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ISS Special Seminar Series: Beyond Financialisation

Money and Finance: The 'Real' Determinants of Economic Development

Jan Kregel, Levy Economics Institute

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Two Hand Luke

• No One-handed Economists• Everything is dual

– Nominal - Real: Money is a veil– Productive - Unproductive: Professors are a waste– Finance - Production: Financialisation– Labour - Capital: Source of Profit – Micro - Macro: Individuals v. Aggregates– Firm - Market (Industry) – Planning - Market: Coase on non-market organisation– National - International: GNP-GDP

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Inherent {Classical} Bias

• Real is Real• Productive supports growth• Individual is better• Market is better• Micro is Foundation

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Keynes’ Paradox

• Money is “Real”• Maximise Money Profit - Share price• Marx M-C-M’• Business does not maximise

– Real Output– Employment– Sustainable environment– Gender equality

• Everything is “Finance”

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False Divisions

– Finance - Production• Money- Real• Firms Earn Profits from Finance and Production

– General Electric– General Motors

– National - International• Tradeable -- non-Tradeable• Trade is “Real”• Impact of Capital Flows

– interest arbitrage– direct investment

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Integration of Production and Finance

• Obvious: • Decline in 1970s Profitability - exchange rate• Change in Technology Paradigm

– Perez: from Mass Production to ICT– Economies of Scale to Economies of Scope

• Not So Obvious: Impact of Finance on Industry• Lazonick: Influence of the Stock Market

– No Finance from Equity Issues• “Impatient Capital” -- short term return

• Change in the Financial Structure– The decline (death?) of commercial banks

• Deregulation (Finance and Utilities)• Rise of “Managerial Capitalism” - Short-termism

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Share of Corporate Profits in GNP

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Impact of Stock Market

•Lazonick: Old to New Economy Business Model

•OEBM: What is good for General Motors is Good for America• Objective: Long-term growth and survival of firm• Career employment with one company• Stock market: separation of ownership and managerial control• Government investment in infrastructure; knowledge

•NEBM: What is good for Silicon Valley•Objective: Profitability, Shareholder value•Stock market for corporate control:

• Shares as takeover/buyout moneyCorporate Raiders, Private Equity FundsIncentive Compensation: Stock OptionsNASDAQ IPO support for venture-capital investment

• Outsourcing, globalisation of Value Chain

IPO: induces financial commitment to new firm formation by

enabling private equity holders to monetize their stakesMarket for Corporate Governance: enables separation of share

ownership from managerial controlShares as Money: Equity provides a currency for mergers and

acquisitions, thus permitting the extension of strategic control Compensation: the stock market provides a currency for

recruiting, retaining, and possibly motivating personnel, thus facilitating their organizational integration

Finance: the stock market serves as a source of financial commitment, providing a company with funds without the guarantee of a return

Five functions of the stock market in the industrial corporation

Source of Finance? NO!

Industrial corporations provide cash to the stock market, not vice versa

Source: Federal Reserve Board Flow of Fund Accounts

Components of income of top 0.1%, 1916-2008

Dominance of property income

Dominance of financial market income

Source: Saez 2010 http://elsa.berkeley.edu/~saez/

spike in salaries from stock option

gains

Rise in CEO pay depends on gains from stock options: see Lazonick, “The Explosion Executive Pay and the Erosion of American Prosperity,” Entreprises et Histoire, 57, 2010.

http://www.aflcio.org/corporatewatch/paywatch/

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Financial System Deregulation

• Glass-Steagall: Monopoly straightjacket– Protected deposit business– evaporated with financial innovation– innovations used securities markets– Commercial banks could not deal in securities

• Banks lobbied to lift their “protected” monopoly to allow them to compete for business with investment banks

• And to compete with Japanese and European Banks not limited by G-S Regulation

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Commercial Banks in Trouble

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Example: Regulation Q

• zero rate on deposits - cheap funding• Business depositors moved their

funds into Treasury bills• Commercial Banks (City) offered

negotiable certificates of deposits– primary dealers provided market making– Provided an interest earning alternative

to offer to corporate clients

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Money Market Mutual Funds

• Corporate commercial paper cheaper than short-term bank borrowing

• Mutual Funds bought short CP• Issued Constant $1 NPV “shares”• Offered an interest earning equivalent to a

commercial bank deposit• Offered lower borrowing rates to corporate

clients• Commercial banks lost both corporate loan

and retail deposit business

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Banks fight Back

• Section 20 Exemptions– Allowed limited securities dealing

• 1999 Gramm-Leach-Bliley– Commercial banks become Financial

Holding Companies– “Relationship (Tying) Loans” – IPOs and Stock Analysts– Merger Financial & Consulting Business

• The New Debt Pushers

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Deregulation of Utilities Industry

• Transportation– Airlines, Road transport

• Energy– Electric public utilities– Natural Gas– Petroleum

• Telecommunications– Break up of ATT long-distance fix line– introduction of wireless

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Impact on “Productive” Sector

• Commodity Futures Modernisation Act– Exempts Derivatives from reg– Enron loophole

• SPVs, electronic energy supply market trading

• Telecom Act 1996– long-term capacity swaps– Global Crossing, World Com

• IPO Spinning• Concentration from Deregulation for

Competition• Use of Stock Options for Compensation

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Contractual Saving

• Health and Pension Benefits• Public Incentives to Save

– 401Ks– IRAs– Private Pension Provisions

• Created the Asset Management Industry• Long Term Obligations• But Short Term Performance Benchmarks

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Rise of Alternative Investment Vehicles

• Michael Milken -- Junk Bonds• Hedge Funds

– Interest Arbitrage, Risk Arbitrage

• KKR - type Corporate Raiders• Private Equity Funds• Venture Capital Funds• Vulture Capital Funds

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Short-termism

• Value Extraction -- Private Equity• Shareholder Value• Money Manager (Shareholder) Activism• Option-based compensation• Meeting Profit targets

– Earnings Smoothing

• Emphasis on Quarterly Performance• Incentive to

– Outsourcing of production– Global Diversified Production - low costs

• Recovery of Corporate Profits• Global Diversification of Portfolios

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National v. International

• Impact of international finance on productive structure is not new!!– Keynes: The City hurt British Industry– Vargas: LatAm financed US!– Mira Wilkins: “Free Standing Companies

• British Companies List in London to Raise Capital but to Exploit opportunities in Colonies

• RTZ, BP are examples

• The Recovery in International Finance comes in the late 1990s !

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Global Finance and International Accounts

• International accounts track exchange of final goods

• Ignore the dominant role of interindustry trade and the increasing importance of trade in semifinished intermediate goods

• importance of private autonomous capital flows and their impact on factor service payments

• International accounts do not reflect change in the productive structure of the U.S. economy– geographical dispersion of production process– geographically integrated production and

supply chains.

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NEBM International Division of Labour

• Restructuring of U.S. manufacturing after the profits crisis of the 1970s– increased role of capital flows in the global economy after

the financial deregulation and collapse of Bretton Woods– Exploited opening of developing economies to trade after

the tariff reductions of Uruguay round

• Most important components of trade are no longer final goods, but trade in semifinished intermediate inputs – research and development for design-marketing of

internationally traded goods remains in the developed country headquarters of the multinational corporations

– stages of the actual production process are spread across low- wage developing economies

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False Division: National:Global

• Geographical dispersion of production distorts reported trade balances.

• If a U.S. transnational company undertakes foreign direct investment through the creation of a foreign subsidiary to produce goods it had formerly produced in the United States, the payments balance shows a capital outflow from the United States to establish the foreign subsidiary and records the imports of the goods or services produced by the foreign subsidiary.

• If the increased profits that result from the lower production costs in the foreign subsidiary of the U.S. corporation are not repatriated, they are recorded as a credit in the factor services balance with an offset entry under foreign direct investment in the capital account.

• Rather than appearing as the export of the design technology for the production of the good by the foreign subsidiary, what appears instead is the profit of the foreign affiliate of the U.S. company in the factor services account.

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Misrepresentation of Tech Trade

• U.S. corporation innovates with new production design • Transmits it via internet to a foreign-owned production facility• Imports the output produced with the new design to US• Accounts record import incorporating the design representing only the

foreign value-added—i.e low wage costs and the return to the foreign producer.

• The export of technology appears as the increased domestic profit reported by the U.S. company represented as difference between the foreign cost and the domestic selling price

• The external accounts record a deterioration and would not reflect the nonrecorded increase in the export of technology that only appears in improved earnings of the U.S. company and the increase in wealth to its shareholders.

• A deterioration of U.S. trade balance could reflect increased profitability observed for U.S. companies operating in the global market.

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International Imbalances and Crisis

• A Major Cause of Credit (mispricing) Crisis• Surplus represents excess saving in Asia • Net capital flows led to low interest rates,

search for yield and higher risk investments• Funded excessive consumer borrowing and

consumption in US• Shifts in Net flows generates instability in

money and exchange markets• Reducing Asian Saving creates stability

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Imbalances:Money or Real?• Current Account represents net transfer of real resources: Real Saving

– Impact on (real) interest rates: – S>I reduces interest rates : Classical Loanable Funds

• Keynes: Financial Balances:

• Govt balance (T-G) + Private Balance (S-I) = Foreign Balance (X-M)– An individual decides to consume or save, saving is financial or real assets. – In aggregate the portfolio decision is net zero: – increase in financial assets of savers = issue of liabilities by dissavers. – This is also true across countries: net saving has no impact on global net

financial assets.

• An increase in net financial assets requires liquidity creation• US consumers were financed by liquidity created by US and European

banks. Their imports produced net surpluses which were allocated to US financial assets.

• Financial conditions determined by liquidity creation: Gross Flows

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Who Funded US Consumer Spending?

Lending to US Residents by Non-US Banks By Residencetrillions of $US

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Who Funded US Consumer Spending? Where is Asia?Lending to US Residents by Non-US Banks by Bank Nationalitytrillions of $US

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Gross Global Flows and Developing Countries

• Impact of FDI on production• Impact of Gross Flows on domestic

monetary conditions; Exchange Rates– Increased Reserves due to Sterilisation,

control of exchange rate

• New Kind of Dutch Disease• QE does not fund flows, portfolio

reallocation does

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Conclusions

• Money rate rules the roost• Money determines real• Money determines real production

structure of the economy• National Accounts are misleading• Global Accounting needs new approach• Lack of Liquidity Control not Imbalances

proximate cause of crisis

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Thank You

www.levyinstitute.org