.K. Rose (1998), ‘Endogeneity of the optimum currency criteria’, Economic Journal, 108(449), 1009–25. Krugman, P. (1993), ‘Lessons of Massachusetts for EMU’, in G. Torres and F. Giavazzi (eds), Adjustment and Growth in European Monetary Union, Cambridge: Cambridge University Press, pp. 241–61.
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2 Bad banks David G. Mayes
The global financial crisis has led to a resurgence of interest in and indeed use of the concept of ‘bad banks’. In essence a bad bank is created when a troubled bank is divided into a ‘good bank’ that can readily be sold or recapitalized at a cost acceptable to the shareholders/creditors, and a ‘bad bank’ that contains the remaining, impaired, assets. Indeed the term ‘bad bank’ is actually a misnomer as the entity is not a bank in the sense that it is registered, takes deposits and makes loans. It is normally an asset management company that works through the impaired assets, steadily realizing them for the best it can manage for the creditors/owners. To take a well-known example, Northern Rock, the UK bank that got into difficulty early in the crisis in August 2007, and was subsequently nationalized, has been split into a good bank – ‘Northern Rock Plc’, which has been sold as a going bank to a third party, Virgin Money – and a bad bank ‘Northern Rock (Asset Management)’, which is realizing the impaired assets for the benefit of the taxpayer. The great attractiveness of bad banks is that when a bank gets into difficulty it offers a way of keeping much of the activities going without a break and without having to work out immediately what the extent of the problem is with the impaired assets. The good parts of the bank should be reasonably easy to value in a hurry and then sell to a third party or otherwise recapitalize. This is particularly important if the authorities want to transfer the insured deposits to another provider, so that people can have uninterrupted access to their funds. The use of bad banks is controversial because there is debate over whether this does actually realize the best value for the creditors/ shareholders and minimize the loss for society at large. If the bank can be recapitalized then as a bank it has a rather wider range of options over how to manage the impaired assets than does an asset management company, because it can make new loans and repackage assets in a more flexible manner. While there is experience of both routes there are no really good natural experiments of both techniques in a similar environment. Perhaps the best comparison comes from the Nordic crisis at the beginning of the 1990s where both Sweden and Finland used bad banks and Norway did not (Moe et al., 2004). 13
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THE SHORT RUN AND THE LONG RUN The problem in a crisis is that the authorities have to act quickly, before anyone knows the likely path of the crisis or the full extent of the losses in any particular financial institution. Actions therefore have to be taken on the basis of summary information and a probability distribution of likely outcomes for the economy as a whole. It is inherent that the pricing of assets in these circumstances may be wildly off the mark as markets are not functioning properly. Thus short-run decisions have to be taken about failure or survival and only over the long term can one work out what the appropriate valuations should have been as the assets concerned are either sold or liquidated. Ideally the authorities want to inject sufficient confidence into the system in the short term so that markets reopen, solvent institutions can recapitalize and any temporary facilities offered to the market can be wound down without cost to the taxpayer. If an institution makes losses, then the first call should be on the shareholders. If they cannot cover the loss then the bank will fail and the burden will fall on the junior debt-holders, moving upwards through seniority until the losses are all accounted for. The final determination can only be made when the last asset has been sold and the administrators’ bills have all been paid. That may take many years. If it is decided to keep the bank running then it will never be possible to find out conclusively how big the loss might have been.1 If a problem bank can be resolved by taking away the readily saleable and functioning parts from the existing shareholders and paying a fair price for them, then the financial system can continue to function uninterrupted, satisfactory capitalization levels can be achieved and the problems can be left to be sorted out slowly as the situation returns to normal and the assets mature. This is what a bad bank can achieve. An alternative employed in the USA through the Troubled Asset Relief Program (TARP) and to an extent for the Lloyds Group and the Royal Bank of Scotland in the UK is to remove the problem assets from the bank and make the remainder of the bank ‘good’ in that way. The difficulties that the USA had in pricing the assets and the fact that this places the main downside risks on the taxpayer rather than the shareholders and the creditors suggest that this is not such a good way to go. It focuses on what is difficult in the short run, namely valuing the impaired assets, and allows those who knowingly took risks to exit, creating a potential moral hazard for the future. The main argument against the bad bank/good bank split is largely practical. In many jurisdictions it cannot readily be achieved without insolvency and where it can, it still results in the taxpayer taking on the risk. This was the position in the UK at the outset of the financial crisis in 2007. The problem was recognized and the Banking Act of 2009 now enables a good bank/bad bank split, with responsibility for
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Bad banks 15 losses largely falling on those who took the risks. This offers a template for other countries to consider.
THE NATURE OF THE DIVISION A key feature that affects the attractiveness of forming a bad bank is the nature of the process by which the troubled bank can be divided. If the good bank can be carved out of the old bank as a going concern then the decision is fairly straightforward. If on the other hand such a division can only be made if the bank is allowed to fail then the authorities face a dilemma if they want the good part of the bank to continue its operations uninterrupted. To avoid failure they have to ‘save’ the whole bank and then carve out the bad bank from the whole bank. This was the arrangement with Northern Rock and a major reason why the UK authorities completely changed the arrangements under the Banking Act 2009. Now the authorities can step in before the bank fails – but when failure is judged inevitable – and carve out the good bank or indeed good banks if a division into more parts makes sense and sell them to willing purchasers. The most important aspect of this is the protection of insured depositors, who can be transferred to another provider at the expense of the deposit insurance fund. Under the Act if there is insufficient time to find a buyer the UK authorities – in this case the Bank of England – can form a bridge bank to keep the operations running interrupted. They only need to transfer those parts of the bank they wish to preserve to the bridge, with the remainder being left in a residual bank. Thus at this stage there is already a split between good and bad banks. The example of the Dunfermline Building Society is helpful as it was the first exercise of these powers under the new Act (in March 2009). It was possible to transfer some of the operations immediately to another provider (Nationwide Building Society), create a bridge bank for part of the remainder that was deemed saleable and leave the rest behind in a ‘residual’ bank, which was to be wound up in due course. (The bridged part of the bank was indeed resalable and the bridge then closed after the sale.) The residual or bad bank under these circumstances may have more functions than simply an asset management company. It may very well not be possible to make a simple division of a bank into free-standing separate parts, because premises, computer systems and other functions are not readily divisible or at least not divisible rapidly. In that case one part of the bank may continue to have to provide services for another. It is possible that one or other of the good banks may have to provide services for the bad bank but more likely the other way round. An acquirer may wish to move all the accounts onto its own systems but be unable to do so immediately or during the few hours of the transfer. In which case it will have to continue to
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use the services of the existing bank, which will be provided by the residual bank. Under the Banking Act 2009, the provision of these services can be compelled, although naturally the user is expected to pay the cost. Determining what those costs are might be contentious and there are options for independent determination of appropriate values. Where such a neat solution is not available, as in the case of Norway, the attraction of a bad bank is much smaller. In the Norwegian case, if the operations of the good bank are to be kept running, the bank as a whole has to be saved as otherwise the operations to be transferred get locked out of the payments system and the bank will default on the contracts that the authorities wish to preserve. To make such a move it is therefore necessary to come up with a valuation for the whole bank, so that it can effectively be recapitalized and the bad bank bit then stripped out. However, in these circumstances the authorities will be the ‘owner’ of the bad bank rather than leaving it effectively with the creditors in the insolvency estate. Since the short-run problem of recapitalization has been solved, the need to separate out activities is reduced and it may make sense to manage the impaired assets in the recapitalized bank rather than turn them over to a separate bad bank. The difference between the Norwegian approach and open bank assistance may be small. In open bank assistance, as with the assistance that the Lloyds Group and the Royal Bank of Scotland received in the UK, the government provides recapitalization for the existing bank, often by the purchase of preference shares that can be turned into ordinary equity if the bank gets into further difficulty. In this case there is no good bank/bad bank split, although it is open to the authorities to try to strip out the impaired assets from the bank explicitly, as was also done in these cases. This has the advantage that a line is then drawn under the potential losses of the good bank and the taxpayer agrees to pick up further losses should the impairment be greater than thought. This is a difficult decision. If things turn out well, the government does not end up meeting any of the losses from the impaired assets and indeed may make a little from the loans and guarantees offered to help the bank through its difficulties. In the same way, when they come to sell the shares, the authorities may be able to make a considerable profit. Such shares will have been bought when the market was depressed and no sources of private capital were forthcoming. Loans on the other hand, even if paid back in full with interest, have a strictly limited upside and do not let the taxpayer participate directly in the success. Hence equity participation tends to be preferred, if the bank cannot be divided and the good parts preserved. If things turn out badly, then the taxpayer makes further losses on both the good and bad banks. With government ownership, while the pre-existing
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Bad banks 17 shareholders might still be wiped out, it is likely that the creditors will not lose unless the authorities decide to close the bank. Thus since all three Nordic countries made open bank assistance to the main banks they supported, the only difference in payoff will depend upon whether they held share capital or debt as a result of the support and whether the use of bad banks as in the Swedish and Finnish cases resulted in any lower losses (larger gains) than in Norway. In the Norwegian case the existing share capital of the largest three banks was written down to zero – that of Christiania Bank and Fokus Bank by royal decree and that of Den norske Bank by agreement of the shareholders. (The Parliamentary review after the event judged that the government had been correct in estimating that all shareholder value in the respective banks had been lost by the time of the writedown.)2 Perhaps the key question then is why bother to create the good bank rather than why create the bad bank? The concern is simply that to provide insured depositors with continuing access to their funds those deposits at least must be transferable to another bank, as simply closing the bank and paying out depositors in cash is difficult to arrange and rarely the lowestcost solution. (Hardly any of the more than 400 banks that have been closed by the Federal Deposit Insurance Corporation in the USA during the crisis have used a payout as the cheapest method.) If depositors fear they will lose access to their funds even for a short period there will be a run on the bank as the Northern Rock experience demonstrated, and that is to be avoided. With larger banks, their failure might lead to a loss of confidence in the financial system as a whole, so the authorities tend to want to keep them running. The impaired assets are not an essential part of this operation. Nor do the impaired assets have to be dealt with quickly as this is not likely to maximize their value for the creditors. A bad bank may well be an efficient way to administer this, especially if it avoids the taxpayer having the bail out the entire bank.
NOTES 1.
2.
One of the main consequences of the global financial crisis has been that the authorities have sought ways to make failure less likely, first by increasing the size of the capital buffers to absorb shocks but second by encouraging ‘contingent capital’; that is, debt that can be converted into equity in the event of a crisis. In this way much larger shocks can be accommodated and the need to look for good/bad bank splits reduced. In the global financial crisis both Iceland and Ireland got into severe difficulty. Both countries used versions of the good/bad bank split, which helps in understanding the limitations and advantages of the scheme. Iceland created new banks out of the failures of its three main banks, shifting domestic deposits and domestic assets to them with some recapitalization, while leaving foreign deposits, with priority, and all the remaining
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REFERENCE Moe, T.G., J.A. Solheim and B. Vale (2004), ‘The Norwegian banking crisis’, Occasional Paper No. 33, Oslo: Norges Bank.
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3 Bank regulation Geoffrey Wood
INTRODUCTION The recent financial crisis had many causes, but there is agreement that to prevent such events, regulation, particularly of banks, must change. This chapter first considers why banks are so important in this discussion and then briefly reviews the types of banking crises. This leads to a discussion of possible regulatory responses to encourage banking stability, shows the dilemma intrinsic to that discussion, and considers in conclusion whether it can be resolved.
THE IMPORTANCE OF BANKS Ever since, in 1795, Francis Baring wrote of the consequences for the British banking system of the outbreak of the Napoleonic Wars, banking systems have been regarded as special. The reasons are clear. In a modern economy bank balances are a large part of the money stock. If banks fail, the money stock falls, and the inevitable consequences of that, certainly in the short run, are a fall in output. Second, banks are also a major transmission channel of funds from lenders to borrowers; indeed, for some sectors of the economy (small firms, for example) they are the only such channel of transmission. If that channel is blocked even partially, both recession and subsequently slow growth can result. It was in recognition of this that the concept of the ‘lender of last resort’ was developed – developed by Henry Thornton (1802) and popularized and further developed by Walter Bagehot (1873). The problem that concerned them was that a scramble for liquidity – for cash – could in the extreme lead to the collapse of a banking system: ‘If any bank fails, a general run upon the neighbouring banks is apt to take place, which if not checked in the beginning by a pouring into the circulation of a very large quantity of gold, leads to very extensive mischief’ (Thornton, 1802, p. 182). ‘[I]f the Bank of England, in future seasons of alarm, should be disposed to extend its discounts in a greater degree than heretofore, then the threatened calamity may be averted’ (ibid., p. 188). The reason a ‘pouring into the circulation’ 19
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(to use Thornton’s phrase) would stop a panic and thus protect the system was described with great clarity by Bagehot in 1873: What is wanted and what is necessary to stop a panic is to diffuse the impression that though money may be dear, still money is to be had. If people could really be convinced that they would have money … Most likely they would cease to run in such a herd-like way for money. (Bagehot, 1873, pp. 64–5)
That nineteenth-century discussion contains an implicit assumption: that a banking crisis is always the result of a scramble for liquidity. As it happens, most of the time crises have resulted from that. But there is another possible cause. Banking crises are of two types: liquidity crises and capital crises. One type of crisis rapidly merges with the other, so that beyond the initial stage of a crisis there are both liquidity and capital problems. But in principle the distinction is clear. A liquidity crisis is when one bank for some reason can not meet all its payment obligations. In consequence other banks experience runs; they too then get into difficulties because, by the nature of fractional reserve banking, they can not immediately pay out on all deposits, and in the extreme the entire banking system collapses like a row of dominoes. A capital crisis in contrast is the consequence of a sharp decline in the value of a bank’s capital. As bank balance sheets are opaque to customers (and apparently often to management too if recent experience is anything to go by) this leads to fears about the solvency of other banks, runs take place on them, and again in the extreme the whole system fails.1 The first crisis of the twenty-first century was a capital crisis, not a liquidity crisis. Banks suddenly found themselves with insufficient capital to reassure their creditors. There was then a scramble for liquidity, to which central banks all round the world responded, but capital shortage came first. There was another difference, at least as important, between the earlier crises in which lender of last resort had been used and the most recent crisis. A quotation highlights it: It is by no means intended to imply that it would become the Bank of England to relieve every distress which the rashness of country banks may bring upon them: the Bank by doing this, might encourage their improvidence. … The relief should neither be so prompt and liberal as to exempt those who misconduct their business from all the natural consequences of their fault, nor so scanty and slow as deeply to involve the general interests. (Thornton, op. cit. p. 188)
Individual banks should be allowed to fail, so long as action is taken to maintain the stability of the system as a whole. In the recent crisis, there was concern not about every individual institution, but certainly about most.
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Bank regulation 21
THE REGULATORY RESPONSE Rules are under consideration (at the Basel Committee on Banking Supervision) that would compel banks to hold more capital and more liquidity. This seems reasonable; after all, banking crises result from shortage of one or the other (or of both, of course). But there is a fundamental problem with this response. It will not make banks failure-proof. There will be more failures. What is to be done? When the regulators examine the grocery business in the UK they are invariably concerned with competition. A question that is never asked is how robust a particular individual firm is. Why not? First, a well-established and well-tested insolvency regime is available for most firms. That regime has for many years worked well in the sense of enabling orderly winding up or selling on of insolvent businesses. Second, there is no fear that a vacuum would be left by such an insolvency. If Tesco, for example, were to fail, far from there being a dearth of groceries, within hours Sainsbury, Morrison, and so forth would be fighting vigorously over this new market opportunity. Analogy with the grocery business implies that if we have a suitable bankruptcy code and easy entry and exit for banking, regulators need no longer concern themselves with individual firms. Why can regulators not think that way about banking? There are two reasons – barriers to entry and the insolvency code. The term ‘barriers to entry’ originated in the industrial economics literature of the immediate post-World War II period. Many industrial economists of that period were concerned to explain data apparently inconsistent with the competitive model, and resorted to monopoly as an explanation. The particular phenomenon that troubled them was the persistence of higher rates of return in some industries than in others. Why, they asked, did new entry not eliminate this?2 In the context of banking, this discussion suffered from a crucial weakness – speed of entry was not discussed. If the concern is to secure a stable industry, then it must be possible for a new firm to enter rapidly, and, equally important, for a failed firm to leave rapidly. Why can new firms not enter banking rapidly? We must consider familiarity and the clearing house. It is plain that, when banking, people prefer to deal with familiar names. A well-known demonstration of this is the notorious difficulty with which foreign banks enter a country and start business there (see, for example, Hoggarth et al., 1998). The only obviously successful way of circumventing this is to take over an existing firm, and gradually gain acceptance of the new name and business practices through slow development of the previously well-known company. But that route can face a difficulty. There must be no possibility of exclusion from the clearing house. This has implications
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for the ownership of the clearing house. Having it owned solely by its users presents tremendous opportunities for delay. A preferable ownership structure would be a free-standing regulated monopoly, regulation being of the same model as that used for the UK’s regulated utilities. Ownership by the state might seem attractive, but apart from the inefficiency such ownership usually brings there must be no question of political influence over entry to the clearing house. Even the fear of it could deter potential entrants – foreign potential entrants might well fear implicit protectionism.3 It is also crucial that struggling firms leave the industry, and are not supported by the taxpayer through their agent the government. Support for this has been the recent practice. Consider an example. When at the end of 2008 Northern Rock got into difficulties, there was a determined attempt to keep the institution going, or to find a rescuer for it. Several considerations were relevant – see Milne and Wood (2009) – but the most basic was that it would have been subject to the normal law of corporate insolvency. Its transactions, its assets and its liabilities would be frozen. A court-appointed liquidator would try, avoiding a ‘fire sale’, to dispose of the assets at the best possible price, taking quite possibly some time to do so in order to minimize the loss for creditors. This would cause problems for a modern banking system, as it could leave many transactions uncompleted for months or even years.4 It is now possible in the UK (under the Banking Act of 2009) to take a bank away from its shareholders while it is still solvent. The bank can then be sold on, in an orderly way, in whole or in parts, to buyers who will keep it running and restore it to financial health. The procedure has already been used successfully to carry out the closure of the Dunfermline Building Society in 2009. Does anything else need to be done to secure ease of exit?
THE LIVING WILL The Governor of the Bank of England has recently urged that banks be required to draw up ‘living wills’. The Treasury Select Committee of the House of Commons has recommended the idea. What are these wills? Why are they desirable? The term ‘living will’ comes from a development in English law relating to individuals and their well-being. When an individual dies, if he or she leaves a will that is legal then whatever property left on death is disposed of according to the testator’s wishes, subject to taxes and any challenges from parties who think they were entitled to a bequest (or a bigger bequest). A ‘living will’ does very much the same thing, but for an individual who although incapacitated is not dead. The ‘will’ appoints ‘attorneys’, who can take decisions for the individual who can no longer do so, either according
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Bank regulation 23 to instructions given in the ‘living will’ or if discretion has been given then according to what they think best for the individual. The idea is then that banks draw up an analogous document. But with a special insolvency regime for banks in place, why is more needed? The existing legislation applies in principle to all commercial banks and building societies. It does not cover investment banks even in principle, and while it does in principle cover large, complex, international banks, there are, and surely correctly, doubts about whether it could be applied to them. The current prompt closure procedure does not apply to investment banks simply because these banks are not deposit-taking institutions, but rather institutions that arrange deals and act as counterparties in complex transactions. A very important aspect of the latter is shown by their role in structured products such as the fairly widely sold ‘guaranteed equity return’ funds. These guarantee a minimum return from a portfolio in return for there being a cap on returns from the portfolio. Orderly closure along the lines of prompt corrective action would not help much here, nor would it help with, for example, holdings of credit default swaps. Large and complex international banks because they have assets and liabilities in many countries can if they face an emergency capital shortage call on many countries – which could mean that no country felt responsible; and in addition they could quite simply be beyond the capacity of the liquidators to understand and wind down in a reasonable period of time. These are the problems ‘living wills’ are designed to deal with.
WHAT THE WILLS WOULD DO Essentially, they would tell an outsider how the bank worked. They would clearly assign different assets and liabilities to different subdivisions of the bank. They would describe provisioning and write-off procedures that had been adopted in particular cases and were adopted as general rules. In short, just as a person’s living will lays out what should be done when he or she can no longer do it for themselves, so would a bank’s living will provide all the information needed for someone to intervene when it was in trouble and to run it down (or otherwise dispose of it) in a prompt and orderly manner. These living wills would be important in two ways. First, they would ensure that when some institution, however large or complex, got into difficulties, it could be handled without major and harmful spillover effects. Second, and associated with that, these wills would make future crises less likely. For they would ensure that no bank was ever again ‘too big to fail’. The ‘brooding presence’ (to quote Lee Buchheit5) of the risk of failure would once again make bankers act in a prudent way.
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CONCLUSIONS – THE DILEMMA Regulators can try to ensure that it is hard for banks to fail, or they can try to ensure that bank failures can be handled in a way that is not disruptive to normal commercial and financial life. The former course is itself doomed to failure, and further, to the extent that it protects existing firms it encourages inefficiency, poor service, and indeed, risk-taking. The latter course is preferable and feasible, but it is not yet widely accepted or politically popular. Regulators must choose the popular course or the wise course. That is their dilemma.
NOTES 1.
2. 3.
4.
5.
These runs may well, in modern circumstances, be what are called ‘silent runs’. These are runs by relatively well-informed participants in wholesale markets, who can often ‘run’ simply by declining to roll over their loans. These runs can but need not be well founded, for a bank’s balance sheet is also to an extent opaque to its banking counterparties. The three best-known discussions are those of Bain (1968), Ferguson (1974) and Stigler (1968). The regulated monopoly would have as part of its monopoly right the duty not to ‘unreasonably exclude’ new entrants. Tests of unreasonableness could be laid down in advance, but no doubt these would have to be examined in the courts. In an insolvency repurchase agreement (REPO), borrowing (financing through an initial sale of a security and its later repurchase at a slightly higher price) is closed out, in a similar way to over-the-counter derivative transactions, but unsecured borrowing, such as Northern Rock relied on because it lacked eligible collateral for REPO finance, must be left finally to be resolved through the insolvency procedure. ‘The sanction that capitalism imposes on imprudence, incompetence, sometimes just bad luck, is failure. It is the brooding presence of that sanction that keeps managers on their toes, that keeps them acting in a prudent way’ (Lee Buchheit, Cleary Gottlieb Steen & Hamilton LLP, to the House of Lords Economic Affairs Committee, 2009).
REFERENCES Bagehot, W. (1873), Lombard Street, London: Henry King. Bain, J.S. (1968), Industrial Organization, New York: John Wiley and Sons. Ferguson, J.M. (1974), Advertising and Competition: Theory, Measurement, Fact, Cambridge, MA: Ballinger. Hoggarth, G., A. Milne and G. Wood (1998), ‘Alternative routes to banking stability’, Bank of England Financial Stability Review, Autumn, Issue 5, 55–68. Milne, A. and G. Wood (2009), ‘Shattered on the rock? British financial stability from 1866 to 2007’, Journal of Banking Regulation, 10(2), 89–127.
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Bank regulation 25 Stigler, G. (1968), ‘Barriers to entry, economies of scale and firm size’, The Organization of Industry, Homewood, IL: R.D. Irwin. Thornton, H. (1802), An Enquiry in to the Effects of the Paper Credit of Great Britain, reprinted 1978, Fairfield, NJ: Augustus Kelly.
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4 Capital controls Giovanni Cozzi
BRETTON WOODS AND CAPITAL CONTROLS Following the Great Depression and World War II many countries adopted capital controls as an important policy toolkit in order to create stability and achieve economic prosperity. To this end the 1944 Bretton Woods agreement legitimated the imposition of capital controls on short-term capital movements that were not directly related to trade flows (Goodman and Pauly, 1993). When the negotiation to construct the post-war economic order began, John Maynard Keynes concluded that, in order to eliminate the problems caused by capital flights, capital controls should be permitted in the new international monetary order (Crotty, 1983). Furthermore, Keynes believed that such controls would be most effective if countries developed comprehensive national regulation of foreign exchange transactions and collaborated in the enforcement of these regulations. The monetary order that emerged after World War II had as core objectives currency stability and convertibility. In order to achieve these objectives the Bretton Woods system developed in a de facto fixed exchange rate system and restored currency convertibility. Thus, states removed existing exchange controls limiting currency convertibility, but at the same time they were not obliged to refrain from regulation of capital-account transactions, and were encouraged to adopt capital controls to reduce the destabilizing effects of hot money flows. In this new economic order, the financiers had a weakened role in influencing economic policy. Indeed, the rentier class and central bankers were held to account for their role in causing the Great Depression of the 1930s. Many central banks, including the Federal Reserve and the Bank of England, lost their autonomy and were brought under the control of their governments. At the same time, the newly influential industrial capitalists were calling for a rejection of free capital mobility. Consequently, virtually all countries implemented capital control measures on inflows, outflows or both. With capital controls and national financial regulations in place countries succeeded in channeling funds to priority domestic use and in reducing the power of domestic rentiers over the accumulation process (Crotty and Epstein, 1996). 26
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Capital controls 27
THE RISE OF FINANCIAL GLOBALIZATION AND FREE CROSS-BORDER CAPITAL MOBILITY In 1971 the breakdown of the Bretton Woods agreement, together with the development of international financial markets and the globalization of production, led to the removal of capital controls in many parts of the world and a move towards more flexible exchange rate regimes. The increased openness of financial markets that was taking place in the 1970s–80s led to an increase in size and power of the rentier class. As this class became larger, it started forming alliances with industrial capitalists interested in shifting production to countries where labor costs were cheaper. Over this period rentiers and industrialists created powerful alliances to demand greater capital mobility and financial liberalization. As a result, by the end of the 1970s the USA had become decidedly hostile to international capital controls, and by the middle of the 1980s many countries around the world loosened or eliminated capital controls in order to meet the demand of rentiers and industrialists. At the macroeconomic level, this move towards financial liberalization and capital mobility was justified by the macroeconomic trilemma or impossible trinity thesis. The basis of this thesis is that open economies constrain government economic policy in that any exchange rate system involves sacrificing some important objectives to achieve others (Krugman, 1999). In particular, the thesis contends that three conflicting objectives exist. First, countries would like to retain independent monetary policy. Second, they would like to have more or less stable exchange rates. Third, governments would like to maintain full convertibility, in order to assure businesses that money can move in or out of the country (ibid.). As a result, policy-makers are forced to give up one objective, since only two out of the three can be achieved simultaneously. The trilemma forces open economies, developed and developing alike, to choose among three exchange rate regimes: a floating exchange regime, which allows freedom of international transactions and lets the government use monetary policy to fight recession at the costs of erratic fluctuations; a fixed exchange rate regime, which purchases stability at the expense of monetary independence; or capital controls, which can reconcile a relatively stable exchange rate with some monetary independence. Since the breakdown of the Bretton Woods system the conventional wisdom among mainstream economists has been in favor of floating exchange rate regimes and against capital controls (ibid.). Thus, it is held that within the trinity, capital mobility should not be challenged. Indeed, the dominant macroeconomic literature of the 1980s and 1990s argued that financial globalization and free cross-border capital mobility
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have positive effects on economic development and world welfare and lead to an efficient allocation of the world’s capital. Furthermore, using models of global portfolio diversification, economists argue that an economy that opens its asset markets to trade will experience a substantial rise in national welfare. International asset trade allows countries to hold a globally diversified portfolio of risky investments and encourages all countries simultaneously to shift from low-return, safe investments toward high-return risky investments. At the same time, by holding a globally diversified portfolio, countries can reduce risk substantially through sharing.
FINANCIAL CRISES AND CAPITAL CONTROLS Following a series of emerging market financial crises in the 1990s and 2000s (such as in Mexico, Argentina and Southeast Asia), and the more recent and ongoing global financial crisis that started in 2007, the view that globalized financial markets would allocate capital efficiently and boost economic growth and stability has been seriously challenged by several leading economists (such as Bhagwati, 1998; Rodrik, 1998; Stiglitz, 2002). For instance, Stiglitz (2002) argues that capital markets’ liberalization has negative effects on growth and welfare as it entails stripping away the regulations intended to control the flow of hot money in and out of a country. Furthermore, given the highly volatile nature of short-term capital, many countries, and particularly developing countries, can become exposed to an abrupt reversal or sudden stop (contraction in international credit) of capital inflows, which can push a country into insolvency and a full-blown financial and currency crisis (Calvo, 2001). Thus, these economists argue that the policy goal to prevent and manage financial and currency crises should support long-term capital flows (especially FDI and equity portfolio flows) and at the same time limit short-term capital flows to the financing of short-term trade transactions through some form of restrictions and controls on international capital movements (Krugman, 1998; Radelet et al., 1998). Since the Asian financial crisis of 1997–98, the International Monetary Fund (IMF) has also reviewed its position on capital controls. Prior to this crisis, the Fund believed that all international private capital flows should be liberalized. However, following the Asian crisis the IMF started to change its view on capital controls, moving from a fundamental opposition to any interference with the free flow of capital to conditional support for some form of controls on inflows under certain circumstances (Grabel, 2010). Indeed, a number of recent studies conducted by the IMF recognize that there is little empirical evidence to substantiate the claim that international
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Capital controls 29 capital flows are good for economic growth or even for consumption smoothing (e.g., Prasad et al., 2003 and Kose et al., 2006). The current position of the IMF on capital controls is expressed by Ostry et al. (2010, p. 5), who argue that ‘if the level of reserves is adequate, if the exchange rate is not undervalued, and if the flows are likely to be transitory, then the use of capital controls … is justified as part of the policy toolkit to manage inflows’. The Fund’s position on capital controls on outflows is less consistent. On the one hand, the IMF has displayed sympathy for the use of controls on outflows in some countries, for instance in Iceland where controls on outflows were introduced under the auspices of the Fund in 2009 (Buiter, 2009). Yet, a recent IMF Global Financial Stability Report (GFSR), published in April 2010, endorses Williamson’s (2000) view that controls on inflows have a better chance of working because incentives to evade them are not as high as incentives to evade controls on outflows. Furthermore, the GFSR also emphasizes that in order to be effective, capital controls should be temporary in nature as they tend to lose effectiveness as market participants find ways to circumvent them. Other mainstream economists also stress the importance of gradually relaxing capital controls as economic conditions improve and global financial stability returns. To this end, Buiter (2009, p. 2) argues that ‘Capital controls create rents whose allocation is at the discretion of public officials. They therefore encourage bribery, graft and corruption’. In sum, mainstream economists and the IMF contend that countries can impose some forms of temporary capital controls, preferably on inflows, as a second-best and emergency policy option.
ALTERNATIVE APPROACH TO CAPITAL CONTROLS The current conventional stance on capital controls downplays the role that they can play in gaining control over the international flow of money. By emphasizing the temporary nature of capital controls, several mainstream economists and the IMF fail to recognize that controls are an essential component of any serious package of progressive structural reforms (Crotty and Epstein, 1996). Indeed, Cooper (1999), with reference to developing countries, questions the conventional wisdom that capital controls can only be used as part of a temporary policy toolkit. He argues that capital account liberalization has not been universally accepted as the way forward, and that free capital movements are incompatible with both pegged and floating exchange rate regimes of imperfectly developed financial markets (i.e., all developing countries). Thus, he concludes:
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Handbook of critical issues in finance [U]nless countries are prepared to fix the value of their currencies permanently to some leading currency, or to adopt some leading currency as their national currency, they may reasonably choose to preserve the right to control at least certain kinds of capital movements into and out of their jurisdictions, in the interests of reducing both nominal and real exchange rate variability. (Ibid., p. 124)
In addition, Crotty and Epstein (1999) argue that permanent capital controls are needed by both developed and developing economies. In developing countries controls are required to prevent speculative financial cycles, extreme exchange rate instability and to facilitate state-led industrial policies. In developed countries controls are needed to facilitate the construction of a new era of high employment, falling inequality, and a stronger social welfare system. At the policy level, the alternative view on capital controls envisages the need for global institutional changes together with cooperative capital controls. To this end, Nissanke and Stein (2003) argue for the need of a reorientation towards the transformation of new norms, regulations, organizations and capacities. They highlight that ‘complex multifaceted institutional requirements are needed to integrate domestic and global financial circuits. Integration must be circumscribed by a high degree of regulation governing the categories and terms of access to global finance’ (ibid., p. 305). The alternative approach maintains that there is no single policy with respect to controls that is optimal in all countries, but at the same time highlights the most politically viable forms of controls that countries can adopt. Among the most feasible forms of capital controls the alternative approach emphasizes a system of international stand-by controls on capital flight that requires countries to return capital that crossed borders in violation of any national laws (Block, 1993 in Crotty and Epstein, 1996). Spahn (2002) also argues for the adoption of a ‘Politically Feasible’ Tobin Tax (PFTT) on foreign exchange transactions with a small rate, combined with a high-rate surcharge on externalities resulting from speculation. Such a tax on foreign exchange transactions would allow for an indirect approach to taxing globalized capital income, in view of the difficulties in taxing them through national income tax. This would also lead to a reduction of exchange-rate volatility and to a redistribution of resources, particularly among developed and developing countries (ibid.). Furthermore, Nissanke (2003) argues that when the two-tier tax suggested by Spahn is utilized in conjunction with other measures such as capital controls or Securities Transaction Taxes (STTs) there will be substantial benefits for achieving global financial stability.
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Capital controls 31 However, as Crotty and Epstein (1996) highlight, prospects for attaining such a regime are dim. A key constraint for the implementation of such a system is not economic but political; governments are beholden to national and global economic elites who are content with the status quo or want to push the neoliberal agenda even further.
REFERENCES Bhagwati, J. (1998), ‘The capital myth’, Foreign Affairs, 77(3), 7–12. Buiter, W. (2009), ‘The return of capital controls’, available at http://www.voxeu.org/ index.php?q=node/3104; accessed 15 May 2010. Calvo, G.A. (2001), ‘The case for hard pegs in the brave new world of global finance’, in J.B. De Macedo, D. Cohen and H. Reisen (eds), Don’t Fix, Don’t Float, Paris: OECD Publishing. Cooper, R.N. (1999), ‘Should capital controls be banished?’, Brookings Papers on Economic Activity, 30(1), 89–124. Crotty, J.R. (1983), ‘On Keynes and capital flight’, Journal of Economic Literature, 21(1), 59–65. Crotty, J.R. and G. Epstein (1996), ‘In defence of capital controls’, The Socialist Register, 32, 118–49. Crotty, J.R. and G. Epstein (1999), ‘A defense of capital controls in light of the Asian financial crisis’, Journal of Economic Issues, 33(3), 427–33. Goodman, J.B. and L.W. Pauly (1993), ‘The obsolence of capital controls? Economic management in an age of global markets’, World Politics, 46(1), 50–82. Grabel, I.( 2010), ‘Not your grandfather’s IMF: the emergence of policy space in the wake of the global economic crisis’, GDAE Economic Research and the Heinrich Boell Foundation, available at http://triplecrisis.com/not-your-grandfathers-imf/; accessed 3 June 2010. IMF (2010), Global Financial Stability Report, Washington, DC: IMF, available online at http://www.imf.org/external/pubs/ft/gfsr/2010/02/index.htm; accessed 31 March 2012. Kose, M.A., E. Ayhan, E. Prasad, K.S. Rogoff and S. Wei (2006), Financial Globalization: A Reappraisal, IMF. Krugman, P. (1998), ‘Saving Asia: it’s time to get radical. The IMF plan not only has failed to revive Asia’s troubled economies but has worsened the situation. It’s now time for some painful medicine’, Fortune, 7 September. Krugman, P. (1999), ‘The return of depression economics’, Foreign Affairs, 78(1), 56–74. Nissanke, M. (2003), ‘Revenue potential of the Tobin Tax for development finance: a critical appraisal’, WIDER Discussion Paper, December, Helsinki. Nissanke, M. and H. Stein (2003), ‘Financial globalization and economic development: toward an institutional foundation’, Eastern Economic Journal, 29(2), 287–308. Ostry, J.D., A.R. Gosh, K. Habermeier, M. Chamon, M.S. Qureshi and D.B.S. Reinhardt (2010), ‘Capital inflows: the role of controls’, IMF Staff Position Note, IMF. Prasad, E., K.S. Rogoff, S. Wei and M.A. Kose (2003), Effects of Financial Globalization on Developing Countries: Some Empirical Evidence, IMF. Radelet, S., J.D. Sachs, R.N. Cooper and B.P. Bosworth (1998), ‘The East Asian financial crisis: diagnosis, remedies, prospects’, Brookings Papers on Economic Activity, 29(1), 1–90.
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Rodrik, D. (1998), ‘Who needs capital account convertibility?’, in Stanley Fischer and others, Should the IMF Pursue Capital-Account Convertibility? Essays in International Finance No. 207, International Finance Section, Department of Economics, Princeton University, May. Spahn, P.B. (2002), On the Feasibility of Foreign Exchange Transaction, Report to the Federal Ministry for Economic Cooperation and Development, Frankfurt: Goethe University. Stiglitz, J.E. (2002), Globalization and its Discontents, London: Penguin Books. Williamson, J. (2000), Exchange Rate Regimes for Emerging Markets: Reviving the Intermediate Option, Washington, DC: Institute for International Economics.
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5 Capital market inflation Henryk Braun
The theory of capital market inflation was developed by Jan Toporowski in the early 1990s, when he was writing his book The Economics of Financial Markets and the 1987 Crash (1993). He was trying to make sense of a clearly unstable capital market: his first job was in fund management for the Church Commissioners for England where he witnessed at first hand the stock market crash of 1974 and the associated secondary banking crisis. The mainstream theory was preoccupied with informationally efficient (or inefficient, in the case of new Keynesian theory) equilibrium in the financial markets, an equilibrium clearly absent at critical times, and not just because of temporary adjustment difficulties. The theory was inspired by Toporowski’s reflections on financial aspects of the business cycle theories of Michał Kalecki (on whom Toporowski labours incessantly) and a superficial reading of the work of Hyman P. Minsky, whom Toporowski had met a few years earlier. The actual term ‘capital market inflation’ came from a remark by the French post-Keynesian Alain Parguez who, at a special seminar in University College London, observed that Keynes’s theory was a ‘theory of capital market inflation’. His reflection on this observation brought Toporowski to the conclusion that the long stock market boom, which followed the financial crises of the 1970s, was just such an inflation of the capital market, but induced not so much by monetary policy as by a shift towards funded pension schemes. According to Toporowski, the systems of general equilibrium that are commonly used to analyse asset markets routinely ignore what Minsky identified early on as the market process that actually occurs in such markets. Those markets do not fix prices that make supply equal to demand, except in a notional sense. Financial markets typically operate for extended periods out of equilibrium. When the demand for financial securities exceeds the amount of money that holders and issuers of those securities are prepared to take out of the market, prices rise. As prices rise, demand for those assets, far from falling off, is enhanced by a speculative demand for assets to benefit from capital gains. However, prices of securities do not rise equally across all markets. Short-term securities and bonds usually have the price at which they are repaid written into the terms of the bond. As the date of their repayment approaches, their market price converges on their repayment price. The market price of such bonds will only exceed that 33
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repayment price by a small margin, reflecting any differences between the interest payable on such a bond and the interest payable on equivalent new issues. Excess demand for new securities will therefore inflate most of all equities (common stocks) that do not have any guaranteed repayment value. The majority of securities are issued by financial intermediaries and bought by other financial intermediaries. This issue therefore does not constitute any net expansion of credit, or of the balance sheets of nonfinancial businesses, such as would take out of the markets any excess net inflow of money into those markets. The non-financial sectors that do take money out of the markets are governments and corporations. The finance that governments take out of the markets is limited by their fiscal position (the balance between government income and expenditure). An excess demand for securities, such as was set off by the inauguration of funded pension schemes in the UK and the USA, therefore impacts most directly on the balance sheet operations of corporations. During the 1980s, corporations that issued securities in the capital markets found that they could issue shares very cheaply. In particular, with capital market inflation, shares came to be held not just for the sake of their dividend income, which is paid by the company, but also for capital gains, which are not paid by the company but by other buyers in the market for the shares. With capital market inflation, this capital gain becomes a key factor in the low cost of equity finance. As a result of the excess demand for shares, corporations in countries affected by capital market inflation have issued capital in excess of what they need to finance their commercial and industrial operations. In the past the over-capitalization of companies might have been avoided because it would have involved the ‘watering down’ of profits (sharing a given amount of profits among more shareholders), or loss of control by the directors of a company who could no longer control the majority of shares at a company general meeting. However, today’s shareholders are mostly institutions whose large diversified portfolios are subcontracted to professional fund managers and rated on financial returns, rather than on their active intervention in the running of companies. By and large they have too many diverse holdings to take anything other than a financial interest in a company. At the same time, new techniques of senior management remuneration have tended to replace profit-related pay with share-price-related pay, through stock options. Along with new techniques of debt management, stock option remuneration has removed inhibitions about the over-capitalization of companies. Excess capital has been used to replace bank borrowing with cheaper long-term capital. Replacing borrowing with shares also has the advantage that pre-tax profits can be made to rise by the reduction in interest cost.
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Capital market inflation 35 Where excess capital has not been used to reduce debt, it has been used to buy short-term financial assets, whose yields have been helpfully kept high by central banks as part of anti-inflationary policy, or exchange rate management. This might suggest that capital market inflation merely affects companies through the differential impact of such inflation on the yield curve. But once the expectation of future capital market inflation is established then excess capital is committed to buying and selling companies. Hence the extended festival of merger and takeover activity and balance sheet restructuring that has characterized corporate finance since the 1980s. A key theme in the theory of capital market inflation is the impact of such inflation on industrial investment. The revival of such investment has typically been a central argument in support of inflating capital markets. At the end of the 1970s, it was argued that funded pension schemes would make more long-term capital available for industrial investment. The general equilibrium view, expounded, for example, by James Tobin in his ‘q’ theory, relating industrial investment to the value of financial liabilities, has been that cheaper financing will promote industrial investment. By and large these hopes have not materialized. Britain and the USA remain economies with weak industrial investment and performance. Toporowski has argued that large corporations, which account for the vast bulk of private sector investment, now have excess capital and engage more in balance sheet restructuring (buying and selling financial assets, issuing and repaying liabilities). Such restructuring leaves corporations with larger risky financial market exposures, which therefore require the holding of greater amounts of liquid assets (short-term deposits, holding of financial paper). If a company finds itself with too many liquid assets, profits can be immediately increased by using the excess liquid assets to repay debt. Indeed, this is a far more certain way of raising profits than the prolonged, uncertain and even dreary business of investment in plant and equipment. The overall effect of company over-capitalization on banks has been to make them more fragile. Before the 1970s, the largest, most reliable borrowers from banks were large corporations. From the end of the 1970s, such corporations found that they could borrow much more cheaply by issuing their own bills (company paper) or directly from the inter-bank market. If banks want to hold company loans, they have to buy them as securities in the market at yields that gave banks no profit over their cost of funds in the capital or money markets. The loss of their best customers has turned banks towards fee-related business in derivatives and debt obligations markets, and towards lending into the property market and to other risky customers that they had hitherto treated with much more caution. In recent years in the USA, the UK, and many countries catching up on the sophisticated credit mechanisms of those ‘financially advanced’ countries,
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lending to households has been the fastest-growing segment of bank credit. The overall effect, from the savings and loans scandals of the early 1980s, to the sub-prime market crisis since 2007, has clearly been to make banking markets much more fragile. In more recent work, Toporowski has emphasized a more macroeconomic aspect of his theory, namely the importance of household debt in stimulating (middle class) household consumption. This in turn has led to a build-up of ‘excess debt’ in households. The term ‘excess debt’ originates in the work of one of Kalecki’s closest associates, Josef Steindl. Steindl had criticized the mainstream view that debt is voluntarily entered into with the fairly certain prospect of repayment out of future income. Rather, Steindl, like Minsky, argued that borrowing is also undertaken by firms facing a financial deficit, and therefore needing credit in order to make required payments to their suppliers and holders of their financial liabilities. Such ‘forced debt’ is a burden on the normal income and expenditure of households and firms (Steindl, 1988). This then gives rise to debt deflation as households attempt to reduce such debt (Toporowski, 2009). In the corporate sector, Toporowski has highlighted the role of merger and takeover activity and equity funds in inflating debt liabilities on company balance sheets (Toporowski, 2010a). In his view, both households and non-financial corporations succumb to excess debt because of asset inflation. In the case of households, the asset in question is residential property. In the case of non-financial businesses, the cause of excess debt is the expansion of firms’ debt liabilities to profit from capital market inflation. The theory of capital market inflation is therefore a view of business capitalism in which the capital markets induce a major shift in the structure of economic activity towards turning over capital in the financial markets, rather than in the markets for goods and services as is commonly presumed in economic theory. Such a shift alters the financial structure of capitalist firms, which in turn affects the nature and the dynamics of capitalism. Methodologically, Toporowski’s work is characterized by a certain scepticism about the pretensions and achievements of economic theory that relies too much on mathematical necessity. As a result, his analysis tends to read like a series of insightful observations bound together with notions drawn from the circular flow of income and flow of funds identities. He provides minimal empirical support for his theory, relying rather too much on the reader’s credulity; or recognition that his insights are in tune with the way in which finance or the economy works; or familiarity with the ideas of Kalecki. The diffidence with which he has approached finance theory suggests that he regards his published work in that branch of economics as a distraction from his major task of recent years, his intellectual biography of Kalecki. These flaws in his published writings may account for the general
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Capital market inflation 37 lack of appreciation of his work in academic or professional circles. It is to be hoped that one day, perhaps he, when he has completed his labours on Kalecki, or one of his outstanding students, will produce the rigorous, empirically verified version of his theory that his ideas on finance deserve.
FURTHER READING Steindl, J. (1988), ‘Saving and debt’, in A. Barrère (ed.), Money, Credit and Prices in a Keynesian Perspective, London: Macmillan. Toporowski, J. (1993), The Economics of Financial Markets and the 1987 Crash, Cheltenham, UK and Northampton, MA, USA: Edward Elgar. Toporowski, J. (2000), The End of Finance: The Theory of Capital Market Inflation, Financial Derivatives and Pension Fund Capitalism, London: Routledge. Toporowski, J. (2005), Theories of Financial Disturbance: An Examination of Critical Theories of Finance from Adam Smith to the Present Day, Cheltenham, UK and Northampton, MA, USA: Edward Elgar. Toporowski, J. (2009), ‘The economics and culture of financial inflation’, Competition and Change, 13(2), 145–56. Toporowski, J. (2010a), ‘Excess debt and asset inflation’, in S. Kates (ed.), Macroeconomic Theory and its Failings: Alternative Perspectives on the Global Financial Crisis, Cheltenham, UK and Northampton, MA, USA: Edward Elgar, pp. 221–34. Toporowski, J. (2010b), Why the World Economy Needs a Financial Crash and Other Critical Essays on Finance and Financial Economics, London: Anthem Press.
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6 Central bank policy Juan Pablo Painceira
Radical political economy analysis claims the centrality of money and credit markets in capitalism. More importantly, in this theoretical tradition, money has real effects on capital accumulation in the long run and the interaction of the monetary and financial relations with the real economy shapes the path of economic development. The latter can be mainly seen through the literature on finance and development that is connected to the existence of bank-based financial systems in continental Europe and Japan, and to market-based financial systems in Britain and the United States. Therefore, monetary and credit markets have significant importance for the modern capitalist economy as well the institutional context in which those markets take place. In particular, money markets are crucial to the setting of the financial conditions to credit markets since they define the basic interest rate in any economy. On the opposite side to this view on money and finance, there is the neoclassical or orthodoxy tradition in which money has no effects on capital accumulation in the long run (Friedman, 1956, 1970), and more recently the issues related to monetary and financial spheres have been understood in terms of asymmetrical information problems. Therefore, the importance of monetary and credit markets to the modern capitalist economy is primarily driven by lack of available information and not by monetary issues per se as money does not produce permanent effects. As a consequence of these distinct views on money and finance, there are different understandings on how different institutions, such as banks and central banks, operate in the financial markets and what their functions are. The focus of this chapter is on the role of the central bank in the heterodox tradition. In the modern mainstream tradition, the understanding of central banks has been based around central banking independence (CBI) theory, which in turn is based on the inflation-targeting regime as the guide for monetary policy. This theory on central banking can be understood as the conciliation between the assumptions from the quantitative theory of money (QTM), which is the standard framework for monetary matters in this tradition, and the asymmetric information approach. The importance of the first question is addressed by Bernanke and Mishkin (1997), where it is established that there is a stronger rationale to 38
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Central bank policy 39 treat inflation as the primary goal of monetary policy over medium- to long-term horizons, since most professionals in economics agree that monetary policy only has real effects, such as affecting employment and output, in the short term. Consequently, money has a neutral role in the long term. On the other hand, the importance of reducing asymmetric information in the economy through institutional reforms related to financial markets has been reinforced by the independence of central banks. According to Bernanke and Mishkin (1997, p. 6): this seems to be a logical consequence of making price stability the overriding goal of policy, since the central bank is the best place to make the technical decisions necessary to achieve price stability and to make judgments about whether the pursuit of other objectives is consistent with this goal. (Italics added)
Therefore, an independent central bank aiming at price stability would act as general policy coordinator in order to guarantee the functioning of the market economy equilibrium. There is coherence between arguments about CBI and the role of money claims in the neoclassical tradition. CBI is the modern expression of the assumptions contained in the quantity theory of money in which the main difference would be the instruments used to achieve price stability: the interest rate in CBI, in contrast to the control of monetary aggregates in monetarism. As money is only viewed as a means of exchange in the QTM, an independent central bank would avoid any disturbance in prices coming from monetary management as it does not matter in the long run. However, in the heterodox tradition, monetary management by the central bank will affect capital accumulation in the long term. A historical analysis of finance and central bank functions, in which there are connections to government, economic development and mainly to the money markets (bank of banks), has provided the empirical basis for the heterodox approach to central banking. In this tradition it is possible to identify two main positions: post-Keynesian and Marxist. The post-Keynesian view on central banking is based on the endogenous creation of money through the banking system in which the liquidity preference is fundamental. Based on Keynes’s and Minsky’s contributions, liquidity preference can be understood as a theory of capital assets pricing or portfolio allocation decision in which the process of funding or financing those assets positions is considered. Money is the most liquid asset per se. In this perspective, however, there are at least two views on the shape of the money supply curve. The terms ‘verticalism’ and ‘horizontalism’ are used to refer to how the theorists on monetary relations understand the
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behaviour of money supply. The former group (Minsky, 1986; Kregel, 1988; and Davidson, 2002) regards the money supply to be vertical or almost vertical, that is, fixed at any point in time, and thereby under control of the central bank. More importantly, money and credit markets will not accommodate the demand for money from the productive sector. The banks’ behaviour is a function of their conventions and expectations on the perspectives of economic process such as the institutional structure of the economy and on their clients. The latter group (Moore, 1988 and Lavoie, 1992) considers money supply as being entirely regulated by the money and credit markets in which banks fully accommodate the needs of the productive sector and households, leaving only the basic interest rate in the control of the central bank. However, the monetary authority is assumed to provide all of the liquidity necessary for the money markets. In this sense, there are differences of opinion on how liquidity preference operates among economic units, mainly banks. As a result there are two different views on the role of the banking system in the determination of the money supply and, consequently, on the role of central banks. However, it will only be possible to assign an active role to the central bank in the context in which the monetary authority is able to affect the liquidity preference of financial institutions, and consequently their credit allocation and liquidity provision to the real sector. Even though, in both views, monetary relations have long-term effects, an active role for the monetary authority is only possible in the ‘verticalist’ view of the money supply. Then, in the post-Keynesian view, central banks can affect investment decisions through changes in the banking system’s liquidity preference. In the Marxist approach, in which monetary and credit markets are embedded in social relations of production, money is the expression of those relations. The full understanding of the role of central banks is based on their relations with the capitalist credit system as a whole, mainly the banking system. This structure takes the form of a pyramid (from the top downwards), which consists of the money market, banking credit for any economic unit (mostly including lending to enterprises) and, in the bottom layer, spontaneously emerging, is inter-company commercial credit, within which are found the trade credit relations amongst capitalist companies. The pyramid itself rests upon the process of capital accumulation. In this sense, the central banking operations are at the top of the pyramid in direct connection with money markets. This theoretical framework is developed by Itoh and Lapavitsas (1999) based on Marx’s analysis in Capital (1973) and Lapavitsas (2003). This pyramidal structure shows only the domestic dimension of the credit system, and consequently only the domestic relationships with the central bank. However, central banks also have an international dimension through
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Central bank policy 41 hoarding foreign exchange reserves. In having this function they act as the pivot between the domestic and international spheres. This role of central banks is fundamental, mainly in the context of capital mobility. In the Marxist tradition, ‘world money’ is a necessary development in the category of money as: it is only in the markets of the world that money acquires to the full extent the character of the commodity whose bodily form is also the immediate social incarnation of human labour in the abstract … money of the world serves as the universal medium of payment, as the universal means of purchasing, and as the universally recognised embodiment of all wealth. (Marx, 1973, pp. 141–2)
Consequently countries find it necessary to hoard world money in order to participate in international transactions. In the Marxist approach, and also with reference to the international dimension, the key aspects of central bank operations relate to movements of loanable capital, with a focus on the lending and borrowing activities of banks – within which are included the interest-bearing capital managed by them. In this respect, central bank policy relies on the fundamental banking characteristics of the financial markets, which in turn are based on the nature of dealing with money as money and money as capital. It is within this process of dealing with money that credit creation and liquidity provision by banks are located. Thus, the Marxist political economy analysis of central banks is established through the relationship between loanable capital movement, banks and central banks – in which the role performed by central banks in the money markets is fundamental to the dynamics of the banking system, and consequentially to the financial system as a whole. Then, central banks, by affecting the movement of loanable capital, can have an impact on capital accumulation. In spite of the differences among the heterodox traditions on money and finance, the common feature of central banks is their relevance to capitalist accumulation in the long run. More importantly, it is possible to argue that the unfolding of 2007–09 global financial crises has reaffirmed the centrality of money and finance to the capitalist economy in radical political economy and the revival of an active role of central banks around the world. More specifically, the central banks’ interventions in the crisis have reaffirmed that their functions go beyond price stability as the heterodox tradition has claimed for a long time.
REFERENCES Bernanke, B. and F. Mishkin (1997), ‘Inflation targeting: a new framework for monetary policy’, NBER Working Paper Series No. 5893, Cambridge, MA: NBER.
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Davidson, P. (2002), Financial Markets, Money and the Real World, Cheltenham, UK and Northampton, MA, USA: Edward Elgar. Friedman, M. (1956), ‘The quantity theory of money: a restatement’, in M. Friedman (ed.), Studies in the Quantity Theory of Money, Chicago, IL: University of Chicago Press. Friedman, M. (1970), ‘A theoretical framework for monetary analysis’, The Journal of Political Economy, 78(2), 193–238. Itoh, M. and C. Lapavitsas (1999), Political Economy of Money and Finance, London: Macmillan. Kregel, J. (1988), ‘The theory of demand and supply of labour: the post-Keynesian view’, in J. Kregel, E. Matzner and A. Roncaglia (eds), Barriers to Full Employment, London: Macmillan. Lapavitsas, C. (2003), Social Foundations of Markets, Money, and Credit, London: Routledge. Lavoie, M. (1992), Foundations of Post-Keynesian Economic Analysis, Aldershot, UK and Brookfield, VT, USA: Edward Elgar. Marx, K. (1973), Capital Vol. 1, London: Lawrence & Wishart. Minsky, H.P. (1982), Inflation, Recession and Economic Policy, Sussex: Harvest Press Group. Minsky, H.P. (1986), Stabilizing an Unstable Economy, New Haven, CT: Yale University Press. Moore, B. (1988), Horizontalists and Verticalists: The Macroeconomics of Credit Money, Cambridge: Cambridge University Press.
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7 Central banks Tim Congdon
The first examples of ‘money’ took the form of a commodity, usually a precious metal such as gold or silver. Meanwhile embryonic banking evolved from other kinds of business activity (such as the trading of coin or bullion) and was characterized by competition between different suppliers. However, in the modern world, commodity money has been almost entirely replaced by paper substitutes in the form of notes or scriptural money like bank deposits. Economies have benefited from this development, because the production of notes – unlike the mining of precious metals – requires negligible resources. But an interesting problem of social organization is implied. Who should benefit from the so-called ‘seigniorage’ on money, the difference between the notes’ production cost and their face value? The answer – found more or less uniformly in all sovereign nation states – is in three parts. The state consolidates the note issue to establish a single national currency, it gives the monopoly right to issue the notes to a distinct type of banking institution called ‘a central bank’, and it requires this institution to hand over the profits from the note issue to the government. The central bank’s notes invariably have legal tender status, which ensures that the notes are accepted in the settlement of debts. Since it can acquire assets by issuing money, which has only a trifling cost of production, the central bank is undoubtedly a privileged organization. Since these privileges would make it an unfair competitor in lending to the private sector, a common understanding is that it must not be a direct rival to profit-seeking commercial banks. Instead it is usually both owned by the government and provides banking services to the government. The central bank also assumes the role of banker to the banking system or the ‘bankers’ bank’. Because nowadays commercial banks’ deposit liabilities must be convertible into central bank notes, the commercial banks maintain cash reserve balances with the central bank. While the central bank’s powers derive from its prerogative to issue legal tender notes, its responsibilities arise from its dual franchise to serve as banker to the government and banker to the banking system. However, the exact definition of these responsibilities has been a matter of intense and long-standing controversy. One of the earliest institutional blueprints was in Ricardo’s (1823) ‘Plan for the establishment of a National Bank’. At that date the Bank of England was already more than 125 years old, but its 43
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constitutional position was unsettled. Ricardo envisaged that a newly established ‘National Bank’ could both accept deposits from the government and issue notes fully backed by gold. But he wanted it to have no other assets. The new bank was to be prohibited from lending to the government as well as the private sector, while Ricardo also recommended the withdrawal of the note-issuing prerogative from every other bank, including the Bank of England. The proscription on central bank finance to the government was intended to avoid a repetition of the inflationary disasters in revolutionary France, which had arisen from over-issue of assignats to its government in the 1790s. Restrictions or outright bans on central bank lending to government have been a recurring theme ever since. The original legislation behind the founding of the USA’s Federal Reserve in 1914 forbade it from lending to the Federal government, but this proved unsustainable in the various financial emergencies (the Great Depression of the early 1930s and the two World Wars) of the twentieth century. The Federal Reserve’s assets now include large holdings of government securities. The 1992 Maastricht Treaty, the founding document for the European single currency, said that the new European Central Bank was not to lend on overdraft to the government of any member state. In practice it too holds a significant portfolio of government securities, although no claims on government that carry the ‘overdraft’ label. In May 2010 it purchased Greek government bonds with the more or less undisguised purpose of seeing Greece through a crisis in its public finances. This may not have been overdraft money in strict terms, but it was analogous to an overdraft in effect. Ricardo’s writings were a major influence on the debate between the Banking and Currency Schools in early Victorian England, and his views were reflected in the 1844 Bank Charter Act that split the Bank of England into two departments. One department – the Issue Department – was to operate on the lines of Ricardo’s National Bank, maintaining the gold backing for the note issue and conducting no banking business at all; the other department – the Banking Department – was in theory free to operate like any profit-motivated bank, with its scope to expand its balance sheet subject only to the same constraints as other banks with private shareholders. The flaw in the Ricardian scheme became apparent within a few years after the 1844 Act. Private sector entities were entitled both to maintain in the Banking Department deposits convertible into notes and to ask for gold in return for those notes. Contrary to Ricardo’s conception, the Issue and Banking Departments were chained together. When the Banking Department tried to grow its business rapidly, its deposits expanded too fast. Two booms – one in the mid-1840s and the other in the mid-1850s – culminated
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Central banks 45 in financial crises, in which the Bank’s customers demanded notes in return for their deposits and gold in return for their notes. With its gold holdings liable to fall beneath the minimum allowed by the law, the Bank Charter Act had to be suspended in 1847 and 1857. After these setbacks the Bank of England realized that the size of its overall liabilities – the liabilities of the Issue and Banking Departments combined – had to be monitored, so as to preserve a safe ‘proportion’ of gold to total liabilities. The larger message, again one that recurs in episode after episode, is that excessive growth of the central bank balance sheet can be inflationary. An inflationary outcome is particularly likely if central bank operations not only enlarge commercial banks’ cash holdings, but also provoke them to expand their own deposits (i.e., money) much faster than the underlying growth rate of national output. Given the much-feared inflationary dangers of central bank overexpansion, what assets can and should the central bank acquire? Commercial banks keep cash reserve balances at the central bank in order to settle inter-bank obligations, most of which arise from payment instructions from their customers. The UK’s ‘clearing banks’ obtained that name because they were members of the London Clearing House, where adverse closing balances after a day of adding up debits and credits were ‘cleared’ by drawing on cash at the Bank of England. (The debits and credits were mostly the result of customers’ cheque instructions to make payments.) But opening an account with the Bank of England – which members of the London Clearing House first did in 1854 – also starts a business relationship with it. One vital aspect of this relationship is that commercial banks may from time to time want to borrow from the central bank. Of course a central bank that not only takes deposits from banks, but also lends to them on a systematic basis, is quite different from the Ricardo model. The advantage of a borrowing facility at the central bank is that it allows the commercial bank concerned to reduce its cash reserve and still feel confident about covering settlement obligations. Since cash reserve balances have traditionally not paid interest, banks operating with a small cash ratio tend to have a low ratio of non-earning assets to total assets. In the first instance that boosts banks’ return to capital, but eventually competition forces down loan margins and wipes out excess returns. Assuming a standard neoclassical production function, a drop in margins (or ‘credit spreads’) in bank lending lowers the cost of capital to companies and increases the capital/labour ratio in production, which raises equilibrium output per head. If a central bank knows that it may – from time to time – have to lend cash to commercial banks, it needs to pay attention to banks’ asset quality and capital strength. After all, the central bank wants its money back on any
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loans it makes. The assumption of the ‘bankers’ bank’ role usually develops therefore into wider responsibilities for banking supervision and regulation. Once all members of the central bank ‘club’ know that it has undertaken the supervisory task, they will feel more confident about the solvency of other banks. Greater confidence in each other’s financial robustness may then allow banks to lower their ratios of capital to assets, again boosting returns on capital if the loan margin is given. But – if we again conjecture that competition drives down the rate of return on bank capital to a ‘normal’ level – the fall in the capital/asset ratio results in lower loan margins, and hence higher equilibrium levels of both the capital/labour ratio and income per head. In short, when a central bank accepts the role of being the banker’s bank, the commercial banking system can operate on lower ratios of cash and capital to assets than before, which is of wider benefit to society. Walter Bagehot provided the first extended account of how an active central bank could improve the efficiency of the banking system in his 1873 classic essay ‘Lombard Street’. It was to a large extent a response to the Overend crisis of 1866, in which the Bank of England acted as so-called ‘lender of last resort’ and added to banks’ cash so that they could meet their obligations. The thesis of ‘Lombard Street’ was not only that the Bank of England should act as lender of last resort, but that it should accept publicly in advance of a crisis that it would do so. The Bank had preferred to stay silent on the issue, causing Bagehot to remark that it seemed ‘exceedingly strange that so important a responsibility should be unimposed, unacknowledged and denied’. A fair generalization is that central banks have refused to make the commitment suggested by Bagehot and have preferred to preserve a ‘constructive ambiguity’ in their relationship with the banking industry. A narrowly focused Ricardian central bank, extending no loans and taking deposits only in order to acquire bullion, is clearly a very different institution from a Bagehotian central bank, with a wide range of tasks that include occasionally extending large loans to privately owned banks. Different philosophies of central banking were much in evidence in the worldwide financial crisis that began in August 2007. The trigger for the crisis was the closure of the international wholesale inter-bank market, as this implied that banks heavily dependent on borrowing from other commercial banks would face acute difficulties rolling over their liabilities (and hence continuing to finance their assets) in coming years. In principle the world’s central banks ought to have been largely able to fill the ‘funding gap’ that then emerged. But the preparedness of the main central banks to lend to banking systems (or to organize government guarantees so that their inter-bank liabilities could be rolled over) was not unlimited. In the USA the Federal Reserve grew its balance sheet quickly in
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Central banks 47 late 2008, with the stated aim of preserving the flow of credit to companies. But Congress was anxious that the taxpayer would be ‘on the hook’ (i.e., liable to lose money) if the newly acquired assets turned out badly. There was even a faction, led by Senator Ron Paul, which argued that the Federal Reserve should be abolished because it had over-interpreted its role and taken too much risk onto the public sector balance sheet. In late 2007 the European Central Bank provided generous refinancing facilities to Europe’s banking industry, seeming to fulfil its lender-of-last-resort responsibilities. By contrast, Mervyn King, the Governor of the Bank of England, said that it had never been the Bank of England’s job to extend large loans to private sector banks for the long term. Implicitly he repudiated the lender-of-lastresort activities that had been blessed by Bagehot over 130 years earlier. In 2008 the Treasury Committee of the House of Commons published The Run on the Rock, a report on a crisis at the Newcastle-based mortgage lender, Northern Rock. It too cast doubt on the merits and effectiveness of lastresort lending by the Bank of England. The debates about central banking are therefore fundamental to the place of money, banking and finance in theorizing about how modern economies ought to work. In addition to the debates at the practical level in response to current challenges, the main theoretical schools have divergent approaches. The Austrian school takes perhaps the most radical position, with Hayek suggesting in a late work that money should be de-nationalized, the legal tender laws scrapped and the central bank closed down. Recent proposals for ‘narrow banking’, with banks limited to the utility role of money transmission and low-risk lending for socially benign purposes, beg the question of how the restriction of banks’ activities is to be policed. Many bankers value the central bank’s help in extending emergency assistance in cash crises and in economizing on the cash in their balance sheets, but they also resent prescriptive intervention on narrow-banking lines. In short, the exact status of central banks will remain controversial for many years to come. The definition of both their legitimate sphere of operations and appropriate balance-sheet structures, and their position in different nations’ economic constitutions, leave huge room for debate.
REFERENCES Bagehot, W. ([1873] 1978), ‘Lombard Street’, in Norman St John-Stevas (ed.), The Collected Works of Walter Bagehot, Volume IX, London: Economist Books. House of Commons Treasury Committee (2008), The Run on the Rock, Fifth Report of Session 2007–08, available at: http://www.publications.parliament.uk/pa/cm200708/ cmselect/cmtreasy/56/56i.pdf; accessed 5 March 2012.
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Ricardo, D. ([1816/1823] 1951), ‘Proposals for an economical and secure currency’, pp. 43– 141, and ‘Plan for the establishment of a national bank’, pp. 271–300, in P. Sraffa (ed.), Pamphlets and Papers 1815–23: The Works and Correspondence of David Ricardo, Volume IV, Cambridge: Cambridge University Press.
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8 Commodity markets Luigi Ventimiglia
THE STABILIZATION AGENDA UNTIL BRETTON WOODS Throughout the history of economic thought, different schools have covered the issue of stabilizing primary commodity markets in relation to the behaviour of commodity prices, more precisely to their trend and volatility. Regarding trend, the Prebisch–Singer hypothesis argues that the price of primary commodities relative to manufacturing goods tends to decrease over time with consequent loss of real income for primary commodity producer countries. The resulting policy implications are based on import substitution industrialization. However, the origins of the literature on commodity markets can be traced back to Keynes and Hayek who, from opposite political perspectives, promoted international cooperation to coordinate international demand and supply. Since the first studies, heterodox economists after Keynes concentrate on various proposals aimed at the stabilization of either prices or quantities. These recommendations are based on the idea to transfer the risk of price changes from producer and consumers to governments with direct intervention in the market (buffer stocks, export quota) or by stabilizing national income (marketing boards, compensatory financing schemes). Buffer stocks Institutional buying and storing of one or more commodities during production surplus, and selling in case of shortages. The more general proposition of using a basket of commodities to stabilize output and prices as a whole is proposed by Graham (1937, 1944). That the surpluses of goods, which should be regarded as greater wealth, could cause so much damage in the Great Depression is perceived as paradoxical. Reserve currency A commodity reserve currency (F.D. Graham, 1941; B. Graham, 1944) would work effectively like a gold standard. However, the backing up currency would not be a single volatile commodity (gold), but an entire basket of commodities. The ‘gold reserves’ that previously determined the supply of money would be replaced with the ‘commodity reserves’, thus anchoring the money supply to real purchasing power. The 49
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idea is resumed in the 1960s (Kaldor et al., 1964) and especially after the breakdown of Bretton Woods. Recently, Hall (1982) and Yeager (1983) begin the recent resurgence of interest in ‘sound money’ and economic stability, particularly in light of the Asian crises of 1997–98. Export restrictions The price stability is achieved by controlling the quantity marketed by quotas for production or export. The risk is taken on by individual countries, instead of an international institution. All major producers and consumers need to comply with the scheme in order to discourage outside or extra-quota producers to take advantage of it. Mainstream economics has always shown little sympathy for these measures, and since the trade policies enforced by the General Agreement on Tariffs and Trade (GATT), countries shifted from quotas to tariffs. International agreements Multilateral contracts specify a maximum price at which producing countries are obliged to sell stipulated quantity to consuming countries and minimum price at which consuming countries are obliged to buy those quantities. International Commodity Agreements (ICAs) have been attempted since the collapse of commodity prices during the Great Depression in the 1920s. World War II made economists and politicians of developed countries aware of their vulnerability regarding supply of primary commodities. Several international commodity agreements have been signed since then. However, today ICAs are not in vogue as market liberalization has prevailed. The need for considerable start-up capital and for the existence of ‘normal’ market conditions at the outset, built-in flexibility to deal with changes in market requirements, the chances of being subject to market speculations if target prices are not credible, difficulties over the choice of currencies to denominate target prices and the need to control the agreement determine their unfeasibility (Gilbert, 1996). Contingency financing The Compensatory Financing Facility (CFF) was established in 1963 by the International Monetary Fund (IMF) to facilitate countries affected by temporary commodity-related external shocks, but from 1983 access limit has been reduced. Another facility, the Système de Stabilisation des Recettes d’Exportation (Stabex) was established by the European Commission in 1973, but abolished in 2000. The procyclicality effect due to the time lag in delivering the compensation and the increasingly tight conditionalities attached were the main causes of their failure.
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Commodity markets 51
THE END OF A DREAM AND THE DISCOVERY OF VOLATILITY Since the gradual dismantling of the stabilization measures following the breakdown of Bretton Woods, empirical studies attempt to find further evidence for theories explaining commodity secular trends and different price patterns. Subsequently, the Prebisch–Singer hypothesis has been tested, but the overall result is controversial. The focus shifts to the cyclical behaviour of commodity prices. Cuddington (1992) and Reinhart and Wickham (1994) study the duration and persistence of commodity-price cycles using the theory of growth cycle. Price booms (slumps) are so described as periods of absolute increase (decrease), not as a period above-trend (below-trend) growth in the series. According to Cashin and McDermott (2002) there are 18 completed cycles from 1862 to 1999, where a cycle includes one boom and one slump. The critical observation is: ‘The amplitude of price movements increased in the early 1900s, while the frequency of large price movements increased after the collapse of the Bretton Woods regime’ (ibid., p. 175). Moreover, Blattman et al. (2004) examine the price behaviour of 42 commodities on world markets and found that the most important feature over 70 years (1870–1939) is not the long-term drift, but their volatility. In fact, volatility across products varies by more than a factor of ten. Commodity prices experienced the highest average growth and lowest volatility from 1890 to 1909, and the highest volatility and slowest growth during the inter-war years. Within each period some primary products were very volatile (tobacco and coffee), while others were more stable (iron and wheat); while some commodity prices rose (tobacco and wool), others decreased (rubber, which was supplanted by cheaper synthetics in the inter-war period). Other researchers analyse whether, with different volatility, commodity prices co-move within the same business cycle. According to orthodox theory, current and expected values of macroeconomic variables affect current and future demands and supply of all commodities. For example, higher interest rates should decrease real commodity prices if one considers the ‘convenience yield’ (the term was introduced by Kaldor, 1939) from holding inventory relative to treasury yield, then speculators allocate away from commodities to treasury bills (Frankel, 2006). Pindyck and Rotemberg (1990) estimate whether the co-movement of commodity prices is fully explainable by macroeconomic variables or there is excess movement due to inefficient commodity market structure (for example, herding behaviours of commodity traders; this case then represents a rejection of the standard market-clearing competitive storage model of Samuelson, 1971). They run a correlation analysis of
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prices of commodities that are supposed to be the least related for the period 1960–85. This means that they cannot be substitutes or complements, or not co-produced or used as major input for the production of another commodity. While Pindyck and Rotemberg (1990) find that prices tend to move together despite macro-considerations, Deb et al. (1996) reach an opposite conclusion. Cashin et al. (1999) join the debate using a different measure of co-movement, ‘concordance’, which measures the proportion of time when the prices of two commodities are synchronized in the same boom or bust period. The result based on an extended period of time, 1957–99, shows co-movements only for oil and gold, which may be explainable by the desire to hold gold during inflationary periods. Summarizing, comovements is not a clear phenomenon as volatility gets dispersed in various types of commodities. Concluding, the attempts to stabilize prices came to a halt with the collapse of Bretton Woods. Higher commodity price volatility since then is due to the closing down of domestic marketing boards and the ending of international commodity agreement (Maizels et al., 1997). The role of financial markets becomes dominant; producers and consumers are left with the only option of hedging against price uncertainty through the usage of derivatives, mainly futures.
COMMODITY FUTURES AS AN ASSET CLASS The latest commodity cycle, and in particular the 2003–08 boom, shows price fluctuations with new characteristics. Since commodity markets appear to have changed once more, an in-depth analysis of the commodity derivative market may be required. The current stage of capitalism is said to be dominated by ‘money managers’ (Minsky and Whalen, 1996). Their need to hedge against financial risks, such as rises in interest rates or exchange rate movements, drives the search for new asset classes. Existing asset classes are defined as a category of assets, a collection of securities that show analogous characteristics, behave similarly and are often subject to the same regulation. These may be cash equivalents, stocks or bonds. In order to hedge effectively, a new asset class needs to show low levels of correlation with other asset classes (Ventimiglia and Tavasci, 2010). The commodity futures market is a recent example of a new asset class. Today, a significant and increasing part of the total nominal value of the commodity futures contracts is in the portfolios of money managers (UNCTAD, 2009). The result is that the characteristics, in terms of price movements and volatility, of the underlying physical commodity markets
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Commodity markets 53 are subject to the financial market as a whole (Masters and White, 2008; Wray, 2008). For an analysis of this transformation it is necessary to investigate the behaviour of the actors involved, the money managers, the transformation of the new asset class, the commodity futures market, the effect of the involvement of money managers on the underlying asset, the physical commodity market. The passive index managers, a new group of commodity investors who have access to large funds, have contributed to the boom in prices (Master and White, 2008). The effects have been extraordinary. During the 2002–08 boom, the number of futures and options contracts outstanding on commodity exchanges has increased about five-fold and the notional volume of outstanding over-the-counter commodity-related contracts increased about 20 times (UNCTAD, 2009). This indicates that commodity derivatives are a new asset class. The identification of a new asset class by financial investors depends on a series of factors related to the way in which financial investors act. De-regulation has allowed the pervasiveness of financial markets to create a new asset class, through the diffuse usage of swap contracts between investors and investment banks, and the cancellation of speculative position limits. In terms of risk, the market for derivatives on commodities has traditionally been considered as a natural hedge to inflation as energy and food prices have a strong component or secondary effects on consumer price indexes. However, it has also shown a low correlation with bond and equity markets (Gorton and Rouwenhorst, 2005). In reality, low correlation with the other markets was also given by the under-utilization of such markets by financial investors. The overall historical size of the market in terms of total nominal size of transactions has been marginal relative to bond and equity markets. Commodity derivatives have also been chosen as a new asset class because the underlying physical commodities were experiencing a boom since 2002, becoming particularly attractive after the severe equity bear market of the period 2000–02. Empirical evidence supports the idea that there is always a ‘fundamental’ reason on which the financial market builds its euphoria. In fact, both exchange-traded commodities and non-exchange-traded commodities, or commodities not included in commodities indexes have seen a major increase in price (UNCTAD, 2009). Moreover, the proliferation of funds dedicated to derivatives on commodity markets, a financial ‘mania’, epitomizes the fact that world liquidity has increased during the last economic boom cycle in coincidence with an increase of leverage in the financial system. Nevertheless, once the market has been expanded, the low correlation has tended to
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fade. The recent sub-prime crisis has unveiled an increasing correlation between price movements of bond, equity and commodity markets. The dramatic increase in both real prices and in financial commodity prices leads to the question of whether the financial market has driven the real price up or vice versa. The most popular explanation for the real market is given by the ‘fundamental’ imbalance between demand and supply originated by the growth of China, which caused metal and energy prices to rise in particular, and by geopolitical factors, such as the Middle East crisis in relation to the increase in energy prices (Winters and Yusuf, 2007). Actually, commodity markets are subject to speculation on the physical market as well (Wray, 2008). For example, Veneroso (2008) reports that 1 million metric tons (of 17–18 million produced every year) of copper is missing, disappearing into un-recorded inventories in China. To conclude, in the contemporary history of commodity markets there are two main events that have determined significant changes. First, the disappearance of price commodity stabilization policies and the prevailing of a free-market-oriented approach. The post-Bretton Woods era has known significant changes in prices, volatility and trends of commodities. However, the market was still restricted to consumers and producers, hedgers or speculators. Second, the inclusion into the financial investment world through financial innovations and de-regulation. The participation of money managers has aligned this ‘new’ asset class to equities and bonds in such a way that it has incorporated those characteristics, including volatility and pro-cyclicality, which are typically associated with booms and busts. During these different phases commodity markets have changed, showing an increase in volatility of prices that appears to be contrary to the idea that speculation facilitates convergence of prices on equilibrium between supply and demand.
REFERENCES Blattman, C., J. Hwang and J.G. Williamson (2004), ‘The impact of the terms of trade on economic development in the periphery, 1870–1939: volatility and secular change’, NBER Working Paper No. 10600. Cashin, P. and J. McDermott (2002), ‘The long-run behavior of commodity prices: small trends and big variability’, IMF Staff Papers, 49(2), 175–99. Cashin, P., J. McDermott and A. Scott (1999), ‘The myth of co-moving commodity prices’, IMF Working Paper No. 169. Cuddington, J. (1992), ‘Long-run trends in 26 primary commodity prices’, Journal of Development Economics, 39(2), 207–27. Deb, P., P. Trivedi and P. Varangis (1996), ‘The excess co-movement of commodity prices reconsidered’, Journal of Applied Econometrics, 11(3), 275–91.
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Commodity markets 55 Frankel, J. (2006), ‘The effect of monetary policy on real commodity prices’, in J. Campbell (ed.), Asset Prices and Monetary Policy, Chicago: University of Chicago Press, pp. 291– 327. Gilbert, C. (1996), ‘International commodity agreements: an obituary notice’, World Development, 24(1), 1–19. Gorton, G. and G. Rouwenhorst (2005), ‘Fact and fantasies about commodity futures’, Yale Working Paper No. 04-20. Graham, B. (1937), Storage and Stability: A Modern Ever-normal Granary, New York: McGraw Hill. Graham, B. (1944), World Commodities and World Currency, New York: McGraw Hill. Graham F.D. (1941), ‘Transition to a commodity reserve currency’, The American Economic Review, 31(3), 520–25. Hall, R.E. (1982), ‘Explorations in the gold standard and related policies for stabilizing the dollar’, in Robert E. Hall (ed.), Inflation, Causes and Effects, Chicago: University of Chicago Press. Kaldor, N. (1939), ‘Speculation and economic stability’, Review of Economic Studies 7, 1–27. Kaldor, N., A.G. Hart and J. Tinbergen (1964), ‘The case for a commodity reserve currency’, in N. Kaldor, Essays in Economic Policy, Vol. 2, London: Duckworth. Maizels, A., R.W. Bacon and G. Mavrotas (1997), Commodity Supply Management by Producing Countries: A Case-study of the Tropical Beverage Crops, Oxford: Clarendon Press. Masters, M.W. and A.K. White (2008), ‘How institutional investors are driving up food and energy prices’, The Accidental Hunt Brothers Blog, special report posted 31 July. Minsky, H.P. and C.J. Whalen (1996), ‘Economic insecurity and the institutional prerequisites for successful capitalism’, The Levy Economics Institute of Bard College Public Policy Working Paper No. 165. Pindyck, R. and J. Rotemberg (1990), ‘The excess co-movement of commodity prices’, The Economic Journal, 100(403), 1173–89. Reinhart, C. and P. Wickham (1994), ‘Commodity prices: cyclical weakness or secular decline?’, IMF Staff Papers, 41(2), 175–213. Samuelson, Paul A. (1971), ‘Stochastic speculative price’, Proceedings of the National Academy of Science, 68, 335–7. UNCTAD (2009), The Global Economic Crisis: Systemic Failures and Multilateral Remedies, Report by the UNCTAD Secretariat Task Force on Systemic Issues and Economic Cooperation. Veneroso, F. (2008), ‘Financial crisis: on the prospect of a second wave of copper: a commodity calamity to come: speculation to the point of manipulation in base metals’, Veneroso’s View, 28 April, available at www.venerosoassociates.net/. Ventimiglia, L. and D. Tavasci (2010), ‘Money manager capitalism in primary commodity dependent developing countries’, in D. Tavasci and J. Toporowski (eds), Minsky Crisis and Development, Basingstoke and New York: Palgrave Macmillan. Winters L. and S. Yusuf (2007), Dancing with Giants: China, India and the Global Economy, Washington, DC/Singapore: International Bank for Reconstruction and Development/ World Bank/Institute of Policy Studies. Wray, R.L. (2008), ‘The commodities market bubble’, The Levy Economics Institute of Bard College Public Policy Brief No. 96. Yeager, L.B. (1983): ‘Stable money and free market currencies’, Cato Journal, 3(1), 305–26.
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9 Cooperative banking Panu Kalmi
INTRODUCTION The aim of this chapter is to describe the main ideas behind cooperative banking and how they are manifested in the two principal embodiments of these ideas, cooperative banks and credit unions. I exclude certain important topics, notably financial cooperatives that concentrate on housing finance (mutual savings and loans in the USA and building societies in the UK). These have a different origin than the financial cooperatives discussed here. They have also lost their market share drastically both in the UK and the USA since the 1980s following the financial liberalization measures, conversions and financial crises. I also do not discuss many studies on comparing the performance of cooperative banks with commercial banks, or studies explicitly focusing on their behaviour.1 Concerning credit unions, Ferguson and McKillop (1997) have proposed a useful typology of credit union movements into nascent, transition and mature movements. Characteristic of a nascent movement is the small size of credit unions, the existence of a strong common bond of members, the limited range of services, lacking or imperfect deposit insurance, and an emphasis on voluntarism. Mature credit union movements, in contrast, are characterized by liberal interpretations of common bond, credit unions may be large, services offered are comparable to banks, and there is limited liability, deposit insurance and professional management. Transitory institutions are somewhere in between. The classification of Ferguson and McKillop (1997) does not include continental European cooperative banks. Whereas credit unions are ‘like banks’, continental European cooperative banks are banks, for they do not face restrictions in their operations compared to commercial banks, although they may not have advantages that credit unions sometimes possess (such as favourable tax treatment). European cooperative banks are, according to the classification above, a mature movement. However, the European cooperative banks have also developed from two branches, of which the ‘village’ (or ‘rural’) banks following the Raiffeisen model can be viewed as precursors of credit unions. In many developing countries, financial cooperatives resemble the Raiffeisenian cooperatives. In contrast, 56
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Cooperative banking 57 the ‘popular’ banks started by Schulze-Delitzsch were already at their inception more growth-oriented and advanced in their operations. Despite the differences, all movements share four main characteristics: (1) owner-members are the customers of cooperatives; (2) voting is not proportional to capital but each member has one vote only; (3) profitability is not the main goal; the primary goals are to support the financial and social needs of the members; (4) membership is voluntary. Characteristics (1) and (2) imply that cooperatives are self-help organizations, which differentiates cooperative banks from charitable financial organizations, such as the Catholic Monte de Pietà or savings banks.
F.W. RAIFFEISEN’S MODEL OF FINANCIAL COOPERATIVES I will start my discussion by outlining what could be called the Raiffeisen model of cooperative banking. Friedrich Wilhelm Raiffeisen (1818–88) was a German social reformer who by profession served as Bürgermeister (mayor) for several municipalities in the Rhineland. Contrary to some sources he cannot be regarded as the father of financial cooperatives: his own experiments started out as imitations of the works of a Prussian lawyer and politician Hermann Schulze-Delitzsch. In the Anglo-Saxon countries financial cooperatives had existed even longer. Organizationally, cooperatives strictly adhering to the Raiffeisen model were later absorbed by other models, notably the cooperatives directed by Wilhelm Haas. Nevertheless, many of today’s cooperative banks bear the name Raiffeisen in one form or another. The most important contribution of Raiffeisen was his role as the ideological leader of cooperative banking. Many (e.g., Klein, 1999; Goglio and Leonardi, 2010) have argued that for Raiffeisen the spiritual goals of cooperatives were primary and the economic goals merely instrumental. Even though it is possible to see the tenets of his cooperatives in purely functionalist terms, as many economic historians have done (e.g., Guinnane, 2001; Prinz, 2002), it is important to recognize that Raiffeisen represents a fundamentally different ideological attitude towards finance than that of mainstream bankers or even other people working within the cooperative movement. Raiffeisen’s significant contribution was related to extending credit services to rural poor, a population regarded as unbankable.2 The grand goal was to combat usurious practices of moneylenders. His motivation to use cooperatives as a means to extend credit was not particularly inspired by democratic ideals. Raiffeisen’s attitude towards the poor was rather paternalistic and he turned towards using cooperatives only after it became clear
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that schemes based on charity were not successful. Raiffeisen was a politically conservative Christian, who had a strong sense to help the poor, in the spirit of the Sermon on the Mount. A crucial feature of the Raiffeisen conception of cooperatives is the primacy of social goals over the narrow self-interest of the people who participate in financial cooperatives. This is evident, for instance, in the idea that managerial work should be unpaid. Instead of financial incentives, managerial work should be provided out of a sense of duty. Often the original Raiffeisen cooperatives were managed by priests. Raiffeisen cooperatives were also characterized by the lack of any financial incentives to the members: any surplus should remain undistributed and added to reserves. Members of cooperatives also had an unlimited liability of the obligations of the cooperative. The main idea was to utilize the social solidarity inherent in communities (social capital in modern parlance) in the functioning of the financial cooperatives, and in turn to use the cooperative to strengthen the community under the pressure of the possibly destabilizing influence of moneylenders. This meant that the Raiffeisen-type cooperatives could be viable only if the members shared a strong common bond, all members came from a limited geographical area, and the cooperatives remained small so that managers and officials of the cooperative could easily verify the character of the members. Finally, solidarity was expressed in a one member/one vote voting structure. The cooperatives could also potentially have destroyed communities, due to the unlimited liability. However, there were important safeguards. First of all, cooperatives were very conservative in their lending policies, focusing on small agricultural loans. The available evidence suggests that in Raiffeisen cooperatives, defaults on loans were unusually low, despite the fact that borrowers were poor (Guinnane, 2001). Second, the loans could be called back at short notice, solving the problem of maturity mismatch and allowing the cooperatives to extend long-term credit. Third, the cooperatives also cross-insured each other. From early on, they formed networks of cooperatives that could rescue failing cooperatives if needed. Raiffeisen succeeded in providing credit access to a population that was previously considered unbankable. It is true that many of his innovations can be perceived in functionalist terms: voluntary management economized on operational expenses, unlimited liability and social bonds provided safeguards against defaults and moral hazard problems, and nondistribution of surpluses helped the accumulation of equity buffers. However, at the same time these features are also consistent with a fundamentally different attitude towards finance: one that is stressing self-help, solidarity and the support of productive activities, instead of profit-maximization and speculative gains.
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Cooperative banking 59 The other main strand of cooperative banks were (and are) known as Volksbanken (popular banks). Following the ideological leadership of Hermann Schulze-Delitzsch (1808–83), a liberal German parliamentarian, the popular banks were based on much larger equity investments made by the members. They had limited liability, professional management, and they paid dividends to their members. The members of popular banks were mostly artisans and skilled workers, and they were located primarily in urban settings. In many respects, they were closer to commercial banks than Raiffeisen cooperatives, even though they were also owned by depositors and managed on a one member/one vote basis.
COOPERATIVE BANKING TODAY Continental European Cooperative Banks Cooperative banks nowadays belong to the largest banking institutions in many European countries, gathering over 50 million members. In France, the three cooperative banking groups have more than 50 per cent of deposits and together they have around 20 million members. The market shares of cooperative banks in deposits are over one-third in Austria, Finland and the Netherlands, and they are important in many other countries, for instance in Germany and Italy. The distinction between Volksbanken and Raiffeisenbanken has become in many cases rather irrelevant. In Germany, the central institutions have merged. In Italy there remain some differences: Banche Popolari are more market oriented and some of them have their shares listed on the stock exchange (even though there are limits to concentration of voting shares), whereas the Raiffeisen-inspired Banche di Credito Cooperativo have remained closer to Raiffeisen’s vision. There are several shared elements in European cooperative banks that clearly separate them from commercial banks. Large European cooperative banking groups are networks of locally managed banks. The ultimate control in the network belongs to the banks at the local level; thus, the hierarchical structure is inverse to that of commercial bank groups, where the centre has full control over local operations. At the local level, the one member/one vote rule survives. With the exception of Banche Popolari, the primary-level cooperatives do not have tradable shares and distribution of profit to members is rather limited. Usually a rather limited equity investment is required for membership, and members are unlikely to regard their membership as financial investment. Due to dispersed ownership, limited financial investment and government protection of deposits, member involvement in governance is mostly fairly passive.
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However, the number of members in a typical cooperative bank is now much larger than it used to be in the Raiffeisen-type cooperatives; even in most decentralized groups, the local banks have on average several thousand members. Consequently, the governance mode that relies on social bonds and peer pressure has largely waned, and the exchange between members and the bank is now arranged more on an economic, rather than a social, basis. Networks have played an immensely important role for cooperative banks. Initially their main function was to promote the entry of financial cooperatives, supervise them and give managerial support, standardize operations, provide liquidity, and bail out in the case of financial difficulties. More recently, networks have assumed the role of clearing payments, organizing joint marketing, providing IT platforms and new products, and outlining strategic development plans. The network model has given small cooperative banks economies of scale they would be unable to attain otherwise. However, the relationship between local banks and the central agency can potentially be – and at times has been – conflictual. From the central agency’s perspective, small local banks are difficult to manage and for this reason central agency often promotes mergers, which at times may be economically rational, but also risks eroding the special character of cooperatives. Much of the risk-taking within the cooperative banks is also concentrated in the central agencies, which are responsible for the investment banking operations. Many European cooperative banks, especially the French, have extensive investment banking operations and some have invested heavily into emerging markets, for instance the Austrian banks to Eastern Europe. These issues sometimes go beyond central agency’s duty to support the business of local banks. The economic troubles of cooperative banks during the crisis of 2008–12 have been almost entirely due to the activities outside their traditional core competencies. Credit Unions Credit unions are a particularly Anglo-Saxon application of financial cooperatives, started in the early part of the twentieth century especially by the efforts of the Canadian Alphonse Desjardins and two Americans, Edward Filene and Roy Bergengren. From there the movement spread to Australia (in the 1940s), Ireland (in the 1950s) and the UK (in the 1960s). With the exception of the UK where the industry is still relatively small, credit unions have become major players in the financial markets and the penetration rates are impressive. The World Council of Credit Unions (WOCCU) estimates that in 2010 the membership in credit unions worldwide was around 188 million. The penetration rates for 2010 were 46 per cent of
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Cooperative banking 61 economically active population in Canada and 44 per cent for the USA.3 Especially in the USA, with the demise of mutual savings and loans, credit unions have become the main form of financial cooperative (Wilcox, 2006). Credit union development differed from that of continental cooperative banks in several respects. In the credit union movement, there was never a rift into rural and urban movements, as there was in cooperative banks. Moreover, credit unions from early on developed largely at the workplace, again differently from European financial cooperatives. Perhaps reflecting the greater diversity of membership between cooperatives and more stringent interpretations of common bond requirement (leading into greater homogeneity of members within cooperatives), the credit union movement has remained rather fragmented. Even though the Credit Union National Association (CUNA) was established already in the 1930s and in the past few decades there has been a development towards corporate credit unions (serving credit unions rather than individuals), the US credit unions are still much less integrated than European cooperative banks (Desrochers and Fischer, 2005). Although there exists some really large credit unions (like Navy Federal CU in the USA with over 3 million members, or VanCity in Canada with over 400 000 members), most credit unions tend to be small and local. Compared to cooperative banks, credit unions tend to exhibit more volatile performance, and there is more industry dynamics (exit but also entry of new credit unions). Many credit unions have an orientation towards serving low-income populations who can more easily open accounts in credit unions than banks, due to the fact that credit unions typically do not require minimum balances in savings accounts. While credit unions have traditionally had more restrictive charters than banks, both in the USA and the UK these restrictions have gradually been removed and credit unions are able to offer their members the same services as banks offer to their retail clients.
RECENT DEVELOPMENTS OF FINANCIAL COOPERATIVES Financial Cooperatives and Microfinance in Developing Countries The key idea of Raiffeisen was to extend credit to those who did not have access to credit markets and combat loan sharks and their usurious practices; in modern parlance, to promote financial inclusion. There are obvious historical parallels between the Raiffeisen cooperatives and the modern microfinance movement (for a discussion, see, e.g., Hollis and Sweetman, 1998). Financial cooperatives have been present in developing countries for
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decades and they have been practising microcredit much prior to the ‘microcredit movement’ led by Muhammad Yunus and others. Both national and multinational cooperative agencies have been active in promoting the establishment of financial cooperatives in developing countries. A famous case is the promotion of financial cooperatives by the British colonial rule in India in the early twentieth century. Financial cooperatives still serve a much larger number of people and are more sizable in assets than the microfinance institutions (CGAP, 2009), despite the considerable publicity hype associated with the latter. However, the rise of non-governmental organization (NGO)-led microfinance may be seen as a reaction to the disappointment in the results of both state-sponsored rural banks and financial cooperatives during the first decades of the independence of former colonies. As elaborated by Cuevas and Fischer (2006), the use of cooperatives, which are essentially self-help organizations, as development tools is highly problematic. Cooperatives in developing countries, especially in Africa, tended to be weakened by the heavy state involvement in their central organizations. In this way, cooperative organizations became prey to the general governance problems in these countries and the national organizations often collapsed together with the governments that sponsored them. At the micro-level, cooperatives were often vulnerable to fraud by the management, especially in areas where even general literacy, not to mention financial literacy, was at a low level. Currently, financial cooperatives are experiencing a period of renewal in Africa (Develtere et al., 2008) and there are hopes for a brighter future. Cooperatives are being reinvented at the same time as it is becoming clear that the high hopes attached to NGO-led microfinance may have been exaggerated. There is a lack of convincing evidence that the NGO-led microfinance movement is leading to marked poverty reduction (see, e.g., Honohan, 2004), so there are good reasons for maintaining a plurality of methods for promoting financial access. The success of financial cooperatives in promoting development are enhanced if they are able to mobilize sufficient local support and governments and outside donors concentrate on improving the general framework (legislation, technical support by education etc.), but refrain from operational involvement. Ethical Banking and Cooperatives Ethical banking is a recent term that is used to denote banks that have some social and/or environmental aims in addition to the financial ones. In this tradition, it is easy to see Raiffeisen, with his insistence on the primacy of social and spiritual goals over financial ones, as a forerunner of the ethical banking movement as well. Financial cooperatives have a long tradition of
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Cooperative banking 63 regarding profitability only as an instrumental condition towards achieving more desirable objectives, rather than as an end in itself. Of the 24 members of the European Federation of Ethical and Alternative Banks (FEBEA), seven are explicitly structured as financial cooperatives, while the majority of the rest are either savings banks or joint-stock banks owned by non-profit organizations (http://www.febea.org). A difference between ethical banks and traditional cooperative banks is that the former try to reduce the difference between lenders (depositors) and borrowers, whereas in the latter these roles are interchangeable. In ethical banks, the people who lend money (by making deposits) do it under the assumption that this money is used for purposes that they generally endorse, but depositors and borrowers are two distinct groups. In this way, ethical banks are closer to savings banks, with their emphasis on support by the economically better-off rather than self-help. For this reason, it is unlikely that the ethical banking sector will become dominated by cooperatives. Nevertheless, in developed economies the ethical banking sector will probably be one of the main sources for new cooperative banks.
CONCLUSION The financial cooperatives, inspired by the ideas of F.W. Raiffeisen, are based on a fundamentally different ideology than mainstream financial organizations. At the same time, there have from time to time been assimilation processes that have caused financial cooperatives to become more like commercial banks. On the other hand, there have been processes of renewal and new forms of cooperative banks have emerged. There is a great diversity among financial cooperatives. The European cooperative banks and Anglo-Saxon credit unions started from the same roots, but had a different evolutionary track. The European banks are now well-established. At the time of writing (May 2012), they have fared relatively well in the economic crisis. They are strongly federated and cross-insured, which means that the cooperative banking groups can weather well crises of isolated banks within the group, but may be vulnerable to systematic crisis, which may well be provoked by the sophisticated operations performed by central agency. This observation is supported by the fact that so far the main problems in European cooperative banks during the crisis of 2008–12 have originated from the investment banking operations rather than retail operations, and those problems have not yet been so bad as to undermine any group, although the Austrian Volksbank group has been under serious pressure. There is little dynamics in the composition of banks, and it is almost always in the direction of exit (due to mergers) rather than entry.
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Credit unions are smaller and less federated than cooperative banks, and as a sector they are more dynamic. At the same time they probably forego some economies of scale they might gain through tighter federation. Cooperative banks have new opportunities in microfinance or ethical banking, although they are not the only players in those fields. Their in-built orientation towards financial inclusion and social responsibility makes them good candidates for successful banking.
NOTES 1.
2. 3.
Useful reviews of the literature include McKillop and Wilson (2011) on credit unions and Fonteyne (2007) on European cooperative banks. See, for example, Amess and Howcroft (2001), Alexopoulos and Goglio (2009) and Coco and Ferri (2010) on comparisons between mainstream and cooperative financial organizations. Raiffeisen’s methods are aptly explained in his book ([1887] 1970). In the following paragraphs, I also draw heavily from the biography by Klein (1999). The statistics are from www.woccu.org.
REFERENCES Alexopoulos, Y. and S. Goglio (2009), ‘Financial deregulation and economic distress: is there a future for financial cooperatives?’, Euricse Working Paper, No. 01/09, University of Trento. Amess, K. and B. Howcroft (2001), ‘Corporate governance structures and comparative advantage of credit unions’, Corporate Governance: An International Review, 9(1), 59–65. CGAP (2009), Financial Access 2009: Measuring Access to Financial Services Around the World, Washington, DC: Consultative Group to Assist the Poor. Coco, G. and G. Ferri (2010), ‘From shareholders to stakeholders finance: a more sustainable lending model’, International Journal of Sustainable Economy, 2(3), 352–64. Cuevas, C.E. and K.P. Fischer (2006), Cooperative Financial Institutions: Issues in Governance, Regulation and Supervision, Washington, DC: The World Bank. Desrochers, M. and K.P. Fischer (2005), ‘The power of networks: integration and financial cooperative performance’, Annals of Public and Cooperative Economics, 76(3), 307–54. Develtere, P., I. Pollet and F. Wanyama (2008) (eds), Cooperating Out of Poverty: The Renaissance of the African Cooperative Movement, Geneva: International Labour Office. Ferguson, C. and D. McKillop (1997), The Strategic Development of Credit Unions, Chichester: Wiley. Fonteyne, W. (2007), ‘Cooperative banks in Europe: policy issues’, IMF Working Paper No. 159/07. Goglio, S. and A. Leonardi (2010), ‘The roots of cooperative credit from a historical and theoretical perspective’, Euricse Working Paper No. 11/10, University of Trento. Guinnane, T.W. (2001), ‘Cooperatives as information machines: German rural credit cooperatives, 1883–1914’, Journal of Economic History, 61(2), 366–89. Hollis, A. and A. Sweetman (1998), ‘Microcredit: what can we learn from the past?’, World Development, 26(10), 1875–91. Honohan, P. (2004), Financial Sector Policy and the Poor: Selected Findings and Issues, Washington, DC: The World Bank.
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Cooperative banking 65 Klein, M. (1999), Leben, Werk und Nachwirkung des Genossenschaftgründers Friedrich Wilhelm Raiffeisen dargestellt am Zusammenhang mit dem Deutschen Sozialen Protestantismus, Bonn: Habert. McKillop, D. and J.O.S. Wilson (2011), ‘Credit unions: a theoretical and empirical overview’, Financial Markets, Institutions and Instruments, 20(3), 79–123. Prinz, M. (2002), ‘German rural cooperatives, Friedrich Wilhelm Raiffeisen and the organization of trust’, manuscript, University of Bielefeld. Raiffeisen, F.W. ([1887] 1970), The Credit Unions, translated from German by Konrad Engelmann, Neuwied: Raiffeisen Association. Wilcox, J.A. (2006), Credit Union Conversions to Banks: Facts, Issues, Incentives and Reforms, Madison, WI: The Filene Institute.
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10 Credit cycles Dirk Bezemer
The credit cycle is the periodical increase and decrease in credit conditions (supply, demand and price) in an economy. Credit cycle theories address the questions ‘What are credit cycles and why do they occur?’ and ‘Does the credit system cause volatility in the rest of the economy?’. Writers as early as the British ‘Assay Master of the Mint’ De Malynes (1601, Ch. 2) claimed that ‘[t]he Want of Money is the First cause of the Decay of Trade, for without money, commodities are out of request’. Sismondi (1815, Ch. 2) wrote, ‘[i]f it be then asked why [the entrepreneur] stops, he will answer, like the workman, that money is wanting, that money does not circulate’. Roscher (1878, p. 209) wrote that ‘a general crisis may be produced, especially by a sudden diminution of the medium of circulation’. Marx (1887, Ch. 30) observed that ‘[i]n a system of production, where the entire continuity of the reproduction process rests upon credit, a crisis must obviously occur … when credit suddenly ceases’.
MAINSTREAM ECONOMICS AND REFLECTIVE FINANCE Such observations found no place in the theoretical system of classical political economy, which viewed the economy through the prism of the circular flow of goods and money, where Say’s Law holds. Say’s Law posits that the purchasing power embodied in the funds acquired by producers to produce goods will pass via wages and profit to become the funds that embody the demand for those goods. In a truly circular flow, it cannot be else; no value appears ex nihilo or leaks away, so that inputs and output must be equal in money terms. A major conundrum therefore is how profit can exist – how, in the aggregate, can the value of produce exceed the value of factor inputs? An implication is also that investment is constrained by savings. Both observations arise because the classical circular flow depicts a barter economy. Modern neoclassical economics follows this. The core macro-models view money as an optional add-on to the real economy, a mere unit of account that allows for comparing the values of goods and services. They ignore the conundrum and maintain that investment is constrained by 66
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Credit cycles 67 savings, and thereby rule out the possibility of credit cycles. Credit cycles, though, can only exist if there is a systematic tendency towards overborrowing (more borrowing beyond a rate strictly in proportion to resources and output), as explained below. They are impossible in models where money is a value unit for transactions of current output, and which therefore must exist in a one-on-one proportion to output. All attempts to integrate finance into a general equilibrium (GE) model world therefore picture it as a mere conduit of existing money from savers to investors, in line with a ‘loanable funds’ theory of banking. General-equilibrium macroeconomics so espouses a ‘reflective finance’ view, where the credit system is seen as reflecting economic ‘fundamentals’ in the real sector, such as productivity and resources. Finance itself cannot be the cause of economic volatility; at most, imperfections in financial markets may be the cause, just as wage rigidity in labour markets can be (Kiyotaki and Moore, 1997). This explains why there is little theorizing on credit cycles in mainstream economics, so that Bernanke (1983, p. 258) could note that ‘only the older writers seemed to take the disruptive impact of financial breakdown for granted’. As Arestis and Mihailov (2010) show in a recent overview of monetary theory, ‘reflective finance’ is still dominant despite innovations in secondary issues such as inclusion of transaction costs, heterogeneous agents, risk, information imperfections, and sticky prices. It characterizes the earliest money-less Walrasian models up to the currently dominant dynamic stochastic general equilibrium (DSGE) models, of which Tovar (2008) notes that ‘the main weakness in current DSGE models, is the absence of an appropriate way of modelling Financial markets’ (p. 5). In consequence, in DSGE models ‘aggregate financial wealth does not matter for the behaviour of agents or for the dynamics of the economy’ (p. 7). This is true also of models ostensibly focusing on credit, as in the ‘credit channel’ view, where changes in borrowers’ balance sheets should have an impact on their decisions to lend and spend, and procyclical movements in balance sheets can amplify business cycles – a mechanism known as the ‘financial accelerator’ (Bernanke et al., 1999; Aoki et al., 2004). Kiyotaki and Moore’s much cited ‘Credit cycles’ (1997) shows theoretically how credit constraints interact with asset prices so that sectoral shocks may be amplified and spill over to other sectors – a model of how credit conditions may amplify (not cause) external shocks to the economy. Likewise, the ‘bank lending channel’ approach (Bernanke and Blinder, 1988) suggests that monetary policy may affect the external finance premium by shifting the supply of intermediated credit, particularly loans by commercial banks. This literature explores whether ‘imperfect information and other “frictions” in credit markets might help explain the potency or otherwise of
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monetary policy’ but no independent effect of credit flows on the real economy is presumed. Indeed, in describing it, Bernanke and Gertler (1995, p. 44) assert that it is ‘inappropriate’ for ‘some authors to focus on the behavior of credit aggregates’ since ‘examining the dynamic responses of various credit aggregates is … largely uninformative’. They advise that it is unwise to ‘think of the credit channel as a distinct, free-standing alternative to the traditional monetary transmission mechanism, but rather as a set of factors that amplify and propagate conventional interest rate effects’ (ibid.). This stance is in line with the passive role of finance imposed by a general equilibrium view of the economy, as explained above. But reality asserts itself in the widespread recognition that credit is not merely unit-of-account money, and that cycles in credit exist and are causal factors in cycles in economic activity. For instance, Stiglitz and Weiss (1988, p. 4) wrote, ‘the central means by which the banking system (and the monetary authorities) affect the level of economic activity is through control of the availability of credit, not through the medium of exchange’. Likewise, Austrian economists attribute errors in mainstream analysis to theorists’ confusing the demand for credit with the demand for money (Yeager and Greenfield, 1986), which obfuscates the role of asset markets. Geanakoplos (2009, p. 963) asserts that ‘regulating leverage is the solution for a troubled economy’. Benk et al. (2005), building on Uhlig (2004), identify credit shocks as candidate shocks that matter in determining GDP. Caporale and Howells (2001) analyse the interactions between bank loans, bank deposits and total transactions in the economy (both in the real economy and in the financial sector). They conclude that ‘loans cause deposits and that those deposits cause an expansion of wealth/ GDP transactions’ (ibid., p. 555). Werner (2005) shows that bank credit Granger-causes GDP growth and asset price inflation.
CRITICAL CREDIT CYCLE THEORIES These and similar observations are poorly theorized in general equilibrium economics, given its limited theoretical scope. They fit into alternative ‘critical’ theories of finance (Toporowski, 2005) where variation in credit conditions do constitute a causal factor in the wider business cycle – not because of some imperfections, but because of the very nature of finance and its role in the economic system. To illustrate the distinction, Irving Fisher in a 1907 book attributed credit-caused economic volatility to variations and imperfections in investors’ ‘foresight’ – that is, outside the credit system. Only in his 1933 paper ‘The debt deflation explanation of the Great Depression’ did he describe how finance always and by definition tends to instability and to destabilize the economy (Toporowski, 2005,
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Credit cycles 69 pp. 75–6). The remedy following from his 1907 book is that with better information and training of investors, instability can be avoided; the policy implication from his 1933 paper is that instability is inevitable, and must be managed. The dichotomy was apparent in the 2007–08 Great Financial Crisis and its aftermath. Public debate informed by the reflective finance view suggested that financial reform should focus on breaking up banks, banning bonuses, reintroducing a separation of deposit taking and investment banking, and the like. Only a handful of post-Keynesian and Austrian economists had been pointing out (long before the crisis, as documented in Bezemer, 2010, 2011) that financial instability trends were ever present and needed constant rather than occasional regulation. Wicksell, Mises, Veblen, Hayek, Fisher, Schumpeter and Keynes/Minsky theorized how credit fluctuates and causes the business cycle. The key features of their and others’ critical credit cycle theories are: + ‘free’ credit flows not linked to real-sector growth; + assets distinguished from money; and + debt as the counterpart of credit. Free credit (i.e., debt flows not linked to production) can only exist if credit (and credit-money) is recognized as being created ‘out of nothing’, in contrast to the ‘loanable funds’ theory of banking. There are no ‘free resources’ (or savings) in the real sector that are the loanable funds that limit the expansion of the credit system. Rather, crediting bank accounts is how free (financial) resources are created, in excess of current real-economy output. There is no necessary link to real-sector income; credit expansion can be self-propelled for long periods of time. Moreover, credit flows over and above those linked to current output have to be linked to some other market, namely asset markets; these are dispensable in the core GE models but central to ‘critical’ theories of finance. Such theories always need a dual economy, with finance distinguished from the real economy and assets distinguished from money. Finally, by balance sheet identity credit is also debt, which is key to the peaking of a credit boom and the adverse real-sector consequences of a debt deflation. The common scenario in credit cycle theories starts with over-borrowing. While Adam Smith and subsequent ‘real bills’ advocates had argued that money demand would be limited by the ‘needs of trade’, Henry Thornton (1802) noted that there is no natural limit to the amount of bills of exchange that merchants may demand. Hence over-borrowing is possible: in a money system based on convertibility into such notes, money growth may exceed output growth. Knut Wicksell (1898, 1906) built on this to originate the best-known theory of a credit cycle. He broke the mould of Say’s Law and
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the quantity theory by recognizing investment to be independent of savings. If money is (trade or bank) credit, it is freely expandable. This implies that aggregate demand and investment is free to rise above (or fall below) a given aggregate supply. Wicksell (1898, 1906) theorized a ‘natural’ interest rate (the return on capital, or the real profit rate) and the ‘money’ rate of interest (the loan interest rate, determined in the financial system with no necessary reference to real-sector returns). If the natural rate is greater than the money rate (so that the marginal product of capital is greater than its cost), then entrepreneurial borrowing for investment in capital goods is attractive and investment will rise above savings. The excess demand that this eventually causes will push up prices, encouraging entrepreneurs to borrow yet more, so that a self-propelled credit boom is in existence. The peak will be reached when banks increase their loan rates and/or restrict lending (for instance, because they have limited reserves), or when the inflation reduces the real return on capital, and thereby the real rate. Either or both of these processes eventually cause the money rate to exceed the natural rate, undermining entrepreneurs’ incentive for further borrowing. By introducing selfpropelled money growth with real-sector effects, Wicksell did away with the (neo)classical view that money is merely a ‘veil’ over the real sector, and with the exogeneity of the money supply. He specified how credit cycles may engender the business cycle via investment decisions and separate markets for productive capital and financial assets. In the same period Veblen (1904) published a theory drawing upon the distinction between asset valuations equal to the discounted stream of future profit and asset valuations based on expectations of capital gain. There is a parallel to Wicksell’s natural and money rates of interests, but Veblen’s account is less systematic and richer psychologically and institutionally. Collateralized lending is the key reason for a credit boom where capital gains and credit extension become mutually reinforcing. Once the disparity with expected income streams becomes too obvious, the resulting change in mood curtails not only credit and asset prices, but also investments in the real economy. The result is redistribution of ownership claims towards creditors; different from Wicksell’s account, any real effects of the entire boom-and-bust episode (e.g., on efficiency) are only secondary. In fact, Veblen’s theory is the polar opposite of the (neo)classical exclusive emphasis on the real side of the economy. The link from credit to physical production is psychological and credit has no effect whatsoever on physical production capacity. This links to Veblen’s vision of the role of finance in the economy, which is about controlling and manipulating rather than supporting and facilitating physical production.
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Credit cycles 71 The term ‘credit cycle’ is often linked to the Austrian school. Austrian credit cycle theory was originated by Ludwig von Mises ([1912] 1981), as a consequence of his exploration of banking theory, and further developed by Friedrich Hayek. The theory is clearly rooted in Wicksell’s, but combines elements from Menger’s and Böhm-Bawerk’s emphasis on individual choice and preferences, and the role of heterogeneous capital investment in economic expansion. The Austrian business cycle also starts with overborrowing: an (unsustainable) expansion of bank credit through fractional reserve banking (caused, for instance, by low interest rate policy). The resulting enlarged supply of funds and further falling interest rates prompt investors to shift investment from consumer to capital goods, and causes entrepreneurs to invest in longer processes of production, lengthening the capital structure and increasing the ‘roundaboutness’ of production that Böhm-Bawerk had noted. Monetary expansion so misleads investors by artificially pushing up capital prices and reducing people’s time preferences (the degree to which they prefer present to future satisfactions). The results, as with Wicksell, are over-investment and the speculative borrowing to sustain this. The boom comes to an end as the ‘artificial’ increase in the money supply eventually results in all-round price increases. This inflation restores time preferences, causes people to increase consumption and decrease investment, and so reduces investment funds. In sum, for the Austrians the cycle is based on monetary sleight of hand, and generates unsustainable ‘malinvestment’: the longer the unsustainable shift in capital goods continues, the more violent and disruptive the necessary readjustment process will be – and rightly so. Fractional reserve banking coupled with government interference is the source of all problems and the resulting recession is seen as essentially healthy, realigning investment to ‘real’ savings. Austrians view ‘free’ credit flows – financial development in excess of real-sector development – as problematic, not promising. Not so Joseph Schumpeter, who was Austrian by birth and often viewed as part of the Austrian school. His seminal Theory of Economic Development ([1912] 1934) is entirely set in the context of ‘the circular flow of traded goods’ (ibid., p. 8). In it, he notes that ‘the fundamental proposition of the equality between the value of the product and of the services of labour and land still excites astonishment’, because it implies zero profit and interest. Schumpeter made the analysis of this puzzle the framework for his theory of profit, interest and entrepreneurship in the rest of the book. He proposed credit as the solution. Schumpeter’s name is therefore linked to the acceptance of the idea that the financial system can promote economic growth. King and Levine in their 1993 paper ‘Finance and growth: Schumpeter might be right’ started a large empirical literature on this theme. Schumpeter ([1925] 1994, p. 119) distinguished between the role of credit
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in stable (non-development) conditions, referring to it as ‘circulating credit’. Development, in contrast, requires ‘the expansion of bank credit whereby new purchasing power is created out of nothing’ – or ‘free’ credit flows. Credit expansion so facilitates (rather than causes) the upward swing of the business cycle. Likewise, as innovations spread, ‘the advanced credit will find its way back to the investor’ (ibid.), and prices fall as the boom wears out and turns into slump. Also in his 1939 Business Cycles, the source of development is innovation and credit is seen as indispensible to innovation. But for Schumpeter, credit is the proximate and innovation the ultimate cause of development; he did not pinpoint causes of instability within the credit system itself. Development and the business cycle to Schumpeter is an interaction between the stable Walrasian system and revolutionary innovations, facilitated by credit expansions and contractions. In discussing, in Chapter XI of Business Cycles, the section on ‘Deposits and loans’, Schumpeter warns against the ‘misleading associations’ that readers may have when discussing loans as ‘the source of expenditures’. ‘We are not now moving towards the origin of the cyclical process but, on the contrary, away from it’. He eschews ‘any implications of mechanical effects of the “flow of funds”’ (Schumpeter, 1939, p. 578). In the 1934 preface to The Theory of Economic Development (p. lxii) he had written that he hoped ‘to supply before long the detailed material which is here missing by more “realistic” studies in money and credit, interest, and cycles’. It may well be that Schumpeter’s material never materialized because later in life he came to favour a general equilibrium framework of analysis, which, as discussed in the introduction, excludes money and interest. A more explicitly credit-based theory of the business cycle was put forward by Irving Fisher (1933). He theorized in ‘The debt deflation explanation of the Great Depression’ that low interest rates, and hence cheap money, was the cause of over-borrowing, over-investment and speculation, like the Austrians had done. But different from Wicksell and the Austrians, his emphasis was not on the upswing, but on the aftermath of a credit-boom-turned-bust. Over-indebtedness is followed by the asset owner’s distress selling in an attempt to reduce debt levels, causing asset prices to decline. The growing gap between falling asset values and fixed debt levels leads to widespread balance sheet problems, more distress selling, de-investment and so to a general slump with deflation, bankruptcies and unemployment. Fisher’s contribution was to detail the real-sector implications (in his time, the 1930s’ Depression) of the credit cycle. He highlighted the role of debt and asset values in the downturn (‘balance sheet effects’) more than any predecessor. Like Schumpeter, John Maynard Keynes placed the financial nature of capitalism at the heart of his mature analysis. It may therefore come as a
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Credit cycles 73 surprise that novel credit cycle theorizing was absent from his work. Keynes viewed money as a financing ‘veil’ between the real asset and the wealth owner. The resulting uncertainty explains why capitalist economies are ‘so given to fluctuations’ (Keynes, 1936, p. 169). But Keynes did not locate the mechanisms of instability within the ‘veil’. Understanding the credit cycle was important to Keynes in the 1920s. His investment approach for some years was to ‘play the credit cycle’ (i.e., anticipate how credit flows and turning points would influence returns), and this linked to a growing theoretical interest. In 1924, Keynes wrote in a letter that ‘[t]he conversation with Sraffa about the Credit Cycle has made me very eager to begin writing my book’, which was to become his 1930 Treatise on Money (Naldi, 2006). In it, he included a Wicksellian theory of the credit cycle. But his distinction in the Treatise between ‘money in the real circulations and money in financial circulations’ – a cornerstone of critical credit cycle theories – did not lead him to develop a new theory of finance-induced cycles. When Keynes wrote on ‘The consequences to the banks of the collapse of money values’ in his 1931 Essays in Persuasion, he did not elaborate on an economy-wide debt deflation but confined his analysis to banks. Nor was he specifically interested in credit. As Naldi (2006) notes, with the phrase ‘credit cycle’ Keynes generally referred to the business cycle. For instance, Naldi (2006) notes that in the 1924 article ‘The speeches of the bank chairmen’, ‘the stability of the internal price level and the damping down of the credit cycle’ is presented as synonym of ‘to keep prices steady and trade on an even keel’. In one of the earliest versions of the Treatise on Money, the heading ‘The analysis of the credit cycle’ was corrected by Keynes in ‘The analysis of the trade cycle and the theory of credit’ (1930). And Keynes never mentioned debt as a causal factor in the cycle. In Chapter 22 of the General Theory, titled ‘Notes on the trade cycle’ he wrote that ‘the predominant explanation of the crisis is, not primarily a rise in the rate of interest, but a sudden collapse in the marginal efficiency of capital’ (Keynes, 1936, p. 315). For Keynes, cycles were fundamentally caused by physical investment decisions, in turn determined by the interplay of prices, stocks and costs of production as well as (on a deeper level) by uncertainty and ‘animal spirits’. Keynes was primarily concerned with the possible persistence of slumps due to demand deficiency. Accordingly, credit in the Treatise on Money is not a causal factor in business cycles, but figures as a possible countercyclical policy tool. And in the General Theory six years later, his focus had altogether shifted. In the preface to the General Theory (p. vii), he noted that ‘whilst it is found that money enters into the economic scheme in an essential and peculiar manner’, he let ‘technical monetary detail fall into the background’. There are echoes of Schumpeter’s preface two years earlier.
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Hyman Minsky (1919–96) was unique in that he developed an original theory of finance-induced cycles that differs from the Wicksellian account and the variations on it discussed so far. Minsky was a student of Schumpeter at Harvard and a follower of Keynes and Veblen. He developed Keynes’s emphasis on expectations into his ‘financial instability hypothesis’: financial instability is inherent in monetary capitalism because of expectations. Periods of prolonged prosperity give rise to increasingly optimistic expectations. These will cause the financial system to progressively increase its leverage, return rates and risk exposure (i.e., its ‘fragility’), proceeding through the stages of ‘hedge finance’ on to ‘speculative’ and finally ‘Ponzi’ finance. In this view, the monetized economy is inherently dynamic, since the key economic transaction is the exchange of money today (current goods) for money tomorrow (financial assets). Financial commitments on capital markets reflects such transactions, and have to be made in the face of intractable uncertainty (as opposed to calculable risks). This implies that views about the future can undergo marked changes in short periods of time, generating instability (Minsky, 1978). Contemporary credit cycles research builds on the above traditions and a number of contemporary writers are further developing and applying credit cycle theory. The ‘monetary circuit’ school has developed models of the circular flow that include the circulation of credit-money, where money is created endogenously, and banks are modelled separately from firms and consumers (Graziano, 2003). Post-Keynesian researchers such as Keen (1995) have further developed and formalized Minsky’s hypothesis and combined it with circuit theory (2009). Wynne Godley, in joint work with Francis Cripps in the 1980s and Marc Lavoie in the 2000s, has developed stock-flow-consistent flow-of-fund models of the macroeconomy, applied to the USA and UK. These have been the basis for policy concerns of growing indebtedness, unsustainability of growth and accurate predictions of financial crisis (Godley and Wray, 2000; Godley and Zezza, 2006) and have resulted in an alternative macroeconomic textbook (Godley and Lavoie, 2007) where the flow of funds is central. Werner (e.g., 2005) has extended the Fisher equation of exchange to include asset markets, and developed a theory where over-extension of credit into financial and property markets, and the debt dynamics it implies, causes cycles in credit, and therefore cycles in economic activity, in the context of the Japanese economy. Gardiner (2006) has provided a rationale for the business cycle as credit cycle from the accounting nature of money. The 2007 Great Financial Crisis appears to have reinvigorated interest in the role of credit in the macroeconomy, and these are just some of the recent contributions.
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Credit cycles 75
REFERENCES Aoki, K., J. Proudman and G. Vlieghe (2004), ‘House prices, consumption, and monetary policy: a financial accelerator approach’, Journal of Financial Intermediation, 13(4), 414–35. Arestis, P and A Mihailov (2011), ‘Classifying monetary economics: fields and methods from past to future’, Journal of Economic Surveys, 25(4), 769–800. Benk, S., M. Gillman and M. Kejak (2005), ‘Credit shocks in the financial deregulatory era: not the usual suspects’, Review of Economic Dynamics, 8(3), 668–87. Bernanke, B (1983), ‘Nonmonetary effects of the financial crisis in the propagation of the Great Depression’, American Economic Review, 73(3), 257–76. Bernanke, B. and A. Blinder (1988), ‘Credit, money, and aggregate demand’, American Economic Review, Papers and Proceedings of the 100th Annual Meeting of the American Economics Association, 78(2), 435–9. Bernanke, B. and M. Gertler (1995). ‘Inside the black box: the credit channel of monetary policy transmission’, Journal of Economic Perspectives, 9(4), 27–48. Bernanke, B., M. Gertler and S. Gilchrist (1999), ‘The financial accelerator in a quantitative business cycle framework’, in J.B. Taylor and M. Woodford (eds), Handbook of Macroeconomics, Volume 1C, Amsterdam: North-Holland, pp. 1341–93. Bezemer, D. (2010), ‘Understanding financial crisis through accounting models’, Accounting, Organizations and Society, 26, 676–88. Bezemer, D. (2011), ‘The crisis and recession as a paradigm test’, Journal of Economic Issues, 45(1), 1–18. Caporale, G. and P. Howells (2001), ‘Money, credit and spending: drawing causal inferences’, Scottish Journal of Economics, 48(5), 547–57. Fisher I. (1907), The Rate of Interest, New York: Macmillan. Fisher, I. (1933), ‘The debt deflation explanation of the Great Depression’, Econometrica, 1(4), 337–57. Gardiner, G. (2006), The Evolution of Creditary Structures and Controls, Houndsmills, Basingstoke: Palgrave McMillan. Geanakoplos, J. (2009), ‘End the obsession with interest’, Nature, 457(7232), 963. Godley, W. and M. Lavoie (2006), Monetary Economics: An Integrated Approach to Credit, Money, Income, Production and Wealth, Houndsmills, Basingstoke: Palgrave-Macmillan. Godley, W. and L.R. Wray (2000), ‘Is Goldilocks doomed?’, Journal of Economic Issues, 34(1), 201–6. Godley, W. and G. Zezza (2006), ‘Debt and lending: a cri de coeur’, Levy Institute at Bard College, Policy Notes No. 2006/4. Graziani, Augusto (2003), The Monetary Theory of Production, Cambridge: Cambridge University Press. Keen, S. (1995), ‘Finance and economic breakdown: modelling Minsky’s Financial Instability Hypothesis’, Journal of Post Keynesian Economics, 17(4), 607–35. Keen, S. (2009), ‘The dynamics of the monetary circuit’, in J.-F. Ponsot and S. Rossi (eds), The Political Economy of Monetary Circuits: Tradition and Change, London: Palgrave. Keynes, J.M. (1930), A Treatise on Money, reprinted in Keynes, Collected Writings, Vol. 6, Cambridge: Cambridge University Press. Keynes, J.M. (1931), ‘The consequences to the banks of the collapse of money values’, in Essays in Persuasion, New York: Macmillan. Keynes, J.M. (1936), The General Theory of Employment, Interest and Money, New York: Harcourt, Brace and Company. King, R.G. and R. Levine (1993), ‘Finance and growth: Schumpeter might be right’, Policy Research Working Paper Series No. 1083.
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Kiyotaki, M. and J. Moore (1997), ‘Credit cycles’, Journal of Political Economy, 105(2), 211–48. Malynes, G. de (1601), The Canker of Englands Common Wealth, available at http:// socserv.mcmaster.ca/econ/ugcm/3ll3/malynes/canker.pdf; accessed 5 March 2012. Marx, K (1887) Capital, English translation at http://www.marxists.org/archive/marx/works/ 1894-c3/ch30.htm; accessed 1 April 2012. Minsky, H. (1978), ‘The financial instability hypothesis: a restatement’, Thames Papers on Political Economy, London: Thames Polytechnic. Mises, L. von ([1912] 1981), The Theory of Money and Credit, 3rd English edition, Indianapolis: Liberty Classics, available at http://www.econlib.org/library/Mises/ msT.html; accessed 3 March 2010. Naldi, N. (2006), ‘November 1924: Piero Sraffa and Keynes’ new theory’, Quaderni di Ricerche No. 62, available at http://www.enteluigieinaudi.it/pdf/Pubblicazioni/Quaderni/ Q_62Naldi.pdf; accessed 6 March 2012. Roscher (1878), Principles of Political Economy, translation by J.J. Lalor of Die Grundlagen der National Okonomie, Chicago. Schumpeter, J.A. ([1912] 1934), The Theory of Economic Development: An Inquiry into Profits, Capital, Credit, Interest and the Business Cycle, translated by Redvers Opie, London: OUP. Schumpeter, J ([1925] 1994), ‘Old and new banking policy’, in Y Shionoya and M Perlman (ed.), Schumpeter in the History of Ideas, International Schumpeter Society/University of Michigan Press. Schumpeter, J.A. (1927), ‘Die goldene Bremse an der Kreditmaschine. Die Goldwaehrung und der Bankkredit’, Cologne Lectures, vol. I, Die Kreditwirtschaft. Schumpeter, J. (1939), Business Cycles: A Theoretical, Historical and Statistical Analysis of the Capitalist Process, New York/Toronto/London: McGraw Hill. Sismondi, J.C.L.S. de (1815), Political Economy, available at http://socserv.mcmaster.ca/ econ/ugcm/3ll3/sismondi/poliec; accessed 5 March 2012. Stiglitz, J. and A. Weiss (1988), ‘Banks as social accountants and screening devices for the allocation of credit’, NBER Working Paper No. 2710. Thornton, H. (1802), An Enquiry into the Nature and Effects of the Paper Credit of Great Britain, available at http://oll.libertyfund.org/; accessed 6 March 2012. Toporowski, J. (2005), Theories of Financial Disturbance: An Examination of Critical Theories of Finance from Adam Smith to the Present Day, Cheltenham, UK and Northampton, MA, USA: Edward Elgar. Tovar, C (2008), ‘DSGE models and central banks’, Bank for International Settlements, Monetary and Economic Department Working Paper No. 258. Basel: Bank for International Settlements. Uhlig, H. (2004), ‘What moves GNP?’, Econometric Society 2004 North American Winter Meetings. Veblen, T. (1904), The Theory of Business Enterprise, New York: Charles Scribner’s Sons. Werner, R. (2005), The New Paradigm in Macroeconomics: Solving the Riddle of Japanese Macroeconomic Performance, Houndsmills, Basingstoke: Palgrave Macmillan. Wicksell, K. (1898), Interest and Prices, New York: Augustus M. Kelley. Wicksell, K. (1906), Lectures on Political Economy, Fairfield, NJ: Augustus M. Kelley. Yeager, L. and R. Greenfield (1986), ‘Money and credit confused: an appraisal of economic doctrine and Federal Reserve procedure’, Southern Economic Journal, 53(2), 364–73.
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11 Emerging markets Kobil Ruziev
Economic growth in any country depends on capital accumulation and capital accumulation in turn requires investment supported by saving. Harrod’s (1939) dynamic growth theory is a useful starting point for analysing the relationship between output growth, saving and investment in a closed economy. Harrod (ibid., p. 17) expressed the actual growth of output in terms of the ratios of investment and saving to output. Because of its simplicity and intuitive appeal, this formula has proven remarkably useful for the purposes of planning and forecasting of development plans in emerging economies (Thirlwall, 2003). Suppose a country wants to achieve a target output growth of 5 per cent; given an incremental capital–output ratio of 4 per cent, the country needs to save and invest at least 20 per cent of its national income to achieve this target. Generally, the difference between a targeted growth rate and the saving ratio required to achieve this target is called a saving–investment gap. If the required saving rate to achieve 5 per cent output growth rate is 20 per cent, and the country’s actual saving rate is only 15 per cent, the saving–investment gap is 5 per cent. According to the Harrod growth equation, when the country saves less than the required amount, it will grow at a slower rate than the targeted rate unless it manages to increase efficiency of its investments; it may also borrow from abroad to fill the gap. But, as was argued by Chenery and Strout (1966), in an open economy with international trade, there is an additional constraint, that is, export–import gap, which also needs to be financed. In other words, for open economies, foreign borrowing helps to bridge not only the savings– investment gap but also the export–import, or foreign exchange, gap. The general conclusion that emerges from the Harrod, Chenery and Strout framework is that both domestic saving and foreign borrowing are of paramount importance in facilitating output growth. Although economists have debated the determinants of economic growth for centuries, the study of the association between financial development and economic growth is a relatively new phenomenon. One of the most important explanations for this is that, in classical economic models, money is seen as a technical input with no real influence on economic activity (it is simply a ‘veil’ that ‘wraps’ the real economy); and ‘capital markets are perfectly efficient and all agents have full information, so there is no 77
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important function served by financial intermediaries’ (Beim and Calomiris, 2001, p. 69). However, Keynes (1970), through his rigorous and revolutionary analysis of the working of capitalist economies, contributed to a new analytical tradition that highlighted the role and importance of money and finance in the economic process. More specifically, the importance of financial deepening in economic development was discussed in pioneering works by Gurley and Shaw (1955), Gerschenkron (1962), Cameron (1967) and Goldsmith (1969) among others, but it was McKinnon (1973) and Shaw (1973) whose works changed the direction and depth of research and became the point of reference for all mainstream works in this area. In the 1960s and 1970s almost all less developed countries (LDCs) had underdeveloped financial sectors and exercised various capital controls in their balances of payments, which discouraged both domestic saving and foreign borrowing. Development policies of most of the LDCs during this period, which were deliberately employed by policy-makers to promote industrialization and economic growth, were characterized by high reserve requirements, interest rate ceilings on bank loans, directed lending by state-owned and statecontrolled banks to certain industries, restricting entry into the financial services industry (especially by foreigners), maintaining multiple exchange rate regimes and restricting international capital inflows and outflows. McKinnon (1973) and Shaw (1973) criticized these policies as counterproductive and argued that full financial liberalization policies would encourage more saving, improve the efficiency of resource mobilization and contribute to economic growth. For instance, higher real interest rates would induce agents with surplus funds to lend by way of depositing their savings in banks, thus increasing available volumes of external finance for entrepreneurs. On the other hand, higher real interest rates would increase banks’ borrowing costs, which would translate into higher lending costs. But, it was argued that this policy would actually improve the average efficiency of aggregate investments by replacing projects with lower expected returns, which thrived under repressed financial conditions, with those with higher expected returns. As a result, output growth would increase. As saving and investment were assumed to be positively related to output growth, higher real output growth would increase the volume of both saving and investment further (Fry, 1997). Due to its straightforward policy implications, the McKinnon and Shaw thesis gained much popularity throughout the 1970s and 1980s, providing the intellectual basis in the design of International Monetary Fund and World Bank programmes for financial sector restructuring as a part of more general structural adjustment programs. Financial liberalization policies were first implemented in South American countries in the late 1970s,
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Emerging markets 79 spreading to most LDCs by the late 1990s (Williamson and Mahar, 1998). Regrettably, however, financial liberalization reforms did not bring the expected fruits in the majority of the cases. First, empirical studies did not find conclusive evidence to support the hypothesis that higher real interest rates would increase saving. Gupta (1987), using 22 Asian and Latin American countries over the period 1967–76, found that the most important determinant of saving was real income, and that there was no strong evidence to support the hypothesized positive relationship between high real interest rates and saving. Demetriades and Devereux (1992), using a sample of 63 developing countries over the period 1960–90, found that the negative effect of higher real interest rates on the cost of capital was stronger than their positive effect on enhancing the supply of loanable funds. Greene and Villanueva (1991), using 23 developing countries over the period 1975–86, also found a negative and significant effect of real interest rates on investments. Fry (1995) in his detailed survey of theoretical and empirical studies on this topic concluded that the effect of higher real interest rates on saving was small and diminished over time. Empirical studies on the impact of higher real interest rates on the efficiency of investment seem to be fewer but more supportive: a study by De Gregorio and Guidotti (1995) estimated that around three-quarters of the positive correlation between financial intermediation and output growth was due to increased efficiency of investment, rather than an increase in its volume; and the World Bank (1989) also claimed that the average productivity of investment, as measured by the incremental capital–output ratio, was four times higher in countries with positive real interest rates compared to those with strongly negative interest rates. Second, one of the most important criticisms of the financial liberalization models is that they are based on the loanable funds theory, which does not take into account the credit-creating potential of contemporary banking systems (Chick and Dow, 1988). In the McKinnon and Shaw framework, banks’ ability to increase the supply of credit to the economy depends entirely upon the volume of savings it attracts from the general public. In modern economies, however, the banking sector as a whole can create credit without an equivalent prior increase in the volume of its deposits. This is explained by the development of the lender of the last resort function of central banks along the stages of banking development in market economies (Chick, 1993). Availability of the lender of last resort facility means that banks ‘collectively expanding credit can now do so without the risk of being caught short of reserves, for they will reliably be supplied by the authorities’ (ibid., p. 83). If the central bank has a stable interest rate policy and does not charge a penalty rate, the willingness of banks to expand will be greatest. As
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a result, the supply of bank credits becomes endogenous as it will depend more upon the demand for loans, rather than the supply of deposits. The implication of this critique is that it is not saving but investment that needs encouragement in the form of, for example, lower real interest rates (Thirlwall, 2003). Third, ironically, rather than increasing saving and investment, financial liberalization policies led to deep financial crises in most countries. Latin American countries such as Argentina, Chile, Mexico and Uruguay were the first LDCs to implement policies of financial sector restructuring in the 1970s. But, soon after, they all experienced banking sector crises, which subsequently also resulted in capital flight and balance of payments and currency crises. The title of a paper (Diaz-Alejandro, 1985) that studied the Latin American experience reflects the link between financial liberalization and crises rather accurately: ‘Good-bye financial repression, hello financial crash’. Proponents of financial liberalization argue that incorrect sequencing of reforms were to blame for the failure of the reform programmes (Edwards, 1984; McKinnon, 1993). They also argue that achieving macroeconomic stability and developing sound prudential supervision and regulatory frameworks should precede liberalization of domestic financial systems; and that lifting of capital controls should be placed at the end of the process. Liberalization of capital flows in turn also should be sequenced: controls on long-term inward capital flows and trade-related flows should be abandoned as soon as possible; long-term and short-term outflows should be liberalized after achieving macroeconomic stability; and short-term capital inflows can only be liberalized after establishing a sound supervisory and regulatory system (Fischer and Reisen, 1992). A study by Williamson and Mahar (1998), which surveyed postliberalization experiences of 34 countries, found that the majority of countries in its sample did not follow the recommended sequencing of reforms and subsequently faced similar ‘twin’ crises. Another study (Kaminsky and Reinhart, 1999) that considered financial crises in LDCs in pre-liberalization and post-liberalization periods observed that during the 1970s there were 26 balance-of-payments-related crises and banking crises were rare (only three taking place during this period). However, in the post-liberalization period, that is, during the 1980s and 1990s, the number of banking crises per year more than quadrupled and increasingly occurred together with balance of payments crises. Table 11.1 shows a selection of emerging countries with a resolution cost of at least 10 per cent of GDP. The majority of these countries implemented liberalization reforms prior to the crisis (Williamson and Mahar, 1998). As Table 11.1 reveals, the resolution costs of banking sector crises in most
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Emerging markets 81 affected countries were enormous. In Argentina, for example, the cost was equivalent to a staggering 55 per cent of the country’s GDP. Table 11.1 Resolution costs of bank crises in selected emerging economies Country
Crisis Years
Cost as % of GDP
Country
Crisis Years
Cost as % of GDP
Argentina Benin Bulgaria Chile Ivory Coast Czech Republic Hungary Indonesia Korea Republic Macedonia
1980–82 1988–90 1990s 1981–83 1988–91 1991–94 1991–95 1997–99 1997–99 1993–94
55 17 13 41 25 12 10 50 20 32
Malaysia Mauritania Mexico Philippines Senegal Taiwan Tanzania Thailand Uruguay Venezuela
1997–99 1984–93 1995 1981–87 1988–91 1997 1987 1997–99 1981–84 1994–95
20 15 15 19 17 11 10 42 24 18
Source:
Adapted from Beim and Calomiris (2001, pp. 279–89).
The new consensus on financial liberalization rests heavily on orderly sequencing of reforms, with particular emphasis on the establishment of a strong supervisory and regulatory framework prior to the implementation of financial deregulation policies. But, the fact that the most recent global financial turmoil originated in the United States and affected mostly developed countries (Reinhart and Rogoff, 2009), both with ‘state of the art’ supervisory and regulatory frameworks, casts serious doubt on the feasibility of ever establishing a supervisory and regulatory structure that is capable of preventing financial crises. On a more fundamental note, the reoccurring nature of financial crises in developed and developing economies in general and the breadth and depth of current financial crises in particular have exposed the fallacy of another more general but essential assumption of the liberalization argument regarding the operation of the financial markets. This is the assumption that financial markets are inherently stable and robust, and that periods of instability may occur as a result of government interventions, but financial crises are rare and short-lived because financial markets possess endogenous forces that re-establish stability when it is disrupted (Arestis, 2001). This explains why only the facilitating role of finance in the economic process is emphasized and why no mention is made regarding its potentially disruptive role.
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Contrary to this, an alternative theory developed by Minsky (1975, 1982) argues that capitalist markets are inherently unstable and financial instability is an inevitable part of the economic process. One of the important aspects of Minsky’s analysis is that it takes into account both the creditcreating capacity of contemporary banking systems and profit-seeking behaviour of firms as well as financial institutions. According to Minsky these forces endogenously breed cyclical instability. During the upturn in the business cycle, over-optimistic firms increase their demand for external funds, which will be eagerly satisfied by banks. The combination of factors such as low interest rates, euphoric expectations and competitive pressure put upward pressure on asset prices. Increased use of loans for financing speculative activities leaves the financing of real economic activity behind and intensifies the fragility of the overall economy. When reasonable expectations about returns reach a ceiling, it takes very little to puncture asset price expectations, and for the process to reverse. When the downturn starts, interest rates start rising, whereas prices of capital assets fall. Although demand for credit to finance new investments goes down, cashstrapped firms’ demand for credit to pay interest commitments on existing loans goes up. As the rate of interest on loans rises, investment decisions will be postponed. When this happens, demand for credit falls and thus interest rates also fall. With lower interest rates business activity, however, does not revive at once as it takes time for the business confidence to recover. Although there are already a few interesting works such as Arestis and Glickman (2002) and Kregel (2001) that attempt to expand Minsky’s model of financial instability to explain financial crises in emerging economies, more research needs to be done in this area.
REFERENCES Arestis, P. (2001), ‘Recent banking and financial crises: Minsky versus the financial liberalizationists’, in R. Bellofiore and P. Ferri (eds), Financial Keynesianism and Market Instability. The Economic Legacy of Hyman Minsky, Volume I, Cheltenham, UK and Northampton, MA, USA: Edward Elgar, pp. 159–78. Arestis, P. and M. Glickman (2002), ‘Financial crisis in South-East Asia: dispelling illusion the Minskyian way’, Cambridge Journal of Economics, 26(2), 237–60. Beim, D.O. and C.W. Calomiris (2001), Emerging Financial Markets, New York: McGrawHill. Cameron, R. (1967), Banking in the Early Stages of Industrialization, New York/London/ Toronto: Oxford University Press. Chenery, H.B. and A.M. Strout (1966), ‘Foreign assistance and economic development’, American Economic Review, 56(4), 679–733.
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Emerging markets 83 Chick, V. (1993), ‘The evolution of the banking system and the theory of monetary policy’, in S. Frowen (ed.), Monetary Theory and Monetary Policy: New Tracks in the 1990s, Basingstoke/New York: Macmillan/St. Martin’s Press. Chick, V. and S.C. Dow (1988), ‘A post Keynesian perspective on the relation between banking and regional development’, in P. Arestis (ed.), Post Keynesian Monetary Economics, Aldershot, UK and Brookfield, VT, USA: Edward Elgar. De Gregorio, J. and P.E. Guidotti (1995), ‘Financial development and economic growth’, World Development, 23(3), 433–48. Demetriades, P.O. and P.E. Devereux (1992), ‘Investment and financial repression: theory and evidence from 63 LDCs’, Working Paper in Economics No. 92/16, Keele University. Diaz-Alejandro, C.F. (1985), ‘Good-bye financial repression, hello financial crash’, Journal of Economic Development, 19(1–2), 1–24. Edwards, S. (1984), ‘The order of liberalization of the external sector in developing countries’, Princeton Essays in International Finance, No. 156, Princeton, NJ: Princeton University. Fischer, B. and H. Reisen (1992), Towards Capital Account Convertibility, OECD Development Centre, Policy Brief No. 4, Paris: OECD. Fry, M.J. (1995), Money, Interest, and Banking in Economic Development, Baltimore, MD: Johns Hopkins University Press. Fry, M.J. (1997), ‘In favour of financial liberalization’, Economic Journal, 107(442), 654– 770. Gerschenkron, A. (1962), Economic Backwardness in Historical Perspective: A Book of Essays, New York: Praeger. Goldsmith, R.W. (1969), Financial Structure and Development, New Haven, CT: Yale University Press. Greene, J. and D. Villanueva (1991), ‘Private investment in developing countries: an empirical analysis’, International Monetary Fund Staff Papers, 38(1), 33–58. Gupta, K.L. (1987), ‘Aggregate savings, financial intermediation, and interest rate’, The Review of Economics and Statistics, 69(2), 303–11. Gurley, G.J. and E.S. Shaw (1955), ‘Financial aspects of economic development’, American Economic Review, 45(4), 515–38. Harrod, R.F. (1939), ‘An essay in dynamic theory’, Economic Journal, 49(193), 14–33. Kaminsky, G.L. and C.M. Reinhart (1999), ‘The twin crises: the causes of banking and balance of payments problems’, American Economic Review, 89(3), 473–500. Keynes, J.M. (1970), The General Theory of Employment, Interest and Money, London/New York: Macmillan/St. Martin’s Press. Kregel, J.A. (2001), ‘Yes, “it” did happen again – the Minsky crisis in Asia’, in R. Bellofiore and P. Ferri (eds), Financial Keynesianism and Market Instability. The Economic Legacy of Hyman Minsky, Volume I, Cheltenham, UK and Northampton, MA, USA: Edward Elgar, pp. 194–212. McKinnon, R.I. (1973), Money and Capital in Economic Development, Washington, DC: Brookings Institution. McKinnon, R.I. (1993), The Order of Economic Liberalization: Financial Control in the Transition to a Market Economy, Baltimore, MD: Johns Hopkins University Press. Minsky, H. (1975), John Maynard Keynes, London: Macmillan. Minsky, H. (1982), Inflation, Recession and Economic Policy, Brighton: Wheatsheaf Books. Reinhart, C.M. and K. Rogoff (2009), This Time Is Different: Eight Centuries of Financial Folly, Princeton, NJ: Princeton University Press. Shaw, E.S. (1973), Financial Deepening in Economic Development, New York: Oxford University Press.
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Thirlwall, A.P. (2003), ‘The mobilization of savings for growth and development in developing countries’, Working Paper No. 5, Central Bank of Dominican Republic, available at http://www.bancentral.gov.do/trabajos_investigacion/paperNo05.pdf; accessed 7 March 2012. Williamson, J. and M. Mahar (1998), ‘A survey of financial liberalization’, Princeton Essays in International Finance, No. 211, Princeton, NJ: Princeton University Press. World Bank (1989), World Development Report 1989, Washington, DC: World Bank.
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12 The exchange rate Annina Kaltenbrunner
Few topics of investigation have occupied mainstream economic theory as much as the attempt to understand, explain or even forecast exchange rate movements. As such, exchange rate theory has evolved in interdependence with a changing international economic environment and shifting paradigms in economic theory. This, however, changed nothing of the neoclassical view of the exchange rate as a market equilibrating price, which stands in a causal and permanent relationship with underlying ‘fundamentals’ and remains firmly embedded in the classical dichotomy. This is also true for the Marxist approach of the real exchange rate based on the principle of absolute cost advantage. The important structural component of international monetary relations is highlighted in Marx’s concept of ‘world money’. Post-Keynesian approaches in contrast – in line with their view of economies as essential monetary economies – stress the role of the exchange rate as an asset class per se and the driving role of expectations in short-term financial markets, both in the short and the long run. In the world of managed exchange rates and closed capital accounts of Bretton Woods the role of the exchange rate as relative price that adjusts to real fundamentals to restore external balance stood at the fore of neoclassical analyses. Probably one of the oldest theories based on this mechanism is purchasing power parity (PPP), which states that – given a constant real exchange rate – the nominal exchange rate of two countries is only determined by their relative price levels. While for Gustav Cassel (1918), who rediscovered the parity in the 1920s, the PPP was a gravitation centre for a broad measure of domestic and foreign relative prices, the modern prevailing theory relies on an arbitrage argument in the goods sector (e.g., MacDonald, 1993). However, the empirical evidence on PPP is at best inconclusive. The reaction of mainstream exchange rate theory was twofold: one line of research considers departures from PPP as ‘structural’ in the sense that they arise systematically in response to new and lasting changes in relative prices. In this external balance approach to exchange rate determination, changes in underlying real fundamentals, for example, productivity as in the Balassa-Samuelson effect, require a change in the real exchange to restore equilibrium in external balances (e.g., Williamson, 1994; Clark and MacDonald, 1998). 85
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In a second line of research, deviations occur in a ‘transitory’ fashion due to disturbances to which the economy adjusts with different speeds in goods and asset markets. The growth of financial markets and the advent of floating exchange rates at the end of Bretton Woods rendered the view of exchange rates as equilibrating prices of goods markets increasingly at odds with empirical evidence. As a result, the analytical focus of mainstream exchange rate theory shifted to the exchange rate as equilibrating price on asset markets as a short-run phenomenon, which temporarily misaligns the exchange rate from its long-run path determined by goods market arbitrage. Maintaining the basic principle that a floating exchange rate should be determined by some contemporary market-clearing mechanism, exchange rate movements in these models result from the need to restore equilibrium in money markets, such as in the flexible price monetary approach (e.g., Frenkel, 1976; Mussa, 1976), or international asset markets as in portfolio balance models (Branson and Henderson, 1985). Stressing the role of the exchange rate as market equilibrating price, mainstream exchange rate theory remains firmly committed to the efficient market paradigm where changes in relative prices restore an efficient and desired equilibrium in production and exchange relations. In addition, it remains anchored in the classical dichotomy, where price flexibility allows a separation of real and nominal variables: while in the short run price stickiness or asset market disturbances deviate real exchange rates from their real ‘fundamental’ values, these influences will evaporate in the long run and trade/current account adjustments will determine exchange rate movements anew. Furthermore, these short-run deviations will have no lasting effect on real variables, as long-run money neutrality is maintained. The incorporation of agents’ behaviour and their expectations in mainstream theory – formed rationally, that is, endogenously to the model under consideration or ‘irrationally’ as in recent behavioural finance models – did little to change this view of exchange rate determination as rational traders are ultimately seen to keep the exchange rate in line with ‘fundamentals’ as specified in mainstream theory (e.g., Friedman, 1953; De Grauwe and Grimaldi, 2006). The continuing insistence on the efficient market paradigm and assumption of an ergodic world, where stable probability functions are used to forecast future ‘fundamentals’, forces these theories to recur to indeterminate behavioural assumptions to account for empirical phenomena such as bubbles and ‘excess’ volatility. The focus on the real exchange rate as long-run phenomenon and equilibrating price mechanism is also maintained in Marxist approaches to the exchange rate, most notably in the work by Anwar Shaikh (1998). However, while mainstream exchange rate models are based on the fundamental hypothesis that, in the long run, real exchange rates will move in
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The exchange rate 87 such a way as to make countries equally competitive, Shaikh argues that it is a country’s competitive position, as measured by the real unit costs of its tradables, that determines its real exchange rate. In this view, differential unit costs – real wages and productivity – set in motion capital flows that equalize profit rates across countries through changes in tradable goods prices, that is, the real exchange rate. Thus, pinned down by unit labour costs the real exchange rate is not free to adjust trade balances, explaining persistent deficits and surpluses in the world economy. In this view, capital flows are important to restore balance of payments and can even have short-run effects on the nominal and real exchange rate, but their effects will be temporary and in the long run exchange rates adjust to their trend given by unit labour costs. However, empirical evidence shows that the increased importance of financial factors leads to permanent deviations in real exchange rates from such theoretically defined equilibrium levels. In addition, these deviations cannot be explained by mainstream asset market approaches, based on the market equilibrating approach. Thus, an explanation of exchange rate dynamics requires abandoning the classical dichotomy and the view of the exchange rate as market equilibrating price, and has to consider it as an asset class per se. This, then, has to account for the institutional characteristics and inherently forward-looking nature of foreign exchange markets and the nature of the institutions operating in them. One interesting approach in mainstream exchange rate theory that accounts for the institutional specificities of foreign exchange markets and the way they shape the trading decisions of agents operating in them, is the microstructure approach to exchange rate determination. Although a very scattered literature ranging from attempts to explain empirical phenomena such as market location and trading volume to bid–ask spread determination and market maker’s behaviour, one approach has become most closely associated with this literature: Evans and Lyons’s order flow approach acknowledges that the price of the exchange rate is the result of the quotes set by dealer banks based on the information they receive and influenced by the structure they operate in (Lyons, 2001; Evans and Lyons, 2002). In their view, one of the most important pieces of information and thus driver of the exchange rate are private order flows received from clients that are – to varying degree and speed – incorporated in the publicly observable price. However, although acknowledging the driving role of trading and offering some interesting insights into the microcosms of foreign exchange markets, the order flow approach ultimately offers little explanatory value for understanding exchange rate movements. Order flows are nothing more than a proxy for underlying ‘fundamentals’, which remain either uncovered or assumed as exogenous and given by mainstream exchange rate theory.
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However, once the exchange rate is considered an asset class per se and market actors are acknowledged to be the driving force of exchange rates, their relationship to fundamentals becomes creative rather than reactive in a process that necessarily has to be context- and time-specific. In addition, these monetary phenomena will have long-run effects, leading to permanent changes in the real economy. These are the two tenets of the post-Keynesian approaches to exchange rate determination. Compared to the prolific work of mainstream economics, post-Keynesian writings on the exchange rate are relatively scarce. On the one hand, this could be due to the fact that large parts of mainstream theory have their roots in Keynes’s work itself. On the other hand, post-Keynesians’ emphasis on the driving role of expectations for price formation, which in turn are considered specific to the historical and institutional context, seems to defy the development of a general theory of the exchange rate and its determinants. Keynes’s theoretical analysis of holding of foreign currencies stems from his first post-war writings (1922), later collected in his Tract on Monetary Reform (1923). After a criticism of PPP he sets out his view on the currency futures market, a view that is today reflected in the covered interest parity theorem: forward rates are determined by differentials in interest rates in the respective currencies, as arbitrage operations restore return equality in short-term money markets. However, while for mainstream economists forward rates are a reflection of rational exchange rate expectations, which equilibrate short-term money markets, post-Keynesians view covered interest parity as a pure arithmetic operation as banks charge their customers forward rates that simply reflect the spot rate plus a mark up incorporating the interest rate differential (Lavoie, 2000). Thus, while covered interest parity holds for post-Keynesian economists, uncovered parity fails as exchange rate expectations are not a rationally formed price, which equilibrates money markets, but an autonomous variable that has causal importance for the spot rate itself. While mainstream economics had to recur to, often unexplained, timevarying risk premiums to theoretically account for the failure of uncovered interest parity, academics referring to Keynes’s original work, embarked on two different routes to accommodate the empirical fact. One strand, pioneered by Davidson (2002) and pursued by Harvey (2009), stresses the important ontological distinction between risk and fundamental uncertainty and the autonomous and driving role of exchange rate expectations. In the presence of fundamental uncertainty, no stable probability function exists to forecast future ‘fundamentals’, which can then be used as a reliable guide to the ‘correct’ equilibrium price of financial assets over time, but convention – the assumption ‘that the existing state of affairs will continue indefinitely’ –
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The exchange rate 89 and the psychological confidence with which we hold this convention govern investment behaviour (Keynes [1936] 1997). In Harvey’s work, which represents probably the most complete post-Keynesian analysis of exchange rate dynamics, expectations in short-term capital markets drive exchange rates. These in turn are determined by psychological phenomena to deal with the reigning uncertainty and macroeconomic variables that for historical and conventional reasons have come to be considered the main drivers of exchange rates. ‘Fundamentals’ are whatever market actors expect to be fundamentals, only anchored by social convention. A second, far less explored, strand is the attempt to apply Keynes’s liquidity preference theory and ‘own rate of interest’ analysis to open macroeconomics. As pointed out by Kregel (1982), if one considers domestic currency (sterling) as ‘the “money” of the system with durable assets comprised of foreign currency’, Keynes’s interest parity theorem ‘provides an explanation of the “preference” for “liquidity” (sterling) influencing decisions to take positions in other (foreign currencies) assets in terms of their spot and forward prices relative to the sterling’ (p. 454). In this view, recognizing liquidity preference as a general theory of asset choice, the exchange rate – as the relationship between domestic and foreign money – becomes determined by the ability of domestic money to meet the three motives of holding liquidity – the transactions motive, the speculative motive and the precautionary motive – through acting as means of payment, stable unit of account and store of value (Herr, 1992; Dow, 1999). The precautionary motive for holding money introduces the central role of financial structure to the understanding of exchange rate dynamics in an open economy where receipts and costs, especially debt payments, are denominated in different currencies. In line with Minsky’s (1975) writings, the ability to meet outstanding external contractual obligations will thus determine a currency’s liquidity premium. The important role of the speculative motive for a currency’s liquidity premium is highlighted by Kaldor (1939), who sought to make Keynes’s liquidity preference theory consistent with his analysis on the ‘own rate of return’ and speculation (Toporowski, 2005). For Kaldor, the three attributes of asset demand specified by Keynes – q(yield) – c(carrying cost) + l(liquidity premium) – are an explanation of speculative activity, determined not only by an asset’s liquidity premium, but also its carrying cost. In his view, due to their high liquidity and low carrying cost, foreign exchange is a prime target for such speculative demand defined as ‘the purchase or sale of goods with a view to re-sale (re-purchase) at a later date, where the motive behind such action is the expectation of a change in the relevant prices relative to the ruling price and not a gain accruing through their use’ (p. 17). Kaldor’s implicit emphasis on ‘capital gain’ as a driving factor of
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currency demand is more explicitly modelled by Kregel (1982) and Davidson (1999). Referring to Sraffa’s (1932) important critique of Hayek’s view of money, Kregel incorporates capital gain or appreciation in Keynes’s ‘own return equation’, which becomes: a + (q – c) + l. This approach is extended by Davidson (1999) to explain speculative foreign exchange holdings, primarily driven by expected capital gain or appreciation. The application of Keynes’s ‘own rate of return’ analysis to exchange rate economics can theoretically accommodate a series of empirical phenomena unanswered by mainstream economics: first, the emphasis on speculative operations driven by autonomous exchange rate expectations, rather than market equilibrating arbitrage, can explain deviations from uncovered interest parity and its frequent violation through the profitability of carry trade as current interest rate differential leads to future exchange rate appreciation. Second, liquidity preference theory has not only got more theoretical substance than mainstream’s time-varying risk premium, but can also accommodate exchange rate changes due to exogenous shifts in liquidity preference unrelated to domestic economic conditions. This is especially important to understand exchange rate dynamics in developing and emerging countries. Finally, Keynes’s liquidity premium allows accounting for the importance of financial structure, both on the micro- as well as on the macro-level. The interesting German monetary Keynesian school after Hajo Riese (1986) stresses that the differential liquidity premium of currencies creates a hierarchic monetary system, with the ‘Leitwährung’ (lead currency) – as the country with the highest liquidity premium – on the top of the hierarchy and value unstable currencies of developing and emerging countries at the bottom of the hierarchy. This makes them more vulnerable to sudden changes in exchange rates as international liquidity preference changes and/or might require consistently higher interest rates to maintain demand for the domestic currency. This structural component of the international monetary system is also highlighted by Marx (1967) in his writings on ‘world money’: ‘Money of the world serves as the universal medium of payment, as the universal means of purchasing, and as the universally embodiment of all wealth’ (p. 142). While in Marx’s time this function was fulfilled by gold or silver, the US dollar nowadays fulfils this function for Marxist writers (e.g., Itoh and Lapavitsas, 1999). This privileged role of the US dollar implies that US monetary policy is transmitted in the international financial system and maintains other countries – unable to issue world money – in a subordinate if not exploitative relationship. To conclude, although post-Keynesian and Marxian approaches might defy econometric estimation, their view of the exchange rate as international money, whose price is formed in a hierarchical monetary system,
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The exchange rate 91 depending on time and context, is key to understanding probably the most important relative price in international economic relations.
REFERENCES Branson, W.H. and D.W. Henderson (1985), ‘The specification and influence of asset markets’, in R.W. Jones and P.B. Kenen (eds), Handbook of International Economics, Volume II, Amsterdam: North-Holland. Cassel, G. (1918), ‘Abnormal deviations in international exchanges’, Economic Journal, 28(112), 413–15. Clark, P.B. and R. Macdonald (1998), ‘Exchange rates and economic fundamentals: a methodological comparison of BEERs and FEERs’, IMF Working Paper. Davidson, P. (1999), ‘Global employment and open economy macroeconomics’, in J. Deprez and J. Harvey (eds), Foundations of International Economics: Post-Keynesian Perspectives, London: Routledge. Davidson, P. (2002), Financial Markets, Money and the Real World, Cheltenham, UK and Northampton, MA, USA: Edward Elgar. De Grauwe, P. and M. Grimaldi (2006), The Exchange Rate in a Behavioral Finance Framework, Princeton, NJ: Princeton University Press. Dow, S. (1999), ‘International liquidity preference and endogenous credit’, in J. Deprez and J. Harvey (eds), Foundations of International Economics: Post Keynesian Perspectives, London: Routledge. Evans, M. and R.K. Lyons (2002), ‘Order flow and exchange rate dynamics’, Journal of Political Economy, 110(1), 170–80. Frenkel, J.A. (1976), ‘A monetary approach to the exchange rate: doctrinal aspects and empirical evidence’, Scandinavian Journal of Economics, 78(2), 200–24. Friedman, M. (1953), The Case for Flexible Exchange Rates, Chicago: Chicago University Press. Harvey, J. (2009), Currencies, Capital Flows and Crisis, New York: Routledge. Herr, H. (1992), Geld, Währungswettbewerb und Währungssysteme: Theoretische und Historische Analyse der internationalen Geldwirtschaft, Frankfurt: Campus Verlag. Itoh, M. and C. Lapavitsas (1999), Political Economy of Money and Finance, London: Macmillan. Kaldor, N. (1939) ‘Speculation and economic stability’, in N. Kaldor (ed.), Essays on Economic Stability and Growth, London: Gerald Duckworth & Co. Keynes, J.M. (1922), ‘The forward market and foreign exchanges’, Manchester Guardian, commercial supplement, ‘Reconstruction in Europe’, 20 April, 11–15. Keynes, J.M. (1923), A Tract on Monetary Reform, London: Macmillan. Keynes, J.M. ([1936] 1997), The General Theory of Employment, Interest and Money, Amherst, New York: Prometheus Books. Kregel, J. (1982), ‘Money, expectations and relative prices in Keynes’ monetary equilibrium’, Economie Appliquée, 35(3), 449–65. Lavoie, M. (2000), ‘A post Keynesian view of interest parity theorems’, Journal of Post Keynesian Economics, 23(1), 163–79. Lyons, R.K. (2001), The Microstructure Approach to Exchange Rates, Cambridge, MA: MIT Press. MacDonald, R. (1993), ‘Long-run purchasing power parity: is it for real?’, Review of Economics and Statistics, 75(4), 690–95. Marx, K. (1967), Capital, Unabridged, Volume 1, A Critical Analysis of Capitalist Production, New York: International Publishers.
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Minsky, H.P. (1975), John Maynard Keynes, New York: Columbia University Press. Mussa, M. (1976), ‘The exchange rate, the balance of payments and monetary and fiscal policy under a regime of controlled floating’, Scandinavian Journal of Economics, 78(2), 229–48. Riese, H. (1986), Theorie der Inflation, Tübingen: Mohr. Shaikh, A. (1998), ‘Explaining long term exchange rate behavior in the United States and Japan’, The Jerome Levy Economics Institute of Bard College Working Paper No. 250. Sraffa, P. (1932), ‘Dr. Hayek on money and capital’, The Economic Journal, 42(1), 42–53. Toporowski, J. (2005), Theories of Financial Disturbance: An Examination of Critical Theories of Finance from Adam Smith to the Present Day, Cheltenham UK and Northampton, MA, USA: Edward Elgar. Williamson, J. (ed.) (1994), Estimating Equilibrium Exchange Rates, Washington, DC: Institute for International Economics.
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13 Financial crises Martin H. Wolfson
The Great Financial Crisis of 2008 was widely regarded as the most serious financial crisis since the Great Depression. It seriously challenged not only the stability of the global economy, but also the ability of standard economic theory to explain it. The crisis centered on the speculative boom in housing prices in major urban areas in the United States, but the speculative fervor spread more broadly as well. As housing prices escalated, loans were extended and houses were purchased on the assumption that housing prices would only continue to escalate. The speculation in housing prices would have put homes out of the reach of many borrowers if not for the development of the subprime market. Lenders who ordinarily would not have lent to these subprime borrowers (whose credit quality was less than ‘prime’) rushed to extend mortgages at high interest rates and with innovative repayment requirements. For instance, ‘option adjustable rate mortgages (ARMs)’ reduced initial monthly payments with low teaser rates (that adjusted upwards later) and allowed borrowers to choose the amount of monthly payment they would make (but with a corresponding increase in the total amount eventually owed). Often, though, borrowers did not understand the terms of their contract and took on a greater repayment commitment than they could really afford. Prudent lending standards would have been expected to limit loans that had little likelihood of repayment. Several aspects of the financial environment, though, encouraged such recklessness. An important encouragement was the speculation in housing prices. If difficulties in repayment arose, it was anticipated that housing price increases would generate sufficient equity in the house to allow a successful refinancing of the mortgage. Innovative financial practices also contributed. Many of the mortgages generated were immediately sold and then packaged into mortgage-backed securities. Thus the mortgage originators generated fees but had no longterm interest in whether or not the mortgage would be repaid. Seemingly, the investors in the mortgage-backed securities would be concerned about credit quality, but these potential fears were relieved through the magic of financial innovation. By repackaging these securities into derivatives 93
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known as collateralized debt obligations (CDOs), investment banks seemingly made the credit quality problems disappear. The mortgage-backed securities were combined with other securities and sliced and diced into ‘tranches’ by order of repayment. The tranches that would be paid first (80 percent or more of the total) were rated AAA by all the major rating agencies. It was also possible to purchase insurance to guard against default, through another financial innovation called credit default swaps. In exchange for premiums, the insurer (such as AIG) would promise to make the purchaser of the credit default swaps whole in the event of default. But because default was considered unlikely, insurers like AIG did not maintain sufficient reserves to pay claims. Profits were being made by all these financial institutions. But the profits were based upon continuing increases in the prices of houses. When the housing speculation inevitably collapsed, the whole house of cards came tumbling down. As it became clear that defaults on mortgages would threaten repayment on derivatives, whose value depended on the underlying mortgages, investors rushed to protect themselves. In a flight to quality, investors pulled back from financial institutions with exposures to derivatives and bought Treasury securities. When the investment bank Lehman Brothers failed unexpectedly in September 2008, creating losses for investors and threatening an inability to redeem investments tied up bankruptcy proceedings, a full-scale panic erupted that threatened the stability of the global financial system. (For an excellent analysis of the dynamics of the crisis, see Jarsulic, 2010.) It is perhaps an understatement to say that standard economic theory had difficulty in explaining this crisis. The standard model starts with a rational individual ‘agent’ who maximizes under constraint, with full knowledge of all possible future events and their likelihood of occurring. If agents can operate in markets unconstrained by bureaucratic government agencies and meddlesome regulators, a stable, efficient outcome is expected to occur. The ‘Maestro’ (Woodward, 2000) Alan Greenspan, Chairman of the Federal Reserve Board from 1987 to 2006, claimed that there was no speculative housing bubble and cautioned against interference by regulators in derivatives markets. Yet, in an appearance before the Oversight Committee of the US House of Representatives on 23 October 2008, Greenspan admitted that he had made a mistake and said that ‘Those of us who have looked to the self-interest of lending institutions to protect shareholders equity, myself included, are in a state of shocked disbelief’. He added that ‘The whole intellectual edifice [of what Greenspan referred to as ‘the modern risk management paradigm’], however, collapsed in the summer of last year’ (Andrews, 2008, p. B1).
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Financial crises 95 Although the standard model has been unable to explain the events of the financial crisis, heterodox economic analysis has fared much better. Indeed, an examination of the analysis of John Maynard Keynes and Karl Marx, supplemented with an institutional analysis of historical change in the financial system, can shed much more light on the causes of the tumultuous events of 2008. Keynes’s analysis of the sources of speculation and financial instability is brilliantly explained in Chapter 12 of The General Theory. He states, ‘Our knowledge of the factors which will govern the yield of an investment some years hence is usually very slight and often negligible’ (Keynes, 1936, p. 149). Economists writing in the Keynesian tradition (Davidson, 1994) have differentiated Keynes’s analysis of this fundamental uncertainty about the future from neoclassical analyses of risk. In a world of risk, agents know all the possible outcomes of any given action and can assign a probability to each. The expected value derived from such a probability distribution function can then be taken as the rational choice to be undertaken by the agent (as in Greenspan’s ‘modern risk management paradigm’). Keynes, however, knew that ‘human decision affecting the future … cannot depend on strict mathematical expectation, since the basis for making such calculations does not exist’ (Keynes, 1936, pp. 162–3). Although standard economists claim that a coherent macroeconomic theory is impossible under such conditions of uncertainty, Keynesian economists have demonstrated that it is indeed the only way to realistically understand the speculation and instability of modern financial markets (Crotty, 1994). In the absence of a firm knowledge of the future, people fall back on conventions, generally accepted perceptions of what the future might hold. Often these are simply projections of the present into the future, for example, since housing prices in the past have increased, they will continue to increase. Expectations in this Keynesian framework are based on what average opinion expects the average opinion about the future to be. There can be stability in financial markets as long as people can rely upon the maintenance of the conventions. For example, large bets could be made with extraordinary leverage, and thus outsized profits could be achieved, as long as the convention of rising housing prices could be maintained. But since conventions are not based on solid knowledge, they are quick to collapse: ‘A conventional valuation which is established as the outcome of the mass psychology of a large number of ignorant individuals is liable to change violently … since there will be no strong roots of conviction to hold it steady’ (Keynes, 1936, p. 154). Hyman P. Minsky (1982) showed how expectations about the future develop endogenously over the course of the business cycle. As bets made
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on the basis of the existing conventions turn out to be profitable, confidence increases, standards for lending decline, and more debt is extended. So in the expansion leading up to the recent financial crisis, the profitable derivatives trading based on the speculative housing bubble served only to increase the expectations that housing prices would continue to increase and that it made sense to leverage as much as possible. Since such a rosy scenario could not be based on any firm knowledge of the future, it could collapse quickly and be replaced by fear in the subsequent panic. Karl Marx also had a theory of financial crises, based on his concept of money as a means of payment and the relationship between crises in the real and financial sectors (Crotty, 1985). In addition, basic concepts of Marxian analysis help to explain the context of the financial crisis of 2008. Marx viewed the economy through the lens of class conflict, and his theory of the state explained how class interests could affect public policy. Using the guise of free-market ideology, corporations since the early 1980s waged a successful class war on workers, unions, and the social safety net that underpinned worker living standards. Multinational corporations and banks successfully pushed for the removal of constraints on capital mobility and financial activities. The repeal of the Glass–Steagall Act in 1999 was the legislative counterpart of increasing lax regulatory oversight of the financial system. The consequence was the speculative, risky, and highly leveraged financial system that collapsed in 2008. Building up to that collapse were the conditions caused by the worsening distribution of income that resulted from the policies and legislation pushed by large corporations and banks. Referring to the tax cuts for the wealthy brought about by the Reagan Administration in the 1980s, John Kenneth Galbraith observed that ‘they sluiced funds into the stock market; that is what well-rewarded people regularly do with extra cash’ (Galbraith, 1988, pp. xiii–xiv). In the 2000s, the Bush tax cuts and the increasing wealth at the top of the income distribution sluiced funds into the hedge funds and other financial institutions eager to invest in the derivative products being created by Wall Street firms. The increasing wealth of the richest Americans also led to bigger, fancier, and more expensive houses that priced less wealthy Americans out of the housing market. Into this breach stepped the mortgage brokers and predatory lenders that pushed subprime mortgage loans onto unsuspecting borrowers and fed the ravenous appetites of the derivatives shops on Wall Street. The result, as discussed above, was the Great Financial Crisis of 2008. To fully understand the nature of financial crises, though, it is necessary to investigate more deeply institutional and historical developments. For example, in the post-World War II period in the United States, up until 1966, there were no financial crises. From 1966 to 1982, financial crises appeared
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Financial crises 97 regularly at the end of the business cycle. Since 1982, however, financial crises have appeared outside of the context of the business cycle and with increasing frequency and intensity. So the nature of financial crises depends not only on basic processes in a capitalist financial system, but also on the particular institutional and historical conditions. These conditions are usefully analyzed with concepts of a long-lasting, but eventually eroding, institutional structure like a system of financial regulation (Wolfson, 1994) or social structure of accumulation (Wolfson and Kotz, 2010). Indeed, even Keynes’s analysis of speculation and financial instability is institutionally and historically specific (Crotty, 1990). Ultimately, if we are to understand the nature of financial crises, we need to go beyond standard theory’s abstract analyses of rational individual agent maximization. We need to rely upon the insights and analysis of Keynes, Marx, and institutional heterodox economists.
REFERENCES Andrews, E.L. (2008), ‘Greenspan concedes error on regulation’, The New York Times, 23 October. Crotty, J. (1985), ‘The centrality of money, credit and financial intermediation in Marx’s crisis theory’, in S. Resnick and R. Wolff (eds), Rethinking Marxism, New York: Autonomedia, pp. 45–82. Crotty, J. (1990), ‘Keynes on the stages of development of the capitalist economy: the institutional foundation of Keynes’s methodology’, Journal of Economic Issues, 24(3), 761–80. Crotty, J. (1994), ‘Are Keynesian uncertainty and macrotheory compatible? Conventional decision making, institutional structures, and conditional stability in Keynesian macromodels’, in G. Dymski and R. Pollin (eds), New Perspectives in Monetary Macroeconomics, Ann Arbor: University of Michigan Press. Davidson, P. (1994), Post Keynesian Macroeconomic Theory, Aldershot, UK and Brookfield, VT, USA: Edward Elgar. Galbraith, J.K. (1988), The Great Crash: 1929, Boston: Houghton Mifflin Co. Jarsulic, M. (2010), Anatomy of a Financial Crisis, New York: Palgrave Macmillan. Keynes, J.M. (1936), The General Theory of Employment, Interest, and Money, New York: Harcourt, Brace, and World. Minsky, H.P. (1982), Can ‘It’ Happen Again? Essays on Instability and Finance, Armonk, NY: M.E. Sharpe. Wolfson, M.H. (1994), Financial Crises: Understanding the Postwar U.S. Experience, Armonk, NY: M.E. Sharpe. Wolfson, M.H. and David M. Kotz (2010), ‘A reconceptualization of social structure of accumulation theory’, in T. McDonough, M. Reich and D.M. Kotz (eds), Contemporary Capitalism and its Crises: Social Structure of Accumulation Theory for the 21st Century, New York: Cambridge University Press. Woodward, Bob (2000), Maestro: Greenspan’s Fed and the American Boom, New York: Simon & Schuster.
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14 Financial fragility Eric Tymoigne
An economic unit is said to be financially fragile when its financial positions are expect to require a high reliance on debt refinancing and/or selling assets in order to meet its liability commitments (debt services, margin calls, insurance premiums, and all other contractual cash outflows induced by financial contracts). The term ‘financial positions’ refers to the structure of the balance sheet (defined broadly to include off-balance-sheet items) and the cash inflows and cash outflows induced respectively by assets and liabilities. Alternatively, financial fragility can be defined as the high sensitivity of financial positions to changes in asset prices, credit conditions, and economic growth, in such a way that not-unusual fluctuations in the previous variables create difficulties to meet liability commitments. Irving Fisher’s Booms and Depressions (1932) has been highly influential in the study of financial fragility even though economists like Thorstein Veblen, Joseph Schumpeter, and Wesley Mitchell dealt with the subject earlier than him. Fisher had the advantage of observing the disintegration of the economy (and his personal finances) during the Great Depression, which allowed him to develop a much richer framework of analysis. Notably, he explains how ‘overindebtedness’ could lead to a ‘debtdeflation’ process. The latter is a situation in which financing and refinancing sources have been shut down (credit crunch) and the only solution left to overindebted economic units is to sell assets; however, the more asset liquidation occurs, the more asset prices go down, and so the more difficult it is to meet liability commitments by selling assets. The resulting general deflation in output prices and asset prices generates difficulties for economic units that were previously financially sound. Today, the concept of debt-deflation is a core element of economic analysis and is probably one of the few non-controversial theoretical concepts of economics. One of the central goals of economists has been to provide a more precise definition of financial fragility than the rough concept of overindebtedness, and to explain how financial fragility emerges. As shown below, there are significant disagreements regarding how an economy ends up in a debt-deflation process, which leads to very different ways of defining and measuring financial fragility, as well as very distinct policy implications. 98
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Financial fragility 99 The first, and older, approach to the study of financial fragility states that overindebtedness is the inherent result of well-functioning market economies. During long periods of economic expansion that may record minor contractions, market mechanisms tend to be destabilizing rather than selfcorrecting. As a consequence, the more perfect market competition is, the more prone to instability and debt-deflation an economy becomes. If there is a large involvement of the government, the economy will be more stable but additional sources of instability emerge via market mechanisms, government intervention, and the interaction between the two. A major contributor to this approach of financial fragility is Hyman P. Minsky (1986) who states that economic ‘stability is destabilizing’. By relying on the work of Fisher and combining Keynes’s and Schumpeter’s, he defines three different degrees of financial fragility and explains how an economic unit becomes financially fragile. According to Minsky, the degree of financial fragility of any economic unit can be classified as hedge finance, speculative finance or Ponzi finance. Hedge finance means that an economic unit is expected to be able to pay its liability commitments with the net cash flow it generates from its routine economic operations (work for most individuals, going concern for companies). Thus, even though indebtedness may be high, an economy in which most economic units rely on hedge finance is not prone to debt-deflation processes, unless unusually large declines in routine cash inflows and/or unusually large increases in cash outflows occur. Even then, cash reserves and liquid assets are usually large enough to deal with unforeseen problems. Speculative finance means that routine net cash flow sources and cash reserves are expected to be too low to pay the capital component of liabilities (principal servicing, margin calls, and others). As a consequence, an economic unit needs either to borrow funds or to sell some less-liquid assets to pay liability commitments. This state of financial fragility is especially common among economic units, like commercial banks, whose business model involves funding the ownership of long-term assets with short-term, external sources of funds and so requires constant access to refinancing sources to work properly. Ponzi finance means that an economic unit is neither expected to generate enough net cash flow from its routine economic operations nor to have enough cash reserves to meet the capital and income servicing due on outstanding financial contracts. Note that this implies that Ponzi finance involves an expected growing need for refinancing operations given outstanding liabilities and/or an expected liquidation of assets at rising prices. If a majority of economic units is involved in Ponzi finance the economic system is highly prone to debt-deflation.
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According to Minsky (1975a, 1986), when an economy is stable and performs well over an extended period of time, more and more economic units move away from hedge finance and become involved in Ponzi finance. The explanation he proposes is called the ‘financial instability hypothesis’ and it relies on psychological, sociological, economic, and policy factors to explain how the previous move occurs. According to him, it is possible to use a ‘big bank’ (central bank) and a ‘big government’ (federal/national treasury) to delay the growth of financial fragility and to eliminate deflationary tendencies but there is a price to pay in terms of moral hazard and potential stagflation. This is especially so if the authorities do not fully recognize the strong stabilizing influences they can have on the economic system. Thus, Minsky was highly critical of the ‘Keynesian’ policies of the 1950s and 1960s for not accounting for the fact that deflationary pressures were no longer a major concern, and for only taking from the Great Depression the idea that deficit spending can help to stabilize the economy. More broadly, according to Minsky, promoting financial stability is always a work in progress and there is no definitive policy solution to an everchanging economic system in which economic freedom is the rule. A second approach to financial fragility developed from the mid-1980s within mainstream economics. It argues that financial fragility is the result of market imperfections and/or individual imperfections. A lot of emphasis is put especially on the existence of asymmetries of information (Mishkin, 1991, 1997). More precisely, banks have much less information about the quality of an economic project than potential borrowers and the former know that the latter tend to provide a rosy view of their project. Bankers try to protect themselves by requiring more collateral, but during periods of economic instability that follow a shock the value of collateral declines, which leads borrowers to limit their entrepreneurial effort and so increases the chances of financial difficulties (Bernanke and Gertler, 1990). Lenders take notice and start to ration credit to limit adverse selection. This, in turn, generates a credit crunch, which leads to further declines in net worth and collateral and so less effort and greater default risk. This story, however, leaves unexplained the cause of the ‘shock’ and recent efforts have been made to endogenize this view by linking effort and the business cycle (Suarez and Sussman, 1997, 2007). The more effort people put into their business, the more productive they are, which leads to greater supply of commodities and so lower prices. Lower prices in turn lead to lower net gains, which leads to lower effort and so greater risk of default. Behavioral finance has complemented this imperfection approach by challenging the idea that people behave in a homo economicus fashion (De Bondt and Thaler, 1995; Shiller, 1999). It shows that not only people tend to have ‘biases’ (overoptimism, etc.) but also these behaviors are contagious
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Financial fragility 101 (De Long et al., 1990, 1991). Keynes already made the point that even financial market participants following a long-term strategy must concern themselves with the views of speculators because the latter can have a very strong influence on asset prices. As a consequence, a market economy is prone to bubbles, herd behaviors, and misallocation of resources, leading to overindebtedness and ultimately debt-deflation processes. All this can be complemented by arguing that people have limited cognitive capacities that restrict their capacity to acquire and interpret information. Overall, both approaches have some commonalities, especially in the recognition of the psychological and social behaviors of individuals, but the causes of financial fragility and the means to correct it are different. The evolutionary view of financial fragility sees the emergence of debt-deflation processes as the inherent result of the way the capitalist economy works. The imperfection view sees debt-deflation as a rare anomaly in an otherwise self-correcting system. This has strong implications in terms of policy and empirical studies. In terms of empirical analysis, if one follows the evolutionary view, hedge, speculative and Ponzi finance guide the empirical detection of financial fragility (Niggle, 1989; Schroeder, 2009). In this case, the point is neither to measure bubbles nor to predict financial crises. On the contrary, the goal is to detect the growth of financial fragility when the economy is on a non-inflationary growth path. A clear example of this can be found in the 2003–07 period when residential mortgage default rates were falling until 2006, while net worth of households and other sectors of the economy was growing rapidly. At the same time, however, households with good credit started to buy primary residences with the expectation that home prices and refinancing would be available, and were allowed to ‘use their home equity’ to borrow without reference (or with limited reference) to their incomegeneration capacity. They were followed rapidly by subprime and Alt-A borrowers. Data shows that from 2004, one can detect the existence of Ponzi finance in residential housing. Thus, the evolutionary approach puts a lot of emphasis on cash flows and position-making operations in order to detect unsustainable financial practices. This should be done for each sector of the economy and not only for investment in the non-financial sector, which is Minsky’s theoretical basis. For example, Isenberg (1994) shows that empirical manifestation of financial fragility was limited in the non-financial sector during the Great Depression, and Minsky (1984) notes that the Great Depression was mostly caused by unsustainable residential mortgages and the depressive impact of government surpluses. If one follows the imperfection view, the goal has been to predict the occurrence of financial crises through early warning systems rather than to measure the growth of financial fragility (Gaytàn and Johnson, 2002;
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Lestano and Kruber, 2003; Berg et al., 2004; Schinasi, 2006; International Monetary Fund, 2009). More precisely, measuring the probability of the former has been associated with measuring the latter. Some of the most ambitious authors want not only to predict crises but also to detect their timing and amplitude; however, there is an internal debate about the possibility to do this given that shocks that lead to a crisis tend to be random (Bell, 2000). In order to predict crises, it is necessary to find leading variables that help to detect financial crises; favorite variables include, among others, declining business profits, rising default rates, rising government deficits, rapid growth of credit to the private sector, rapid growth of the money supply, rising real interest rates, declining real GDP, among others. The success of early warning systems, however, has been subject to numerous debates and most authors find a limited predictive capacity. In addition, most authors also find that government budget surpluses, rather than deficits, are leading indicators of currency crises (Bussiere and Fratzscher, 2002). In terms of policy, according to the imperfection view, the point is to eliminate, or to compensate for, market and individual imperfections. Market imperfections can be corrected through market deregulation and pro-market policies in order to improve competition. In order to deal with individual imperfections, policy-makers should promote financial education, create new market indicators and improve existing indicators so that people can make more informed decisions. In addition, one should make sure that only economic units that are sophisticated enough can enter some segments of a market. The risks induced by both imperfections and by exogenous shocks can be accounted for through high enough buffers against unexpected losses (capital requirement), expected losses (loan loss reserves), and liquidity shortages (liquidity requirements). Once all this is done, market mechanisms will be more efficient and will be better protected against adverse exogenous shocks. In the evolutionary view, the point is to discourage, and if necessary, forbid any economic growth process that is not based on solid financial practices, even if everybody is profiting from the continuation of this process in the short term, and even if the financial community ends up considering those practices acceptable and a normal way to do business. In order to do so, the financial practices of economic agents should be checked carefully and growing signs of Ponzi finance should be tackled immediately, even if there is no bubble, no rising default rate, rising wealth and profit. In order to detect growing financial fragility, regulators should focus especially on cash flows from assets and liabilities, and on position-making needs (i.e., refinancing and liquidation needs) that result from them (Minsky, 1975b). This policy agenda is, of course, much broader and more
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Financial fragility 103 ambitious than the previous one, but its relevance has been demonstrated many times. For example, prior to the savings and loans crisis several in-field supervisors wanted to shut down some thrifts that were recording massive profits because they were suspected to be involved in Ponzi finance sustained by massive frauds. However, there were strong pressures from their bosses and politicians not to close them because, given their profitability, they were seen as a model for the industry (Black, 2005). Thus, those thrifts were allowed to continue to operate but ended up costing hundreds of billions of dollars when they failed. Similarly, during the housing boom of the mid-2000s, household wealth grew very rapidly, financial companies registered record-high profits, and homeownership also reached a record high, but all those gains were wiped out once the economy collapsed. Steps should have been taken since at least 2003 to prevent the unsustainable growth of home ownership and dangerous business practices. This should have been done by forbidding no-doc loans, by limiting access to payoption mortgages to people with enough cash buffer and income, by not allowing financial institutions to create Ponzi-generating financial innovations, and by regulating closely all new financial activities. In addition, Ponzi processes, especially if fully collateral based, are impossible to buffer properly in an economically profitable way and so should not be allowed. An alternative would be to remove any government backing from economic activities that rely on fully collateral-based Ponzi finance (which implies isolating the payment system from those activities). Thus, the evolutionary policy implies a change in the view of policy-makers in terms of how to detect problems and how to interpret economic news. It also implies moving away from a growth-focused regulatory framework that tries to extract as much economic growth as possible, to a sustainability-focused regulatory framework that promotes economic growth only as long as it promotes permanent welfare gains.
REFERENCES Bell, J. (2000), ‘Leading indicator models of banking crises: a critical review’, Bank of England Financial Stability Report, December, pp. 113–29. Berg, A., E. Borensztein and C. Pattillo (2004), ‘Assessing early warning systems: how have they worked in practice?’, International Monetary Fund Working Paper No. WP/04/52. Bernanke, B.S. and M. Gertler (1990), ‘Financial fragility and economic performance’, Quarterly Journal of Economics, 105(1), 87–114. Black, W.K. (2005), The Best Way to Rob a Bank is to Own One: How Corporate Executives and Politicians Looted the S&L Industry, Austin: University of Texas Press. Bussiere, M. and M. Fratzscher (2002), ‘Towards a new early warning system of financial crises’, European Central Bank Working Paper No. 145.
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De Bondt, W.F.M. and R.H. Thaler (1995), ‘Financial decision-making in markets and firms: a behavioral perspective’, in R. Jarrow, V. Maksimovil and W.T. Ziemba (eds), Handbook in Operations Research and Management Science, Volume 9, San Diego: Elsevier, pp. 385– 410. De Long, J.B., A. Sheilfer, L.H. Summer and R.J. Waldmann (1990), ‘Noise trader risk in financial markets’, Journal of Political Economy, 98(4), 703–38. De Long, J.B., A. Sheilfer, L.H. Summer and R.J. Waldmann (1991), ‘The survival of noise traders in financial markets’, Journal of Business, 64(1), 1–19. Fisher, Irving (1932), Booms and Depressions: Some First Principles, New York: Adelphi. Gaytàn, A. and C.A. Johnson (2002), ‘A review of the literature on early warning systems for banking crises’, Central Bank of Chile Working Paper No. 183. International Monetary Fund (IMF) (2009), Global Financial Stability Report, April, Washington, DC: International Monetary Fund. Isenberg, D.L. (1994), ‘Financial fragility and the Great Depression: new evidence on credit growth in the 1920s’, in G.A. Dymski and R. Pollin (eds), New Perspectives in Monetary Macroeconomics: Explorations in the Tradition of Hyman P. Minsky, Ann Arbor: University of Michigan Press, pp. 201–29. Lestano, J. and G.H. Kuper (2003), ‘Indicators of financial crises do work! An early-warning system for six Asian countries’, University of Groningen, CCSO Centre for Economic Research, Working Paper No. 200313. Minsky, H.P. (1975a), John Maynard Keynes, Cambridge, UK: Cambridge University Press. Minsky, H.P. (1975b), ‘Suggestions for a cash flow-oriented bank examination’, in Federal Reserve Bank of Chicago (ed.), Proceedings of a Conference on Bank Structure and Competition, Chicago: Federal Reserve Bank of Chicago, pp. 150–84. Minsky, H.P. (1984), ‘Banking and industry between the two wars: the United States’, Journal of European Economic History, 13(2), 235–72. Minsky, H.P. (1986), Stabilizing an Unstable Economy, New Haven, CT: Yale University Press. Mishkin, F.S. (1991), ‘Asymmetric information and financial crises: a historical perspective’, in R.G. Hubbard (ed.), Financial Markets and Financial Crises, Chicago: University of Chicago Press, pp. 69–108. Mishkin, F.S. (1997), ‘The causes and propagation of financial instability: lessons for policymakers’, in Federal Reserve Bank of Kansas City (ed.), Maintaining Financial Stability in a Global Economy, Kansas City: Federal Reserve Bank of Kansas City, pp. 55–96. Niggle, C.J. (1989), ‘The cyclical behavior of corporate financial ratios and Minsky’s financial instability hypothesis’, in W. Semmler (ed.), Financial Dynamics and Business Cycles, New York: M.E. Sharpe, pp. 203–20. Schinasi, G.J. (2006), Safeguarding Financial Stability: Theory and Practice, Washington, DC: International Monetary Fund. Schroeder, S.K. (2009), ‘Defining and detecting financial fragility: New Zealand’s experience’, International Journal of Social Economics, 36(3), 287–307. Shiller, R.J. (1999), ‘Human behavior and the efficiency of the financial system’, in J.B. Taylor and M. Woodford (ed.), Handbook of Macroeconomics, Volume 1C, Amsterdam: North-Holland, pp. 1305–40. Suarez, J. and O. Sussman (1997), ‘Endogenous cycles in a Stiglitz-Weiss economy’, Journal of Economic Theory, 76(1), 47–71. Suarez, J. and O. Sussman (2007), ‘Financial distress, bankruptcy law and the business cycle’, Annals of Finance, 3(1), 5–35.
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15 Financial Keynesianism Riccardo Bellofiore
In an interview for Challenge magazine in 1988, the American financial economist Hyman P. Minsky said that, before he was called a postKeynesian, he would call himself a ‘financial Keynesian’, ‘a label that is more descriptive of the perspective I take in economic theory and policy’ (Minsky, 1988, p. 23). The term ‘financial Keynesianism’ is open to some ambiguity. This ambiguity refers, first of all, to the meaning of ‘finance’: it may be intended as the bank financing of capitalist production, or as the financing through securities on the stock markets. There is then a second issue about what is Keynes’s legacy as a monetary economist. In the Treatise on Money (1930), his argument was based on the former meaning of finance within a class capitalist economy. Banks advance credit to firms to pay the wage bill and start production, whether for consumption goods or investment goods, with the money supply fully endogenous. Thanks to this privilege in their access to money as purchasing power, entrepreneurs define the composition of output, irrespective of consumers’ sovereignty. In the General Theory (1936) the focus was on the latter meaning of finance. With the money supply taken as given (inaccurately understood by mainstream interpreters as the same as taking money as exogenous), the demand for money balances as a store of wealth (as an alternative to securities in the financial markets) may skyrocket. Liquidity preference may lead to involuntary unemployment equilibria, even in the case of price and wage flexibility. In a few 1937–39 articles (1937a, 1937b, 1938) the same Keynes integrated the two views – money as a flow of finance, money as a stock of wealth – building a complete picture of the capitalist economy as a circular process of money creation. Together with the transaction, precautionary and speculative motives, there is primarily the entrepreneurial ‘finance motive’. This is the demand for money to be spent to cover the interval between planning and execution of expenditure, and thus to begin the activity of production. In the basic abstraction, the finance motive is also present in stationary reproduction: in this case, prior finance is constant as a revolving fund. As Keynes insists, ‘finance’ as an advance provision of funds is necessary for production goods as well as for capital goods. The two lines of thought remained separate for a long time. Starting from the 1960s–70s there were two original developments to which the term 105
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‘financial Keynesianism’ may well apply, and that somehow tried to integrate them: the French-Italian circuit theory of money and Minsky’s financial instability hypothesis (FIH) (Minsky, 1975; Graziani, 2003; see also Alain Parguez and his work as editor at the journal Monnaie et Production from 1984 to 1996). For ‘monetary circuitists’, capitalism is a sequence of concatenated phases opened by the creation of purchasing power by banks. Money is neither a commodity nor bilateral credit, but a credit instrument in a triangular transaction, allowing the payer to finally settle payment obligations with the payee by means of promises to pay from a third agent: nowadays, a bank (even outside the pure credit model, however, money is nothing but a debt for circuitists). Monetary payments for inputs are made prior to production and to the selling of output on the commodity market. As in Keynes’s Treatise on Money, differential access to money as purchasing power sets up asymmetries of power among social agents and this differential access is the principal factor determining the real structure of the economy. This vision, which also characterized Schumpeter’s monetary theory of economic development (see Schumpter, 1911),1 can be ultimately traced back to Marx’s of the second and third volumes of Capital (1867). It was further extended by Luxemburg (1913) and Kalecki (1967): from a macroeconomic point of view firms may earn surplus money and pay interest only thanks to net exports and/or ‘internal exports’ (i.e., monetarily financed government deficits). Even Mises (1912) endorsed Wicksell’s (1898) pure credit model as the basic abstraction for monetary theory. The Austrians had thereby to place the burden of ‘automatic’ re-adjustment, stopping the forced savings induced by monetary inflation, on relative price movements, as Hayek (1931) forcefully stressed. Sraffa retorted in 1932: ‘[w]hen the robbery comes to an end, it is clear that the victims cannot possibly consume the capital which is now well out of their reach’ (p. 48). The simplest circuit model takes place in a closed economy without the state: the basic agents are the commercial banking sector (the Central Bank is initially excluded, and added in a second approximation), firms and households (workers). The monetary circuit is made up of three phases. First, the banking system ex nihilo creates purchasing power, enabling all firms to cover their current costs of production (the wage bill). Loans make deposits, with the banking system meeting no ceiling in the creation of money (a view connected to post-Keynesian horizontalism). There is then production, according to the autonomous decisions of entrepreneurs concerning the level and allocation of employment (and, thereby, the size and composition of real output). Finally, workers choose how to divide money income between consumption and savings. Setting the monetary demand for consumption against the real output made available to workers by firms
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Financial Keynesianism 107 settles the price of consumption goods, and hence the real wage (the same result follows if oligopolistic firms charge a mark-up on their direct costs). Savings may be spent in the financial market, buying securities issued by firms (on which a long-term interest rate is paid), or be kept as money balances (liquidity preference). If savings are entirely spent in the financial market, firms get back from households the whole finance they received and may then return the principal to the banks. The role of the financial market is thus to allow firms to recover the leakages from consumption expenditure due to savings, and get back the ‘initial’ finance anticipated. If, on the other hand, savings add bank deposits to liquid balances, firms remain indebted to banks: the permanence of a money stock signals an equivalent credit of households with the banking sector. If the state or a foreign sector is included, there can be inflows of money for firms, which, in a sense, are ‘free’ of borrowing from banks. The same can be said of consumption financed through collateralized debt (e.g., thanks to capital asset inflation): private debt is, however, destabilizing, where public debt is stabilizing. Hyman Minsky’s contribution is an extension of Keynes, combining an investment theory of the business cycle with a financial theory of investment. In his financial instability hypothesis, after a period of ‘tranquil’ growth and ‘robust’ finance, firms’ and banks’ liability structures spontaneously give way to fragility (Minsky, 1975). Capitalism as a complex financial structure is a production of money by means of money. Each economic unit is a money in–money out device: it must estimate the monetary receipts from its assets, deduct the financial commitments of holding positions, and assess their liquidity. All units, like banks, finance with short-term liabilities the ownership and control of longer-term, illiquid and risky, assets. Availability and terms of financial agreements govern investment, investment brings about gross profits, gross profits feed back into the financial structure. Finance is needed to produce current output, to buy new capital goods, and, more generally, to own capital assets. Finance for production, including the production of investments goods, is short term and provided by banks selecting borrowers and financing deals. Production of investment goods, however, is special in this sense, that their construction time spans across many periods and their returns flow from an uncertain future. The short-term debt of investment goods producers is ‘funded’, that is, the short-term bank finance initially needed to produce investment goods is turned into the longer-term external finance needed to buy the new capital goods – by the financing arrangement of investment goods purchasers. Consumption demand is immediately financed by wage income, while investment demand in excess of the money recovered on the financial markets is immediately financed either by banks or by financial intermediaries. Positions in capital assets require long-term finance, and this latter is a
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combination of internal and external funds. They may be financed by intermediaries other than banks, or directly by savers, through instruments whose liquidity is subject to their convertibility into bank money. Like commercial banks, financial intermediaries are profit-seeking agents, which constantly try to extend credits, financing new positions. Therefore, not only may a given amount of reserves support more bank loans and demand deposits, a given amount of bank loans and demand deposits may also support a higher volume of finance. In prosperity, economic units lower their margins of safety, their liability structures embody a higher degree of risk, while the money (and finance) supply becomes infinitely elastic. In a complex financial system, investment may also be financed through portfolio adjustment, reducing balance sheets’ liquidity and causing a rise in the price of capital assets. If a restrictive monetary policy actually wants to constrain the larger, effective, quantity of money, the Central Bank must determine a dramatic compression in reserves, and this usually happens when the boom is already well underway. In his later writings Minsky, however, rejected the idea that the Central Bank is able to control reserves (see Minsky, 1986).2 When the economy is financially robust, most agents are in a hedgefinancing position, that is, prospective income cash flows from positions in assets are greater than contractual cash payment commitments on debts for every period. The validation of outstanding debts and risky projects fosters euphoric growth, developing into boom, and then a bubble. A rising debt–equity ratio is associated with higher short-term financing of fixed capital and long-term financial assets. The share of positions that are speculative (i.e., the income cash inflows are higher than interest charges on external finance, so that the repayment of the principal is met through refinancing) or even Ponzi (i.e., the income part of cash inflows is lower than the payments of all the contractual cash-commitments to debt holders except for a hoped for, late, bonanza, so that additional debt is needed also to fulfil interest-payment units) goes up. As more and more of the financing of investment – both production and demand – comes about through external debts, and since firms increasingly enter speculative and Ponzi positions, the demand for finance becomes almost inflexible in the course of the cycle. When ‘something happens’ and the supply of finance is constrained by more prudent bank attitudes or tougher restrictive actions from the Central Bank, with a sudden, severe and unexpected increase in the cost of financing, the crisis breaks out. A recursive negative spiral gets going. Some firms get into financial trouble, others fail. The missing validation of cash payment commitments on outstanding debts leads to the revaluation of borrowers’ and lenders’ risks, and to the reassessment of liability structures. In the meantime, the
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Financial Keynesianism 109 rising rates of interest endanger the liquidity and solvency of banks and financial intermediaries. Liquidity preference goes up, demand deposits contract, financial instruments may not be ‘accepted’ by the banking system. The struggle to ‘make positions by selling positions’ turns out to be ruinous because of the immediate fall in asset prices. Investments completely stop and gross profits plummet. Even hedge-financing units become speculative or Ponzi. Debt-deflation and financial turbulence strike the real economy, curbing income growth and bringing about mass unemployment. In an economy with a small public sector and with a Central Bank that does not act as a lender of last resort, the lower turning point will occur only after monetary contraction and bankruptcies restore ‘robust’ finance. In a capitalist economy with endogenous money the collapse of goods and asset prices results in a decrease in cash inflows and perhaps a rise in cash outflows. Moreover, the drop in endogenous money slows down the adjustment process through deflation and impedes the rise in the so-called ‘real money balances’, while expectations of further falls in prices motivate private agents to postpone demand: the Pigou-Patinkin effect does not work. The Big Government and the Central Bank as lender of last resort may sustain gross profits (which are positively related to government budget deficits) and support the liability structure (thanks to the higher cash inflows helping to meet cash commitments, and to the refinancing and reserves helping to prevent banks’ and financial intermediaries’ bankruptcies). ‘Keynesian’ economic policies are, however, unable to abolish the fundamental processes leading to instability: what they can and must do is repress and counteract the most harmful ills, and to make sure that ‘it’ does not happen again. A better solution would rather be a policy of ‘socialization’ of investments (through public ‘productive’ expenditure), employment (the state as ‘employer of last resort’), banking and finance (promotions of small and medium firms), and other ‘structural’ measures. Part of the solution is to support (or reinstate) Big Labour. Minsky goes beyond Keynesianism reinventing the New Deal. The evolution of capitalism at the turn of the twenty-first century – but also internal theoretical difficulties – is forcing a redefinition of the Minskian and circuitist traditions. On the one hand, Kalecki (1954) and Steindl (1982) showed (in accordance with circuitism, and some friction with the standard Minskian story: but not with his vision) that when profits increase or, equivalently, household saving decreases, investment comes to ‘finance itself’ – and the other way round. On the other hand, in the last decades more and more credit creation has been fuelled not so much by firms’ indebtedness but rather by consumers’ indebtedness: the new role of banks and financial intermediaries has deepened speculative rentier behaviour,
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very often directly managed by the same industrial conglomerates turning into financial market intermediaries. Until the recent global crisis, the most relevant features of a ‘new capitalism’ have been the following. The model of banking was not anymore ‘originate to hold’ but ‘originate to distribute’: banks seek to maximize their fees and commissions by issuing and managing assets in offbalance-sheet affiliate structures. In this context, bankers had no interest in credit evaluation, which was now provided by rating agencies. At the same time, with the public sector trying to reduce its deficits everywhere, in the Anglo-Saxon type of capitalism the household sector became a net borrower, and the non-financial business sector a net lender. Though household saving behaviour was helping to overcome the stagnationist tendency, banks were losing their best customers, while the financial system was increasingly characterized by an intrinsic (though hidden) instability. Financial innovations won the day: they reduced risk individually, but increased it globally (an example being ‘subprime’ lending). In the meantime, workers were ‘traumatized’ on the labour markets and labour processes, so that the Phillips curve was flattened, and price inflation was not a problem (except for oil and commodities). Instead, pension and institutional funds nurtured that ‘capital asset inflation’, which, at least for a while, was ex-post hedging corporations’ balance sheets. While savers entered into a ‘manic’ phase, and the apparent wealth appreciation was leading to a fall of the propensity to save on income, effective demand was internally driven by ‘indebted consumers’, providing outlets also externally, to Asian and European neomercantilism. This renewed ‘financialization’ phase should be better understood as a ‘real subsumption of labour to (financial) capital’ (Bellofiore and Halevi, 2010). Workers’ and lower-income households’ dependence on stock exchanges and banks had non-fictitious effects not only on demand, but also on firms’ corporate governance and real production. The increase in working time went along with a centralization of capital without concentration. This dynamic favoured firms’ ‘overcapitalization’ and households’ collateralized lending. Integral to it was a new ‘horizontalism’ of the Central Banks as ‘lenders of first resort’ to support the ‘irrational euphoria’ on asset markets. Contrary to too-simple stagnationist views, and after a monetarist phase (roughly, 1979–87), ‘money manager capitalism’, to borrow Minsky’s (1993) characterization, was able to metamorphose itself into a paradoxical asset-bubble-driven ‘privatized Keynesianism’ (1987–2007). This latter is indeed the third meaning of the term ‘financial Keynesianism’: a meaning that – to be fully understood – requires an understanding and critique (in the Marxian sense of ‘going beyond, maintaining the internal truth’) of both circuitism and the FIH in their original formulation. This new
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Financial Keynesianism 111 phase of capitalism proved unsustainable, and savers entered, after the ‘manic’, a ‘depressive’ phase. Economic policy was able to avoid the total collapse of activity, but not (yet?) to create the conditions for a revival.
NOTES 1.
2.
See also Schumpeter’s opposition between real analysis and monetary analysis, and between a monetary theory of credit and a credit theory of money in his History of Economic Analysis (1954, pp. 277–8 and 717–18) respectively. For a discussion see Wray (1992).
REFERENCES AND FURTHER READING Bellofiore, R. (2005), ‘Monetary economics after Wicksell: alternative perspectives within the theory of the monetary circuit’, in G. Fontana and R. Realfonzo (eds), The Monetary Theory of Production. Tradition and Perspectives, Basingstoke: Palgrave Macmillan. Bellofiore, R. and P. Ferri (2001), ‘Things fall apart, the centre cannot hold’, Introduction to R. Bellofiore and P. Ferri (eds), The Economic Legacy of Hyman P. Minsky, 2 vols, Cheltenham, UK and Northampton, MA, USA: Edward Elgar. Bellofiore, R. and J. Halevi (2010), ‘Magdoff-Sweezy, Minsky and the real subsumption of labour to finance’, in D. Tavasci and J. Toporowski (eds), Minsky, Crisis and Development, London: Palgrave. Bellofiore, R. and J. Halevi (2011), ‘The great recession and the third crisis in economic theory’, in E. Brancaccio and G. Fontana (eds), The Global Economic Crisis. New Perspectives on the Critique of Economic Theory and Policy, London: Routledge. Bellofiore, R. and J. Halevi (2012), ‘Deconstructing labor: a Marxian–Kaleckian perspective on what is “new” in contemporary capitalism and economic policies’, in C. Gnos, L.-P. Rochon and D. Tropeano (eds), Employment, Growth and Development: A Post-Keynesian Approach, Cheltenham, UK and Northampton, MA, USA: Edward Elgar, pp. 11–27. Crouch, C. (2009), ‘Privatised Keynesianism: an unacknowledged policy regime’, British Journal of Politics & International Relations, 11(3), 382–99. Graziani, A. (2003), The Monetary Theory of Production, Cambridge, UK: Cambridge University Press. Hayek, F.A. (1931), Prices and Production, New York: Augustus M. Kelly. Kalecki, M. (1967), ‘The problem of effective demand with Tugan Baranowski and Rosa Luxemburg’, reproduced in 1991 in J. Osiatynsky (ed.), Collected Works of Michał Kalecki, Vol. II, Oxford: Oxford University Press, pp. 451–8. Kalecki, M. (1954), Theory of Economic Dynamics: An Essay on Cyclical and Long-run Changes in Capitalist Economy, New York: Rinehart & Co. Keynes, J.M. (1930), A Treatise on Money, 2 volumes, New York: Harcourt Brace and Company. Keynes, J.M. ([1936] 2007), The General Theory of Employment, Interest and Money, Basingstoke: Palgrave Macmillan. Keynes, J.M. ([1937a] 1973), ‘Alternative theories of the rate of interest’, Economic Journal, 47, reprinted in The Collected Writings of John Maynard Keynes, vol. 14, London: Macmillan, pp. 201–15.
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Keynes, J.M. ([1937b] 1973), ‘The “ex ante” theory of the rate of interest’, Economic Journal, 47, reprinted in The Collected Writings of John Maynard Keynes, vol. 14, London: Macmillan, pp. 215–23. Keynes, J.M. ([1938] 1973), ‘Mr Keynes and “finance”’, Economic Journal, 48, reprinted in The Collected Writings of John Maynard Keynes, vol. 14, London: Macmillan, pp. 229–33. Luxemburg, R. (1913), Die Akkumulation des Kapitals (English translation as The Accumulation of Capital, Introduction by Tadeusz Kowalik, London: Routledge, 2003). Marx, K. (1867), Capital, Volumes I and II, available at: http://www.marxists.org/archive/ marx/works/cw/index.htm; accessed 2 April 2012. Minsky, J.M. (1975), John Maynard Keynes, London: Macmillan. Minsky, H.P. (1986), Stabilizing an Unstable Economy, New Haven and London: Yale University Press. Minksy, H.P. (1987), ‘Securitization’, Handout Econ 335A, Fall 1987, mimeo, available at http://digitalcommons.bard.edu/hm_archive/15/; accessed 10 March 2012. Minsky, H.P. (1988), ‘Back from the brink’, Challenge, 31(1), January–February, 23. Minsky, H.P. (1993), ‘Schumpeter and finance’, in Salvatore Biasco, Alessandro Roncaglia and Michele Salvati (eds), Market and Institutions in Economic Development: Essays in Honor of Paolo Sylos Labini, New York: St. Martin’s Press. Mises, L. von (1912), Theorie des Geldes und der Umlaufsmittel (English translation as Theory of Money and Credit, New Haven, CT: Yale University Press, 1953). Schumpeter, J.A. (1911), Theorie der wirtschaftlichen Entwicklung (English translation in 1934 as The Theory of Economic Development: An Inquiry into Profits, Capital, Credit, Interest and the Business Cycle, Cambridge, MA: Harvard University Press, from the second German edition, 1926). Schumpeter, J.A. (1954), History of Economic Analysis, London: Allen & Unwin. Sraffa, P. (1932), ‘Dr. Hayek on money and capital’, Economic Journal, 42, 42–53. Steindl, J. (1982), ‘The role of household saving in the modern economy’, Banca Nazionale del Lavoro, Quarterly Review No. 140, March, 69–88. Toporowski, J. (2005), Theories of Financial Disturbance: An Examination of Critical Theories of Finance from Adam Smith to the Present Day, Cheltenham, UK and Northampton, MA, USA: Edward Elgar. Wicksell, K. (1898), Geldzins and Güterpreise (English translation as Interest and Prices, London: Macmillan, 1936). Wray, L.R. (1992), ‘Minsky’s financial hypothesis and the endogeneity of money’, in S. Fazzari and D. Papadimitriou, Financial Conditions and Macroeconomic Performance, Armonk, NY: M.E. Sharpe, pp. 161–80.
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16 Financial markets in developing countries Noemi Levy Orlik*
There is a wide discussion regarding financial markets and financing production that adopts particular features in developing countries. The main argument of mainstream economics is that financial markets are mere financial intermediaries that guarantee finance at full employment economic activity, diminishing (or not acknowledging) the negative effects of capital mobility and financial gains. Financial markets solely intermediate between ‘representative’ agents or firms exchanging ‘resources’ (Minsky, 1996), so that issues of differential access to liquidity, that is, the rationale for financial intermediation, are not present in mainstream economics. In the heterodox stream of thought, the banking structure is the main provider of economic growth finance, putting forward different views on the relation between financial markets, banking structure and non-financial enterprises. Keynes ([1936] 1964) attached to financial non-banking institutions the function of providing long-term finance that annuls short-term bank debts, while Minsky (1975) argued that security markets increase the liquidity of non-liquid assets and endogenize private money supply. Toporowski states that in financial markets a distribution of income takes place that favors capital owners, delinking financial markets from production finance (Toporowski, 2000).
FINANCE IN THE CAPITALIST SYSTEM The main argument of this section is that finance for the productive sector (including production and capital accumulation – investment) is mainly issued by commercial banks, which takes place through a process of money creation and destruction, so long as borrowers are solvent and the projects financed generate returns above costs (including interest, commission, and fees). There are two important relations in this process. First, there is a direct relation between commercial banks and non-financial corporations and, second, there is a direct connection between commercial banks and central banks. We begin by discussing the first set of these relations. 113
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Commercial Banks and Non-financial Corporations The main argument of this section is that banks issue credit on demand from non-financial corporations to finance profitable productive activity (Parguez and Seccareccia, 2000). Another key idea is that money advances are subject to borrowers’ solvency. Specifically, a credit demand needs to undergo a creditworthiness assessment by the bank of the productive project and is subject to finance and borrowers’ credit records (Rochon, 2006). Credit issuance takes place through banks’ deposits, defined as banks’ own acknowledgment of debt (Keynes, 1930, p. 5), which creates a private money supply that increases income and production. Borrowers are nonfinancial enterprises that demand finance to pay for productive factors (wages and interest) and intermediate goods. Credit issuance unleashes two key elements: the expansion of goods and services on one hand and the expansion of effective demand on other. These are free of financial instability unless there is payment default. Therefore, the process of money destruction becomes a central element, whereby productive factor owners (workers, entrepreneurs, and financiers) use their income to acquire (demand) the produced goods and services, thereby circulating the private money (initial credit finance) back to nonfinancial enterprises, which annuls their commercial bank debts (household income can also be deposited at commercial banks, creating a more complicated system of commercial papers). Hence, higher credit volumes amplify income and effective demand that realize the increased supply of goods and services, cancelling out debt, issued at the beginning of the production process. The central point of this discussion is the destruction of debt, which ought to take place in the same production period, refuting Keynes’s and Minsky’s view that productive spending and income receipts take place in different periods (see Lavoie and Seccareccia, 2001; Toporowski, 2008; and Levy, 2010 for a critical assessment). Various elements disturb the monetary circuit closure. First, nonfinancial borrowers may be unable to cancel out their debts because of bad non-financial corporation management or inadequate bank solvency assessment of productive projects. Second, macroeconomic changes (mainly higher central banks’ rates of interest) can modify debt commitment above expected returns. Third, there is no agreement whether some activities, specifically investment, can be realized in the same period. (Within the circuitist stream of thought there is no agreement in relation to the sources of investment finance. Graziani, 2003, argues that banks do not provide finance for capital accumulation; Rochon, 2005, assumes that the process
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Financial markets in developing countries 115 of money destruction of investment finance takes place in various periods; while Parguez and Seccareccia, 2000, suppose that credit finance investment and debt destruction occur in the same period, since bank credits also monetize the profits of the investment sector.) Fourth, the interbank market may not operate efficiently. The main argument is that money (private or public) is the only instrument capable of settling debts. Therefore, idle balances or highly liquid financial instruments need to be converted into money (deposits) to finance the process of production or accumulation. Le Bourva (1992, p. 452), argues that since loans are costly they are demanded only after borrowers have exhausted all other means of financing their operations, ‘that is, once they have used their precautionary balance. At the outset, therefore, an increase in the demand for money is usually characterized by the activation of idle balances’. Summing up, the process of production and accumulation requires money advances that ought to be cancelled. This occurs as long as bank credits are channeled to productive projects that create profit. Hence, money is structurally non-neutral (Parguez and Seccareccia, 2000, p. 102) and effective demand cancels out debts acquired at the onset of the production process. It is important to note that commercial bank creditors are nonfinancial enterprises, rejecting the Moore and Gnoss argument of worker credit convenience to banks (ibid., p. 104). Financial instruments not converted into money can increase liquidity without increasing finance for the productive process. The central bank plays a key role in stabilizing the commercial bank’s balance sheet, guaranteeing payment finality as well as the minimum non-financial firm’s return and affects the money destruction process. It should be emphasized that non-banking instruments do not intervene in the process of financing production.
FINANCIAL MARKETS AND THEIR EFFECT ON FINANCE AND ECONOMIC GROWTH AND STABILITY Financial markets therefore have enormous impact on liquidity, unfolding a wide discussion on the influence of financial innovations (‘new types of financial institutions and instruments put in use’, Minsky, 1964, p. 173) on economic growth and stability. Financial innovations raise leverage rates and create more ‘layers of financial intermediaries that are interposed between the bank and the ultimate household owner of bank liability’ (Minsky, 2008, p. 4), which broadens the sources of income of financial institutions (including banks).
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Brokerage activity and endorsing liabilities diversifies balance sheet activities and income sources, adding fees and income commissions to interest spreads. The effects of financial innovation became clear in the aftermath of the Bretton Woods period, when banks became de-regulated and globalization dominated the financial system and government bonds ceased to guarantee banks’ fully invested position (Minsky, 1991) and capital mobility was liberalized, unfolding new financial instruments and institutions (that is, securitization techniques), diversifying bankers’ portfolios. In this context, banks’ behavior changes from sole ‘originators’ to ‘originators and distributors’ in which banks ‘seek to maximize [their] fee and commission income from originating assets, managing those assets in off-balance sheet affiliate structure, underwriting the primary distribution of securities collateralized with those assets and servicing them’ (Kregel, 2008, p. 11), creating a credit boom, channeled mainly to the housing sector and consumption. Toporowski (2000) disputes the idea that financial markets (specifically capital markets) finance economic activity. He argues that corporations turn to stock market ex post spending (investment) for marginal finance to equilibrate their balance sheet. There is no rationale for resorting to finance in capital markets if finance is followed by production and increased profits and, more importantly, if financial markets are highly instable. Therefore, extra capital market finance techniques are not required for financing production and, therefore, the process of financial innovation (and inflation) is related to new economic relations, where financial capital dominates productive capital and the share of financial gains increase, modifying the distribution of income. Moreover, it is argued that financial deepness did not evolve (induced by new institutions and instruments) because of central banks not wanting to accommodate commercial bank reserves, as Minsky argues, but because financial institutions issue liquidity more cheaply or financial gains can be obtained in this market. Specifically, central banks’ higher rates of interest (in the 1970s) and increasing stock market commerce (during the 1980s) diminished corporations’ bank credit demand and banks moved away from central bank funding and searched for alternative funding sources. In addition, economic privatization (public enterprises and basic government activities – pensions health and education) developed institutional investors and new non-financial corporation structures, which increased capital market activity through overcapitalization.
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Financial markets in developing countries 117
FINANCIAL MARKETS IN DEVELOPING COUNTRIES Capital markets were not relevant to capital accumulation in developing countries prior to the opening up of money markets to the international market. The banking structure was the main source of finance, with public and central banks having important financial policy roles. Specifically, legal commercial bank reserve requirement policy, instead of limiting the volume of credit was used to channel credit to ‘priority’ sectors, and central banks also financed specific productive sectors determined by government industrial policy. Although the process of deregulation and globalization modified developing economies’ financial systems, which adopted the structure of developed countries’ financial markets, credit advances remained the main source of productive finance. The novelty of developing countries is that financial depth did not induce internal economic booms. The engine of economic growth moved to external demand, turning exports into the main driver of economic activity, dominated by multinationals, whose productive structure is based on maquilas, dominating low value-added processes of production, with low resulting internal demand and increased external dependence. Thereby, reduced levels of exports (as a result of industrial countries’ recessions) stopped economic growth and lowered imports (preventing external current account deficits), and bank credit, with income (production) being the accommodating variable. Hence, financial crisis did not induce economic decline, contradicting Minsky’s view of the importance of financial institutions in economic recession. In the context of the 2008 economic stagnation, developing economies underwent an industrial crisis with no neutralizing effect from the financial sector. In addition, private financial institutions did not organize massive risk reduction schemes in order to expand credit advances to low-income families. Instead, a reduction of credit in terms of production shrank internal markets even more. Therefore, even though the composition of finance altered, favoring consumption and housing credits, its increments were low since it took place within an environment of finance reduction in terms of GDP. Moreover, financial inflation and deflation of developing economies cannot be explained in terms of domestic capital movement (increasing layers between bank and borrowers) or due to increased turnovers within financial institutions (banks, institutional investors, and non-financial corporations). It is a result of external capital in and out flows, to and from developing financial markets. Therefore, as a consequence of the 2008 crisis, the key prices of the economy were not drastically affected, even
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though external (and domestic) capital returned to developed financial market countries, at the expense of domestic production. In almost all Latin American countries, especially in Mexico, there were economic recessions. It can be argued that the new financial structure (dominant from the 2000s) in Latin America became more independent from the real sector and the exchange rate stability was fortified through central bank reserve policy, based on credit lines from official multilateral institutions (e.g., IMF).
CONCLUSIONS Bank and money advances remain the centerpiece of financing activities. Bank debts are the main source of expanding production and capital accumulation so long as borrowers are creditworthy, productive projects are correctly assessed, and total productive returns are above financial costs. In this process, central banks are key institutions since they guarantee bank deposits, the finality of payments, and determine the minimum productive returns. Financial crisis occurs due to bad creditworthiness assessment, channeling credit to non-productive sectors or to projects with profits below credit costs. Central bank policy is a key element for financial (in)stability since increases in the central bank rate of interest can reduce productive credit so that non-financial businesses are unable to stay in business or finish investment projects. Alternatively, for economic activity to expand in a relatively stable environment, economic authorities need to issue adequate regulations (guarantee that banks channel credits to solvent borrowers and to projects producing adequate profit rates) and guarantee stable central bank interest rates, thereby stabilizing the financial share in total returns. Second, increased liquidity (brokerage activity and endorsement facilities and derivative bonds issuance on original assets) need not mean more finance to productive sectors. If financial securities are not monetized it means that financial resources are not channeled to the production sector and profits don’t increase, redistributing income between the financial and real sector. This conclusion applies if credits are channeled to existing goods (consumption credits and mortgages for existing houses), backed by financial inflation that amplifies credits to non-solvent borrowers, inducing bank balance sheet disequilibria or financial bankruptcies. Therefore, higher liquidity may impact economic growth indirectly by increasing credit to non-solvent borrowers with reduced profits, causing crisis when ultimate borrowers are unable to fulfill previous debt commitments. The result is economic recession with financial deflation. It is argued that the industrial recession of developing economies in the 1970s was
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Financial markets in developing countries 119 neutralized through increasing corporation financial values, since effective demand increases in non-traditional sectors. The main contribution of Keynes, Minsky, and other heterodox economists is that financial inflation is attributed to increased capital mobility in search of higher returns rather than the disconnection between the creation and destruction of money advances. Hence, the 1929 and 2008 crises are not a result of expanding economic growth and increasing liquidity of nonliquid assets but the increased financial values that were unable to cover debt commitments once financial deflation set off. Developing economies underwent a process of financial deepening, modifying the financial structure and diversifying financial institutions and instruments. That, however, was induced by external capital inflows, with low financial market turnovers, which come with reduced credit advances and a shrinking domestic market. The effects of financial prosperity on developing economies’ industry has been limited. The main peculiarity of developing countries’ financial markets is that the banking structure did not turn into ‘creators and distributors’ and financial markets remain as ‘holders’ instead of ‘traders’. In developing economies the 2008 (and 1929) economic crises are explained in terms of external demand reduction, within reduced internal markets, with low rates of credit in relation to GDP and massive unemployment with low wages. Therefore, economic stagnation has not been a consequence of financial crisis but a result of industrial crisis that has not been neutralized by increased financial wealth.
NOTE *
This paper is part of the project IN. 301508, sponsored by UNAM-DGAPA.
REFERENCES Graziani, A. (2003), The Monetary Theory of Production, Cambridge: Cambridge University Press. Keynes, J.M. (1930), A Treatise on Money, London: Macmillan and Co, reprinted, 1935, pp. 3–31. Keynes, J.M. ([1936] 1964), The General Theory of Employment, Interest, and Money, New York: Harcourt, Brace and World. Kregel, J. (2008), ‘Changes in the US financial system and the subprime crisis’, Working Paper No. 530, Annandale-on-Hudson, NY: The Levy Economics Institute of Bard College.
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Lavoie, M. and M. Seccareccia (2001), ‘Minsky’s financial fragility hypothesis: a missing macroeconomic link’, in R. Bellofiore and P. Ferri (eds), Financial Fragility and Investment in the Capitalist Economy, Volume II, Cheltenham, UK and Northampton, MA, USA: Edward Elgar, pp. 76–96. Le Bourva, J. (1992), ‘Money creations and credit multipliers’, Review of Political Economy, 4(4), 447–66. Levy, N. (2010), ‘Minsky’s financial instability hypothesis in the new financial institutional framework. What are the lessons for developing countries?’, in D. Tavasci and J. Toporowski (eds), Minsky, Crisis and Development, Basingstoke: Palgrave Macmillan. Minsky, H.P. (1964), ‘Research Study Two: Financial crises, financial systems, and the performance of the economy’, in Private Capital Markets, Englewood Cliffs, NJ: Prentice Hall, pp. 173–380. Minsky, J.M. (1975), John Maynard Keynes, London: Macmillan. Minsky, H.P. (1991), ‘The endogeneity of money’, in E. Nell and W. Semmler (eds), Nicholas Kaldor and Mainstream Economics, New York: St. Martin’s Press, pp. 207–20. Minsky, H.P. (1996), ‘Uncertainty and the institutional structure of capitalist economies’, Journal of Economic Issues, 30(2), 357–68. Minsky, H.P. (2008), ‘Securitization’, Preface and Afterword by L.R. Wray, Policy Note 2, Annandale-on-Hudson, NY: The Levy Economics Institute of Bard College, pp. 1–6. Parguez, A. and M. Seccareccia (2000), ‘The credit theory of money: the monetary circuit approach’, in J. Smithin (ed.), What is money?, London: Routledge, pp. 101–23. Rochon, L.P. (2005), ‘The existence of monetary profits within the monetary circuit’, in G. Fontana and R. Realfonso (eds), The Monetary Theory of Production. Tradition and Perspectives, New York: Palgrave Macmillan, pp. 125–38. Rochon, L.P. (2006), ‘Endogenous money, central banks and the banking system: Basil Moore and the supply of money’, in M. Setterfield (ed.), Complexity, Endogenous Money and Macroeconomic Theory: Essays in Honor of Basil J. Moore, Cheltenham, UK and Northampton, MA, USA: Edward Elgar, pp. 220–43. Toporowski, J. (2000), The End of Finance: Capital Market Inflation, Financial Derivatives and Pension Fund Capitalism, London: Routledge. Toporowski, J. (2008), ‘Minsky’s “induced investment and business cycles”’, Cambridge Journal of Economics, 32(5), 725–37.
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17 Financialization Engelbert Stockhammer
Financialization is a term that summarizes a broad set of changes in the relation between the ‘financial’ and ‘real’ sector, which give greater weight to financial actors or motives. The term has been used to encompass phenomena as diverse as shareholder value orientation, increasing household debt, changing attitudes of individuals, increasing incomes from financial activities, increasing frequency of financial crises, and increasing international capital mobility. The debate on financialization covers contributions from different disciplines ranging from economics to sociology, history, political science and business studies and from different theoretical traditions (see Ertürk et al., 2008, for a useful collection of seminal contributions). One of the first prominent works to use the term financialization was Arrighi (1994) who identified long waves of economic development in global capitalism that involve hegemonic and geographic shifts. While the upswings of these long waves are characterized by increased manufacturing and trade activity, in the downturns a process of financialization occurs: the leading power had initially established a competitive advantage in terms of production, but it shifts towards financial activities as its growth model gets exhausted and other players catch up. In contrast to Arrighi most of the recent debates use the term more narrowly to refer to the period since the 1970s. Many authors regard financialization as one of the key components of a broader societal shift in social and economic relations from a Fordist accumulation regime to a new ‘neoliberal’ regime (Harvey, 2005), even though labels as well as analyses differ. Financialization was made possible by a series of measures to deregulate the financial sector and to liberalize international capital flows. Many of these measures were themselves reactions to increasing activities on the part of private agents to circumvent financial regulation. These measures include the phasing out of controls on international capital flows, a deregulation of the type of transactions that banks are allowed to engage in, and the lifting of the interest rate ceiling (on deposits as well as on credit). The new financial landscape that arose was populated by new financial institutions ranging from money market funds to private equity and hedge funds and by a seemingly untiring wave of financial innovation that led to ever new financial instruments. Financialization thus describes an increasing volume 121
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of financial transactions (relative to ‘real’ transactions) and the direct and indirect effects these changes have on the non-financial sectors. A first important area of debate was the financialization of non-financial businesses. A re-assertion of shareholders in the form of activist institutional investors and a wave of mergers and acquisitions often in the form of hostile takeovers have led to what has become known as ‘shareholder value orientation’: firms’ goals now prominently feature the rate of return on equity. This is done by means of increasing payouts in the form of dividends and via share buybacks. Remarkably these developments have come with lower rates of investment by firms and, at the same time, with higher debt ratios of firms. In other words, firms have often taken out loans to buy back shares to increase shareholder value. What causes these developments is the subject of an ongoing debate. Some authors argue that shareholders (or rentiers) have increased their power within the firm, for example, Lazonick and O’Sullivan (2000) argue that there has been a shift from what they call ‘retain and reinvest’ to ‘downsize and distribute’. Others, like Fligstein (1990), argue that financial control is a particular model of controlling an organization, thus locating the source of financialization of non-financial firms in management. In the meantime a growing empirical literature has aimed to demonstrate that increasing financial activity of non-financial firms has had a negative effect on (real) investment of these firms (Stockhammer, 2004; Orhangazi, 2008; Demir, 2009). The effects of financialization on households have been as profound as those on businesses. Individuals and households have become used to relying on credit. This has involved changes in attitudes as well as changes in financial institutions and instruments, among which the widespread use of credit cards is the most obvious. Household debt levels have risen sharply since the mid-1970s. In terms of volume, mortgage credit is the most important form of credit to households in all countries. Some authors have argued that consumption expenditures in Anglo-Saxon countries seem to be determined by changes in asset prices or in credit rather than by income (Guttmann and Plihon, 2010). Mainstream economic institutions, not least the central banks, have investigated to what extent consumption expenditures react to asset prices. While a marginal propensity to consume out of wealth of 5 per cent is often quoted (Girouard et al., 2006), overall the relation remains elusive. There are important technical issues like the need to distinguish between different types of wealth such as housing wealth and financial wealth, which may be associated with different consumption propensities. However, the more fundamental issue is whether the increase in household debt should be regarded as part of a rational decision process in the face of increasing wealth or as the outcome of increasing consumption norms and of a different strategy on the part of banks (Cynamon and
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Financialization 123 Fazzari, 2009). A second important area where households have become financialized is with respect to the provision of old-age retirement. Many countries have shifted from a state-provided social security scheme to an increase in prominence of private, market-based provision of pensions (Langley, 2004; Blackburn, 2007). Financialization has brought about important ramifications for the financial sector itself. First the emergence of a shadow banking system, a substantial and growing part of the financial sector, does not take the form of (traditional) banking (or insurance), but of other, typically much less regulated, institutions such as investment funds, money market funds, hedge funds, private equity funds and special purpose vehicles. This shadow banking system has been a result of, as well as a motor for, financialization (for an early account see D’Arista and Schlesinger, 1993). One important result has been an increase in the leverage rate of these institutions. Second, within banking this development has led to a shift towards fee-generating business rather than traditional banking, which generates income as a result of interest differential between rates on deposits and on loans. Third, within banking there has been a shift to lending to households rather than to firms. In particular, mortgages are now by far the largest loan positions (Ertürk and Solari, 2007; Lapavitsas, 2009). There are several important effects of financialization along the international dimension. First, financialization is part of the globalization of production. International production networks require international financial transactions and, in a setting with market-determined exchange rates, have given rise to various instruments to hedge against exchange rate variations. Foreign direct investment and its associated income flows will show up as financial income, for example, in the form of dividends paid by a foreign subsidiary (Milberg and Winkler, 2009). Second, the liberalization of international capital flows has given rise to a substantial rise in the volatility of exchange rates, which are increasingly determined by capital flows rather than by economic fundamentals such as current account positions. Indeed, episodes of massive capital inflows followed by sudden and sharp capital flow reversals resulting in exchange rate crises have been a common feature in particular for emerging and developing countries (Epstein, 2005). Third, the liberalization of capital flows has also allowed countries to sustain current account deficits (or surpluses) at higher levels and for a longer time than during the Bretton Woods period. The question of how strongly financialization has affected the macroeconomic structure is the subject of an ongoing debate (Van Treeck, 2009). Certainly the basic macroeconomic circuit according to which households save and firms borrow (in order to invest) has to be modified: increasingly it is households that borrow rather than firms. The theoretical discussion of
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the overall macroeconomic consequences has focused on the interaction of the pursuit of shareholder value orientation by firms and credit-driven consumption by households. Boyer (2000) presented a framework that allows the identification of the conditions for a finance-led growth regime, which is defined as a regime where an increase in the ‘financial norm’, that is, the rate of return on financial investment, would lead to an overall increase in economic growth. This contribution has inspired a whole set of papers that use different macroeconomic frameworks to analyse the effect of debt on household consumption and of shareholder value orientation (e.g., Dutt, 2006; Hein, 2011). International considerations have hardly entered these macroeconomic discussions and the modelling of financial instability has remained a distinct debate. There is an ongoing debate on the characteristics of a ‘finance-led’ or ‘finance-dominated’ accumulation regime. Financialization has, overall, contributed to a sluggish overall economic performance, with rising debt levels. Many countries have experienced a credit-driven consumption boom. Stockhammer (2010) argues that financialization has given rise to two different growth models: a consumption-driven growth model and an export-oriented growth model, both of which are explained as the result of the interaction of trends in the polarization of income distribution and of financialization. Financialization also has had effects on income distribution. The rise of what is often called ‘rentiers income’, that is, interest and dividend income as well as capital gains, has been well documented (Duménil and Lévy, 2001; Powers et al., 2003). Several studies have found econometric evidence that international financial globalization has led to a decline in wage shares (Jayadev, 2007; Stockhammer, 2009). Supporters of financial deregulation have argued that financialization will provide a superior way of dealing with risk. For example, securitization was supposed to slice risk into different parts (by means of different securities) and allocate it to those who were best equipped to hold it. The financial system would thus be more stable (e.g., IMF, 2006, p. 51) and society better off. In contrast, critics have highlighted conflicts of interest and the dangers of the belief that risk could easily be sliced by means of looking at past correlations (Aglietta and Rebérioux, 2005; Crotty, 2009). More generally, financialization is part of a process by which various kinds of provisions against risks and the uncertainties of the future are organized via private capital market arrangements rather than through institutional arrangements. Prime examples include the shift from publicly provided pay-as-you-go pension systems to capital-based systems, but health insurance and the financing of education are other examples. The debate on financialization is one where theories lag behind societal and economic changes. It draws on different theoretical and methodological
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Financialization 125 approaches. Cultural economists have highlighted the incompleteness and contradictions of the discursive strategies of financialization (Froud et al., 2006), while macroeconomists have tried to identify the conditions for viable growth regimes; economic sociologists have argued that (financial) markets have to be constructed by specific actors with specific interest (MacKenzie and Millo, 2003), while post-Keynesian economists have highlighted the fragile nature of finance-led growth. It is thus only appropriate to end this survey with a list of research questions rather than an evaluation. In terms of distribution, is financialization the new incarnation of rentiers and finance capital or is it merely a re-assertion of capitalist class interests (Duménil and Lévy, 2001)? Or does it constitute a new form of ‘financial expropriation’ (Lapavitsas, 2009)? How deep are the transformations; is it justified to speak of a ‘finance-dominated’ regime of accumulation or is financialization rather a symptom of the crisis of real (manufacturing) accumulation (Brenner, 2003)? And, finally, will it last or will it go down in the thunder of further financial crises?
REFERENCES Aglietta, M. and A. Rebérioux (2005), Corporate Governance Adrift. A Critique of Shareholder Value, Cheltenham, UK and Northampton, MA, USA: Edward Elgar. Arrighi, G. (1994), The Long Twentieth Century, London: Verso. Blackburn, R. (2007), Age Shock: How Finance is Failing Us, London: Verso. Boyer, R. (2000), ‘Is a finance-led growth regime a viable alternative to Fordism? A preliminary analysis’, Economy and Society, 29(1), 111–45. Brenner, R. (2003), The Boom and the Bubble, London: Verso. Crotty, James (2009), ‘Structural causes of the global financial crisis: a critical assessment of the “new financial architecture”’, Cambridge Journal of Economics, 33(4), 563–80. Cynamon, B. and S. Fazzari (2009), ‘Household debt in the consumer age: source of growth – risk of collapse’, Capitalism and Society, 3(2), 1–30. D’Arista, J. and T. Schlesinger (1993), ‘The parallel banking system’, in G. Dymski, G. Epstein and R. Pollin (eds), Transforming the U.S. Financial System: Equity and Efficiency for the 21st Century, Armonk, NY: M.E. Sharpe. Demir, F. (2009), ‘Financial liberalization, private investment and portfolio choice: financialization of real sectors in emerging markets’, Journal of Development Economics, 88(2), 314–24. Duménil, G. and D. Lévy (2001), ‘Costs and benefits of neoliberalism: a class analysis’, Review of International Political Economy, 8(4), 578–607. Dutt, A.K. (2006), ‘Maturity, stagnation and consumer debt: a Steindlian approach’, Metroeconomica, 57(3), 339–64. Epstein, Gerald (ed.) (2005), Financialization and the World Economy, Cheltenham, UK and Northampton, MA, USA: Edward Elgar. Ertürk, I. and S. Solari (2007), ‘Banks as continuous reinvention’, New Political Economy, 12(3), 369–88. Ertürk, I., J. Froud, S. Johal, A. Leaver and K. Williams (eds) (2008), Financialization at Work. Key Texts and Commentary, London: Routledge.
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Fligstein, N. (1990), The Transformation of Corporate Control, Cambridge, MA: Harvard University Press. Froud, J., C. Haslam, S. Johal and K. Williams (2006), Financialization and Strategy: Narrative and Numbers, London: Routledge. Girouard, N., M. Kennedy and C. André (2006), ‘Has the rise in debt made households more vulnerable?’, OECD Economics Working Paper No. 535. Guttmann, R. and D. Plihon (2010), ‘Consumer debt and financial fragility’, International Review of Applied Economics, 24(3), 269–83. Harvey, D. (2005), A Short History of Neoliberalism, Oxford: Oxford University Press. Hein, E. (2011), ‘Financialization, distribution and growth’, in E. Hein and E. Stockhammer (eds), A New Guide to Keynesian Economics and Economic Policies, Cheltenham, UK and Northampton, MA, USA: Edward Elgar. IMF (2006), Global Financial Stability Report, April, Washington, DC: IMF. Jayadev, A. (2007), ‘Capital account openness and the labour share of income’, Cambridge Journal of Economics, 31(3), 423–43. Langley, P. (2004), ‘In the eye of the “perfect storm”: the final salary pensions crisis and the financialization of Anglo-American capitalism’, New Political Economy, 9(4), 539–58. Lapavitsas, C. (2009). ‘Financialised capitalism: crisis and financial expropriation’, Historical Materialism, 17(2), 114–48. Lazonick, W. and M. O’Sullivan (2000), ‘Maximizing shareholder value: a new ideology for corporate governance’, Economy and Society, 29(1), 13–35. MacKenzie, D and Y. Millo (2003), ‘Constructing a market, performing theory: the historical sociology of a financial derivatives exchange’, American Journal of Sociology, 109(1), 107–45. Milberg, W. and D. Winkler (2009), ‘Financialisation and the dynamics of offshoring in the USA’, Cambridge Journal of Economics, 34(2), 275–93. Orhangazi, O. (2008), ‘Financialization and capital accumulation in the non-financial corporate sector: a theoretical and empirical investigation on the US economy: 1973–2003’, Cambridge Journal of Economics, 32(6), 863–86. Power, D., G. Epstein and M. Abrena (2003), ‘Trends in the rentier income share in OECD countries 1960–2000’, PERI Working Paper No. 58a. Stockhammer, E. (2004), ‘Financialization and the slowdown of accumulation’, Cambridge Journal of Economics, 28(5), 719–41. Stockhammer, E. (2009), ‘Determinants of functional income distribution in OECD countries’, IMK Studies, No. 5. Stockhammer, E. (2010), ‘Neoliberalism, income distribution and the causes of the crisis’, Research on Money and Finance Discussion Paper No. 19. Van Treeck, T. (2009), ‘The political economy debate on “financialisation” – a macroeconomic perspective’, Review of International Political Economy, 16(5), 907–44.
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18 The flow of funds Jo Michell
The flow of funds refers both to a set of national accounts and to a methodological and theoretical apparatus derived from those accounts. Whilst the set of accounts that make up the flow of funds are straightforward in their depiction of the complete set of real and financial transactions that have taken place over a given time period, the question of the correct theory that should be deployed to tie these transactions together into a cohesive whole is open to a wide range of interpretations. As Alan Greenspan observed in 1958: [T]he basic problem in handling flow of funds accounts is the primitiveness of our financial theory. These accounts are extremely elaborate and extraordinarily well constructed. But unless we know what we want to use them for, they are of as much practical value as a table of random numbers. (Greenspan et al., 1958, p. 171)
Since then a number of attempts have been made to find a systematic way in which to organize the flow of funds accounts theoretically. However, none have come to hold a position equivalent to that taken by the ‘Keynesian’ system of equations as the ‘default’ theory used for organizing real-sector consumption, expenditure and investment identities. Origination of the flow of funds accounts is credited to Morris Copeland, who in the 1940s published two papers (Copeland, 1947, 1949) on ‘money flows accounting’, followed by a detailed study of money flows in the United States in 1952 (Copeland, 1952). These writings put forward a systematic way in which to integrate, in an accounting framework, all real and financial transactions within an economic system. The accounting framework was presented as an alternative to the standard national accounts. Copeland’s ideas were taken up by the Federal Reserve, which began publishing flow of funds accounts in 1955. A highly simplified example of a flow of funds matrix is shown in Table 18.1.1 The matrix depicts, at the aggregate level, the complete set of real and financial transactions in a closed system over a given time period. These transactions are classified either as ‘sources’ or ‘uses’ of funds. For this example, the economic system is divided into three sectors: households, firms and a stylized ‘bank’, which represents a unified banking 127
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system incorporating the central bank.2 The banking sector is assumed not to engage in any real transactions, but operates as a pure intermediary between the household and firm sectors. The first two rows of the matrix contain the real income and expenditure of each sector, with the difference between the two recorded in the third row as net real saving. The difference between this value and the level of real investment recorded in row four gives the net financial balance of a sector. For the sake of simplicity, financial transactions in the matrix are limited to changes in the holdings of bank deposits and in the level of loans taken out against the banking system. Note that an increase in the holdings of deposits by households or firms corresponds to a use of funds for the sector, while issuing fresh liabilities in the form of increased borrowing is a source of funds. The reverse is the case for the banking system. Since all entries in the matrix represent flow magnitudes, D and L refer here to changes in the volume of stocks of deposits and loans. For the system to retain internal consistency, the transactions that comprise the matrix must be constrained by a number of identities that ensure that two conditions are fulfilled. The first of these conditions is that the discrepancy between real saving and real investment – the net financial balance – for any given sector is exactly offset by a compensating change in the holdings of financial assets and issuance of liabilities. One identity per sector (represented by a column of the matrix) is obtained by setting the difference between real uses and sources equal to the difference between financial sources and uses. These identities are implied by the zero totals at the bottom of each column. The second constraint that must be imposed on the system is that, for each transaction type, total uses of funds must equal total sources. For real sector transactions this is equivalent to enforcing the Keynesian identity that saving must equal investment.3 In the case of financial transactions this constraint ensures that any new issuance of a given type of financial liability is exactly matched by a corresponding increase in the holdings of that type of liability. One identity is obtained from each row in the ‘financial transactions’ section of the matrix. For the simple matrix shown in Table 18.1, these constraints result in a total of six identities: one for each sector of the economy, one for each type of financial asset – deposits and loans – and one that is equivalent to the Keynesian identity that total real saving and investment must be equal: Sh – Ih = Dh – Lh
(18.1)
S f – If = Df – Lf
(18.2)
D=L
(18.3)
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Financial sector transactions
Real sector transactions
Dh
Ih
3. Net saving = Y–E 4. Investment 5. Change in deposits 6. Change in loans (S – I) – (D – L)
Eh
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0
Lh
Sh
Df
If
Ef
Uses
Yh
Sources
Uses 2. Expenditure
1. Income
Firms
Households
Table 18.1 Simplified system of flow of funds accounts
Sources
0
Lf
Sf
Yf
L
Uses
Bank
0
D
Sources
L
Dh + Df
Ih + If
Eh + Ef
Uses
Total Sources
Lh + Lf
D
Sh + Sf
Yh + Yf
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(18.4)
D h + Df = D
(18.5)
Lh + L f = L
(18.6)
Two important related points should be made about this system of identities. The first is that these identities will only necessarily hold ex post: intentions on saving, investment and holdings of financial assets at the start of the period may not be mutually compatible, with the result that the end of period configuration of stocks and flows will not match ex ante expectations. The second is that the system of equations derived from the identities of a flow of funds matrix will be over-determined: any single equation in the system is implied by the other remaining equations. The connection between these points lies in the fact that they both relate to the problem of imposing causality on the system of identities. Whilst saving and investment must be equal ex post, the direction in which causation between the two runs depends on one’s theoretical perspective. Likewise, given a collection of flow of funds identities, without imposing further assumptions on the system, we are faced with the problem that ‘everything depends on everything else’ (Green and Murinde, 2000). A number of approaches have been employed to connect the transactions contained in the flow of funds accounts and to thus provide a coherent modelling method that integrates financial and real sector transactions. The most straightforward models use the above identities in their pure form, while more complex models mix a subset of these identities with behavioural or structural equations. The most basic models rely on the result that real sector surpluses and deficits must, ex post, balance out, and that such imbalances will find their counterpart in changes in the stocks of financial assets and liabilities. To illustrate using our simple model, equation (18.1) states that any surplus occurring in the household sector, due to an excess of saving over investment Sh – Ih will have its counterpart in a reduction in the difference between the sector’s financial assets and liabilities Dh – Lh: if the household sector does not consume all of its real income, it will either be accumulating bank deposits or paying off loans.4 For equation (18.4), the Keynesian saving–investment identity, to be fulfilled, firms collectively must be running a deficit exactly equal to the surplus in the household sector. From equation (18.2), financing this deficit requires that the difference between changes in assets and liabilities in the firm sector will be the inverse of the financial operations undertaken in the household sector: the firm sector will face an increase in net liabilities. Finally, equations (18.5) and (18.6) ensure that, for each of the two financial instruments, total issuance of liabilities is
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The flow of funds 131 equal to the total volume of purchases of the equivalent asset. These five equations collectively imply that the total increase in the level of deposits in the system is equal to the total increase in the level of loans. The remaining unused identity – the balance sheet of the banking system, equation (18.3) – is redundant. The problem with analyses of this type is that they do not overcome the problem of causation. Although the exposition started from household saving and found the bank’s balance sheet to be the redundant equation, causation could equally well run from credit-financed investment by firms, via the banking system, and find the requirement that the household sector balances its books through net real saving to be the redundant equation. Copeland (1952, p. 259) proposed a way to overcome this issue by using a classification of sectors based on the relative rates of change of real incomes and expenditures. Sectors are classified as either bulls, bears or sheep. Bulls are those deficit sectors for which real outlays (expenditure plus investment) are increasing faster than incomes, thus pushing the sector further into deficit. Conversely, bears are those surplus sectors for which the level of real outgoings are decreasing faster than their incomes, so that the financial surplus of the sector is increasing. Those sectors that are neither bulls nor bears are classified as sheep. These are sectors that are reducing their net financial position – either surplus or deficit – in each subsequent period. Real uses of funds by these sectors will increase less than sources in expansionary periods, and decrease less than sources in deflationary periods. They are thus ‘passive hoarders and dishoarders’. The underlying assumption made by Copeland in this classification system is that sectors have a greater ability to determine their expenditures than to determine their incomes. The economic system is thus viewed as being driven by investment and consumption decisions, with saving determined as the residual. Those sectors for which expenditure is increasing faster than income are viewed as exerting expansionary pressure on the system, leading to an increase in economic activity and the money supply when these sectors predominate. The opposite effect is observed when ‘bears’ predominate, resulting in deflation and a reduction in economic activity. In order to derive more formal predictive models, assumptions must be made about the basis upon which the demand for assets and liabilities arises. By replacing some of the matrix identities with behavioural equations that specify asset demands as a function of prices, interest rates or the level of some stock or flow, the flow of funds becomes the basis for formal models that attempt to capture the dynamics of adjustment in complex systems of real and financial variables.
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An early and influential model of this type is the ‘general disequilibrium’ framework introduced by Brainard and Tobin (1968). The key observation introduced in this model is that in a fully specified multi-asset flow of funds model, asset demand functions cannot be independent. For example, if one sector makes a decision to reduce its deposit holdings, this requires either an increase in the holdings of other assets, a reduction in financial liabilities, or a change to real-sector behaviour such as the level of investment. If these types of cross-effects are not explicitly included in asset demand functions, all adjustment will occur in whichever stock or flow is specified as the residual. Brainard and Tobin’s model is based on a partial adjustment mechanism through which financial portfolios are gradually updated in response to exogenous shocks to the system such as changes in government policy or portfolio preferences, hence the ‘general disequilibrium’ title. The most recent – and most comprehensive – attempt at building fully specified dynamic flow of funds models was introduced by Godley and Lavoie in 2001. Godley and Lavoie make use of an extended version of the social accounting matrices, first developed by Richard Stone at Cambridge, and the associated double-entry book-keeping approach to give a fully ‘stock-flow consistent’ system of accounting for all real and financial transactions. Onto this accounting framework is grafted a modified version of Kaldor’s (1966) ‘neo-Pasinetti’ growth model, augmented with the Brainard-Tobin portfolio choice method. The result is a growth model that, with the aid of computer simulations, can be used to examine the consequences of changes to a wide range of exogenous variables, such as preferences, rates of interest and real wages, in a closed monetary model. The ‘stock-flow consistent’ modelling approach is further developed and refined in Godley and Lavoie’s (2007) book Monetary Economics. This work presents detailed transactions-based models of both domestic and international economic systems that incorporate many of the features – absent from both Walrasian general equilibrium models and large-scale macro-models of the ‘computable general equilibrium’ type – that are necessary for any realistic simulations of a monetary economy. These models represent the current cutting edge of flow-of-funds-based research, but also go beyond pure flow of funds modelling in their integration of real-sector growth models. The intention of the authors is thus to provide a new methodological foundation upon which to base economic and financial modelling. Problems still remain, however, in the failure so far to integrate into these models the types of endogenous capital market inflation processes that were central to Minsky’s analysis of financial fragility. To what extent the adherence to formal mathematical modelling techniques will
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The flow of funds 133 constrain this new class of flow of funds models in their ability to provide new insights into the workings of financial and economic systems remains to be seen. The development of Copeland’s flow of funds accounts was initially greeted with optimism that within this new framework lay the possibilities of an alternative approach to the formalization of the workings of the economic system, with potentially wide-ranging consequences for economic theory. However, theoretical breakthroughs did not materialize and progress stalled completely during the 1980s and 1990s with the dominance of New Classical and New Keynesian microeconomic theory and the ascendency of the efficient markets hypothesis and the capital asset pricing model as the textbook approach to the financial markets. Recently there has been a revival of interest in flow of funds modelling, sparked in part by Godley’s early prediction of an impending recession in the wake of the collapse of the US housing boom. This renewed focus on flow of funds modelling is a positive development. The method has several advantages over neoclassical equilibrium theorizing. As Dawson (1996, p. 5) observes, Copeland ‘was at pains to show the incompatibility of the quantity theory of money with flow of funds accounting’. Although neoclassical theory, in the form of the ‘new neoclassical synthesis’, has finally overcome the ‘classical dichotomy’, this has been achieved only through the introduction of price rigidities into a general equilibrium model otherwise devoid of any institutional or historic specificity. In contrast, models based on accounting techniques attempt to capture the disequilibrium dynamics of financial flows through structures determined by the specific institutional context in which they occur. In setting the transaction centre stage, rather than deriving propositions from the constrained optimization of individuals, the flow of funds represents a viable alternative starting point for the construction of economic models in which interactions between real and financial sectors of the economy play a meaningful role.
NOTES 1.
2.
This example is primarily intended to allow for an illustration of the theoretical issues involved in dealing with the flow of funds system. The accounts published by the Federal Reserve, for example, are presented at a detailed level of disaggregation and include a much wider range of financial assets and liabilities. This model shows a system similar to the theoretical ‘pure credit economy’ used by Wicksell in Interest and Prices (1936), with the difference being that in Wicksell’s system, a distinction is drawn between capitalists, who lend money, and entrepreneurs,
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who borrow funds via the banking system in order to undertake production. Households consume all of their income in Wicksell’s model and therefore do not engage in financial transactions. Income, Y, and expenditure, E, do not enter the identity directly because these are subsumed into net real saving, S. More precisely, the rate at which deposits are being accumulated will be higher than the rate of increase of loan liabilities.
REFERENCES Brainard, W.C. and J. Tobin (1968), ‘Pitfalls in financial model building’, The American Economic Review, 58(2), 99–122. Copeland, M.A. (1947), ‘Tracing moneyflows through the United States economy’, American Economic Review, 38(2), 31–49. Copeland, M.A. (1949), ‘Social accounting for moneyflows’, The Accounting Review, 24(3), 254–64. Copeland, M.A. (1952), A Study of Moneyflows in the United States, New York: NBER. Dawson, J.C. (ed.) (1996), Flow of Funds Analysis: A Handbook for Practitioners, NewYork: M.E. Sharpe, Inc. Godley, W. and M. Lavoie (2001), ‘Kaleckian models of growth in a coherent stock-flow monetary framework: a Kaldorian view’, Journal of Post Keynesian Economics, 24(2), 277–311. Godley, W. and M. Lavoie (2007), Monetary Economics: An Integrated Approach to Credit, Money, Income, Production and Wealth, Basingstoke: Palgrave Macmillan. Green, C.J. and V. Murinde (2000), ‘Flow of funds: implications for research on financial sector development and the real economy’, Economic Research Paper No. 00/6, Loughborough University. Greenspan, A., P.B. Simpson and A.T. Cutler (1958), ‘Papers and proceedings of the seventieth annual meeting of the American Economic Association’, American Economic Review, 48(2), 171–7. Kaldor, N. (1966), ‘Marginal productivity and the macro-economic theories of growth and distribution’, Review of Economic Studies, 33(4), 309–19. Wicksell, K. (1936), Interest and Prices. A Study of the Causes Regulating the Value of Money, London: Macmillan.
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19 The Franc Zone Jan Toporowski
The Franc Zone consists of fourteen countries in Africa together with the Islamic Federal Republic of the Comoros, who use a currency that was on a currency board with the French Franc, and now with the Euro. The guarantee of convertibility at a fixed rate against the French Franc, and now the Euro, has made those countries unique among developing countries in possessing a convertible currency, along with low inflation. Years before the development of optimal currency area theory, the Zone served as an example of how a monetary union could function, and the disadvantages of such monetary arrangements. However, it is not clear to what extent those disadvantages are consequences of the specific arrangements of the Zone, as opposed to being features of all monetary unions, or to what extent those undesirable features are the effects of other circumstances specific to the countries concerned. Apart from the Banque de France, which serves metropolitan France and its overseas territories and dependencies, the Zone has three banks of issue. The Banque Centrale des États de l’Afrique de l’Ouest (BCEAO), based in Dakar, Senegal, issues the Franc de la Communauté financière d’Afrique for the Union économique et monétaire Ouest-Africaine (UEMOA) made up of Senegal, Benin, Burkina Faso, the Côte d’Ivoire, Guinea Bissau, Mali, Niger and Togo. The Banque Centrale des États de l’Afrique Centrale et du Cameroun (BCEAC), based Yaoundé, Cameroon, issues the Franc de la Co-opération financière en Afrique for the Communauté économique et monétaire de l’Afrique Centrale (CEMAC). The initials of the two francs give them their name, the CFA Franc, and the notes of each central bank circulate interchangeably throughout the two regions. The third central bank is the Banque centrale des Comores, which issues the Franc Comorien for the Comoros. Originally, the guarantee of convertibility for the currencies was a guarantee to convert them into French francs (see below). But since the establishment in 1999 of the Euro as the common currency of the European Monetary Union, of which France was a founder member, the CFA and Comoros Francs are tied to the Euro at rates of CFA Fr. 655.957 and Comoro Fr. 491.96777 per Euro respectively. The Franc Zone was set up after the Second World War to provide currencies for the French colonies. The arrangements within the Zone were influenced by the French monetary theorist and proponent of the gold 135
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standard Jacques Rueff. Accordingly, the Zone is organized to restrict credit expansion to net export revenue by suppressing the mechanisms that would expand credit ‘endogenously’ through either credit advanced against assets, in particular financial assets, or fiscal stimulus. Governments in the Zone are obliged to maintain a balanced budget in current revenue and expenditure – a separate capital budget may show a deficit, but must show sources of finance. While the Banque de France provides technical expertise to the three central banks, the key institutional link with the French financial system are the operating accounts that member governments have at the French Ministry of Finance. These accounts provide the Euros to cover deficits in the foreign payments of member countries. In general deficits are covered by the surpluses of commodity-exporting countries in the Zone. The rules of the Zone require at least 20 per cent of the sight liabilities of each central bank to be covered by foreign exchange reserves and at least 50 per cent of those reserves must be held in the operating accounts at the French Treasury. The colonial character of the monetary system and its dependence on the Banque de France and the French Finance Ministry proved intolerable to many governments of those colonies once independence was achieved. All the former French colonies of North Africa (notably Algeria and Tunisia) left on independence, as also did Guinea in 1958. Madagascar left in 1972, and Mauretania in 1973. However, the stable currency has attracted new members. The former Spanish colony of Equatorial Guinea joined UEMOA in 1985, and the former Portuguese colony of Guinea-Bissau joined in 1997. These institutional arrangements account for the duration of a currency board that has now lasted over sixty years. The Zone represents a remarkable history of monetary stability, with inflation only emerging briefly in the wake of the 1994 devaluation of the CFA Franc by 50 per cent – the last devaluation in the history of the Zone. The apparently impressive record of monetary stability, especially when set against the contrasting record of monetary instability in neighbouring African countries, has impressed economists who value such monetary equilibrium. Other experts have underlined the trade benefits that the Zone has brought to countries in Africa. For example, Boughton (1993) has argued that ‘the positive factor … is that membership in the zone has given these countries access to France and to Europe … First and foremost it has generated a great deal of trade … Access to Europe has enabled the countries in the zone to maintain currency convertibility and open capital movements, which has further promoted the growth of trade and output.’ However, aside from trade openness, which has tended to keep these countries as captive markets for French companies, and low inflation, there
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The Franc Zone 137 is little evidence of superior performance relative to other sub-Saharan African countries. The practice of open trade and capital movements is facilitated by strong deflationary pressures on countries in the system. Governments are subject to political pressures to reduce spending and raise taxes if their operating accounts turn into deficit. Similarly, private enterprise is hampered by an inelastic supply of credit, evidenced by the weak development of banking and financial institutions in the Zone, by comparison with neighbouring countries such as Ghana or Nigeria. Restricting credit to inflows of foreign exchange encourages commodity export dependence. The result is that the countries of the Franc Zone have developed little in the way of manufacturing industry and many French companies operating in the Zone have looked with envy at the more buoyant markets of neighbouring countries. At the same time, the obligation to deposit the foreign currency counterparts of trade surpluses in the central banks encourages corruption to evade this requirement, by understating exports and having payments for them deposited in bank accounts abroad. In the past such capital flight has been linked to payments to French political parties in return for financial and military support. Since the total GDP of the Zone amounts to around 3 per cent of the GDP of France, the Zone has been an inexpensive way of maintaining that country’s influence in Africa. It was this French colonial legacy of corruption and low economic growth, breeding unemployment and resentment of foreigners, that broke out into civil wars in Chad during the 1980s and the Côte d’Ivoire in 2010. The way in which the Zone works and its operating or financing mechanisms are an application of an extreme monetarist theory that inspired the Zone. That theory argued that tying a currency to imported foreign exchange would result in price stability. In turn, price stability was supposed to be conducive to balanced economic development. In narrow monetary terms the Franc Zone may be deemed a success on account of its record of price stability. However, the political and developmental consequences of the monetary union are less favourable. They have only been tolerated because successive French governments have promised to reform their politics, rather than the Franc Zone, and initiatives such as the Economic Community of West African States promise more development. Two questions therefore arise out of the experience of the Franc Zone. The first is whether, within the existing institutions of the currency union, a greater impetus towards economic development can be obtained with greater democracy and transparency. This is the official aim of successive French governments, backed by the International Monetary Fund, the Africa Development Bank and other multilateral agencies in the twentyfirst century. The second, and in many respects the much more critical question, is whether modifications in the operating mechanisms of the
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Zone, allowing greater credit flexibility, could support economic development in a more effective way.
REFERENCE Boughton, J.M. (1993), ‘The economics of the CFA Franc Zone’, in P. Masson and M.P. Taylor (eds), Policy Issues in the Operation of Currency Unions, Cambridge: Cambridge University Press.
FURTHER READING Fielding, D. (2002), The Macroeconomics of Monetary Union: An Analysis of the CFA Franc Zone, London: Routledge. Fielding, D. and K. Shields (2001), ‘Modelling macroeconomic shocks in the CFA Franc Zone’, Journal of Development Economics, 66(1), 199–223. Gulde, A.-M. and C. Tsangarides (eds) (2008), The CFA Franc Zone: Common Currency, Uncommon Challenges, Washington, DC: International Monetary Fund.
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20 Globalization Jonathan Perraton
Of all the developments from the 1980s broadly termed ‘globalization’, growing cross-border financial activity attracted most attention. Commentaries prophesying the ‘death of distance’ and ‘end of geography’ envisaged the emergence of a seamless global capital market. This was variously expected to lead to allocative efficiency gains, international risk sharing and consumption smoothing, and major capital flows from the rich North to the capital-scarce South. Governments would be constrained, if not effectively prohibited, from pursuing inefficient policies. The potential for external crises was downplayed, attributed to government policy failures or seen as the occasional price to be paid for faster growth through exploiting risk– return trade-offs. Financial globalization in these accounts was largely attributed to the impact of new information and communication technologies. Whilst these technologies facilitated the exponential growth of cross-border transactions in assets and derivative products, a more historical perspective qualifies this account. The laying of intercontinental cables in the latter part of the nineteenth century provided the infrastructure to underpin global financial market integration; the circa 1870–1914 period saw large-scale global capital flows in the context of adherence to the Gold Standard. Contemporary financial globalization reflects clear political choices to remove capital controls after the demise of the Bretton Woods system. External financial liberalization was a policy choice by developed countries in the 1980s and, increasingly, emerging market economies from the 1990s. There is no single definition or measure of financial globalization. Prasad et al. (2003, p. 7) advance the following definitions: Financial globalization is an aggregate concept that refers to increasing global linkages created through cross-border financial flows. Financial integration refers to an individual country’s linkages to international capital markets. Clearly, these concepts are closely related. For instance, increasing financial globalization is perforce associated with increasing financial integration on average.
External financial liberalization is central to this process in dismantling capital controls, but it is not quite synonymous with it: some countries have 139
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managed to attract significant inflows despite retaining capital controls, whilst others – particularly poor countries – have opened their capital account without succeeding in attracting inflows. Broadly, evidence points to unprecedented levels of integration on almost any measure, although it may not have been until the 1990s that financial globalization surpassed its Gold Standard levels (Prasad et al., 2003; Obstfeld and Taylor, 2004). Obstfeld and Taylor (2004) find a U-shaped evolution of financial globalization with the collapse of international financial markets during the Great Depression and their control under Bretton Woods giving way to contemporary globalization (cf. Eichengreen, 2008). There has been widespread dismantling of formal barriers, and in practice the effectiveness of those that remain has often been eroded. Cross-border financial flows have risen so that foreign asset and liability positions have risen sharply relative to national income (Lane and Milesi-Ferretti, 2007). Earlier strong correlations between national savings and investment rates have diminished; a high correlation between national savings and investment shares can still be consistent with high international capital mobility if the two are jointly determined and/or the government targets the current account. Cross-border financial transactions have risen sharply from negligible levels for much of the Bretton Woods period: cross-border transactions in bonds and equities typically exceed GDP for major economies. Most dramatically, turnover in foreign exchange and derivatives markets has soared, with turnover in the former estimated to exceed $1 trillion daily or over 50 times world trade. Nevertheless, in key respects current global capital markets fall short of ideal models: international diversification of portfolios and convergence of asset prices still falls short of what would be expected in a hypothetical perfect global financial market. But this is scarcely a useful benchmark with which to assess contemporary developments; as Blecker (in Eatwell and Taylor, 2002, p. 136) comments: The world still does not fit the traditional model of perfect capital mobility, in which all national savings flow into one global ‘pool’ of savings, with equalized real interest rates and domestic investment completely uncorrelated with national saving in each country. This, however, is not due to a lack of integration of financial markets, but rather to other features of the contemporary global economy which were ignored in the traditional model.
Even before the onset of global financial crisis in 2008, there was widespread acknowledgement that contemporary financial globalization had not led to the gains its proponents had predicted. The World Bank acknowledged that ‘contrary to expectations, financial liberalization did not add much to growth, and it appears to have augmented the number of crises’ (World Bank, 2005, p. 21; cf. Prasad et al., 2003; Kose et al., 2009; Rodrik
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Globalization 141 and Subramanian, 2009). Stiglitz, in particular, has highlighted how the asymmetric information problems endemic to financial markets have become particularly acute with cross-border flows under the current international financial regime (e.g., Stiglitz, 2002). Obstfeld and Taylor (2004, Ch. 7) contrast the ‘development finance’ flows of the pre-1914 Gold Standard period, a period of net capital flows to poorer economies notwithstanding some unevenness and wealth bias, with contemporary ‘diversification finance’ where most financial flows are between rich countries. Further, in contrast to the Gold Standard period, capital flows to developing countries are strongly pro-cyclical (Vos, 1994). Since the 1990s international financial crises have become much more frequent relative to the Bretton Woods period; moreover, they have entailed significant budgetary costs and output losses, particularly when they have occurred as ‘twin crises’ of the banking system, that have been persistent or permanent (Cerra and Saxena, 2008). There have been numerous mainstream attempts to explain the patterns and impact of contemporary financial globalization. Since Lucas’s seminal paper (Lucas, 1990), an extensive orthodox literature has attempted to explain the ‘paradox’ of why presumed high rates of return in capital-scarce countries haven’t attracted capital inflows. This is variously explained by the role of human capital, capital market imperfections or domestic institutions. More generally, the difficulties of financial globalization, and the apparent absence of predicted gains, have been attributed to the failure of liberalizing countries to institute effective regulatory regimes and broader arrangements to maximize potential gains and minimize potential costs. Thus, for example, initial mainstream ‘third generation’ models of 1990s’ crises typically had some multiple equilibrium element but largely attributed the crises to moral hazard generated by inappropriate domestic institutional arrangements and policies. Some more recent models have emphasized financial fragility amongst economies attracting inflows and have come close to a Minskian perspective as well as potentially explaining the international contagion effects typically associated with these crises and their negative effects on output. In an influential, but contested, interpretation the likelihood of multiple equilibrium crises effectively hollows out countries’ choice of exchange regime, leaving only full monetary union or floating as viable policy options (Eichengreen, 2008). There is a growing literature from a heterodox post-Keynesian tradition that examines the patterns and effects of contemporary financial globalization. Mainstream accounts are typically grounded in purchasing power and interest rate parity conditions, yet evidence for these is generally weak and their theoretical foundations are weaker than generally presumed
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(Blecker, 1999; Eatwell and Taylor, 2000; Harvey, 2009). Further, deviations from interest rate parity are hard to reconcile with the efficient market hypothesis holding in foreign exchange markets. There is scant evidence of international risk sharing or consumption smoothing amongst developed countries, let alone amongst developing countries; rather, the variation in current account balances exceeds that for consumption smoothing in several developed economies, consistent with speculative flows. Developments since the demise of Bretton Woods have seen the rise of speculative global financial flows, with increased risks for countries and agents – often those least able to bear these risks. Mainstream perspectives have downplayed aggregate demand issues at the global level and essentially modelled the determination of real interest rates in a loanable funds framework. As noted above, this abstracts from key features of the operation of global capital markets and fails to provide an adequate account of the evolution of global interest rates (cf. Bibow, 2009, esp. Ch. 8). The emergence, persistence and patterns of international payments imbalances can be explained within a post-Keynesian framework. There is no presumption that rates of return would be higher in poorer economies and thus no expectation of systematic North-to-South capital flows. Access to global capital markets and risk premiums on flows to developing countries are both strongly pro-cyclical. During upswings, spreads on developing country rates attract capital inflows, but this creates balance sheet mismatches between short positions in foreign claims and long positions in domestic assets; financial fragility, or even classic Minskian cycles, result (Eatwell and Taylor, 2000, Ch. 5; cf. Vos, 1994). The role of derivatives in fuelling these developments may be crucial, but under-researched (see Dodd and Neftci in Eatwell and Taylor, 2002). More generally, speculative flows and exchange rate movements in response to interest rate differentials through carry trade mean that exchange rates have not moved to restore payments imbalances (UNCTAD, 2007, Ch. 1). These flows lead to exchange rates diverging from values consistent with either interest rate differentials or the relative costs of producing goods and services. The result of this is that exchange rates cease to be an effective equilibrating mechanism or an effective policy tool for individual countries, nor globally do they operate to effect smooth adjustment to payments imbalances. The global financial crisis since 2008 illustrates several of these insights. The mainstream wisdom that countries will benefit from financial globalization provided that they have appropriate regulatory structures and institutions appears harder to sustain in the light of the failure of systems in leading economies to prevent a systemic crisis. The crisis can be seen to have its origins in the effects of globalization, broadly conceived (Turner,
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Globalization 143 2008). Global capital imbalances saw major inflows to the United States and other economies fuelling asset price bubbles. Whilst globalization pressures limited the growth of real wages, households maintained their consumption levels by borrowing against expected house price inflation. The absence of an effective global regulatory regime meant that unsustainable positions developed, leading to a systemic crisis. Some mainstream and post-Keynesian analyses see the absence of a global financial regime as preventing full financial globalization from emerging. There is less agreement on the desirable future course of international financial regulation. Governments do not face clear policy rules, but uncertainty over market reactions as markets have periodically supported policies before turning suddenly and sharply against them. This induces policy caution amongst governments and tends to lead to a deflationary bias in macroeconomic policy. The instability of contemporary financial integration inhibits rational planning for firms and governments and raises systemic risks; Eatwell and Taylor (2000) point to a number of possible policy responses to reduce this instability in terms of a World Financial Authority; Arestis and Basu (2003) argue that full financial globalization, if desired, would require a single global currency. The aftermath of the East Asian crisis has put capital controls back onto the agenda and whilst national regulatory authorities have largely played catch-up with international financial integration, potential leverage remains: banks remain dependent on national central banks to act as crisis managers and lenders of last resort as the 2008 crisis has dramatically shown.
REFERENCES Arestis, P. and S. Basu (2003), ‘Financial globalization: some conceptual problems’, Eastern Economic Journal, 29(2), 183–9. Bibow, J. (2009), Keynes on Monetary Policy, Finance and Uncertainty, London: Routledge. Blecker, R. (1999), Taming Global Finance, Washington, DC: Economic Policy Institute. Cerra, V. and S. Saxena (2008), ‘Growth dynamics: the myth of economic recovery’, American Economic Review, 98(1), 439–57. Eatwell, J. and L. Taylor (2000), Global Finance at Risk, Cambridge, UK: Polity Press. Eatwell, J. and L. Taylor (eds) (2002), International Capital Markets, Oxford: Oxford University Press. Eichengreen, B. (2008), Globalizing Capital: A History of the International Monetary System, Princeton, NJ: Princeton University Press. Harvey, J.T. (2009), Currencies, Capital Flows and Crises, London: Routledge. Kose, M.A., E. Prasad, K. Rogoff and S.J. Wei (2009), ‘Financial globalization: a reappraisal’, IMF Staff Papers, 56(1), 8–62. Lane, P. and G. Milesi-Ferretti (2007), ‘The external wealth of nations mark II: revised and extended estimates of foreign assets and liabilities, 1970–2004’, Journal of International Economics, 73(2), 223–50.
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Lucas, R.E., Jr. (1990), ‘Why doesn’t capital flow from rich to poor countries?’, American Economic Review, 80(2), 92–6. Obstfeld, M. and A. Taylor (2004), Global Capital Markets, Cambridge: Cambridge University Press. Prasad, E., K. Rogoff, S.J. Wei and M.A. Kose (2003), Effects of Financial Globalization on Developing Countries: Some Empirical Evidence, Washington, DC: International Monetary Fund. Rodrik, D. and A. Subramanian (2009), ‘Why did financial globalization disappoint?’, IMF Staff Papers, 56(1), 112–38. Stiglitz, J. (2002), Globalization and its Discontents, London: The Penguin Press. Turner, G. (2008), The Credit Crunch: Housing Bubbles, Globalization and the Worldwide Economic Crisis, London: Pluto Press. UNCTAD (2007), Trade and Development Report 2007, New York: United Nations. Vos, R. (1994), Debt and Adjustment in the World Economy, Basingstoke: Palgrave Macmillan. World Bank (2005), Economic Growth in the 1990s, Washington, DC: World Bank.
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21 Hedge funds Photis Lysandrou
Hedge funds belong to that group of non-depository financial institutions that merely perform a ‘transfer’ function, in that assets placed under their management by clients are redeployed with the aim of generating better returns subject to a given level of risk than is possible for those clients. This said, hedge funds differ from other investment firms such as pension and mutual funds in three important respects: they are not required to maintain the same high level of transparency regarding their actions; they are not subject to the same regulatory constraints on the types of investment activities that they can engage in or on the types of investment tools that they can use; and, finally, they are not obliged to factor risk on anything like the same scale into their return-generating strategies, a feature that explains why the latter are often classified as ‘absolute return’ strategies. The characteristics that distinguish hedge funds from other institutional asset managers are also those that have drawn the latter into rapidly expanding their investments in hedge funds over the past decade. High net worth individuals have traditionally been the predominant clients of hedge funds, but following the collapse in yields in the US government and corporate bond markets in the early to mid-2000s – caused principally if not exclusively by the huge influx of foreign funds – institutional investors also became an important part of the hedge fund client base in their quest for yield. The ‘institutionalization’ of the hedge fund industry that has accompanied its recent expansion in size can be gauged by the changes in the source of hedge funds’ capital: wealthy individuals accounted for 60 per cent of this capital in 1997 but for only 40 per cent in 2006, while the institutional investors’ share rose from 20 per cent to about 45 per cent in the same period (Bank of England, 2008) (this figure includes the assets of funds and of endowments and foundations as well those of pension funds). Hedge fund investment strategies can be divided into two broad categories: ‘market neutral’ and ‘directional’. The market-neutral category aims to obtain returns that are uncorrelated with market movements and include ‘arbitrage’ strategies (these exploit price differences within and across financial markets), ‘event-driven’ strategies (these exploit opportunities created by specific transaction events such as mergers, spin-offs and share buy-backs or by specific situations such as corporate bankruptcies), and equity market-neutral strategies (these exploit price differences in equity 145
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markets through long/short combinations). The directional category aims to obtain returns by speculating on market movements and include ‘macro’ strategies (taking bets on movements in stock market prices, interest rates, currency exchange rates and commodity prices) and ‘emerging market’ strategies (investing long in emerging markets’ sovereign debts and corporate securities). Up to the mid-1990s, directional strategies were the most popular amongst hedge funds with the ‘macro’ sub-category alone accounting for approximately 55 per cent of all assets under management. By the mid-2000s, hedge fund assets were not only more evenly divided between the directional and market-neutral strategies but also more evenly spread across the different sub-categories. Thus ‘macro’ strategies accounted for approximately 12 per cent of assets at this time while arbitrage and event-driven strategies increased their share to 26 per cent and 21 per cent respectively (McKinsey, 2007b). The shift towards a greater diversity of hedge fund strategies manifested the new competitive pressures in the hedge fund industry resulting from the steep increase in the volumes of money pouring into it after 2001 (hedge fund assets tripled between 2002 and 2007, rising from $500 billion to about $1.5 trillion) and from the increase in the number of firms operating within the industry (this number doubled in the same five-year period, rising from approximately 5000 to just under 10 000) (Bank of England, 2008). These changes in the scale and structure of the hedge fund industry are seen as having both advantages and disadvantages. Before discussing these it should first be noted that although the industry has become more heterogeneous with the new entrants and the proliferation of different investment styles and specialisms, it still remains heavily concentrated in terms of the distribution of the assets under management. There may have been 10 000 hedge funds by 2007, but just 200 of them accounted for approximately 65 per cent of all hedge fund assets (McKinsey, 2007b). Hedge funds are said to confer a number of benefits, the foremost of which concern market liquidity and financial innovation. Many of the hedge fund strategies that were outlined above involve frequent trading, with the result that the share of hedge funds in the daily trading volumes in many financial markets is out of all proportion to the size of their assets. Thus while the latter currently come to about 1–2 per cent of all global financial assets, the hedge funds’ share of trading is estimated to be between 30 and 50 per cent in the New York and London stock exchanges, about 45 per cent in emerging market bonds and between 25 to 30 per cent in the markets for US Treasuries and high-yield corporate bonds (McKinsey, 2007a). The trading behaviour of hedge funds is said to be beneficial in that by improving the liquidity of the financial markets they thereby enhance price discovery and reduce the possibility of pricing inefficiencies, all of which in
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Hedge funds 147 turn helps to lower the costs of financing for corporations. Hedge funds are also said to have a beneficial impact on the financial markets insofar as they force the pace of development of new financial instruments and technologies that can in turn facilitate a more efficient allocation of risk across market participants and a better management of risk within portfolios. The chief dangers posed by hedge funds are that they can greatly increase market volatility and systemic risk. As already stated, hedge funds account for a substantial proportion of trades in many markets and while the spreading of trades across assets can help improve liquidity and price efficiency it is also possible that a particular event or disturbance can lead to ‘herding’, that is, the concentration of trades on particular assets or the convergence in particular strategies, which can subsequently amplify the effects of the original disturbance. Hedge funds are still comparatively small in size, but their heavy use of leverage means that should a number of hedge funds fail at the same time this could create contagion across asset classes as they unwind their positions. Furthermore, the simultaneous failure of highly leveraged hedge funds could have a general destabilizing impact on the financial markets through default on the funds that banks lent to them. The realization that hedge funds have the potential to seriously disrupt the financial markets has prompted calls that these private investment vehicles be made subject to the same disclosure standards and regulatory constraints as are currently binding on the public investment vehicles. While these calls began to be made before the outbreak of the subprime crisis in 2007, they became louder and more insistent after the crisis. Given that what began as a crisis in the market for subprime-backed securities rapidly mutated into the worst global economic crisis since the Great Depression, it stands to reason that the hedge funds would have been very quickly brought to account had it been generally recognized that these institutions bore the major responsibility for the growth of the toxic securities. However, this was not the case. Rather, the general consensus was that it was the banks and their associates who created the structured finance collateralized debt obligations (CDOs) that were chiefly responsible for the subprime crisis. Even in continental Europe, where the drive towards closer regulation of the hedge funds is at its most powerful, it is still widely accepted that the hedge funds played a secondary, amplifying role in the crisis rather than a primary, causal one. To quote from a report published in February 2009, by the High-Level Group on Financial Supervision in the EU: ‘Concerning hedge funds, the Group considers they did not play a major role in the emergence of the crisis. Their role has largely been limited to a transmission function, notably through massive selling of shares and short-selling transactions’ (de Larosière, 2009, p. 24).
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This conclusion is wrong. The hedge funds may have played no part in the actual construction of the CDOs that were at the epicentre of the crisis but this is not the point. The point is that had it not been for the hedge funds’ unique intermediary position between the investors seeking yield on the one side and the banks who created the high-yielding securities on the other, the supply of these securities could never have reached the proportions that were critical to causing the collapse of the whole financial system. A mass market for CDOs should never have existed given that their complex and opaque structure broke all the rules of transparent commodity exchange. Without the hedge funds such a market would not in fact have existed. Wealthy individuals did not have the requisite expertise to participate in this market while liquidity and other considerations prevented institutional asset managers from having more than a limited participation. In both cases, the preferred solution to the yield problem that was becoming increasingly acute after 2001 was to pour money into the hedge funds, which in turn believed that one of the surest ways of satisfying the demand for yield was to redirect substantial proportions of this money into CDOs. By the end of 2006, there was approximately $3 trillion worth of CDOs outstanding, with half of this sum comprising ‘cash’ CDOs and the other half comprising ‘synthetic’ CDOs (Blundell-Wignall, 2007). It has been estimated that the hedge funds held about 60 per cent of the cash CDOs and about 30 per cent of the synthetic CDOs, while the banks, insurance companies and pension and mutual funds held the rest (House of Commons Treasury Committee, 2008). After the subprime crisis, the hedge funds played the role of the innocent and gullible investor. But, far from being lured by the banks into buying the CDOs they, on the contrary, pressured the banks into accelerating the rate of supply of these products, particularly of the super senior and senior variety. When the heads of some of the biggest US hedge funds were called before a US Senate hearing on the subprime crisis in November 2008, they declared that they were in no way to blame for the financial carnage. The ‘focal point of carnage’, to quote Kenneth Griffin one of the hedge fund chiefs, was not us ‘but the regulated institutions, the commercial banks who originated and securitized the sub-prime mortgages and the investment banks who then used these securities as backing for Collateralized Debt Obligations and other structured financial products’ (Kirchgaessner and Sender, 2008). By their ‘fanciful’ ratings of these products, to quote James Simmons, another of the hedge fund chiefs, the credit rating agencies must take particular blame for the carnage in that they facilitated the sale of ‘sows’ ears as silk purses’. (To quote from testimony given by Gerald Corrigan of Goldman Sachs at the 2008 House of Commons hearing on the financial crisis: ‘To a significant degree it has been the reach for yield on the part of institutional investors in particular that
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Hedge funds 149 goes a considerable distance in explaining this very rapid growth of structured credit products’; House of Commons Treasury Committee, 2008, p. 16.) Hedge funds applied pressure on the banks to accelerate the supply of the products because these AAA-rated products served a double purpose for the hedge funds in that on the one hand they generated a higher return than did US Treasuries even while having the same rating, and on the other they could be used as collateral in credit arrangements on account of their high rating. Given that hedge funds borrow heavily from their prime brokers to leverage up their various exposures it was only logical that they should use CDOs as collateral to reduce borrowing costs, while the prime brokers for their part were obliged to accept the CDOs as collateral in reverse repos given that it was they themselves who helped to create these structured credit products in the first place. In sum, there is sufficient evidence to indicate that the hedge funds were directly responsible for the growth of the toxic securities that eventually led to the financial crisis and for this reason they must be made subject to new controls that go further than anything that has been previously suggested. This proposition will, of course, meet with many objections, the most predictable of which is that to make the controls on hedge funds too tight is to destroy their ability to function as an alternative investment vehicle and thus the very rationale for their existence. This line of argument obviously leads to the more fundamental question of whether hedge funds are necessary to the functioning of the contemporary financial markets and thus to the continued development of capitalism. Aside from the hedge funds themselves, there is a body of academic and official opinion that answers this question in the affirmative (see, for example, Danielsson et al., 2004 or McKinsey, 2007b). However, the peculiar circumstances surrounding the emergence and subsequent growth of the hedge funds point to a different answer. The idea of hedge funds may have originated in 1949 when Alfred Jones went long in some assets to hedge his short positions in other assets, but they only became properly established as private pools of capital in the 1980s with the shift towards neoliberal macro-policies and the consequent rise in the scale and concentration of private wealth. Since that time the hedge funds have grown in tandem with the growth in the number of high net worth individuals and in the volume of assets owned by them, but if this trend towards the increasing concentration of wealth ownership was ever to be reversed the flow of cash into the hedge funds originating from this particular source would dry up in an instant. So also would the flow of cash originating from institutional investors if bond and other securities markets were to become more developed in Asia, Latin America and in other parts of
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the world. These investors would not have become major clients of the hedge funds in the early to mid-2000s had the rate of growth in the global supply of investable securities kept up with the rate of growth in global demand, for in this event the yield problem would not have become as acute as it did and consequently the need to rely on the hedge funds for yield would not have become as intense. In the final analysis, hedge funds continue to exist and continue to grow because of continuing anomalies in the global capitalist system rather than because they constitute an essential part of that system.
REFERENCES Bank of England (2008), Financial Stability Report, October. Blundell-Wignall, A. (2007), ‘An overview of hedge funds and structured products: issues of leverage and risk’, OECD, available at http://www.oecd.org/dataoecd/36/62/ 40972327.pdf; accessed 12 March 2012. Danielsson, J., A. Taylor and J.P. Zigrand (2004), ‘Highwaymen or heroes: should hedge funds be regulated?’, Discussion Paper: IAM Series No. 004, 518, London School of Economics, November. de Larosière, J. (2009), The High-Level Group on Financial Supervision in the EU, de Larosière Group Report, Brussels, 25 February, 2009, available at http://ec.europa.eu/ internal_market/finances/docs/de_larosiere_report_en.pdf; accessed 1 April 2012. House of Commons Treasury Committee (2008), Report on Financial Stability and Transparency, 26 February, available at http://www.publications.parliament.uk/pa/cm200708/ cmselect/cmtreasy/371/371.pdf; accessed 12 March 2012. Kirchgaessner, S. and H. Sender (2008), ‘Hedge fund chiefs blame the system for financial crisis’, Financial Times, 13 November, available at www.ft.com/cms/s/0/0f8c0216-b19311dd-b97a-0000779fd18c.html#axzz1hB5fGiqm; accessed 1 April 2012. McKinsey Global Institute (2007a), The New Power Brokers: How Oil, Asia, Hedge Funds and Private Equity are Shaping Global Capital Markets. McKinsey Global Institute (2007b), ‘Hedge funds: from mavericks to mainstream’, in The New Power Brokers: How Oil, Asia, Hedge Funds and Private Equity are Shaping Global Capital Market.
FURTHER READING Lysandrou, P. (2012), ‘The primacy of hedge funds in the subprime crisis’, Journal of Post Keynesian Economics, 34(2). McKinsey Global Institute (2007), ‘Hedge funds: from mavericks to mainstream’, in The New Power Brokers: How Oil, Asia, Hedge Funds and Private Equity are Shaping Global Capital Market.
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22 The Iceland crisis Robert H. Wade and Silla Sigurgeirsdóttir*
They [the Icelandic banks] shouldn’t be worried about the fundamental soundness of their business model. I think it is very sound and very good. Any market turmoil is just prompted by some misplaced misunderstandings of market analysts. (Richard Portes, Professor at the London Business School, May 2008)1 It was absolutely obvious … that its banking model was not viable. (Buiter and Sibert, 2008)2
The small island of Iceland (population 310 000, area 42 per cent that of the United Kingdom whose population is 60 million) has lessons for the world. It is an unusually pure example of the dynamics that blocked regulation and caused financial fragility across the developed world for 20 years. In 2007, just before the financial crisis, the country’s average income was the fifth highest in the world, 60 per cent above US levels; Reykjavik’s shops were stuffed with luxury goods, SUVs choked the narrow streets, and its restaurants made London seem cheap. Icelanders were the happiest people in the world according to an international study in 2006 (World Database of Happiness, 2006). It also had one of the two or three least corrupt public administrations in the world, according to Transparency International. Much of Iceland’s apparent success rested on the super-fast growth of three Icelandic banks that rose from small, public utility organizations in 1998 to being, after privatization and mergers, among the world’s top 300 banks eight years later, increasing their assets from 100 per cent of GDP in 2000 to almost 800 per cent by 2007, a ratio second only to Switzerland. They borrowed massive amounts on the back of implicit government guarantees, and lent to private equity firms owned by the bankers themselves or their close friends and relatives, against little or no real collateral. The holding companies went on a wild mergers and acquisitions spree, buying up firms in several parts of Europe with borrowed money. They extracted vast profits for themselves and also for paying salaries, wages and taxes back home in Iceland. In essence, Iceland’s success, which earned the country the sobriquet of ‘Nordic Tiger’ (to match Ireland’s ‘Celtic Tiger’), was based on a mechanism whereby a small group of financiers borrowed colossal amounts from 151
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international capital markets, bought up foreign assets, restructured the assets, and redistributed profits back into Iceland. The Icelandic elite and masses cheered them on. This, of course, is not how the success was interpreted in Iceland and in the rest of the world at the time. Instead, the success was said to prove the validity of free-market economics as the route to prosperity. The leading Icelandic champion of free-market economics declared in the Wall Street Journal: ‘[Prime Minister] Oddsson’s experiment with liberal policies is the greatest success story in the world’ (Gissurarson, 2004).3 Arthur Laffer, the Reagan-era guru of supply-side economics, announced on a visit to Iceland in November 2007 that fast economic growth with a large trade deficit and ballooning foreign debt were signs of success: ‘Iceland should be a model to the world’, he declared (Laffer, 2007). The crisis came in September 2008 when money markets seized up after the Lehman meltdown. Within a week, Iceland’s three big banks collapsed and were taken into public ownership. They then entered a less glorious league – Moody’s list of the 11 biggest financial collapses in history. The economy experienced the third biggest fall in output and the fourth biggest fall in employment among the 30 OECD countries. The contraction stopped in late 2010, at 11 per cent below the peak in the first quarter of 2008. Real GDP is expected to grow by just over 2 per cent in 2011 and may grow slightly faster in 2012 (much faster than the zero growth likely in the Eurozone in 2012). Thanks to increases in welfare spending, only 14 per cent of the population said they were finding it ‘very difficult’ to make ends meet in 2011, well below the EU average (Olafsson, 2011). The government re-entered capital markets for the first time in June 2011 when it sold $1bn worth of bonds at a spread of only 3.2 percentage points above LIBOR, much less than the other crisis-hit governments are having to pay, which testifies to the credibility of the government’s stabilization performance in the eyes of financial markets. How did Iceland come to enjoy such apparent economic success as to be dubbed the ‘Nordic Tiger’? How was the increasing financial fragility hidden from view; and how was the crisis handled?
ICELAND MODERNIZES After more than 600 years of foreign (Norwegian and Danish) rule, Iceland’s social structure was the most feudal of all Nordic countries at the beginning of the twentieth century; and it was about the poorest national economy in Western Europe. After World War II, with the country newly independent from Danish rule, the economy grew strongly thanks to: Marshall Plan aid (the US-Nato
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The Iceland crisis 153 military base provided 15–20 per cent of foreign exchange earnings between 1954 and 1960); an abundant export commodity, cold-water fish; and a small, literate, hard-working and ethnically homogeneous population with a strong sense of national identity. At the same time the economy, though capitalist, was heavily regulated, with elaborate trade protection and multiple exchange rates. In 1960 the government began cautiously to liberalize. It unified and devalued the exchange rate, reduced tariffs and quantitative restrictions, raised interest rates, and banned the indexing of wages to prices. But the government retained a large role in managing the economy, especially by rationing credit through the state-owned banks and directing investment to particular sectors. Growth zoomed ahead at an average of 4 per cent a year from 1960 to 1989, though with high variability from year to year (related to fish yields). 1960–89 was the period of the ‘Icelandic miracle’ (Olafsson, 2011). By the 1980s Iceland had shot up from being one of the poorest places in Western Europe at the start of World War II to being one of the most prosperous. It established a welfare state in line with the tax-financed Scandinavian model, and by the 1980s had attained a level and a distribution of disposable income equal to the Nordic average. Yet it remained both more regulated and more patron–client-dominated than its European neighbours; a local oligopoly restricted political and economic opportunities. A bloc of 14 families, popularly known as ‘The Octopus’, constituted the economic and political ruling elite. The families controlled imports, transport, banking, insurance, fishing and supplies to the US-Nato base, and provided most top politicians. The Octopus controlled the right-wing Independence Party (IP), which dominated the media and decided on senior appointments in the civil service, police and judiciary. The other right-wing party was the Centre Party (CP), also known as the Progressive Party, based in the rural economy and controlled by its business arm. These two parties provided most of the governments for the past 60 years. They effectively ran the state-owned banks, and prominent figures within them owned the two main daily newspapers. The IP controlled the Justice Ministry for 93 per cent of the years from 1926 to 2008, and thereby appointed almost all senior judges, including those of the Supreme Court. While left-wing parties were weak, trade unions were strong. One of their main aims was to defend real wages from the effects of the government’s main tool of macroeconomic management, devaluation to secure profitable conditions for the export industries (mainly fish and later aluminium in the 1970s). All through the fast growth period of 1960–89 Iceland experienced high inflation driven by price–wage spirals, and intense labour conflict, sometimes coming close to general strikes. Not only was the work force
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strongly unionized, the agricultural and fisheries sectors were strongly corporatized, in the sense that their collective organizations decided what they wanted to see by way of government policy for the sector, and the government mostly obliged (Thorhallsson, 2010). Looking back from later decades, Iceland at this time was a paradox when seen through neoliberal eyes: a highly statist and corporatist economy, with a relatively ‘closed access’ political and economic regime run by a right-wing bloc, which also controlled the media; a strong union movement; and high economic growth accompanied by falling post-tax income inequality (as the right-wing bloc had no choice but to negotiate with the unions). Iceland’s statist and corporatist political economy began to be challenged from within by a neoliberal faction, the Locomotive group, which had coalesced in the early 1970s after law and business administration students at the University of Iceland took over a journal, The Locomotive, and promoted free-market ideas. The future IP Prime Minister, DavíW Oddsson, was a prominent member. Oddsson, born in 1948, from a middle-class background, was elected mayor of Reykjavik in 1982, where he led privatization campaigns, including selling of the municipality’s fishing industry to the benefit of members of the Locomotive group. In 1991 he led the IP to victory in the general election, and reigned (not too strong a word) as Prime Minister for 14 years, overseeing the growth of the financial sector, before installing himself as governor of the Central Bank in 2004. He had little experience or interest in the world beyond Iceland. His Locomotive group protégé Geir Haarde, Finance Minister from 1998 to 2005 (with a degree in economics from Brandeis University in Boston in the early 1970s), took over as Prime Minister shortly after. These two men most directly steered Iceland’s strategy to create an international financial centre cum tax haven in the North Atlantic, conveniently midway between Europe and America.
ICELAND LIBERALIZES The liberalization of the economy began in 1994, when accession to the European Economic Area, the free-trade bloc of EU countries, plus Iceland, Lichtenstein and Norway, lifted restrictions on cross-border flows of capital, goods, services and people. From the 53rd freest economy in the world in 1975 (by the Economic Freedom of the World index), it shot up to 9th freest by 2004. The Oddsson government began to privatize the banks in 1998. Landsbanki was allocated to IP grandees, Kaupthing to their counterparts in the CP, its coalition partner. Foreign bidders were excluded, an important point
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The Iceland crisis 155 to note for understanding what was to happen. Later, Glitnir, a private bank formed from the merger of several smaller ones, joined the league. So Iceland roared into international finance aided globally by abundant cheap credit (thanks to US loose monetary policy over the 1990s and 2000s), and aided domestically by strong political backing for the banks. The new banks merged investment banking with commercial banking, so that the former shared the implicit government guarantee of the latter. And the country had low sovereign debt, which gave the banks high marks from the international credit-rating agencies. The major shareholders of Landsbanki, Kaupthing, Glitnir and their spin-offs reversed the earlier political dominance of finance: finance now dominated government policy rather than the other way around. The established format of Iceland’s corporatism was helpful to this takeover. As noted, from the start Iceland’s statism had been integrated with a form of corporatism in which both agriculture and the fishing industry more or less regulated themselves. When aluminium smelting began in the 1970s the government extended the same governance dispensation to the (foreign-owned) aluminium firms. It was only ‘natural’ then that when finance emerged as the big new growth sector after 2000, both it and the IP-led government expected that it would tell the government what it wanted and the government would oblige. The result was very light regulation, justified by the efficient markets hypothesis. The regulatory body (the Financial Supervisory Authority, FME) had a total staff of 45 in 2006, for regulating a financial system including three of the world’s 300 biggest banks. Its decrepit offices were entered behind a fast-food joint, and many of its staff were in effect in training to cross the street to join a bank and multiply their salary several times. Oddsson’s government relaxed the state-provided house mortgage rules in 2004, allowing 90 per cent loans. The post-crash government enquiry into the bubble identified this one decision as perhaps the most serious economic policy blunder of many, given that the economy was already in the grip of bubble dynamics (SIC, 2010). It prompted the newly privatized banks to rush to offer even more generous terms, accelerating the house price bubble. Also, the government lowered income tax and VAT rates with the aim of turning Iceland into a low-tax international financial centre. The stock market soared. Meanwhile, Iceland’s banking elite were driving through mergers and acquisitions at home and abroad, competing and cooperating with each other. Using their shares as collateral, some took out large loans from their own banks, and bought more shares in their own or related banks, inflating share prices. Bank A lent to shareholders in Bank B, who bought more shares in B using shares as collateral, raising B’s share price. Bank B
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returned the favour. The share prices of both banks rose, without new money coming in. The banks not only grew bigger, they grew more and more interconnected. The owners and managers of financial firms and law firms remunerated themselves on an ever more extravagant scale. The richer they were, the more political support they attracted. The bankers made large financial contributions to the governing parties and giant loans to key politicians. Income and wealth inequality surged, helped by government policies that shifted the tax burden to the bottom half of the distribution (Olafsson and Kristjánsson, 2010). In 2000 the Gini coefficient of disposable income including capital gains was about 0.26; by 2005, 0.36; by 2007, 0.43. Most of the rise of inequality happened in the share of the top few percentiles of the distribution as they galloped away from the rest. In the euphoria the dangers of a strategy of ‘economic growth with vast foreign borrowing’ were overlooked (Pereira, 2010). With almost all the media controlled by the IP and CP, and with the government having closed down the National Economic Institute in 2002 (on grounds that its research duplicated what the banks were researching), there were few cautionary voices. When some staff of the Central Bank urged an increase in banks’ reserve requirements they were overruled from the top, on grounds that the bankers opposed an increase.
THE MINI-CRISIS In 2006 worries began to be expressed in the foreign and domestic financial press about the stability of the big banks, which were starting to have problems raising funds in the short-term money markets (on which their business model depended). Iceland’s current-account deficit had soared from 5 per cent of GDP in 2003 to 20 per cent in 2006, one of the highest in the world. The stock market multiplied itself nine times over between 2001 and 2007. Landsbanki, Kaupthing and Glitnir were operating far beyond the capacity of Iceland’s Central Bank to support them as lender of last resort; their liabilities were real, but many of their assets were dubious. In February 2006 Fitch downgraded Iceland’s outlook from stable to negative and triggered the 2006 ‘mini-crisis’: the króna fell sharply, the value of banks’ liabilities in foreign currencies rose, the stock market fell and business defaults rose, and the sustainability of foreign-currency debts became a public problem. Danske Bank of Copenhagen described Iceland as a ‘geyser economy’, on the point of exploding (Danske Bank, 2006). The IMF wrote an alarmed Article IV consultation report in 2006. Its private
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The Iceland crisis 157 version to the government described the imbalances as ‘staggering’, which was toned down in the public version to ‘remarkable’ (IMF, 2006). Icelandic bankers and politicians brushed aside the crisis. The Central Bank took out a loan to double the foreign-exchange reserves, while the Chamber of Commerce, run by representatives of Landsbanki, Kaupthing, Glitnir and their spin-offs, responded with a PR campaign. It paid the American monetary economist Frederic Mishkin $135 000 to lend his name to a report attesting to the stability of Iceland’s banks.4 It allegedly paid the London Business School economist Richard Portes £58 000 to do the same on a later report.5 The Chamber and the University of Iceland invited a string of conservative economists to come to Iceland to assure the audience of the stunning success of the neoliberal model. With their blessing no one paid attention to the Danske Bank and IMF reports.6 Though they survived 2006, Landsbanki, Kaupthing and Glitnir had trouble raising money to fund their asset purchases and repay existing debts, largely denominated in foreign currencies. So Landsbanki pioneered Icesave, an Internet-based service that aimed to win retail savings deposits by offering more attractive interest rates than high-street banks. Established in Britain in October 2006 and in the Netherlands 18 months later, Icesave caught the attention of best-buy Internet finance sites and was soon flooded with deposits. Millions of pounds arrived from Cambridge University, the London Metropolitan Police Authority, even the UK Audit Commission, responsible for overseeing local government funds, as well as 300 000 Icesave depositors in the UK alone. Icesave entities were legally established as branches, rather than subsidiaries, so they were under the supervision of the Icelandic authorities, rather than their hosts. No one noticed the tiny size of the Icelandic regulatory agency and its high staff turnover. No one worried much that, because of Iceland’s obligations as a member of the EEA deposit insurance scheme, its population of 310 000 would be responsible for compensating the depositors abroad in the event of failure. Landsbanki’s shareholders reaped the short-term profits, while the general public in Iceland knew nothing about Icesave and the obligations it was imposing on them.
LOVE LETTERS The second ‘solution’ to difficulties in raising new funds was a way to get more access to liquidity without pledging real assets as collateral. The Big Three sold debt securities to smaller regional banks, which took these bonds to the Central Bank and borrowed against them, without having to supply further collateral; they then lent back to the initiating big bank. The bonds were called ‘love letters’ – mere promises. By participating in this game and
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accepting as collateral claims on other Icelandic banks the Central Bank was conniving in the banks’ strategy of gambling for resurrection. Then the banks internationalized the process: the Big Three established subsidiaries in Luxembourg and sold love letters to them. The subsidiaries sold them on to the Central Bank of Luxembourg or the European Central Bank and received cash in return, which they could pass back to the parent bank in Iceland or use themselves. The OECD calculates that just the domestic love letters, between the Central Bank and the Icelandic banks, incurred losses to the Central Bank and the treasury of 13 per cent of GDP (OECD, 2011).
THE FINANCIAL COLLAPSE AND POLITICAL RESPONSE The Icelandic banks fell two weeks after Lehman Brothers. On 29 September 2008, Glitnir approached Oddsson at the Central Bank for help with its looming liquidity problem. To restore confidence, Oddsson suggested that the treasury should buy 75 per cent of Glitnir’s shares. The effect was not to boost Glitnir but to undermine confidence in Iceland. The country’s rating plunged, and credit lines were withdrawn from Landsbanki and Kaupthing. A run on Icesave’s overseas branches began. On 6 October the Icelandic parliament passed emergency legislation that fenced Iceland’s banks off from foreign operators and guaranteed the savings of domestic depositors while excluding depositors in the banks’ foreign branches. Two days later the then UK Prime Minister, Gordon Brown, froze Landsbanki’s UK assets under the anti-terrorism laws. The stock market, bank bonds, house prices and average income went into free-fall, along with the currency. The IMF arrived in Reykjavik in October 2008 to prepare a crisismanagement programme, the first time the Fund had been called in to rescue a developed economy since Britain in 1976. It offered a conditional loan of $2.1bn to stabilize the króna and backed the British and Dutch governments’ demands that Iceland should honour the obligations of the European deposit-guarantee scheme and recompense them for their bailouts of Icesave depositors. Iceland’s normally placid population erupted in an angry protest movement, principally targeted at Haarde, Oddsson and the IP, and also at Gordon Brown and the British government for lumping Iceland in with terrorist states. Thousands of people assembled in Reykjavik’s main square on freezing Saturday afternoons between October 2008 and January 2009, banged saucepans, linked arms in a circle around the parliament building to
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The Iceland crisis 159 demand the government’s resignation, and pelted the building with food. The anger may help to explain why various measures of psychological stress, including admissions to emergency cardiac units, showed little increase in the weeks after the crisis among men (though there was a steep increase in such measures among women). In January 2009, the Independence Party–Social Democratic Alliance coalition broke (having been elected in May 2007). A new coalition of Social Democrats and Left Greens (SDA–LGM) was elected in April 2009. Remarkably, this was the first time since World War II that Iceland has had a left-wing government, which has been the standard governing power bloc in the other Nordic countries during this time. To date, Iceland is the only country to have shifted distinctly to the left after the financial crisis.
ICESAVE DEBT REJECTED The SDA–LGM government came under immediate pressure to repay the Icesave debt; much of the IMF loan was withheld until Reykjavik agreed. After long negotiations, the government presented the terms they had agreed on the Icesave debt to the parliament in October 2009: €5.5bn, or 50 per cent of Iceland’s GDP, was to be paid to the British and Dutch treasuries between 2016 and 2023 (a high but uncertain part of this would be recovered from the sale of the failed bank’s assets). The government forced the bill through parliament on 30 December 2009, against strong feeling in the country. On 5 January 2010 President Grímsson announced that he would not sign it into law, out of respect for the national sentiment. In the ensuing referendum (the second in the republic’s history) the bill was decisively rejected by 93 per cent of the voters. The British and Dutch negotiators put a new deal on the table, which the government put to a referendum in April 2011 and was rejected by 66 per cent of the voters. After the no vote, the disagreement has been taken to the European Free Trade Association Court. But in the meantime it seems that the failed bank’s assets, slowly being recovered, may cover more than 90 per cent of the outstanding principal. The Icesave debt is no longer a burning issue.
THE POSTPONED CRISIS The cost of losses on loans and guarantees, added to the cost of restructuring financial organizations, brings the total direct fiscal costs of the crisis to about 20 per cent of GDP, higher than in any other country except Ireland.7 But the postponement of major public spending cuts until 2011 gave the
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economy breathing space; and the sharp devaluation has helped to generate a trade surplus for the first time in many years (due mainly to import compression). As noted, the contraction of GDP stopped in late 2010 at 11 per cent down from the peak, and modest growth is expected for 2011 and 2012. The unemployment rate, only 2 per cent in 2006, has been between 7 per cent and 9 per cent since 2009. Inflation fell to around 3 per cent but rose to over 6 per cent by early 2012. Net public debt is manageable, net foreign debt stands at 65 per cent of GDP, far below Ireland’s 100 per cent. The fall in the króna by about 50 per cent (90 to the euro in early 2008 to 166 by late 2011) boosted the domestic profits of export firms. However, the average household has suffered a 30 per cent fall in purchasing power since 2008. The private sector remains heavily indebted, with household debt exceeding 200 per cent of disposable income and corporate debt over 200 per cent of GDP. Corporate investment is at its lowest share of GDP for many decades. In the name of fiscal consolidation the SDA–LGM government announced substantial cuts in public spending for 2011 and beyond, with the aim of generating an overall budget surplus (including interest payments) by 2013. Local governments now have no budget for fresh projects. Hospitals and schools are cutting salaries and putting employees on shorter hours. The freeze on house repossessions expired in 2010. Political resistance is rising. People say, ‘We have been in this crisis for three years. Surely we can’t be expected to take more cuts. This government is working for the financial sector and failing us’. In contrast, the big public spending slashers like Ireland, Estonia and Lithuania now have a worse economic situation to deal with than Iceland but an easier political one – because their governments cut deeply when the population was too shocked to resist. All things considered, the governments of Ireland and the Southern European countries would surely sooner face Iceland’s problems than their own.
FINANCE IN THE DRIVING SEAT Iceland is an extreme case of the financial sector taking over a national government and running it for its own advantage – while redistributing enough to other elites and the population at large for them to support it. As the boom continued over the 2000s a kind of Minsky effect occurred not only in banks and non-financial companies (which cut their cushions of reserves) but also in the public administration. The boom induced civil service complacency about the government’s regulatory role, a blurring of the government/business boundary, and de-bureaucratization in the conduct
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The Iceland crisis 161 of government business (meetings with no minutes, appointment of senior civil servants on the basis of one-on-one interviews with the minister with no one else present, and the like). The pre-existing ‘shadow elite’ had even more room to manoeuvre (Wedel, 2009). The IP–SDA government’s decision in 2008 to provide unlimited bank deposit guarantees to domestic savers illustrates its debt to the financial elite and the strength of financial corporatism. Had it limited the guarantee to 5m króna ($70 000), it would have protected the entire deposits of 95 per cent of depositors; only the wealthiest 5 per cent, including many politicians, benefited from the unlimited guarantee, which now means further constraints on public spending. Iceland’s tiny scale seemed to make it easier to challenge the government’s financial deregulation and then its denial of impending crisis, but the opposite was true. People close to the dominant political parties driving the financial project controlled the main media. Once the Oddsson government abolished the National Economic Institute in 2002, the banks, international rating companies and the Chamber of Commerce provided almost the only information and commentary on the state of the economy; in effect, the supply of relevant information was privatized. The powerful Confederation of Labour might have been a cautionary voice, but for decades it has been the co-manager, with the Federation of Employers, of the enormous pension funds (now equal to 130 per cent of GDP), and as such, inclined to favour people and policies promising high rates of return to assets. While the boom lasted it was all too willing to buy in to the bankers’ claims that Iceland had discovered a new sustainable growth model. In the wake of the crisis the government has driven through impressive reforms to the financial regulatory regime; but has so far managed to do little to make the public administration work in a more bureaucratic, less informal, less clientelistic way. Ministers and their senior civil servants continue to be relatively unconstrained. What has happened in Iceland since late 2008 illustrates in miniature the process of ratcheting down of mass living standards across the western world as the debt cushion is removed and as competition from the several billion workers, managers and entrepreneurs in developing countries now producing for western consumers renders current western living standards unviable. The ratcheting down is accompanied by disorientation and conflict between social groups as they fight to protect their own position. Income polarization will probably increase as the owners and senior managers of globalized capital, and others in the top few percentiles of the income distribution, further increase their share. The active distributional struggle will centre on who takes the biggest share of the losses – whether people in the middle and upper middle class (deciles 5 to 9) or in the lower
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class (deciles 1 to 4). If history is a guide, it will be the latter.8 But politics matters. In Iceland, one of the Social Democratic Alliance–Left Green Movement government’s striking achievements since 2008 is to ensure that the bottom half of the population has not so far taken a disproportionate hit. Yet the Independence Party, which presided over the bubble, has convinced a large part of the population that their troubles are due to the SDA–LGM coalition, and it will probably win the next election. Then we can expect the Special Prosecutor’s efforts to prosecute bankers (over one hundred cases are pending) to be halted for the sake of encouraging the bankers to deploy their talents to restore Iceland’s fortunes.9
NOTES *
1. 2. 3. 4.
5. 6.
7. 8. 9.
This paper builds on the authors’ articles ‘Iceland’s loud no’, Le Monde Diplomatique (English), August 2011; ‘Lessons from Iceland’, New Left Review, No. 65, Sept–Oct 2010, 5–29; and ‘Iceland’s meltdown: the rise and fall of international banking in the North Atlantic’, Real-world Economics Review, No. 56, February 2011. Speaking on Icelandic television, May 2008, reprised in the film Maybe I Should Have, directed by Gunnar Sigurdsson. The report was written at the start of 2008 for an Icelandic bank, which kept it confidential. Gissurarson is professor of political theory at the University of Iceland, and also affiliated with the Instituto Millenium, Rio de Janeiro and Friedrich-Nauman-Stiftung Institute, Sao Paulo. Mishkin and Herbertsson (2006). After the crash the title of this paper mysteriously changed to ‘Financial stability in Iceland’, as listed on his website: http://www0. gsb.columbia.edu/faculty/fmishkin/VITA.pdf; accessed 12 March 2012. Mishkin’s fee is given in the Wall Street Journal (2008a, 2008b). Portes and Baldursson (2007). Portes’s fee is given in SIC (2010). It is unclear to what extent Mishkin and Portes did not know how to recognize high financial fragility, and therefore took their fees under false pretenses, or to what extent they said what they said because they knew that their paymaster, the Chamber of Commerce with the banks behind it, hired them with a view to using their names to support a predetermined conclusion. In any case, those who say that academic economists have at most a minor role in such advisory situations should consider how Mishkin’s and Portes’s endorsements (they endorsed reports written by Icelandic economists hired by the Chamber) gave senior politicians justification to follow the wishes of the bankers and ignore the warnings of, among others, the Danish Bank, the IMF, Wade, Robert Aliber, and Willem Buiter and Ann Siebert, as well as several Icelandic economists. OECD (2011). The IMF says the OECD figure is a big underestimation. The total cost is more like 60 per cent of GDP, the amount by which public debt is estimated to rise over the medium term after the crash. See Palma (2011) and Wade (2011). On 23 April 2012 Geir Haarde, Finance Minister from 1998 to 2004 and then Prime Minister from 2006 to January 2009, was convicted by a special court. The special court, as stipulated in the constitution, is to try ministers for failure to discharge ministerial responsibilities, but it had never before been convened. The court judged that Haarde had
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The Iceland crisis 163 been grossly negligent in not bringing up the problems of the banks for cabinet discussion and decision in the months before October 2008. Haarde and members of the Independence Party vehemently and contemptuously rejected the judgment. However, the discussion around the court case brought out clearly the effects of Haarde’s neglect. First, he escaped pressure from fellow cabinet members to act. Second, he gave cabinet members an opportunity to claim ignorance and thereby escape political accountability. It is striking that the Prime Minister, having established in 2006 a co-ordinating group on financial stability entrusted with monitoring the banking system and planning in case of crisis (comprised of civil servants from the Prime Minister’s Office, the Central Bank, the FME, Ministry of Finance and Ministry of Economic Affairs), did not ask for and did not receive a briefing from this group, let alone a crisis-response plan, or at least there is no record of such. The Minister of Foreign Affairs and leader of the coalition party later claimed that she had forgotten that the group even existed. A third important effect is that by not acting even to involve other cabinet ministers, Haarde allowed the bubble to continue, which gave important people in the know ample time to get their own shares and deposits out of the banks and into other currencies before the bubble burst.
REFERENCES Buiter. W. and A. Sibert (2008), ‘The Icelandic banking crisis and what to do about it: the lender of last resort theory of optimal currency areas’, Centre for Economic Policy Research, Policy Insight No. 26, October. Danske Bank (2006), ‘Iceland: geyser crisis’, Copenhagen, available at http://www.mbl.is/ media/98/398.pdf; accessed 12 March 2012. Gissurarson, H. (2004), ‘Miracle on Iceland’, Wall Street Journal, New York, 29 January. IMF (2006), Staff Report: Iceland, 13 July, available at http://www.imf.org/external/pubs/ft/ scr/2006/cr06296.pdf; accessed 12 March 2012. Laffer, A. (2007), ‘Overheating is not dangerous’, Morgunblaðið, Reykjavik, 17 November. Mishkin, F. and T. Herbertsson (2006), ‘Financial stability in Iceland’, Iceland Chamber of Commerce, Reykjavik. OECD (2011), OECD Economic Surveys: Iceland, June. Olafsson, S.(2011), ‘Icelandic capitalism – from statism to neoliberalism and financial collapse’, in Lars Mjøset (ed.), The Nordic Varieties of Capitalism (Comparative Social Research, Volume 28), Emerald Group Publishing Limited, pp. 1–51. Olafsson, S. and A.S. Kristjánsson (2010), ‘Income inequality in a bubble economy: the case of Iceland 1992–2008’, paper presented at the Luxembourg Incomes Study Conference, 28–30 June, available at http://www.lisproject.org/conference/papers/olafssonkristjansson.pdf; accessed 12 March 2012. Palma, J.G. (2011), ‘Homogeneous middles vs. heterogeneous tails, and the end of the “inverted U”’, Development and Change, 42(1), 87–153. Pereira, L.C.B. (2010), Globalization and Competition: Why Some Emergent Countries Succeed While Others Fall Behind, Cambridge, UK: Cambridge University Press. Portes, R. and F.M. Baldursson (2007), The Internationalisation of Iceland’s Financial Sector, Iceland Chamber of Commerce, Reykjavik, available at http://www.vi.is/files/ 15921776Vid4WEB.pdf; accessed 12 March 2012. Special Investigation Commission (SIC) (2010), Special Investigation Report to Parliament, April. Thorhallsson, B. (2010), ‘The corporatist model and its value in understanding small European states in the neo-liberal world of the twenty-first century: the case of Iceland’, European Political Science, 9, 375–86.
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Wade, R. (2011), ‘Global trends in income distribution: what is happening, and should we worry?’, European Journal of Development Research, 23, 513–20. Wall Street Journal (2008a), ‘Mishkin resigns: a look back’, 28 May. Wall Street Journal (2008b), ‘Ex-Fed governor’s report on Iceland stability missed crisis’, 17 October. Wedel, J. (2009), Shadow Elite: How the World’s New Power Brokers Undermine Democracy, Government, and the Free Market, New York: Basic Books. World Database of Happiness (2006), available at worlddatabaseofhappiness.eur.nl; accessed 12 March 2012.
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23 International banking* Trevor Evans
Banking has a long international history. The first European banks emerged in Italy in the fourteenth century and were involved in financing trade across much of Europe. In the seventeenth century, when the focus of European commercial capitalism shifted briefly to the Netherlands, Italian banks moved to Amsterdam and, following the so-called Glorious Revolution in Britain in 1688, bankers followed the Orange King William to London, which established itself as the leading international financial centre in the eighteenth and nineteenth centuries, with banks predominantly providing finance for trade and sovereign debt (Arrigi, 1994, p. 13). After World War I, New York supplanted London as the principal international banking centre but, in the aftermath of the 1929 crash and subsequent banking crisis, the international economy largely collapsed into currency blocs and international banking was sharply curtailed. After World War II, the major capitalist countries all maintained controls on international capital flows and for many years international banking continued to be very limited. The re-emergence of international banking dates from the late 1960s when US banks began to open branches in Europe, in particular London. One reason for this was that big US industrial corporations, which had invested extensively in Canada in the 1950s, began to invest in Europe in the 1960s and the big US banks opened branches to serve their major customers in Europe. Another important factor was that in the mid-1960s the US government tightened controls on the outflow of capital from the country. Although the USA had a trade surplus at the time, this was greatly exceeded by the outflow of dollars, in particular for foreign direct investment and military spending. As a result, other governments had acquired large reserves of dollars and, under the terms of the Bretton Woods agreement, these could be redeemed in gold from the USA on request. Such foreign claims had come to exceed the USA’s gold reserves, and if many countries had demanded gold – as France did – the USA would have been unable to comply (Block, 1977; Parboni, 1981). The attempt to reduce the outflow of capital from the USA through tighter capital controls prompted big US banks to conduct their international lending in Europe. By making loans in dollars in Europe (so-called ‘euro-dollars’ or ‘xeno-dollars’) the US banks were able to circumvent the US controls, and they were also not subject to 165
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controls on lending in European currencies – especially in London where the authorities were keen to re-establish the city’s international status. International banking expanded rapidly in the 1970s (the number of US bank branches in London increased from eight in 1960 to 130 by 1980; Muzruchi and Davis, 2003). This was accompanied by the internationalization of the inter-bank money market and the growth of short-term capital flows between banks in different countries played a major role in bringing the Bretton Woods system to an end (BIS, 1983). At the end of the 1960s, speculation against the dollar mounted in the expectation that it would eventually have to be devalued, and in 1971 the US unilaterally ended its commitment to convert dollars into gold. Then in 1973, as the scale of international inter-bank flows increased, the system of pegged exchange rates that had been established in 1945 was allowed to collapse. Since 1973 the value of the currencies of the major capitalist states has been left to the foreign exchange markets, which have registered a massive expansion. International banks have been the greatest beneficiaries of the shift to flexible exchange rates. While industrial and commercial enterprises have been faced with either the risk of losses due to adverse movements in exchange rates or the additional cost of insuring against such losses, foreign exchange business has become a major source of profit for banks. According to tri-annual surveys conducted by the Bank for International Settlements, by 2007 the average daily turnover was equal 3.2 trillion dollars (BIS, 2007). This business is highly concentrated, with 75 per cent of turnover being accounted for by 12 banks in London (the largest market with 34 per cent of global turnover) and only ten banks in New York (the second largest with 16 per cent of global turnover). In the second half of the 1970s, international banks played a prominent role in intermediating large amounts of excess capital, leading to what became known as the Third World Debt Crisis in the 1980s. The first internationally synchronized recession since the 1930s occurred in 1974–75 and, as industrial and commercial companies in the advanced capitalist countries cut their investment in plant and equipment, the demand for finance from the banks’ corporate customers declined. At the same time, big banks received a large influx of deposits from oil-producing countries, flush with cash following the large rise in oil prices in 1973. The international banks responded by promoting a major expansion of lending to the governments of middle-income countries, notably in Latin America. As a number of the biggest banks rushed to expand this lending in the late 1970s, several developed a dangerously high level of exposure to larger countries like Mexico and Brazil. The crisis arose because the interest rate on the sovereign loans was set as a mark-up on US interest rates and, when US rates were sharply raised in the
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International banking 167 early 1980s, the borrowers were faced with a dramatic rise in the cost of servicing their foreign debt. At the same time the high US interest rates resulted in a prolonged international recession and a sharp fall in primary commodity prices – the main source of many of the debtor countries’ income. As first Mexico and then other Latin American countries were unable to meet their debt service payments, their governments turned to the International Monetary Fund for emergency loans. As a condition for providing such loans, the IMF insisted that governments impose harsh cuts in public spending. But, by enabling countries to meet their debt-service payments, several of the big international banks were rescued from the threat of bankruptcy. While US banks initially dominated the new phase of internationalization in the 1970s, a number of Japanese banks developed a major international presence in the 1980s, reflecting the success of the Japanese export-oriented model and the financial resources at the disposal of its largest banks. However, the expansion of Japanese banks was curtailed in the early 1990s when a major bubble in Japanese financial and property asset prices burst and, weighed down with non-performing loans, many banks were left technically bankrupt (the Japanese authorities did not require the banks to write down the value of bad loans on their books, most notably in the case of those associated with property). Japanese banks were also disadvantaged by the introduction of internationally agreed rules on minimum capital requirements (see below), which required them to curtail lending and build up their capital reserves, which had historically been lower than those of banks in the USA or Europe. In Europe, by contrast, following a wave of mergers around the turn of the new century, big banks have followed aggressively expansive policies and emerged as major international players (in the summer of 1999, six months after the introduction of the euro, the European Commission launched the Financial Services Action Plan, an ambitious series of 42 measures designed to promote a more competitive, integrated financial system in Europe, modelled very much on the US system; for details, see Frangakis, 2009, pp. 91–114). Indeed, in the first decade of the new century, international bank transactions were dominated by big US and European banks, with each becoming deeply embroiled in the economies of the other – much to the subsequent cost of European banks, who were inordinately hit by the 2007–08 financial crisis. The most recent development, reflecting the broader shift in global economic power, has been the inclusion of several Chinese institutions amongst the world’s largest banks. Nevertheless, their international activities remain restricted by the country’s continuing controls on international capital transactions.
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Since the 1980s, international banks have been involved in promoting a significant expansion of investment banking, advising and assisting international companies on raising capital by issuing securities and – increasingly – trading in securities on their own account. In the USA, a 1933 law that imposed a legal separation between commercial and investment banking was interpreted increasingly flexibly from the late 1980s, and formally repealed in 1999, allowing the re-emergence of giant financial conglomerates that spanned both activities. In the USA and Europe, big banks bought up investment banks in order to acquire the staff and their trading skills. Inexplicably, the regulatory authorities in many countries allowed the big banks to employ subsidiaries in the Caribbean or other offshore financial centres to shelter their investments and, in this way, circumvent national regulations (Spain, where the regulators could remember a serious banking crisis in the early 1980s, was one of the only countries that did not allow this). Investment banking activities contributed significantly to the profitability of big banks, which consistently obtained higher returns on their capital than other firms prior to the outbreak of the crisis in 2007. (For a discussion of how banks have been able to sustain higher than average profitability, see Crotty, 2007. In Europe, Joseph Ackerman, the head of Deutsche Bank, became notorious for his incessant drive to achieve a rate of return on capital of 25 per cent.) International banks have also been important players in the carry trade. This involves borrowing money in countries where interest rates are low and using the funds to acquire assets that pay a higher return in another country. These can range from Indonesian government bonds to financing Icelandic mortgages – at least before the collapse of the Icelandic financial system in 2008. The carry trade also played an important role in fuelling the emergence of a speculative bubble in primary commodity prices in 2008 (UNCTAD, 2009, pp. 53–84). Japan has been one of the major sources for borrowing because, in the aftermath of the crisis in the early 1990s, the central bank held its main interest rate close to zero for many years. After the Federal Reserve pushed US interest rates to almost zero following the near collapse of the financial system in 2008, the dollar also functioned as a source for such borrowing. However, the carry trade is widely considered to have contributed to increased exchange rate instability. The expectation that a currency will appreciate and lead to a potential loss can prompt a sudden unwinding of the loans and, as borrowers seek to repurchase large amounts of the currency involved, it can indeed lead to a sharp rise in the exchange rate. The growth of international banking since the 1970s has posed big challenges for regulators. In 1974, the German Bank Herstatt went bankrupt, having failed to make payments in NewYork for Deutsche marks it had
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International banking 169 received earlier in the day. The so-called Basel Committee was then set up under the auspices of the Bank for International Settlements to agree on international banking standards. The most important proposal of the Basel Accord, which was adopted in 1988, concerned the minimum amount of capital that international banks were required to hold as a cushion against any losses (the original proposal, Basel I, called for banks to hold capital equal to 8 per cent of their risk-adjusted assets, with the risk adjustment ranging from 0 per cent for government bonds issued by the developed capitalist countries, through several steps to 100 per cent for most loans to private firms and households). However, because tying up capital in this way cut into profitability, it prompted big banks to develop forms of business that did not require them to hold capital, including the expansion of investment banking activities. After several years of negotiation, a revised set of international regulations, known as Basel II, was published in 2004. Strongly promoted by the US Federal Reserve, these proposed that big banks would be allowed to use their own computer models to assess risk. Because this enabled risk to be more finely graded than under the original rules, it would allow big banks to hold relatively less capital (significantly, the proposals were not supported by the US Congress, since numerous smaller banks, which would have to continue using the older measures of risk, would be put at a disadvantage). These measures, which were introduced in the European Union in 2008, but were delayed in the USA, have been widely criticized for their potential to exacerbate crises. In particular, in a downturn when risk rises, higher capital requirements would worsen the situation by leading to a further tightening of credit. The major US and European international banks were centrally involved in originating and propagating the financial crisis that began in 2007. At the height of the crisis in late 2008, a chain of bank failures was only detained by the partial nationalization of a number of major international banks, including such well-known names as Citibank, Bank of America and JPMorgan Chase in the USA, and the Royal Bank of Scotland and HBOS in Britain. Because the banks occupied such a strategic financial position, nationally and internationally, governments considered they could not allow them to fail. The need for such massive intervention led to a widespread expectation that international regulation would be seriously strengthened. Initial discussion of what came to be known as Basel III did envisage a significant tightening of the rules regarding minimum capital requirements, both in terms of what could be counted as capital and the amount that banks would be required to hold. But, following massive lobbying by the banks, the proposals were then considerably diluted (according to Masters and Murphy, 2010, bankers succeeded in convincing
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regulators that the combined effect of the proposed measures would seriously depress economic growth). Many of the big international banks were once again posting large profits, benefiting from the unusually low central bank interest rates, and those that had survived had been able to increase their share of banking business. Mainstream economics has, for the most part, held a very uncritical view of international banking. Banks are seen as promoting the international intermediation of capital, ensuring that finance is made available where it can be most effectively employed; large-scale operations are viewed as enabling the banks to benefit from economies of scale and so to achieve greater efficiency; and a wider diversification of assets is thought to ensure that risk is managed more effectively than by institutions with a more local focus. The reality has been very different. Since international banking re-emerged in the 1970s, banks have displayed a herd-like tendency to rush from one type of business to another. Large sums have been made available for sovereign loans, for financing mergers or for investments in dubious mortgage-backed securities, with a sudden outflow of funds when each proved to have rested on a precarious basis. New forms of business have been developed, often prompted by the search for means of circumventing banking regulations. As a result big banks have increasingly relied for their profits, not on lending capital, but on investment banking activities, constructing and trading in securities whose complexity was often designed to obscure the risks involved. While banks have striven for ruthless efficiency in cutting certain costs, they have paid extraordinarily high salaries to large numbers of senior staff, drawing highly able people away from other branches of the economy. As regulations have been relaxed, and banks have operated with ever greater amounts of borrowed capital, they frequently generated returns that were much higher than those of non-financial companies. But, the much-lauded risk analysis, based on highly sophisticated computer models, proved at key moments to be founded on unrealistic assumptions, overlooking, for example, that adverse events might be correlated. As international banks have contributed to the integration of national financial systems, the business cycle has – as before World War II – become more tightly synchronized, so that downturns in different countries reinforce one another and thereby exacerbate the degree of disruption. When the big international banks have themselves been threatened with the risk of failure, national or even international authorities have felt obliged to intervene in order to order to ensure that the systemic impact would be limited. But each rescue emboldened the banks to yet further heights. In this way, while international banks have been appropriating an increasing share
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International banking 171 of the economic surplus, their activities have contributed to ever greater international financial instability.
NOTE *
This chapter draws partly on material in Evans (2009).
REFERENCES Arrigi, G. (1994), The Long Twentieth Century, London: Verso. BIS (1983), ‘The international inter-bank market: a descriptive study’, BIS Economic Papers, No. 8, Geneva: Bank for International Settlements. BIS (2007), Triennial Central Bank Survey of Foreign Exchange and Derivatives Market Activity, April. Block, F. (1977), The Origins of the Current Economic Disorder, Berkeley: University of California Press. Crotty, J. (2007), ‘If financial market competition is so intense, why are financial firms’ profits so high? Reflections on the current “golden age” of finance’, Political Economy Research Institute, University of Massachusetts Amherst, Working Paper No. 134. Evans, T. (2009), ‘International finance’, in John Grahl (ed.), Global Finance and Social Europe, Cheltenham, UK and Northampton, MA, USA, pp. 29–52. Frangakis, M. (2009), ‘EU financial market integration policy’, in John Grahl (ed.), Global Finance and Social Europe, Cheltenham, UK and Northampton, MA, USA: Edward Elgar. Masters, B. and M. Murphy (2010), ‘Suspense over’, Financial Times, 19 August. Muzruchi, M. and G. Davis (2003), ‘The globalization of American banking, 1962 to 1981’, in Frank Dobbin (ed.), The Sociology of the Economy, New York: Russell Sage. Parboni, R. (1981), The Dollar and Its Rivals, London: Verso. UNCTAD (2009), ‘The financialization of commodity markets’, Trade and Development Report 2009, Geneva: United Nations Conference on Trade and Development.
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24 International finance Jeff Powell
Over 40 years ago, Raymond Goldsmith (1969) developed the financial intermediation ratio to illustrate the steady increase in the ratio of financial assets to money income as a country becomes richer. He anticipated that financial assets would level off at somewhere less than double national income. In recent years, financial assets to GDP have reached as high as eight to ten times GDP, and finance now accounts for over 10 per cent of global economic output. This has led an increasing number of observers of all political stripes to ask again what finance is for.1
WHAT IS INTERNATIONAL FINANCE? One way to answer this question, admittedly banal and descriptive, is that international finance is that set of institutions, instruments and rules that are concerned with financial flows between countries (see Table 24.1). There are at least two obvious shortcomings to this approach. First is that all of these elements are variously evolving, merging, vanishing and/or proliferating. While a descriptive approach captures the outward appearances of international finance, it has nothing to say about its causes or its contribution to society. It leaves us running to stand still. Second is that, as various chapters in this handbook illustrate, there are intense debates over the functioning, nature and purpose of many of the components. Without a framework in which to situate them, the field of international finance must appear bewildering at best. Another way to answer this question might be to look at pedagogic reference points on the topic. Browsing through the most popular textbooks on international finance,2 a student might be forgiven for thinking that the subject was synonymous with exchange rate dynamics.3 Textbooks are split between those targeted at business students,4 which serve as corporate ‘how to’ manuals of international finance, and those for economics students, which share a lot in common with the favoured tomes of macroeconomics. In both cases, students of international finance are offered a fairly standardized menu of topics from which to choose: exchange rate determination, balance of payments and monetary policy in an open economy, the post-war international monetary system, and usually some discussion of capital flows 172
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International finance 173 and crisis. The underlying economics is generally ‘new consensus macro’ with a nod to behavioural economics thrown in to newer editions for good measure. The picture of international finance that emerges from these texts is piecemeal and its explanatory power feels unsatisfactory in light of the violent ruptures that students will have confronted in the real world. It is one thing to know that a complex phenomenon exists and to be able to describe its component parts. It is a step further to try to understand how pieces of this phenomenon operate (or, as is often the case, understanding how they do not operate). But what has become lost in the focus on increasingly sophisticated partial understandings is the broader analysis. What is international finance for and why is it the way that it is? The obligatory response to (and dismissal of) this naive question resorts to functional tautologies. International finance is surely a system that – in no particular order – manages risk, facilitates international payments, finances trade and investment, funds broader development, and so on. However, implicit in such responses are assumptions that these objectives are mutually complementary; that the institutional structure of international finance has arisen as a response to these needs; and that international finance actually does these things effectively and efficiently. Beyond these challenges lies the fact that international finance is implicated in many phenomena that run counter to human development. One needs only to think of its role in tax evasion, the drug trade, and war, for example. Even leaving aside such obvious perversions, what should we make of the role of international finance in facilitating capital flows from poor countries to rich ones; rising instability; yawning inequality within and between nations; and the funding of environmental ruin?
FINANCE AS EPHOR OR PASSIVE? Post-war attempts to understand the raison d’être of finance were understandably focused at the domestic level and pivoted on the role of banks. Gerschenkron’s ‘timing of industrialization’ thesis (1962), which argued that a successful financial system needed to respond to the ‘backwardness’ of the economy in order to facilitate industrialization, was for a long time influential. Catch-up economies such as Germany had required universal banks that could direct credit to industrial development. More ‘backward’ economies such as Russia required state intervention in the financial system to accomplish the same. Schumpeter similarly placed great importance on financial systems in the process of creative destruction, which he saw as the driving force of capitalism: ‘“credit creation” is the monetary complement of innovation’
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Table 24.1 A snapshot of the thicket of international finance Institutions
Instruments
Regulatory Bodies and Rules
Grants, loans
IMF and World Bank
Securities, derivatives Export-credit guarantees
G8, G20, OECD-DAC Monterrey Consensus
Investment guarantees
Declarations on aid effectiveness Paris Club, HIPC
Public flows Bilateral development agencies Export-credit agencies Multilateral development banks Central banks and finance ministries Bond markets Credit rating agencies
Santiago Principles on SWFs
Sovereign wealth funds (SWFs) Private flows International banks
Loans, trade credit
Non-bank financial intermediaries Corporations
Securities
Stock exchanges Credit rating agencies Export-credit agencies Investment promotion authorities Offshore centres
Derivatives Guarantees Remittances Microfinance
IMF, BIS, FSB, BCBS, CPSS, WTO-GATS IAIS
Equities
IASB-IFRS, ICSID, UNCITRAL IOSCO Regional bodies (esp. EU) National bodies (esp. US)
Private foundations, NGOs Note: FSB = Financial Stability Board; BCBS = Basel Committee on Banking Supervision; CPSS = Committee on Payment and Settlement Systems; HIPC = Highly Indebted Poor Countries; IAIS = International Association of Insurance Supervisors; IASB-IFRS = International Accounting Standards Board-International Financial Reporting Standards Foundation; ICSID = International Centre for the Settlement of Investment Disputes; IOSCO = International Organization of Securities Commissions; OECD-DAC = Organisation for Economic Co-operation and Development-Development Assistance Committee; UNCITRAL = United Nations Commission on International Trade Law; WTO-GATS = World Trade Organization-General Agreement on Trade in Services.
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International finance 175 (1964, p. 85). Banks act as the ephor (‘one who oversees’) of an economy, reducing the purchasing power of existing funds that are with old firms, while creating new funds that are put at the disposal of new firms set up by ‘new men’ (Schumpeter [1912] 1934). Against Gerschenkron, Schumpeter believed that due to their ‘critical, checking role’ banks needed to be independent of both the industry that they funded, and of politics more generally. Later scholars kept the central role for financial systems in all their increasing diversity, but placed their evolution within the structural characteristics of a particular economy (Goldsmith, 1969; Cameron, 1972). Differing laws, regulations and customs might mean that different financial systems are appropriate at various stages of development. This led them to investigate the impact of issues such as the size of the financial system relative to the economy, the demand for financial services, and the attitudes of authorities and elites toward finance. This line of investigation was cut short by the neoliberal turn. There had always been a recurring thread running through a variety of economic schools of thought (Coase, Rostow, Robinson) that said that financial institutions do not matter greatly; instead they respond passively to the needs of the market as determined through the forces of demand and supply. The dominant analysis in the 1970s began to emphasize the function of finance as an intermediary between rational, utility-maximizing savers and investors. Efficiency in this role was therefore paramount, and eliminating so-called ‘financial repression’5 became the overriding obsession (McKinnon, 1973; Shaw, 1973; Fry, 1988). With the state out of the way, increasing the size of a financial system (modelled after the Anglo-Saxon marketbased archetype) relative to the economy – so-called ‘financial deepening’ – was increasingly accepted as a sine qua non of economic growth. The special role of the banking system in determining the money supply was to be regulated by an independent central bank with inflation control as its sole objective. Any allocative role of institutions other than an idealized invisible hand was to be stamped out. It was at this point and with this understanding that the post-war expansion of international finance gathered pace. Proponents of the new international economic order, seeking to avoid foreign capital exploitation of their resources, clung to the then passé understanding that domestic financial systems could be used to fund and direct development. In contrast, the World Bank’s influential Pearson Report stated that: ‘most low-income countries would welcome a larger flow of foreign investment, sharing our belief that such plans could contribute to faster growth’ (1969, p. 105). To facilitate this foreign investment, the Report recommended that governments offer investment incentives, and remove balance-of-payment restrictions and other
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barriers to the free entry of private capital.6 A few years after the Report’s publication, as the US abandonment of the gold standard led to skyrocketing interest rates, countries would be converted by hook or by crook to this view.
INTERNATIONAL FINANCE, IMPERIALISM, FINANCIALIZATION What the neoliberal turn obscured was a long history of scholarship that interpreted the raison d’être of international finance through the lens of political economy, and particularly through the study of imperialism. For the liberal school, imperialism is a product of pre-capitalist elements (Brown, 1974). Schumpeter (1951) believed that this residual imperialism resulted not from capitalism, but from the monopoly form of capitalism that served the interests of an alliance of high finance and industrial cartels. In contrast, both Keynesians and Marxists saw contemporary imperialism as a way of overcoming the problems inherent in capitalism. For Keynesians, under conditions of profound uncertainty, there is a chronic tendency for the inducement to invest to be weak. Foreign trade and colonialism can stir the animal spirits and ensure a captive market for the output of imperial producers. For Marxists, while there is disagreement over the specification of the causes of capitalist crises and the strength of countervailing tendencies, imperialism is an inevitable byproduct of the leading powers’ drive to expand the process of capital accumulation.7 In both of the latter schools, international finance plays an active role, though Marxist writers have dominated its discussion. Luxemburg (1973) described an ambiguous role for international lending in both funding capitalist development in ‘backward’ states, but also reducing these same states to servitude. Her thinking was influential on later writers in the dependency school. Bukharin (1966) exemplified the more conventional Marxist view that capital export would accelerate development in underdeveloped areas. His theory of imperialism pivoted on the notion of blocs of finance capital taking on a national character, and then military and political rivalry developing between these national blocs. Hilferding (1981) took the opposite view; finance capital, an amalgam of industrial capital under the control of bank capital, would bring about a stabilization of capitalism. Advanced finance capital countries (Germany) would then export capital by direct investment, while less advanced countries (USA, UK) would do so by portfolio investment. The point of drawing attention to these debates is not to evaluate their merit. Instead, note how different their implications are for understandings, not of the transitory outward appearances and functioning of international
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International finance 177 finance, but of the questions of why finance is the way that it is and what it is for. Contemporary scholarship captured under the heading of ‘financialization’8 picks up this thread. The term financialization itself denotes a critical view of the potential costs and benefits of the growth of the financial sector and its penetration into all facets of life. Crudely put, post-Keynesian scholars view financialization as a problem resulting from the rising political influence of the rentier (Epstein, 2005). Marxist writers set this analysis on its head. Financialization is an answer, albeit an unsustainable one, to underlying crises in the material process of accumulation (Sweezy and Magdoff, 1987; Arrighi, 1994; Brenner, 2003). What is common to both understandings is a critical assessment of the role of international finance in the process of capital accumulation. This distinguishes the financialization literature from the earlier body of work on finance and imperialism. For the latter, international finance may have been dysfunctional for the colonies, but was a servant of the accumulation process of the imperial powers. One of the most important contributions of the financialization literature is that it has brought to the fore questions about what international finance is for and whose interests it serves.9
WHITHER INTERNATIONAL FINANCE? The contemporary growth of international finance has accompanied the rise of neoliberal theory. This asserted that international finance, once freed of the restraints of political intervention, would respond efficiently to the productive needs of an increasingly global marketplace. The task of policymakers and students of international finance alike was to analyse the operations of an idealized open macroeconomy, and take appropriate actions to facilitate private investment within a proscribed set of policy options. But, as recent events have borne witness, finance is neither passive nor functional when left to its own devices. The ideological battle over the functions of international finance has determined institutional choices and distributional outcomes. Understanding these developments demands that students of international finance are able to place them within a political economy framework. Undoubtedly this raises many complex issues that are challenging to translate into textbook presentation. But the contrary risk is that another generation of students is able to navigate the finer points of monetary policy using the IS-LM-BP model without a clue why finance thrives while productivity languishes.
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NOTES 1.
2.
3.
4. 5.
6.
7.
8.
9.
Two of the most famous such episodes of soul-searching came from the UK’s former head of the Financial Services Authority, Lord Adair Turner, who described much of the financial innovation of the last decade as ‘socially useless’, and from former head of the US Federal Reserve, Paul Volcker, who challenged students to justify the value-added of the financial sector in the last 20 years. An unscientific survey of textbooks in international finance yields fairly consistent results. Search for the words ‘international finance’ + ‘textbook’ using Google Books, Google Scholar or various electronic databases, flags up such works as International Finance, by Maurice Levi (2005); International Finance, by Ephraim Clark (2002); International Finance: Theory into Practice, by Piet Sercu (2009); International Finance and Open-Economy Macroeconomics, by Giancarlo Gandolfo; and Exchange Rates and International Finance, by Laurence Copeland (2008). Such a student might be especially frustrated after finding out in the conclusion to Copeland’s seminal text devoted to the issue of exchange rates that, in the end, ‘we don’t know very much about them’. Exemplars of this are Sercu’s (2009) ‘CFO Summaries’ at the end of each chapter – see note 2 above. A term used to denote a whole series of measures including capital controls, restrictions on entry to the financial sector, government ownership of banks, the use of directed credit (say to agriculture or SMEs), interest rate ceilings, and so on. If one theme were to be chosen to characterize the work of the World Bank in the 40 years since the Pearson Report, it would be the facilitation of a ‘good investment climate’ for foreign investment (see, for example, Van Waeyenberge, 2009). Again, there was disagreement over whether this drive would lead to Bukharin and Lenin’s war between imperial powers or Kautsky’s ‘ultra-imperialism’ with a division of the proceeds of the imperial project. Financialization has been variously defined to include any of the following (Fine, 2011, p. 2): ‘the phenomenal expansion of financial assets relative to real activity; the proliferation of different types of assets; the absolute and relative expansion of speculative as opposed to real investment; a shift in the balance of productive to financial imperatives within the private sector whether financial or not; increasing inequality in income arising out of the weight of financial rewards; consumer-led booms based on credit; the penetration of finance into ever more areas of economic and social life such as pensions, education, health and provision of economic and social infrastructure’. Perhaps one of the weaknesses of some of the financialization literature is its failure to grapple with the institutional specificities of finance and their impact on differing paths of accumulation. An exception to this is the work of the RMF group on the distinctive role of banks in the process of financialization (www.researchonmoneyandfinance.org).
REFERENCES Arrighi, G. (1994), The Long Twentieth Century, London: Verso. Brenner, R. (2003), The Boom and the Bubble, London: Verso. Brown, M.B. (1974), The Economics of Imperialism, Harmondsworth: Penguin Books Ltd. Bukharin, N. (1966), Imperialism and World Economy, New York: H. Fertig. Cameron, R. (ed.) (1972), Banking and Economic Development: Some Lessons of History, New York: Oxford University Press.
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International finance 179 Epstein, G. (2005), Financialization and the World Economy, Cheltenham, UK and Northampton, MA, USA: Edward Elgar. Fine, Ben (2011), ‘The state and developmentalism in the twenty-first century’, in ‘The role of governments for economic development in the 21st century’ workshop paper, 16 February 2011, Tokyo. p. 2, available at: http://eprints.soas.ac.uk/11594/; accessed 13 March 2012. Fry, M. (1988), Money, Interest and Banking in Economic Development, Baltimore: Johns Hopkins University Press. Gerschenkron, A. (1962), Economic Backwardness in Historical Perspective, Cambridge, MA: The Belknap Press of Harvard University Press. Goldsmith, R.W. (1969), Financial Structure and Development, New Haven, CT: Yale University Press. Hilferding, R. (1981), Finance Capital, London: Routledge. Luxemburg, R. (1973), The Accumulation of Capital: An Anti-Critique, New York: Monthly Review Press. McKinnon, R.I. (1973), Money and Capital in Economic Development, Washington, DC: The Brookings Institution. Pearson, L.B. (ed.) (1969), Partners in Development: Report of the Commission on International Development, London: Pall Mall Press. Schumpeter, J.A. ([1912] 1934), The Theory of Economic Development, Cambridge, MA: Harvard University Press. Schumpeter, J.A. (1951), Imperialism and Social Classes, Oxford: Basil Blackwell. Schumpeter, J.A. (1964), Business Cycles: A Theoretical, Historical and Statistical Analysis of the Capitalist Process, New York: McGraw Hill. Shaw, E. (1973), Financial Deepening in Economic Development, New York: Oxford University Press. Sweezy, P. and H. Magdoff (1987), Stagnation and the Financial Explosion, New York: Monthly Review Press. Van Waeyenberge (2009), ‘Selectivity at work: country policy and institutional assessments at the World Bank’, European Journal of Development Research, 21(5), 792–810.
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25 Islamic banking Ewa Karwowski
Islamic banking refers to banking practice that is in line with Muslim written and unwritten law, the Sharia. Generally, three main differences between mainstream and Islamic banking are observed (Khan and Mirakhor, 1992; Dhumale and Sapcanin, 2004): (1) interest rate payments are prohibited in Islamic banking transactions; and (2) so are collateral requirements; (3) a compulsory charitable tax, zakat, must be paid on profits. While the last point is not unfamiliar to Western bankers because of ethical banking practices, interest- and collateral-free banking seems incompatible with mainstream financial instruments and underlying economic models. Conventional economic theory often uses the concept of asymmetric information to explain the need for collateral and interest rates in bank lending (Bernanke and Gertler, 1989). The idea is that the bank has limited information as to what its client intends to do with the borrowed money, whereas the debtor has perfect knowledge of this. According to asymmetric information models, collateral and interest payments prevent the abuse of credit penalizing the borrower if they are unable to service their debt on time. Hence, collateral- and interest-free banking is difficult, if not impossible, to understand using this framework. Interest and collateral are prohibited according to Islamic law since in the case of consumption credit they exploit the needy and in the case of investment credit they transfer entrepreneurial risk entirely to the borrower. Financier profit purely derived from the possession of money without sharing the investment risk or entrepreneurial effort – such as interest income – is perceived as immoral and destabilizing to the economic system. The moral dimension of Islamic economics distinguishes it essentially from mainstream economics and is the discipline’s raison d’être (Chapra, 2006). Conceptually the distinction is made through the homo Islamicus as opposed to the homo economicus. Mainstream economics uses the homo economicus to stress the point that all economic frictions or crises can be traced back to missing or asymmetric information. The homo economicus is typically a self-interested profit-maximizing agent without moral consideration, in contrast to the homo Islamicus who is guided by commonly shared Islamic values in his or her decisions. While the homo economicus causes informational asymmetries leading in their extreme to crisis, the morality of 180
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Islamic banking 181 the homo Islamicus solves the asymmetric information problem, eliminating frictions and leading to a self-equilibrating market similar to a setting à la Arrow and Debreu. Proponents of Islamic banking claim that interest-free banking is superior to conventional banking, because, based on the morality of the homo Islamicus, it has a developmental character and most importantly it is inherently stable. Islamic finance is perceived to be developmental since more credit can be extended at a lower cost in the Arrow–Debreu-like situation than with informational imperfections. Borrower and lender face less risk because of commonly shared moral values, resulting in mutually aligned interests. Hence, borrowers are willing to invest more while lenders are willing to grant more credit. According to Islamic scholars, credit extension should primarily take place to finance productive investment (Chapra, 2000). They share this belief with mainstream economic models where firms are the typical ‘borrower-spenders’. So-called primary modes of finance or profitand-loss sharing (PLS) agreements are the preferred structure for Islamic financial transactions. They strongly resemble joint venture arrangements where the financial partner is either passive with no direct influence on the investment project (mudharabah) or active with certain decision rights (musyarakah). In PLS arrangements no interest is paid or received. Instead, profit (or loss) is shared at a predetermined ratio between the depositor and the bank on the supply side and between the bank and the credit recipient on the demand side. The intermediation of the Islamic bank means that risk, mainly in the form of loss sharing, is passed on from the borrower through the bank to the depositor. The absence of a predetermined interest rate combined with the belief that banks channel credit mainly towards productive investment makes Islamic banking incompatible with mainstream economic thinking because the loanable funds theory cannot apply. In practice, PLS agreements make up a marginal and decreasing fraction of overall Islamic banking transactions in major Islamic banking markets (Siddiqui, 2008; Chong and Liu, 2009). Secondary modes of finance constitute the bulk of Islamic credit although they are not ‘truly Islamic’ because of their debt-like character and missing emphasis on productive investment (Aggarwal and Yousef, 1996). They are essentially mark-up pricing or leasing arrangements mostly used for consumption credit. Consequently, it can be argued that in practice they involve collateral since the goods purchased on credit remain on the bank’s balance sheet until the debt is repaid. According to Islamic law, credit servicing and repayment takes place in the form of predetermined absolute amounts independent of the credit period. In practice, it is difficult to imagine that the mark-up does not implicitly account for conventional interest rates. In fact in Malaysia, one of the biggest Islamic financial markets, payments on Islamic mortgages
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explicitly depend on the Central Bank’s interest rate to ensure the competitiveness of Islamic banks vis-à-vis conventional banks (Endut and Hua, 2009). It is also often argued that Islamic banking mobilizes savings of Muslim households not using conventional saving accounts because of their noncompliance with Muslim law. Increased savings ultimately leads to a higher investment rate and accelerated development. This argument is based on two over-simplified economic concepts: the loanable funds theory and the hydraulic savings–investment mechanism. The loanable funds theory assumes the price and extension of credit is solely dependent on the supply of funds treating money and credit like any other commodity in the general equilibrium framework. This concept overlooks that credit is typically endogenous to the economic system, crucially dependent on credit demand and the willingness of banks to extend it (Keynes, 1930). Furthermore, savings are assumed to convert automatically into (cheaper) credit, which in turn transforms into investment. Mainstream thinking – both conventional and Islamic – ignores that investment causes savings and not vice versa. Hence, an increase in savings will not necessarily result in more investment. Since it is questionable whether Islamic banking provides better credit conditions to borrowers or generates more investment than conventional banking, its claim to be developmental – particularly more developmental than conventional finance – is unconvincing. The single biggest preoccupation of Islamic economics is economic and financial stability. Islamic banking is claimed to be inherently stable and consequently more stable than conventional banking. The most salient microeconomic arguments supporting this claim evolve around banks’ liquidity risk and lending practices. Macroeconomic considerations address the adverse impact of interest rates on price volatility, entrepreneurial debt, production, full employment and the distribution of income. Because investors share equally in profit and loss Islamic banks are arguably more ‘run-proof’ than conventional banks contributing to systemic stability (Lewis and Algaoud, 2001). If the bank has a temporary liquidity problem, rather than a permanent solvency problem, investors might be more inclined to maintain their investment position. In theory instant withdrawal would aggravate the problem and result in loss while waiting would restore liquidity and increase profitability as long as the bank is sound in terms of solvency. In practice, Islamic banks do not operate in isolation and a simple shortfall in Islamic investment return relative to conventional interest might suffice to result in investors withdrawing funds. This outcome is even more likely since conventional banks have access to Islamic investment opportunities while Islamic banks are limited to assetbacked investment according to the Sharia. Maybe surprisingly, Islamic
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Islamic banking 183 investment accounts can be dissolved on relatively short notice (often of one month), making withdrawal a viable option. Surveys show that it is questionable whether religious consideration would prevent an actual homo Islamicus from investing in conventional finance (Dar and Presley, 1999). Because of the required focus on primary modes of finance Islamic banks are arguably required to gather more information on their borrowers than conventional banks and therefore make more prudent lending decisions given the absence of collateral requirements (Lewis and Algaoud, 2001). Since such a business model is increasingly costly with growing size, smaller Islamic banks should be more profitable than larger ones. A recent IMF study (Cihak and Hesse, 2008) appears to confirm this assumption, showing that small Islamic banks are in fact more stable than small conventional ones.Yet, smaller banks are more exposed to idiosyncratic risk than big ones since they cannot diversify their investment as effectively. Furthermore, large banks are more likely to enjoy government support during crisis, especially if they are too big to fail. The results of the IMF study have to be treated with scrutiny especially since the panel data methodology used seems more than dubious and the majority of the results are in fact statistically insignificant. From a macroeconomic perspective, the replacement of interest through a variable Islamic profit rate is claimed to increase stability since misalignments between the real rate of interest, equalizing demand and supply of loanable funds, and the bank rate of interest will be eliminated (Khan, 1985). The concept of a real rate of interest can be traced back to Wicksell (1907) who believed that a persistent misalignment, all other things being equal, would lead to volatility of the price level in the economy. Replacing interest with a profit rate would then reduce this volatility.Yet, Wicksell also believed in the self-equilibrating market equalizing the banks’ lending rate with the real interest rate if a discrepancy between the two occurs. Therefore, the profit and the interest rate should be identical in theory and economic stability ensured at any time regardless of the rate. In dynamically growing economies bank interest is observed to be below the real interest level, since credit demand exceeds supply (Hayek, 1929). Therefore, Wicksell’s critics such as Hayek argue that instability does not originate from the existence of interest but is rather generated through the credit cycle, the expansion and subsequent contraction of credit endogenous to the system (ibid.). As a consequence, some Islamic scholars demand the prohibition of credit and the establishment of a banking system based on 100 per cent reserves (Choudhury and Hoque, 2004). But the majority of Islamic scholars advocate fractional-reserves banking, acknowledging that credit extension can stabilize the economic system as it serves to offset the leakage
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of household saving that results in under-consumption (Siddiqi, 1983; Khan, 1985). Keynes’s concept of the marginal efficiency of capital is another concept used to support the case against interest rates: ‘The money rate of interest by setting the pace for all the other commodity rates of interest, holds back investment in the production of these other commodities without being capable of stimulating investment for the production of money, which by hypothesis cannot be produced’ (Keynes, 1936, p. 235). To free up investment, money interest merely has to be forbidden and replaced by profit rates (Ahmad, 1952). Yet, Keynes defined interest as the output an asset produces minus its carrying cost and plus its liquidity premium. Money is the only asset for which the liquidity premium exceeds the carrying cost. Therefore, the profit rate cannot replace the liquidity premium of money. PLS agreements would transfer the liquidity premium from the depositor to the bank and then possibly to the borrower. Under certain conditions – such as in the liquidity trap – this could deter depositors from investing their funds in PLS arrangements, exacerbating existing instability. Following arguments of Western economists such as Hobson (1910), Islamic economists warn that increasing levels of income inequality are destabilizing for the economic system (Ahmad, 1952). Arguably, interest transfers purchasing power from the debtor to the creditor. By definition the latter has a lower propensity to consume than the former. If the creditor is simultaneously an entrepreneur he or she will invest interest income into production. Hence, while demand decreases because of shrinking disposable income of those willing to consume, production is increasing since entrepreneurs’ income increases through interest receipts. Nevertheless, a systemic explanation as to why Islamic banking using the profit rate should prevent inequality is lacking. Links to more recent Western theory of financial instability such as Minsky’s financial instability hypothesis (FIH) have been encouraged but have been little explored by Islamic economics. In the FIH, interest rates tend to increase over the business cycle with the result that firms’ debt servicing exceeds their income at the peak of the cycle. At that point firms have to downscale investment to meet repayment costs, economic activity slows dramatically and the economy moves into a recession. Although PLS agreements might in theory decrease the risk of an interest-rate-induced downswing, in practice PLS agreements are a marginal phenomenon even in Islamic banking. More importantly, Minsky perceived the ability of financial markets to innovate to circumvent regulation as a very powerful source of financial instability (Minsky, 1986). Islamic banking shows a
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Islamic banking 185 strong drive towards financial innovation, turning transactions that appear non-compliant with the Sharia into Islamic products. Hence, Islamic finance behaves very similarly to conventional finance and there is little evidence of its superiority.
REFERENCES Aggarwal, R.K. and T. Yousef (1996), ‘Islamic banks and investment financing’, Social Science Research Network paper. Ahamad, Shaikh M. (1952), Economics of Islam, Lahore: Ashraf Press. Bernanke, B.S. and M. Gertler (1989), ‘Agency costs, net worth, and business fluctuations’, The American Economic Review, 79(1), 14–31. Chapra, M.U. (2000), The Future of Economics, An Islamic Perspective, United Kingdom: The Islamic Foundation. Chapra, M.U. (2006), ‘Why has Islam prohibited interest? Rationale behind the prohibition of interest’, in Abdulkader Thomas (ed.), Interest in Islamic Economics, London: Routledge. Chong, B.S. and M.H. Liu (2009), ‘Islamic banking: interest-free or interest-based?’, Pacific-Basin Finance Journal, 17(1), 125–44. Choudhury, M.A. and M.Z. Hoque (2004), An Advanced Exposition of Islamic Economics and Finance, Lampeter: The Edwin Mellen Press. Cihak, M. and H. Hesse (2008), ‘Islamic banks and financial stability: an empirical analysis’, IMF Working Paper, Washington, DC: International Monetary Fund. Dar, H.A. and J.R. Presley (1999), ‘Islamic finance: a western perspective’, International Journal of Islamic Financial Services, 1(1), 1–14. Dhumale, R. and A. Sapcanin (2004), ‘An application of Islamic banking principles to microfinance’, Technical Note, Study by the Regional Bureau for Arab States, Washington, DC: United Nations Development Programme in Cooperation with the World Bank. Endut, N. and T.G. Hua (2009), ‘Household debt in Malaysia’, BIS Papers, No. 46, 1–32. Hayek, F.A. (1929), Geldtheorie und Konjunkturtheorie, Wien: Hölder-Pichler-Tempsky A.G. Hobson, J.A. (1910), The Industrial System, London: Longman. Keynes, J.M. (1930), The Treatise on Money, London: Macmillan. Keynes, J.M. (1936), The General Theory of Employment, Interest and Money, London: Macmillan. Khan, M.S. and A. Mirakhor (1992), ‘Islamic banking’, in The New Palgrave Dictionary of Money and Finance, London: Macmillan Press. Khan, W.M. (1985), Towards an Interest-Free Islamic Economic System, A Theoretical Analysis of Prohibiting Debt Finance, Leicester/Islamabad: The Islamic Foundation/The International Association for Islamic Economics. Lewis, M.K. and L.M. Algaoud (2001), Islamic Banking, Cheltenham, UK and Northampton, MA, USA: Edward Elgar. Minsky, H.P. (1986), Stabilizing an Unstable Economy, New Haven, CT: Yale University Press. Siddiqi, M.N. (1983), Banking Without Interest, Leicester: The Islamic Foundation.
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Siddiqui, S.A. (2008), ‘An evaluation of research on monetary policy and stability of the Islamic economic system’, The Ghair Soodi Bankari 7th International Conference in Islamic Economics, 1–3 April, Conference Papers, pp. 235–70. Wicksell, Knut (1907), ‘The influence of the rate of interest on prices’, The Economic Journal, 17(66), 213–20.
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26 John Maynard Keynes Michael S. Lawlor
John Maynard Keynes was born in Cambridge, England, in 1883. He was raised in an orthodox, but academic, ‘Late Victorian’ household (Cockshut, 1964). From this upbringing, his later biographers noted (Harrod, 1951; Skidelsky, 1983, 1992, 2000; Moggridge, 1992), Keynes was imbued with an enduring sense of duty toward British society and also with the values of free-ranging academic curiosity. His father was a member of Alfred Marshall’s faculty in the Economics Department at Cambridge University, then the centre of English language economic thought. Keynes was later to observe that he had literally grown up alongside the composition of Marshall’s Principles of Economics (Marshall [1920] 1962; Keynes, 1925; Groenewegen, 1995). Keynes was educated at Eton and King’s College, Cambridge. He matriculated at Cambridge in 1902, graduated in 1905, stayed on one year as a postgraduate student, during which time he took economics courses from Alfred Marshall and from other economists. This was the extent of his formal economic training. Yet, he quickly assumed editorship of the Economic Journal, then the premier economics forum in the English-speaking world. He also became a Fellow at King’s College, Cambridge in 1909. He was to remain a loyal Fellow of his college, always devoted to serving it for the rest of his life despite significant other activities and duties. It is important to note that Keynes’s early interest at Cambridge was in philosophy and statistics, not in economics. The culmination of his philosophical work in this area is contained in an abstract way in his book A Treatise on Probability (1921). But other activities of a more practical nature also shaped Keynes’s unique and evolving views of rational action and of economics. These activities more directly led to his influential ideas on the basic nature, economic function and social utility of speculation. It is this aspect of his life’s work that is most relevant to ideas in critical finance. Keynes was unusual in having direct, personal experience of both the theory of economics and the business of trading on financial markets. His training, teaching and research were mainly in the area of ‘monetary’ economics. Keynes’s trading (for his own account, those of his friends and his college), his experience as an investment advisor to large insurance companies and his role as a civil servant to the British government, particularly his service in the Treasury during World War I and his role as 187
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the chief Treasury representative to the Versailles Peace Conference, brought him into close contact with individuals from, and the characteristic behaviour of, England’s financial epicentre, the City of London. He applied this personal knowledge of speculation to his economic theorizing and he applied his knowledge of economics to his financial dealings. Both improved from this reciprocal interaction (Davenport, 1974, p. 50). Keynes’s views on speculation and monetary theory are usefully divided into three distinct periods, each period corresponding to his different phases of trading experience (Lawlor, 2006, Part II). The first period stretches from 1909 to 1914. It roughly covers the time period from when Keynes began teaching at Cambridge until he entered the British Treasury, where he took a leading part in the Allied effort to finance World War I. During this time period, Keynes was heavily burdened with both lecturing and tutoring. Also during this time, Keynes held and taught what were predominantly orthodox views concerning the role and function of money and speculation. Most of these orthodox ideas he derived from the writings of John Stuart Mill and Alfred Marshall. Nevertheless, what is unique, and worth noting, from Keynes’s earliest conceptualization of speculation is that, even in this period, he analysed speculation from the standpoint of his personal theory of probability. This was a theory that did not conceive of all probable events as ‘frequency’ outcomes from a ‘random’ and ‘repeatable’ experimental situation as is common in financial theory today. We are today interested in Keynes’s evolving views of financial markets precisely because Keynes’s ideas are based on a conception of probability that is so at odds with the theory of probability that undergirds so much of modern ‘finance’ theory and practice. In Keynes’s probability theory, the definition of probability is as the measurement of the rational ‘degree of belief’ with which one holds a proposition, given the available information on the subject of that proposition and relative to the desired information that would be needed to hold that proposition with certainty. At this early stage Keynes concluded that orthodox economics and his theory of ‘practical reason’ implied that financial markets provided a useful social function. Thus Keynes’s earliest financial market view was that the activity of speculation should be viewed as benign. The economic and social function of speculators, in this view, a common one in economics then and now, was that speculation represented specialization in the carrying of risk and that this risk-carrying specialization was a service that other economics actors were prepared to pay for. Keynes was driven to this observation by a combination of confidence in orthodox economic theory and by his own theory of probability. The innovative twist that Keynes gave to this view was that speculation could only be successful due to the possession of superior knowledge on the part of the speculators, compared to the knowledge available to the general
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John Maynard Keynes 189 public. In terms of modern finance theory, Keynes in this period can be said to have thought that speculation was equivalent to ‘insider’ trading. Although already in this time period Keynes had started an investment account of his own (Moggridge, 1992, p. 194), his personal interest in financial markets was to be interrupted by World War I. Thus it is notable that up to this point in his life, Keynes had little personal experience with active financial market speculation (Lawlor, 2006, pp. 126–32). After World War I ended, and when he had more personal leisure time, Keynes started actively speculating on a large scale, for himself, and with partners. His first attempts at speculation (in currencies) were with his Bloomsbury friends’ money and a substantial sum that he had borrowed for this purpose from Samuel Courtauld, a wealthy British art collector and an heir to an industrial fortune. Thus began the second stage of the evolution of Keynes’s views on speculation, those that he developed and held from 1919 to 1930. This coincides with the period from the end of Keynes’s experiences in the British Treasury during World War I and at the Versailles Peace Conference to the publication of his Treatise on Money (Keynes, 1930). During this period, Keynes operated on the assumption that both his practical experiences with financial markets during the war and his now academic immersion in financial economics and of the theory of the ‘trade cycle’ gave him unique insights into financial markets. One could accurately say that Keynes’s rationale for speculation in the second stage of his career was his belief that successful speculation required accurate timing of the swings in asset prices and that this was possible with the possession of either superior information or superior theoretical insight. Thus, in modern terms, during this period, Keynes assumed that a well-informed and intelligent speculation operated by ‘timing’ trading and could routinely ‘out guess’ markets. Based on this assumption, Keynes engaged in large-scale speculation in currencies and commodities. He immediately ran into setbacks. At one point during his early attempts to speculate in currency movements he lost both his own capital, that of his Bloomsbury friends and the sum he had borrowed from Courtauld. He quickly jumped back in, though, and made up his losses and later paid back all of his debts. He became particularly adept at speculation in commodities (Moggridge, 1992). The influence of this experience in practical ‘speculation’ was that Keynes’s economic writings during this period benefitted from a thorough understanding of the ‘machinery’ of modern financial markets (Keynes, 1923). His goal in economics theory was to provide the answer to the riddle of that day in the form of a theory of the ‘trade cycle’. He became convinced that the answer to this riddle lay in the operation of banking and in the behaviour of financial markets. But Keynes also began to believe by the end of the 1920s that even the activities of skilled traders and the attempt to gain ‘inside’ information
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was not always enough to provide superior financial market outcomes. Keynes also began to suspect that all speculation was not benign. He ended this period with mixed views about speculation. One conclusion was that Keynes clearly differentiated between speculation on commodities from that of currency, bonds and equity shares. He would forever after recognize a useful social economic function for commodity speculation (essentially attributing to it the ‘risk-bearing’ function mentioned above), but grew highly sceptical of the ultimate social and economic function of currency, bond and stock speculation. Thus, this period is crucial in the evolution of Keynes’s ideas about financial market behaviour. It sowed seeds of doubt that financial market speculation, particularly that on stock exchanges, was always a benign and calmly rational activity as it had always been assumed to be in economic theory (Lawlor, 2006, pp. 132–42). The last period of Keynes’s evolution as a theorist of financial market behaviour and as a financial trader occurred over the period from 1930 until his death in 1946. It is to this period that can be traced most of the ideas about financial speculation that are today commonly considered characteristically ‘Keynesian’. These ideas were expressed in his major economic publications during this period, A Treatise on Money (Keynes, 1930) and The General Theory of Employment, Interest and Money (Keynes, 1936). In the first of these (Keynes, 1930), Keynes expounded what later became known as the ‘liquidity preference’ theory of interest rates. According to this theory, speculation on bonds is grounded in ‘uncertainty’ over the future course of interest rates. Here we see his earlier theory of probability emerging, to now explain asset prices and interest rates. Since actual knowledge about future interest rates is impossible to obtain, speculations as to the future value of bonds divide up into a variety of camps determined by the degree that traders hold bull or bear expectations. The structure of bond prices, and so the whole complex of market rates of interest, according to this theory, represents a balancing between the two camps and the variety of the current degrees of bullish sentiment and bearish outlooks. Interest rates appear as if ‘hoist by their own petards’. The second of Keynes’s books in this period, The General Theory of Employment, Interest and Money (Keynes, 1936) largely repeated this ‘liquidity preference’ theory of interest rates, but it also contained two crucial additions. One was that in Chapter 12 of the General Theory Keynes explicitly addressed the behaviour behind, and practice of, equity speculation. He had observed and participated in equity speculation for around 20 years at this point. He explicitly stressed that the knowledge context of such speculation was best compared with the uncertain case he had defined in his earlier theory of probability, and which we have described above. In theorizing the part that stock speculation plays in the capital investing of an
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John Maynard Keynes 191 economy and a society, Keynes equated stock trading with the formation of long-term expectations as to the future value of shares in equity ownership of commercial firms. As he described it there, such trading had, like in his interest rate theory, arisen historically to make formerly illiquid capital investment appear ‘liquid’ to the individual investors in shares in individual firms, even though capital investment could never really be liquid to whole societies. Once regular trading activity of this character had been established in equity exchanges, though, the outstanding social facts that Keynes observed on these markets was the extreme precariousness of traders’ uncertain long-term expectations and the liability of these expectations to rapid and extreme fluctuation. The second advance of Keynes’s General Theory over his earlier Treatise on Money was that Keynes promulgated a theoretical explanation of how fluctuating expectations could lead to fluctuating investment, and how this could cause high and persistent unemployment. Part of the potential precariousness of investment activity, in Keynes’s General Theory view, is because of the knowledge context that investment occurs in and the long, productive lives of capital goods – facts that must inherently be part of valuing firms that utilize capital goods and so an aspect of the formation of long-term expectations. After all, Keynes reasoned, there can really be no current basis for determining with any degree of confidence the value of a capital investment in 20 years’ time. Thus, since judgements of value in such uncertain investment activity cannot by nature ever be uniquely ‘correct’, investment is prima facie likely to also be precarious and fluctuating. Moreover, said Keynes, the role and incentives of professional speculators, traders and advisors only intensifies this inherent instability. This is because individual speculators and traders are engaged in ‘guesses’ as to what ‘opinion’ is about the future prospects of various equities by the majority of traders a short time hence. Strictly speaking, he said, such short-term ‘speculative’ behaviour defines most of the activity of professional traders. Finally, Keynes concluded, in what was to be his most mature and informed description of financial market behaviour, with the observation that the professional investment advice could likewise not be relied upon to guide investment into socially beneficial channels. Unfortunately, said Keynes, the majority of professional investment advice is also based upon guesses as to the future short-term value of individual stocks. So configured and operated upon, he said, markets that are dominated by speculation are unlikely to rank equities based on the long-term profitability of firms, as is suggested by orthodox economic and financial theory in his day and now. Finally, even in retrospective evaluation of cases of obvious fault in financial advice or in the conduct of financial trading, said Keynes, some protection could be expected if behaviour hewed closely to the
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‘conventional’ average opinion. Such ‘herd’ behaviour assured that trades could not be blamed later since the average opinion had likewise been faulty. In other words, the incentives faced by market professionals were unlikely to correct socially dangerous and often wrongly held expectations of the long-term profitability of investments. Human psychology and financial market institutions were more likely to enforce the conventional nature of long-term expectations. Professional financial market speculation could not be expected to ‘correct’ faulty long-term expectations. Thus, in Keynes’s most mature view, speculation could have anti-social and unemployment-generating effects. Armed with this theory, Keynes increasingly handled his own accounts and recommended to his college and to life insurance companies that they also invest on the basis of what he termed a theory of ‘faithfulness’. This consisted of a policy of evaluating firms on the basis of long-term profitability, an activity that Keynes identified as enterprise, to contrast it with what he now saw as the potentially socially harmful effects of short-term speculation. In modern financial terminology, Keynes’s final judgement, that socially beneficial investment should be guided by enterprise, not speculation, can be identified with a ‘buy and hold’ strategy.
REFERENCES Cockshut, A.O. (1964), The Unbelievers: English Agnostic Thought 1840–1890, London: Collins. Davenport, N. (1974), Memoirs of a City Radical, London: Weidenfeld & Nicolson. Harrod, R.F. (1951), The Life of John Maynard Keynes, London: Macmillan. Groenewegen, Peter (1995), A Soaring Eagle: Alfred Marshall 1842–1924, Aldershot, UK and Brookfield, VT, USA: Edward Elgar. Keynes, J.M. (1921), A Treatise on Probability, London: Macmillan. Keynes, J.M. (1923), A Tract on Monetary Reform, London: Macmillan. Keynes, J.M. (1925), ‘Alfred Marshall, 1842–1924’, in A.C. Pigou (ed.), Memorials of Alfred Marshall, London: Macmillan. Keynes, J.M. (1930), A Treatise on Money, 2 vols, London: Macmillan. Keynes, J.M. (1936), The General Theory of Employment, Interest and Money, London: Macmillan. Lawlor, M. (2006), The Economics of Keynes in Historical Context: An Intellectual History of the General Theory, Houndsmills, Basingstoke: Palgrave Macmillan. Marshall, A. ([1920] 1962), Principles of Economics, 8th edition, London: Macmillan. Moggridge, D.E. (1992), Maynard Keynes: An Economist’s Biography, London and New York: Routledge. Skidelsky, R (1983), John Maynard Keynes. Volume One: Hopes Betrayed, 1883–1920, London: Macmillan. Skidelsky, R. (1992), John Maynard Keynes. Volume Two: The Economist as Saviour 1920–1937, London: Macmillan. Skidelsky, R. (2000), John Maynard Keynes: Fighting for Britain, London: Macmillan.
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27 Limited liability Stephanie Blankenburg
Limited liability is a legal concept that governs restrictions on the extent to which owners of economic resources can be held financially liable for damage caused to third parties through the use of these resources. Limited liability can arise from private contracts, statutory law, bankruptcy or the use of limited liability forms of firms. Modern corporate limited liability is based on the legal doctrine of ‘separate corporate personality’, according to which a company constitutes a separate legal entity from its ownershareholders. If the company fails and/or causes harm, the liability of its owner-shareholders is limited to the nominal value of their shares. With the rise of corporate groups since the inter-war period, the legal principle of ‘separate personality’ has been extended to the relationship between parent and subsidiary companies, and the protection of limited liability granted to parent companies in regard to claims against their subsidiaries, independently of the degree to which parent companies own and/or control subsidiary companies. Historically, limited liability in Europe served two distinct purposes. First, it was used by private entities, such as trading and commercial partnerships, to facilitate the finance of risky investments. This is the case of the commenda, an early form of a limited commercial partnership, which goes back to at least the twelfth century. The commenda differentiates between a general (or travelling) partner who has managerial control of the enterprise and fully assumes all risks, and a passive (or sleeping) partner who provides a share of the capital required for the enterprise and is liable only to the extent of this financial investment. Originally used mainly to finance high-risk sea trade, the commenda spread quickly throughout medieval Continental Europe and beyond maritime trade. Second, limited liability was a privilege bestowed by rulers on semi-public entities, such as monasteries and trade guilds, operating on the basis of commonly held property. As late as 1906, the UK Trade Disputes Act granted a number of immunities to trade unions. This included the provision that they could not be sued for damages incurred during a strike, thus rooting the right of workers to organize and strike in the concept of limited liability as a privilege granted by rulers to semi-public organizations. 193
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It was only with the rise of European capitalism that the differing private and public interests underlying the legal concept of limited liability gradually became intermingled, resulting in the formation of the modern shareholding corporation. Whilst the commenda had been a private arrangement between partners in business (and never took hold in England), the jointstock companies of the sixteenth and seventeenth centuries became the successors of medieval guilds, thriving on monopoly or trading privileges granted for specific sectors or regions by the state. The Hudson’s Bay Company, the Dutch and the British East India Companies, and the Royal Africa Company, for instance, were an extended arm of states with colonial ambitions, risking criminal prosecution for violating or contravening the national interest, as perceived by the royal authorities. Unincorporated joint stock companies practising various forms of de facto limited liability without an express royal grant operated throughout the seventeenth and eighteenth centuries, prompting the 1720 Bubble Act in England that followed one of the first great financial crises, the so-called South Sea Bubble. This declared common law companies with transferable shares a ‘common nuisance’ and prohibited trading in shares of unincorporated joint stock companies. The Industrial Revolution of the late eighteenth and early nineteenth centuries remained dominated by the private unlimited liability partnership, ‘not because of the impediments to the formation of JSCs [joint stock companies], but because of the relatively modest capital requirements of most industries’ (Ireland, 2010, p. 839). This changed in the second half of the nineteenth century, with the introduction of free incorporation (no longer tied to royal charters or Parliamentary Acts) and general limited liability. Landmark legislation includes the UK’s Companies Acts of 1855 and 1862, the 1886 decision by the US Supreme Court to grant private companies the status of natural persons under the US constitution, and the UK Salomon principle of separate corporate personality, established through case law in 1896. The 1886 US Supreme Court decision that, to this day, serves as the basis for what is arguably the most important cornerstone of US corporate law, namely the doctrine of corporate personhood, invoked the Fourteenth Amendment of 1868 to protect the rights of freed slaves, extending the legal recognition of freed slaves as free human beings to private corporations. The House of Lords ruling (1897, A.C. 22 H.L.) that established the same principle of corporate personhood in the UK, is similarly remarkable: Mr Salomon, a boot manufacturer, had sold his business to a new corporation, Salomon & Co., owned by seven shareholders (then the minimum legal requirement): his five children, his wife and himself. His wife and children each obtained one share in the company, while Mr Salomon retained the remaining 20 001 shares, also assuming the position of managing director
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Limited liability 195 of the new company. Since, as the sole proprietor of the original business, he had sold this to the new corporation for cash as well as debentures, Mr Salomon was simultaneously the managing director, main ownershareholder as well as a creditor of Salomon & Co. When the company went into liquidation, the liquidators, treating Mr Salomon as the owner, demanded payment of his creditors. Mr Salomon, claiming his status as shareholder and holder of debentures against the company, argued that he should be paid rather than pay. The trial judge sided with the liquidators against the shareholders, as did the court of appeal, on the grounds that Salomon & Co. had been formed for fraudulent purposes and constituted an abuse of the privileges of incorporation and limited liability. The House of Lords overturned these decisions, arguing that the Companies Act of 1862 had created companies as legal persons separate and distinct from the shareholders without specifying a requirement for independence between shareholders or a ‘disinterested’ approach by shareholders to the company’s management. It was not the role of judges to impose limitations where these had not been imposed by parliament. Alongside free incorporation and general limited liability, another important building block to complete the legal construction of the modern shareholding corporation concerned the establishment, in law, of intangible financial property rights. Into the nineteenth century, the predominant legal concept of property was of concrete and tangible ‘things’; private property rights over ‘things’ were regarded as publically constituted, conferring powers of control and coercion on the owners of ‘things’, together with obligations and responsibilities. For shares to attain the legal status of property, it was necessary to disassociate the concept of property rights from the notion of tangible ‘things’, and to create, instead, a concept of ‘property’ that could accommodate the idea of a freely circulating bundle of rights, largely unattached to natural persons on whom specific obligations and responsibilities could be conferred (Ireland, 2003). Initially, free incorporation and general limited liability was highly contentious territory. Already Adam Smith had voiced two core concerns about joint-stock companies, then still bound by royal charter or an act of parliament. The first anticipates the well-known Berle–Means hypothesis of the separation of ownership and control (Berle and Means, 1932), arguing that this separation of owners from manager-directors would give rise to inefficient management and impropriety: ‘Negligence and profusion, therefore, must always prevail, more or less, in the management of the affairs of such a company’ (Smith [1776] 1981, Book V, Pt III, Art. 1, Para. 18, p. 741). Smith’s second objection rested on a broader political consideration, namely the charge of arbitrary and unjust rule, if privileges such as
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limited liability were granted to private parties without a clearly established public purpose: To establish a joint stock company, however, for any undertaking, merely because such a company might be capable of managing it successfully; or to exempt a particular set of dealers from some of the general laws which take place with regard to all their neighbours, merely because they might be capable of thriving if they had such an exemption, would certainly not be reasonable. To render such an establishment perfectly reasonable … it ought to appear with the clearest evidence that the undertaking is of greater and more general utility than the greater part of common trades. (Ibid., Book V, Pt III, Art. 1, Para. 36. p. 757)
Smith’s concerns were shared, to varying degrees, by other leading economists, such as John Stuart Mill and Alfred Marshall. The Tory Prime Minister, Robert Peel, Britain’s richest industrialist in the 1820s, became an uncompromising campaigner against corporate limited liability. And public perceptions and criticisms of limited liability as encouraging excessive speculation, rendering credit provision more difficult and promoting fraudulent investment schemes were sufficiently widespread to leave their imprint on contemporary literature: Anthony Trollope’s The Way We Live Now (1873) is a portrayal of corporate fraud, brought on by limited liability and insufficient financial disclosure. In 1893, a year marked by a severe financial crisis, Gilbert and Sullivan dedicated a whole opera – Utopia Ltd – to a scathing indictment of free incorporation and limited liability. The Economist magazine did not revise its critical stance on corporate limited liability until 1926 (The Economist, 23 December 1999). By 1885, only around 10 per cent of important British firms had taken advantage of incorporation with limited liability (Carney, 1999, p. 663), and by 1900 fewer than 100 000 UK Ltd companies had been formed (Martin, 2006, p. 1). Western Europe was even slower in adopting and generalizing free incorporation and limited liability, and in the USA, where limited liability spread earlier and more rapidly, important exceptions to this rule have remained in place to this day. By contrast, the later twentieth century has seen a proliferation of limited liability companies, in particular since the 1980s, with now more than 2 million such companies registered in the UK alone (ibid.). In addition, the past two decades have witnessed a rapid extension of limited liability privileges to enterprise forms other than (listed) shareholding corporations, such as limited liability partnerships (LLPs) and (confusingly) so-called limited liability companies (LLCs), the latter particularly popular in the USA. LLPs combine limited liability with the tax advantages and lower disclosure requirements of partnerships. A conventional limited liability corporation is usually ‘double-taxed’ through corporate tax on the company
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Limited liability 197 and tax paid by shareholders on their dividends. In partnerships, the partners’ share of earnings is taxed, but the partnership itself is not taxed. LLPs extend limited liability to the limited partners (the equivalent of owner-shareholders). LLCs constitute a hybrid between LLPs and fully quoted limited liability corporations. Differently from LLPs, there is no ceiling on the number of limited partners/shareholders, who are allowed to be active in the management of the company. Thus, business owners can avoid corporate tax while fully enjoying the advantages of limited liability. Mainstream economic and legal theories of the firm have been intent on writing any involvement of the state in the creation of the modern shareholding corporation out of history, in the same vein in which liberal market theory has re-invented ‘the market’ as an a-historical place of private exchange and contracting, unencumbered by collective political, institutional, social and cultural action and beliefs. The dominant approaches are the ‘nexus-of-contract’ and the ‘collection of assets’ theories of the corporation, respectively associated with Jensen and Meckling (1976) and Grossman and Hart (1986). The ‘nexus-of-contract’ theory has the firm and the corporation dissolved into a loose ensemble of voluntary contractual arrangements between owners of resources, indistinguishable from contractual exchanges in markets. The ‘collection of assets’ approach recognizes that voluntary contracting can be ‘incomplete’ and that, therefore, residual control allocation matters for efficiency. It resurrects the firm or corporation from being simply a figment of our imagination to the status of an aggregate of assets with property rights defined over them, without, however, providing any insights into what might hold this bundle of assets together. Where free incorporation and general limited liability even enter the frame of analysis, they are usually regarded as the legal ‘bedrock’ of free enterprise (Hansmann and Kraakman, 2001), brought about by the efficiency requirements of financing private investment initiatives in the presence of risk. There is no equivalent of the mainstream ‘law and economics’ movement (see also Easterbrook and Fischel, 1991) in heterodox analyses of the firm. Dissident legal scholars (Ireland, 2003, 2010) have long argued that ‘the explanation for the introduction of free incorporation and general limited liability and the gradual development of the modern corporate legal form is to be found not in the needs of industry but in the needs of finance’ (Ireland, 2010, p. 841). In this view, corporate limited liability is the result, primarily, of the rise of wealthy middle classes towards the end of the nineteenth century. Rather than the enshrinement in law of efficiency-inducing institutional arrangements, free incorporation and general limited liability were the result of protracted lobbying of the state by financial rentiers, looking for opportunities to invest their increasing financial wealth without having
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to shoulder entrepreneurial risks. The bulk of heterodox legal analysis has, however, been preoccupied less with limited liability per se but with its extension to corporate groups and the protection of parent companies from claims made by tort victims against multinational enterprises (Blumberg, 1993; Muchlinksi, 2007, 2010). By contrast, heterodox economic theories of the firm have largely been silent on the legal foundations of the modern shareholding corporation, and general limited liability in particular. Post-Keynesian cost-plus theories of pricing and investment as well as Marxist theories of monopoly capitalism, for example, have tended, explicitly or implicitly, to treat the modern shareholding corporation as a ‘representative firm’, and have focused on exploring the impact of the increasing concentration of capital and market power on short- and long-run capitalist macroeconomic dynamics. More recently, authors writing, broadly, in the institutionalist tradition of firm theory (Hodgson, 2002; Gindis, 2009) have begun to call attention to the relevance of arguments about the legal nature of the firm for building a realist theory of the firm that is grounded in the historical analysis of the social, institutional and political determinants of organizational change at the firm level. With the rise of multinational enterprises and corporate power since the 1980s, the rapid financialization of corporations as well as of the global economy and, eventually, the financial crisis of 2007/08, debates on corporate reform and regulation have gained renewed attention. These debates have been dominated by the concepts of ‘(good) corporate governance’, emanating mostly from management and corporate legal studies (e.g., Schleifer and Vishny, 1997), and ‘corporate social responsibility’, promoted primarily by civil society pressure groups, but increasingly also generating a considerable body of academic literature (e.g., Blowfield, 2008; Crane et al., 2009). At the heart of both approaches is the validity, or otherwise, of shareholder primacy as the guiding principle of the management of large corporations. The core question addressed is whether the increasing diversification of shareholders and a competitive market for corporate control (the growing role of hostile takeover bids) constitute sufficiently reliable mechanisms of control, accountability and transparency of corporate managers and boards, in the interests of both economic efficiency as well as public concerns over the wider social, macroeconomic and environmental impacts of the operations of multinational corporations. Heterodox scholars of legal and management studies as well as representatives of the ‘corporate social responsibility’ movement have tended to argue that, in addition to such indirect mechanisms to broaden and empower the control of corporate management by shareholders, a more explicit recognition of stakeholder interests – employees, creditors, tort victims – is also
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Limited liability 199 required. Hence, Strine (2007), for instance, questions the presumption that a wider social base of share ownership in funded pension schemes equals a higher degree of social control over corporate management, arguing that the growing contingent of shareholders largely comprises ‘forced capitalists’, deprived of access to defined benefit pension plans and other public benefits and with ‘little choice but to invest in the market’, doing so ‘primarily through intermediaries. It is these intermediaries, and not the forced capitalists, who determine how the latter’s capital is put to work and how the mountain of shares owned for their benefit is used to influence the management of public corporations’ (ibid., pp. 6–7; italics added). So far, the debate about corporate reform and regulation, whether inspired by mainstream or heterodox scholars, or by civil society campaigners, has converged on a policy agenda that promotes voluntary codes of practice, such as the 1992 ‘Cadbury Code’ in the UK or the 2004 OECD corporate governance principles, as the main avenue to attaining higher degrees of the accountability of corporate boards and of the transparency of corporate activities. The 2006 UK Companies Act also translates some of these codes into legally enforceable liabilities of company directors, though leaving ample space for interpretation through case law. The obvious mismatch between actual corporate power – not least evidenced in failure of the financial crisis of 2007/08 to give rise to a fundamental reform of contemporary capitalism – and appeals for (mostly) voluntary adoptions of codes of practices for directors, boards and managers of large corporations, signals the need for a more thorough and inter-disciplinary re-assessment of the modern shareholding corporation as a legal, historically bounded and state-governed, construction. This may not entail a blanket abolition of corporate limited liability. It may, however, help to raise the threshold of contemporary debates about the reform of global capitalism (Blankenburg et al., 2010).
REFERENCES Berle, A.A. and G.C. Means (1932), The Modern Corporation & Private Property, NewYork: Harcourt, Brace & World Inc. Blankenburg, S., D. Plesch and F. Wilkinson (2010), ‘Limited liability and the modern corporation in the theory and in practice’, Cambridge Journal of Economics, 34(5), 821–36. Blowfield, M. (2008), Corporate Social Responsibility: A Critical Introduction, Oxford: Oxford University Press. Blumberg, P.I. (1993), The Multinational Challenge to Corporation Law, Oxford: Oxford University Press. Carney, W. (1999), ‘Limited liability’, in B. Bouckaert and G. De Geest (eds), Encyclopedia of Law and Economics, Volume III, The Regulation of Contracts, Entry 5620, Cheltenham UK and Northampton, MA, USA: Edward Elgar.
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Crane, A., A. McWilliams, D. Matten and J. Moon (2009), The Oxford Handbook of Corporate Social Responsibility, Oxford: Oxford University Press. Easterbrook, F. and D. Fischel (1991), The Economic Structure of Corporate Law, Cambridge, MA: Harvard University Press. Gindis, D. (2009), ‘From fiction and aggregates to real entities in the theory of the firm’, Journal of Institutional Economics, 5(1), 25–46. Grossman, S. and O. Hart (1986), ‘The costs and benefits of ownership: a theory of vertical and lateral integration’, Journal of Political Economy, 94(2), 691–719. Hansmann, H. and R. Kraakman (2001), ‘The end of history for corporate law’, Georgetown Law Journal, 89(2), 439–68. Hodgson, G (2002), ‘The legal nature of the firm and the myth of the firm–market hybrid’, Journal of Institutional Economics, 9(1), 37–60. Ireland, P (2003), ‘Property and contract in contemporary corporate theory’, Legal Studies, 23(3), 453–509. Ireland, P. (2010), ‘Limited liability, shareholder rights and the problem of corporate irresponsibility’, Cambridge Journal of Economics, 34(5), 837–68. Jensen, M. and W. Meckling (1976), ‘Theory of the firm: managerial behavior, agency costs and capital structure’, Journal of Financial Economics, 3(4), 305–60. Martin, D. (2006), Corporate Governance: Practical Guide on Accountability Requirements, Abingdon: Thorogood Publishers. Muchlinski, P. (2007), Multinational Enterprises and the Law, 2nd edition, Oxford: Oxford University Press. Muchlinski, P (2010), ‘Limited liability and multinational enterprises: a case for reform?’, Cambridge Journal of Economics, 34(5), 915–28. Schleifer, A. and R. Vishny (1997), ‘A survey of corporate governance’, Journal of Finance, 52(2), 737–83. Smith, A. [1776] (1981), An Inquiry into the Nature and Causes of the Wealth of Nations, edited by R.K. Campbell and A.S. Skinner, The Glasgow Edition of the Works and Correspondence of Adam Smith, Volume II, Indianapolis: Liberty Fund. Strine, L.E. (2007), ‘Toward common sense and common ground? Reflections on the shared interests of managers and labor in a more rational system of corporate governance’, Harvard Law School, John. M. Ohlin Center for Law, Economics and Business Discussion Paper Series No. 585. The Economist (1999), Millennium Issue. ‘The key to industrial capitalism: limited liability’ 23 December available at: http://www.economist.com/node/347323; accessed 2 April 2012.
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28 Liquidity Anastasia Nesvetailova
INTRODUCTION ‘Liquidity’ has always been central to the operation of any economy, often being referred to as the lifeblood of the financial system. At the same time, it remains one of the least understood concepts of modern finance. The elusive nature of liquidity was highlighted by the global financial crisis of 2007–09. Indeed, a paradox of the crisis was the sudden and fatal disappearance of ‘liquidity’ from markets and institutions, which only days before had apparently suffered from what Ben Bernanke dubbed a ‘global liquidity glut’ (Bernanke, 2005). Unsurprisingly perhaps, liquidity has been likened to the ‘dark matter’ or an ‘Achilles’ heel’ of contemporary finance. How come then, that ‘liquidity’ is at once a lifeblood and a dark matter of the financial system? Why does the idea of liquidity prove to be such an elusive notion? This chapter addresses these questions, drawing on contemporary studies of market liquidity and on historical inter-disciplinary theorizations of the nature of liquidity.
TYPES AND NATURE OF LIQUIDITY Liquidity is typically defined as ‘the degree to which the assets can be traded freely or not’ (Tett, 2009, p. 285). While hardly controversial in the context of a given market at a given moment of time, this definition does not address the systemic (or aggregate) character of liquidity, which remains a matter of theoretical and methodological contention. Historical scholarship on liquidity has distinguished between two schools of thought. One is known as the shiftability school. It maintains that the essence of liquidity lies in the ability to sell or shift an asset at relatively short notice. The other approach may be described as the economic circuit school: it is based on the idea that all assets are moving at varying degrees towards the place of their final consumption in economic life. Liquidity, according to this view, is the sale of an asset to a customer who thereupon consumed it or changed its form in some manner (Brown, 1940, p. 8). Contemporary economic studies of liquidity descend, by and large, from the shiftability school: they prioritize the role of market mechanism in 201
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ensuring the liquidity of assets. The few critical insights into the theory of liquidity made in recent years are intellectually closer to the economic circuit school; they prioritize the ‘public good’ aspect of liquidity and its function of tying together the various segments of the economic system and ensuring financial stability. Carruthers and Stinchcombe for instance, have defined liquidity ‘as the degree to which an asset is a fungible, generalized resource’ (1999, p. 375). The ascendance of the financial markets across the global economy has meant that any asset, be it an item of real estate or even an expectation, can be made into a liquid security by the magic of financial innovation. Indeed, since the 1970s, securitization, the essence of which is to transform previously untradeable assets into liquid securities, has brought profits and economic benefits to various participants of the economic system. At the same time, however, securitization and the advance of new financial products such as credit derivatives, have precipitated a series of financial crises during the past few decades. Examining the role of liquidity in economic stability leads us to consider another analytical challenge of the liquidity concept: namely, its multi-dimensionality.
THE FOUR DIMENSIONS OF LIQUIDITY At first cut, the idea of liquidity is straightforward and quite intuitive. Liquidity describes the convertibility of an asset into a form of money (most commonly, cash), and thus is often likened to an asset’s ‘money-ness’. At the same time, liquidity also describes a state of the (financial) market where transactions can be executed within the prevailing price levels. Although seemingly comprehensive and uncontroversial, this two-fold perspective on liquidity opens up several analytical hurdles. On the one hand, it is difficult to disentangle the two aspects of liquidity, since assets are only tradable if the institution facilitating such a trade – a market – is functional. On the other hand, however, the market mechanism, especially a financial market mechanism, is a complex socio-political construction, embedded in a specific legal, socio-economic and political context. It is therefore prone to its own problems of operation, which can, in turn, affect the nature of asset liquidity. The analytical dilemma can be disaggregated further. On reflection, the singular term ‘liquidity’ comprises at least four dimensions: spatiality, quality, quantity and probability, a typology recognized by both the shiftability and the economic circuit schools of thought. Liquidity is a spatial notion to the extent that it can be a characteristic of various parts of the economic system, including individual assets and persons, portfolios of financial actors, or an economic community more generally. Liquidity is a
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Liquidity 203 qualitative notion, because it describes either an inherent characteristic of an asset or a property that is attributed to it by to the operation of some financial mechanism. Liquidity is a quantitative notion because it can be a measure of a certain reservoir of funds, such as reserves, or at a broader level, a pool of available credit or money in given circumstances. Finally, liquidity is an inter-temporal notion: although the concept implies currentness of operations or flows, it is prospective liquidity that determines an asset’s marketability and price (the shiftability school), or its socioeconomic function (economic circuit school). This four-fold complexity makes any generalizations and simplified definitions of liquidity analytically problematic. Liquidity as a Spatial Notion The spatial dimension of liquidity describes a state of an economic unit. In this case, liquidity is defined as an ability to meet existing obligations without incurring huge losses or disruptions. Liquidity of a national economy, as in the case of an emerging market country, can be understood as an ability to meet obligations related to the present value of its currency. In other words, definitions of liquidity ultimately depend on the part of the economic system that is being characterized. Here, the key challenge in generalizing individual meanings of liquidity lies in the method by which analyses of individual parts of the economic system are being aggregated into a holistic vision, since the shiftability and the economic circuit theories of liquidity identified above each suggest different paradigms of aggregation, leading in turn, to contrasting policy implications. Liquidity as a Quality As mentioned above, liquidity is most often conceived as being synonymous with the tradability of assets and more narrowly, with an asset’s proximity to a form of money. For instance, a 1931 definition suggested that ‘liquid or cash assets are those assets of any kind which may readily be converted into cash’ (Special Committee on Terminology, 1931). The notion of proximity to a form of money implies that different types of assets possess various degrees of liquidity, with high-earning and riskier assets assumed to be less liquid, and with cash and high-quality governmental securities, such as US Treasury bills, to be most liquid. This vision is based on an inverse relationship between an asset’s liquidity and its earning potential. There are, however, three major problems with approximating liquidity to ‘money’ and cash. First, the convertibility of an asset into ‘cash’, while a useful gauge of an asset’s money-ness (and thus safety) in most
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circumstances, does not work as a universal criterion. Economic history provides many examples of situations where cash was non-functional as a means of payment, either because of specific political and historical factors or due to hyperinflation and related problems of currency credibility (Mueller, 1953). Second, the advance of financial innovation over the past few decades has crowded cash out to the margins of the daily life of the modern credit system. In response, and by way of an alternative, analysts suggested distinguishing between funding liquidity (the ability of financial institutions to perform their intermediation functions) and market liquidity (the ability to undertake transactions in such a way as to adjust portfolios and risk profiles without disturbing underlying prices) (e.g., Crockett, 2008; Brunnermeier and Pedersen, 2009). At the same time, in real-life context, it is increasingly difficult to separate the two concepts. As Borio (2000, pp. 38–9; 2004) stressed, the nexus of cash and market liquidity remains crucial for determining the robustness of financial markets, because the mechanisms that lead to the disappearance of cash liquidity under stress can be similar to those that lead to the evaporation of market liquidity. Third, although many studies have argued recently that financial innovation has stretched the frontier of liquidity, the major problem with classifying assets along a liquidity spectrum is that it assumes that the liquidity of an asset is fundamentally a question of market equilibrium and a right price. Essentially therefore, the problem of ‘liquidity’ is deemed solvable by the operation of the market mechanism. The problem with this classification is that it conflates ‘liquidity’ with marketability. Fundamentally, this vision presumes the existence of an unallocated fund waiting upon the demands of those possessing particular assets. But in reality, there is no such reservoir of funds. While individual members of the aggregate may at one time be ‘liquid’, it is not true for all members (Keynes, 1936, p. 155, cited in Mueller, 1953). Thus in terms of qualitative analysis of liquidity, we again encounter the problem of aggregation: convertibility of an asset into money or cash provides a criteria of liquidity only as long as analysis remains confined to individual practices; at the level of the system, this understanding simply does not work. Liquidity as Quantity The quantitative facet of liquidity describes a financial ‘cushion’ – either in a form of reserve capital held by a financial institution, or as a stock of global credit more broadly. For example, one widely accepted notion of international liquidity refers to ‘those assets available to the authorities of a
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Liquidity 205 country for the purpose of stabilizing the external value of its domestic currency’ (Genberg and Swoboda, 1993, p. 271). Recent IMF studies distinguished several indicators of liquidity, including central bank liquidity (base money), household and corporate liquidity (monetary aggregates), and an economy’s liquidity (measured as all of the above plus currency liabilities of the central bank). There also exist more complex composite measures of liquidity as a general financial climate. Most popular among these is the so-called financial conditions index, first suggested by Goldman Sachs. It is a weighted combination of the real three-month interbank lending rate, the interest rate on corporate bonds, the market capitalization of equities in relation to GDP, and the real effective exchange rate. Finally, in 2005, the IMF suggested a more refined definition of global liquidity as holdings of a financial asset that represents a claim on a foreigner, which could be turned readily into foreign exchange, and which can be held by the private or the public sector (IMF, 2005, Box 2.1, pp. 14–15). Elaborate quantitative measures notwithstanding, in the international sphere, liquidity, while quantifiable, is not reducible to a single formula or concept. More problematically, the validity of the definition of an economy’s liquidity (and indeed, global liquidity), is highly questionable in the era when the ‘visible’ balance sheets of banks represent only a fraction of the complex web of financial institutions, many of which constitute the ‘shadow banking system’ and therefore, operate with shadow liquidity. While this problem may not be acute in times of economic stability, it came to the fore in October 2008, when the viability of basic banking services was threatened by the crisis of the shadow banking system precipitated by the failure of Lehman Brothers. Liquidity as Time, or Speed Finally, from the above it can be inferred that liquidity also denotes a probability of completing a transaction in given circumstances at certain speed. At a broader level, liquidity implies the viability of maintaining financial flows over time and during different stages of an economic cycle more generally. Correspondingly, economic examinations of liquidity tend to focus on various problems that arise in the operation of the price mechanism, efficiency and transparency of the financial market, typically aiming to find a quantitative solution to these problems. For instance, the look of the bid–ask spread curve is what determines market liquidity. The smoother the curve the more liquid the market is considered to be. If the curve is erratic, it means that it is difficult to match bid and ask prices for a particular asset, and thus market liquidity is impaired.
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Thus liquidity also denotes a probability of executing a particular transaction (be that a simple sale of an asset, a rollover of debt or a complex restructuration of a deal in the financial markets). The probability aspect of liquidity highlights that it is an inter-temporal notion: a specific stage of a business cycle does affect the nature of liquidity, because ‘liquidity’ in good times is not the same as liquidity in bad times. In this instance, Crockett (2008) refined the four dimensions of market liquidity: market ‘depth’ (or the ability to execute large transactions without influencing prices unduly); ‘tightness’ (or the gap between bid and offer prices); ‘immediacy’ (or the speed with which transactions can be executed); and ‘resilience’ (or the speed with which underlying prices are restored after a disturbance).
SECURITIZATION, LIQUIDITY AND THE FINANCIAL SYSTEM The complex, multidimensional nature of liquidity has prompted many observers to consider alternative definitions and approaches to liquidity. Here, three notable attempts are worth mentioning. One comes from a market participant. Paul McCulley of investment authority PIMCO, acknowledging the ever-elusive nature of liquidity, defined it simply as ‘appetite for risk’ (McCulley, 2008). Kevin Warsh, one of the governors of the Federal Reserve, suggested that market liquidity is synonymous with confidence (Warsh, 2007). Andrew Crockett (2008), elaborating on the concept in a more comprehensive manner, proposed that the essence of liquidity lies in the ease with which value can be extracted from assets. Value may be affected either on the basis of an asset’s creditworthiness or through its sale. These definitions seem fairly inclusive, and they resolve many conceptual dilemmas presented by the four facets of liquidity noted above. They attempt to reconcile liquidity as a quality of the moment, and liquidity as a quality of an asset. Both appetite for risk and general confidence in the economy depend on the publicly available knowledge about economic assets and how best to discount future outcomes into today’s present value. At a glance therefore, the idea of ‘liquidity as confidence’ does accommodate economic agents’ expectations and knowledge about the future. The problem, however, is that definitions based on the factor of confidence (and hence risk), ultimately locate liquidity in the realm of the financial market, rather than the economy as a whole. As a result, these views do take into account the issue of the fungibility of an asset, yet only within the limits of the financial market. As a consequence, analytical dilemmas of aggregation and in this specific case, of the role of liquidity in
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Liquidity 207 economic stability, are not resolved. One key question that remains open is whether liquidity implies extracting value from the assets because such an extraction is facilitated by some intermediating mechanism, or whether value extraction is possible because value is inherent in an asset. This question, in turn, relates to a much more controversial issue of financial vis-à-vis social (or economic) value and to the wider questions about the place and function of the financial market in the socio-economic system. In this context, a study linking the concept of liquidity with the concept of working capital (Mueller, 1953), is instructive. The author proposed distinguishing between financial and economic liquidation of an asset. In his vision, converting an asset into a form of money constitutes merely the financial liquidation of an asset, where from the standpoint of the producer, financial liquidity is the purchase of money (ibid., p. 171). Economic liquidity, on the other hand, is the employment of an asset for the productive purposes of the economy (and not for attainment of money values from the assets). This, Mueller argues, is where the heart of liquidity lies. At a broader level, therefore, the ‘economic circuit’ tradition of thought on liquidity implies that liquidity ties together the various stages of the production, consumption and accumulation process; it is not a quality that is confined to the financial system as such, since ultimately ‘liquidity’ is a process that describes the productive employment of an asset in the economic system. The financial process of securitization was assumed to tighten the link between the real economy and the financial sector, and hence between financial and economic liquidity. In parallel, the ascendance of the global financial market led to the popularization of the view that the vibrancy of the financial market is synonymous with the general ‘health’ and liquidity of economic system as a whole (Warburton, 2000). Effectively as a result, over the past few decades, the complex and multi-faceted concept of ‘liquidity’ has been reduced to a one-dimensional notion: that of market liquidity. This trend has prevailed both in popular and in policy discourse. The notion of market liquidity – and according to Berle and Pederson’s theory (1934), artificial (and thus necessarily fragile) liquidity – has become the dominant concept in the analyses of the state of the global financial system. Put differently, the idea of marketability has become synonymous with the notion of liquidity. The main problem with this mainstream method of aggregation, as the global credit crunch revealed, is that the theory assumes the markets to be liquid, while assets that are traded in them, or more accurately, debts, are known not be to liquid (Borio, 2004). In times of stress or crisis, ‘attempts to increase the stock of liquid assets only succeed in reducing it’ (Dow, 1993, p. 150, in Lavoie, 2010). Moreover, the complex process of financial
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innovation through layering, while ostensibly generating more liquidity, actually makes the system progressively illiquid (Nesvetailova, 2007). As Hyman Minsky warned, ‘every institutional innovation that leads to both new ways to finance business and new substitutes for cash assets, decreases the volume of liquidity available to redeem the debts incurred’ (Minsky, 1982, p. 173; italics added). This phenomenon may be understood as an illusion of liquidity, defined either as a collective underestimation of liquidity risks by economic agents (CGFS, 2001, p. 2), or a situation where the four dimensions of liquidity – qualitative, quantitative, spatial and temporal – are conflated, leading to the belief that market liquidity is enhanced by financial innovation, and hence is infinite and sufficient for the continuing economic turnover (Nesvetailova, 2010). In this instance, one of the many dilemmas posed by the process of financial innovation concerns the effect of securitization on the liquidity of the financial system. While most commonly assumed to have greatly increased the fungibility of various assets by pricing, marking and liquefying them, securitization, in fact, has led to compartmentalization of liquidity in various segments, both visible and not, of the economy (Kregel, 2010). In the wake of the credit crunch, and in light of the arguments outlined above, it is clear that reducing the many facets of liquidity to the overarching concept of market liquidity has concealed many problems associated with growing risks and leverage in the financial system. The principle of light-touch, institution-centred regulation also reflected the fallacies of aggregation (Toporowski, 2009; Lavoie, 2010). While regulatory oversight was focused on individual institutions and their liquidity status, the conditions of the system as a whole had been ignored, to the detriment of the public good of economic stability.
THE LINGERING QUESTION Here lies the greatest puzzle of liquidity in the context of twenty-first century financial innovation. What is the best way to understand ‘liquidity’ at the level of an economic system? On the one hand, this question does not seem to have an obvious answer, since even according to Keynes, plainly, there is no such thing as liquidity for a system as a whole. At best therefore, analysts and policy-makers can aim to examine the dynamics of liquidity at the level of individual markets and institutions, correlate these with other estimations of risk, and hope that a focus on market developments will suffice in preventing a systemic outbreak of a financial crisis. On the other hand, however, this approach evidently did not work in the attempts to foresee the 2007–09 financial meltdown, nor was it sufficient in preventing any of the earlier financial crises. The concept of systemic liquidity and its
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Liquidity 209 relation to the political-economic context thus remains a critical unresolved dilemma in the age of financial innovation and change.
REFERENCES AND FURTHER READING Berle, A. and V. Pederson (1934), Liquid Claims and National Wealth, New York: Macmillan. Bernanke, B. (2005), ‘The global savings glut and the U.S. current account deficit’, remarks at the Sandridge Lecture, Virginia Association of Economics, Richmond, Virginia, 10 March. Borio, C. (2000), ‘Market liquidity and stress: selected issues and policy implications’, in BIS Quarterly Review, November, Basel: Bank for International Settlements. Borio, C. (2004), ‘Market distress and vanishing liquidity: anatomy and policy options’, BIS Working Paper No. 158, Basel: Bank for International Settlements. Brown, C. (1940), Liquidity and Instability, New York: Columbia University Press. Brunnermeier, M.K. and L.H. Pederson (2009), ‘Market liquidity and funding liquidity’, Review of Financial Studies, 22(6), 2201–38. Carruthers, B. and A. Stinchcombe (1999), ‘The social structure of liquidity: flexibility, markets, and states’, Theory and Society, 28(3), 353–82. CGFS (2001), ‘Structural aspects of market liquidity from a financial stability perspective’, CGFS Discussion Paper, BIS, Committee on the Global Financial System, June. Crockett, A. (2008), ‘Market liquidity and financial stability’, Financial Stability Review (Special Issue on Liquidity), Paris: Bank of France, February. Dow, S.C. (1993), Money and the Economic Process, Aldershot, UK and Brookfield, VT, USA: Edward Elgar. Genberg, H. and A. Swoboda (1993), ‘The provision of liquidity in the Bretton Woods system’, in M. Bordo and B. Eichengreen (eds), A Retrospective on the Bretton Woods System, Chicago: NBER, University of Chicago Press. IMF (2005), ‘Gauging global liquidity conditions’, World Economic Outlook, Washington, DC: International Monetary Fund. Keynes, J.M. (1936), General Theory of Employment, Interest and Money, New York: Harcourt, Brace & Co. Kregel, J. (2010), ‘No going back: why we cannot restore Glass–Steagall’s segregation of banking and finance’, Public Policy Brief No. 107, Levy Economics Institute, Bard College. Lavoie, M (2010), ‘The subprime financial crisis: reflections from a post-Keynesian viewpoint’, Working Paper, Department of Economics, University of Ottawa, April. McCulley, P. (2008), ‘The liquidity conundrum’, CFA Institute Conference Proceedings Quarterly, March. Minsky, H. (1982), Can ‘It’ Happen Again?, New York: M.E. Sharpe. Mueller, F. (1953), ‘Corporate working capital and liquidity’, The Journal of Business of the University of Chicago, 26(3), 157–72. Nesvetailova, A. (2007), Fragile Finance, Debt, Speculation and Crisis in the Age of Global Credit, Basingstoke/New York: Palgrave Macmillan. Nesvetailova, A. (2010), Financial Alchemy in Crisis: The Great Liquidity Illusion, London: Pluto. Special Committee on Terminology (1931), A Preliminary Report, American Institute of Accountants, New York: Century Co. Tett, G. (2009), Fool’s Gold, New York: Free Press. Tirole, J. (2010), ‘Illiquidity and all its friends’, BIS Working Paper No. 303, Basel: Bank for International Settlements.
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Toporowski, J. (2009), ‘It’s not about regulation …’, DIIS Working Paper No. 2009:08, Copenhagen: Danish Institute for International Studies. Warburton, P. (2000), Debt and Delusion, London: Penguin Press. Warsh, K. (2007), ‘Market liquidity – definitions and implications’, remarks at the Institute of International Bankers Annual Washington Conference, Washington, DC, 5 March.
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29 Karl Marx Andrew Trigg
In times of economic crisis contemporary solutions are developed in response to particular financial instruments, institutions or geopolitical structures. Phenomena such as subprime mortgage products, hedge funds, and the decline of US financial hegemony have, for example, been highlighted in the global economic crisis that started in 2007. To take a step back from such specifics, in an attempt to provide a more comprehensive and general view of capitalist dynamics, a radical alternative is offered by the writings of Karl Marx.
SIMPLE CIRCULATION Marx was so keen to start with general, rather than specific, foundations that Volume 1 of his great work, Capital, does not even begin with an analysis of full-blown capitalism. The first three chapters abstract from the unequal power relations of capitalism to concentrate on the simple circulation of money and commodities. In this rudimentary model of capitalism, individuals are self-employed producers exchanging commodities for money. Although in some respects this model of simple circulation is sophisticated, with a uniform wage rate and an advanced division of labour between producers, these are simple beings, only carrying out production in order to satisfy their individual consumption needs. The circulation of money in this framework is not so simple. It has a surprisingly rich suite of functions, even before we turn to full-blown capitalism. To keep things as simple as possible, Marx assumes that gold is the money commodity that facilitates exchange between commodities. Commodities are commensurable in exchange because they have different values based on the amount of labour required for their production. Gold is uniquely suited to facilitate this comparison since it too is produced by labour. It provides a measure of value – the first function of money – through which the relative prices of different commodities can be calculated. With money functioning as a measure of value, it enables the circulation of commodities between producers. In simple circulation, the circulation of commodities is characterized as C–M–C, with commodities (C) circulating 211
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for money (M) that is used only for the purpose of purchasing other commodities (C). There are two phases in this process. In the first (C–M) the seller hands over commodities and in return receives gold coins; in the second (M–C), the seller uses these coins to purchase new commodities. The worker may produce linen, for example, that is exchanged for money, which is then used to buy wheat. Given the multitude of commodities that are produced under the social division of labour, these cannot be feasibly exchanged in a barter system (C–C). Under simple commodity exchange money must function as a medium of circulation. Even at the abstract level of simple circulation, Marx is able to formulate a critique of one of the pillars of orthodox economics: Ricardo’s adherence to Say’s Law, the supply-side proposition that supply creates its own demand. At the most abstract level, with money as a measure of value, the price form itself contains a realization problem. The producer expends a particular quantity of labour time in the commodity’s production, but since the commodity must exchange for money there is the distinct possibility that this will represent a lower quantity of realized labour time. There is for Marx ([1876] 1976, p. 196) the possibility of ‘a quantitative incongruity between price and magnitude of value’. Marx further develops this realization problem by separating the circulation process into the two phases, C–M and M–C. Since supply and demand are separated there is a possibility of disequilibrium. The individual may, for example, sell linen for money (C–M) but there is no guarantee that the money receipts will be immediately spent on another commodity (M–C), such as wheat. As Marx (ibid., p. 208) explains, ‘no one directly needs to purchase because he has just sold’. On this basis, Marx develops his possibility theory of crisis, a theory in which the conditions necessary for economic crisis are developed. Starting from the most general of these conditions, Marx introduces more concrete phenomena in incremental steps. The next step for Marx in the disjuncture between demand and supply is the formation of money hoards, where receipts from commodity sales can rest when not translated into demand for other commodities. Since gold represents a crystallization of value, it can be held by individuals as an alternative to demanding the commodities produced by others. A ratcheting up in the power of money takes place as ‘the lust for gold awakens’ (ibid., p. 229). Whereas the classical economists such as Ricardo, together with modern-day orthodox theorists, seek to confine money to its role as a circulating medium, for Marx considerable importance is attached to the functioning of money as a hoard. In a final step for developing the role of money in simple circulation, this most abstract formulation of Marx’s possibility theory of crisis is made
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Karl Marx 213 more concrete by the introduction of debit and credit relationships – the rudiments of a financial theory. Instead of money changing hands simultaneously with commodities, a time delay can take place, in which the seller is paid by the buyer at a later date. The two parties enter into a financial contract, which is settled by money in its function as a means of payment. The introduction of debt contracts brings with it a more complex network of social relationships. The buyer is able to purchase the commodity by taking out a debt contract, but this can only be settled by selling the commodity, or something produced with it, to a third party. This means that the initial seller of the commodity is dependent on both the immediate buyer and the new customer of that buyer. It follows that in this more interconnected model of simple circulation the possibility of crisis is more pronounced. When a producer gets into financial difficulty this cascades throughout the economy with enhanced effect, forcing more parties to settle their contracts, driving a hole in the collective confidence that depends on these contracts. Hence the role of money as a means of payment adds to the financial fragility of the system (see Crotty, 1985). These four functions of money, as a measure of value, circulating medium, hoard and means of payment are brought together in Table 29.1. And as the functions of money are introduced the possibility of crisis becomes more concrete. As we have seen, inimical to the measure of value is the possibility that price may deviate from value, which means that the producer might not be paid in full for the labour expended. With money as a circulating medium there is a separation between the acts of buying and selling, which can be interrupted by producers hoarding money. Once credit relationships are introduced with money as a means of payment, the possibility of crisis is even more concrete because of the complexity and potential fragility of contractual relationships between producers. Table 29.1 Money and crisis under simple circulation Function of Money Measure of value Circulating medium Money as hoard Means of payment
Possibility of Crisis Price–value deviation Separation of demand and supply Interruption of money circuit Financial fragility
This possibility theory of crisis is therefore based on establishing conditions for disequilibrium. Under simple circulation (C–M–C) money takes on different guises that open up the possibility that the circulation of commodities will be incomplete. For capitalism, however, this is only the start of the
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problem. No longer are there self-employed producers exchanging with each other on an equal basis. Moving on from this bourgeois ideal, a consideration of actual capitalist relations requires the consideration of social classes. One class in particular – the capitalist class – enjoys a position of dominance, which requires a further step change in how we consider the circulation of money.
SIMPLE AND EXPANDED REPRODUCTION Building on simple circulation, Marx then formulates models of simple and expanded reproduction. The main substance of this contribution is to be found in Marx’s unpublished and unfinished writings in Volumes 2 and 3 of Capital, so an exposition of Marx’s approach has to be somewhat tentative; but as a way forward the advantage of Marx’s approach is that it builds up in successive steps, as any scientist might change the conditions at each stage of an experiment. Simple reproduction is a static model in which the surplus is not invested for purposes of expansion – a profligate capitalist class consumes the entire surplus as luxury consumption. Instead of the self-employed artisans of simple circulation, exchanging their wares produced under a Protestant work ethic, in simple reproduction we have a shameless class of capitalists, consuming all of the profits extracted from an exploited working class. Capitalists are now employing workers to produce goods for profit. Outlays M on capital inputs are used to produce new outputs, which are realized as M’. The new formula for the circuit of money takes the form M–C–M’. But the problem, as identified by Marx ([1893] 1978, p. 407) is where does the money come from for the outlay of M to be realized as a higher amount of money M’? The answer is that capitalists must draw on their hoards of money gold to purchase the surplus output. For each individual capitalist it ‘means nothing more than that he has to cover his individual consumption for the first year out of his own pocket’ (ibid., p. 409). This function of money as a hoard, first introduced as an interruption to simple exchange, now takes centre stage as the basis for the realization of profits. Of critical importance is the advance of money required for simple reproduction by the capitalist class as a whole. Here we see the formulation of a macro-monetary approach in which class aggregates (capitalists and workers) are related to aggregate categories (wages and profits). Whereas simple circulation looks at a micro-web of exchange relationships, under simple reproduction capitalism is viewed from a macroeconomic perspective. Parallels can be drawn here with Kalecki’s notion that capitalists earn what they spend (Sardoni, 1989).
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Karl Marx 215 This introduces a realization problem to the system in which aggregate profits depend on capitalist demand decisions. When capitalists decide to hoard money instead of spending, this threatens the realization of profits. The key step change in this realization problem is when capitalism expands. Under expanded reproduction, the sheer scale of the system, with capitalists investing their profits into ever-increasing amounts of capital, places the realization problem at a peak level of difficulty. In Part 2 of Theories of Surplus Value, Marx (1968, p. 535) summarizes the problem for capital as one of over-production: Over-production is specifically conditioned by the general law of the production of capital: to produce to the limit set by the productive forces, that is to say, to exploit the maximum amount of labour with the given amount of capital, without any consideration for the actual limits of the market or the needs backed by the ability to pay.
Capitalists drive their expansion to the limits of how much of the everincreasing mass of profits can be realized by the market. Central to stretching the limits of expanded reproduction is the role of finance (debt and credit relationships). Since production is ‘dependent on the extent of the money capital which the individual capitalist has at his disposal’, Marx ([1893] 1978, p. 433) argues: ‘This limit is overcome by the credit system and the forms of association related to it, e.g., joint-stock companies’. Foley (1986, p. 87) puts the problem succinctly: ‘hence the solution of having capitalists start with a money reserve, which worked for simple reproduction, will not work for expanded reproduction. Any finite initial reserve of money would be exhausted at some point on the path of expanded reproduction’. So not only is there a realization problem at the heart of expanded reproduction, there is also a problem of how realization is financed. Capitalists must borrow from beyond their own money hoards. We have reached the point, which Marx developed in Capital, Volume 3, where financial institutions and processes form a part of Marx’s analysis of capital. Money is no longer restricted to the hoards of individual capitalists; it must be pooled through joint stock companies and collected in the reserve funds of banks (Marx [1894] 1981, p. 529). Money is no longer restricted to the money commodity; banks issue banknotes and drafts (ibid., p. 676). And, as we have seen, this role of finance is not supplementary to Marx’s system; it is critical to its expansion. Furthermore, finance is autonomous to expanded reproduction. A key variable such as the money rate of interest charged by banks is for Marx dependent on purely institutional monetary arrangements (see Rogers, 1989). The rate of interest is a monetary variable independent of the rate of
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profit. Marx ([1894] 1981, p. 654), for example, argues: ‘In times of crisis the demand for loan capital, and with it the interest rate, reaches its maximum; the rate of profit as good as disappears, and with it the demand for industrial capital’. This is a somewhat heretical interpretation of Marx, since the whole gamut of Marxian analysis has tended to give primary status to the real aspects of his theories. But for Marx (ibid., p. 649): ‘As long as the social character of labour appears as the monetary existence of the commodity and hence as a thing outside actual production, monetary crises, independent of real crises or as an intensification of them, are unavoidable’. As Crotty (1985) argues, rather than the monetary sphere simply being a reflection of the real sphere of economic activity, in Marx’s system the two spheres work as co-determinants of equal status – a far cry from the neutral role of money in orthodox economics. From this perspective, the global crisis that started in 2007 should, following Marx, be approached with an open mind, in a general framework of analysis, giving full consideration to both real and financial causes. And as illustrated by recent events, any crisis, whatever its cause, is also a monetary crisis. We have shown that even at the highest level of abstraction there is a potential disjuncture between production and its monetary realization. Furthermore, using the incremental approach suggested here, specific institutional phenomena, such as hedge funds, can be set in the context of expanded reproduction. For example, it might be asked whether, by engaging in financial gambling, hedge funds contribute any capitalist expenditure to help realize the mass of profits produced under capitalism. The model of expanded reproduction provides a general framework in which to pose this type of question in relation to concrete issues that arise in particular crises.
REFERENCES Crotty, J.R. (1985), ‘The centrality of money, credit, and financial intermediation in Marx’s crisis theory: an interpretation of Marx’s methodology’, in S. Resnick and R. Wolff (eds), Rethinking Marxism: Essays for Harry Magdoff and Paul Sweezy, New York: Autonomedia, pp. 45–81. Foley, D.K. (1986), Understanding Capital: Marx’s Economic Theory, Cambridge, MA: Harvard University Press. Marx, K. ([1876] 1976), Capital, Volume 1, London: Penguin. Marx, K. ([1893] 1978), Capital, Volume 2, London: Penguin. Marx, K. ([1894] 1981), Capital, Volume 3, London: Penguin. Marx, K. (1968), Theories of Surplus Value, Part 2, London: Lawrence & Wishart. Rogers, C. (1989), Money, Interest and Capital, Cambridge: Cambridge University Press.
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Karl Marx 217 Sardoni, C. (1989), ‘Some aspects of Kalecki’s theory of profits: its relationship to Marx’s schemes of reproduction’, in M. Sebastiani (ed.), Kalecki’s Relevance Today, Basingstoke: Macmillan, pp. 206–19.
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30 The methodology of finance Sheila C. Dow
The methodology of finance is crucial to the field. The way in which financial markets and behaviour are analysed depends on the methodological approach taken to building knowledge. This methodological approach includes both the methods of enquiry and the principles by which some theories are judged to be better than others. But in finance there is more reflexivity than normal, in that finance theory and modelling directly inform and guide actual market behaviour. Therefore the methodology of finance theory carries over into the methodology of practice. For example, we have seen in the financial crisis that broke in 2007 that the methodology of finance, particularly the reliance on quantitative models, was a major contributor to the situation, as well as colouring the way in which the crisis was then analysed. Ultimately the methodology of finance is determined by the way in which the real practice of finance is understood, and thus framed. This framing then determines the form of the analysis and the way in which practice itself is organized. It is the purpose of what follows to explain what this involves. We start with the mainstream methodology of finance, and then consider alternative methodologies. Methodological approach stems from the way in which real processes are understood. The ontology that underpins any methodological approach is conditioned, not just by simple experience, but also by ‘deep background’ (Searle, 1995) as well as by the more obvious influences of education and institutional environment emphasized by Kuhn (1962). Reality and ‘facts’ are thus understood in a particular way, even before consideration is given to explicit methodological principles by which the search for knowledge is guided. We therefore start each methodological account with the way in which finance is framed.
MAINSTREAM FINANCE The mainstream approach understands financial markets as a close approximation to the perfectly competitive markets of mainstream microeconomic theory, given the large number of suppliers, the availability of specialist expertise, the free availability of large amounts of detailed information, 218
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The methodology of finance 219 relatively free entry, and thus a competitive environment. Such markets are associated with efficiency in terms of producing a socially optimal outcome in terms of price and quantity. With this as the benchmark, we will see that anomalous results are explained by some impediment to the proper functioning of financial markets, the outcome being socially suboptimal. These market imperfections include regulation, which inhibits freedom of entry, asymmetric information, transactions costs and particular incentive arrangements. Within this market framing, the price mechanism is central. Asset pricing is determined by specialist analysts who study the value of the underlying assets with reference to risk of future price variation, including risk of default. Where assets are structured products, the estimation of risk is highly complex. But the benchmark for pricing is ‘fundamentals’ (real economic conditions), which determine equilibrium values that are regarded as ‘true’ values. The estimation of risk is also treated as objective, such that a ‘true’ estimate of risk is established by the market. Deviations of price from equilibrium provide a profit opportunity for arbitrageurs, who act to eliminate those deviations. Market prices are thus equilibrium prices. The methodology employed to analyse these markets is deductivist with respect to the rationality axioms. Market participants are understood to be rational in the strict sense of optimizing with respect to the profit goal on the basis of close-to-perfect information. Assuming rational behaviour, in this sense, results are deduced to predict the equilibrium price implied by a set of initial conditions. While these results can be derived by pure theory, financial markets are unusual in yielding a massive amount of pricing data, which allows for quantitative prediction, as well as ex post testing of theory. The methodology conforms therefore to logical positivism (Caldwell, 1982). As a result, highly sophisticated quantitative models have been developed to take account of the complexity of modern financial products and the interrelations between markets for different products. These models have been developed further by market participants themselves as a core tool for predicting future price developments as initial conditions change. The most famous of these is the Black–Scholes model, which received academic recognition with the Nobel Prize, but also was the basis for the market success of the US hedge fund Long-Term Capital Management in the 1990s. (But then LTCM collapsed because the model could not handle the structural changes in asset prices following the crises in South-East Asia and Russia.) This methodological approach determines the type of theory that follows, the core theory being the efficient markets hypothesis (Fama, 1970). This theory posits that financial markets are ‘informationally efficient’; prices
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reflect all available information, such that there are no persistent (riskadjusted) profit opportunities; arbitrage between financial assets (as perfect substitutes) drives all asset prices to their equilibrium level (taking account of probabilistic risk and return). Movement in asset prices therefore either reflects changing fundamentals, changing information on fundamentals, or ‘white noise’ (the latter implying that asset prices follow a ‘random walk’). Subsidiary theories include the capital asset pricing model, which provides the detailed modelling basis for valuing assets or portfolios in terms of risk assessment. Another is the Modigliani–Miller theorem, which states that the capital structure of firms is irrelevant (in the absence of market imperfections) since sources of finance are perfect substitutes (see, further, Glickman 1997–98). Indeed, Davidson (2002, Chapter 3) has identified the gross substitution axiom as one of the basic axioms of mainstream theory. Overall, this theoretical structure provides justification for liberalizing financial markets in order to allow them to generate the most efficient, and socially optimal, outcome in the form of an array of prices. There have been challenges over the years to the efficient markets hypothesis in particular (emphasizing some market imperfection or another), but it has come under increasing scrutiny in the light of the crisis from 2007 as concerns emerged that liberalization had gone too far. Some of these challenges have been based on contrary empirical evidence, encouraging new approaches to finance within the mainstream. Challenges from outside the mainstream are based on a more broadly based difference of view as to how financial markets work (referring to the level of real forces rather than just the empirical level). We consider these alternative approaches in the next section.
ALTERNATIVE METHODOLOGIES Mainstream Framing with Modifications Drawn from Evidence Within the mainstream there are two strands of theory that start from empirical challenges to traditional finance theory. This reflects well the mainstream logical positivist methodology, whereby theoretical statements should be confronted with data, and theory then adapted accordingly. Both approaches aim to build up an alternative deductivist theoretical structure that more fully accords with evidence. The older strand is the New Keynesian approach, which draws on evidence that challenges the Modigliani–Miller theorem. It is argued that small and medium-sized firms do not have the same access to capital markets as large firms, and are therefore more dependent on bank finance. The key is different information sets held by different parties (Bernanke,
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The methodology of finance 221 1993). It is further argued that asymmetric information prevents banks from identifying the true risk posed by borrowers, so they use rules of thumb for pricing credit in a way that requires rationing when market rates are rising. The asymmetric information argument has been applied most recently to financial markets more generally, focusing on the difficulties experienced in pricing structured financial products (see, for example, Calomiris, 2008). Asymmetric information is treated as a market imperfection whose removal would prevent further crises; the policy implication is to ensure more market transparency. The other stream, new behavioural finance, derives from empirical evidence with respect to individual behaviour derived from experimental economics; this evidence seems to run counter to the axioms of rational behaviour (see Camerer et al., 2004, for a survey). The analysis of the reasons for this seemingly irrational behaviour draws on psychology, referring to cognitive issues (how choices are framed) and to preferences (e.g., as to risk). However, behaviour continues to be defined as either rational or irrational, and the goal continues to be to build a deductivist model (albeit with modified axioms) (see, for example, Kahneman, 2003, p. 1469). Again the methodology is consistent with mainstream finance, but with more of a focus on what are understood to be market imperfections (irrational behaviour), with an empirical justification. Heterodox Framing There is another range of theoretical analyses of finance that adopt a quite different methodological approach. All are realist in the sense of starting from a particular understanding of economic processes as being grounded in institutions and conventions (‘old’ institutionalists and ‘old’ behavioural economists respectively) that have evolved in order to allow society to deal with uncertainty (Post Keynesian economics). Since social systems are understood to be open, such that behaviour and structures evolve in a non-deterministic way, the future is uncertain and thus cannot be captured in probabilistic measures. There is therefore no true price based on a true measure of risk. Finally markets are understood to be unstable, given the inability of the efficient equilibrating forces identified by mainstream theory to deal with unanticipated structural change and other unexpected developments. The methodological approach is inductivist in the sense of stemming from an understanding of the real social system, rather than being based on axioms (like the rationality axioms of mainstream finance) that are taken to be true. But it is not pure induction; it is rather what critical realists call
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‘retroduction’, which seeks to move from detailed observation to identifying underlying causal mechanisms (Lawson, 1997, p. 24). It is accepted that our understanding of reality involves perspective, or theory. But the grounding in reality is regarded as crucial. Theories are developed on a provisional basis for application to particular contexts, with the understanding that theory may require revision for different contexts. Financial markets are understood as competitive and sophisticated, yielding unusual volumes of information. Nevertheless, the pervasive presence of uncertainty requires that pricing be based on available information, but even more on conventional interpretations of that information, conventional expectations, and conventional practices that have evolved within particular institutions. So heterodox finance theory emphasizes analysis of these conventions and institutions, including the particular convention, drawn from mainstream theory, of basing decisions on quantitative models. Other disciplines provide input, notably psychology to explain motivations for behaviour that may be subconscious (Tuckett, 2009) to explain behaviour, avoiding the mainstream dichotomizing of rationality and irrationality. Similarly, recourse is made to sociology to explain the social setting of markets (Preda, 2007). The pluralism reflected in interdisciplinary analysis also appears in terms of the range of methods employed, with mathematical formalism only one of those methods. Uncertainty is seen, not only as justifying this open-system methodological approach, as well as a determinant of the development of institutions and conventions, but is also seen as a determinant of portfolio behaviour. A central plank of Post Keynesian finance theory is the theory of liquidity preference, whereby increased uncertainty about asset valuation encourages a preference for a more liquid portfolio (Bibow, 2009). This has implications for the behaviour of asset markets, providing part of the explanation for financial crises. Minsky’s (1982) financial instability hypothesis analyses the consequences of increasing leverage as conventional asset valuations rise in an upturn; this reflects falling liquidity preference in all sectors, including the banks (encouraging more lending). The reverse occurs in the downturn, which has been spurred on by cash-flow problems as highly leveraged firms face difficulties in meeting commitments when markets turn around. A Minskyan analysis of financial crisis that takes instability as the norm thus differs fundamentally from mainstream explanations that take stable equilibrium as the norm. Policy differences follow. While the mainstream methodology generates policy recommendations for removing market imperfections, a Minskyan methodology generates policy recommendations for mechanisms to stabilize financial market activity.
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CONCLUSION We have seen that the framing of financial markets requires a particular methodological approach, which in turn requires that theory takes a particular form, and policy be approached in a particular way. Even when mainstream finance theory has been challenged by various types of evidence, and new theories have emerged, this methodology acts as a powerful constraint. Theory must classify any results that deviate from a socially optimal competitive equilibrium as the outcome of some market imperfection, and policy options are accordingly limited to addressing these imperfections. By framing financial activity and institutions rather in terms of uncertainty, non-mainstream finance theory has developed along very different lines, dealing with such matters as liquidity preference and financial instability that are heavily circumscribed in mainstream theory. This open-systems approach allows for a fuller input from other disciplines, and adaptation of theory to address particular institutional contexts, as well as a different type of input from policy-makers.
REFERENCES Bernanke, B. (1993), ‘Credit in the macroeconomy’, Federal Reserve Bank of New York Quarterly Review, 18(1), 50–70. Bibow, J. (2009), Keynes on Monetary Policy, Finance and Uncertainty: Liquidity Preference Theory and the Global Financial Crisis, London: Routledge. Caldwell, B.J. (1982), Beyond Positivism: Economic Methodology in the Twentieth Century, London: Allen & Unwin. Calomiris, C.W. (2008), ‘The subprime turmoil: what’s old, what’s new, what’s next’, Annual Jacques Polak Conference, IMF, November, available at http://www.imf.org/external/np/ res/seminars/2008/arc/index.htm; accessed 16 March 2010. Camerer, C., G. Loewenstein and M. Rabin (2004), Advances in Behavioral Economics, Princeton, NJ: Princeton University Press. Davidson, P. (2002), Financial Markets, Money and the Real World, Cheltenham, UK and Northampton, MA, USA: Edward Elgar. Fama, E.F. (1970), ‘Efficient capital markets: a review of theory and empirical work’, Journal of Finance, 25(2), 383–417. Glickman, M. (1997–98), ‘A post Keynesian refutation of Modigliani–Miller on capital structure’, Journal of Post Keynesian Economics, 20(2), 251–74. Kahneman, D. (2003) ‘Maps of bounded rationality: psychology for behavioral economics’, American Economic Review, 93(5), 1449–75. Kuhn, T.S. (1962), The Structure of Scientific Revolutions, Chicago: University of Chicago Press. Lawson, T. (1997), Economics and Reality, London: Routledge. Minsky, H.P. (1982), Inflation, Recession and Economic Policy, Brighton: Wheatsheaf. Preda, A. (2007), ‘The sociological approach to financial markets’, Journal of Economic Surveys, 21(3), 506–28. Searle, J.R. (1995), The Construction of Social Reality, Harmondsworth: Penguin.
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Tuckett, D. (2009), ‘Addressing the psychology of financial markets’, Economics: The Open-Access, Open-Assessment E-Journal, 3(2009-40), available at http://www. economics-ejournal.org/economics/journalarticles/2009-40; accessed 16 March 2012.
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31 Microfinance Judith Tyson
INTRODUCTION In 1976 Professor Muhammad Yunus lent a small amount of money to finance income-generating activities on an uncollateralized basis to poor people in a rural village in Bangladesh, who had been refused loans from commercial banks on the grounds that such people were ‘unbankable’. His experiment to provide credit to the poor has since evolved into today’s global microfinance movement. Whilst this huge explosion of microfinance, and its promise to provide a path out of poverty for the poorest, has many advocates and success stories, its increasing growth and complexity is giving rise to a new series of challenges and issues.
FROM EARLY TO CURRENT MICROFINANCE: PRACTICE AND THEORY The Early Microfinance Model: The Grameen Model The microfinance idea, born in 1976 in Bangladesh, under the leadership of Yunus, developed into the Grameen Bank (Yunus, 1999). The concept that was developed by the Grameen Bank was to lend on an uncollateralized basis to the poor to provide them with capital to generate income. Traditional banks had avoided such lending due to the inability of the poor to provide collateral and because the servicing of such small loans was seen as cost-intensive and unprofitable. In order to overcome this issue of credit risk the Grameen Bank loans were made on a group basis, with small groups of villagers being held jointly responsible for repayments. In addition, future loans to other members of the group were made contingent on repayments being made and repayment schedules were fixed with first payments due shortly after the loan was made, with links to compulsory savings. Over time the Grameen Bank also evolved to focus almost exclusively on female borrowers as women were believed to show stronger patterns of repayments as well as higher levels of social impact. 225
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Microfinance and the Theory of Asymmetrical Information Sourcing capital at an appropriate cost is seen by economic theory as an important precondition to the investment that underpins economic growth. However, in developing economies, financial markets and services for the poor have been widely underdeveloped, including an absence of formal financial services (Honohan and Beck, 2007). Informal financial services are, however, common and typically comprise such activities as money lending, informal saving clubs, cooperatives and informal assistance within social networks (Collins et al., 2009). This market gap would appear surprising from a basic microeconomic viewpoint. Given the principle of diminishing marginal returns on capital, the marginal return on capital should be higher for the poor capital-starved entrepreneur, enabling higher interest rates to be paid and causing a supply of capital to flow to the poor. In answering this puzzle, and in addressing the success of microfinance, economic theory has pointed to the theory of asymmetrical information (Stiglitz, 1990). In underdeveloped credit markets, little information is available relating to the creditworthiness of the borrower, leading to moral hazard and adverse selection. In addition, this cannot be compensated for by collateral and contract enforcement. This leads formal banks to withdraw from the market. Moneylenders on the other hand are able to overcome these problems due to their strong local knowledge and ability to enforce contracts through local relationships. However, the higher level of risk requires compensation through high interest rates. In this framework, microfinance is a method to overcome the issues of asymmetrical and incomplete information through group lending. Here the group self-selects members known to them, ensuring that only the creditworthy are included. In addition, the group is jointly liable for any loan and so provides ‘social collateral’ or ‘peer monitoring’ (Stiglitz, 1990) through pressure on individuals within the group to avoid the negative impact on the group of a failure to repay. Increasing Diversification and Complexity In the last three decades microfinance has evolved and expanded hugely. Table 31.1 shows that by 2008 globally there were over 3500 microfinance institutions (MFIs), 150 million customers and $60 billion in assets. Average assets per institution were $47.5 million. Outreach – defined as the number of the ‘poorest’ being reached – has also increased in both absolute and percentage terms.
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Microfinance 227 Table 31.1 Growth of microfinance, 1997–2008 Year
Total Number of MFIsa
Total Number of Clients (millions)a
Number and % of ‘Poorest’ Clients (millions)a
Average MFI Assets (USD millions)b
1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008
618 925 1065 1565 2186 2572 3931 3164 3133 3316 3552
13.5 20.9 23.6 30.7 54.9 67.6 80.9 92.2 113.3 133.0 154.8
7.6 (56%) 12.2 (58%) 13.8 (58%) 19.3 (62%) 26.8 (49%) 41.6 (61%) 54.8 (68%) 66.6 (72%) 81.9 (72%) 92.9 (70%) 106.6 (68%)
n/a n/a n/a n/a n/a 32.4 33.5 42.5 46.6 47.3 47.5
Sources: a. Microcredit Summit Campaign; b. Microfinance Information Exchange (‘MIX’).1
In addition to this expansion in scale overall, the nature of MFIs has also changed. MFIs have evolved away from their origins as village-based NGOs to being large-scale, regulated financial institutions. As Table 31.2 reveals, although numbers of all types of MFIs have grown approximately equally, the assets of banks and regulated financial institutions have grown most rapidly, with asset growth of $26.9 billion between 2003 and 2008. In contrast, NGOs’ and credit unions’ assets only grew by $10.3 billion in the same period. Thus we can see a pattern of increasing concentration of MFI assets in large-scale, regulated MFIs. Within organizations these changes are reflected by increasing use of more sophisticated technology, especially mobile banking platforms, and internal organizations and numbers of employees, as reported by practitioners.
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Table 31.2 Changes in the types of institutions, 2003–08 Type of Institution
Regulated financial institutions NGOs and credit unions
2003
2008
MFIs (% and number)
Total Assets (% and $ billion)
MFIs (% and number)
Total Assets (% and $ billion)
50% (115)
84% (6.2)
47% (504)
76% (38.4)
50% (116)
16% (1.2)
53% (571)
24% (11.5)
Note: Regulated financial institutions are fully regulated banks, non-banking financial institutions and rural banks. Source:
MIX, elaborated by author.
These changes have also meant an increasing diversification away from the origins of microfinance as reflected in group lending and increasing concentration in individual lending. As shown in Table 31.3, from 2003 to 2008, again all types of lending grew. However, individual lending grew most rapidly, with the number of MFIs nearly quadrupling and assets increasing by $10.1 billion. In contrast, group-based lending MFIs doubled in number but only increased assets by $1.3 billion. MFIs are also offering increasingly comprehensive financial services. This includes the increasing importance of non-income-generating lending (such as for housing, health and education), savings and microinsurance. For example, MIX reports that 92 per cent of MFIs in 2008 have saving accounts, up from 41 per cent in 2003. Some of these changes have been driven by an increasing sophistication in understanding how the poor manage their financial lives and acceptance of both the capacity of the poor to save and the need to provide risk management tools to reduce their vulnerability (Collins et al., 2009). Savings that allow the poor to make safe and flexible short-term deposits and to build longer-term assets for emergencies or life events (such as weddings, funerals, education, pensions etc.) are increasingly seen as important. Similarly, insurance is being developed, covering life, health and agricultural- (or weather) related risks.
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Microfinance 229 Table 31.3 Types of lending practices, 2003–08 Type of Lending Practice
Individual Individual and group Group lending only Source:
2003
2008
MFIs (% and number)
Total Assets ($billion)
MFIs (% and number)
Total Assets ($billion)
32% (74) 41% (96)
5.5 1.6
41% (281) 40% (272)
15.6 6.6
26% (61)
0.3
18% (125)
1.9
MIX, elaborated by author.
However, changes have also been driven by pressure on MFIs to be ‘sustainable’ – defined as achieving net profitability without grants or donor funds – and the increasing engagement of the private sector in microfinance as a commercial, rather than charitable, activity. Funds were originally from charitable sources, often as donations, but evolved as international financial institutions, including the World Bank and International Finance Corporation (IFC), increased funding, with the majority being as debt.2 Sustainability as a goal for MFIs and a preference for grants to be ‘start-up’ funds rather than provided on an ongoing basis have been sponsored by these institutions. Subsequently, further pressure has built as the private sector increases investment in microfinance as a commercial enterprise seeking profitable returns. This included, by 2008, 24 specialist microfinance equity funds, $100 million from private pension funds and further investment by venture capitalist funds and similar.3 There have been several public listings of MFIs (for example, Equity Bank in Kenya in 2005, Compartamos in Mexico in 2007 and SKS in India in 2010). Major international investment banks, such as Citibank and Standard Chartered, have started to develop microfinance as a commercial business. A few MFIs have also issued bonds directly in private capital markets including Compartamos and IFC. These changes have put increasing pressure on MFIs to be profitable and act as commercial rather than social enterprises and have intensified competition between MFIs in the most profitable markets.
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THE CHALLENGES OF TODAY’S MICROFINANCE The Challenges of Increasing Scale and Complexity As discussed above, MFIs are increasing the scale and complexity of their operations. While the increase in scale and thus outreach is welcome, there are challenges to be addressed. In particular, the management of such organizations requires high levels of institutional capacity. This includes general management capacity, risk management expertise and the need for operation platforms with higher technology and internal control. Worryingly in this context, indicators of operating soundness and quality of management are weak and are reported as important risks by practitioners and researchers. These issues are highlighted in Table 31.4. Table 31.4 ‘Microfinance Banana Skins’ranking of management and operating risks amongst the top 25 ‘biggest risks’4 ‘Biggest Risk’
2008
2009
Management quality
1st
4th
Corporate governance
2nd
7th
Staffing
5th
14th
Managing technology
8th
15th
Back office operations
18th
22nd
Additionally, growing internal risk at MFIs increases the possibility of losses or institutional failure, especially when combined with weak internal management expertise. Most important is, of course, credit risk where deterioration in asset quality, as measured by portfolio-at-risk (‘PAR’) has risen, with MIX average PAR rising from 2 per cent to 3 per cent and average PAR for the top 50 global MFIs rising to 4.5 per cent. Some countries where growth has been most rapid have shown above-average deterioration. For example, in Morocco where MFIs’ loan portfolios have multiplied 11 times between 2003 and 2007, PAR rose to 10 per cent by June 2009. According to CGAP, the causes were that ‘unprecedented growth had overstretched MFI capacity, translating into lenient credit policies…lack of internal controls and substandard governance’ (Reille, 2010). Similar issues have been reported in Russia, Mexico, Syria, Indonesia, Cameroon, Pakistan, Nicaragua and Bosnia-Herzegovina (CSFI, 2009; Chen et al., 2010; Reille, 2010).
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Microfinance 231 Other notable risks are foreign exchange, liquidity and reinsurance risk. These risks are again highly ranked amongst practitioners, as illustrated in Table 31.5. Table 31.5 ‘Microfinance Banana Skins’ranking of risk categories amongst the top 25 ‘biggest risks’ ‘Biggest Risks’
2008
2009
Credit
10th
1st
Liquidity
12th
8th
Foreign currency
20th
2nd
Foreign exchange risk at many MFIs is high due to funding being largely in hard currency – CGAP, for example, reports that 84 per cent of funds are in hard currency – incurring foreign exchange exposure versus its local currency lending. Women’s World Bank (WWB), a major MFI network, cited up to 70 per cent loss of earnings due to foreign exchange losses (Schneider-Moretto and Abrams, 2004). Liquidity risk, highlighted for all global financial institutions by the 2008/09 crisis, is also high. Both foreign exchange and liquidity risk are increased, as reliance on private markets increases as most MFIs operate in emerging markets subject to volatility and thin liquidity. Insurance risk, although not currently highlighted by practitioners, is also rising with the growth of microinsurance. This issue is important as MFIs are often concentrated in geographical or population groups with correlated insurance risks and because reinsurance opportunities are limited. For example, crop insurance is often concentrated in areas subject to the same weather or other crop shocks, or, similarly, health insurance is provided for populations with the same exposures to certain health issues. These issues are especially important as MFIs are increasingly deposittakers and insurers, and hence not only lenders but guardians of the poor’s savings and insurance. Many developing countries are moving towards incorporating MFIs within the regulatory framework and, as we have seen, MFIs are increasingly becoming regulated banks and other financial institutions. While this is encouraging, it should be recognized that the regulators within many developing countries already have weak capacity in regulating the formal banking system and their ability to take on a broader remit, including developing specialist supervision appropriate to MFIs, is limited (Rosenberg and Peck-Christen, 2000).
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The ‘Double Bottom Line’: Balancing Profitability and the Social Mission As discussed, both donors and investors are pressuring MFIs to achieve sustainability or profitability without subsidies in addition to MFIs’ social goal of assisting the poor. Many practitioners have sought to maintain a ‘double bottom line’ approach to managing MFIs where both social impact and financial performance are assessed but this has proved difficult as they can be seen as mutually exclusive. Most MFIs continue to struggle to be sustainable with average MIX net profit margins between 2003 and 2008 being a loss of 9 per cent. However, profitability is highly differentiated by different types of MFIs, as illustrated in Table 31.6, with better-performing MFIs being formal institutions and engaged in individual and high-end or small business lending. Table 31.6 Average net profit margins by different categories for 2003 to 2008 Type of % Institution
Type of Lending
%
Client Type
%
Banks
Individual
+0.1%
+0.2%
Solidarity
–27.3%
Small business High-end individual
Village Banking
–20.6%
Low-end individual
–20.4%
–0.7%
Non-bank –9.7% financial institution NGO –13.7% Source:
+2.3%
MIX; elaborated by author.
Given the net margins above, the trend to be sustainable is likely to push MFIs to reduce outreach as they seek to serve only the most commercially attractive clients and markets, and empirical studies to date have largely found this to be the case, with a payoff between outreach to the poorest and profitability (Cull et al., 2007). Interest rates have long been a focus in microfinance due to the very high, some claim usurious, rates, with an average interest rate of 26 per cent.5 Basic economic theory indicates that increasing competition should push down the ‘price’ of credit as represented by interest rates. However, evidence remains mixed with no clear pattern linking competition and interest rate declines.6 Given the pressure to obtain profitability and so to
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Microfinance 233 maximize interest rates, a number of countries are seeking legal caps on interest rates to protect the poor. Competition is also giving rise to a breakdown of lending discipline in some markets and has been linked to rising PAR. For example, in Pakistan and Nicaragua average PAR rose to 13 per cent and 12 per cent respectively. Causes are different by country and institution, but a recent study by CGAP identified common causes as high levels of competition for the same clients, leading to multiple borrowing, stretched operation capacity as MFIs rapidly expanded operations, and an erosion of MFI lending discipline (Chen, 2010). The issue of multiple borrowing in particular has been driven by the growth of multiple MFIs competing for the same client combined with an increase in individual but still uncollateralized lending and the continuing lack of credit bureaus. Overall, it seems likely that MFIs will continue to becoming increasingly commercial and focus on profitability. Whether MFIs’ social goals, including outreach and reasonable interest rates, are lost remains to be seen. However, one clear policy consideration is that donors should both focus on those MFIs that have strong outreach to the poorest, who otherwise may be left behind in the race to profitability, and that such subsidies are appropriate on an ongoing basis to MFIs with strong outreach. Challenges to Economic Research and Theory As discussed in an earlier section, economic theory originally looked to the theory of asymmetric information to provide a theoretical underpinning to microfinance. However, the increasing diversity of microfinance today means that this theory is too limited to be able to explain the full range of activities and that practice itself has moved away from the group-based lending the theory sought to explain. In addition, much support of microfinance has historically been based on personal conviction, often supported by inspiring but anecdotal examples of success, rather than empirical research. Empirical economic research to date has failed to provide clear-cut answers to the key questions addressing microfinance today such as the payoff between profitability and competition and key indicators of social mission such as outreach and reasonableness of interest rates. Some of these issues have been methodological. In particular, examination of individual factors has been difficult due to the absence of statistically satisfactory control groups where the only differentiating factor is accessing microfinance. Similarly macro-level comparative studies, such as crosscountry studies, often provide information but again have difficulty in controlling for multiple factors. More recent studies have started using
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randomized control trials with large samples but results to date have been inconclusive and over short time series (for example, Rosenberg, 2010a uses data over only a three-year period). However, a new publication, Portfolios of the Poor: How the World’s Poor Live on $2 a Day (Collins et al., 2009) offers us the start of an alternative and more comprehensive understanding of microfinance by developing a much richer microeconomic understanding of financial lives of the poor. The study collected year-long financial diaries from hundreds of low-income households in South Africa, India and Bangladesh and sought to understand both the assets and cash flow of the poor and the types of risks they sought to manage and the methods by which they did so. Coming out of that study is a rich picture of the sources of financial vulnerability of the poor showing how they are impacted by low and volatile income, a high level of exposure to shocks (such as health events) and a lack of long-term assets for important life events such as education, family events (such as weddings, funerals etc.) and retirement. The diaries show us how the poor manage these issues through the use of savings, as well as lending, and their complex interaction with the informal financial system such as savings clubs, moneylenders, family and social networks. When microfinance is placed into this context, it is much easier to see the potential it offers to assist the poor in managing their ‘portfolios’. For example, the need to provide safe and reliable savings, insurance and flexibility that reflect volatility in cash flow and shock management are placed as key offerings from an MFI in addition to lending. Equally, and perhaps most critically, such understanding indicates how microfinance might return to its original inspiration – that of providing the poor with a way to help themselves out of poverty – by allowing them to overcome the forces that keep them poor. Further development of economic and development theory in this area may well be the most productive way of assessing and assisting the next stage of microfinance.
NOTES 1. 2.
3. 4.
MIX data throughout the chapter reflects only MFIs that report to MIX. These reporting entities also change year on year but this has not been adjusted for in the data presented. For example, by 2008, CGAP (Consultative Group to Assist the Poor) reported that the top funders were the World Bank, European Bank for Reconstruction and Development (EBRD), International Finance Corporation (IFC) and Kreditanstalt für Wiederaufbau (KfW). Sixty-three per cent of funds were in the form of debt, 17 per cent equity and 11 per cent grants (CGAP, 2008). Source: CGAP. ‘Microfinance Banana Skins’ is an annual survey of microfinance practitioners conducted by the Centre for the Study of Financial Innovation, a non-profit think-tank and is sponsored by CGAP and Citi Microfinance.
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Microfinance 235 5. 6.
Source: Rosenberg (2010b). Examples of studies include the following: (1) a CGAP global study found declining rates but could not clearly assign this to competition vs. other factors and only covered a three-year period from 2003 to 2006 (Rosenberg et al., 2009); (2) an IADB study for Latin America found interest rates declined with increasing competition (Campion et al., 2010); (3) a study of Bolivia, Uganda and Bangladesh by found no decline in interest rates from competition (Porteous, 2006).
REFERENCES Campion, A., R.K. Ekka and M. Wenner (2010), ‘Interest rates and implications for microfinance in Latin America and the Caribbean’, IDB Working Paper Series No. IDB-WP-177. Centre for the Study of Financial Innovation (CSFI) (2009), ‘Microfinance Banana Skins 2009’, available at http://www.cgap.org/gm/document-1.9.35203/Microfinance%20 Banana%20Skins%202009.pdf; accessed 8 March 2012. CGAP (2008), ‘Results of the 2008 Microfinance Funder Survey’, available at http://www. cgap.org/gm/document-1.9.7448/2008%20Funder%20Survey-resource%20presentation %20final.pdf; accessed 1 April 2012. Chen, G., S. Rasmussen and X. Reille (2010), ‘Growth and vulnerabilities in microfinance’, CGAP, available at http://www.cgap.org/p/site/c/template.rc/1.9.42393/; accessed 8 March 2012. Collins, D., J. Morduch, S. Rutherford and O. Ruthven (2009), Portfolios of the Poor: How the World’s Poor Live on $2 a Day, Princeton, NJ: Princeton University Press. Cull, R., A. Demirgüç-Kunt and J. Morduch (2007), ‘Financial performance and outreach: a global analysis’, The Economic Journal, 117(517), 107–33. Honohan, P. and T. Beck (2007), Making Finance Work for Africa, Washington, DC: The World Bank. Microfinance Summit Campaign (2009), ‘State of the Microcredit Summit Campaign Report’, available at http://www.microcreditsummit.org/uploads/socrs/SOCR2009_ English.pdf; accessed 8 March 2012. Porteous, D. (2006), ‘Competition and microcredit interest rates’, CGAP, available at http://www.cgap.org/p/site/c/template.rc/1.9.2575/; accessed 8 March 2012. Reille, X. (2010), ‘The perils of uncontrollable growth’, CGAP, available at http:// microfinance.cgap.org/2010/01/11/the-perils-of-uncontrolled-growth/; accessed 8 March 2012. Rosenberg, R. (2010a), ‘Does microcredit really help poor people?’, CGAP, available at http://www.cgap.org/gm/document-1.9.41443/fn59.pdf; accessed 8 March 2010. Rosenberg, Richard (2010b) ‘Why do microcredit interest rates vary so dramatically around the world?’, CGAP, available at http://microfinance.cgap.org/2008/06/20/why-domicrocredit-interest-rates-vary-so-dramatically-around-the-world/; accessed 8 March 2012. Rosenberg, R. and R. Peck-Christen (2000), ‘Regulating microfinance – the options’, in M. Harper (ed.), Microfinance: Evolution, Achievements and Challenges, London: ITDG Publishing. Rosenberg, R., A. Gonzalez and S. Narain (2009), ‘The new moneylenders: are the poor being exploited by high microcredit interest rates?’, CGAP, available at http://www.cgap.org/p/ site/c/template.rc/1.9.9534/; accessed 22 March 2012. Schneider-Moretto, L. and J. Abrams (2004), ‘Foreign exchange risk management in microfinance’, New York: Women’s World Banking, available at http://www.swwb.org/ publications/foreign-exchange-risk-management-microfinance; accessed 8 March 2012.
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Stiglitz, J. (1990), ‘Peer monitoring and credit markets’, World Bank Economic Review, 4(3), 351–66. Stiglitz, J. and K Hoff (1990), ‘Introduction: imperfect information and rural credit markets – puzzles and policy perspectives’, The World Bank Economic Review, 4(3), 255–50. Yunus, M. (1999), Banker to the Poor: The Story of Grameen Bank, London: Aurum Press.
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32 Hyman P. Minsky Jan Kregel
Hyman Minsky is best known for his financial instability hypothesis. It is based on a reaction to two strands of theory that were dominant when Minsky was starting his career. The first was that the cyclical behavior of the economy was the result of, and could be modeled as, the reaction of a stable mathematical system to exogenous shocks. The second was that deficient aggregate demand could place the economy in a stagnant underemployment equilibrium, which could be transformed into stable full employment equilibrium with appropriate Keynesian fine-tuning of monetary and fiscal policy. Indeed, the confidence of mainstream economics in the latter position was reflected in a Social Science Research Council Conference with the title ‘Is the Business Cycle Obsolete?’ For Minsky these positions ignored the fact that capitalism was a dynamic, ever-changing system, adapting its methods and employing new innovations in search of the maintenance of the profit required to remunerate capital employed. The very concept of a static equilibrium or stable expansion would have meant the collapse of the capitalist system. In a modern economy where new capital and technology were the source of profitable expansion, the ownership of capital was usually financed by the issue of debt. Profits thus had to meet the claims of bond holders and other creditors as well as provide a competitive return to equity owners. In such a system the return to equity can be raised by increasing the share of external borrowing known as leverage. The very success in producing profit to meet financing costs would lead the system to increase leverage, raising the share of fixed interest costs in total financing costs and increasing the probability that a shortfall in earnings from those expected would place a firm in a position where not only could it not pay dividends to equity holders, but could not meet its commitments to its creditors. If it could not obtain additional financing, the firm would have to default on its external commitments. This led Minsky to argue that even if fine-tuning managed to stabilize the real economy, there was an inherent logic in the capitalist system that would produce increasing leverage and financial layering, leading to increasing financial fragility, which would eventually lead to a breakdown into a financial crisis. Thus, instability is the result of an endogenous process of capitalist financing that will occur even in the presence of stability of the real economic system. It would take more than 237
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Keynesian fine-tuning to achieve stable full employment over time. Although Minsky viewed such instability as inevitable, he also believed that appropriate regulation and supervision of the financial and corporate sector could lessen the strength of the crisis when it inevitably arrived. But his proposals of measures to this end went beyond the financial sector. In addition to the famous hypothesis, a great deal of his work was dedicated to general economic policy capable of ‘stabilizing an unstable economy’, the title of his last book (1986). Starting from the premise that the ownership and operation of capital assets is acquired through the issue of debt leads Minsky to an emphasis on the balance sheets of businesses and financial institutions that highlights the interconnectedness of the economic system. The capital assets on the firm’s balance sheet are offset by the issue of liabilities in the form of equity, bonds, or bank loans that are the assets of investors and other financial institutions. In turn these assets are financed by liabilities in the form of bank deposits and other bank liabilities. Any capitalist economy is thus a web of inter-related assets and liabilities that represent commitments to pay that were entered into on the expectation that the assets they financed would produce income sufficient to meet them. Equilibrium in such a system will depend on revenues from assets are always sufficient to meet the commitments to pay interest or profit that they generated. This would require that expectations are always confirmed, for Minsky a highly unlikely prospect given the Schumpeterian nature of competitive capitalist investment: creative destruction. Every successful investment will displace and create disappointment in returns in an existing project. Minsky baptized such conditions as ‘hedge’ financing, characterized by cash inflows always exceeding cash commitments on the financing of the project by a substantial margin, which he called a ‘cushion of safety’, such that the firm would never fall short on its payment commitments. If this condition prevailed over the entire economy the business sector would be a net saver, and require appropriate dis-saving by households or the government: Keynesian finetuning. However, Minsky argued that if an economy were ever in such a position the continued experience of being able to meet financing commitments comfortably would soon lead firms to believe that they were underinvesting and to expand their indebtedness and their financing commitments. Thus there would be a natural endogenous process in which leverage would increase, and the increase in firm liabilities would create more assets in the financial system that would have to be funded by the issue of more liabilities and an increase in what Minsky called financial ‘layering’, more commonly known as the share of financial assets to GDP. This would create a reduction in the cushion of safety between cash inflows and
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Hyman P. Minsky 239 outflows. When this cushion shrinks to the point that a chance disappointment in expectations of increased cash inflows from increased loan financed investment makes it difficult to meet current commitments the firm is in what Minsky called a ‘speculative’ financing framework. To continue its current investment plans will require additional short-term financing from the financial system to meet the unpaid claims in the current period on the expectation that the shortfall was due to a random fluctuation in sales (perhaps an unusually heavy winter snow storm). If the additional financing could not be obtained firms could not meet their commitments – what Minsky characterized as financial distress. What would cause financial distress to produce a full-scale financial crisis? Minsky did not reject that it might come from an exogenous shock, but he believed that it was much more likely to come from an endogenous event such as a change in monetary policy by the central bank increasing interest rates in order to slow the economy because of a fear of inflation. Such action would be designed to decrease sales and cash inflows at the same time as it increases interest rates and commitments to pay cash. Expectations will now be disappointed with certainty and for some firms inflows will no longer cover outflows and the net present value of their reduced cash flows (due to lower sales and higher interest rates) may fall below the value of the liabilities issued to fund the investment. The firm is thus technically insolvent and can only remain in business by convincing its creditors that conditions will improve so that they can protect their investments by increasing their financing. This is what Minsky called a ‘Ponzi’ financing position, since the firm would have to borrow simply to pay its interest and amortization on its ever-increasing liabilities. As expansion continues, Minsky argued that more and more firms will shrink their cushions of safety until the system as a whole becomes more and more fragile in the sense of an increased probability of financial distress in which current claims cannot be met without additional accommodation from the financial system. More and more firms will shift from hedge to speculative to Ponzi financing structures. It is important to remember that the interrelated nature of the financial system means that the value of the assets held by the financial system will also be deteriorating. Since banks are by their very nature speculative financing operations, increasing instability in the real system will be reflected in increased fragility in the financial system. This will lead banks to refuse additional accommodation as they try to strengthen their balance sheets. As a consequence of a failure to obtain additional financing Ponzi firms will have no choice but to start to sell assets in order to meet their cash commitments. This may induce a price deflation for the firm’s assets, which could produce what Irving Fisher called a ‘debt deflation’ (Fisher, 1933).
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Since liabilities are fixed in nominal terms, liabilities will be increasing in real terms as prices fall. It may thus be possible that an attempt to pay down debt by selling assets cannot succeed, and the system goes into a severe recession similar to the 1930s. While Minsky believed in an inexorable march of capitalism from hedge to Ponzi finance, he also believed that it would be possible to prevent a deep debt deflation. There were two elements that operated in the postwar period that had prevented ‘it’ (another Great Depression) from happening again. The first was the advent of Big Government. When government spending is a large share of GDP through deficit financing, aggregate spending will be more stable, even in the presence of volatile private investment spending. Government liabilities, which are riskless, will also form a larger proportion of private sector balance sheets, making them more stable. This means that the variations in cash inflows in excess of cushions of safety that push firms from hedge to speculative finance would be smaller. The second was the advent of a Big Bank, a central bank that recognized the necessity of acting as lender of last resort, providing support to banks when their balance sheets become more fragile, so that they can continue to lend to speculative firms until conditions improve. It was for this reason that one of his first recommendations for monetary policy of the central bank (Minsky, 1964) was that the discount window providing lender of last resort protection should be open to all financial institutions. This is precisely what the Federal Reserve and the European Central Bank were eventually forced to do in stopping the current crisis. Had they done so earlier, as Minsky had recommended already in the 1960s, the deflation in asset prices might have been avoided. While these measures may help prevent a fragile economy from experiencing full-scale financial instability they come at a cost. If the central bank is financing bank assets that have a negative net present value because the firms they have lent to do not have the cash flows to service them, then there will be an increasing accumulation of bad assets in the economy. They must either be liquidated with the associated capital losses and impact on spending and employment, or the cash flows must be restored to initial levels to make them viable. This may involve an increase in prices and inflation (a policy that was advocated by Fisher in the 1930s and by many economists today for resolving the 1990s’ debt deflation in the Japanese economy, and more recently for restoring growth to the US economy). This would place the central bank in a self-contradictory policy position of acting to support financial asset prices at the cost of inflation, which they would have to take action to control, thereby recreating instability. As a result Minsky considered the policy objective of financial stability and price
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Hyman P. Minsky 241 stability to be incompatible and recommended that the central bank concentrate on financial stability and leave price stability to overall fiscal policy. This is precisely the opposite of what is proposed in the recent reform of the US financial system in which the Federal Reserve maintains regulatory authority and economic policy prerogative. But Minsky believed that there were some structural changes that could be introduced to resolve some of these contradictions. Since Minsky considered inappropriate financing of investment and capital asset ownership the major destabilizing influences in the economy he proposed the substitution of higher levels of employment for higher levels of investment as the proximate objective of economic policy since a full-employment economy is bound to expand, whereas an economy that aims at accelerating growth through capital-intensive private investment not only may not grow, but also may be increasingly inequitable in its income distribution, inefficient in its choices of techniques, and financially unstable. Thus increased stability in an inherently unstable economy could be attained through a direct Government Employment Guarantee Program in which the government offers employment to all those willing and able to work at a wage near the prevailing minimum. In this way the cash flows that validate assets would be created through actual sales rather than through increasing borrowing or increasing prices. This would imply the application of Lerner’s concept of ‘functional finance’ in which the objective of government budget policy should be employment rather than balance. When faced with the current crisis, largely driven by consumption spending, Minsky would certainly have replied that if consumption had been financed by wages increasing in step with productivity rather than being transferred to the financial sector much of the crisis would have been avoided. Consumer debt would have been lower. If banks had transferred their higher earning to their capital reserves rather than paying large bonuses to their star traders their capital structure could have easily resisted the losses incurred in the crisis. For Minsky the inequitable distribution of income was a major factor in creating financial instability. Thus, Minsky would have much preferred that the recent increase in budget expenditures would have been directed first to households facing reduced incomes and an impaired ability to meet their mortgage commitments rather than directly to the banks to remove the impaired mortgages from their balance sheets. But, this simply reflects his basic belief that both the government and the financial system exist to serve the private citizen rather than vice versa.
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FURTHER READING Fisher, I. (1933), ‘The debt-deflation theory of great depressions’, Econometrica, 1(4), 337–57. Kregel, J. (2008), ‘Minsky’s cushions of safety: systemic risk and crisis in the U.S. sub-prime mortgage market’, Public Policy Brief No. 93, Annandale-on-Hudson, NY: Levy Economics Institute of Bard College. Minsky, H.P. (1964), ‘Financial crisis, financial systems and the performance of the economy’, in Commission on Money and Credit, Private Capital Markets, Englewood Cliffs, NJ: Prentice-Hall, pp. 173–380. Minsky, H.P. (1975), John Maynard Keynes, New York: Columbia University Press. Minsky, H.P. (1982), Can ‘It’ Happen Again? Essays on Instability and Finance, Armonk, NY: M.E. Sharpe. Minsky, H.P. (1986), Stabilizing an Unstable Economy, New Haven, CT: Yale University Press.
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33 Money in finance L. Randall Wray
This entry will begin by defining, and distinguishing between, money and finance. It will also address alternative ways of financing spending. We next examine the role played by financial institutions, such as banks, in provision of finance. The role government plays both as regulator of private institutions and as provider of finance will be discussed. Related topics such as liquidity and saving will also be explored. We conclude with a look at some of the new innovations in finance, and at the global financial crisis that could be blamed on excessive financialization of the economy. The term ‘money’ is often used in two different ways, first to designate the money of account and second in reference to specific moneydenominated assets that fulfill several important functions associated with money (medium of exchange, means of payment, and store of value). For example, in the United States the money of account is the dollar, the measure of nominal value designated by the state. Many important economic values are denominated in dollars: taxes, prices including wages, fees and fines, and court-ordered restitutions. In addition, the term dollar is also used to describe the paper notes issued by the Federal Reserve Bank (and coins issued by the Treasury). Most economists would also include in their definition of money bank deposits – certainly demand deposits and perhaps time deposits – against which checks can be written that can be used in payment. Over the past half-century, other ‘non-bank’ or ‘shadow bank’ financial institutions have developed a wide variety of substitutes for bank demand deposits, some of which allow holders to write checks for payment. Increasingly, credit cards and debit cards are used in payments. All of these developments appear to make it difficult to define money with precision. However, another approach is to use the term money to signify the unit of account, and to designate as ‘money things’ the IOUs (debts or liabilities) denominated in the money of account. Some money things can be used as media of exchange for purchases and means of payment to retire debt; all can be used as stores of value (albeit some are more risky than others). We can think of a hierarchy of money things, with the government’s own IOUs (central bank notes and Treasury coins, but also central bank reserves – taken together these are called high-powered money or the monetary base) at the top. Just below that would be the deposit liabilities of banks and other 243
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financial institutions with direct access (or indirect access through correspondent banks) to the central bank. Other (non-deposit) short-term liabilities of financial institutions would be below that, then would come the short-term liabilities of non-financial corporations. Finally, at the bottom would be the short-term liabilities of households and small businesses. Taking this approach, one would be following Hyman Minsky (see Minsky [1986] 2008 and Chapter 32 on Minsky in this handbook), who always said that anyone can create money (things), the problem lies in getting them accepted. There are three dimensions to this pyramid. As we move down from government liabilities through to household liabilities, liquidity of the money things declines (see Chapter 28 on liquidity). This is one of the characteristics that makes a money thing function as a medium of exchange and means of payment. Highly liquid cash can be used immediately in purchase and payment. On the other hand, the IOU of a non-financial firm or household is not very liquid, and must be converted to a more liquid money thing before it can be used in payment. This leads to the second dimension: convertibility. Most modern governments do not promise to convert their IOUs to anything, having long ago abandoned the gold standard. (To be sure, some governments, especially in the developing world, do promise conversion to a foreign currency such as the US dollar. In that case, we can think of the US dollar as the apex of the pyramid.) Bank checking deposits are normally made convertible on demand (hence, they are called demand deposits) to government highpowered money. Other short-term bank liabilities are convertible after some wait, often with a penalty for early ‘withdrawal’ (conversion). And so on. Household IOUs such as mortgages and other consumer debt are convertible to bank liabilities – although conversion is not necessarily easy to accomplish. Finally, as we move down the pyramid, agents use liabilities of those higher in the pyramid for payment: households and firms make payments using bank liabilities, while banks make payments to each other using high-powered money. There are two universal laws of credit and debt (which are the two sides of the IOU – it is a credit for the holder and a debit for the issuer). The first is that credits and debts are denominated in a unit of account – almost always a state money of account (dollar in the USA). The second is that the issuer of an IOU must accept his or her own IOU back in payment, or what is called ‘redemption’. For example, if one has a loan held by a bank, one can always repay that loan by delivering back to the bank one of its own IOUs, by, for example, writing a check on a deposit at the bank. If one owes taxes to the government, one can always pay taxes by delivering high-powered money
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Money in finance 245 (the government’s debt) in payment. (The debtor ‘redeems him or herself’ by handing back to his or her creditor the creditor’s own debt – or a third party debt the creditor is willing to accept. The similarity of the terminology to religious concepts is not a coincidence; see Atwood, 2008.) If a debtissuing economic entity refuses to redeem its own IOU when it is submitted in payment that is a default. We can thus think of a network of credits and debits – entries on balance sheets – all denominated in the money of account. One is able to cancel one’s debts by delivering another entity’s debts (often an entity higher in the money pyramid) – either a second party’s debt (the party holding one’s debt as a credit) or a third party’s debt (for example, a household uses a bank IOU to make a payment on a car loan debt held by the auto finance company). Banks often intermediate these payments, for example, delivering highpowered money (in the form of bank reserves) to government on behalf of taxpayers (while it appears to the taxpayer that taxes are paid by writing checks on bank accounts, in reality the taxes are paid by debiting the bank’s reserves from its account at the central bank). Similarly, a household pays down its credit card balance by writing a check – with the bank making the payment for the household using reserves while debiting the household’s deposit account. To conclude this section, it is apparent that drawing a sharp dividing line between what we want to call a ‘money thing’ versus what we designate merely a ‘debt thing’ is neither possible nor desirable. All are IOUs denominated in the money of account, and all are ‘redeemable’, accepted in payment of debts held by their issuer. Only some can be used directly in payment (using a third-party debt in purchase or in debt payment). They have varying degrees of liquidity, which is one of the factors determining whether they will circulate among third parties. For many transactions, banks operate as intermediaries, making payments for clients, because they operate a major part of the national payments system in all countries. We now turn to finance. If one wants to make a purchase, there are three options for financing the transaction: use of one’s income, use of one’s assets, or issuing debt. (The sovereign currency-issuing government is in a different situation – as discussed below – as it is the only entity that makes payments only by issuing its own IOUs.) Income is a flow over time – so many dollars per hour, week, month, and year. This is accumulated as a stock, for example, as a demand deposit held at a bank. If one’s weekly pay is $100, one could use that income to finance purchases equal to $100 each week, writing checks against deposits. One’s employer’s deposit account would be debited as wages are paid; one’s own deposit account would be credited when income is received, and then debited as groceries were purchased; and finally the grocer’s deposit account would be credited. In all
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these transactions we see the ‘money thing’ simply shifting pockets as the employer pays wages, as the employee makes purchases, and as the grocer makes sales. The grocer might then pay the food manufacturer, who had advanced inventories to fill the grocer’s shelves and who now uses the receipt (taking the form of a credit to the manufacturer’s bank deposit account) to retire a short-term loan that had been used to make the wage payment in the first place. At that point, the loan and bank deposit are simultaneously cancelled. We can think of that as a closed monetary circuit, from creation of bank money when the loan is made through to its destruction when the loan is retired. As the money deposit makes its circuit, the wage bill, household consumption, purchase by the grocer, and sales by the manufacturer all get financed. Obviously the circuits can get much more complicated, and need not close. Still, this simple example lets us see how income leads to monetary receipts that are used to finance spending. The notion of ‘velocity’ of circulation applies as the single demand deposit created in the initial bank loan is used to finance the whole stream of purchases and payments until the loan is finally retired. The second method of financing is to use accumulated assets. If one spends only $90 per week out of an income of $100, then savings will accumulate as unspent deposits. An individual can directly spend accumulated savings held as deposits, running down financial wealth. If savings are held in a less liquid form (say, corporate bonds) then they must first be sold (exchanged for a bank deposit) before they can be used to finance expenditure. This is where liquidity returns as a useful concept – how quickly can accumulated wealth be converted, with little loss of monetary value, to a medium of exchange. Of course, one’s ability to finance expenditure by running down wealth is limited to one’s wealth and ability to convert it. Finally, one can finance expenditure by going into debt – issuing an IOU to obtain a spendable credit. This can be done by approaching a bank to take out a loan. From the borrower’s perspective, the loan is a liability, issued to obtain a credit to a bank deposit (an asset of the borrower). From the bank’s perspective, the loan is an asset held against its demand deposit liability. The bank makes profits by charging a higher interest rate on the loan than it pays on the deposit. When the borrower spends the deposit, his or her account is debited and the seller’s account is credited. Because the seller will normally use a different bank, there will be a transfer between banks – the bank that made the original loan will accept a check drawn against it, leading to a transfer of reserves to the bank presenting the check. (Recall from above that banks make payments to each other using high-powered money.) We need not go further into the details of these check-clearing
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Money in finance 247 procedures except to note that a bank losing reserves through clearing will normally issue another liability to replenish reserves. The important thing to note is that in all three scenarios examined, ‘money things’ are involved in financing expenditures. As Robert Clower (1965) famously remarked, money buys goods and goods buy money but goods do not buy goods. In other words, in our monetized economies, barter (‘goods buying goods’) is not normal practice. That does not mean that it does not occur but rather that for most economic analysis it is not relevant. Also note that because all money things are debts, the monetary purchases always involve debts. Even when one is spending income, one is using another’s debts to make purchases. If no one were willing to issue debt, no monetary payments could be made. Still we can distinguish between use of ‘internal finance’ and use of ‘external finance’. In the first case, one finances spending using one’s existing credits (spending reduces the credits one holds on others), while using external finance means increasing one’s debt. Obviously these have very different implications. Use of external finance commits one to servicing debt – paying interest and eventually paying off the principal. As Minsky put it, debt represents a prior commitment of future cash flows that will be generated through income receipts or by selling assets. Since there is some uncertainty about future income flows as well as the revenue to be generated by selling assets, it is possible that the debtor will not be able to meet these commitments. At that point, either refinance or default becomes necessary. In other words, use of external finance rather than relying on internal finance is risky – both for the borrower as well as for the creditor. This is a key insight behind Minsky’s financial instability hypothesis – the argument that over a run of good times, confidence leads to growing debt that ultimately gets too big to service. Defaults can generate a debt deflation process, such as the one in the 1930s analyzed by Irving Fisher (1933). There are many fallacies surrounding finance, and probably no topic in economics is more confounding than money. One problem arises if transactions are analyzed as if they are barter. As we have discussed, in reality, most transactions – and all monetary transactions – involve debt. Even if no external finance is used, expenditure still requires that someone has issued debt. Even government spending is financed by debt – in the case of a government that issues its own currency, spending always takes place through high-powered money issue. While it is not generally recognized, government spends by issuing debt and taxes by redeeming it – taxpayers pay their taxes by delivering back to government the debt issued when government spent. In other words, taxes cancel government’s debt – they do not really ‘finance’ government spending, which is actually financed by
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issuing liabilities. When government spending exceeds taxes, we call that a deficit and it allows accumulation by the non-government sector of credits against the government. Since private sector credits and debits necessarily cancel one another, there is no net financial wealth except for claims on government. Thus, we can think of government deficit spending as the source of net non-government sector financial wealth – the government’s deficit ‘finances’ non-government savings held in the form of government debt. It is commonly believed that ‘savings finance investment’. Indeed, we discussed above the possibility that an individual finances spending (which could be investment spending) by running down financial wealth that was accumulated whilst saving. True enough. But the saving of the individual is in the form of claims on others – debt issued by others to allow spending to take place. At the aggregate level, saving is not really a source of finance – a point made by J.M. Keynes ([1936] 1964), simplified as the ‘paradox of thrift’ taught through the textbooks: reducing consumption in order to increase saving only reduces aggregate income and results in no additional saving. Instead, saving is increased by spending more on investment. The textbooks, however, generally do not explain how the extra investment is financed. The answer is that if we want a higher national income and gross domestic product through higher investment, it must be financed through additional debt. This additional investment will then create higher income and through the marginal propensity to save, additional aggregate saving – accumulated as credits against debtors. Above we looked at a simple circuit of money and admitted that circuits might not close so that monetary debts are not cancelled. Saving can be thought of as resulting when a circuit does not close, so that debt was left outstanding. If that finances individual spending (including investment) it merely allows the circuit to close. Saving can never be a net source of finance at the aggregate level – when accumulated saving is spent, that merely returns debt to its issuer. New finance requires new debt. There is also a myth about a ‘deposit multiplier’, according to which bank lending and deposit creation requires a raw material – central bank reserves – that are lent out. It is claimed that individual banks cannot ‘create money’, but with a fractional reserve system banks in the aggregate create a multiple of deposits (and loans) for every dollar of reserves provided by the central bank. This is a fallacy. Banks do not lend reserves. When a bank accepts a borrower’s IOU, it creates a demand deposit – as discussed, a ‘money thing’ – through a keystroke, simultaneously creating a bank liability and an asset in the form of a checkable deposit in the name of the borrower. No raw material (other than electrons on a computer tape) is required. In some countries, there is a legal reserve requirement; in all cases, since banks
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Money in finance 249 promise to convert deposits on demand they either hold reserves or ensure they can obtain reserves as needed to meet redemptions. Yet, banks make loans and then seek reserves – in private markets (the Fed funds market in the USA) or at the central bank (often through overdraft facilities) – and not the reverse. In any case, almost all central banks in developed countries now operate with an explicit overnight interest rate target, supplying reserves on demand to ensure the target is hit within a discretionary range. Providing more reserves than banks want will not encourage lending but rather will place downward pressure on the overnight interest rate. This is why the US Fed has found that adding a trillion dollars of reserves to the private banking system has not prodded it to increase lending – put simply, banks do not need reserves to make loans but, rather, need good borrowers. Government regulates, oversees, and protects financial institutions. Access to the central bank as lender of reserves – and, especially, lender of last resort – is essential to keeping bank liabilities liquid by ensuring that banks can always convert them to high-powered money on demand (see Chapter 7 on central banks). This ensures ‘par clearing’ – protected bank liabilities always trade one-for-one against government liabilities. That is essential for maintaining a well-functioning payments system. This is further guaranteed by deposit insurance – government ensures that even if a financial institution becomes insolvent, its insured liabilities can be redeemed against government liabilities at par. With such a guarantee, markets cannot possibly ‘discipline’ the activities of protected institutions – which can use insured deposits to finance positions in risky assets. Hence, government regulates the kinds of assets banks can purchase using government insured liabilities, and oversees bank practices to reduce risk. When all goes well, government regulation and supervision channel bank activities to serve the public purpose. In recent years, that most certainly has not been the case – as government often abandoned its responsibilities on the misguided belief that somehow ‘markets’ would guide financial institutions to provide financial services that not only generated private profits but also met the public interest. That did not work. It remains to be seen what shape financial reforms will take. Above we offered a definition of money – or more precisely, of money things. Throughout history, economists have tended to give pride of place to a very narrow definition of money: high-powered money plus checkable deposits (called M1 in the USA). It has been argued that there is a close relation between this narrowly identified money and spending. Banks can create ‘money’ and finance spending, but other financial institutions cannot – they can only create substitutes for money, intermediating between banks and final users. The explosion of financial innovation of the past three or more decades should have finally put such views to rest. In truth, all
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economic agents can be analyzed as if they were ‘banks’ – taking positions in assets by issuing liabilities. Bank liabilities are highly liquid while the liquidity of liabilities issued by other financial and non-financial firms can be enhanced through a variety of methods developed over the past 40 years. For example, large corporations discovered they could issue commercial paper to finance operations at interest rates below those charged by banks on loans. To enhance liquidity of commercial paper, they obtained back-up lines of credit from banks. When commercial paper matures, if holders decide they do not want to ‘roll over’ into new commercial paper, the issuing firm can use its line of credit to pay off the paper. In this manner, the corporation only needs access to bank credit if something goes wrong in the commercial paper market. A given quantity of M1-type money (issued by banks) can finance a larger amount of economic activity because other money things (issued by shadow banks and non-financial corporations) are used. As Minsky always argued, the fundamental activity of banking is ‘accepting’ – determining who is creditworthy by accepting IOUs. It is true that they ‘intermediate’ by accepting liabilities of borrowers and then issuing their own IOUs that are more liquid. But there is no alchemy involved by which they lend out reserves created by the central bank. They also take positions in assets (loans, corporate and government bonds) while issuing liabilities (deposits and short-term paper) just like all other economic units. But as they also operate much of the payments system, they make payments for their customers – which is what a loan really is, a payment made by a bank for its customer. As another example, the household can finance most of its consumption over the course of the month through use of credit cards – running up debt. The retailers do not have to hold the consumer debt directly because the credit card company uses its bank to make payments on behalf of the customer. At the end of the month, the household’s bank account is credited by the amount of wages received, the household writes a check to the credit card company, and the household’s bank makes the payment to the credit card company (actually, to its bank – with reserves shifting). In general outline this is how economic activity gets financed mostly outside the banking system, with banks entering only when the payments system is involved. As discussed above, banks also intermediate between taxpayers and government tax collectors – allowing taxpayers to write checks on deposit accounts and delivering for them high-powered money the government ‘redeems’ for tax payments. When government spends, the intermediation is reversed: government spending leads to credits to bank deposits and to bank reserves. Hence, taxes serve the purpose of redeeming government
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Money in finance 251 liabilities – taxpayer liabilities are reduced and government liabilities outstanding are also reduced, with banks intermediating. Recent innovations have added layers of complexity – what can be called financialization and leveraging of economic activity (see Chapter 17 on financialization). Perhaps the best example is securitization of home mortgages (see Chapter 40). Very briefly, home mortgages – like all consumer loans – were low in the money pyramid. Mortgage loans were made by banks and specialized thrifts that carefully underwrote (assessing creditworthiness) the loans. The lenders knew the borrowers and the local real estate markets. Mortgage loans almost never went bad, but they were very illiquid – long-term and heterogeneous (the lending bank knew the borrower’s individual characteristics) – hence, almost unmarketable so they were held to maturity. For a variety of reasons that we will not investigate, mortgage origination got separated from holding the debts, as the ‘originate to distribute’ model took over. Instead, mortgages were ‘securitized’ – packaged and sold. They became marketable, made liquid through standardization (standardized loan terms and use of credit scores to assess risk) and diversification (mortgages originated across the country in many real estate markets would eliminate problems caused by a downturn in one region). Moreover, the securities were ‘sliced and diced’ in complex ways to offer riskier tranches, interest-only pieces, and principal-only pieces. It all became even more complicated because the worst tranches of securities could be re-securitized, and then re-re-securitized; and, even more esoterically, it was possible to construct purely virtual financial instruments (synthetic collateralized debt obligations) that were bets that securitized mortgages would either remain solvent, or go bad. The result was that each mortgage – serviced out of income flows of the homeowner – might serve as collateral behind all sorts of securities, and securities of securities, and securities cubed, and all manner of other derivatives that were essentially bets on default. If we look at aggregate numbers, each dollar of US income was devoted to servicing five dollars of debts and securities, and unknown dollar amounts of derivatives. Worse, the terms of the debts were – literally – impossible for homeowners to meet. The whole superstructure of finance began to collapse in late 2007. How it will all turn out is impossible at this juncture to predict. While much of the attention has been directed to mortgage-backed securities, all kinds of debts were also securitized – everything from credit card debt to student loans. Most of this took place outside normal banking – which helps to explain why the bank share of financial markets fell to less than a quarter. Again, this drives home the point made above that focusing on banks and narrow definitions of ‘money supply’ is a mistake. Still, much of the problems that originated off the balance sheets of banks came right back to haunt them due
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to various kinds of guarantees and other linkages provided by banks to the so-called shadow banking sector. Asset-backed securitization is just one important innovation. Another is ‘junk bonds’ – or what is euphemistically called ‘high yield’ debt. The leveraged buy-out craze began in the 1980s, but was actually much bigger in the 2000s. The basic idea is this: find a corporation that has not used much external finance – a so-called ‘cash cow’ that generates free revenue that is not committed to debt service. Then issue bonds that commit future revenue streams to servicing debt – debt that is issued in a hostile take-over. The buyer of the firm uses the revenue stream of the target to finance the purchase. Often the buyer then strips the firm of assets – selling them to reap profits – and leaves the hollowed hulk with a heavy debt burden that cannot be serviced out of its revenue stream. Michael Milken is the best-known protagonist – and he served prison time for improprieties – but the practice has become mainstream. The long-term implication is that firms must protect themselves by taking on debt – no one wants to be a sitting cash cow. There are many other reasons why debt ratios have risen over time. Attitudes toward debt changed, as memories of the Great Depression faded. In the USA, at least, inflation-adjusted median wages did not rise since the early 1970s, leaving households reliant on debt to finance rising living standards. State and local governments found that commitments rose faster than revenues – forcing them to take on more debt. Ditto pension funds, which increased leverage, took on riskier portfolio allocations, and paid big fees to money managers who promised to obtain high returns to cover pension obligations. More generally, baby boomers demanded high returns on financial assets even as economic growth suffered lower long-term prospects – which required greater leverage ratios and more financialization. In short, in the context of slower economic growth, an aging population, and chronically higher unemployment and underemployment, the economic system that generates income and output was expected to service an ever-larger financial superstructure as reliance on external finance grew. Claimants on that financial superstructure included all the financial institutions (and their traders and management) as well as the growing number of retirees who expected high living standards based on financial claims. At the peak, financial institutions captured 40 percent of all corporate profits, debt ratios reached five times GDP, and if derivatives are included the debt ratio is several orders of magnitude higher (estimates of total notional values of derivatives peaked at $70 trillion globally just before the crisis). This is what is meant by financialization – a financial system that is far too large relative to the size of the economy.
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Money in finance 253 There are complex micro- and macro-reasons for this development. We have already mentioned Minsky’s belief that the relative tranquility of the postwar period would naturally lead to more risk-taking, including debt leveraging of income flows. In addition there was growing competition between regulated banks and the relatively unregulated shadow banks. At times, one or the other would have the upper hand, but competition not only led to innovations but also to de-regulation and eventually to selfregulation. These innovations stretched liquidity, increased leverage and layering of debt upon debt, and ultimately led to the collapse of 2007. Also at the macro-level were the various trends that depressed wages in developed nations, that increased inequality of the distribution of income and wealth, and that produced serial bubbles (and busts) of asset prices. All of these in one way or another fueled growth of debt that became too big to service out of income flows. So far, the financial crisis has not changed the situation in any significant way. The last time the economy was financialized to a similar extent – back in 1929 – the Great Depression led to substantial reforms that downsized finance and put it under substantial government control. Only time will tell whether that will happen this time around.
REFERENCES Atwood, M. (2008), Payback: Debt and the Shadow Side of Wealth, Toronto: House of Anansi Press. Clower, R. (1965), ‘The Keynesian counter-revolution: a theoretical appraisal’, in F.H. Hahn and F. Brechling (eds), The Theory of Interest Rates, London: Macmillan. Fisher, I. (1933), ‘The debt-deflation theory of great depressions’, Economica, 1(4), 337–57. Keynes, J.M. ([1936] 1964), The General Theory of Employment, Interest and Money, New York and London: Harcourt Brace Jovanovich. Minsky, H.P. ([1986] 2008), Stabilizing an Unstable Economy, New York: McGraw Hill.
FURTHER READING Wray, L.R. (1990), Money and Credit in Capitalist Economies: The Endogenous Money Approach, Aldershot, UK and Brookfield, VT, USA: Edward Elgar. Wray, L.R. (1998), Understanding Modern Money: The Key to Full Employment and Price Stability, Cheltenham, UK and Lyme, NH: Edward Elgar. Wray, L.R. (ed.) (2004), Credit and State Theories of Money: The Contributions of A. Mitchell Innes, Cheltenham, UK and Northampton, MA, USA: Edward Elgar.
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34 Money manager capitalism Charles J. Whalen
Money manager capitalism is the name Hyman P. Minsky (1919–96) assigned to the current economic era in his historical analysis of US capitalist development. This era emerged in the 1980s as institutional investors – holders of the largest share of corporate stocks and bonds by the end of that decade – began to exert their influence on financial markets and business enterprises. The study of money manager capitalism was the main focus of Minsky’s attention during the final decade of his life.
CAREER CONTEXT Minsky’s career can be divided into four periods. After earning his PhD from Harvard University in 1954, Minsky devoted two decades to various explorations of the impact of financial and business institutions on economic performance. Then, in 1975, publication of John Maynard Keynes (Minsky, 1975) signaled the start of a period focusing on macro-financial cycles, the centerpiece of which was his ‘financial instability hypothesis’. In the first half of the 1980s, Minsky’s attention shifted to the problem of increasing US economic instability, culminating in Stabilizing an Unstable Economy (Minsky, 1986a). The final period began after publication of that volume and featured investigations of capitalist development, with special attention to the US economy; the notion of money manager capitalism emerged in the course of those investigations. Minsky set the stage for the final phase of his career with a 1986 essay on Joseph A. Schumpeter and John Maynard Keynes. He wrote: ‘The task confronting economics today may be characterized as a need to integrate Schumpeter’s vision of a resilient intertemporal capitalist process with Keynes’ hard insights into the fragility introduced into the capitalist accumulation process by some inescapable properties of capitalist financial structures’ (Minsky, 1986b, p. 121). As that statement suggests, Minsky retained his interest in macro-financial cycles and increasing economic turbulence, but they were now placed in a broader context.
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ECONOMIC CONTEXT According to Minsky (1990, p. 65), Schumpeter argued that capitalism is resilient ‘because it takes many particular forms’. In Minsky’s own words (1993a, p. 3), ‘There are as many varieties of capitalism as Heinz has of pickles’ – a reference to that company’s ‘57 Varieties’ slogan. Each variety tends to yield different economic results, however, and Minsky was troubled by what money manager capitalism offered. Minsky expressed concern about the fragile financial structure that accompanied the emergence of money manager capitalism and that made it highly susceptible to an economic crisis, but he was also uneasy about the new era’s ability to contribute to the capital development of the US economy. He believed money manager capitalism promised not only a level of investment insufficient to create a full employment economy, but also a composition of investment inadequate to ensure that US capitalism would remain technologically dynamic (Minsky, 1990, p. 72; 1992, pp. 21–6; 1993b, pp. 111–13). Minsky had other concerns as well. He was apprehensive about the growth of securitization, the declining competitiveness of American industry, the erosion of economic security for US workers, and the widening of income inequality in the midst of overall economic expansion (Minsky, 1986c, 1993a). He saw the need for a more robust small-business sector and for widespread community economic revitalization (Minsky, 1993c). And he worried that money manager capitalism had become global, rendering it impossible for US policy-makers to resolve a financial crisis through unilateral action (Minsky, 1986c). In Minsky’s mind, all those concerns were interrelated and connected to the evolution of US capitalism. Finance was central to the nation’s economic challenges, but far from the whole story; money manager capitalism was the organizing concept that held everything together. By the early 1990s, the research constructs he relied on in earlier career phases were no longer sufficient: ‘To create a worthy successor to the financial system that served us so well between the 1930s and the 1980s requires a deeper look at our institutions than we have taken so far’, wrote Minsky (1991, p. 16).
CAPITALIST DEVELOPMENT Minsky’s ‘deeper look’ came from constructing and applying a theory of capitalist development. He believed that integrating the insights of Schumpeter and Keynes was possible because they had a common perception of the task of economics: ‘They each define the problem that economic theory
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must explain as the path of development of an accumulating capitalist economy through historical time’ (Minsky, 1986d, p. 285). From that perspective, the economy is a complex, time-dependent system – an ‘evolutionary beast’, changing in response to endogenous as well as exogenous factors, not an equilibrium-seeking and -sustaining system (Ferri and Minsky, 1992; Minsky, 1993b, p. 104). Further, the economy’s institutional structure is a fundamental determinant of the particular path of development; that structure – which is itself evolving – facilitates, influences, regulates, and constrains economic activity (Minsky, 1986a, pp. 3–10). Institutions of credit and finance are at the center of capitalist development. While standard economic theory emphasizes exchange, Minsky’s recognition of historical time caused him to emphasize that production precedes exchange and that finance precedes production. ‘Because credit is essential to the process of development, a theory of economic development needs to integrate money into its basic formulation’, he wrote. The result is an approach inconsistent with Walrasian theory: ‘Monetary factors cannot be added on after a prior or dominant model has determined the basic output and relative price variables’ (Minsky, 1990, p. 55). Another essential element in Minsky’s theory is the driving force of the profit motive. That motive was a vital component in Minsky’s writings throughout his career. He had long argued that present and prospective profits influence economic activity within the context of a given institutional structure – and that the structure itself changes in response to profit-seeking. As Minsky gave increasing attention to capitalist development, profit-driven structural change took on increasing importance in his writings (Minsky, 1986b; Ferri and Minsky, 1989, p. 135; Minsky, 1993b). Financial innovation is also an essential element in Minsky’s theory – indeed, such innovation is a crucial determinant of institutional evolution. Scholars often observe Schumpeterian forces of creation and destruction in product markets and manufacturing processes, but Minsky emphasized that Schumpeter also gave attention to changes in financial systems. Minsky’s theory stresses that financial markets evolve not only in response to the profit-driven activity of business leaders and individual investors, but also due to the profit-seeking entrepreneurialism of financial firms (Minsky, 1986d, 1990, 1993b). In fact, Minsky (1993b, p. 106) wrote: ‘Nowhere are evolution, change and Schumpeterian entrepreneurship more evident than in banking and finance and nowhere is the drive for profits more clearly the factor making for change’. Government action – public policy – is the final key element in Minsky’s theory of capitalist economic development. Policy decisions shape the institutional framework that conditions economic activity. As Minsky (1986a, p. 7) wrote in Stabilizing an Unstable Economy, ‘Policy can change
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Money manager capitalism 257 both the details and overall character of the economy’. Thus, economists and policy-makers must be concerned with the design of institutions as well as with economic activity within a set of institutions. Since the economy evolves endogenously, no policy regime will provide a ‘once-and-for-all’ solution to economic difficulties. In time, policies that once worked well may no longer be adequate, due to innovations in finance and business or to the emergence of new problems (Minsky, 1986a, p. 293). Minsky recognized that it is neither possible nor desirable for policymakers to engage constantly in major institutional reform, but he stressed that such change is essential when the public becomes greatly dissatisfied with economic performance (Minsky, 1986a, p. 7).
FROM COMMERCIAL CAPITALISM TO MONEY MANAGER CAPITALISM In the early 1990s, Minsky published two major essays that applied his finance-driven theory of capitalist development to the United States (Minsky 1990, 1993b). They described an economy that evolved through four capitalist stages: commercial, financial, managerial, and money manager. His discussion of each stage centered on three questions: What is being financed? What is the pivotal source of financing? What is the balance of economic power between business and banking? The stages begin with commercial capitalism, a period that involved the financing of goods in process, storage (inventories) or transit. Merchant banks and commercial banks provided that financing, while business owners usually used their own funds to acquire capital assets. Economic power was fragmented and dispersed. Financial (or ‘finance’) capitalism emerged to support the establishment and expansion of railroads, mills, and other industrial enterprises. That period saw the rise of investment banks and large corporations. During this stage, investment bankers came to hold a dominant position in the economy. Managerial capitalism emerged in response to the Great Depression, which redirected the financial spotlight to macroeconomic revitalization. The New Deal and World War II moved the pivotal source of financing from the private sector to the federal government, where fiscal and monetary policy were expected to help ensure economic growth and stability. When the war ended, household and business indebtedness was minimal, and the balance of economic power favored corporate managers – who often operated in oligopolistic markets – not private bankers. Money manager capitalism was a product of the success of managerial capitalism. In the prosperity and stability of the managerial era, employers
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offered pension plans to more and more workers. At the same time, financial institutions became increasingly aggressive in managing those retirement funds and the other asset holdings of individuals and organizations, especially in response to the inflation that was a byproduct of government efforts to prevent a deep recession. The maturing of managerial capitalism was accompanied not only by the evolution of a more fragile financial system (the focus of Stabilizing an Unstable Economy), but also by the growth pension funds, mutual funds, bank trust funds, and other managed-money funds. During the long expansion that began in 1982, it became increasingly clear that money managers – institutional investors – were the new masters of the economy and that their funds were the new pivotal source of financing. The aim of money managers, and the sole criterion by which they are judged, is maximization of the value of the resources entrusted to them. As a result, business leaders grew increasingly sensitive to short-term profits and to the stock-market valuation of their enterprises. Minsky’s dissatisfaction with money manager capitalism is clear from both of his essays on the transition from commercial capitalism to the present era.1 The rise of institutional investors encouraged further financialsystem evolution by providing a ready pool of buyers for securitized loans, the commercial paper of finance companies, and other innovations. It also fueled the trend toward mergers, acquisitions, corporate breakups, leveraged buyouts, and stock buybacks, since fund managers have a strong incentive to support whatever initiatives promise to boost near-term portfolio value; managed-money funds often provided the resources raiders needed to secure corporate control. The problem is that such trends exacerbated financial fragility. They were also disconnected from generation of technological breakthroughs as well as from major product and process innovations. According to Minsky (1993b, pp. 111–12): Keynes’ famous remark about speculation and enterprise is especially relevant for money manager capitalism: ‘Speculators may do no harm as bubbles on a steady stream of enterprise. But the position is serious when enterprise becomes the bubble on a whirlpool of speculation. When the capital development of a country becomes the by-product of the activities of a casino, the job is likely to be ill-done’.
EXTENSIONS AND FURTHER APPLICATIONS In the two essays described above, Minsky provided the historical analysis that served as the backdrop to the rest of his career. Nearly everything he
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Money manager capitalism 259 published afterward can be seen as an examination, application, or extension of their themes. Money manager capitalism influenced his thinking about both economic theory and public policy. An important extension of Minsky’s analysis was offered in his two final journal articles. One summarizes an address he delivered upon receipt of the Veblen-Commons Award, conferred by the Association For Evolutionary Economics (Minsky, 1996). The other, co-authored by Charles J. Whalen, appears in the Journal of Post Keynesian Economics (Minsky and Whalen, 1996–97). Both describe the connection between the rise of money managers and increasing worker insecurity. The connection is as follows. Money manager pressures – often in combination with the force exerted by growing international competition – encouraged corporate restructuring, downsizing, union avoidance, and job outsourcing. Even managers and highly skilled, ‘professional’ employees soon faced a workplace in which productivity pressures and temporary employment were on the rise and where worker benefits, job ladders, and training opportunities were being eroded. In short, worker insecurity and money manager capitalism are two sides of the same coin. As a team of US researchers concluded in 1997, employment relations in this new era is characterized by a rush toward treating human resources as a cost to be minimized: corporate executives have increasingly come to view labor as just another ‘spot market’ commodity (Cappelli et al., 1997). A few years later, Whalen (2002) revisited Minsky’s analysis, assessing it in the wake of the ‘dotcom’ boom and bust.2 He concludes that Minsky was correct in identifying money managers as major players in the new economy, especially given the explosive growth in mutual funds in the 1990s. Minsky was right that ‘block trading’ in the money manager era added to market fragility and that institutional investors enabled corporate takeovers. Minsky was even on target with the suggestion that companies exhibited ‘an almost chronic need’ to downsize and pursue workplace flexibility at the expense of worker security (Minsky, 1996, p. 363); in fact, there was evidence that the trend continued even when labor markets were tight at the peak of the Internet-driven boom (Whalen, 2002). Whalen’s article also notes some unexpected developments. Minsky did not anticipate that many institutional investors would use their power to change corporations from within, but that is what happened.3 Minsky also did not foresee either the tremendous growth of venture capital financing or the investment-led boom of the late 1990s. Indeed, at first blush the high-technology developments of that era seem incompatible with Minsky’s analysis, which suggested that technological dynamism in the money manager era would require substantial state assistance. However, Whalen
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finds a partial explanation in the work of Barry Bluestone and Bennett Harrison (2000), who described the boom as the long-awaited information revolution that government initiated and supported for decades (Whalen, 2002). Minsky’s notion of money manager capitalism has received increased attention in the wake of the recent global financial crisis and subsequent Great Recession. An especially noteworthy contribution to that literature is by L. Randall Wray (2009), whose essay presents an excellent examination of the rise and fall of the money manager era. After reviewing Minsky’s analysis of American capitalism’s earlier stages, Wray provides a detailed account of how financial-sector innovators and policy-makers put the entire global economy at risk. Special attention is given to the relationship of money managers to securitization, credit default swaps, and commodities futures contracts. Wray also explores the role of three crisis triggers: interest rates, commodity prices, and tax revenue.4 To be sure, while Minsky may have been among the first, he is not the only scholar to highlight the rise of institutional investors.5 And his attention to money manager capitalism has considerable overlap with the burgeoning literature on ‘financialization’.6 Nevertheless, it is clear that the study of money manager capitalism is essential to understanding not only the economics of Minsky, but also the contemporary world economy.
NOTES 1. 2. 3. 4.
5. 6.
For an even earlier discussion critical of the economic impact of money managers, see Minsky (1986d, p. 291). Whalen also fleshed out Minsky’s analysis in a separate article; see Whalen (2001). See also Useem (1996). For more on Wray’s interpretation of Minsky’s analysis and its applicability to the Great Recession, see Nersisyan and Wray (2010); for a complementary interpretation as well as a discussion of public policy designed to promote economic recovery and reform, see Whalen (2010); and for a look at developing countries in the context of money manager capitalism, see Ventimiglia and Tavasci (2010). Others highlighting institutional investors include Useem (1996) and Hawley and Williams (2000). For a discussion of the overlap between Minsky’s economics and financialization, with special attention to the problem of inequality, see Zalewski and Whalen (2010).
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Money manager capitalism 261
REFERENCES Bluestone, B. and B. Harrison (2002), Growing Prosperity, Boston: Houghton Mifflin. Cappelli, P., L. Bassi, H. Katz, D. Knote, P. Osterman and M. Useem (1997), Change at Work: Trends That Are Transforming the Business of Business, Washington, DC: National Policy Association. Ferri, P. and H.P. Minsky (1989), ‘The breakdown of the IS-LM synthesis: implications for post-Keynesian economic theory’, Review of Political Economy, 1(2), 123–43. Ferri, P. and H.P. Minsky (1992), ‘Market processes and thwarting systems’, Structural Change and Economic Dynamics, 3(1), 79–91. Hawley, J.P. and A.T. Williams (2000), The Rise of Fiduciary Capitalism: How Institutional Investors Can Make Corporate America More Democratic, Philadelphia: University of Pennsylvania Press. Minsky, H.P. (1975), John Maynard Keynes, New York: Columbia University Press. Minsky, H.P. (1986a), Stabilizing an Unstable Economy, New Haven: Yale University Press. Minsky, H.P. (1986b), ‘Money and crisis in Schumpeter and Keynes’, in H.-J. Wagener and J.W. Drukker (eds), The Economic Law of Motion of Modern Society: A Marx-KeynesSchumpeter Centennial, Cambridge, UK: Cambridge University Press. Minsky, H.P. (1986c), ‘Global consequences of financial deregulation’, The Marcus Wallenberg Papers on International Finance, 2(1), 1–19. Minsky, H.P. (1986d), ‘The crises of 1983 and the prospects for advanced capitalist economies’, in S.W. Helburn and D.F. Bramhall (eds), Marx, Schumpeter and Keynes: A Centenary Celebration of Dissent, Armonk, NY: M.E. Sharpe. Minsky, H.P. (1990), ‘Schumpeter: finance and evolution’, in A. Heertje and M. Perlman (eds), Evolving Market Technology and Market Structure: Studies in Schumpeterian Economics, Ann Arbor: The University of Michigan Press. Minsky, H.P. (1991), ‘The rationale for the conference: an agenda for the good financial society’, prepared for ‘Restructuring the Financial Structure for Economic Growth’, a conference at The Levy Economics Institute of Bard College, 21 November, photocopy. Minsky, H.P. (1992), ‘The capital development of the economy and the structure of financial institutions’, Working Paper No. 72, The Levy Economics Institute of Bard College. Minsky, H.P. (1993a), ‘Finance and stability: the limits of capitalism’, Working Paper No. 93, The Levy Economics Institute of Bard College. Minsky, H.P. (1993b), ‘Schumpeter and finance’, in S. Biasco, A. Roncaglia and M. Salvati (eds), Market and Institutions in Economic Development: Essays in Honor of Paulo Sylos Labini, New York: St. Martin’s Press. Minsky, H.P. (1993c), ‘Community development banks: an idea in search of substance’, Challenge, 36(2), 33–41. Minsky, H.P. (1996), ‘Uncertainty and the institutional structure of capitalist economies’, Journal of Economic Issues, 30(2), 357–68. Minsky, H.P. and C.J. Whalen (1996–97), ‘Economic insecurity and the institutional prerequisites for successful capitalism’, Journal of Post Keynesian Economics, 19(2), 155–71. Nersisyan, Y. and L.R. Wray (2010), ‘Transformation of the financial system: financialization, concentration and the shift to shadow banking’, in D. Tavasci and J. Toporowski (eds), Minsky, Crisis and Development, Basingstoke: Palgrave Macmillan. Useem, M. (1996), Investor Capitalism: How Money Managers are Changing the Face of Corporate America, New York: Basic Books. Ventimiglia, L. and D. Tavasci (2010), ‘Money manager capitalism in primary commodity dependent developing countries’, in D. Tavasci and J. Toporowski (eds), Minsky, Crisis and Development, Basingstoke: Palgrave Macmillan. Whalen, C.J. (2001), ‘Integrating Schumpeter and Keynes: Hyman Minsky’s theory of capitalist development’, Journal of Economic Issues, 35(4), 805–23.
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Whalen, C.J. (2002), ‘Money manager capitalism: still here, but not quite as expected’, Journal of Economic Issues, 36 (2), 401–6. Whalen, C.J. (2010), ‘A Minsky perspective on the Global Recession of 2009’, in D. Tavasci and J. Toporowski (eds), Minsky, Crisis and Development, Basingstoke: Palgrave Macmillan. Wray, L.R. (2009), ‘The rise and fall of money manager capitalism: a Minskian approach’, Cambridge Journal of Economics, 33(4), 807–28. Zalewski, D.A. and C.J. Whalen (2010), ‘Financialization and income inequality: A post Keynesian institutionalist analysis’, Journal of Economic Issues, 44(3), 757–77.
FURTHER READING Minsky, H.P. (1992), ‘Reconstituting the United States’ financial structure: some fundamental issues’, Working Paper No. 69, The Levy Economics Institute of Bard College. Whalen, C.J. (1997), ‘Money-manager capitalism and the end of shared prosperity’, Journal of Economic Issues, 31(2), 517–26. Whalen, C.J. (2008), ‘The credit crunch: a Minsky moment’, Studi e Note di Economia, 13(1), 3–21. Whalen, C.J. (ed.) (2011), Financial Instability and Economic Security after the Great Recession, Cheltenham, UK and Northampton, MA, USA: Edward Elgar. Wray, L.R. (2008a), ‘Financial markets meltdown: what can we learn from Minsky?’, Public Policy Brief No. 94, The Levy Economics Institute of Bard College. Wray, L.R. (2008b), ‘The commodities market bubble: money manager capitalism and the financialization of commodities’, Public Policy Brief No. 96, The Levy Economics Institute of Bard College. Zalewski, D.A. (2002), ‘Retirement insecurity in the age of money-manager capitalism’, Journal of Economic Issues, 36(2), 349–56.
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35 Option pricing models Paulo L. dos Santos
Mainstream financial theory suffers from the characteristic analytical weaknesses of its neoclassical economic foundations. Its central results are defined and functionally derived in relation to ahistorical and asocial market ‘equilibria’, conceptualized with systematic reference to neither the agencies nor regulating forces that may create and define them. Its approach to knowledge offers little insight into how economic actors and observers may each learn about economic circumstances. And it tends to conflate theorization with mathematical formalization, with a notable lack of attention to the correspondence of its premises and axioms with economic behaviour and structures under analysis. The potential difficulties arising from these shortcomings are manifold. This brief chapter discusses some of those as evident in influential theories of option pricing.1 Like the efficient markets hypothesis (EMH), option pricing models rely upon a problematic, neoclassical conceptualization of the exercise of arbitrage. Competitive financial markets are held to offer no opportunity for systematic, risk-adjusted gains by exploiting misalignments in asset prices. Yet analysis offers no account of price formation, or of the processes, actions and knowledge that may ensure that financial markets exhibit this property. The lack of such a theory of entrepreneurship (subjectivist or otherwise) in financial markets poses relatively modest problems for the EMH, which advances a statement of observer ignorance about the evolution of price. Matters are fundamentally different in option pricing models. Those statements of precise observer knowledge of pricing formulae for derivative assets are deduced on the basis of arbitrage arguments.Yet the origins of this knowledge pose awkward logical problems. In the models, the economist derives the pricing function by assuming market behaviour that requires arbitrageurs to already know the pricing function and to use it to guide their actions. The theory behind the mathematical formalization is thus circular – the pricing function becomes only true in a setting where all market agents already believe it to be true. The well-documented performativity of option pricing models,2 namely their property of actually causing markets to behave in line with their predictions, is in fact a logical requirement in their very definition and derivation. Notably, this in turn opens the door conceptually for complex interactions between genuine entrepreneurial strategies 263
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seeking to exploit the use of particular pricing models and practices, and the development and change of those models and practices. The discussion below details these limitations, arguing they follow from a positivist, careless attitude towards the complex relationship between economic realities, attempts by economic agents to describe them, and the actions those condition. Such attitudes towards economic agency pervade contemporary financial theory, with significant implications for analysis and financial stability.
ARBITRAGE, KNOWLEDGE AND THE EFFICIENT MARKETS HYPOTHESIS Option pricing models are founded conceptually and instrumentally on the efficient markets hypothesis – the equivalent contentions that asset prices reflect ‘all present relevant knowledge’, that only new knowledge moves prices, and that future price movements are random relative to present knowledge.3 The EMH has been robustly criticized from a range of vantage points, including arguments for the existence of behavioural trading patterns and balance-sheet effects that affect the evolution of prices and returns. It is also in the unfortunate position of being a theory of the properties and evolution of financial asset prices that is lacking a theory of price formation, as Austrian economists have most prominently emphasized.4 Put differently, the EMH postulates that ‘all present relevant knowledge’ is reflected in prices without offering a systematic account of the origins of this knowledge or of the agencies that impart it onto prices. It is possible to construct consistent theories of the financial market process that bridge this gap, but they require abandoning neoclassical, homogeneous, price-taking agents. Under those theories some agents may be in a position to discover price misalignments that define profit opportunities, leading to trading actions that align prices and impart onto them the ‘relevant knowledge’. Such theories need not be radical subjectivist,5 in which case individual entrepreneurial discovery is seen as an irreducibly subjective act, but may also be structural. In accounts of the latter type, the location of certain market players within networks of buyers and issuers of securities may be seen to condition their capacity to obtain price-relevant knowledge.6 Agents with balance sheets whose liability structure allows wider arrays of asset positions, particularly in downturns, will also be in a better position to trade on any potential entrepreneurial discoveries. Interestingly, neither approach necessarily requires that financial market prices reflect fundamental economic realities. All they need is that prices be continuously pushed to reflect the existence of potential profits in trading
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Option pricing models 265 financial assets. Such opportunities may in fact follow precisely from the promotion and perpetuation of illusions about asset prices and fundamental economic realities.7 Strict neoclassical interpretations of the EMH refrain from theorizing along any such lines. Yet the absence of a clear conceptualization of the origins of knowledge in financial markets is not analytically devastating as long as the EMH is taken principally to contain a statement of observer ignorance about the future evolution of prices. Economists (and less informed market agents) need not know much about the knowledge on which arbitrageurs trade in order to draw conclusions about their own ignorance about the resulting price changes.
A LOGICAL SALTO MORTALE Option pricing models fundamentally reverse this epistemological relationship. They seek to derive statements of full knowledge about prices that putatively arise only after arbitrageurs have eliminated any potential free profits. But this of necessity requires that the theorist and arbitrageurs share the same knowledge about potential arbitrage opportunities. This is satisfactory neither for the theorist, who is left with no account of the market origins of the relevant knowledge, nor for the would-be ‘arbitrageur’, whose potential abilities to discover profitable misalignments are emasculated to those defined by a commonly known pricing model. As a result, theory offers not a description of ‘objective’ prices, but of pricing relations under which individual knowledge and actions are mutually compatible. This property can support much of derivatives trading, in which agents acquire assets chiefly to change market or regulators’ perceptions of the quality of their liabilities.8 But inasmuch as deviating from the theory’s conventions creates genuine arbitrage opportunities, this support will be fragile and potentially unstable. These points can be shown in relation to the delta-hedging derivation of the Black–Scholes–Merton option pricing relation. In the model, stock prices S(t) are posited to follow an Itô process, so that their continuous-time evolution is given by: dS = μS(t)dt + σS(t)dz
(35.1)
Where dt is the differentially small lapse of time, μ is consequently the deterministic expected rate of return on the stock, σ is the process variance rate, and dz a Weiner process – a continuous time stochastic ‘shock’ proportional to independent drawings from a standard normal distribution. This specification relies on the EMH in that the rate of return on stocks has a
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deterministic component, presumably proportional to risks of holding the asset that cannot be diversified, and a stochastic component grounded on drawings from a normal distribution. Deviations from risk-adjusted returns expectations are random and expected to be zero. The model reasonably assumes that the price of an option will be a function H(S(t), t) of the spot price of the underlying stock. But a function of an Itô process is known also to follow an Itô process, in this case: ⎛ ∂H ⎞ ∂H 1 ∂ 2 H 2 ⎛ ∂H ⎞ μS (t ) + + σ S (t ) 2 ⎟ dt + ⎜ σS (t ) ⎟ dz dH = ⎜ 2 ∂t 2 ∂S ⎝ ∂S ⎠ ⎝ ∂S ⎠
(35.2)
This result implies that the image of the pricing function H(S(t), t) is exposed to the same source of randomness as the asset price itself. As a result, it is possible to construct a dynamic, perfectly hedged position h(t) with holdings of the option and the underlying stock. At each point of time, this perfectly hedged position h(t) consists of being short one unit of the option, and holding )H(S(t), t)/S units of the underlying stock. The value of the position will be: V (h(t )) =
∂H ( S (t ), t ) S (t ) − H ( S (t ), t ) ∂S
(35.3)
From (35.1) and (35.2), over some small discrete lapse of time Δt the variation in the value of this position will be given by: ⎛ 1 ∂ 2 H 2 2 ∂H ⎞ ΔV (h(t )) = ⎜ σS − ⎟ Δt 2 ∂t ⎠ ⎝ 2 ∂S
(35.4)
so that the change over time in the value of this position is deterministic. As there are thus no risks to its rate of return, the absence of arbitrage opportunities requires that it yield exactly the same rate of return as the risk-free asset. Denoting that rate as r this condition may be expressed as: ΔV (h(t )) = r Δt V (h(t ))
(35.5)
Equations (35.5), (35.4) and (35.2) yield the necessary relation for any derivative price function: ∂H ∂H 1 2 ∂2H + rS (t ) + σ S (t ) 2 = rH ( S (t ), t ) ∂t ∂S 2 ∂S 2
(36.6)
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Option pricing models 267 This partial differential equation may be solved for different boundary conditions, corresponding to different contractual details of different options, yielding explicit option pricing functions. The mathematical derivation of (35.6) and the identification of explicit solutions for the pricing relations for particular contingent assets are unimpeachable on logical grounds. But the entire exercise rests upon problematic theoretical premises concerning the functioning of options markets, the actions and knowledge of entrepreneurs, and their relationship to the knowledge of observers/theorists. In order to ensure that position h(t) yields the same returns as the risk-free asset, arbitrageurs must be able to identify deviations from relation (35.5) and trade accordingly. But to do so requires them to know the pricing function H(S(t), t) and its derivative with respect to S(t) at all times. This throws up a puzzle concerning the origins of the pricing formula. Its very definition and discovery by observers or market agents requires it already to be defined and known to market agents. It also betrays a limiting view of entrepreneurship, in which the only profitable discoveries would-be arbitrageurs can make is defined on the basis of public knowledge, including the pricing relation being ‘derived’. The possibility of genuine entrepreneurial discoveries, including of profit opportunities premised on the very circular or performative character of pricing relations, is not entertained. This is a considerable restriction for a theory in which the actions of arbitrageurs purportedly create prices. While not pursued here, the same substantive criticism may be levelled in relation to the more general and abstract equivalent martingale measure derivations of option pricing constructed on the basis of Harrison and Kreps (1979). In fact, the criticism applies to any claim that observers may obtain precise knowledge about what any prices will be on the basis of the actions of would-be ‘arbitrageurs’. The only considered interpretation of the line of reasoning contained in equations (35.1)–(35.6) is that they help define a pricing relation that, if accepted by all market agents and observers as invariably and uniquely applicable, will lead to mutually compatible actions and no arbitrage profits.
BROADER SIGNIFICANCE AND CONSEQUENCES The analytical problems discussed here follow from a promiscuous conceptualization of the relationship between the knowledge of different agents, their attempts to understand their circumstances, and the impact on economic reality of the actions undertaken on those bases. The theory refrains completely from inquiry into the consequences of sufficient numbers of
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agents using bases other than the derived models in their search for potential arbitrage opportunities, including those posed by the use of the models themselves. Dynamic and indeterminate interactions between existing pricing models, innovations, and entrepreneurial discoveries and profits are likely to result. Positivist approaches founded on price-taking agents and static equilibria impervious to their actions are ill suited to the analysis of such processes. These problems pervade contemporary financial theory. Instruments and tools like collateralized debt obligations and value at risk have been constructed on the unacknowledged assumption that asset performance is independent of the actions of agents using them. Yet the very use of new financial tools offering statistical descriptions of asset performance will in turn affect allocations of capital, balance sheets, and thus financial and firm performance. The recurring failures of such models to perform as expected follow not simply because underlying distributions of financial asset performance may exhibit ‘fat tails’ or other departures from normality, but because the economic processes generating those distributions are driven endogenously by agent actions shaped by the models themselves. Far from eliminating instability, financial innovations appear more capable of generating periods of self-fulfilling expectations in financial markets punctuated by catastrophic, unforeseen ‘surprises’. In this, contemporary financial markets continue to function in line with the historical norm, and to pose a formidable analytical challenge requiring innovative theoretical approaches.
NOTES 1. 2. 3. 4. 5. 6. 7. 8.
Black and Scholes (1973), Merton (1973) and Harrison and Kreps (1979). As discussed in the work of D. MacKenzie and collaborators; see for instance MacKenzie and Millo (2003). Fama (1970). See Pasour (1989) and Shostak (1997). As those following Hayek (1945). Morrison and Wilhelm (2008), for instance. Loasby (1982). dos Santos (2009).
REFERENCES Black, F. and M. Scholes (1973), ‘The pricing of options and corporate liabilities’, The Journal of Political Economy, 81(3), 637–54. dos Santos, P. (2009), ‘On the content of banking in contemporary capitalism’, Historical Materialism, 17(2), 180–213.
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Option pricing models 269 Fama, E (1970), ‘Efficient capital markets: a review of theory and empirical work’, The Journal of Finance, 25(2), 383–417. Harrison, J and D. Kreps (1979), ‘Martingales and arbitrage in multiperiod securities markets’, Journal of Economic Theory, 20(3), 381–408. Hayek, F. (1945), ‘The use of knowledge in society’, American Economic Review, 35(4), 519–30. Loasby, B (1982), ‘Economics of dispersed and incomplete information’, in I. Kirzner (ed.), Method, Process and Austrian Economics, Lexington, MA: Lexington Books. MacKenzie, D. and Y. Millo (2003), ‘Constructing a market, performing theory: the historical sociology of a financial derivatives exchange’, American Journal of Sociology, 109(1), 107–45. Merton, R. (1973), ‘The theory of rational option pricing’, The Bell Journal of Economics and Management Science, 4(1), 141–83. Morrison, A. and W. Wilhelm (2007), Investment Banking, Institutions, Politics, and Law, New York: Oxford University Press. Pasour, E. (1989), ‘The efficient-markets hypothesis and entrepreneurship’, Review of Austrian Economics, 3(1), 95–107. Shostak, F (1997), ‘In defense of fundamental analysis: a critique of the efficient market hypothesis’, Review of Austrian Economics, 10(2), 27–45.
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36 Overcapitalization Jan Toporowski
The efficient functioning of the capital market depends on the scarcity of capital in at least two respects. In the first place it depends on the scarcity of capital in the market for securities so that there are willing buyers of securities in the market and firms can thereby raise capital for productive purposes. Second, capital market efficiency depends on the scarcity of capital inside the firm, so that companies apply their scarce capital to the most productive uses of that capital, rather than squandering it on unnecessary investment, management and conspicuous aggrandisement. Overcapitalization, that is, the issue of equity or common stock in excess of what is required for the productive and commercial activities of a firm, makes the capital market less efficient. By keeping capital in firms that have run out of profitable investment opportunities, overcapitalization means that a firm’s excess capital may not be reallocated through the capital market to other firms where it may obtain a higher return. Furthermore, companies that are overcapitalized are under less internal financial pressure to allocate their capital to the most efficient uses. Overcapitalization first appeared as an important question of corporate finance at the end of the nineteenth century and in the first decades of the twentieth century, in the work of Alfred Marshall, Frederick Lavington, John A. Hobson and Thorstein Veblen. For these authorities, overcapitalization was associated with the ‘watering down’ of a company’s shares when a company promoter, responsible for the sale of new shares, would sell shares in excess in order to obtain a higher commission for managing the share issue. The result would be that the shares would receive lower dividends, because there was insufficient profit made by the company to give a good return, or even the projected return, on the stock. Overcapitalization disappeared from corporate finance discussions in the middle of the twentieth century with the decline of stock market activity following the 1929 crash and following the widespread acceptance by financial economists of the doctrine that the financing of a company is irrelevant to its true value. This doctrine was promoted at the end of the 1950s by Merton Miller, Franco Modigliani and James Tobin. Actual overcapitalization emerged in the final quarter of the twentieth century in the United States and Great Britain with the rise of institutional investors (pension funds, insurance companies and intermediaries to which 270
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Overcapitalization 271 they sometimes allocate the more speculative parts of their portfolios, hedge funds and equity funds). Because of their large portfolios, the interest of institutional investors in the companies that they own is usually restricted to obtaining returns on their portfolio investment. The concentration of saving in long-term financing institutions from the 1970s and 1980s led to a process of capital market inflation that increased capital gains from holding stocks. Such capital gains accrue on sale of a security and are paid for by the buyer of the security rather than by the company that originally issued the security. The process of capital market inflation reduced the proportion of dividends in the total return from shares. The process made shares a very cheap form of finance for companies, which, in a period of capital market inflation, could rely on the market to pay a considerable part of the return on shares that were issued. This encouraged companies to overcapitalize. Conventional finance theory would suggest that firms would only issue capital up to the point where the return from their commercial and industrial activities would exceed the cost of financing that capital. In practice, firms issue capital beyond that point and invest the excess capital in liquid assets (bank deposits, foreign currencies, company paper). If the return from these assets is less than is necessary to pay the cost of the excess capital, the margin between them is a ‘cost of liquidity’. That cost may be worth incurring if it makes the firm’s balance sheet more liquid, giving it a higher credit rating and cheaper cost of capital. Such liquid assets may, furthermore, be used as collateral against borrowing, or to buy and sell companies in balance sheet restructuring that may be profitable as long as capital markets are inflating. The profit from such balance sheet restructuring off-sets, and may even exceed, the cost of liquidity. Moreover, the lower cost of capital, due to a company’s greater liquidity, may then encourage overcapitalization still further. Right up to the financial crisis of 2008, General Electric Company used its financial assets in this way, through its subsidiary GE Capital, to maintain profit growth when profits from industrial activities failed to meet their targets. Not least among the benefits of overcapitalization is the facility that it offers to companies to grow their balance sheets rapidly by extending leverage, that is, borrowing with a larger equity base. This can allow companies to expand their commercial activities, through buying other companies, much more quickly than they can by means of ‘organic growth’, that is, by buying additional machinery or building new factories and putting these into production. In this way, companies with access to the capital markets, most famously ArcelorMittal, or CEMEX, could become multinational as capital markets became internationally more integrated. The conventional theory of multinational companies centres around management decisions to produce at home or abroad. Overcapitalization, along
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with the ability to engage in portfolio investment abroad, offers a much more expeditious route to multinational status (Toporowski, 2010). In the case of banks, overcapitalization became an officially sanctioned policy under the Basel rules of the Bank for International Settlements. These rules became the internationally agreed standard prudential regulation for banks from 1989 onwards. Under the agreement, banks with foreign exposures were supposed to keep additional capital in proportion to the perceived riskiness of those foreign exposures. These capital requirements rose from zero, in the case of lending to governments in the Organisation for Economic Co-operation and Development (that is, the governments of industrialized countries) up to 100 per cent of lending to companies and governments outside the OECD area. Such rules were incorporated into national legislation and European Commission Banking Directives. There has been much discussion about the revision of the rules since the outbreak of emerging market crises in the 1990s. Since 2008, many banks have had their capital wiped out in the international financial crisis. Aside from their recapitalization, the discussion among bank regulators and economists has turned upon the desirability of obliging banks to increase their capital still further. The general consensus among bankers, their regulators and their expert advisers is that some form of additional capital requirements need to be enforced on banks as macroeconomic conditions indicate greater risks in their lending. This policy of bank overcapitalization illustrates neatly how overcapitalization makes the capital market less efficient. Capital that is tied up in supporting banks against putative risks is neither being used by them in any productive way, nor can it be used by other firms that may have more productive uses for such capital. Bank overcapitalization ‘crowds out’ other more productive applications of such capital not only by making less capital available to them, but also by raising the cost of capital to non-bank firms and forcing such firms into debt. Because banks are obliged by regulation to have a certain amount of capital, they will pay whatever price is necessary to obtain that capital, even raising that price if that is necessary in order to meet their capital requirements. This raises the price in the capital market that non-bank firms must match in order to raise capital. Alternatively, since non-bank firms have only minimal capital requirements, they will issue debt instruments or borrow from banks if they cannot raise capital. This higher indebtedness makes non-bank firms even more reluctant to invest in productive and commercial activities. The ‘crowding out’ of non-bank firms from the capital market, due to overcapitalization, is usually less obvious because of the heterogeneity of non-bank firms. In most capitalist economies, even those outside Europe or
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Overcapitalization 273 North America, there is a range of firms that may be classified by their access to capital markets. Multinational companies have access to capital markets in more than one country and large domestic firms have access to their domestic capital market. Below them, in size, is a range of companies without access to the capital market that are dependent on bank borrowing. The largest of these may have the opportunity to access the capital market if there is capital in that market that multinational companies and large domestic companies (which, on account of their size and their existing track record as companies, have a better credit rating and therefore better access to the market) do not wish to take up. It is this intermediate stratum of companies, rather than all non-bank firms large and small that, in reality, contains the principal losers from the overcapitalization of banks and larger companies. However, following the 2008 crisis, it became very obvious that even some multinationals, such as Tata, CEMEX, ArcelorMittal and GEC, were unable to raise capital because the capital requirements of banks were taking up the little capital that was available in the market. Overcapitalization thus distorts the operations of the capital market, making it less efficient in the allocation of capital to various activities. In the case of banks, capital requirements in excess of what is necessary for them to conduct their business, deprives non-bank firms of capital, raises the cost of capital to them, and forces such firms to use debt instruments instead of capital. This makes the economy more fragile financially, and reduces productive investment.
REFERENCES AND FURTHER READING Breit, M. (1935), ‘Ein Beitrag zur Theorie des Geld- und Kapitalmarktes’, Zeitschrift für Nationalökonomie, 6(5), 632–59. Toporowski, J. (2008) ‘Notes on excess capital and liquidity management’, Working Paper No. 549, Annandale-on-Hudson, New York: The Jerome Levy Economics Institute of Bard College, November, pp. 1–10. Toporowski, J. (2009), Evidence in House of Commons Treasury Committee, ‘Banking crisis: international dimension of the banking crisis’, Eleventh Report of Session 2008-09, HC 615, London: The Stationery Office, 24 July, pp. 59–63. Toporowski, J. (2010), ‘The transnational company after globalisation’, Futures, 42(9), 920–25.
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37 Private equity funds Jan Toporowski
A private equity fund is a fund established to buy and sell companies, through buying their equity (or common stock) in the stock market (where a company is said to be ‘public’, that is, available for members of the public to buy or sell) or buying it from its owners (in the case of a privately held company), and reselling the ownership claims on the company at a profit. Most private equity funds are limited partnerships of investors in the fund, typically pension funds, insurance companies, endowments or very rich individuals. These investors place large amounts of cash in the fund, usually in excess of $1m per investor, more commonly around $10m. The limited partnership has reporting and tax advantages over more usual financial investment vehicles such as investment trusts or mutual funds. Typically the fund will have a fixed term of, say, ten years, after which the investors obtain their funds back with a profit. Annual extensions of the fund may be made after the term of the fund is completed. Private equity funds are managed by private equity firms, such as Blackstone, or Kohlberg Kravis Roberts & Co. Such firms are paid usually between 1 and 2 per cent per year of the committed capital of the fund, sometimes with restrictions making the fees dependent on the performance of the fund. A private equity firm will also usually charge ‘carried interest’, that is, a ‘success fee’, usually around 20 per cent, on the profits made in excess of a minimum ‘hurdle rate’, commonly around 8 per cent. Private equity firms usually start new funds as established ones become fully paid up, that is, after promised contributions are paid in, usually three to five years after one is established. Private equity firms manage the funds by using them to buy out controlling stakes in companies whose shares are traded in a stock market, or from existing private owners of a company. For larger companies this usually requires the fund to borrow additional amounts of money, that is, ‘leverage up’ the money in the fund. This, as well as joint purchases with other private equity firms, allows private equity funds to buy even larger companies, such as the multinational company United Biscuits, bought for a total of $600m in 2001 by funds managed by three private equity firms, PAI, MidOcean and Cinven. Many well-known companies, such as Hilton Hotels or the Boots pharmacy chain in the UK, are now owned by private equity funds. 274
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Private equity funds 275 Private equity firms managing the funds focus on their ‘exit strategy’, that is, the point at which they sell the companies that they buy either as an initial public offering (IPO) back into the market, or to other funds, or to another strategic investor, for example a company in the same business. Sales of the assets must generate sufficient funds to satisfy the investors in the fund and preferably encourage them to invest in other funds run by the firm. Money borrowed by the fund must be repaid and this is typically done by the sale of assets that the company has. In the case of United Biscuits, its Southern European businesses in Spain and Portugal were bought by the US food company Kraft for $860m in July 2006. In October that year the remainder of United Biscuits was bought by PAI and Blackstone for $2.3bn. Such strategies give private equity funds something of the character of Ponzi schemes, in which investor interest in the funds is maintained in part through the sale of companies or their subsidiaries at ever-increasing valuations to other companies, or to other, sometimes not unrelated, private equity funds. Investor interest in the funds has also been sustained by capital market inflation in general, which greatly facilitated the generation of capital gains in the stock market, and, since the end of the twentieth century, the weak performance of the stock market, which made financial investors more credulous of the possibilities of exceeding that weak performance. Institutional investors, such as university endowments and pension funds, lack the focus on the financial performance of individual companies and the application of enterprise to finance that is required to take advantage of capital market inflation to organize M&A activity. Such activity is therefore subcontracted to private equity firms run typically by former investment bankers with expertise in M&As. The tying up of funds for a decade at a time in unquoted investments, at the end of which the fund returns the money invested with profits, obscures the possibility that as good a return may have been obtained (and was in the 1980s) with greater liquidity just by holding quoted stocks. While stock markets were inflating during the 1980s and 1990s, it was easy for private equity funds to make profits: a company going ‘private’ for a few years and then sold back into the stock market was almost bound to be sold back into the market at a higher value because of the strong liquidity in the market and the resulting general rise in stock prices. By the twenty-first century, following the collapse of the dotcom boom, it was becoming more difficult to buy and resell companies at a profit. In such a situation resale to other equity funds, the sale of assets, and the ‘sweating’ of the remaining assets – forcing through reductions in labour costs and capacity, and reduced maintenance expenditure on premises and equipment – become
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ways of generating profits and repaying debts. Trades unions have complained that the ten-year investment horizon of the funds leads to underinvestment. Private equity funds are the result of capital market inflation, as well as feeding off such inflation. The establishment and entry into the stock markets, most notably in the USA and UK, of large pension funds in the 1980s gave rise to an equity boom. Under textbook finance conditions (no arbitrage equilibrium) this would have strengthened US and UK companies by offering them more stable equity (common stock) finance. However, under conditions of entrepreneurial finance, the increase in the price of equity that was supposed to signal to companies to issue more equity to maintain equilibrium in the equity market, became a capital gain that attracted the merger and acquisition activity that forms the basis of private equity business. With the ‘maturing’ of funded pension schemes (that is, the point at which pension payments exceed contributions plus investment income, so that assets have to be sold) at the end of the 1990s, the large bulk of equities directly held in pension fund portfolios became something of a liability, since they could not be sold in the market on any scale without causing a fall in prices. This enhanced the attraction to institutional investors of private equity funds: The ten-year term of the funds make for a much more reliable short-term way of investing in equities than buying them in a market whose mechanisms of securing capital gains are so much more hazardous. Hence the boom in private equity finance in the first years of the twenty-first century. From the point of view of companies, the spectacular growth of private equity funds has correspondingly reduced the benefits to companies of stable equity financing. The advantage of equity financing for a company is supposed to be that the capital thus provided does not have to be paid back, and payments on it, the dividends, are discretionary. Private equity funds effectively reduce the term of the equity to ten years, so that, after ten years, new funds have to be sought to buy the equity of companies owned by the funds. At the same time, dividend payments are no longer driven by the financial requirements of the company, but by the much shorter-term financial requirements of the equity fund. However, there may in practice be little difference between the dividends paid to satisfy the stock market, and the dividends paid to satisfy private equity owners. The financial crisis since 2007 has made conditions for equity finance business much more difficult. The new issues market in company stocks has been largely taken up by bank recapitalization. This has made equity funds’ exit strategies depend to a much greater extent on the refinancing through
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Private equity funds 277 new equity funds, or through increasingly debt-financed management buyouts, both effectively forms of Ponzi financing. Equity finance firms have responded to the crisis by concentrating and coordinating their activities in collaborative purchases of companies. At the same time, they have extended the range of their activities, moving into the areas of financing management buy-outs, commodities markets, distressed assets turnaround (‘vulture’ funds), ‘special situations’ (lending to major borrowers excluded by temporary circumstances from banking or capital markets), and speculating in short-term assets. This has made private equity funds much more like hedge funds. However, private equity funds have maintained two characteristics that distinguish them from hedge funds and other financial institutions. The first of these is the ‘locking in’ of contributions from partners in a private equity fund for the period for which the fund is established. The partners in a private equity fund cannot demand a return of their contribution before the fund is liquidated. This has the advantage to the managers of the fund that they do not have to hold liquid assets against the possibility of withdrawal of contributions, as a bank has to hold cash and liquid assets against the possibility of deposit repayment. In effect it allows private equity funds to deal in the kind of illiquid assets that a hedge fund would avoid. The second distinctive feature is a private partnership structure for the funds, even if the firms managing them are publicly quoted companies that therefore have to report on the activities of the firms. The private partnership structure means that managers of the funds are not subject to the usual reporting requirements of public companies. This results in a lack of transparency. The way in which private equity funds conduct their business and generate the profits that they distribute to the partners in the funds is kept obscure. In the final analysis, the rise and success of private equity financing is merely the latest incarnation of the inability of the US and UK capital market model to provide adequate financing of industrial and commercial enterprise, because the purpose of such financing is to make money out of capital markets rather than out of industry and commerce.
ACKNOWLEDGEMENT Thanks are due to Ms Judith Tyson and Mr Niyaz Laiq for helpful comments on a first draft.
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FURTHER READING Long, M.S. and T.A. Bryant (2007), Valuing the Closely Held Firm, New York: Oxford University Press. Pensions Investment Research Consultants (PIRC) (2007), Private Equity – Guide for Pension Fund Trustees, London: Trades Union Congress. Prowse, S.D. (1998), The Economics of the Private Equity Market, Federal Reserve Bank of Dallas.
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38 Quantitative easing Shujoya Venugopalan
WHAT IS QE? Quantitative easing (‘QE’) refers to the highly publicized monetary policy response employed by major central banks across the world. The policy was first used by Japan between 2001 and 2006, and more recently by the USA and UK in response to the global financial crisis of 2008–09. While there are some variations between these states in the details of how QE was implemented, in all cases it involved the respective central bank purchasing government bonds matched by a corresponding increase in the level of reserves (termed ‘excess’ reserves) held by banks at the central bank. This policy response produced a rapid and large increase in the size of central bank balance sheets within these countries not experienced since the Great Depression. Yet the significance of QE lies not only in the extent and pace of monetary easing, but perhaps more importantly in how it represents a break with the monetary policy theory that predominated prior to the global financial crisis, otherwise known as the ‘new consensus’. The new consensus itself was a significant break from monetarist thinking that dominated in the 1980s. In new consensus thinking, the central bank policy rate is viewed as the most important monetary policy tool for controlling the level of aggregate demand and the rate of inflation within an economy. What is particularly interesting about QE is that it once again focuses on the level of money in the economy, and as a result has more similarities with monetarism, where monetary aggregates are seen as more important than interest rates.
RATIONALE FOR QE In order to gain a clearer understanding of QE it is crucial to understand the reasons given for its implementation. In the case of the USA and UK, the official rationale for QE was the failure of the conventional monetary transmission mechanism (MTM), highlighted by the severe dislocation of their respective financial systems in 2008–09. This failure of the conventional MTM makes it difficult for central banks to stimulate aggregate demand and influence inflation expectations using the policy rate. 279
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In order to avoid deflation and secure a negative real interest rate, monetary policy-makers felt the need to enact ‘unconventional’ policies such as QE in order to ‘reactivate’ the MTM and boost inflation in the economy. The need for alternate policy responses such as QE becomes even more important when the nominal interest rate in the economy is close to zero. Indeed, some advocates of QE would argue that a central bank should even suffer higher than normal inflation rates in the short term in order to reduce the real interest rate, thereby stimulating interest-sensitive spending. It is argued that QE works on the economy through a number of channels. Some policy-makers claim that as banks gain more reserves this encourages them to lend in order to re-establish their target reserve ratio, thereby stimulating activity. This is the rationale behind a former approach to monetary policy called the ‘reserve position doctrine’. This maintained that it is the reserves with the central bank that should be chosen as an operational target of monetary policy implementation. Views of monetarists are generally in the tradition of the reserve position doctrine; however, QE is in marked contrast with the new consensus view, which argues that it is the overnight interest rate that should be the operational target of monetary policy. It could be argued that QE represents a return to a view of monetary policy where the level of bank reserves is an important driver of the bank lending channel. ‘Portfolio rebalancing’ effects are also used by policy-makers to justify QE. They argue that the purchase of government bonds results in investors demanding other assets, thereby ‘rebalancing’ their portfolio back to its ideal investment allocation. It is argued that this results in demand for other assets, notably equities. This bids up financial asset prices; and the corresponding rise in household wealth stimulates demand. Some argue that the main channel through which QE works is via its impact on inflationary expectations. A policy like QE could provide assurance to investors that short-term rates will be kept lower in the future than they currently expect and, if credible, this will lower yields throughout the term structure and therefore impact the pricing of long-lived financial assets such as equities and mortgages.
PAST EVIDENCE The actual consequences of QE are relatively untested. The previous Japanese episode of QE is considered the last time (other than during 2008–10) when the policy was implemented. The Bank of Japan began a policy of QE in 2001, specifically changing the monetary policy instrument to targeting current account balances (or reserves) held by commercial banks with the central bank. QE was formally concluded in 2006. However,
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Quantitative easing 281 the results were disappointing, with no increase in broad money growth, and the exercise was followed by several years of negative real GDP growth. However, some have argued that the subsequent poor GDP performance that Japan suffered does not represent a failure of QE to work, but instead reflects other policy mistakes. Specifically, some have argued that Japanese policy-makers did not go far enough in loosening monetary conditions, and also were too slow in taking up QE when the zero lower bound on nominal interest rates was reached. Furthermore, others have argued that the Bank of Japan exited QE too soon. Clearly any assessment of the success of QE is further complicated by the ongoing difficulties with empirical studies. For example, it is very difficult to isolate the effects of QE from other global effects on equity or debt prices. In addition, one cannot know what the situation would have been had a central bank decided to do nothing and not implement QE, and there is also a problem with time lags, since it is widely accepted that changes in monetary policy take time to impact the economic system.
OTHER CRITICISMS Yet the problems with QE are not just empirical validity. One criticism is that it focuses on boosting bank lending via increasing the level of reserves that commercial banks hold at the central bank, ignoring the fact that during times of uncertainty like a financial crisis banks are less willing to lend as they are unsure of the creditworthiness of borrowers. Moreover, to the extent that financing costs are lowered, borrowers during times of uncertainty are more likely to use new funds to pay down existing debt rather than to invest, particularly where the downturn has been caused by a reduction in asset prices. Furthermore, even if QE does work in the short term, a policy that is aimed at bidding up asset prices, including equities, in order to increase household wealth, can build up domestic economic distortions. For instance, while higher QE may help increase asset prices, once policymakers decide to ‘normalize’ rates the removal of monetary stimulus could lead to a reversal of any ‘asset bubbles’, with the greatest impact on leveraged investors, which could result in another fall in economic activity. Another problem with QE is that it assumes the additional money supply will remain within the domestic economy, but evidence suggests this may not be the case. Indeed, lower interest rates in developed countries can result in large capital inflows to other emerging or less developed countries where potential returns are much higher, resulting in limited impact on domestic asset prices but huge implications for recipients of capital inflows. Not only can these capital inflows erode export competitiveness by strengthening
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currencies (highlighted by the debate over the ‘currency war’, a term coined by Brazil’s Finance Minister in 2010 to depict the active devaluation of one’s currency), they also fuel equity and fixed income bubbles in emerging and developing countries. This is a dilemma for central bankers who fear that tightening rates to avoid asset bubbles will increase the interest differential with financially developed states, fuelling further capital inflows. An exit strategy for QE is complicated by the fact that government bonds are likely to be sold when the market has improved and long yields are rising. This suggests potential losses on a central bank’s government bond portfolio. Furthermore, due to increased levels of reserves held by banks, post a policy of QE, much higher levels of interest rates could be needed in order to curb inflationary pressures. These higher interest rates might themselves have a destabilizing impact on an economy in the future.
FURTHER READING Bernanke, B. and V. Reinhart (2004), ‘Conducting monetary policy at very low short-term interest rates’, American Economic Review, 94(2), 85–90. Bini Smaghi, L. (2009) ‘Conventional and unconventional monetary policy’, Member of the Executive Board of the European Central Bank, Keynote Lecture at the International Center for Monetary and Banking Studies (ICMB), Geneva, 28 April. Borio, C. and P. Disyatat (2009), ‘Unconventional monetary policies: an appraisal’, BIS Working Papers, No. 292. Dale, S. (2010), ‘QE – one year on’, speech at the Centre for International Macroeconomics and Finance (CIMF) and Money Macro and Finance (MMF) Research Group Conference ‘New instruments of monetary policy: the challenges’, Cambridge, 12 March. Posen, S.A. (2010), ‘The realities and relevance of Japan’s Great Recession: neither ran nor rashomon’, STICERD Public Lecture, London School of Economics, 24 May 2010.
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39 Risk Tracy Mott
Risk, in economics, has traditionally been taken to be a matter of the variability of a magnitude of wealth or income or of the utility of such a magnitude. To differentiate risk from uncertainty, which also signifies variability, economists have generally followed Frank Knight ([1921] 1985), who defined risk as a situation where the outcomes can be given specific probabilities and uncertainty where specific probabilities cannot be assigned. Knight thus held that risk can be insured against, while uncertainty cannot. A situation where either risk or uncertainty, as so defined, exists, however, cannot be one of certainty, so one might ask whether Knight’s distinction is one of degree or difference. Taking risk to be variability has quite naturally led economists to measure risk by the standard deviation or by the variance of the distribution of the relevant variable. This has been criticized on the grounds that these measures require a utility maximizer to have a quadratic utility function, which imposes some implausible conditions on an individual, such as greater aversion to constant additive risk at high levels of wealth than at low levels of wealth, which contradicts observed behavior, and Karl Borch’s (1969) demonstration of an inconsistency in the rank-orderings generated by the mean-standard deviation approach. Attempts to overcome this have mainly been those like Michael Rothschild and Joseph Stiglitz’s (1970, 1971, 1972) work on increasing risk, which, however, can only provide a partial ordering of the riskiness of random variables, and which succeeds in overcoming the limitations of the mean-standard deviation approach really only by being more precise about what it means for the variance of a quantity of wealth to be increasing. The biggest success of the mean-standard deviation approach to the measurement of risk has been the modern portfolio theory, culminating in the capital asset pricing model (CAPM). This approach to financial behavior argues that the ability to reduce risk by portfolio diversification means that the only risk an investor should care about is the covariance of any particular asset with the overall market and that any extra-normal returns relative to those of the market should only be for bearing extra risk of this type. This last result has not been borne out empirically, and many would argue that this failure has to do with the treatment of risk in the model. 283
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Some of these empirical failures may well be due to the fact that proxying future variance by using data already in hand is problematic. Other problems have been argued to arise because the model’s predictions require data from a broader base of assets than can reasonably be acquired to represent the true ‘market portfolio’ with which investors should be concerned. Further issues go back to the ways in which we should model people’s attitudes towards risk, mentioned above. It is not just that quadratic utility towards wealth is questionable. The observation that the same person may both buy insurance and engage in gambling raises questions. Conventional wisdom, as also described by the Friedman and Savage (1948) utility function, holds that people seem to be risk-averters in most of their wealth-holding behavior but are risk-lovers if wagering a small amount of wealth on long shots, thus explaining some of the failure of more risky assets under the terms of the CAPM to bring high enough long-term returns to fit the theory’s predictions. This, however, is not the only anomaly that contradicts the CAPM, and further considerations of investment results and investor behavior have led to the rise of ‘behavioral finance’, a school of thought that questions the assumptions about the rationality of investors taken by the standard theory. A more fundamental questioning of variance as a measure of risk arises from the evidence that asset returns seem not to be normally distributed, exhibiting ‘fatter tails’ (leptokurtosis) than the normal distribution, among other things. As this is true, variance is certainly not the proper measure of risk, and indeed many have posited that asset return distributions belong to the ‘stable Paretian’ family, which have infinite variance. Mandelbrot and Hudson ([2004] 2008) have argued that financial returns are subject to not only greater volatility than that assumed by the normal distribution but also that current asset price movements are not independent of past movements, though the direction of change is not predictable. Edgar Peters (1991) has described the types of common stock return movements we observe as ‘biased random walks’. Movements in one direction have a greater than 50 percent probability of being followed by another movement in the same direction, but once there is a shift in the direction of movement, the next movement will be greater than 50 percent likely to continue in the new direction. Mandelbrot finds that the size of the movements also show some persistence, so that large price changes are more likely than not to be followed by large changes, but a drop in the size of the changes will then tend to persist for an unpredictable length of time. All of this makes financial investing more risky, in the sense of potential loss, than the CAPM or the efficient markets hypothesis would allow. Mandelbrot and others thus argue that our measures of risk used to calculate things like capital
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Risk 285 adequacy for financial institutions are terribly flawed, and many would say that this was revealed in the 2007–08 financial crisis. The real ‘risk’ facing any wealth-holder is, after all, the chance of loss. Thinking about risk as a threat to the objective value of wealth is the approach taken in Michał Kalecki’s ([1937] 1990) ‘principle of increasing risk’, which he applies to explain that the fundamental limit on the expansion of any firm is the size of its own capital. Kalecki ([1954] 1990) argued that the limit coming from the size of own capital arises because the more own wealth that is tied up in a particular fixed investment, the more danger to one’s wealth position is present in the event of failure and the more trouble one is under in case of a sudden need for liquidity. Issuing debt will compound this problem by setting up an additional claim on liquidity to be met. Issuing new equity avoids the fixed commitment of debt repayment but dilutes the value of the investment to the original holders more than debt by letting new shareholders in on an equal footing. The work of Stiglitz, along with his co-authors, on credit and equity rationing (e.g., Stiglitz and Weiss, 1981; Greenwald et al., 1984) deals with objections to these attitudes towards debt or new equity that arise from Franco Modigliani and Merton Miller’s (1958) arguments about shareholders’ abilities to arrange their own preferred degree of leverage or arguments that new share issues by any particular firm would be too small to affect their value by appealing to asymmetric information between debt or equity issuers and debt or equity providers. If borrowers have greater knowledge of a venture’s prospects than lenders, adverse selection concerns should lead lenders to make loans at a below-market-clearing interest rate with restrictions on the quantity of credit available. Under asymmetric information, new equity issue then sends a signal that the firm may be unable to issue new debt because of greater bankruptcy risk, as in George Akerlof’s (1970) used car ‘lemons’ discount applied as soon as a car is driven off the car lot. Kalecki’s view towards risk is another way to justify John Maynard Keynes’s ([1936] 1964, Chap. 13) notion of ‘liquidity preference’, and it can be subsumed into the mean-standard deviation approach as capital risk aversion, but it really is about using money to make money, and it reminds us of the limits on the ability to reduce risk by portfolio diversification. Saying that the only risk that matters for any particular asset is its covariance with the market as a whole still leaves a lot of riskiness facing anyone’s overall wealth-holdings due to the risk facing the market as a whole. Furthermore, the fact that assets to some are often liabilities to others or that some assets have been purchased by issuing liabilities means that there is a degree of interconnectedness to investments that leads what happens to one investment to affect what happens to other investments. This is what Keynes
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(ibid., Chap. 12, p. 130) was talking about when he wrote that ‘each individual investor flatters himself that his commitment is “liquid”’, as he can sell out at any time, but ‘there is no such thing as liquidity for the community as a whole’. Jan Toporowski (2000) has argued that a firm’s concern for the value of its equity makes it a liability in its effect on firm behavior. The same kinds of concerns that lead rising indebtedness to cause reduced business investment spending leading to cycle downturns in Hyman Minsky’s (1986) theory can come about in the attempt to protect equity values. Since such spending cuts in the aggregate economy will lead to debt defaults and impairment of capital, as described in Greenwald and Stiglitz (1993), Keynes’s relating of individual fears to aggregate developments, as in his ‘paradox of thrift’, gives us a classic prisoner’s dilemma situation in the financial and real economy. Seeing risk as a collective matter rather than just as something facing individuals as individuals may mean that our concern for finding a precise measure of risk is less important than dealing with its consequences for the economy overall. Taking risk as not solely a problem facing individuals as individuals may also mean that thinking of it as a matter of how investors act according to their individual preferences is a mistake. The appeal of the mean-standard deviation approach and the faults that have been discovered with it may themselves arise from ignoring the systemic, in the sense of ‘system-wide’, nature of risk. Asset values are not determined as outcomes on a roulette wheel are determined but rather by the interactions of the individuals and institutions in the economic system as a whole, or at least of a significant subset of that system. Even in horse track betting the odds on the horses and so the financial results to the bettors will change with their actions, though the order of finish in a race should still be a matter of how the horses run, with negligible influence from whatever the bettors may be doing. Changes in the betting in economic races will change the financial results additionally by changing the actual race results. The bettors are participants in the races. Thus risk for the individual cannot be completely separated from risk for the community, and the idiosyncratic risk that can be eliminated by diversification will be somewhat insignificant when contagion effects across assets are present. This can justify regulatory restrictions on investment behavior, but it may fundamentally require macroeconomic stabilization policy to reduce risk. All of this also means that risk-bearing is not something that can be assigned completely to the holders of particular assets. This social nature of risk complicates the moral hazard considerations that affect economic regulatory policy. As policy reduces the bad consequences of risk, it can induce greater risk-taking. This may then justify social control over the
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Risk 287 rewards received for bearing risk, as Keynes ([1936] 1964, Chap. 24) also argued for. If we act to protect people from the consequences of bad outcomes, shouldn’t we need to limit their potential rewards to keep them from taking socially dangerous risks and to prevent our social riskinsurance from contributing to greater inequality? The counter-argument to this, of course, is the danger of discouraging socially productive risk-taking. Keynes (ibid., p. 374) thought, however, that ‘it is not necessary for the stimulation of these activities…that the game should be played for such high stakes as at present’. And, once the social aspect of risk-bearing is recognized, the idea that the risks and rewards to any act of investment are solely an individual matter can no longer be upheld.
REFERENCES Akerlof, G. (1970), ‘The market for lemons: qualitative uncertainty and the market mechanism’, Quarterly Journal of Economics, 84(3), 288–300. Borch, K. (1969), ‘A note on uncertainty and indifference curves’, Review of Economic Studies, 36(1), 1–4. Friedman, M. and L. Savage (1948), ‘Utility analysis of choices involving risk’, Journal of Political Economy, 56(4), 279–304. Greenwald, B. and J. Stiglitz (1993), ‘Financial market imperfections and business cycles’, Quarterly Journal of Economics, 108(1), 77–114. Greenwald, B., J. Stiglitz and A. Weiss (1984), ‘Informational imperfections in the capital market and macroeconomic fluctuations’, American Economic Review, Papers and Proceedings, 74(2), 194–9. Kalecki, Michał ([1937] 1990), ‘The principle of increasing risk’, reprinted in J. Osiatynˇski (ed.), Collected Works of Michał Kalecki, Vol. I, Oxford: Clarendon Press, pp. 285–93. Kalecki, Michał ([1954] 1990), ‘Entrepreneurial capital and investment’, reprinted in J. Osiatynˇski (ed.), Collected Works of Michał Kalecki, Vol. II, Oxford: Clarendon Press, pp. 277–81. Keynes, John Maynard ([1936] 1964), The General Theory of Employment, Interest, and Money, New York: Harcourt, Brace & World. Knight, F. ([1921] 1985), Risk, Uncertainty and Profit, Chicago: University of Chicago Press. Mandelbrot, B. and R. Hudson ([2004] 2008), The (Mis)Behavior of Markets, New York: Basic Books. Minsky, H.P. (1986), Stabilizing an Unstable Economy, New Haven, CT: Yale University Press. Modigliani, F. and M. Miller (1958), ‘The cost of capital, corporation finance and the theory of investment’, The American Economic Review, 48(3), 261–97. Peters, E. (1991), Chaos and Order in the Capital Markets, New York: John Wiley and Sons. Rothschild, M. and J. Stiglitz (1970), ‘Increasing risk I: a definition’, Journal of Economic Theory, 2(3), 225–43. Rothschild, M. and J. Stiglitz (1971), ‘Increasing risk II: its economic consequences’, Journal of Economic Theory, 3(1), 66–84. Rothschild, M. and J. Stiglitz (1972), ‘Addendum to “Increasing risk I: a definition”’, Journal of Economic Theory, 5(2), 306.
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Stiglitz, J. and A. Weiss (1981), ‘Credit rationing and markets with imperfect information’, American Economic Review, 71(3), 393–411. Toporowski, J (2000), The End of Finance, London and New York: Routledge.
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40 Securitization Sanjay Krishnan
There is a parallel between the development of economic theory and that of financial developments. By itself, securitization is a neutral asset–liability management tool that is not to be feared. The incentives for seemingly unlimited profit exploitation are what lights the fuse. This also means that unless the rules of the game are changed worldwide such that they alter or reduce the current set of incentives, when the debris of the current crisis settles, securitization will still be around – which, just to clarify, is of neutral consequence.
INCENTIVES IN SECURITIZATION – A VICIOUS CIRCLE Banks used the low interest rates, a result of the savings surplus from Asian countries, to lend liberally to subprime borrowers and with limited checks on the borrower’s ability to repay. Banks used securitization to raise significant amounts of cash, which were then ploughed back into giving out more loans. The investors for these asset-backed securities were other foreign investors who were pumping money into the US securitization market and economy, which in turn worsened the current account imbalance. But the problem was not the imbalance as much as the credit problems and the leveraging caused by the securitization. From this point of view, securitization provided the transmission mechanism between the low interest rates and the vicious circle of ever-rising debt. This link was snapped by the shock of rising defaults in the real economy as a result of the indiscriminate lending practices of originating banks and non-bank financial companies. With profit from loan originations and the relief of transferring the credit risk out of the balance sheet, the originating bank was happy. Arranging banks, legal counsel and rating agencies, and pretty much all parties that were in this circle, profited from the extraordinarily fast increase in volume of securitization. Investors such as pension funds and hedge funds were getting margins significantly above US Treasury for securities rated ‘AAA’ (the same as the credit rating of the US economy). 289
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Investors such as pension funds believed they were matching maturities of their pension liabilities with that of the asset-backed securities they were investing in. Regulators were happy because the light regulatory touch kept the engine going. Borrowers were happy because some could get loans that would have been otherwise impossible. In short, securitization, like most other bubble-causing mechanisms, created the illusion that everyone could have exactly what they wanted.
WHAT IS SECURITIZATION? Securitization is nothing but one of a myriad set of ALM (asset liability management) tools that companies and financial institutions (bank and non-bank) use to manage the balance sheet of the institution. There can be any number of reasons to do this. One reason could be that a bank wants to remove credit risk off its balance sheet. This lowering of the institution’s credit risk exposure in turn could boost the credit rating of the institution. Another reason could be to boost the company’s return on asset ratio or to lower the debt-to-equity ratio. One of the most common reasons for securitization is that companies and banks can lower their funding costs. A ‘BBB’-rated institution would have to pay funding costs (as measured in spread over Libor over US Treasury notes or UK gilts) corresponding to a ‘BBB’ rating. On the other hand, if the same company was to securitize its assets and issue ‘AAA’-rated bonds, the spreads payable, and hence the company’s funding costs, decrease significantly. Another key reason for using off-balance-sheet financing is to set aside lesser amounts of capital in order to meet regulatory requirements such as Basel II. The key differences between structured finance and some other ALM tools are (1) tranching and (2) structural features. It is in fact the features of structured finance transactions such as credit enhancement mechanisms (through reserve funds, subordination, excess spread, etc.) that allow the achievement of tranching. These structural features allow junior notes to earn much higher yield than the senior notes. But in return junior notes are first in line to absorb losses if defaults in the securitized portfolio were to increase. This allows investors of various risk appetites to subscribe to these issuances. Thus risk is sliced through pooling and de-linking from the originator’s credit risk and diced through tranching, thus satisfying issuers’ and investors’ appetites.
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CONFUSION IN COMPARISON There is a general lack of understanding and agreement (both within and without the structured finance industry) as to the default risk and distribution of a structured finance instrument in comparison to a corporate or sovereign bond. Using the instrument’s rating as an indicator of the risk of default (or loss) of the instrument, the question arises as to which instrument would you rather own? US sovereign debt (rated ‘AAA’) or the senior note of a collateralized debt obligation (CDO) (also rated ‘AAA’)? What is the economic and financial rationale to obtain higher returns from holding the senior tranche of a CDO compared to US sovereign debt when both have the same credit-risk metric? Furthermore, even within a rating category, say of ‘AAA’, the default distribution and susceptibility to tail risk and the behaviour under tail risk events are higher for a structured finance bond compared to sovereign or even corporate bonds. Lastly, ratings volatility is perhaps higher among structured finance instruments compared to sovereign and corporate bonds. As shown above, given that ratings do not seem to capture a variety of risks inherent in structured finance bonds, it is injudicious to either rely on ratings as a complete measure of credit risk or to compare various assets within the same rating category. If this is the case, it makes even less sense for all market participants to use credit ratings as an arbiter of risk. So why use ratings? Because securitized assets can be extremely complex and the outsourcing of risk analysis to rating agencies removes the necessity of some market participants to truly understand these instruments. In securitization, the investors face the risk of prepayments and defaults affecting their cash flows. These risks are seemingly mitigated by the portfolio approach, credit enhancement and tranching mechanisms. Many investors and other key players in the securitization industry confuse this with meaning that such transactions can deal with uncertainty. This willingness to outsource risk analysis to such an extent comes back once again to the issue of incentives. There was too much money for all participants and too little time and pressure to carry out much rigorous proprietary analysis. Unless the incentive to create and hold instruments without truly understanding the risks in structured finance transactions (especially the likelihood and severity of tail risks) is dealt with, this behaviour will continue as the securitization market re-surfaces from the credit crisis.
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MORAL HAZARD EMBEDDED IN SECURITIZATION Securitization reduces the incentives of the originator and servicer to service individual borrowers. The servicer cannot be too lax in its servicing since sharply rising defaults would impact its ability to securitize again. The servicer’s incentives may lie in reducing defaults, reducing delinquencies, increasing recoveries through repossessions, and so on. But the actions of the servicer, while perhaps being beneficial to investors, may not be in the best interests of an individual borrower. In some cases, it might be better to restructure the loan under different terms and conditions than to hasten the loan towards default. The originate-to-securitize model could lead to loosened origination and underwriting standards due to an overwhelming reliance on the portfolio approach and a desire to securitize as much as possible as fast as possible. It might take years for problems in certain vintages of loans to emerge and when the problems emerge, there could be a multiplicative effect of borrower default and collapse in asset prices. An addiction to the originate-to-securitize model means that originating banks have very little reason to diversify away from off-balance-sheet activities. When the going is good, the bank gets access to cheap financing and all the benefits of securitization. When the going gets bad, the bank can expect to get bailed out due to the typical reluctance in most developed countries to allow bank failures in fear of a run on the banking system. The bank’s expectation is founded on the fact that all of its competitors are engaged in similar activities and hence a turn for the worse could affect the entire financial system, not just this bank. In other words, the bank can ‘hide’ behind the fact that it is one of many engaging in such activities. Such addiction and refusal to face the fact that each player, by increasing its risk profile, increases the risk profile of the entire financial system can again be traced to the role of incentives. Higher short-term returns increase the likelihood of personal bonuses as well as bigger returns to shareholders. The short-term nature of these rewards is at odds with the long-term nature of securitization. The prospect of immediate gain propels all market participants to ignore certain risks such as tail risks and systemic risks. The alternative, from each participant’s perspective, is to simply lose the rewards without reducing the risks because a competitor institution gains the fees. This risk/reward mismatch leads to a gradual erosion of alertness to risks under the assumption that each market participant can take on more risks because the other market participants are doing the same and would not do so if a systemic risk is around the corner. In doing so, each market participant wilfully forgets its own role in creating or sustaining the bubble.
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Securitization 293 Market participants such as legal counsel, auditing firms and rating agencies even attempt to exculpate themselves from future liability by stating clearly that their opinion does not cover the very risks that the investors and regulators assume are covered.
THE STING IN THE TAIL One consequence of off-balance-sheet activities is the opacity it creates for analysing a bank’s ‘real’ risk exposure. SIVs (or structured investment vehicles) are off-balance-sheet vehicles that buy long-term assets such as asset-backed securities (ABS) and residential mortgage-backed securities (RMBS) and issue short- to medium-term notes to finance the purchase of these assets. The purpose of SIVs is twofold: (1) to remove the assets from the sponsor’s balance sheet and (2) to exploit the spread differential between long-term assets and short-term liabilities. As defaults in the underlying mortgages increase, the ABS and RMBS bonds are typically downgraded, spreads compress and in the worst case the cash flows generated from the underlying long-term ABS bonds are insufficient even to meet the low margins of the short-term paper. This leads to a downgrade and possible default of the short-term notes. As defaults in SIVs increase, the sponsor of the SIV, the bank that created the SIV, would typically allow the assets to be sold. However, if the defaults start to show extraordinary increases the sponsor has two options: (1) either to allow a fire sale of the assets or (2) to take the assets back onto their own balance sheet, due to inability to find investors who will be willing to buy the short-term paper to keep the SIVs rolling. Neither option is obviously palatable, but these are the choices that faced some of the biggest SIV sponsors, such as Citigroup, HSBC and WestLB, in late 2007 as defaults in their respective SIVs started to skyrocket. Citigroup alone had to take nearly $50bn of SIV assets back onto their balance sheet as part of the bailout. A fire sale of assets would have sparked a downward spiral of prices of such assets, exacerbating the situation in a variety of ways, not to mention the damage to the reputation of the sponsor. This act of suddenly taking on such huge quantities of assets (and the accompanying loss provision and capital charge) severely worsens the sponsor’s capital ratios from one day to the next. However, very little of the analysis of the risk profile of large banks contained concerns about the consequences of such huge amounts suddenly re-appearing in the bank’s balance sheets. This also indicates that the leverage or debt to equity ratio of the sponsor is artificially depressed through off-balance-sheet activities. Taking into account the refinancing liability of the sponsor in bailing out its SIV would paint a significantly different picture in terms of the bank’s leverage.
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CONCLUSION Securitization is a financial innovation that has grown by leaps and bounds since its inception but especially so in the last few years. Despite its central role in the credit crisis of the first decade of the twenty-first century, it is too soon (and unnecessary) to sound the death knell for securitization. This is because securitization has an incredible number of advantages that will remain even after the debris from this crisis has cleared. The lower cost of funding, the need to get credit risk off their balance sheet, and so on remain post-crisis. In future, a broader and yet more specific definition of leverage has to be used in testing the capital ratios of banks. However, even the best metric for leverage will make it difficult for regulators to discover the true leverage the bank holds. If the bank wishes to hide such information there is little that regulators can do. There are only two alternatives to this: (1) either provide incentives for disclosure on true debt ratios or (2) allow a bank that took on undue risk (without providing commensurate information to the regulators) to default. Despite claims to the contrary, securitization is plagued with opacity. The sector suffers from non-standardized reporting, lack of transparency in pricing, lack of agreement on accounting and valuation of these bonds and lack of clearinghouse and exchange-trading mechanisms. These problems make structured finance bonds like a black box, with ratings being one of the few tools (albeit a blunt one) that investors and regulators have. Every one of these points will have to be addressed by regulators. Market participants need to rely less on ratings and develop more standardized risk and stress analysis tools. The players should want to move out of the shadows and into the light of regulatory and market scrutiny in order to protect the sector as a whole. Regulators also need to address the distorted incentives, such as incentives to originate to securitize and shortterm financial incentives that led to the rapid increase in the use of securitization. It is important that the plethora of regulatory bodies such as the Central Bank, the Treasury and agencies overseeing bank supervisions coordinate their oversight. Central Banks need to take into account the asset price bubble created by loosened underwriting standards when setting interest rates; they need to take into account a bank’s leverage and off-balance-sheet activities and their overall reliance on securitization for funding; they need to take into account the impact of cheaper financing on asset prices and consumer behaviour. The main conclusion however, is that securitization is ultimately a capitalist innovation. The behaviour of market participants to want more
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Securitization 295 (more origination, more financing, more bonds to trade) is very much part and parcel of capitalist behaviour. This desire for more, coupled with the incentives and opacity that allow this desire to flourish unchecked, is an intrinsic part of capitalism that exists not just in finance but in several other industries such as utility companies, supermarkets, and so on. Hence financial innovation, bubbles that are formed and burst, the reliance on markets to balance supply and demand, to determine optimal prices and the belief that regulation of the market by the market works, are again intrinsic characteristics of the time-honoured capitalist trajectory of boom and bust. The protracted failure of market participants to acknowledge, let alone find a solution for, negative externalities is part and parcel of the way capitalist development works in new sectors. First, there is general excitement, then there is a gold rush and complete faith in market mechanics, then the bubble bursts, regulation kicks in and the market turns into a more well-behaved and mature version of its adolescent phase. Whether structured finance, which is at a turning point right now, learns the lessons from this crisis and turns into a mature industry remains to be seen.
FURTHER READING Coval, J., J. Jurek and E. Stafford (2008), ‘The economics of structured finance’, Working Paper No. 09-060, Harvard Business School. Fender, I. and J. Mitchell (2005), ‘Structured finance: complexity, risk and the use of ratings’, Bank for International Settlements Quarterly Review, June. Minsky, H.P. (2008), ‘Securitization’, Policy Note, The Levy Economics Institute of Bard College. Pagano, M. and P. Volpin (2010), ‘Securitization, transparency and liquidity’, Working Paper No. 210, Centre for Studies in Economics and Finance, University of Naples. Whalen, C.J. (2007), ‘The US credit crunch of 2007 – a Minsky moment’, Public Policy Brief No. 92, The Levy Economics Institute of Bard College.
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41 Tax havens Ronen Palan
Tax havens are normally treated as a peripheral phenomenon on the margins of legality. This brief chapter stresses, however, that tax havens have become an integral part of the way business and finance is conducted in the modern world. The financial service industry: the banks, the hedge funds, the mutual funds, the accounting firms, the legal firms, the insurance companies, and indeed, the entire corporate world, most probably down to small constructions and otherwise, local service industries, have incorporated tax havens into their daily routine to the extent that an attack on tax havens appears to them to be an attack on business, or at least, on business as they have known for the past four or five decades. Tax havens are at the very heart of globalization. The reasons are fairly obvious, although not, it appears, to economists working in academia. Economists habitually argue that capitalists are in the business of maximizing profits, but they neglect to ask whether businesses are seeking to maximize pre-tax or post-tax profits. Considering that corporate taxation in many OECD countries may reach 30 per cent or even 40 per cent of declared pre-tax profits, this is not a trivial question. Tax havens are used, therefore, extensively by the corporate world in order to achieve higher post-tax profits. In addition, financial regulatory requirements may either add to costs or reduce opportunities for making profits (or both). Hence the financial industry has tended to gravitate towards the permissible environment offered by tax havens. The results are some very spectacular statistics associated with the phenomenon of tax havens. There is no easy way of defining a tax haven. The complexity of modern taxation systems renders practically every country a potential haven from taxation imposed by another. Tax havens are also described confusingly as ‘offshore financial centres’, a concept that has proved equally difficult to define. Nevertheless, some countries are widely acknowledged to be tax havens, and despite the controversies of the intervening years lists of tax havens have changed little since the 1980s. The quintessential tax haven would have the following attributes. First, it is a country with either zero or near zero taxation for – and this is important to stress – non-resident clientele. Many very well-known tax havens, such as Jersey, Guernsey, the Isle of Man, Switzerland and Liechtenstein in fact apply income tax on a worldwide basis on their resident populations but 296
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Tax havens 297 provide mechanisms that ensure that tax exiles using their domains do not suffer some or all of that charge. Other tax havens rely on alternative methods of tax collection from their residents or on the mother country (in case of dependent territories such as Caymans). The second defining characteristic of tax havens is strict confidentiality of financial and commercial information, or opacity. Indeed, some prefer to call tax havens ‘secrecy havens’. Opacity is achieved in three ways, both active and passive. Perhaps the most commonplace is banking secrecy, protected by law. Switzerland is considered the originator of the legal concept of banking secrecy, which it enshrined in 1934. The second popular method of creating opacity is by allowing the establishment of entities whose ownership and purpose is very difficult to identify such as ‘trusts’. They provide secrecy because they do not require any form of registration in most jurisdictions and even where registration is required (for example, for tax purposes) that registration is not placed on public record. The third method of creating opacity may be described as a passive method; it relies, in fact, on inactivity or intentional negligence. Many tax havens have perfected the practice of lack of due diligence, purposeful looseness in regulations, and under-resourced regulatory bodies who asked no questions. A third characteristics of a tax haven is the ease with which entities may be incorporated in that place and the ease with which anonymity can be secured when doing so, and subsequently with regard to the operation of the resulting limited company. Tax havens make it easy and cheap to set up companies, trusts and even banks. Companies can be literally bought ‘off the shelf’ and the cost of incorporation is very low. Due to the definitional difficulties the number of tax havens in the world is also in dispute. Palan et al. (2010) estimate that there are currently between 45 to 60 active tax havens; they are home to an excess of 2 million financial entities, offshore companies, trusts and the like. Most if not all of the household-name multinational enterprises and banks would have at least one subsidiary in well-known tax havens. The majority have many, although the number of such subsidiaries is not known. The Enron scandal revealed, for instance, that Enron had in excess of 900 financial and corporate entities located mostly in Caribbean tax havens. The use of such subsidiaries explains another staggering statistic: approximately a quarter of international lending and borrowing is conducted through tax haven entities, and a third of all international FDI is routed through these jurisdictions. In other words, tax havens are both the recipients, as well as the purported originators, of about a third of the world’s stock of FDI. Successful tax havens are located in small jurisdictions in the vicinity of the major trading centres of the world: the Caribbean basin havens serve
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primarily American clientele, European havens serve EU clientele, Singapore and Mauritius Asian clientele, while some Pacific atolls are used allegedly by Russian capital for capital flight and money laundering purposes (Van Fossen, 2003). Tax havens are used primarily, but not exclusively, as their name suggests, for tax avoidance and evasion purposes. Tax evasion is a criminal offence in most countries, while tax avoidance, or organizing one’s tax affairs in a way that minimizes taxation, is considered permissible. The reality of taxation is so complex, however, that the two types of strategies are not easily distinguishable. It is estimated that about $US21 trillion of high net worth individuals’ wealth is parked in tax havens, the near equivalent of US GDP. Individuals’ tax avoidance and evasion is estimated at around $US1 trillion a year. There are no reliable estimates of the global corporate tax avoidance bill, but it must be in excess of this figure. There is little doubt that tax havens play an important regressive role in both the global and the national distributions of income and wealth. Tax havens have also developed certain niche strategies. British jurisdictions, such as the Channel Islands, Caymans and Bermuda, have evolved into ancillary financial centres with close links to the London money markets (serving, however, all the major international financial centres such as New York, Paris, Frankfurt, and Tokyo as well). On paper, the Cayman Islands are the fourth largest international financial centre in the world (the ranking changes almost every year), while Bermuda is the largest ‘captive insurance’ centre in the world. In reality, complex financial transactions are organized in the major money markets and are only re-routed or ‘booked’ through offshore centres. Although there is evidence that some centres, such as the Caymans and Jersey, have developed a limited capacity to originate and complete complex financial transactions. There are many advantages to re-routing complex financial transactions through tax havens: financial transactions registered in these locations attract low or, in many cases, zero rate taxation. Banks and other financial actors may be located ‘onshore’, and supposedly pay their corporate tax in those jurisdictions, but they can register transactions through offshore subsidiaries. In that sense, tax havens serve as the financial equivalent of transfer pricing techniques – banks and companies would tend to shift costs ‘onshore’ in order to gain certain tax and subsidies advantages, while shifting profits ‘offshore’. In addition, tax havens are among the least regulated financial centres in the world. Even when they appear to be regulated ‘on paper’, the lack of disclosure requirements, secrecy of ownership, the minimal requirement to maintain books and/or lack of auditory or regulatory logistical capacity creates in effect a near zero regulated environment. Tax havens claim, correctly, that they have recently been complying with the OECD and the
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Tax havens 299 IMF advice on financial regulation, and have managed to extricate themselves from all sorts of blacklists. They also claim, correctly, that they are not the only offenders, and in some ways, Delaware or London are worse offenders than they are. But the majority of tax havens tend to comply at best with the bare minimum of regulatory requirements imposed on them by the OECD countries; they do so very reluctantly, they tend to attend to the letter of the law rather to its spirit, and often create simultaneously new parallel facilities (written in many cases by the locally based offshore financial community) that creates new regulatory loopholes aimed at avoiding the very rules that have been agreed only recently. The British-held havens, in addition, have the advantage of political stability offered by the mother country, and English common law. These centres have tended to specialize in modern financial instruments such as futures and derivatives, mortgage-backed securities and the like, and are home to the majority of the world’s hedge funds and special purpose vehicles (SPVs). Combined, these British-based financial centres account for about a third of international financial transactions (in volume). Besides Switzerland, still considered the world’s premier tax haven – although the dubious honour may be snatched soon by Singapore – there is a group of less-known European tax havens that includes the Benelux countries and Ireland, which between them account for about one-fifth of international financial transactions in volume (or roughly twice the size of the US international financial centre). These centres have specialized in ‘asset protection’, and serve primarily an individual and corporate clientele, rather than the modern risk-oriented financial trading that the British specialize in. (Although in these very lucrative markets, each specialist seeks to expand into the other’s turf.) Switzerland is still the world’s largest ‘private banking’ centre, specializing in ‘wealth’ protection of the world’s rich. However, Switzerland had been under enormous pressure from the EU to relax its banking secrecy laws, and the signs are that Singapore is aiming to take its place. Ireland and the Benelux countries have developed the Dutch concept of the holding company, and offer low-cost, low-tax facilities that multinational corporations use for ‘treasury operations’ (Stewart, 2005). MNEs would tend to ‘park’ income from international operations through these centres, and in turn use these centres as originators of further international investment. This explains why Ireland and the Benelux countries are always logged among the most important originators of FDI in the world (see Chapter 42 in this handbook on transnational companies and finance). There are no reliable statistics as to how much ‘value’ is generated to the professional service companies such as international legal and accounting firms from helping businesses to use the offshore world but it could easily
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amount to half or more or their turnover. Not surprisingly, a sleek lobby campaign has been organized by these companies in support of tax havens. They tend to draw on the market efficiency hypothesis put forward by some economists who maintain that offshore financial centres (e.g., tax havens) add a welcome ‘competitive’ pressure on the ‘onshore’ financial centres, and hence improve overall efficiency of the financial markets. A dubious argument at the best of times, the recent financial crisis may have put this argument to rest. The moral argument in favour of tax havens is weak. But for the reasons discussed above, tax havens have become part of the business environment. The run-of-the-mill employee of an international corporate, financial or consulting firm is likely to encounter offshore finance as a daily reality of their lives. Companies that are not taking advantage of the offshore world are viewed as odd anomalies, or as even reneging on their commitments to shareholder value.
REFERENCES Henry, J.S. (2012), ‘The price of offshore revisited’, July, Tax Justice Network, available at: http://www.taxjustice.net/cms/upload/pdf/Price_of_Offshore_Revisited_120722.pdf. Palan, R., R. Murphy and C. Chavagneux (2010), Tax Havens: How Globalization Really Works, Ithaca, NY: Cornell University Press. Stewart, J. (2005), ‘Fiscal incentives, corporate structure and financial aspects of treasury management’, Accounting Forum, 29(3), 271–88. Van Fossen, A.B. (2003), ‘Money laundering, global financial instability, and tax havens in the Pacific Islands’, The Contemporary Pacific, 15(2), 237–75.
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42 Transnational companies and finance Grazia Ietto-Gillies
INTRODUCTION Transnational companies (TNCs) are companies that own assets and conduct direct business activities in at least two countries. There are several modalities of cross-countries business operations: from trade to joint ventures, franchising, licensing to foreign direct investment (FDI). It is the involvement in FDI that characterizes a company as transnational. Foreign direct investment can take place via greenfield investment – in which a plant, building, business is started from scratch – or via mergers and acquisitions (M&As), in which an existing foreign business is bought. Most FDI between World War I and World War II was directed towards developing countries and was mainly in the primary sector. The decades after World War II saw a surge in FDI, particularly in manufacturing, with a shift in geographical direction towards developed countries. In the last 35 or so years there has been considerable growth in FDI alongside a shift in the sectoral shares towards FDI in services worldwide. In the last ten years there have been also growing amounts of FDI originating from emerging countries and directed mainly towards developing countries though with an increasing number of acquisitions of companies in some developed countries. The surge of TNCs’ activities after World War II prompted economists to initiate special studies of them and their activities. The theory of the TNC started with the seminal work of a Canadian doctoral student (Hymer [1960] 1976) working in the USA at the Massachusetts Institute of Technology. Many theories of TNCs have been developed since.1
THE CONTEXT The quantitative, sectoral and geographic trends in FDI are linked to worldwide economic, political and technological developments. On the economic front, the growth rates of Europe after World War II and some developing countries – China, India, Brazil – in more recent decades account for some of the major trends. 301
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On the political front the 1960s and early 1970s were characterized by critical attitudes towards the activities of TNCs and by large numbers of nationalizations of foreign affiliates, particularly in developing countries. The trend reversed and attitudes changed in the last three neoliberal decades. Cooperation followed confrontation between national governments and TNCs. Many governments in developed and developing countries have been doing their best to attract FDI, some of which took the form of acquisition of privatized assets. The 1990s became a decade of confrontation but, this time, not between governments and TNCs (Ietto-Gillies, 2002, Ch. 10). It was a confrontation at global level by protesters – grouped around non-governmental organizations (NGOs) – against TNCs and those international institutions seen as the protectors of TNCs’ interests, such as the World Trade Organization (WTO). Nonetheless governments’ policies did not change. Major influences on the TNCs and their activities have also come from the technological and organizational context. Full control over direct business activities abroad requires not only equity control but also strategic and managerial control. The exercise of the latter has been made progressively easier by the technological and organizational innovations of the twentieth century. The relevant innovations in this context are: (i) changes in the technology and cost of transportation and personal communications, the latter made possible, more recently, by the information and communication technologies (ICTs); and (ii) changes in the internal organization of companies. Hymer (1970) follows Chandler (1962) in charting the relationship between the evolution in the internal structure of the firm and multinationality and, in particular, considers how the former facilitated the latter (Ietto-Gillies, 2012, Ch. 1). Growth strategies – linked to mass production, product diversification and internationalization – led to changes in the internal organization and this, in turn, brought a sharper division of labour within the company. It also had an impact on the international division of labour. The sectoral changes in FDI have, largely, been made possible through a mixture of technological and organizational innovations and within a favourable political context.
THE TNC AND FINANCE The same political and innovation contexts that affected the TNCs, their activities and their relations with other stakeholders have also influenced the growth of the financial sector worldwide, specifically the neoliberal agenda in politics and the information and communication technologies. But what is the relationship between TNCs and finance?2 Quite a close one,
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Transnational companies and finance 303 for various reasons. For a start, there are a very large number of transnational firms operating in the financial sector. Indeed, most large financial sector firms are transnationals. Financial products are easily transmittable and segments of their production processes can be embedded in different geographies and cultures. In 2008 the finance sector accounted for 22.7 per cent of the total world stock of FDI. Second, most large companies are diversified and many of the companies whose activities are largely in manufacturing or distribution are involved in financial activities and offer financial services: a visit to the local supermarket or department store usually ends with offers of financial services. In some cases the financial side outstrips their non-financial activities. Enron is a case in point: a company that began with activities in the primary sector, moved into purely financial and speculative business. Following its collapse, government and media criticisms concentrated on the (il)legal side of business, on the lack of transparency and on the collusion between management and auditors. Yet there are other – legal – more worrying aspects of the Enron saga that have to do with systems: the system of corporate governance; the system of industry (de)regulation; and the macro-system. With regard to the latter we are talking of a system in which the rent-seeking financial side of business became much more lucrative than the production of goods and services.3 Third, all large companies – and most large companies are transnationals – are involved not only in direct investment but also in portfolio investment, that is, investment in which the company does not have equity control and that is, usually, undertaken not as a long-term commitment but with more asset diversification and/or speculative aims. The fourth point emerges from a closer analysis of the FDI modes: greenfield or M&As. (1) In the case of the greenfield mode the investment results in new productive capacity for both the company and the host country where the investment takes place. (2) In the case of M&As the investment operation results in the creation of new productive capacity for the TNC but not for the host country. From the point of view of the host country all that is happening is a change of ownership: a firm and its productive capacity that were owned by nationals, are moved into the ownership of a foreign firm. Indeed, very often, following post-merger restructuring operations, the productive capacity in the host country is reduced in the short to medium term. There may, however, sometimes be further capacity-creation investment in the longer period. Mergers and acquisitions can be seen as purely financial operations to which there is no corresponding creation of capacity but from which there are important consequences for the real sector. These derive from the restructuring operations just mentioned. Moreover, mergers have relevant
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effects on the structure of an industry as they usually lead to reduced competition. This is the reason why competition authorities in various countries often take an interest and rule on whether the deal can go ahead or not. In 2009 over 40 per cent of the value of M&A purchases worldwide was attributed to the finance sector; this is an indicator of the relevance of finance for M&As and FDI. Moreover, the process leading to all M&As – whichever their sector of origin – involves the financial sector. The fifth financial consequence derives from the different regulatory regimes of the nation-states in which TNCs operate. In Ietto-Gillies (2012, Ch. 14) it is argued that the different regulatory regimes of nation-states are the reason why we need special studies of the companies that operate direct business activities across countries. The difference in regulatory regimes generates opportunities for strategic behaviour. The regulatory regimes considered relevant for strategies are: currency regimes, fiscal regimes, social security/labour market regimes and environmental and safety standard regimes. The first two fall within the realm of financial economics directly or in terms of their effects. Another major indirect effect may come about via the manipulation of transfer prices. These are prices charged by one part of the company (headquarters or one of the subsidiaries) to another part (any of the subsidiaries or headquarters) for the internal transfer of goods and services. The internal prices may or may not reflect actual costs and scarcity and therefore they may or may not be set at the same level as market prices, that is, the prices that are actually – or could potentially be – charged to independent, external clients for arm’s length transactions. When the internal transfer of goods and services takes place across borders as part of transnational activities, the corporations have the opportunity to develop pricing strategies that maximize the overall returns for the company as a whole. Such strategies may lead to the so-called ‘manipulation of transfer prices’.4 The word manipulation refers to the setting of prices for internal transfers at different levels compared to the prices that might be charged to external clients, that is, different levels compared to the actual or potential market prices. Why would a company want to manipulate transfer prices? In what conditions and for what reasons would such a manipulation lead to higher overall profits? The main reasons for the manipulation of transfer prices are the following: + To minimize of the tax liabilities for the company as a whole. + To circumvent restrictions to the transfer of profits from host country(ies).
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Transnational companies and finance 305 + To take advantage of expected appreciation or depreciation of currencies. + To record low costs of components in a country/market that the company wants to penetrate through low prices. + To record relatively low profits in countries where it is feared labour and its trade unions might demand wage increases if high profits were disclosed.[/list] The most common – and best known – reason for the manipulation of transfer prices is the minimization of the company’s tax liability. A company with tax liabilities in many countries is likely to be faced with different fiscal regimes and therefore with different tax rates in different countries. If the company can disclose most of its profits in the country with the lowest tax rate, it will avoid the charge of higher tax rates on some of its profits. Such a strategy will minimize the overall tax liability of the company as a whole. This aim can, partly, be achieved by a strategy of transfer price manipulation that leads to the recording of higher profits in the country with the lowest tax rate, and very low profits in countries with high tax rates.5 Companies that engage in international vertical integration strategies have large scope for the transfer of components across countries and therefore have large scope for manipulating transfer prices. Such a manipulation can also occur in the pricing of services transferred between different parts of the company. These can be factor services – like the services of a highly skilled technical expert or manager – or product services. The manipulation of transfer prices is not without problems for the company. First of all, the practice is illegal and no company would own to using such a strategy. However, for most services and components transferred internally to a company, no external market exists and therefore it is difficult for tax revenue officers to compare prices and thus gain evidence about possible manipulations.6 Nonetheless, if the practice is discovered the company may have to pay large fines. Second, it is not as easy to implement as it appears at first sight. It may require some type of double accounting. Moreover, it may lead to conflicts between managers of different units. There are important effects of this practice at the macro-level as well as at the micro (company) level. The strategy leads to minimization of overall tax revenue for the company; the other side of this is that there is a transfer of surplus from the international public domain to the private domain. Essentially, in the world as a whole, less will go to the public sphere as tax revenues, and more will be kept in the private sphere of companies who pay, overall, a lower tax bill than due. Moreover, a transfer of surplus takes place between countries because of this practice. The countries with high tax rates will see their tax revenue siphoned off towards low tax rate countries. In the
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last analysis the practice leads to divergence between private and social benefits worldwide and to the redistribution of surplus between different countries. If the strategy is used for market penetration reasons, there are issues of possible unfair competition and therefore effects on the market structure of the industry in which the company operates. Last, but not least, the manipulation of transfer prices has effects on the volumes and structures of the balance of payments of the various countries involved in the transfers as the recorded values of the transactions are different from the value that should have been invoiced on the basis of arm’s length prices. To conclude, the transnational companies are heavily involved in the financial sectors because most finance companies operate transnationally and indeed the finance sector has been absorbing an increasing share of world FDI. Moreover, most transnationals – whether in the finance sector or not – are involved in financial operations via portfolio investment; their mergers and acquisition deals; and via the manipulation of transfer prices.
NOTES 1. 2. 3. 4. 5.
6.
For general concepts and theories of the TNC see Ietto-Gillies (2012), Part I and III respectively. I am not considering here the impact of the financial sector and of financial crises on the real economy including those for which many TNCs are responsible (see Epstein, 2005, particularly the chapters by Crotty, 2005 and Crotty and Lee, 2005). Ietto-Gillies (2010) puts forward the view that the stagnationist tendency of advanced capitalist systems is at the basis of the shift of investment from the real to the financial sector. On transfer prices and their possible manipulation see Eden (2001). One thing to keep in mind is that this issue is not one of home versus host country – the lowest tax regime country could be the home or a host country. The direction of possible transfer of profits depends on the tax rate of the countries, not on whether they are host or home or whether they are developed or developing countries. OECD (2010) gives guidelines for companies and tax administrators on how to – respectively – set and monitor transfer prices.
REFERENCES AND FURTHER READING Chandler, A.D. (1962), Strategy and Structure: Chapters in the History of the Industrial Enteprise, Cambridge, MA: MIT Press. Crotty, J. (2005), ‘The neoliberal paradox: the impact of destructive product market competition and “modern” financial markets on nonfinancial corporation performance in the neoliberal era’, in G.A. Epstein (ed.), Financialization and the World Economy, Cheltenham, UK and Northampton, MA, USA: Edward Elgar, Ch. 4, pp. 77–110. Crotty, J. and K.K. Lee (2005), ‘The causes and consequences of neoliberal restructuring in post-crisis Korea’, in G.A. Epstein (ed.), Financialization and the World Economy, Cheltenham, UK and Northampton, MA, USA: Edward Elgar, Ch. 14, pp. 334–53.
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Transnational companies and finance 307 Dunning, J.H. (1993), The Globalization of Business, London: Routledge. Eden, L. (2001), ‘Taxes, transfer pricing, and the multinational enterprise’, in A.M. Rugman and T.L. Brewer (eds), The Oxford Handbook of International Business, Oxford: Oxford University Press, Ch. 21, pp. 591–619. Epstein, G.A. (ed.) (2005), Financialization and the World Economy, Cheltenham, UK and Northampton, MA, USA: Edward Elgar. Hymer, S.H. ([1960] 1976), The International Operations of National Firms: A Study of Direct Foreign Investment, Cambridge, MA: MIT Press. Hymer, S.H. (1970), ‘The efficiency (contradictions) of multinational corporations’, American Economic Review, 60(2), 441–8. Ietto-Gillies, G. (2002), Transnational Corporations: Fragmentation amidst Integration, London: Routledge. Ietto-Gillies, G. (2010), ‘The future of international business in the light of the current economic crisis. Can we say anything meaningful?’ Futures, Special Issue on the Future of International Business, 42, 910–19. Ietto-Gillies, G. (2012), Transnational Corporations and International Production, 2nd edition, Cheltenham, UK and Northampton, MA, USA: Edward Elgar. Organisation for Economic Co-operation and Development (OECD) (2010), Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrators, Paris: OECD.
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43 Thorstein Veblen Charles G. Leathers and J. Patrick Raines
With the global economy experiencing financial bubbles of growing frequency and financial crises of increasing severity, Thorstein Veblen’s macro-financial theory merits renewed attention. Developed within the context of his evolutionary analyses of the interplay between institutions and technology in the early twentieth century, the theory explained the systemic nature of debt creation and the macroeconomic consequences in the modern business enterprise economy. But as we explain in the following section, two versions of the theory emerged from Veblen’s analyses of institutional changes between 1904 and 1923. We then note how changes in regulatory policies and financial innovations that exploit advances in information technologies have enabled both versions to provide insights into the new ‘macroprudential risks’ to the financial system from a ‘shadow banking system’ and the ‘shadow trading systems’ (Bernanke, 2010, p. 2; Roane, 2010). We conclude with a Veblenian perspective on the role of the Federal Reserve in this new era of financial instability.
VEBLEN’S MACRO-FINANCIAL THEORY: TWO VERSIONS In The Theory of Business Enterprise, published in 1904, Veblen explained how corporate finance had changed the concept of business capital. Capital had become the capitalized values of expected future profits as determined by share prices in the stock market. But the relationship between debt and capital become blurred as competition forces every business enterprise to maximize use of credit as an auxiliary to its capital (ibid., p. 97). Every increase in capitalized value of tangible and intangible assets becomes collateral for new loans. Thus, ‘capitalization comprises the use of all feasible credit extension’ (ibid., p. 131). In expanding his theory of capital and debt into a macro-financial theory or ‘theory of modern welfare’ (ibid., p. 177), Veblen emphasized that credit is a purely pecuniary phenomenon that does not increase capital goods or real income (1904, pp. 98, 104). Debt is ‘coined into means of payments’ (ibid., p. 103) in a cumulative process, with securities representing funded debt serving as collateral for yet more debt (1904, pp. 101, 118, 192). But 308
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Thorstein Veblen 309 the systemic dependency on debt plays a critical role in linking the financial sector and the business people’s administration of the industrial system. Within the context of evolutionary changes in business institutions and technology in the late nineteenth century, Veblen’s theory explained why the normal course was debt deflation and chronic depression, with shortlived periods of speculative prosperity involving ‘credit inflation’ that end in financial crises (ibid., p. 100). A speculative prosperity is initiated by an increase in demand in some sector(s) of the economy produced by an exogenous event, for example, government spending for the Spanish-American war. Prices rise in the impacted markets, resulting in increases in profits for the firms and providing the basis for a cumulative ‘credit inflation’ (ibid.). As those profits are capitalized by stock market quotations, the higher capitalized values serve as collateral for more loans. With the newly created funds, demand for producers’ goods increases, driving up prices and profits for firms in those markets. The psychological effects come into play with the expectation of rising future profits on a general basis, leading to rising stock prices. In turn, the increased values of business assets become collateral for more loans and more spending (ibid., p. 149). The ‘credit inflation’ ends for two reasons. Wages eventually rise, reducing expected profits, and at some point the increase in demand that started the process comes to an end, for example, the Spanish-American war ended. A sequence follows that ends in a financial crisis. Stock prices begin to fall when the stock market recognizes that actual profits are less than expected profits. That alerts banks to the deteriorating values of assets pledged as collateral for debts and loans are called. Firms desperate for liquidity are forced to sell off their assets and/or declare bankruptcy. While episodes of speculative prosperity were initiated by exogenous events, the normal course was debt deflation and chronic depression. At current prices, the existing firms operating with industrial equipment that embodies the current state of industrial technology and with maximum funded debts are able to realize ‘normal’ profits. But new firms investing in new equipment that incorporates new industrial technologies have the dual advantage of lower production costs and less funded debt. In competitive markets, prices are driven down to levels that allow only the most costefficient firms to realize ‘normal’ profits, hence deflation. Older firms suffer losses and are forced into bankruptcy; hence chronic depression. In 1904, Veblen saw no effective measure that would counter the normal course of debt deflation/chronic depression. A sustained level of government spending, especially if funded by securities rather than taxes, sufficient to support aggregate demand was politically unlikely (ibid., p. 256). Collusive business arrangements had not reached the point to permit
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restricting production to maintain prices that would assure ‘normal’ profits, nor was collusion among financiers sufficient to allow a progressive creation of debt without suffering financial crises. But as exemplified by J. P. Morgan and the ‘money trust’, the trends were moving in that direction, leading Veblen to present a revised version of his macro-financial theory in Absentee Ownership, published in 1923. A ‘new order of business’ had emerged (Veblen, 1923, p. 205), in which a ‘one big union’ of financial interests headed by the large investment banks had gained effective control of corporations in the ‘key’ industries through use of the holding company and collusive control over progressive increases in credit, that is, debt of the companies (ibid., p. 340). Veblen perceived that the trend now was credit inflation: ‘the price-level at large will rise progressively in response to that progressively enlarged volume of purchasing-power which arises out of the progressive creation of credits in the ordinary course of investment, merchandising, and corporation finance’ (1923, p. 390). Investment banks profited from underwriting and marketing an ever-increasing amount of corporate debt, and realized large ‘free incomes’ in the form of bonuses and rises in the prices of securities they held. But the rate of debt creation was being prudently managed to avoid the financial instability of the past. Price levels that assure corporate profits to support market values of securities issued and digestion of new securities were engineered by the investment banks on both the supply and demand side. Their collusive control of corporations enabled restricted production, while aggregate demand was supported by new debt ‘coined into means of payment’ (1904, p. 107) being added to ‘the current volume of purchasing power’ (1923, p. 347, fn). In both The Theory of Business Enterprise and Absentee Ownership, Veblen recognized the influence of financial innovations on the systemic process of debt creation. In the early twentieth century, the most representative product innovation was the preferred stock while the most representative process innovation was the holding company, both of which were expertly used by J. P. Morgan in his ‘trust-making’ deals involving the ‘strategic use of credit’ (Veblen, 1904, pp. 123, 144–5). But Veblen also recognized that ‘distrust of the unknown’ quickly disappears and financial innovations become routine financial practice (1923, pp. 332–3).
THE FEDERAL RESERVE AND THE ‘ONE BIG UNION’ OF FINANCIAL INTERESTS The major institutional change after 1904 was the creation of the Federal Reserve System. Veblen recognized that on a formal basis, the Federal
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Thorstein Veblen 311 Reserve’s powers of surveillance and discipline extended only to commercial banks and to the issuance of fiduciary currency and discounting commercial paper (1923, p. 352, fn and p. 374, fn). But since the ‘creative use of credit in generating and floating corporation securities’ was just another branch of the credit creation by commercial banks, the Federal Reserve was de facto ‘the institution of surveillance and discipline’ over the ‘collusive network of credit creation under the large investment banks’ (ibid., p. 352, fn). Adhering to a position of ‘prudent conservatism’, the Federal Reserve was supporting the ‘continued issue of new capital securities’ (ibid., p. 396) by assuring ‘a balanced and stable progression’ (ibid., p. 226). Banks were disciplined by both the investment bankers and the Federal Reserve to avoid issuing more debt than was digestible.
VEBLENIAN INSIGHTS INTO THE NEW ‘MACROPRUDENTIAL RISKS’ The core principle in Veblen’s macro-financial theory is that the financial sector affects aggregate demand through systemic debt creation. But how debt is created and the effects on financial stability have varied with institutional changes, particularly those involving regulatory policies and financial innovations. The stock market bubble and crash of the 1920s, followed by deflation and depression in the 1930s, marked the return of the phenomena of Veblen’s 1904 analysis. The collusive dominance of Veblen’s investment bankers was undermined by competition from new investment banks that were only interested in marketing the securities that they had underwritten (Edwards, 1938, pp. 227–8). Financial innovations encouraged debt-funded speculative excesses (Galbraith, 1988, p. xiv). The Federal Reserve’s inability to prevent the stock market crash and the bank failures in 1930–31 showed the extent to which Veblen had overestimated its influence. In keeping with his 1904 observation that government expenditures financed by debt would be required to offset the tendency toward chronic depression, a minimal level of government spending aggravated the weakness in aggregate demand, while tax cuts for the high-income groups contributed to speculative excesses in the stock market. Those excesses were enhanced in Veblenian fashion by debt securities becoming collateral for more debt. A long period of relative financial stability with progressive credit inflation was instituted by New Deal reforms and regulations in banking and securities markets. The Federal Reserve’s role in the credit system as envisioned by Veblen became more firmly implemented, and the Securities & Exchange Commission’s regulation of investment banks and the issuance
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of corporate securities gave greater assurance of a more controlled creation of debt. Simultaneously, a Keynesian role of the Federal government in sustaining a high employment/output level corresponded to Veblen’s recognition that government spending would be necessary to avoid the chronic depression tendency in his 1904 analysis. Debt continued to play a major role, with government debt being added to business debt. Since the 1980s, deregulation of financial markets and financial innovations that exploited advances in information technology have resulted in phenomena associated with both versions of Veblen’s financial macrotheory. The episodes of debt-funded speculative prosperities and financial crises in the 1904 version have returned. But the financial system is supported by a much larger and more sophisticated ‘collusive’ support of debt creation than in his 1923 analysis. Continuous increases in the rate of debt creation prevented the return to chronic depression but quickened the pace of credit inflation. Ten years after a stock market bubble collapsed in October 1987 in the worst one-day crash in history, an even larger stock market bubble was inflating. Its collapse in 2001–02 brought expressions of concern from Federal Reserve officials about the return of debt deflation and chronic depression as in Veblen’s 1904 version. Simultaneously, a massive financial bubble was inflating in the housing sector. As that bubble was starting to collapse in 2007, the stock market experienced yet another bubble before both bubbles collapsed in the worst global financial crisis since the 1930s. In the ensuing policy debates over regulatory reforms, special attention has been directed to the new ‘macroprudential risks’ to the financial system from a ‘shadow banking system’ and ‘shadow trading systems’. A Veblenian perspective is particularly relevant here, as both the ‘shadow banking system’ and ‘shadow trading systems’ are recent products of institutional changes, that is, deregulation and financial innovations, and advances in technology that have created complex new ways to maximize use of debt. The ‘shadow banking system’ refers to the network of unregulated non-bank financial institutions in which financial process and product innovations enable huge volumes of loans to be are packaged and securitized in complex and opaque ways with the amount of debt and risk of default becoming greatly magnified into ‘macroprudential risks’ of virtually unknowable proportions for the financial system and the real economy (see Bernanke, 2010, p. 2). This has re-created the type of financial instability that was prevalent when Veblen wrote The Theory of Business Enterprise, but on a much larger scale and magnified by developments in information technologies. In Veblen’s 1904 and 1923 analyses, innovations in industrial technologies that lowered the cost of capital goods interacted with the creation of
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Thorstein Veblen 313 debt, creating debt deflation and chronic depression in the 1904 analysis and requiring the ‘one big union’ of financial interests to prudently restrict industrial production in key industries in the 1923 version to keep prices at profitable levels. Since the 1980s, trading processes and financial derivatives have made maximum use of advances in information technologies to greatly increase the volume of debt creation. Veblen’s observation on the speed with which financial innovations become routine financial practice has been repeatedly validated, as financial crises attributed to portfolio insurance and stock index arbitrage programs and hedge fund and corporate use of derivatives have been followed by ever-growing use of financial derivatives in the ‘shadow banking system’ and high-frequency electronic or ‘shadow’ trading systems that allegedly caused the ‘flash crash’ in the stock market in May 2010 (Roane, 2010). In these highly fragmented systems, computerized programs driven by complex algorithms allow millions of shares to be traded in seconds through interaction of computers.
A VEBLENIAN PERSPECTIVE ON THE ROLE OF THE FEDERAL RESERVE Dirlam (1958, p. 214) observed that the post-World War II era showed ‘a remarkable similarity to Veblen’s projection of the One Big Union of the Major Interests’ with the commercial and investment banks practicing teamwork under the Federal Reserve’s careful supervision with progressive inflation and no apprehension of a general liquidation, with the only difference being government spending underpinning aggregate demand (ibid.). Since the 1980s, the Federal Reserve has effectively supported a progressive increase in credit inflation, but in a manner that revives the financial instability of the 1904 version of Veblen’s macro-financial theory. For example, Greenspan’s response to the 1987 stock market crash with the public announcement that the Federal Reserve would supply liquidity, the Federal Reserve’s arrangement of a bailout of the collapsing Long-Term Capital Management hedge fund, the Greenspan–Bernanke doctrine that the Federal Reserve should not attempt to prick asset price bubbles but flood the system with liquidity after the bubbles burst, and Greenspan’s and Bernanke’s influential objections to regulating over-the-counter financial derivatives such as the collateralized mortgage securities and debt-default swaps. But in its responses to the financial crisis that began in 2007, the Federal Reserve has become engaged in a much closer and more explicit collusive
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arrangement with investment banks than Veblen perceived in 1923. Bernanke opened the Federal Reserve’s discount window to Wall Street securities dealers, allowed investment banks to become bank holding companies, arranged for large commercial banks to take over failing investment banks (Bear Stearns and Merrill Lynch), participated with the Federal government in a number of programs to rescue weak financial institutions’ purchases of mortgaged-backed securities, insured money market funds, and became the buyer of commercial paper. At the same time, the Federal Reserve has endeavored to perform as Veblen perceived, seeking the authority from Congress to be the ultimate controller of a progressive credit inflation with financial stability. In a letter to the US Senate Committee on Banking, Housing, and Urban Affairs, Bernanke (2010, p. 2) stated that ‘the financial crisis has made clear that an effective framework for financial supervision and regulation must address both safety-and-soundness risks at individual institutions and macroprudential risks’. But Bernanke (2008, p. 2) is also on record as stating that ‘prudential supervision’ of investment banks ‘must recognize the distinctive features of investment banking and take care neither to unduly inhibit innovation nor to induce a migration of risk-taking activities to lessregulated offshore institutions’. Thus, proposals for new regulations to deal with the new ‘macroprudential risks’ seek to allow the controlled type of progressive increase in credit inflation envisioned in the 1923 version of Veblen’s macro-financial theory.
REFERENCES Bernanke, B. (2008), ‘Regulatory restructuring’, Washington, DC: Federal Reserve Board, 10 July. Bernanke, B. (2010). ‘The public policy case for a role for the Federal Reserve in bank supervision and regulation’, Washington, DC: Federal Reserve Board, 13 January. Dirlam, J.B. (1958), ‘The place of corporation finance in Veblen’s economics’, in D.F. Dowd (ed.), Thorstein Veblen: A Critical Appraisal, Ithaca: Cornell University Press, pp. 199– 220. Edwards, G.W. (1938), The Evolution of Finance Capitalism, New York: Longmans, Green and Co. Galbraith, J.K. (1988), The Great Crash 1929, Boston: Houghton Mifflin. Roane, K.R. (2010), ‘How NYSE plans to use “Flash Crash” to reclaim its glory’, CNNMoney.com, 12 May. Veblen, T. (1904), The Theory of Business Enterprise, New York: Charles Scribner’s Sons. Veblen, T. ([1923] 1997), Absentee Ownership, New Brunswick: Transaction Publishers.
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Thorstein Veblen 315
FURTHER READING Ganley, W.T. (2004), ‘The theory of business enterprise and Veblen’s neglected theory of corporation finance’, Journal of Economic Issues, June, 397–403. Raines, J.P. and C.G. Leathers (2008), Debt, Innovations, and Deflation: The Theories of Veblen, Fisher, Schumpeter, and Minsky, Cheltenham, UK and Northampton, MA, USA: Edward Elgar. Wray, L.R. (2007), ‘Veblen’s theory of business enterprise and Keynes’ monetary theory of production’, Journal of Economic Issues, 41(2), 617–24.
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Index accumulated assets 246 Ackerman, Joseph 168 adjustable rate mortgages (ARMs) 93 Africa 62, 135–8, 234 aggregation 204, 207, 208 agitators 1–2 Akerlof, George 285 ‘alternative’ finance 1–2 arbitrage 145–6, 220, 264–5, 267 ArcelorMittal 271, 273 Arrighi, G. 121 Arrow–Debreu 181 artificial liquidity 207 ASEAN Free Trade Area (AFTA) 5 ASEAN+3 4–7, 10–11 Asian Bond Markets Initiative 7 Asian Currency Unit (ACU) 7 Asian Monetary Fund (AMF) 6–7 Asian monetary union background 4–7 optimum currency area (OCA) theory 8–9 practical issues 10–11 asset-backed securities (ABS) 289–90, 293 asset bubbles 281–2 asset classes commodity futures as 52–4 exchange rates as 85, 87, 88 asset pricing 219–20 Association of Southeast Asian Nations (ASEAN) 4–7, 10–11 asymmetric information 38–9, 100, 141, 180–81, 221, 226, 233, 285 Austrian finance and economics 47, 60, 68, 71–2, 106 bad banks 13, 17–18 nature of division 15–17 short run and long run 14–15 Bagehot, Walter 19–20, 46 balance sheet restructuring 35, 271 Banche Popolari 59
Bank Charter Act 1844 44–5 bank debts 114, 118 Bank for International Settlements 166, 169, 272 bank lending channel 67, 280 Bank of England 15, 20, 26, 43–7 bank regulation 19–24 bankers’ bank 43, 46 Banking Act 2009 14–16, 22 banking crises types 20 banking secrecy 297, 299 banks bad 13–18 central 43–7 effect of company over-capitalization 35–6 importance of 19–20 regulation of 21–4 Banque Centrale des Comores 135 Banque Centrale des États de l’Afrique Centrale et du Cameroun (BCEAC) 135 Banque Centrale des États de l’Afrique de l’Ouest (BCEAO) 135 Banque de France 135, 136 Baring, Francis 19 barriers to entry 21–2 Basel Accord 169, 272, 290 Basel Committee on Banking Supervision 21, 169, 174 bears 131 behavioural finance 1, 100–101, 221, 284 Berle–Means hypothesis 195 Bernanke, Ben 201, 220–21, 308, 312, 313–14 bid–ask spread 87, 205 Big Bank 240 Big Government 109, 240 Black–Scholes–Merton model 219, 265–7 block trading 259 Böhm-Bawerk, E. 71
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booms and busts credit 69–72, 116, 124 dotcom 259–60 effect on public administration 160–61 equity 276 housing 93–4, 103, 133 in mid-19th century 44–5 price 51–4 stock market, post 1970s 33 trajectory of 295 Boots pharmacy 274 borrowing central bank facility 45 forced debt 36 foreign 77, 156, 168 multiple 233 over-borrowing 67–72 replaced with shares 34–5 Brainard, W.C. 132 Bretton Woods 26, 85–6, 140–41, 165–6 bridge banks 15 Brown, Gordon 158 buffer stocks 49 bulls 131 Cadbury Code 1992 199 capital accumulation 38–41, 77 capital asset pricing model (CAPM) 283–4 capital controls alternative approach to 29–31 and Bretton Woods 26 and financial crises 28–9 financial globalization and free cross-border capital mobility 27–8, 139–40 capital crisis 20 capital market inflation 33–7 capitalist development 255–7 capitalist system, finance in 113–15 carry trade 90, 142, 168 cash cows 252 Cassel, Gustav 85 CEMEX 271, 273 central bank policy 38–41, 118, 279
central banking independence (CBI) theory 38–9 central banks 43–7 connection with commercial banks 116–17 lender of last resort function 79, 110 Chiang Mai Initiative (CMI) 6–7, 10 China amongst world’s largest banks 167 effect of growth of 54 leadership role 10–11 Christiania Bank 17 circuit theory of money 74, 106–7, 114–15, 214, 246, 248 circulation of money and commodities 211–14 clearing banks 45 clearing house 21–2, 45 closed monetary circuit 114–15, 245–6 cluster analysis 9 collateralized debt obligations (CDOs) 93–4, 147–9 collection of assets approach 197 commenda 193–4 commercial banks in relation to central banks 43 in relation to cooperative banks 59 in relation to non-financial corporations 114–15 commercial capitalism 257–8 commercial paper 250 commodity markets commodity futures 52–4 stabilization agenda 49–50 volatility 51–2 commodity-price cycles 51 Companies Acts 195, 199 Compensatory Financing Facility (CFF) 50 competition and breakdown of lending discipline 233 and declining interest rates 232–3, 235 merger effects 303–4 between regulated and shadow banks 253
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Index 319 concordance 52 Consultative Group to Assist the Poor (CGAP) 62, 230–31, 233–5 contingent capital 17 contingency financing 50 convertibility 26, 135–6, 244 cooperative banking 56–7, 63–4 continental European cooperative banks 59–60 credit unions 60–61 in developing countries 61–2 ethical banking 62–3 model of financial cooperatives 57–9 Copeland, Morris 127, 131, 133 corporate governance 198–9 corporate social responsibility 198–9 cost of liquidity 271 credit and debt, universal laws of 244–5 credit cards 122, 243, 250 credit cycles critical theories 68–74 mainstream economics and reflective finance 66–8 credit default swaps 94 credit inflation 309–10, 314 credit issuance 114 credit markets 38, 40 credit rating agencies 148, 155, 174 credit ratings 289–91 Credit Union National Association (CUNA) 61 credit unions 56, 60–61, 64 cross-border capital mobility 27–8 cross-border transactions 139, 140 currency war 282 debt as financing method 246–8, 250 household 36, 122–3, 160, 252 debt creation 308, 310, 311–13 debt deflation 36, 69, 72, 98–9, 101, 239–40, 309–10, 312–13 debt ratios 122, 252 default insurance 94 Den norske Bank 17 deposit insurance 15, 56, 249 deposit multipliers 248–9
developed countries and capital controls 30 developing countries and capital controls 29–30 capital flows 123, 141 dependence on credit 2 effect of higher real interest rates 79 exposure to sudden stop 28 financial cooperatives and microfinance in 61–2 financial markets in 117–19 with open capital accounts 5 directional category of hedge fund investment 145–6 double bottom line 232–3 Dunfermline Building Society 15, 22 dynamic growth theory 77 dynamic stochastic general equilibrium (DSGE) 67 early warning systems 101–2 economic circuit school of thought 201–3, 207 economic growth association with financial development 77–8 effect of financial markets on 115–16 impact of higher liquidity 118–19 economic liquidity 207 economic research and theory challenges 233–4 Economist 196 efficient markets hypothesis (EMH) 219–20, 264–5 emerging markets 77–82 Enron 297, 303 ethical banking 62–3 European Central Bank 44, 47, 240 European cooperative banks 56–7, 59–60, 63 European Economic and Monetary Union (EMU) 4, 5, 10, 11 European Federation of Ethical and Alternative Banks (FEBEA) 63 European integration 11 European international banks 167–9 excess debt 36
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exchange rate determination approaches 85–9 exchange rate regimes 4–5, 27 exchange rates 85–91 expanded reproduction 215–16 export–import gap 77 export restrictions 50 exports 117 familiarity 21–2 fear of floating 5 Federal Reserve and Great Depression 26 lending to banking systems 46–7 lending to government 44 promoting regulations 169 protection to all financial institutions 240 publishing flow of funds accounts 127, 133 pushing US interest rates 168 and union of financial interests 310–11 Veblenian perspective on role of 313–14 finance in the capitalist system 113–15 effect of financial markets on 115–16 Icelandic 160–62 international 172–8 methodology of 218–23 money in 243–53 reflective, and mainstream economics 66–8 and transnational companies (TNCs) 301–6 see also microfinance financial accelerator 67 financial capitalism 257 financial conditions index 205 financial cooperatives contemporary cooperative banking 59–61 model of 57–9, 63 recent developments 61–3 financial crises Asian 4, 143
and capital controls 28–9 Great Depression 26, 49, 50, 72, 98, 101, 140, 253 Great Financial Crisis 46, 93–6, 142–3, 147–9, 169–70, 216 Greek 44 Iceland 17–18, 29, 151–63 nature of 96–7 Nordic 13 South Sea Bubble 194 Third World Debt Crisis 166–7 financial deepness/depth 116, 117, 175 financial development 77–8 financial fragility 98–103 financial globalization 27–8, 139–43 financial innovation 93–4, 115–16, 178, 204, 208–9, 256, 268 financial instability hypothesis (FIH) 74, 82, 100, 107–8, 184–5, 222, 237–41, 247, 254 financial Keynesianism 105–11 financial liberalization 78–81, 139–40 financial liquidity 207 financial markets in developing countries 117–19 effect on finance, economic growth and stability 115–16 finance in the capitalist system 113–15 framing 220–23 financial positions 98 financial sector effect of financialization 123 restructuring 78–80 transnational companies in 303, 306 Financial Services Action Plan 167 financial system, securitization and liquidity 206–8 financialization 121–2, 178, 252 contribution to economic performance 124 debate on 124–5 effect on financial sector 123 effect on households 122–3 effect on macroeconomic structure 123–4 international effect 123
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Index 321 international finance and imperialism 176–7 of non-financial businesses 122 and risk 124 fiscal transfer 10 Fisher, Irving 68–9, 72, 74, 98, 239, 240, 247 fixed exchange rate regime 4, 27 floating exchange rate regime 27, 29, 86 flow of funds 127–34 Fokus Bank 17 forced capitalists 199 forced debt 36 foreign direct investment (FDI) 7, 297, 301–4 foreign exchange risk 231 framing of financial markets 220–23 Franc Zone 135–8 free credit 69 funding liquidity 204 General Agreement on Tariffs and Trade (GATT) 50 general disequilibrium framework 132 General Electric Company (GEC) 271, 273 general equilibrium 33, 35, 67, 68, 132, 133 General Theory of Employment, Interest and Money 1–2, 73, 95, 105, 190–91 Gerschenkron, A. 78, 173, 175 Gilbert and Sullivan 196 Glass–Steagall Act 1999 96 Glitnir 155, 156–8 Global Financial Stability Report (GFSR) 29 global portfolio diversification 28 globalization 139–43 gold 43–5, 49–50, 52, 165–6, 211–12 Gold Standard 139–40, 141, 176 Goldsmith, Raymond 78, 172, 175 ‘good’ banks, see bad banks government action 256–7 Government Employment Guarantee Program 241 government regulation 249
Grameen model 225 Great Depression 26, 49, 50, 72, 98, 101, 140, 253 Great Financial Crisis 46, 93–6, 142–3, 147–9, 169–70, 216 Greek crisis 44 greenfield mode 303 Greenspan, Alan 94, 95, 127, 313 guaranteed equity return funds 23 Haarde, Geir 154, 158, 162–3 Harrod, R.F. 77, 187 Hayek, Friedrich 47, 49, 69, 71, 106, 183 hedge finance 74, 99–100 hedge funds 145–6 benefits of 146–7 continuity 149–50 dangers of 147 role in subprime crisis 147–9 Herstatt 168–9 heterodox framing 221–2 Hilton Hotels 274 Hobson, John A. 2, 184, 270 homo economicus 100–101 vs homo Islamicus 180–81 horizontalism 39–40, 110 household debt 36, 122–3, 160, 252 households, effect of financialization 122–3 housing booms 103, 133 housing prices 93, 95–6 Iceland 17–18, 29, 151–2, 162–3 continuing effects of crisis 159–60 finance collapse and political response 158–9 financial reforms 160–62 Icesave 159 liberalization 154–6 love letters (bonds) 157–8 mini-crisis 156–7 modernization 152–4 political implications 159–62 imperfection approach 100–102 imperialism 176–8 impossible trinity thesis 27
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incentives, role of 292–3 industrial investment 35 inflows capital controls on 28–9 cash 98, 99, 107–9, 238–40 and globalization 140–43, 281–2 long-term and short-term 80 initial public offerings (IPOs) 275 insolvency code 21, 22 insolvency repurchase agreement (REPO) 24 insurance risk 231 interest parity theorem 88–90 international agreements 50 international banking 165–71 International Commodity Agreements (ICAs) 50 international finance imperialism and financialization 176–7 nature of 172–3, 177 as overseeing or passive? 173–6 International Monetary Fund (IMF) and capital controls 28–9 as emergency loan provider 167 on liquidity 205 role in Icelandic bank crisis 156–7, 158–9 study on small Islamic banks 183 IOUs 243–6, 248, 250 Ireland 17–18, 60, 159–60, 299 IS-LM-BP model 177 Islamic banking 180–85 Japan 6–7 Japanese banks 167, 168 leadership role 11 and quantitative easing 279, 280–81 joint-stock companies 195–6, 215 junk bonds 252 Kaldor, N. 50, 51, 89–90 Kalecki, Michał 33, 36–7, 106, 109–10, 214, 285 Kaupthing 154–5, 156–8 Keynes, John Maynard biography 187–92
and capital controls 26 and the credit cycle 69, 72–3 financial instability analysis 95 financial Keynesianism 105–11 on financial markets 113, 119 on liquidity 204, 208 liquidity preference theory 89, 190–91 marginal efficiency of capital concept 184 Minsky’s interpretation of 254, 255–6, 258 money and finance 78 ‘own rate of return’ analysis 90 on risk 285–6, 287 on saving 248 on speculators’ views 101 views on currency futures market 88 King, Mervyn 47 knowledge 263–5 Landsbanki 154–5, 156–8 leadership role 10–11 Lehman Brothers 94, 205 lender of last resort concept 19–20, 79–80, 109, 249 Bank of England 46 Big Bank 240 European Central Bank 47 less developed countries (LDCs) 78–81 leverage 237–8, 294 limited liability 193–9 limited liability companies (LLCs) 196–7 limited liability partnerships (LLPs) 196–7 liquidity dimensions of 202–3 and money 244 as a quality 203–4 as quantity 203, 204–5 scramble for 19–20 securitization and the financial system 206–8 as a spatial notion 202, 203 as time, or speed 205–6 types and nature of 201–2
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Index 323 understanding, in political-economic context 208–9 liquidity crisis 20 liquidity preference 39–40, 89–90, 190–91, 222, 285–6 liquidity risk 231 living wills (banks) 22–3 Lloyds Group 14, 16 loanable capital movement 41 loanable funds theory 67, 69, 79, 142, 181–2 Locomotive group 154 London Clearing House 45 long run decisions 14–15 Long-Term Capital Management (LTCM) hedge fund 219 Maastricht Treaty 1992 44 macro-financial theory 308–10 macroeconomic trilemma 27 macroprudential risks 311–13, 314 mainstream finance 218–20 mainstream framing 220–21 managerial capitalism 257–8 Mandelbrot, B. 284–5 market imperfections 100–102, 221 market liquidity 204–8 market neutral investment strategies 145–6 Marshall, Alfred 187, 188, 196, 270 Marx, Karl on credit 66 simple and expanded reproduction 214–16 simple circulation 211–14 theory of financial crises 96 and world money 41, 90 Marxist approach to central banking 40–41 to financialization 177 to monopoly capitalism 198 of real exchange rate 85, 86 McKinnon, R.I. 78, 79, 80, 175 mean-standard deviation 283–4, 286 mergers and acquisitions (M&As) 275, 303–4 methodology of finance 218, 223
heterodox framing 221–2 mainstream finance 218–20 mainstream framing with modifications 220–21 microfinance asymmetric information theory 226 balancing profitability and the social mission 232–3 in developing countries 61–2 economic research and theory challenges 233–4 Grameen model 225 increasing diversification and complexity 226–9 increasing scale and complexity challenges 230–31 Milken, Michael 252 Mill, John Stuart 188, 196 Minsky, Hyman P. 237–41 on banking accepting 250 on causes of Great Depression 101 on debt 247 on financial fragility 99–100 financial instability hypothesis (FIH) 106, 107–8, 222 as a financial Keynesian 105 on financial markets 113, 115, 116, 119, 184 on future expectations 95–6 on institutional innovation 208 model of financial instability 82 and money manager capitalism 254–60 theory of finance-induced cycles 74 Modigliani–Miller 220, 270, 285 monetary circuit 74, 106–7, 114–15, 246 monetary transmission mechanism (MTM) 68, 279–80 monetary unions, benefits of 4 money in finance 43, 243–53 money manager capitalism capitalist development 255–7 from commercial capitalism to 257–8 economic context 255 extensions and applications 258–60 Minsky’s career 254
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money managers 52–4, 258–60 money markets 38–41, 298 money rate of interest 70, 184, 215–16 money supply curve 39–40 mortgage loans 96, 251 narrow banking 47 natural interest rate 70 networks 59–60 new behavioural finance 221 new capitalism 110 new consensus 279–80 nexus-of-contract theory 197 NGO-led microfinance 62 non-financial businesses cause of excess debt 36 financialization of 122 liquidity 244, 250 relation with commercial banks 114–15 Northern Rock 13, 15, 17, 22, 24, 47 Norway 13, 16–17, 154 OCA index approach 9 Octopus 153 Oddsson, David 152, 154–5, 158 OECD 158, 162, 296, 298–9, 306 open bank assistance 16–17 open capital accounts 4–5 optimum currency area (OCA) theory 4, 8–9 option pricing models 263–8 order flows 87 originate-to-securitize model 292 outflows capital controls on 29 cash 98, 99, 109 long-term and short-term 80 over-capitalization 34, 35–6, 270–73 over-indebtedness 98–9 over-production 215 own rate of return analysis 89–90 par clearing 249 Parguez, Alain 33, 106, 114, 115 passive index managers 53 Paul, Ron 47
payments imbalances, international 142 Pearson Report 175–6 Peel, Robert 196 peer monitoring 226 pension schemes, funded 33, 34, 35, 199, 276 political integration 10 ‘Politically Feasible’Tobin Tax (PFTT) 30 Ponzi finance 99–103, 108–9, 239–40, 277 popular banks 57, 59 portfolio-at-risk (PAR) 230, 233 portfolio rebalancing 280 Portfolios of the Poor: How the World’s Poor Live on $2 a Day 234 possibility theory of crisis 212–14 post-Keynesian approach to credit 69, 74 approach to exchange rates 85, 88–9, 90–91 approach to financialization 177 literature on financial globalization 141–3 theories of the firm 198 view on central banking 39–40 Prebisch–Singer hypothesis 49, 51 price stability 39, 50, 137, 241 private equity funds 274–7 privatized Keynesianism 110–11 profit-and-loss sharing (PLS) agreements 181–2, 184 profit motive 256 profitability, balancing 232–3 prudent conservatism 311 purchasing power parity (PPP) 85 pyramid frameworks 40–41, 243–5 ‘q’ theory 35 quantitative easing criticisms 281–2 nature of 279 rationale for 279–80 untested consequences 280–81 quantitative theory of money (QTM) 38–9
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Index 325 Raiffeisen, Friedrich Wilhelm 56–63 reflective finance 66–8 regulatory regimes 141, 304 rentiers 26, 27, 122, 124, 177, 197–8 reproduction, simple and expanded 214–16 reserve currency 11, 49–50 reserve position doctrine 280 residential mortgage-backed securities (RMBS) 293 residual banks 15–16 ‘retroduction’ 221–2 Ricardo, D. 43–4, 46, 212 risk 124, 231, 283–7, 311–13, 314 Royal Bank of Scotland 14, 16, 169 runs on banks 17, 19–20, 24 Salomon principle 194–5 saving in emerging markets 77–80 household 109–10, 183–4 real 128–31, 134 as source of finance 248 Say’s Law 66, 212 Schulze-Delitzsch, Hermann 57, 59 Schumpeter, Joseph 69, 71–2, 98, 173–6, 254–6 Seccareccia, M. 114, 115 sectors, classification of 131 securities and capital market inflation 33–4 government 44, 203 mortgage-backed 93–4, 170, 251 and sub-prime crisis 147–50 Veblen on 310–12 see also securitization Securities Transaction Taxes (STTs) 30 securitization 124, 202, 294–5 embedded moral hazard 292–3 of home mortgages 251–2 incentives in 289–90 liquidity and financial system 206–8 nature of 290 and SIV sponsors 293 and use of credit ratings 291 separate corporate personality 193, 194–5
shadow banking system 123, 205, 312–13 Shaikh, Anwar 86–7 shareholder primacy 198 Sharia law 180–85 Shaw, E.S. 78, 79, 175 sheep 131 shiftability school of thought 201–3 short run decisions 14–15 silent runs 24 simple circulation 211–14 simple reproduction 214–15 slumps, see booms and busts Smith, Adam 69, 195–6 social collateral 226 sound money 50 South Sea Bubble 194 speculation housing 93–4 Keynes’s analysis of 95, 97, 187–92, 258 speculative finance 99 speed of entry 21–2 Steindl, Josef 36, 109–10 Stiglitz, Joseph 28, 68, 141, 226, 283, 285, 286 stock flow consistent modelling approach 74, 132–3 stock option remuneration 34 structured finance 290–91, 295 structured investment vehicles (SIVs) 293 subprime crisis 93–4, 96, 101, 147–50 sudden stops 28 Switzerland 151, 296–7, 299 Système de Stabilisation des Recettes d’Exportation (Stabex) 50 Tata 273 tax cuts as factors in financial crises 96, 311 tax havens 296–300 tax liabilities, transnational 305–6 taxes, role of 250–51 taxpayers and banks 16–17 textbooks survey 172–3, 178 Third World Debt Crisis 166–7
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Thornton, Henry 19–20, 69 thrifts 103, 251 Tobin, James 30, 35, 132, 270 Toporowski, Jan 33–7, 113, 114, 116, 286 Trade Disputes Act 193 tranching 290 transfer prices 304–6 transnational companies (TNCs) 301 context 301–2 and finance 302–6 Treatise on Money 73, 105–6, 189, 190–91 Trollope, Anthony 196 Troubled Asset Relief Program (TARP) 14 uncertainty 73–4, 88–9, 95, 176, 222–3, 283 United Biscuits 274–5 US dollar impact of Asian monetary union 11 Marxist function of 90
variance, as measure of risk 283–4 Veblen, Thorstein 69, 70, 98, 270 Federal Reserve 310–11, 313–14 macro-financial theory 308–10 macroprudential risks 311–13 vector auto-regression (VAR) approach 9 verticalism 39–40 volatility 51–2, 54 von Mises, Ludwig 71 Wicksell, Knut 69–71, 106, 133–4, 183 Women’s World Bank (WWB) 231 worker insecurity 259 working capital and liquidity 207 World Bank 78–9, 140, 175–6, 178, 229, 234 World Council of Credit Unions (WOCCU) 60–61 world money 41, 85, 90 Yunus, Muhammad 62, 225
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