Download The Political Economy of Shadow Banking

The Political Economy of Shadow Banking
Eloy Fisher
PhD Candidate at The New School
October 7, 2013
Abstract
This paper presents a theoretical overview of the political economy behind shadow banking. Neither new or original, what is modern
in shadow banking are its broader institutional implications and how
it bore witness to the dramatic changes experienced by global capitalism in the last century. Intimately tied to the political economy
of capitalist dynamics, shadow banking is nested in the discontinuous distributive tension between workers and firms. These politics are
a wedge in the operation of the shadow financial system, as government policy internalizes, guides and participates in dealings mediated
by financial intermediaries. This government agency (especially in
spending and borrowing) is itself a result of endogenous, differential
pressures between workers’ desires to push for re-distributive stabilization and firms’ tolerance of increased worker bargaining power.
We present a broad theoretical overview to motivate a formal political economy model of the shadow banking sector (stylized around the
operation of money market mutual funds, or MMMFs) using insights
from Mehrling, Pozsar, Sweeney and Neilson’s model. Our simulations suggest the leading push of distributive dynamics that nest the
operation of shadow banking.
JEL Codes: E12, E62, E63, H5, H6, P16.
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Keywords: Political Cycles, Debt and Public Finance, Shadow Banking, The Political Economy of Finance, Kaleckian Macrodynamics, Political
Macroeconomic Models.
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1
Introduction.
Shadow banking (a term used interchangeably with shadow financial system)
is “money market funding of capital market lending” [19] which generally
takes place outside the regular banking system [3]. This definition highlights the activities of financial intermediaries that use short-term money
market funding, sourced on global dollar markets, to fund long-term investment projects - namely capital loans. Both banks and other types of institutions (a broad array of financial agents allowed to take client deposits to
invest in different types of projects) engage in these activities.
Estimates differ on the size of the shadow banking sector - some pin a
figure around 65 trillion dollars worldwide as of 2011, from a “mere” 26
trillion in 2002 [5]. This eye-staggering growth was direct consequence of
advances in securitization (which sought to minimize risk by packaging and
pooling assets in structured products), a favorable regulatory climate and a
macroeconomic environment of low interest rates.
With the above in mind, this document describes the operation of the
shadow financial system through an approach which not only underscores
the inter-linkages between the sources and the target of this funding, but
also the political economy of profits and wages that lies behind the dense
web of financial intermediaries who participate as dealers, investment banks
or special purpose vehicles (or SPVs, for short) to price funding and risk,
depending on the assets and liabilities they hold on their balance sheets.
However, these assets and liabilities originate in the relationships between
firms and workers, and the rolling clout of special circumstances around
government action and policy. With this in mind, we will argue that the
financial operation of the shadow financial system is not a mere mechanical
outgrowth of advances in securitization and risk management, but the natural
result of tensions at the core of capitalist political development.
Indeed, the 2008 financial crisis and other, perhaps less momentous events
(like the 2011 debt ceiling crisis) turned sour the earlier enthusiasm with
regards to shadow banks, managed money as Hyman Minsky would put it
- the lot of hedge funds, mutual funds and the much-maligned investment
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banks, whose top performers became extinct in the immediate aftermath
of the crisis when they shed their skin to become bank holding companies.
However, perhaps the important link in shadow banking is the operation of
money manager mutual funds (or MMMFs, for short), who came to dominate
an ever-growing share of financial flows after the elimination of interest rate
ceilings on demand deposits in 1982.
According to the Investment Company Institute (or ICI, for short), MMMFs
comprise 17% of total assets held in mutual funds worldwide, behind equity
and bond mutual funds. Unlike the latter two funds, MMMFs are deemed
very safe and liquid investments: MMMFs sell shares to investors, and lend
those funds (via repurchase agreements, or repos) to banks or dealers who
demand liquidity for overnight operations.
At a general level, MMMFs deposit their cash on investment banks or
broker accounts, who in turn provide MMMFs with collateral - usually, high
quality debt, whether commercial or sovereign in nature. The collateral
provided is worth more than the deposit - the difference between the par
value of the collateral provided and cash deposit is commonly known as the
haircut. Under the terms of the repo, the bank repurchases the collateral
at a higher price - or the difference between the initial selling price and the
repurchase price is the repo rate, or interest rate on the loan. If the borrower
fails to pay the repurchase price, the lender gets to keep the collateral at par
value.
Given these terms, the shares of these MMMFs are backed by high quality
debt, namely high quality commercial paper, Treasury bills and sovereign
bonds. Their operation in the United States is closely regulated by the
Investment Company Act of 1940 and subsequent amendments, legislation
which describes what constitutes safe investment assets for these entities.
Furthermore, unlike other types of mutual funds, these MMMFs keep a net
asset value (or the value of its assets minus its abilities) greater than 1, as
their assets are highly liquid and risk-free - at least in theory.
Herein lies the caveat: these MMMFs are viable entities as long as markets provision liquidity and are able to price risk adequately, an ability that
market participants woefully overestimated in the run-up to the crisis. For
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this reason, how markets are organized institutionally and they interests they
represent are of utmost importance to the operation of the shadow financial
sector in general, and particularly to MMMFs (who at the receiving end of
government deficits, trade large amounts of sovereign United States debt).
For this very reason, we need to know not only how these MMMFs operate
within the wider net of the shadow financial sector, but are the drivers of
debt capital markets and the conflicting interests behind government policy.
These questions can be tackled from two analytical vantage points: for
one, this shift towards shadow banking is neither new or original. After this
introduction, the next section claims that shadow banking is steeped deep
into the political economy dynamics of capitalism despite the ever-changing
vagaries of the world economy - this has long being argued by heterodox
writers of both Marxist and Post-Keynesian persuasion. Marx himself took
interesting notes on the appearance of quasi-banking, highly leveraged financial institutions (namely, the “Crédit Mobilier” of the mid-XIX century,
heir to John Law’s General Private Bank a century before) whose operation
was analogous to many shadow banks. His analytical innovation, however,
stressed the political economy behind its operation. Marx highlighted not
only the intimate political linkages of the “Crédit...” with the government of
Napoleon III, but its overall function within French capitalism.
Out of the Keynesian tradition, Hyman Minsky traced much later the
development of what he coined money manager capitalism, a system “in
which the proximate owners of a vast proportion of financial instruments
are mutual and pension funds” [20]. In a later note, L. Randall Wray [28]
updated Minsky’s definition, as “capitalism characterized by highly leveraged
funds seeking maximum total returns (income flows plus capital gains) in an
environment that systematically under-prices risk”. Their views stress the
discontinuous changes in the institutional and political fabric of capitalism
which provides for the rise of these institutions.
In this section we also discuss how politics drives a wedge in the shadow
financial system, as government policy provides needed guidance and collateral in dealings undertaken by financial intermediaries. We claim that
government agency in deficit spending and borrowing is the result of endoge5
nous, differential pressures between workers’ wages and firms’ profits. It is
our view that this tug-of-war is of central importance to fully understand the
role of shadow banking in modern capitalism.
Out of both analytical approaches, the third section presents the stylized
facts we use to build the political economy model of the shadow banking
sector, using insights from Mehrling, Pozsar, Sweeney and Neilson’s work on
shadow banks [19] and data from the United States. Section four presents our
mathematical model and a social-accounting matrix which fully describes our
model. Section five presents our baseline results and alternative scenarios.
Finally, Section six concludes.
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2
Shadow banking in the political economy
of capitalism.
2.1
Marx and Minsky: The role of shadow banks in
capitalism.
In journalistic undertakings and personal exchanges with Friedrich Engels,
Karl Marx discussed the appearance of the Crédit Mobilier system in France.
Sanctioned by the French government of Napoleon III and with direct involvement of cabinet members and influential personalities of the Second Empire,
the Societé Générale de Crédit Mobilier was founded by the Péreire brothers,
a resourceful duo who had in their earlier years toyed with Saint-Simonian
ideas - to Marx’s derision. Their company issued shares to select investors
(later it was opened to the public) who wished to partake in long-term investments in “mobile” property - namely, railways, industrial production (in
contrast to real estate investments) or in stock market listings of these companies.
Marx and other contemporary commentators described this venture as a
“swindle” [26] given the obvious lack of safeguards. Yet, regardless of the
tone he used to describe the “Crédit...”, Marx was intrigued by its financial
operation and its political muscle. For one, the Péreire brothers’ venture was
opposed by none other than baron Rothschild, the premier financier of his
time, whose political leanings sided with the dethroned Bourbon king, Louis
Phillipe.
More importantly for Marx, the “Crédit...” served an important role
in French capitalism. Its increasingly leveraged positions fueled the boom
in industry and economic activity beyond potential capacity, especially as
France lagged behind other industrial powers in this regard. As Marx recognized in notes that would later become the third tome of Capital, this
financial institution would only come to prominence in a country like France,
“where neither the credit system nor large-scale industry was developed to
the modern level. In England and America this kind of thing would have
been impossible” [18]. A long quote below by Marx describes his views,
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notes eerily familiar to modern ears:
[A] second director of the Crédit mobilier [...] decamped leaving
massive debts of about 30-40 million [francs]. This splendid institution’s latest report [...] reveals that, although the net profit
still amounts to 23%, it has nevertheless fallen by about a half
compared with 1855. According to Mr Péreire, the fall is due 1.
to the [order...] by which Bonaparte forbade the Crédit to skim
the cream off the excessive speculation then going on in France;
2. to the fact that, by an oversight, this ‘ordre de la sagesse
suprême’ extended only to sociétés anonymes, thus laying the
Crédit open to highly improper competition [...]; 3. to the crisis
during the last 3 months of 1856. True, the Crédit sought to
exploit that crisis [...] but was obstructed in this ‘patriotic’ work
by the narrow selfishness of the Banque de France and the syndicate of Paris bankers headed by Rothschild; [...] Péreire seems
to be exerting severe pressure on Bonaparte. Should the latter
shrink from giving his authorisation, a middle course would seem
to be envisaged, namely to turn the Banque de France into the
instrument of the Crédit by loftier means, i. e. new draft legislation. [...] it further transpires that the Crédit’s business is
still vastly disproportionate to its capital and that it has used
the capital loaned by the public exclusively to further its gambles
on the Bourse. As a quasi-state institution of Bonaparte’s on the
one hand, the Crédit mobilier declares that it is called upon to
maintain the prices of funds, shares, bonds, in short, of all securities on the national Bourse, by advancing the money borrowed
from the public to companies or individual stock-jobbers for their
operations on the Bourse. As a ‘private institution’, on the other
hand, its main business consists in speculating on the rises and
falls in the stock-market. Péreire reconciles this contradiction by
something [others] might well call ‘social philosophy’ [17].
However, the new draft legislation (namely, Marx’s term for a state8
sponsored bailout) to buttress the finances of the society never came to pass.
The embattled “Crédit...” finally went bankrupt in 1867.
Although characteristically sardonic, Marx’s views on the “Crédit Mobilier” are not anachronistic - the way he saw it, industrial capitalism required
a structured banking sector to finance industrial operations (with intimate
ties to the State), a view later developed in depth by Rudolf Hilferding [10].
Marx and Hilferding rightly sensed how these financial institutions used their
proximity to the political establishment and their financial muster to kick the
can down the road, especially when the productive kernel of capitalism faltered, to support prices of securities and lengthen the boom cycle by debt
layering. It was only in places where the position of industrial capital became
precarious (or where industrialization was led directly by the government)
where speculation prevailed over enterprise via financial institutions. Under
these circumstances, expected cash flows from investment (which fed economic growth) took a back seat to the constant valuation of assets under the
piecemeal management of the ”whirlwinds of optimism and pessimism” (as
Keynes would say in Chapter 12 of the “General Theory...”) of large financial
intermediaries. As Keynes himself would later suggest, this was a recipe for
disaster.
Hyman Minsky framed this issue similarly. The starting point for Minsky
was the recognition that economic stability was a direct result of government
involvement, not of more docile animal spirits. Higher government deficits
backstopped the system, sovereign debt provided a safe asset to park accumulated cash resources. With higher deficits, the financial sector did not
need to increase its portfolio diversity or push for other types of safe assets to meet this demand. But as Wray [28] notes, this New Deal backstop
was an “aberration” (dare I say, political) in the evolution of financial capitalism (which reared its head during Marx’s time) into the money-manager
capitalism of late.
The funding subterfuges of financial capitalism became necessary as the
demand for capital for industrialization made it more expensive - banks syndicated loans to these purposes, efforts which lead to the concentration of
capital under the control of holding companies. But as the world shed the
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last vestiges of the New Deal order, it quickly took up the mantle of moneymanager capitalism.
Aberrations can never survive, and several factors led to the demise
of the New Deal order. Internally, the political coalitions between capital
intensive industries and worker interests which spearheaded the post-War
era slowly weakened, as international trade resumed and competition from
abroad sapped competitive advantages in heavy industries for the United
States [7]. Externally, the collapse of the Bretton Woods system in 1971 created a global dollar market. Floating exchange rates, coupled with dollar’s
exceptional privilege, strengthened the need and the supply of liquidity to
international markets. With the elimination of Regulation Q, these global
dollar markets sourced the already familiar MMMFs - initially, President
Reagan’s deficits backstopped their operations.
But as the United States entered a period of lower deficits (and interest rates) with President Clinton, the demand for safe, high-yielding assets
outstripped supply. With the advent of securitization, synthetic assets were
created to guarantee investor deposits. Low interest rates provided by the
now (in)famous Greenspan put contributed to reduced Treasury rates, and
fueled the need for “safe” substitutes. As argued by Gorton and Metrick
[9], the booming global market in dollars outstripped the capacity of the
Federal Deposit Insurance Corporation (or FDIC, for short) to allow institutions with large cash holdings to seek safe harbor, especially as the 1990s saw
government surpluses - indeed, “the regulatory changes were, in many cases,
an endogenous response to the demand for efficient, bankruptcy-free collateral in large financial transactions [...]”. At the international level, Mehrling,
Pozsar, Sweeney and Neilson [19] provide an explanation:
[...] In today’s world so many promised payments lie in the distant
future, or in another currency. As a consequence, mere guarantee
of eventual par payment at maturity doesn’t do much good. On
any given day, only a very small fraction of outstanding primary
debt is coming due, and in a crisis the need for current cash can
easily exceed it. In such a circumstance, the only way to get cash
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is to sell an asset, or to use the asset as collateral for borrowing.
In the private market, the amount of cash you can get for an
asset depends on that asset’s current market value. By buying
a guarantee of the market value of your assets, in effect you are
guaranteeing your access to cash as needed; if no one else will
give you cash for them, the guarantor will. [...] That, in effect, is
what all the swaps are doing, or at any rate what they are trying
to do. Because the plain fact of the matter is that all the swaps
in the world cannot turn a risky asset into a genuine Treasury
bill.
Given these reasons, therefore, we need to shift gears to two related
venues, the ability and operation of the private sector to package and distribute these “safe” assets, and the drivers behind the issuance of debt - and
hence, government deficits. The first requires grounding on how this shadow
financial sector works, and how it conducted business until very recently, especially in the United States. The second venue prompts an explanation of
how these deficits come to be, and what interests lie behind them. To these
issues we turn next.
2.2
Politics and government in the mechanics (and
crises) of the shadow financial system: Mainstream
and heterodox perspectives.
Without a doubt, the origin of the shadow financial sector is both a natural
outgrowth of an worldwide, liquid dollar market that took root after the
demise of Bretton Woods. Nonetheless, it is also a consequence of government
action - especially of deficits and the role of government expenditure, as these
provide needed securities for the international financial system.
Much has been written around the de-regulatory climate and its intellectual garb which became conventional wisdom after the late seventies (for
some examples, Wray [28], Wray and Nersisyan [30], Skidelsky [24]). As
argued above, New Deal coalitions withered and private markets were left
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to their own devices. On the intellectual side, ideas that promised the selfcorrecting tendencies of financial markets and their alignment with the needs
of the real economy ruled the roost for most of these two decades. As Wray
[28] notes, at their intersection was the repeal in the United States of the
Glass-Steagal Act in 1999 (and specifically the provision that separated retail
and investment activities in banks), the Commodities Future Modernization
Act of 2000 (which excluded a number of financial instruments from regulatory oversight) and the Employee Retirement Income Security Act of 2000
(which expanded the scope of instruments that pension funds could invest
in). As Wray writes:
Some of these changes responded to innovations that had already undermined New Deal restraints, while others were apparently pushed-through by administration officials with strong ties
to financial institutions that would benefit. Whatever the case,
these changes allowed for greater leverage ratios, riskier practices,
greater opacity, less oversight and regulation, consolidation of
power in ‘too big to fail’ financial institutions that operated across
the financial services spectrum (combining commercial banking,
investment banking and insurance) and greater risk [28].
This de-regulation had clear consequences - alongside its forces came pressures to bid up the prices of capital assets. And while the 20th Century bore
witness to a slow shift from expected cash flows to the value of collateral to
gage loan viability, this pace accelerated in this new century - and against
Minsky’s ominous warning that these developments only added increasing
fragility to the economic system.
For example, this movement towards speculation is explained by Wray
and Nersisyan’s analysis of loan composition in the United States before the
crisis [30]: using data of the FDIC for the top three banks in the United
States, they find that while real estate loans remained fairly constant around
22%, small residential loans increased from 13.5% to 17.2% between 1992
and 2008 - as % of total assets. Meanwhile, commercial and industrial loans
decreased from 21.6% to 10.3% for the same period. These figures show the
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marked shift towards a financial system geared towards asset appreciation
(and speculation), not investment.
Meanwhile, the shadow financial sector experienced spectacular growth in
the same period, as recognized by Claessens, Pozsar, Ratnovski and Singh [5].
The need for safe dollar assets and low interest rates allowed for experimentation in securitization via off-balance-sheet intermediation. As dealers and
banks received cash from institutional investors (and especially MMMFs),
they loaned these funds to SPVs, who in turn packaged different types of
securities into tranches, set apart by their combination of safe and riskier
assets. In turn, these SPVs (held by these investment banks and dealers
off their balance sheets given favorable regulatory treatment with respect to
bankruptcy proceedings and taxes) became a source of profits and revenue, as
they packaged securities served as collateral in their dealings with MMMFs
and other institutional investors.
During the financial crisis, especially after the Lehman shock in September 2008, there was a run on these packaged assets: they quickly lost their
value given precarious fundamentals. The first indication of a problem occurred in the repo market tying banks to MMMFs and other institutional
investors. As asset value quickly drained away from banks’ balance sheets,
haircuts on repos increased. As Gorton and Metrick [9] recognized “depositors [namely MMMFs] in repo transactions with banks feared that the banks
might fail and they would have to sell the collateral in the market to recover
their money, possibly at a loss given that so much collateral was being sold
at once.” As haircuts increased, banks had to finance larger amounts of their
normal cash operations by other means, which hiked borrowing rates.
MMMFs were also hit directly, as investors cashed their shares given the
turmoil around the valuation of what was once regarded as quality debt.
The forced liquidation of their assets put downward pressure on the value of
these holdings - for one, there was a run out of private debt MMMFs into
sovereign debt MMMFs, until the temporary guarantee program on MMMFs
sponsored by the government stopped the ebb of funds.
The above panic is in curious contrast to what happened during the debt
ceiling crisis of April-July 2011 when Congress refused to approve the Trea13
sury’s request to issue more debt to meet projected fiscal obligations; then
MMMFs suffered a different type of blowback. As argued by Krishnan, Martin and Sarkar [15], the crisis affected private debt prime funds (which invest
in commercial paper, certificates of deposit and repos) earlier and to a greater
extent than sovereign, non-prime funds, which only saw sharp outflows after
mid-July, when the situation turned critical for the leading banks and financial institutions - not so long after they sent a strongly worded warning to the
political leadership in Washington. The authors argue that the outflow effect
was not as stark given the simultaneity of this crisis with an ever-worsening
European situation.
Given the above contexts, with regards to MMMFs, we can distinguish
the operation of two mechanisms at work within the shadow financial sector,
one financial and another political. As intermediaries, shadow banks react to
systemic economic conditions which affect their financial counterparts - that
happened during the 2008 crisis in their dealings with brokers and banks.
However, as asset managers (especially of sovereign debt), they must also
react to political calculations which affect the price of that debt. If the
United States had (willingly) defaulted on its debt, it would have opened
a downward price spiral, increasing the costs of borrowing and forcing the
government to stop many of its activities. This would have undoubtedly
created massive political unrest. Under these constraints, how is then the
value of this government debt determined in capital markets?
Indeed, the debt ceiling debates did not happen in a vacuum: the hardline
push of house Republicans in denying the request of the Treasury happened
amidst debates of how much government spending was adequate in the aftermath of the 2008 crash to help stimulate the economy. For one, Republicans
(and some moderate Democrats) argued that government spending failed to
jumpstart economic activity, and only raised costs for businesses. Democrats,
in turn, argued that President Obama’s stimulus project (or the American
Recovery and Reinvestment Act of 2009) was not enough, and more spending was needed in critical sectors. Indeed, almost immediately after the 2011
debt ceiling crisis, the Obama Administration proposed the American Jobs
Act, but in its aftermath, garnered little support - especially with the politi14
cal fallout of the Standard and Poor’s downgrade that took place soon after
the debt ceiling crisis was resolved. For this reason, any view which links
sovereign debt and financial markets must also include perspectives on what
interests and political tensions lie behind debt and deficits.
At a theoretical level, the political economy of government debt and
deficits features in treatments by both mainstream and heterodox commentators. With regards to the mainstream, Buchanan and Wagner’s classic
work [4] posited deficit illusion of voters, who seek the benefits of government spending but do not wish to pay for these goods via higher taxes or
inflation. Moreover, Persson and Svensson [22], Alesina and Tabellini [2] and
Tabellini and Alessina [27] argue that high debt burdens can tie the hands
of successor governments who inherit a constrained fiscal space for spending,
and this may lead to overindulge debt beyond ’optimal’ levels.
A more sophisticated version of this argument appears in a paper by
Aghion and Bolton [1] where the authors contend that left-leaning governments will increase debt levels to finance public expenditures geared to their
own constituencies - especially if they harbor certainty in that their opponents will win the next election. On the other hand, conservative-leaning
politicians will favor debt reduction regardless, this to minimize the probability of decreasing the value of savings apportioned by their better-off constituents (assumed to be held in bonds). If default is deemed as an strategic
decision by either party, leftists will be perceived more likely to default than
conservatives. With this in mind, conservatives will issue more debt to create the perception of debt unsustainability and influence election outcomes
to their advantage.
Finally, a less realist view of debt and deficits is picked up by later authors from Rogoff’s seminal paper on political budget cycles [23]. For Rogoff,
deficits are a byproduct of a government’s competence in efficiently delivering
public goods with existing tax resources. Very much like the above authors,
Rogoff assumes that voters will be myopic in their assessment of public consumption goods with respect to investment goods. Yet, Rogoff assumes that
competent policymakers will deliver these goods without the added burden of
deficits (and hence, tax increases over the same period). Over the long-run,
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voters will favor high competency incumbents who deliver a higher level of
public good provision and investment, rather than untested challengers or
outright incompetent politicians.
The limitations of the above models are obvious: with respect to Rogoff’s
work and its extensions, deficits can hardly be construed as a competency
problem. Politicians enact spending policies to cater for votes, and doing so is
their core competency in a democratic political system. With respect to the
rest of the models, while they rightly recognize the strategic use of debt and
deficits (and voters myopia in its assessment), these documents generally are
critical of expansionary activity to sustainably stabilize economic activity.
More importantly, their use of normal distributions to describe a median
income and an median voter does not capture how the functional distribution
of income and the endogenous political forces behind their determination
can change the direction, priorities and overall effectiveness of government
spending.
This critique is developed by heterodox writers. Espoused forcefully by
Michal Kalecki in his famous 1943 paper and in his writings about public
finance, this alternative view proposes a different take on the drivers and
sustainability of deficits and debt. In his political cycle model, Kalecki [11]
thought that government expenditures, at least initially, were knowingly beneficial to both to workers and businesses. Spending would jumpstart effective
demand, accumulation and growth, and in doing so increase wages and profits. The conflict between businesses and workers later on the cycle would
be political in nature. For one, higher deficits led to tighter wage markets
and increased worker bargaining power, which decreased worker discipline.
Also, it shifted the locus of expectations from the private to the public sector, and in doing so, relinquished a powerful tool at their reach to determine
economic activity. For this reason, as political tolerance waned, businesses
would object to full employment policies and promote austerity to regain the
upper hand.
Kalecki does not share the mainstream’s critique of deficit spending. For
him, an increase in government deficit has no adverse effect on output objections to deficits are political, not economic, positions. He recognized
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that state borrowing does compete with private interests for loanable funds,
but Kalecki argued that as the state pays to individuals, that money returns
to the banks in the form of deposits. Interest rate stability would depend
not on budget policy, but “on proper banking” action:
The interest rate will tend to rise if the public do not absorb the
government securities, by the sale of which the deficit is financed,
but prefer to invest their savings in bank deposits. And if the
banks, lacking sufficient cash basis (notes and accounts in the
central bank), do not expand their deposits and do not buy government securities instead of the public doing so, then the rate of
interest must rise sufficiently to induce the public to invest their
savings in government securities. If, however, the central bank
expands the cash basis of the private banks to enable them to expand their deposits sufficiently while maintaining the prescribed
cash ratio, no tendency for a rise in the rate of interest will appear
[13].
Kalecki subscribed to the functional finance argument proposed by Abba
Lerner [16], whereas government deficit management should achieve a public
purpose - in stark contrast to the sound finance narrative that proposed to
keep budgets balanced. As Lerner himself suggested, if the domestic interest
rate is too high, then government had to provide bank reserves to lower it,
as Kalecki argued in the quote above. As Wray [29] writes:
If government issues too many bonds, it has by the same token
issued too few reserves and cash. The solution is for the treasury
and central bank to stop selling bonds, and indeed, for the central
bank to engage in open market purchases (buying treasuries by
crediting the selling banks with reserves). That will allow the
overnight rate to fall as banks obtain more reserves and the public
gets more cash.
However, Wray goes further:
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Essentially, [Lerner] says that government ought to let banks,
households and firms achieve the portfolio balance between “money”
(reserves and cash) and bonds desired. It follows that government
bond sales are not really a “borrowing” operation required to let
the government deficit spend. Rather, bond sales are really a part
of monetary policy, designed to help the central bank to hit its
interest-rate target. (The emphasis is ours).
On that last point, Wray is undoubtedly right to recognize that bond
sales are also an instrument of monetary policy, and not a mere recourse to
deficit finance. However, this dual nature of government action is a source of
political friction within social groups in a polity. While there is an interesting
debate around the fiscal space enjoyed by sovereigns who issue debt on their
own currency (as noted by scholars who subscribe to what is commonly
known as Modern Monetary Theory, or MMT for short), we must underscore,
like MMT theorists, that these sovereign privileges assume institutional and
political trappings. While close financial substitutes, crediting bank reserves
and bond issues may serve different political constituencies with conflicting
attitudes towards government action undertaken by either the Treasury, the
Central Bank or both. All the above may ultimately lead to differential
results in interest rate management and/or stabilization policy.
Furthermore, the characteristics of the security offered itself frames the
market in which is traded. For example, participants in the primary market
for debt in the United States have intimate dealings with the Treasury (and
must subscribe to a set of prerequisites to that purpose, see Dupont and
Sack [6]for an overview). Meanwhile, participants in secondary markets engage in over-the-counter transactions across the global dollar market under
the welter of intervention by the Federal Reserve. With respect to the dollar,
primary and secondary markets are deep, broad and liquid - despite the difference in sizes (the primary market gathers a mere two thousand registered
participants, of which a select few are the most active dealers).
But other countries are not so lucky: In the United States, political considerations around debt are rendered moot by the exceptional privilege of the
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dollar as gatekeeper of the world market. But for marketable debt securities
auctioned by other polities, primary market auctions may serve urgent and
very concrete political aims: if a government needs to spend its way to keep
power amidst fractious politics, recruiting primary auction participants may
prove to be a slow, protracted affair, especially if international market participants understand the underlying reason and directly ask for higher yields
(as political appeasement involves a degree of unpredictability well beyond
some of the most speculative profit-making opportunities). Derivatively, this
will come next to less spending, as higher debt yields slam the brake on the
more ambitious plans for social appeasement.
Under these constraints, instead of waiting (and restraining spending as
markets weight the political uses of these debts to generate employment,
inflation and/or growth, or a combination of the three), a government under political pressure buys time when it nudges a compliant Central Bank
to finance these deficits at the best available price but at the cost of possibly generating inflation over the longer term. If markets are able to test a
government’s willingness (and the people’s tolerance) to resort to inflation,
itself a politically costly endeavor, it may exact a heavy price on government
borrowing.
Finally, there is the issue of who owns this debt and to what purpose.
For one, debt assets held by Central Banks become cash liabilities issued
under its authority. This cash becomes sources of funds for those eager to
spend. However, what if the debt asset also deals as a deposit of value for
other social groups? Given their dual function, who owns these assets and
to what purpose will cause friction and conflict. Keynes himself [14] argued
along similar lines when he wrote:
A poor community will be prone to consume by far the greater
part of its output, so that a very modest measure of investment
will be sufficient to provide full employment; whereas a wealthy
community will have to discover much ampler opportunities for
investment if the saving propensities of its wealthier members are
to be compatible with the employment of its poorer members.
19
In the quote above, Keynes took a strange supply-side view. To keep
employment humming along in a wealthy country, he stated that scientific
discoveries provide for available investment opportunities if saving behavior
remains unaltered. Yet, this supply-side view encounters difficult hurdles
to bypass as societies cannot rely on the goodwill of innovation to provide
needed impetus for investment.
Later in the “General Theory...”, Keynes argued that fiscal policy, pursued as to reduce economic inequality, would increase the propensity to consume in a society. Surprisingly, Keynes never went the extra mile in that
book to posit why such a policy, centered around who ultimately leads government fiscal action, would prompt a political showdown between wealthier
savers and poorer consumers, all which would make this compatibility hard
to achieve (although two years later, Keynes did refer with this issue in an
open letter to President Roosevelt). At the core of this conflict is a simple
fact: debt capital assets act as collateral for the wealth of a number of rentiers, who use these assets as guarantee (and trampoline) to higher returns in
other interest-bearing activities, which are themselves not solely determined
by prospective cash flows out of investment opportunities in innovation and
the like, but in the circulation of profits. To these stylized facts we turn next.
20
3
Stylized facts.
As departure point for the stylized facts in our model, we use Mehrling,
Pozsar, Sweeney and Neilson’s [19] analytical approach. Their model abstracts from traditional banking to devise a bare construction “in which
shadow banking is the only system”. Given the centrality of the MMMFs,
we propose a simpler version of their approach, where MMMFs take the role
of the shadow banking sector. However, our vantage point incorporates the
political economy not only of financial intermediaries (where MMMFs act
directly between businesses and government), but of firms, government and
workers.
Government
Money Market Funds (MMFs)
taxes treasuries treasuries
shares
ΩG
ΩM M F
Firms
shares capital
profits
Table 1: Balance sheets for the government, money market (mutual) funds
(or MMFs for short, we drop an M for convenience) and businesses (ΩG
represents the net worth of the government, ΩM M F is the net worth of money
market funds.)
The first balance sheet included in Table 1 above is the government’s
account at the Treasury. While taxes are not the sole source of revenue for
a government, we assume that the Treasury will hold a positive net worth
ΩG regardless of the amount of debt outstanding - this net worth is not a
mere economic residual, but an institutional balancing factor, determined by
political governance and decision structures. 1
1
Many countries around the world keep a legal and political backstop to their financial
obligations: Perhaps the most famous is the 14th Amendment (Section 4) of the United
States Constitution which reads that the “validity of the public debt of the United States,
authorized by law, including debts incurred for payment of pensions and bounties for
services in suppressing insurrection or rebellion, shall not be questioned”. During the
debt-ceiling debate this clause was raised as final recourse if an agreement was not reached,
although no explicit strategy was articulated with regards to how did this “unquestioning
acceptance” could be enforced. On that count, the Supreme Court did rule on a case
(Perry v. United States, 1935) that “[i]n authorizing the Congress to borrow money, the
Constitution empowers the Congress to fix the amount to be borrowed and the terms of
payment. By virtue of the power to borrow money ’on the credit of the United States,’ the
21
Next, we have MMFs which keep government debt as assets and issue
“shares” (or “deposits”, as Mehrling, Pozsar, Sweeney and Neilson would
put it) to investors - the residual is the MMFs net worth ΩM M F . Finally,
firms accumulate profits and save MMF shares as assets to finance capital
investment. As standard Kaleckian models, we assume that businesses earn
what they spend, so their net worth is zero by construction.
In Mehrling, Pozsar, Sweeney and Neilson’s construction, prices are set by
dealers who quote in two-side market. There are two types of dealers, those
who keep matched books (or whose long positions are completely offset by
their short positions) and those who do not. Unlike the first, who do not
supply market liquidity at all, those who do not keep matched books engage
in constant price revaluations that require a quick sense of how much liquidity
is needed by the market - this involves a degree of risk.
Unlike their model, prices in our stylized system (concretely, yields on
private and government securities and returns on assets) are a byproduct
of political conflict between profits and wages. In this sense, MMFs try to
keep matched book positions but the value of these investments is affected
by class dynamics. Government securities pay a yield on shadow banking
sector holdings, as higher yields on debt securities held by the central bank
will not turn into a direct, payable expense. This yield is given by function
set according to a privately held debt to GDP ratio.
This debt premium is not rationalized as a function of debt levels (and
a possible default), but on the bargaining power of private markets over
the government’s prospects of using debt resources to fulfill political ends
in political stabilization. As governments spend more, private markets will
demand an ever higher premium if the government is hesitant to pursue the
monetization of its debt (and inflation) beyond currency needs, given the
political costs involved, especially if workers’ income is constrained.
Congress is authorized to pledge that credit as an assurance of payment as stipulated, as
the highest assurance the government can give, its plighted faith. To say that the Congress
may withdraw or ignore that pledge is to assume that the Constitution contemplates a
vain promise; a pledge having no other sanction than the pleasure and convenience of the
pledgor. This Court has given no sanction to such a conception of the obligations of our
government (the emphasis is ours).
22
Figure 1: Quarterly series of after-tax corporate profits (with inventory valuation and capital consumption adjustment) as share of real Gross Domestic
Product (blue line) and change (in percent) of assets of MMF (2000-2013).
Source: Federal Reserve of St. Louis http://research.stlouisfed.org/.
Meanwhile, returns on deposits loaned to the shadow banking sector can
be best understood as a function of the overall profits - this is seen in Figure
1 above. More profits in the economy will push up the value of most assets
in an economy, and hence lure investors into shadow financial assets for a
quick return - indeed, the change in assets in MMFs tracks loosely after-tax
corporate profits. As Minsky explained, in money manager capitalism the
“total return on the portfolio is the only criteria used for judging the performance of [...] managers of these funds, which translates into an emphasis
upon the bottom line in the management of business organizations” [20] namely, profits.
Their operation adds further complexity to distributive dynamics: as
Kalecki explained [11, 12], higher profits do not translate into more output
if demand stagnates. Moreover, the reaction of financial intermediaries, also
trapped in the tug-of-war dynamics of distribution, is not as clear-cut, given
their indirect linkages to both parties. They keep stakes both in using government debt as collateral (and in doing so, allow for increasing government
expenditures) but also benefit from higher profits.
This story can be seen in Figure 2 below with respect to the United States,
23
which plots gross corporate profits (red line, as share of real output) and
FIRE (Finance, Insurance and Real Estate, for short - in blue) value added
as share of total gross corporate value added. For the two immediate decades
after the war, both series remained stable in their respective contributions.
In the late sixties both series took off, and rose together until the dot-com
bust and the 2008 crisis slowed the contribution of FIRE to the total, when
many institutions were rescued by government-issued collateral. However, as
the last few quarters show, both profits and FIRE value added series have
resumed their upward climb. One can argue that the fate of the financial
sector, although not exclusively reliant on the fate of corporate profits, feels
its warm embrace.
Figure 2: Quarterly series of gross corporate profits as share of real Gross
Domestic Product (red line) and FIRE (Finance, Insurance and Real Estate) value added as share of total corporate gross value added (1947-2013).
Source: Federal Reserve of St. Louis http://research.stlouisfed.org/.
This leads us to the role of government policy. As deficit expenditures
push up employment and demand, increased worker bargaining power and
employment wanes the political tolerance of firms. For this reason, the government is trapped in a political cycle that oscillates between the narratives
of sound and functional finance, as politicians play a delicate balancing act
between the economic clout of businesses and financiers, and the majoritarian
24
political clout of workers.
Workers and businesses demand stabilization up to a given threshold,
when their interests diverge. As the economy slows down again, their interests align anew. Additionally, the interests behind government expenditures
do not unwind solely around the needs of stabilization, but on the government’s capacity to provide “safe” assets as collateral for the shadow financial
sector via the issue of debt. This adds a wrinkle to the standard Kaleckian
cycle, as wealthy savers will be torn on how to seek government collateral
while keeping a lid on government expenditures.
This careful balancing act does sum up recent political debates regarding
austerity and spending. Democratic capitalist polities with responsive governance structures with respect to worker and business interests are caught in
a debate on who to bailout around a political zero-sum game. Government
stabilization is paid mainly by borrowing (and not through higher taxes) to
avoid disgruntling political constituencies that differ in reach and scope although what can be taxed without fear of effective political repercussion
can differ considerably from place to place. As government borrows it finds
willing lenders amongst financial intermediaries, who then complain that this
borrowing will nudge politicians to continue spending and increase the clout
of workers over firms - without a doubt, it is Kalecki’s political business cycle,
but with a twist.
However, there were more recent warnings: Economists like Wynne Godley [8], struck similar tones many years ago, and more recently, George Soros
[25] argued similarly. As Thomas Palley presciently wrote in 1997 with respect to Europe:
Financial capital may still be able to discipline governments through
the bond market. Thus, if financial capital dislikes the stance
of national fiscal policy, there could be a sell-off of government
bonds [...] This would drive up the cost of government borrowing,
thereby putting a break on fiscal policy. Furthermore, there are
problems in talking about [the European Monetary Union] and
the national economic interest. This is because economies are
25
constituted by different groups which have different interests, and
policies that benefit one group may harm another. This consideration applies forcefully to the issue of EMU, since its institutional
design may advantage capital over labor or vice-versa” [21] (the
emphasis is added).
The conflicting interests of stabilization to directly prop the wages of
workers, and indirectly, via the needs of financial intermediaries, to require
government securities as collateral raises the question of who manages government policy and to what purpose. Under these constraints, the government
cannot be everything to everyone - it is either geared to those who want to expand spending to support wage income directly, those who wish to restrain it
to prop the clout of profits or those who need it to keep the financial system
operating under increasingly strained political circumstances. Indeed, this
complex matter is at the heart of the political economy of modern shadow
banking.
Despite these complications, we strive to keep the nuts-and-bolts of our
model as simple as possible. We shy away from international and exchange
rate dynamics to focus in the political dynamics between workers, financial
firms and businesses. At its barest construction, it could well apply to a
large, capitalist democratic economy like the United States, whose sheer size
puts it at the epicenter of the worldwide dollar-based system. The simplified transaction flow matrix in Table 2 further below explains how stocks of
assets and flows of income are distributed across different actors (workers,
businesses, MMFs and government - divided further into a Treasury and a
Central Bank) - to this we turn next.
26
4
The theoretical model.
We present a closed economy model over the short-medium term where workers, businesses and government interact in the real sector, and businesses and
government transact through a “shadow financial sector” (modeled specifically after a money market fund) which settles financial claims between the
latter two groups. All the relationships explained in this section are presented
in the social-accounting matrix included further below.
Workers consume their after tax wages. Firms invest their profits and
save the rest to buy equity stakes in a money market fund. They accumulate
after-tax profits and buy shares of these funds swayed by the equity returns
on these assets - their investment is endogenously determined as a residual
between their earnings and their spending in MMF shares.
Government is financed via taxes on consumption and issues short-term
treasury bills to make up the difference in spending, its expenditures are set
via a countercyclical policy rule that checks wage earner clout in the economy. A central bank provides cash for workers and firm spending, and buys
government debt as an asset. Finally, the central bank follows an interest rate
stability rule, whereas bonds are bought to credit cash reserves to facilitate
consumption and investment.
The shadow financial sector churns business equity investment into asset purchases of government debt. They pay an equity return to business
investors, itself a function of the overall profit share in the economy - if aggregate profit shares are high, these will push up money market returns and
increase demand of MMF equity.
Aggregate demand: National output Y equals worker consumption Cw ,
capitalist consumption Cπ investment expenditures I and government spending G:
Y = Cw + I + G
We deal with each of these demand components in turn:
27
(1)
Workers: Workers consume their after-tax wages:
Cw = (1 − τ )ψY
(2)
Where τ is the tax rate, and ψY is the wage share of output.
Firms: Investment expenditures are a residual between after-tax profits
earned by firms, interest income of their holdings of financial equity iS and
purchases of financial equity Ṡ.
I = (1 − τ )(1 − ψ)Y + iS − Ṡ
(3)
The change in the holdings of financial equity Ṡ is a function f of the
return on assets of the economy i and of investor confidence in the stability
of the money market sector (as represented by ). :
Ṡ = f (i+ , )
(4)
The return of assets i is itself a positive function h of overall (aftertax) profit levels (1 − τ )(1 − ψ)Y - we posit that higher profits accrue to
the valorization of assets across the economy (as wages are consumed by
workers):
i = h[(1 − τ )(1 − ψ)Y + ]
(5)
The Treasury: Government spending G is a negative function g of G0 ,
a jump variable which is positive if a fiscally active government is in power
(and 0 if otherwise), the wage share ψ and the yield on government debt r:
G = g(G0 , ψ − , r− )
(6)
The yield on government debt r is a positive function j of the government’s holding of private debt:
r=j
DM M F
Y
28
(7)
Where ḊM M F is government debt held in money market funds (MMF).
As argued above, if the government issues short-term debt to finance its
deficit, and firms recognize the political perils of debt monetization, their
stronger bargaining power will force out higher yields of government debt.
This leads to the government’s net deficit position with respect to private
investors as the main driver of the government’s overall deficit:
ḊM M F = G − τ Y + rDM M F
(8)
Where τ Y is effective tax rate of output (as profits and wages are taxed
equally). The last term is the debt payable to private investors, as the public
sector as a whole does not pay interest on its overall debt, but only on the
debt held by the private sector - in our model, money market funds.
The Central Bank: The Central Bank buys government debt to issue
currency. With this in mind:
Ḣ = ḊCB
(9)
Where Ḣ is the supply of cash liabilities issued by the Central Bank and
ḊCB is Central Bank lending to the government. The total supply of cash
to workers and firms is:
Ḣ = Ḣw + Ḣπ
(10)
At each point in time, the Central Bank facilitates consumption and
investment spending by workers and firms respectively - hence:
Ḣw = CW = (1 − τ )ψY
(11)
Ḣπ = I = (1 − τ )(1 − ψ)Y + iS − Ṡ
(12)
The above policy undertaken by the Central Bank (with cooperation of
the Treasury) seeks to keep interest rates stable at r0 via function w by
adjusting currency needs and bond issues to that purpose:
29
r0 = w(Ḋ − ḊCB + Ḣ) = w(ḊM M F + Ḣ)
(13)
Money Market Funds: Our shadow banks, the MMFs, issue equity shares
and buy government debt as collateral for their interest generating operations. MMFs accrue interest income to firm’s asset holdings. As dealers of
the system, they price both firms’ savings and the value of government treasuries used as collateral - this will be further explained when we close the
dynamical section in the last paragraphs of this section.
The multiplier: Using equations (2)-(7) above and replacing to solve for
the multiplier in (1), we get:
Y∗ =
G − Ṡ
1 − (1 − τ )[ψ + (1 − ψ)] − h[(1 − τ )(1 − ψ)Y ]S
!
(14)
Employment and labor markets:
With regards to the labor market
and wage dynamics, the labor force N is assumed to be constant over the
short-run:
N = N̄
(15)
The change in employment Ė is a function x of the gap between actual
output Y and potential output Ȳ 2 and a negative function of exogenous
labor productivity.
Y+ −
Ė = x
, ξL
Ȳ
!
(16)
Based on the above, the change in the employment rate L is:
L̇ =
Ė
=
N̄
p
2
Y+ −
, ξL
Ȳ
N̄
(17)
While we could make potential output Ȳ a function of investment, we keep it constant
- at this time, we are only interested only in short to medium-run dynamics.
30
The change in the wage share of the economy is a positive function z of the
employment rate and a negative function of η, a parameter that gauges the
clout and push-back of capitalists in their bargaining against wage increases:
ψ̇ = z(L+ , η − )
(18)
The dynamical system: Our dynamical model is described by equations
(4), (8), (17) and (18). However, for equation (8) we consolidate the public
sector accounting of the Treasury and the Central Bank. For this we use the
inverse equation (13) and assume no central bank profits, therefore:
ḊM M F = G − τ Y + rDM M F − Ḣ − w−1 (r0 )
(19)
Where w−1 (r0 ) is the inverse function of equation (13). However, as cash
serves the purposes of consumption of workers and investment by firms, we
replace Ḣ with equations (11) and (12):
ḊM M F = G − τ Y + rDM M F − (1 − τ )ψY − I − w−1 (r0 )
(20)
Where w−1 (r0 ) is the inverse function of (13). To sum up, the four state
equations for the system are:
ḊM M F = G − τ Y ∗ + rDM M F − (1 − τ )ψY ∗ − I − w−1 (r0 )
Ṡ = f (i, )
∗
Y
x Ȳ , ξL
L̇ =
N̄
ψ̇ = z(L, η)
Where Y ∗ =
(21)
(22)
(23)
(24)
G−Ṡ
1−(1−τ )[ψ+(1−ψ)]−h[(1−τ )(1−ψ)Y ]S
g(G0 , ψ, r), r = j DMYM F and i =
, I = (1 − τ )(1 − ψ)Y +
iS − Ṡ, G =
h[(1 − τ )(1 − ψ)Y ]. In the
next section we proceed to simulate and analyze a linear (where possible)
specification of this dynamical system.
31
Output Costs
Output Uses
Incomes
Wages
Profits
Government
Interest
W
Π
τY
Business
I
Public Sector
Treasury Central Bank
G
Money Market Funds
iS
τW
−rDM M F
τΠ
rDM M F
32
Flow of Funds
Financial Equity
Government Debt
Cash
Total
Workers
CW
−Ṡ
−ḊCB
Ḣ
Ḋ
Y
−ḢW
−ḢΠ
ΩW
ΩΠ
ΩG
Ṡ
−ḊM M F
Total
Y
ΩW
ΩΠ
ΩG
ΩM M F
0
0
0
ΩM M F
Table 2: Social Accounting Matrix (SAM) for our model economy. CW stands for worker consumption expenditures,
I for business investment, G for government expenditures. W is the total wage bill, and Π total profits. τ W is the
tax bill out of wages (where τ is the effective tax rate on consumption), τ Π is the tax bill out of profits and τ Y is the
tax bill out of total output. rDM M F is the the yield on government debt. iS is the interest-bearing money market
fund (MMF) assets held by firms. ΩW workers’ net worth (which is assumed zero), ΩΠ the firms’ net worth (which
also assumed zero by construction), ΩG is the government’s net worth and ΩM M F is the money market funds’ net
worth. i is money market rate of interest, r are interest payments on government debt and r0 is the central bank
rate. Ḋ is the government deficit, which is financed by central bank lending ḊCB and money market funding ḊM M F .
Ṡ is the change in financial equity. Ḣ are cash liabilities supplied by the central bank for worker consumption ḢW
and investment ḢΠ
.
5
Simulation and analyses
5.1
Specification for simulations and calibration
The concrete specification of the simulation dynamics is:
ḊM M F
DM M F
DM M F
∗
− τ Y + δ3
DM M F
= G0 − δ1 ψ − δ2 δ3
Y∗
Y∗
∗
∗
∗
− (1 − τ )ψY − (1 − τ )(1 − ψ)Y + δ4 (1 − τ )(1 − ψ)SY − Ṡ + δ5
Ṡ = δ4 (1 − τ )(1 − ψ)Y ∗ − ∗
δ6 YȲ − ξL
L̇ =
N̄
ψ̇ = δ7 L − η
Y∗ =
G − Ṡ
1 − (1 − τ )[ψ + (1 − ψ)] − δ4 (1 − τ )(1 − ψ)S
!
We calibrate the above specification with the following values G0 =
L
= 0.0175, η = 0.3125, r0 = 0.08 and parameters
1.25, τ = 0.35, = 0.005, Xi
N
6
= 0.005, δ7 = 0.325.
δ1 = 0.825, δ2 = 1, δ3 = 0.25, δ4 = 0.004, δ5 = 0.02, ȲδN
For our initial conditions we use DM M F (0) = 0, S(0) = 1, L(0) = 1 and
ψ(0) = 0.70.
33
1
r0
5.2
Baseline simulation
Figure 3: (Starting in the top-left panel, in clockwise fashion) Simulations
for 300 time steps for debt DM M F , financial equity S, wage share ψ
and the employment ratio L; time series of ψ and S and a scatter
plot between ψ, DM M F and S. The baseline model has several interesting
features. Higher wage shares are correlated with higher deficits (or lower
negative deficits) as increased output strengthens worker clout and their redistributive demands. Wage shares act as floors and ceilings that allow and
restrain the demand of financial holdings - this is better seen in the time
series plot: high (low) profit (wage) shares accelerate the demand for MMF
assets.
34
5.3
Alternative scenarios
(as deviations from the baseline)
5.3.1
Scenario 1: An increase in the tax rate
Figure 4: (Starting in the top-left panel, left-to-right) Time series for 300
time steps for debt/primary balance DM M F and financial equity S,
profit share deviations from baseline scenario and the volatility of
privately held sovereign debt due to a 2 percentage point increase
in the tax rate.
Although counterintuitive at first, we see how a increase in the tax
rate feeds unstable dynamics to the system, especially via the increase in
financial assets in the economy, which also drive the issue of collateral by
the sovereign. The reason is hinted in the top-right panel, whereas the
profit rate increases. Indeed, the model taxes both wages and profits alike,
so any increase in taxes will differentially hurt wages more than profits,
especially if profits can be saved into financial assets, which are a leakage
of the circular flow (and are not taxed). Nonetheless, as profits increase,
volatility in private held debt (which is used as collateral) increases.
35
5.3.2
Scenario 2: Decrease in the central bank interest rate
Figure 5: (Starting in top-left panel, left-to-right) Time series for 300 time
steps for deviations from baseline in S for scenario 1 and 2, overall
volatility of financial assets and time series for 300 time steps for
deviations from baseline in the profit share for scenario 1 and 2
due to a six percentage point decrease in the central bank interest
rate. This scenario highlights another channel by which distributive conflict
takes place - the control of central bank interest policy. Whereas profits have
greater flexibility to shoulder higher tax burdens (when compared to wages,
as explained in scenario 1) given the model setup, lower interest rates take
on a different dynamic around the accumulation of financial assets (top-left
panel). This accumulation undergoes a more volatile dynamic than scenario
1 (top-right panel). In the bottom-left panel, we see that lower interest
rates, acting as a floor on asset prices, deepen the tension between profits
and wages. This conflict takes place in the private holdings of sovereign
debt: as interest rates decrease, bond prices increase and their yields, the
real interest rates, decrease. Higher bond prices and lower yields increase
the government policy space, lower the costs of political stabilization biased
to workers and facilitates debt as financial collateral. However, as both the
interest payments on this debt and worker clout increase, firms pressure the
government to pull back.
36
5.3.3
Scenario 3: Sensitivity of government to increases in wage
share (and debt yields).
Figure 6: (Starting in the top-left panel, left-to-right) Time series for 300
time steps for financial assets S and wage share deviations from
baseline scenario for a 25% reduction in δ1 , or the sensitivity of
government spending with respect to worker clout.
A dampened fall-back reaction of government action due to increased
worker clout pushes the conflict between wages and profits to the forefront,
as seen in the top-right panel. Lower profit shares decrease the demand
for financial assets as seen in the top-right - the same applies to reduced
sensitivity of government spending to increased sovereign yields.
37
6
Conclusion
This paper presented a theoretical overview of the political economy behind the development of shadow banking. Despite its ominous name, many
features of modern shadow banking are neither new or original and have
been discussed by theorists interested in their broader implications. On that
note, the most enduring of these assessments, like those offered by Marx
and Minsky noted not only how these financial institutions worked, but how
the broader, institutional characteristics of markets and governments which
nested their operation experienced dramatic changes.
Shadow banking is intimately tied to the political economy of capitalism.
The discontinuous distributive tension between wages and profits, itself an
important source of political conflict in the social fabric of capitalism, provides a rich theoretical backdrop of how these institutions survive amidst
endogenous pressures within and outside government agency. This type of
politics drives a wedge in how the shadow financial system operates next
to firms and workers, as government policy provides needed guidance and
collateral in dealings undertaken by financial intermediaries. Government
spending and borrowing is itself the result of endogenous, differential pressures between workers’ desires to push for re-distributive stabilization and
firms’ uneasiness to go to the extra mile, as demand beyond a certain point
undermines their clout.
This tug-of-war is of central importance to fully understand the role of
shadow banking in modern capitalism. As hinted by the theoretical model
and the simulations, government action is crucial to check the power of wages
despite the pressures to sway voters through increased spending. This deficit
spending serves multiple functions: for one, it appeases voters but also, provides collateral. In the end, governments will tread a careful balancing act to
minimize this tug-of-war, although biased towards smoother profit dynamics
and the accumulation (and valorization) of financial assets.
Moreover, given the flexibility of profits to quickly set up shop in the financial corners of the economy, increased taxes tend to hurt workers if these
are not nested into a comprehensive policy objective. Furthermore, the use
38
and control of central bank rates also becomes an important tool for these
shadow financial institutions, who welcome price asset floors through accommodative interest policy. However, these accelerate the political conflict
between workers and firms, as lower interest rates and increased profit shares
prompt worker push-back.
Shadow financial institutions are involved in this conflict inasmuch as
they demand government-issued collateral for their operations, and given
their demand, may ease or constrain government agency. Indeed, as most of
these revenues accrue to profits, shadow (and normal) financial institutions
keep their allegiances to firms, and help brake government action if it tests
given thresholds - but it is in their interest that government issues debt to
spur economic activity and accumulation.
While the model offers a simplified view of these political dynamics, its
insights are not lost in the context of recent United States history. For one,
we must see that serious opposition to deficits is not really about the capacity of the federal government to pay its financial obligations, or due to
an intellectual failure to communicate these ideas: it is an objection of the
government’s political role in strengthening the clout of some social groups
- Upton Sinclair said best: “It is difficult to get a man to understand something, when his salary depends on his not understanding it.”
The above dynamics allow us a better understanding of recent history,
like the (now) recurring debt ceiling showdowns and government paralysis.
For one, the best scenario for firms and finance would be that where government spends to foster capital accumulation, an episode which took place
with President Reagan’s deficits during the eighties and came with sweeping
regulatory changes that favored profits over wages. However, profit-oriented
policies sap demand and growth from the economy over the medium-term,
and prompt push-back from organized labor - while this push has been gentle at best, it cannot be underestimated. It has been a major political force
in the Obama administration, especially with the passage of the stimulus
bill, and has nudged changes in social policy and healthcare - all which have
prompted violent opposition from business groups.
Indeed, it was the (shadow and otherwise) financialization of the econ39
omy which had led to these entrenched political differences. The so-called
Greenspan put set the tone of President Clinton’s administration (and provided a floor on asset prices when the economy slid into recession) and hid
these tensions behind economic growth amidst ever increasing inequality. Indeed, that Great Moderation is now an ironic misnomer of a period which
planted the seeds of the financial fragility we are currently experiencing.
These complexities do not add up to simple solutions: for one, policies
that seek to regulate and restrain the operation of shadow financial institutions as to temper their operation and firewall their linkages to the real economy could strengthen economic fundamentals. However, these policies cannot be undertaken nationally, given the global reach and mobility of finance
and capital. Additionally, institutional reforms which rely on automatic stabilizers (like job-guarantee programs and social insurance mechanisms) over
discretionary policy might minimize the overt political conflict between firms
and workers, without denting prospects of economic growth - although these
must take into account local economic contexts.
Entrenched political impasses are not immutable or permanent: these can
be shrewdly overcome by a reform agenda that seeks to address not only the
economics but also the political economy behind these differences - it remains
to be seen if this agenda will come after a regrettable breaking point.
40
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