Financialization and the Monetary Circuit: A Macro

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Review of Political Economy

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Financialization and the Monetary Circuit: A Macro-accounting Approach Marco Veronese Passarella To cite this article: Marco Veronese Passarella (2014) Financialization and the Monetary Circuit: A Macro-accounting Approach, Review of Political Economy, 26:1, 128-148, DOI: 10.1080/09538259.2013.874195 To link to this article: http://dx.doi.org/10.1080/09538259.2013.874195

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Date: 14 December 2016, At: 04:03

Review of Political Economy, 2014 Vol. 26, No. 1, 128– 148, http://dx.doi.org/10.1080/09538259.2013.874195

Financialization and the Monetary Circuit: A Macro-accounting Approach MARCO VERONESE PASSARELLA Leeds University Business School, Economics Division, Leeds, UK

(Received 11 May 2012; accepted 4 June 2013)

ABSTRACT This paper aims to cross-breed the standard monetary circuit accounting model with elements from the Post-Keynesian literature. The goals are: (i) to analyse the implications of credit-based household consumption fed by capital asset inflation for the soundness of a pure credit-money economy of production; and (ii) to provide a more sophisticated description of the working of modern financial systems than the one grounded in the usual ‘bank-based vs. market based’ distinction.

1. Introduction The Franco-Italian approach to the Monetary Theory of Production (MTP hereafter)—also known as the Theory of the Monetary Circuit (TMC) or the Circulation Approach—has generated a rich body of literature since the mid-1970s (e.g. Barre`re, 1979; Graziani, 1977, 1984, 2003; Parguez, 1975, 1996; for an overview see Lucarelli & Passarella, 2012). This line of research is based on the rediscovery of some of the most far-reaching aspects of the analysis of Karl Marx, whose view of capitalism exhibits a striking resemblance to a number of ‘dissenting’ works of the 20th century, notably the tradition that draws upon Wicksell’s Geldzins und Guterpreise (1898) and Keynes’s Treatise on Money (1930). There is, furthermore, a strong link between the Franco-Italian line of the MTP and the Cambridge School of Keynesian Economics that descended through Richard Kahn, Nicholas Kaldor, Joan Robinson and Michał Kalecki. These theoretical roots account for the high degree of compatibility between the TMC and the modern Post-Keynesian approach (on these affinities, see, for example Godley, 1999; Lavoie, 2004, 2006). There are of course many theoretical differences, some of them deep, among Marx, Wicksell, Keynes and Minsky; but the Franco-Italian approach to the MTP suggests that their differences are less relevant than what they have in common with each other. Correspondence Address: Marco Veronese Passarella, Leeds University Business School, Economics Division, Maurice Keyworth Building, Leeds LS2 9JT, UK, E-mail: [email protected] # 2014 Taylor & Francis

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The keystone of the TMC is the link it posits between the Keynesian concept of ‘initial finance’ with the Marxian notion of ‘money-capital’ (Messori, 1983). On this basis, TMC authors depict the working of capitalism as a ‘monetary circuit’, namely a circular sequence of economic relationships involving the use of credit money that is created ex nihilo by the banking system. The causal chain that marks a simple monetary production economy, made up of only three sectors (non-financial corporations, workers and banks), is triggered by the decision of corporations to borrow from the banking sector. This flow of credit-money, the initial finance, is used to pay the wage bill for the workers required to start the process of production. Once the production cycle is concluded, wage-earners spend part of their income on consumption goods and devote another portion to the purchase of securities issued by firms. For the corporate sector considered as a whole, there is no difference between these two types of expenditure: in both cases, the liquidity flows back to firms in the form of final finance. As long as wage-earners use all of their income to purchase consumption goods and firm-issued securities, corporations will be able to repay their debt and ‘the circuit is closed “without losses”’ (Graziani, 2003, p. 30).1 However, wage-earners can also decide to save a third portion of their income by holding it in the form of bank deposits. In this case, the greater the liquid balances held by wage-earners, the greater the losses of revenue suffered by the corporate sector. The ‘standard’ version of the monetary circuit framework provides an accurate account of how Western capitalist economies functioned from the 1950s to the mid1970s. But since the end of the 1970s, especially in the US and in the UK, stock markets and the financial sector have progressively taken on a role that is considerably more important than the ‘passive’ function assigned by the TMC. To the extent that this development has become a permanent feature of modern financially sophisticated economies, circuitist analysis needs to be updated. This is the starting point of the remainder of the paper, which is organized as follows. Section 2 deals with the remarkable change in the historical structure of the circuit of monetary payments in high-income economies. Sections 3 presents the basic assumptions behind the accounting framework developed in the subsequent sections. Sections 4 and 5 analyse the impact of ‘capital-asset inflation’ on the financial and economic soundness of the corporate sector and hence of the whole economy. In Section 6 we provide a more sophisticated description of the working of modern financial systems than the one grounded on the usual ‘bank-based vs. marked-based systems’ dichotomy. Some concluding remarks are provided in Section 7.

2. The Monetary Circuit in ‘Money-Manager Capitalism’ A distinctive feature of a growth-oriented productive system, such as the one analysed by Keynes and then in the 1970s by TMC authors, is the major role that banks play in 1

We abstract for the moment from the repayment of interest to the banks. Following Zezza (2012), hereafter it is implicitly assumed that the ‘financial period’ (starting with the creation of bank loans and ending with the paying off of the debt) is longer than the ‘production period’ (i.e. the time corporations need to sell output to both wage-earners and banks). This allows us to treat interest payments consistently.

130 M. Veronese Passarella

Figure 1. The logical structure of the monetary circuit (assumptions: no government sector; no foreign sector; households do not desire to hoard bank deposits)

financing production and investment, with the security market having a passive role in channelling household saving to manufacturing corporations. Since the end of the 1970s, however, financial markets have begun to take on a central role first in Anglo-Saxon countries and then in other Western economies. In fact, ‘growing profits and retained earnings associated with a relatively weak business investment have slowly transformed (or rentierized) the nonfinancial business sector itself into a net lender that seeks profitable outlets that provide high financial returns for its internal funds’ (Seccareccia, 2012, p. 282). At the same time, household saving has fallen drastically: since the 1990s, the household sector in most Anglo-Saxon countries has increasingly become a net borrower, rather than a net lender (which had long been considered its ‘traditional’ role). Banks have become ‘financial conglomerates’ that seek to maximize their fees and commissions by issuing and managing assets in off-balance-sheet affiliate vehicles. This has produced a change compared to the standard monetary circuit framework, where the banking system is assumed to finance the activity of the corporate sector. Under so-called ‘Money Manager Capitalism’, the traditional link between non-financial firms and banks ‘has been largely severed . . . , and it is the dynamics of the bank/financial markets axis . . . that has taken center stage’ (Seccareccia, 2012, p. 284). In Figure 1 the simplest version of the monetary circuit is represented by the sequence (1)– (5). For the sake of simplicity, we assume that households use their incomes (both labour-incomes and capital-incomes) to buy commodities and securities (say, bonds) issued by the corporate sector. In a monetary production economy the usual circuit is: (1) commercial banks lend to the non-financial corporations, enabling them to start the process of production, as well as to finance their investment plans; (2) corporations use the initial finance to pay money wages to households in return for labour services; (3) once the production process is completed, households spend a percentage of their income in the commodity market and hold the rest in the form of financial assets; (4) the liquidity (credit-money)

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131

Figure 2. The paradoxical form of the monetary circuit in the ‘new capitalism’ (arrows show only the new ‘tendential’ links among the integrated financial sector, corporations and households)

that is spent in both the bond market and the commodity market comes back to the corporate sector as a whole; (5) insofar as non-financial firms get back their monetary advances, they are able to repay the principal of their bank debt.2 As we have noted, in recent decades financialization has led to a remarkable change in the structure of the monetary circuit. The strategic position of banks and financial markets in this ‘new capitalism’ is depicted in Figure 2. On the one hand, the creation of credit-money has been increasingly sustained by household debt (Lh, hereafter) rather than by the corporate sector’s demand for finance (arrow 1). On the other hand, household debt has fuelled the transactions on the financial markets (both on the corporate stock market and on the other financial asset markets) because of the demand arising from the growing savings (i.e. money profits) of the corporate sector (arrow 3). The ‘new’ monetary circuit is in effect triggered by the decision of banks to grant credit to households on the basis of their wealth. Households spend both this flow of credit-money and a portion of their wage and financial income in the commodity market (arrow 2). To the extent that corporations are able to fund their investment plans, they can assign a percentage of the retained earnings to both the equity market and the market for other financial assets. On the equity market corporations can repurchase their own shares (arrows 4b & 4c).3 In the market for other financial assets, banks and financial intermediaries place financial assets (for instance, derivative products such as the notorious Collateralized Debt Obligations), which are

2

If households do not hoard deposits, then even the sums paid by corporations as interests on bonds flow back to the corporate sector. 3 A corporation might buy back its own shares in order to sustain the price of shares, to adjust the liquidity of its balance sheet, or to distribute income to its owners in the form of capital gains.

132 M. Veronese Passarella indirectly ‘monetized’ by non-financial corporate saving (arrows 3 –4a). This happens because, in the presence of rising prices and returns in the financial markets, ‘it may become profitable for overcapitalized firms to allocate excess capital to financial assets in preference to engaging in real investment’ (Toporowski & Michell, 2012, p. 20). The final outcome is that, eventually, corporations assume the role of net lenders, whereas households become net borrowers.

3. Basic Assumptions and the Accounting Framework In the remaining sections of this paper will analyse the effect of financialization on the soundness of the corporate sector, and hence on the soundness of the circuit of money payments across the entire economy. We will use a social accounting model comprised of three macroeconomic sectors: . Households (or wage-earners). This sector comprises individuals who sell their labour-power to firms in return for a money-wage. They spend their income on consumer goods and financial assets (i.e. bank deposits and equities). They can also borrow in order to undertake spending in excess of their current incomes. However, by definition, households cannot obtain bank (initial) finance in order to start the process of production. . Non-financial corporations (or firms). For the sake of simplicity, this sector is assumed to be comprised of firms that produce a single homogeneous output by means of labour and the same output-good used as an input. To initiate the production process, firms must borrow from banks to finance the purchase labour-power from households. Once the production process is concluded, corporations enter financial markets in order to place their own shares and to purchase financial assets (which may include shares of their own stock). . Integrated financial sector (or financial-banking sector). This includes the central bank, commercial banks and other non-bank financial intermediaries. In a ‘pure credit’ economy, the central bank is supposed simply to regulate the target rate of interest on refinancing, and to lend to commercial banks.4 Commercial banks, in turn, lend to non-financial corporations, households and non-bank financial operators. Finally, financial operators issue financial assets. More precisely, they issue equities that are bought by households, and other securities that are subscribed by the corporate sector. Finally, both banks and financial operators (may) hold a percentage of non-financial corporate capital stock. In order to call attention to the salient features of the new capitalism, we are temporarily neglecting the usual distinctions between commercial banks and investment banks, and between banks and other financial intermediaries. We also ignore, at this stage of the analysis, the government sector and net exports. Furthermore, we assume that households seek (and obtain) bank loans in order 4

For a heterodox perspective on interest rate targeting by the central bank, see Brancaccio & Fontana (2013).

Financialization and the Monetary Circuit

133

to finance consumption beyond the limit of their disposable income. Since those loans are supposed to be an increasing function of household net wealth, consumption increases (decreases) as asset prices in the financial market increase (decrease). If corporate investment is more or less flat, as has been the case in recent years, then ‘autonomous’ consumption induced by asset inflation will constitute as the real engine of growth for the pure credit economy considered here. The literature on Stock-Flow Consistent Modelling (e.g. Godley & Lavoie, 2007) summarizes the assumptions underlying the monetary circuit in terms of a set of sectoral accounting relations such as those depicted in Tables 1, 2 and 3. These social matrixes constitute the ‘skeleton’ of the circuit framework discussed in Sections 4 and 5. The starting point of the Stock-Flow Consistent Modelling approach is that, at the macroeconomic level, every financial asset always needs a counterpart liability, and vice versa. Tables 1, 2 and 3 respect this condition for aggregate stock-flow coherence. Table 1 is the nominal balance sheet matrix of our pure credit-money production economy; Table 2 is the corresponding transaction-flow matrix; and Table 3 shows the uses and sources of funds within the economy, that is to say, it shows the monetary budget constraint faced by households, corporations and the financial sector. Each column of Table 1 shows current stocks of assets and liabilities of every sector; each row of Table 2 shows the flow of expenditures, income and transfers from one sector to another; finally, each column of Table 3 shows how each sectoral balance sheet is affected by current flows. Table 3 warrants further comment. The fourth column of Table 3 shows the identity between the productive investment undertaken by corporations and its sources of financing (bank loans, equities and retained profits, net of the purchase of financial assets). As for the causality, we are assuming that bank loans are defined in ‘residual’ and ‘revolving’ terms, as the external funds that corporations need in order to cover non-self-financed productive investment (in addition to current production). The second column of Table 3 shows household flows of funds. To the extent that bank loans are used to finance consumption in excess of income, this entails an additional and potentially long-lasting indebtedness of the household sector. The point is that consumption, unlike investment (be it ‘financial’ or ‘productive’), does not entail any additional future return. Finally, the sixth column of Table 3 shows the flow of funds of the integrated financial sector. This latter manages a number of different financial assets and its net income is given by the algebraic sum of the corresponding financial revenues (as is shown in the fifth column of Table 2).5

4. The Effect of ‘Capital-Asset Inflation’ on Profits The somewhat paradoxical accounting structure of the ‘new’ monetary circuit depicted in Figure 2 can be derived from Tables 1, 2 and 3. Let us assume that 5

For a Minsky-Kalecki simulation model derived from this accounting framework, see Passarella (2012b).

1. Deposits 2. Loans 3. Capital 4. Derivatives 5. Equities 6. Net worth (Totals)

1. Households

2. Non-financial corporations

3. Integrated financial sector

Totals (column)

+Mh 2Lh

[2Mf] 2Lf +p × K +D 2pEf × EfN Vf

2M +L

0 0 +p K 0 0 p .K

+pEf × Efh + pEb × Eb Vh

2D +pEf × Efb 2pEb × Eb Vb

Notes: A ‘+’ before a magnitude denotes an asset, whereas ‘– ’ denotes a liability; Lh is the total amount of bank loans borrowed by households in order to fund consumption in excess of income.

Table 2. Nominal transactions among economic sectors 1. Households Current 1. 2. 3. 4. 5. 6. 7. 8. 9.

Consumption Investment Wages Consumer credit Interest on loans Interest on deposits Return on derivatives Dividends (distrib. profits) Current saving (Totals)

–C

Capital

2. Non-financial corporations Current

Capital

+C +p × DK 2W

[ – p × DK ]

+W +DLh [2DLh] 2iL( – 1) × Lh(21) 2iL(21) × Lf(21) +iM( – 1) × Mh( – 1) [+iM( – 1) × Mf(21)] +iD( – 1) × D( – 1) +Ffh + Fb – Ff Sh 0 Fuf

0

3. Integrated financial sector Current

+iL( – 1) × L( – 1) 2iM(21) × M(21) 2iD(21) × D( – 1) +Ffb 2Fb Fub

Capital Totals (row)

0

0 0 0 0 0 0 0 0 Stot

Notes: A ‘+’ before a magnitude denotes a receipt, whereas ‘2’ denotes a payment; it is assumed that there is neither a government sector nor a foreign sector; both inventory stocks and capital depreciation are assumed to be negligible.

134 M. Veronese Passarella

Table 1. Nominal balance sheets of each economic sector in a pure credit-money capitalist economy

Table 3. Flow of funds at current prices: uses and sources

Changes in:

1. Households Current

Deposits Loans Derivatives Capital goods Equities

6. Net capital trans. (Totals) 7. Net worth (acc. memo)

Current

+DMh 2DLh +pEf × DEfh + pEb × DEb 0 Sh Sh + DpEf × Efh(21) + DpEb × Eb(21)

[2p × DK]

Capital [2DMf] 2DLf +DD +p × DK 2pEf × DEfN

0 Fuf Fuf 2DpEf × EfN(21) + Dp × K(21)

3. Integrated financial sector Current

Capital

Totals (row)

2DM +DL 2DD

0 0 0 0 0

+pEf × DEfb 2pEb × DEb 0 Fub Fub 2DpEb × Eb(21) + DpEf × Efb(21)

Stot Stot + Dp × Kt21

Notes: A ‘+’ before a magnitude denotes a use of funds, whereas ‘2’ denotes a source of funds; the total amount of deposits is always equal to total amount of loans; ex post total saving always equals total investment; changes in capital do not enter in the column totals (because they are considered in Table 3) and the same goes for loans to households; the difference between current saving (row 9 in Table 2) and net capital transactions (row 6 in Table 3) is always zero.

Financialization and the Monetary Circuit

1. 2. 3. 4. 5.

Capital

2. Non-financial corporations

135

136 M. Veronese Passarella Key to symbols in Tables 1, 2 and 3 D C M Mh Mf Eb Ef EfN Efb Efh Fb Ff Ffb Ffh Fub

Derivatives Total consumption (of households) Deposits (total) Deposits held by households Deposits held by corporations Equities issued by financial sector (and purchased by households) Equities issued by corporations (total) Equities issued by corporations net of share repurchase Corporate equities purchased by financial sector Corporate equities purchased by households Financial sector’s dividends (distributed to households) Corporate dividends (total) Corporate dividends distributed to financial sector Corporate dividends distributed to households Retained earnings of financial sector (; ubiLL)

Fuf iD iM iL K L Lf Lh p pEb pEf Vb Vf Vh W

Retained earnings of corporations (; ufPf) Rate of return on derivatives Rate of return on deposits Rate of interest on loans Quantity of capital Total amount of bank loans Loans to corporations Loans to households (consumer credit) Price of a unit of output (or price level) Price of equities issued by financial sector Price of equities issued by corporations Net worth of financial sector Net worth of corporations Net worth of households Total wage-bill

corporations exhibit two kinds of demand for bank loans: (i) the stricto sensu ‘initial finance’ which the corporate sector as a whole needs to fund current production, Lfw, and which covers the wage bill paid to workers (W, the cost of production); (ii) a further demand for credit, allowing each single firm to fund that part of productive investment which cannot be financed by internal sources, Lfk. The amount of the initial loan sought (and obtained) by the corporate sector is therefore: Lif = L fw + L fk = W + lpDK

(1)

where l is the share of investment funded by loans (i.e. a measure of the leverage ratio of the investment), p is the unit value of the homogenous output (i.e. the price level), and DK is the current change in the existing stock of capital (i.e. the ‘productive’ investment in real terms). At the end of the production process, households can purchase consumer goods and save a share of their income, thereby increasing their stock of financial assets. If we assume that households can also borrow to fund consumption, then their ‘augmented’ budget constraint is: W + F fh + Fb + iM(−1) Mh(−1) + DLh − iL(−1) Lh(−1) = C + DVh

(2)

where Ffh is the flow of dividends from corporations to households, Fb is the flow of dividends from the financial sector to households, iM is the rate of return on

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bank deposits, Mh is the stock of deposits held by households, DLh is the flow of new loans to households, iL is the rate of interest on loans, Lh is the stock of bank loans to households, C is the flow of consumption, and DVh is the change in the stock of household wealth. For the sake of simplicity, let us assume that: (i) bank loans to households can be expressed as a proportion, r, of the value of household stocks of assets (including capital gains, see the seventh row of Table 3); (ii) the interest rate on bank deposits is negligible; (iii) the integrated financial sector does not face any cost of production, and uses any retained earnings to purchase equities issued by corporations; (iv) banks and financial operators do not issue new shares; (v) hence, households divide their savings between corporate equities and deposits only. Given these premises, we have: DLh = r(Vh(−1) + DpEf E fh(−1) )

(3)

DVh = DMh + pEf DE fh

(4)

pEf DE fb = ub (iL(−1) L(−1) + F fb − iD(−1) D(−1) )

(5)

DE fN = DEf (1 − s)

(6)

from which we obtain: pEf DE fN = pEf DE fh + pEf DE fb = (DVh − DMh ) + ub (iL(−1) DL(−1) + F fb − iD(−1) D(−1) )

(7)

where ub is the percentage of the financial sector’s retained earnings; DEfN is the quantity of newly issued corporate shares, net of any stock buyback; and s ≥ 0 is the corporate ratio of stock buyback to current issues. Variables D and iD deserve further comment: D is the overall value of securities issued by banks (through other financial intermediaries) using loans to households as collateral; iD is the corresponding rate of return. In a sense, we are assuming that banks can turn part of their ‘uses of funds’ (i.e. loans to households) into an equivalent amount of ‘sources of funds’ (i.e. new marketable securities). Since the above simplified description roughly corresponds to the actual scheme adopted by banks and financial operators to issue derivative financial products, we will refer to those securities as the ‘derivatives’ (D). For the meaning of the remaining symbols, we refer the reader to key to symbols. Equation (7) shows that the demand for corporate equities arises from household saving and from net receipts of banks and financial operators. If corporations decide to use their retained earnings to repurchase part of the issued shares from households and the financial-banking sector, then the current net change that is described by the left-hand term of equation (6) may be negative; this will be so if s ≥ 1. In this case, households and the financial sector can use the resulting additional flow of credit-money only for consumption.

138 M. Veronese Passarella Consequently, even in the presence of share repurchases, there is only one circumstance that can produce a net loss of liquidity for the corporate sector as a whole: the decision by the other sectors to save a portion of their income in the form of cash balances (i.e. bank deposits, in this simplified model). Finally, if we divide equation (7) by DEfN, and then make use of equation 6, we obtain: pEf =

(DVh − DMh ) + ub (iL(−1) L(−1) + F fb − iD(−1) D(−1) ) DEf (1 − s)

(7′ )

which is a positive function of both the retained earnings of the financial sector and the buy-back of corporate shares. From the second column of Table 2 we can derive also the macroeconomic equation of corporate profits, which roughly corresponds to the well-known Kaleckian aggregate identity between capitalists’ income and capitalists’ expenditure (see Kalecki, 1971): Pf = pDK + C − W − iL(−1) L f (−1) + iD(−1) D(−1)

(8)

It should be noted that the rate of return on derivatives is directly linked to the rate of interest on household debt. The reason is that the integrated financial sector issues bonds that are purchased by corporations looking for higher returns on their internal capital. This process allows the banking system to ‘monetize’ a percentage (call it a) of its credit with households without waiting until the maturity date. However, in order to do so, the financial-banking sector needs to pay interest on the issued bonds, whose rate of return must be higher than the rate on deposits and lower than (or equal to) the rate on loans to households (iM , iD ≤ iL ). From equations (2) and (7′ ) we obtain the following identities: C = W + F fh + Fb + DLh − iL(−1) Lh(−1) − DVh

(9)

pEf DE fN = ub (iL(−1) L(−1) + F fb − iD(−1) D(−1) ) + (DVh − DMh )

(10)

Let us consider two different cases. Case 1. We assume that: (i) the productive investment is entirely financed by the issuing of new equities (so that pDK ¼ pEfDEfN); (ii) both corporations and financial-banking sector do not distribute dividends (so that Ffh ¼ Ffb ¼ Fb ¼ 0 and uf ¼ ub ¼ 1);6 (iii) the rate of return on derivatives is negligible (iD ¼ 0). 6

In this case, the only reason for purchasing equities is to realize capital gains.

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Substituting equations (9) and (10) into equation (8), we get: Pf = DLh − DMh

(11)

DLh . DMh ⇒ Pf . 0

(12)

and hence:

If the amount of loans to households is larger than the amount of deposits that households decide to hold, the corporate sector’s receipts from sales will be sufficient to pay back what the corporations have borrowed (principal plus interest) and to provide a positive net money profit. The conclusion is that non-financial corporations (considered as a wholly integrated sector) realize money profits if households become net debtors to the banking sector (hence, making firms net creditors). Case 2. Let us suppose that: (i) the productive investment of corporations can be debt-financed; (ii) the rate of return on derivatives is positive, allowing corporations to realize financial gains. If we continue to assume that neither the corporate sector nor the financial sector distributes dividends, then the amount of money profits of the corporate sector as a whole becomes: Pf = (DLh + L fk + iD(−1) D(−1) ) − DMh

(13)

Recalling equation (3), we obtain: Pf = r(1 + aiL(−1) )(Vh(−1) + DpEf E fh(−1) ) + lf pDK − DMh

(13′ )

from which:

r(1 + aiL(−1) )(Vh(−1) + DpEf E fh(−1) ) + lf pDK . DMh ⇒ Pf . 0

(14)

where a is the percentage of loans to the household sector that have been turned into derivatives (i.e. that have been ‘securitized’). Once again, we see that the higher the level of productive investment, the higher will be the net money profit realized by the corporate sector: capitalists get what they spend. However, the profitability of the corporate sector is now positively affected by both the receipts from the ‘investment’ in financial assets (i.e. the return on derivatives, in this simplified model) and by household wealth, including capital gains realized by households on the equity market. More precisely, inflation in equity prices has two positive effects: first, it increases the amount of consumer credit, therefore sustaining corporate profits from sales; second, part of the interest accruing to the debt of households is a financial gain for the corporate sector. Furthermore, since asset inflation allows each individual firm to replace its borrowing by the equity financing, the ‘capital-asset inflation’ could reduce the monetary cost of such financing. Nonetheless, if we assume that banks and financial operators spend all of their receipts, then interest-payments on loans are never a ‘real’

140 M. Veronese Passarella cost for the corporate sector, because they inevitably flow back to it in the form of higher consumption and higher levels of equity-financing. This is why interest accruing on bank loans to the corporate sector does not appear in equation (13′ ).7

5. Financialization, Prices and the Distribution of Income Along with most dissenting economists, circuitistes reject the marginalist theory of prices, distribution and employment. Their position is akin to the Post-Keynesian theory developed by Nicholas Kaldor, Joan Robinson and Michał Kalecki. The first step in the analysis of distribution is to determine the equilibrium price level that results from the equality between the aggregate demand and the aggregate supply of goods (see Graziani, 2003). The real value of aggregate supply depends on autonomous decisions taken by the corporate sector about the level and the composition of current output. In algebraic terms, the monetary value of aggregate supply is: AS = ppN

(15)

where p is the (unknown) price of a unit of output, p is the average output per worker, and N is the level of employment. From the first column of Table 2 we can derive the aggregate household demand for consumption goods. Adding the investment demand of non-financial corporations, we get: AD = C + I = (W + F fh + Fb + iM(−1) Mh(−1) − iL(−1) Lh(−1) + DLh − Sh ) + pDK

(16)

Since (i) the money wage bill is the product of the average wage w and the level of employment N, (ii) both the household flow of financial incomes and household saving can be regarded as a percentage of the wage bill and (iii) the productive investment of corporations is nothing but a share, k, of the produced output, it follows that equation (16) can be rewritten as: AD = wN(1 + fh + lh − sh ) + pkpN

(16′ )

7 Herein lies a difference with respect to the traditional TMC. For Graziani (2003), while interests paid on securities are never a real cost to corporations (apart from a possible ‘income effect’), interests paid on bank loans represent a real subtraction from corporate profits. However, in a fully consistent macroeconomic approach: (i) the corporate sector as a whole can, theoretically, always realize its own autonomous investment plans and hence the resulting profits; and (ii) the financial-banking sector can always successfully compete with households in the ‘commodity’ market by setting the rates of return on deposits and loans. Thus, bank interest payments are a subtraction from household real income, rather than from the corporate one. Nevertheless, for the sake of simplicity, in the rest of the paper we will continue to assume that banks use all of their retained earnings to purchase equities.

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Figure 3. The relationship between real corporate profits and financialization. On the one hand, the higher the coefficient of securitization, a, the higher will be, ceteris paribus, the amount of corporate profits (from RP′f to RP′′f , in the picture). On the other hand, the process of financialization is likely to reduce the volume of the productive investment undertaken by firms (I ¼ DK ¼ kpN), thereby bringing down the intercept of the profit function. The final result is therefore ambiguous (from RP′′f to RP∗f , in the depicted case). Finally, notice that the slope of the profit function depends, in turn, on a number of different variables (embedded, for the sake of simplicity, in the scalar z). Among these variables are the rate of interest on bank loans, iL, the household loans to assets ratio, r, the investment to output ratio, k, and further variables linked to household flow of incomes and stock of assets.

where fh is the percentage of net financial incomes and lh is the percentage of bank loans granted to households, both percentages being related to the wage bill. As usual, sh is the propensity of households to save. As mentioned above, the equilibrium price level is determined by the equality between aggregate demand and aggregate supply, which gives us:8 p=

w 1 + fh + lh − sh · p 1−k

(17)

The price of output depends on the unit cost of labour (the first ratio on the right-hand side of the equation) and on the profit margin of the corporate sector (the second ratio on the right-hand side). This latter, in turn, depends on: the average propensity of non-financial corporations to invest, k; the average propensity of households to save, sh; and, finally, the values of fh and lh (i.e. the percentages of financial incomes and consumer-credit, respectively). If corporations’ propensity to invest happens to equal the overall propensity to save of households (k ¼ sh 2fh 2lh), then the equilibrium unit price equals the unit cost of production. This implies that ‘entrepreneurial’ profits are zero. This could only occur by chance, however, for circuit models contain no economic mechanism that ensures that corporate profits will tend towards zero. 8

It is a simple matter to demonstrate that this method leads to results that are equivalent to cost-plus pricing.

142 M. Veronese Passarella

Figure 4. From tranquillity to financial fragility, and from fragility to crisis: the whole sequence

On the other hand, gross profits in real terms are equal to gross money profits (PGf ¼ pDK + C2W + iD( – 1)D(21)) divided by the price level. If, for the sake of simplicity, we assume that rate of return on derivatives is negligible, then we obtain: PGf k + fh + lh − sh = pN p 1 + f h + l h − sh

(18)

As we would expect, on the basis of Kalecki’s reasoning, if consumption equals the wage-bill (C ¼ W ⇒ fh + lh 2sh ¼ 0), then real profit before the deduction of interest payments is equal to real investment (PGf/p ¼ kpN ¼ DK ), and hence non-financial corporations earn exactly what they have spent on productive investment (PGf ¼ pkpN ¼ pDK ). From equation (13′ ) we can also derive net profits in real terms, RPf ¼ Pf/p:   r(1 + aiL(−1) )(Vh(−1) + DpEf E fh(−1) ) − DMh (1 − k)p + lf kpN (19) RPf = w(1 + fh + lh − sh ) Equation (19) is represented in Figure 3. Ceteris paribus, the higher the coefficient of securitization, a, the higher will be the amount of corporate profits (from RP′f to RP′′f , in the figure). But the process of financialization is likely to reduce the volume of the productive investment undertaken by firms (I ¼ DK ¼ kpN), thereby bringing down the intercept of the profit function. The final result is therefore ambiguous (from RP′′f to RP∗f , in the depicted case). The slope of the profit function depends on several different variables (embedded, for the sake of simplicity, in the scalar z). Among these variables are the rate of interest on bank loans, iL, the household loans to assets ratio, r, the investment to output ratio, k, and further variables linked to household flow of incomes and stock of assets. Net profits of the corporate sector depend on several factors, among which are the net worth of households and the coefficient of ‘securitization’ (a). Notice,

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however, that the same possibility of realizing financial gains through the purchase of derivatives is likely to negatively affect the propensity of the corporate sector as a whole to undertake productive investment. More precisely, we could suppose that the greater the prospect of realizing financial returns on derivatives, the lower will be the perceived benefit from undertaking a productive investment and hence from the production of goods. To the extent that this occurs, the final effect on the corporate sector’s net profits will be ambiguous, since the percentage a (which can be regarded as a proxy of the degree of financialization) increases, but the scale of production (N) decreases because of the lower level of productive investment. Since, given the productivity of labour (p), the distribution of output between corporations and households depends on the decisions of the former with regard to the scale of production (N) and the composition of output (k), we can regard the purchasing power of households as the residual term (or the dependent variable) to bridge the gap between total output and the real profit realized by the corporate sector. Finally, once the process of asset inflation starts, it is likely to cause a change in the profile of customers of banks and, hence, an acceleration of the pace of change of the whole financial system. Indeed, to the extent that the corporate sector can obtain finance or can earn profits in the financial markets, commercial banks will have an incentive to shift towards consumer lending and other financial activities. The same increase in the autonomous consumption of households is another factor that allows corporations to increase their internal funds (in the form of retained profits) and to reduce their non-speculative demand for bank loans. The result is that banks face a trade-off: they can expand their business towards households and financial activities only if they accept the risk of reducing their role in the financing the corporate sector’s current production and investment spending.9 But to the extent that they do that, they abandon their function as banks—as institutions which create credit-money, thereby enabling firms to start the process of production—and become financial intermediaries operating as mere clearing houses.

6. Beyond the Market-based versus Bank-based Dichotomy The above considerations bring into question the relevance of the traditional ‘market-based versus bank-based financial systems’ dichotomy that has dominated monetary economics over the past century (see Levine, 2002). According to that approach, financial-based systems are those under which corporations raise most of the funds they need by issuing new securities (especially shares), whereas bank-based systems are those under which corporations mainly borrow from banks. It follows that, in the former, the main source of financial instability is asset price bubbles, whereas, in the latter, the main source of financial instability is over-lending. Arguments for and against each system have been the subject of numerous theoretical debates and empirical analyses. But seldom has it been pointed out that the ‘bank-based/market-based’ dichotomy is implicitly linked to 9 This suggests that implementation of an expansionary monetary policy by the central bank via the reduction of interest rates may have a ‘crowding out’ effect on traditional banking activity unless it is offset by a strict regulation of the financial services industry.

144 M. Veronese Passarella a specific, and very controversial, view of the nature of money, namely, the socalled loanable funds theory. According to the loanable funds theory, the role of financial systems is to coordinate the decisions of net suppliers of funds, or ‘savers’ (typically households) and net demanders of funds, or ‘investors’ (typically corporations). Apart from the sources of instability, the only difference between market-based and bank-based systems is that the former realize the matching of supply and demand through the trading of securities, whereas in the latter saving takes the form of bank deposits and investment takes the form of demand for loans—with deposits being the basis of loans. In both cases, causality runs from the supply of money to the demand of money, and from aggregate saving to aggregate investment. Ultimately, financial markets and the banking sector play the same role, that is, merely to facilitate the matching of the supply of and the demand for loanable funds. The result is that the two institutions appear to be interchangeable: indeed they are perfect substitutes. The adoption of the loanable funds theory is, therefore, the hidden premise of the age-old discussion of the shift of advanced economies from the bank-based ideal-type to the market-based one, and of the closely related debate over the desirability of that historical trend. By contrast, one of the basic features of the TMC is the conception of capitalistic economies as hierarchical structures in which each macro-sector (households, corporations, banking system) and each market (consumer market, financial market) carries out a specific, and hence non-replaceable, function. From the TMC’s viewpoint, the market-based versus bank-based typology is grounded in a twofold theoretical misunderstanding. First, the banking sector is not, and has never been, the ‘cloak-room attendant’ of Cannan (1921) and neoclassical economics, but a capitalistic institution whose function is to create credit-money ex-nihilo, without any need for previously accumulated savings. Second, the logical macroeconomic function of financial markets is to allow corporations to recover the liquidity they injected into the circuit at the beginning of the period, and not to fund corporate operations. In the ‘original’ circuit at least, corporations can only borrow from banks in order to finance current production. During subsequent circuits, each firm will also need to fund its own investment plans, i.e. purchase a portion of output of the previous period. It is this second source of financing that allows the corporate sector as a whole to ‘monetize’ real profits. In any case, the point is that the corporate sector cannot turn to the financial market until household saving is formed (financial markets are not banks!), that is, until the same corporate sector has started the process of production (by obtaining initial financing from banks) and distributed incomes to the participants in that process. Household saving (be it voluntary or ‘forced’), in turn, will match corporate investment, but only ex-post, through the process by which the price level is set. This is why TMC authors call the bank financing ‘the initial finance’, whereas the liquidity coming from newly-issued securities in the financial markets is usually denominated ‘the final finance’. The former is the necessary condition to start the production process and the circuit of payments among sectors; the latter determines the degree of final indebtedness of corporations. Still, the former directly determines the scale of current production and hence the levels of employment and income (at least, if one assumes that the supply of credit is not infinitely elastic); the latter affects the scale of the subsequent circuits only indirectly (in the presence of credit-rationing linked to the corporate leverage ratio).

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Yet, as has been argued in Section 2, in the last three decades the process of financialization has involved a remarkable change in the working of a number of financially sophisticated economies, especially of the US. Hence, some questions arise: does the TMC still provide a fine representation of the effective working of today’s advanced economies? How should the process of financialization be interpreted in the light of the circuit approach? The basic thesis of this paper is that the TMC should not be considered a mere empirical description of the old Fordist manufacturing system (interpreted as a sort of ‘Golden Age’ of capitalism), as opposed to the new financially sophisticated capitalism. Rather, the TMC must be regarded as the general social accounting of a monetary economy of production, be it either ‘traditional’ or ‘financialized’. In particular, the basic circuit framework is a logical meta-model akin to Quesnay’s Tableau e´conomique and Marx’s reproduction schemes. Its function is to define the conditions of macro-monetary reproducibility of the system, in particular the solvency requirements for the corporate sector and hence for the economy as a whole, regardless of the specific properties of the individual behavioural functions. In other words, the TMC defines the necessary monetary relationships between sectors (corresponding to well-defined social classes) and markets. In this sense, the recent crises of the US economy in 2001 and 2008 have exposed an intensifying subterranean conflict between the proper (that is, the logical) function of financial markets (depicted in Figure 1) and the historical evolution they have had in the US (leading to the new scheme of Figure 2). From this viewpoint, the question is not why a pair of deep crises exploded during the 2000s in the US, but why such an episode did not occur earlier. We believe the reason is that the somewhat ‘paradoxical’ monetary circuit depicted in Figure 2 was temporarily (although not indefinitely) sustainable. In fact, it represented, for two decades at least, a powerful counter-tendency to the stagnation tendencies affecting the US economy since the mid-1970s. Such a counter-tendency was anything but spontaneous: rather, it was politically managed and fed by the US authorities, especially after the mid-1980s (see Bellofiore, 2011). The main instrument of intervention was monetary policy; the main source of aggregate demand was autonomous consumption spending fed by asset inflation; finally, the condition of sustainability of the whole system was given by the increasing market value of assets employed as collateral. As we have mentioned, an increase in the percentage of households’ autonomous consumption, by increasing the net profit of corporate sector, allows the corporate sector to reduce its reliance on external finance. Analogously, rising equity prices allow corporations to replace bank borrowing with ‘cheaper’ long-term funds (and hence to reduce their leverage ratio on productive investment).10 Consequently, in the presence of inflation in equity prices banks could be driven 10

One might be tempted to think that asset inflation can have only microeconomic effects but no macroeconomic consequences, since capital gains realized by some units (either households or corporations) offset capital losses suffered by others. However, this is not true whenever: (i) there is asymmetric information, so that agents realizing capital gains react more quickly than agents suffering capital losses; (ii) capital gains and losses entail a redistribution of income among different sectors; or (iii) bank loans are linked to the value of assets, allowing agents to realize capital gains immediately.

146 M. Veronese Passarella to shift further towards consumer-credit or to focus more heavily on fee-based financial services. This happens because they no longer have the non-financial corporate sector as their main category of customer. In the US, since the mid-1980s, this phenomenon had become a self-reinforcing process: the change in the banking model helped to fuel inflation in the prices of financial assets and then of real estate which, in turn, led to a change in the customer profile of banks. This self-reinforcing process, in combination with the Federal Reserve’s stimulus policies, might very well have been the main factor that enabled the paradoxical circuit depicted in Figure 2 to last for a considerable period of time before it collapsed. Let us see how this might occur. In the circuit of payments depicted in Figure 2, the sequence that leads to financial fragility and to the crisis can be split into two different phases. Initially, the increase in financial asset prices and consumer credit may have a positive effect on the balance sheet of the corporate sector, through the reduction in the total cost of financing (for the same level of consumption). As noted, this is likely to be a self-reinforcing process: financial asset inflation fuels credit-based consumption which fuels corporate sector saving which, in turn, fuels financial asset inflation. We may assume that the historical starting point of the described process is the long-run decrease in the rate of return on productive investment, which leads corporations to use their funds to buy financial assets. This very inflow of new funds sustains the quotations of assets in the financial markets. In turn, the increasing value of assets allows households to resort to bank credit in order to maintain their desired level of consumption in the face of stagnating wages. This is precisely what happened in the US during the 1990s and, albeit with some differences, during the upswing of 2003–2007. During its second phase, the financialization process shows its negative side. First, insofar as it becomes profitable for over-capitalized corporations to allocate excess capital to financial assets in preference to engaging in productive investment, this component of aggregate demand must decrease. Second, financialization could lead to the over-indebtedness of some corporations that sought to increase the rate of return on their own funds by using leverage to purchase financial assets (see Minsky, 1975). Third, corporate buyback of shares ends up reducing the resilience of the sector considered as a whole, because it increases the leverage ratio on both financial and productive investment.11 At the same time, both the increase in the price of assets and the growing financial fragility of econ11 Figure 2 shows that, if the stock buyback is ‘internal’ to the corporate sector, then the households sector cannot draw from the financial market the liquidity it needs to pay off its bank debt. However, households can easily keep renewing their bank loans, as the price of financial assets (and hence their wealth) keeps on increasing, thanks of the inflow of corporate saving. The same goes for the corporate purchases of financial assets from banks and other financial entities. By contrast, to the extent that corporations repurchase their shares from households, the latter will be able to pay off part of their debt, but at the cost of ‘de-accumulating’ their stock of assets, with the risk of a debt-deflation crisis. Data seem to indicate that the two hypotheses describe two different phases of the actual process of financialization. On the one hand, the financialization of western economies (which started at the end of the 1970s) has been associated with a tendential fall in the proportion of investment financed by new issues. On the other hand, the equity-to-investment ratio decreased during the upswings (mainly because of the stock repurchases of the non-financial corporate sector) and increased after the crises associated with the Wall Street crashes of 1987, 2000 and 2007 (Passarella, 2012a; Ryoo, 2010).

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omic units can lead to an increase in actual rates of interest. Eventually, all these factors cannot help but force indebted economic actors to cut consumption and investment, thereby giving rise to the crisis.

7. Concluding Remarks This paper revisits the monetary circuit framework in the light of the central role taken, during the last decades, by financial markets in the US and in a number of other advanced economies. The result is a new, although somewhat paradoxical, circuit of payments in which bank lending is sustained by household debt, rather than by the corporate demand for finance. The same household debt fuels the expansion of the financial markets, by virtue of the growing level of corporate saving invested in financial assets. It is this interconnection between increasing household debt, increasing financial profits and progressive changes in the role of banks, that functioned as the ‘artificial heart’ of the new capitalism of the 1990s and 2000s—at least until the crash of 2008. Of course, with the possible end of that model upon us, including the end of the role of US households as buyers of last resort for global surpluses, we may have to rethink once again the contours of the circuit of money payments among sectors and countries. Assessing the recent foreign debt crisis of several Euro Area member-states, for example, would require us to bring both the government sector and foreign markets into the circuit of liquidity.12 In any case, the traditional ‘market-based versus bank-based systems’ dichotomy grounded in the old loanable funds theory is both empirically useless and theoretically wrong. By contrast, the basic framework of the TMC still represents the best logical starting point for any analysis of the historical changes taking place in capitalist economies.

Acknowledgement This paper has a long history. The first draft stems from my work with Riccardo Bellofiore at the University of Bergamo in 2010 –2011. The current version has greatly benefited from my weekly conversations with Malcolm Sawyer in Leeds. Finally, I am grateful for comments by Alessandro Vercelli, Giuseppe Fontana and Herve´ Baron. The usual disclaimers apply.

References Barre`re, A. (1979) De´se´quilibres e´conomiques et contre-re´volution keyne´sienne (Paris: Economica). Bellofiore, R. (2011) Financial Keynesianism, in: J. Toporowski & J. Michell (Eds) The Handbook of Critical Issues in Finance (Cheltenham: Edward Elgar).

12

Government sector deficits financed through the issue of money represent an additional source of funds for the private sector. The same goes for balance of payments surpluses. In the Euro Area, the financial condition of countries marked by external surpluses may be easily likened to that of corporations depicted in Figure 2, whereas the situation of deficit countries can be likened to that of the household sector. In both cases, behind the appearance of sustainability, there are increasing imbalances between sectors or countries, which are bound to lead to financial fragility and to crisis.

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