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Finance and Growth under Neo-liberalism

Prabhat Patnaik (prabhatptnk@yahoo.co.in) is professor emeritus at the Centre for Economic Studies and Planning, Jawaharlal Nehru University, New Delhi.

The monetary policy of a neo-liberal state can only ease the availability of finance for the capitalists by deliberately inducing economic agents to underestimate risk. A continuous easing of the capitalists’ budget constraint in this manner makes the financial system fragile, such that economic booms are merely bubbles, while financial crashes, when they occur, are more devastating than ever.

An earlier version of this article was delivered as the Vineet Kohli Memorial Lecture at the Tata Institute of Social Sciences, Mumbai, on 11 February 2019.

 

The post-World War II years had seen systematic intervention by the state to stabilise capitalist eco­nomies. In fact, state intervention had played the same role in that period that incursions into colonial and semi-colonial markets had played over much of the 19th century, right until World War I. This role consisted in ensuring that one component of aggregate ­demand, whether exports to such markets or the state ­exp­enditure, kept growing even when there was a downswing in the level of activity in the capitalist economy. One component of aggregate demand—which det­ermined the level of activity, but was ­independent of the ­level of ­activity—constituted what one may call an “exogenous stimulus” and prevented the ­system from settling down at a ­stationary state or a state of simple rep­roduction where it would otherwise have converged.1

The post-war state intervention did not just stabilise capitalism in the sense of providing an exogenous stimulus for growth, it also ensured that the system functioned at a level of activity that was close to “full employment.” The state took active countercyclical measures by stepped up its expenditure (or enacted tax cuts) whenever the economy started slipping into a recession, and thereby prevented any serious downturn. The maintenance of a high level of activity encouraged private investment, caused a high rate of growth of the gross domestic product (GDP) and hence a high rate of labour productivity growth. The latter, because of the high employment rate that strengthened the bargaining power of the workers, also led to an impressive rate of growth of real wages. Not surprisingly the period of the 1950s, 1960s and the early 1970s has been called the “golden age of capitalism.”

The period of neo-liberal policies beg­inning in the 1970s, however, corresponds to the hegemony of globalised ­finance. It has evidenced the state withdrawing from this role. This is because finance capital is opposed both to fiscal deficits and to taxes upon capitalists; and, when globalised finance faces the nation state its writ must run (to prevent large-scale financial outflows). Hence, when the economy slips into a recession, the state expenditures, meant to counter such a recession, cannot be increased to prevent such a fall in the level of activity.

‘Stabilising’ Instruments of Neo-liberalism

A neo-liberal capitalist economy therefore does not have the instruments that capitalism earlier had for providing a bulwark against its slipping into recession and stagnation. The moot question here is: Does it have any instruments at all? This is but another way of asking: are there any components of aggregate demand in a neo-liberal economy which constitute “exogenous stimuli,” in the way that incursions into colonial markets or state expenditure, whether fina­nced by a fiscal deficit or a balanced budget (but necessarily entailing in the latter case taxes on capitalists), had been?

The immediate answer to this question would be that “innovations” under capitalism always constitute such exogenous stimuli and neo-liberal capitalism is not bereft of these. They prevent the economy’s settling into a stationary state and keep its growth rate positive. But this is not a persuasive answer since it has been theoretically argued that innovations, however, are not really exogenous stimuli—they only affect the “form” but not the “amount” of investment, which is what matters for aggregate demand (Steindl 1976). And economic historians have pointed out how innovations remained unused during the Great Depression of the 1930s bec­ause of the depressed state of demand (Lewis 1979), rather than causing a revi­val from the depression.

A more pertinent answer is that even though state expenditure no longer plays the role of stabilising the capitalist economy—with most countries now bound by legislation to keep fiscal deficits to within 3% of GDP, and even the United States (US), despite no legislative bound, also keeping its fiscal deficit in check—state intervention does not cease to exist. It operates instead through “monetary policy,” influencing not just private expenditure decisions but also developments in the world of finance. The fact that monetary policy ought to play this role was emphasised by Keynes. Against the argument of another Cambridge economist Dennis Robertson who had suggested that to prevent sharp ­recessions the boom itself must be kept restricted by increasing the interest rate when it really got going, Keynes (1946) had remarked that such a policy would keep the economy in a permanent state of quasi-stagnation. Instead he had suggested that whenever the economy tended to slacken in its performance, the inte­rest rate should be lowered and the recession prevented by aiming at a high level of activity and employment, though he was not very confident about the efficacy of interest rate policy.

The interest rate however is not the only instrument that the state can use or has been using. At least in the neo-liberal era, it has also been using—though in a less obvious manner—the instrument of “socialising capitalists’ risks,” that is, of distributing risks, which would normally have been taken by capitalists, among a wider segment of society that itself is generally unaware of bearing such risks.

Risk Distribution and Investments

Let us first get some preliminaries out of the way. Risks arise because the expected rate of return from any act of investment is not certain. There is a probability distribution around the “best guess,” or the mean expected rate of return, and the standard deviation of this probability distribution can be taken as a measure of risk. The risk premium is the rate at which the capitalists undertaking the ­investment wish to be compensated for subjecting themselves to risk.

For any firm, the investment in any period is determined by the intersection between the curves of marginal efficiency of capital on the one hand, and the marginal interest cost plus marginal risk premium on the other. Even if the interest rate is constant, so that the marginal interest cost does not rise with the size of planned investment, the fact that the marginal risk premium increases with increasing investment, and the marginal efficiency of capital is likely to decrease under imperfect competition (under oligopolistic conditions it would have an inverted L-shape), ensures a ceiling on the planned investment by each firm. The marginal risk premium in turn inc­reases because of the increase in risk ass­ociated with a rise in the ratio of borrowed to own funds. In fact, the margi­nal risk premium rises at a faster rate than risk itself, and at an increasing rate as risk increases (Kalecki 1971).

This is what determines investment in any period. But what can we say about the time profile of investment? I shall not make any specific assumptions here about the investment function. For my present purpose all that is required is the assumption, which is quite realistic, that during the boom the ratio of borrowed to own funds invariably increases. The rise in the risk premium which acc­ompanies this increase ensures that the boom necessarily gets truncated. In every period, the marginal efficiency of capital equates the the sum of marginal interest cost and marginal risk premium in equilibrium. Over successive periods the mar­ginal efficiency curve shifts outwards, as does the interest cost-plus-risk premium curve and the shifting points of int­ersection determine the time profile of investment. In some period however the
increase in investment over the earlier period becomes non-positive because of the rise over time in marginal risk premium during a boom; and then begins the downturn. In short, the euphoria that the capitalists develop as the boom progresses eventually gets trumped by their fears of getting deeper into debt. The way to prolong the boom therefore is either to lower the interest rate or the risk premium or both, at this point of truncation.

One way to lower the risk premium is to ensure that the risk of failure of an ­investment project is not borne exclusively by the entrepreneur undertaking the project but is spread widely. The reason why risk rises with the size of investment is because in the event of its failure the creditors have nonetheless got to be paid, so that the burden borne by the entrepreneur is all the greater. The indivi­dual entrepreneur of course is not the sole bearer of risk since other equity-holders, who provide risk capital, also share this risk. Creditors are not meant to share risk, but when they do so, we have a reduction in marginal risk premium for the entrepreneurs who are the ones taking decisions regarding inve­s­tment, and hence an increase in investment and a prolongation of the boom.

While banks are the proximate creditors, their being mere financial intermediaries basically implies that vast numbers of people who are the depositors of banks are the real creditors. These innumerable real creditors and the innumerable persons—who are sold the loans made by banks to entrepreneurs—are not aware of the risks to which they are ­getting exposed. They do not wish to ­enhance their exposure to risk, they have no desire to share entrepreneurs’ risk. But they are made to do so unknowingly owing to their lack of knowledge about the economic universe facing them. Depositors do not know how banks are lending their resources, while the ren­tiers who buy asset bundles from banks are neither aware of entrepreneurs’ loans included in these bundles, nor the risks associated with these bundles.

A similar situation also arises regarding loans made by banks to consumers. The risks associated with default on such loans are not known to the depositors or to the buyers of asset—bundles consisting of such loans. Thus, there is an underestimation of risk that prevents the overcoming of the euphoria associated with the boom, and hence a truncation of the boom. In short, the hardening of budget constraints of economic agents, which one would expect to occur in the course of the boom given the increase in the ratio of borrowed to own funds, gets put off through the spreading, and the associated underestimation, of risks. This in turn contributes to a prolongation of the boom. The spreading of risk, or the socialisation of risk, which is the typical means under neo-liberal capitalism for prolonging the boom, is a process of camouflaging of risk,2 in which the state plays a major role.

State Intervention

The idea that there tends to be a progressive and pervasive underestimation of risk as the boom develops was adva­nced by Hyman Minsky (1975), who discussed its consequences in terms of the growing fragility of the financial system. Minsky however was visualising this as a spontaneous development. An initial underestimation of risk in the ­eup­horia of the boom causes a larger investment than would have been otherwise undertaken, and hence larger profits (since, as Kalecki (1971) had shown, the level of profits depends upon the level of investment), that further contributes to the ­euphoria; and so on.

What we have been suggesting above, however, pursues a different track. It ­argues in fact that growing risk would spontaneously trump the euphoria of the boom owing to the increase in gearing ratio. But what prevents such a denouement is the state’s intervention. What the above discussion emphasises is the deliberate effort on the part of the state to induce in various ways an under-estimation of risk.

In the US the repealing of the Glass-Steagall Act—instituted during the Great Depression to separate commercial from investment banking, so that the depositors’ wealth was not exposed to unknown risks—by the Clinton administration contributed to the formation of bubbles, and can be interpreted as such a deliberate promotion of risk-underestimation. Likewise, the Federal Reserve Board’s Chairman Alan Greenspan’s red­ucing of interest rates, which had supplanted the dot-com bubble by the housing bubble and created a new boom based upon it, can also be seen in the same light.3

In India where the financial system is dominated by the state-owned banks, such underestimation of risk is institutionally ordained by the state itself by directing the banks to give generous loans to entrepreneurs in the infrastructure sectors (Azad et al 2017). Where the state-owned banks, left to themselves, might have been chary of giving out loans, or at least loans beyond a certain limit, to many such ventures, they have been more or less pressurised by the government into doing so.

Kalecki had argued in the context of the principle of increasing risk that even if firms themselves did not factor in inc­reasing risk, the creditors would, and therefore deny them loans. The principle of increasing risk therefore operated, if not by the capitalists’ own reckoning, then at least according to the reckoning of their creditors, so that what Kornai (1986) was to call a “hard budget constraint” got created. With state-owned banks, however, the directive of the state overcomes the spontaneous tendency of banks to be chary about giving loans to stressed or potentially stressed firms. Underestimation of risk is thus ins­titutionally dictated in a financial system dominated by a bourgeois state that wishes to keep the boom going.

It follows from the foregoing that blaming the “non-performing assets” (NPAs) of banks in India only on wilful default on the part of some particularly avaricious and unscrupulous capitalists, though by no means untrue, is inadequate. NPAs become a structural characteristic of a neo-liberal economy because the only way the bourgeois state can ­intervene to keep the boom going in such an economy, where it cannot intervene fiscally owing to the demands of ­finance capital for “fiscal responsibility,” is by inducing an underestimation of risk, and even dictating an underestimation of risk where the financial system is dominated by public sector institutions. The observed phenomenon of NPAs ­being a characteristic more of the public sector banks than the private sector banks in India is also explained by this fact.

State vs Legitimacy of Capitalism

State intervention to prolong the boom cannot do so ad infinitum. The longer the boom, the greater is the threat to the financial system as it becomes increasingly fragile as a consequence of such prolongation. This means that the slightest shock to the system, in the form of a loss of confidence arising in any segment of the economy and leading to liquidity-preference or “safety-preference” on the part of those economic agents, has a domino effect.

When the domino effect sets in, the state must rescue the financial system by instilling confidence in it, and for this purpose budgetary resources are typically used. The Obama administration in the US had to pledge $13 trillion of support to prevent a collapse of the US financial system (not all of which obviously needed to be used, actually). In ­India the recapitalisation of the public sector banks with the help of the budgetary resources in the event of the NPA crises, represents a similar effort on the part of the state to rescue a financial system whose fragility it has itself explicitly encouraged, or implicitly permitted, in an effort to prolong the boom.

It can of course be argued, especially in the Indian context, that any actual curtailment of government expenditure in other areas for saving budgetary res­ources for capitalising public sector banks, is not necessary. Such recapitalisation could be undertaken through larger borrowing by the government from the central bank, with possibly no ill effects whatsoever. But this argument belongs to a different realm. It still does not ­negate the fact that budgetary resources, whether garnered through taxation or borrowing, and hence resources which belong to society at large, are used to rescue the financial system that has been undermined through a deliberate underestimation of risk.

This fact however has an important implication, namely that such an effort to stimulate a boom cannot keep getting repeated. Unlike incursions into pre-capitalist markets which constituted the main exogenous stimulus in the years before World War I, and the state exp­enditure that played a similar role in the immediate post-World War II period, stimulation of the economy by making finance easily available, either by lowering the interest rate or by systematically ensuring an underestimation of risk, cannot per se put a floor to the level of economic activity. Nor can it necessarily bring about a revival, once the downturn has set in. This fact is underscored by the continuing travails of the current capitalist world economy, despite the ­example of the US being at hand, where even with interest rates being driven down almost to zero,  the situation could not be revived. (The fact that the US unemployment rate is down to 4% now—with labour participation rate being lower relative to that in 2008—does not signal any notable new boom. If the same participation rate had prevailed ­today as was in 2008, then the US unemployment rate would have been 8%.)

What is more, even if perchance the economy does recover from stagnation, and a new boom gets started, a prolongation of this new boom a la the boom before the stagnation, is no longer possible. This is because the government cannot justify its tolerance towards growing financial fragility a second time, which is why new legislation replacing the Glass-Steagall has had to be in place in the US now. And the private economic agents—having been duped into underestimating risk once—would be more careful and hence be less gullible the next time.

Finance, it has been argued by Chandrasekhar (2016), can provide a stimulus reminiscent of what state expenditure had done in the immediate post-war years or pre-capitalist markets earlier. This of course is true, but, as he himself notes, the stimulus provided by finance is not exactly on a par with that provided by pre-capitalist markets or state expen­diture. The purpose of the foregoing has been to suggest that it cannot be the cause of a secular trend. The euphoria it sustains and prolongs can be a one-shot affair (or at best a-couple-of-shots affair) but cannot be a regular feature of the system that generates a positive trend. In short, the stimulus provided by fin­ance can create a more prolonged boom than would have occurred otherwise, but a transient one, nonetheless. It cannot create a secular trend, unlike what pre-capitalist markets or state­ expen­diture in earlier periods had done.

This argument is analogous to what Kalecki (1943) had suggested regarding the interest rate. If the interest rate is ­reduced in the slump to start a new boom, but not increased in the boom in order to let it get prolonged, then it will have to become negative in no time. Reliance on monetary policy in short to generate a positive trend will eventually have to push the interest rate into the negative region, which of course is imp­ossible if cash, which yields zero interest rate, can be held in lieu of any negative yielding asset. The fact that the existence of cash puts a floor to the interest rate at zero, has been called the “curse of cash” by Rogoff (2016), who has argued that since economic recovery in the present context requires negative interest rates, it becomes essential to promote “cashlessness.” It is ironical to note that after three quarters of a century from Kalecki’s writing, which was meant as a critique of capitalism, the truth behind his analysis is being discovered by defe­nders of the system and used by them to suggest ways of making it survive.

Finance capital, I mentioned earlier, was always opposed to state intervention through larger expenditure. This is because state intervention in this manner undermines the social legitimacy of capitalism. But it has no objections to the use of interest rate policy for stimulating economic activity, because interest rate policy works through enhancing private expenditure. The use of interest rate policy does not undermine the ­social legitimacy of capitalism in the way that fiscal policy does (other than that which seeks to stimulate activity by lowering taxes on capitalists).

But both monetary and fiscal policies that try to work by lowering taxes on capitalists, cannot act as exogenous stimuli for introducing a positive trend, the way that state expenditure can do. Interest rates will have to turn negative if these are to work. Income tax concessions to capitalists, for the same reasons, must become income subsidies (that is, income tax rates must become negative). But easing the availability of finance by ensuring risk-underestimation that makes the financial system fragile, cannot be repeated. In other words, the policy instru­ments that preserve the social ­legitimacy of capitalism are instruments that cannot work for generating a positive trend. While the instruments that could possibly impart a positive trend are ­disallowed under neo-liberal capitalism because they undermine the social legiti­macy of the system. Neo-liberal capita­lism, thus, is intrinsically flawed—it does not have an exogenous stimulus for sustained growth, a fact that is ­becoming increasingly clear of late.

Economic Stagnation                             

Preventing the use of fiscal policy is based on a patently illogical argument. To claim that if the state invests by borrowing from the banking system then that is economically harmful, while if the capitalists invest by borrowing from the banking system then that is econo­mically beneficial, is patently illogical. But that has now become ingrained as part of economic wisdom under neo-­liberalism. As a matter of fact, however, the fundamental difference between the state and the capitalists as spenders arises for an altogether different reason— namely, that the capitalists, no matter how large their operations, necessarily face a budget constraint, while the state as visualised by bourgeois economics to be one without any class bias whatso­ever, does not face any budget constraint because it has the power to tax.

Suppose the capitalists invest an additional `100 collectively. Then the additional profits (assuming that the eco­nomy is a closed one, that workers do not save while the capitalists save their entire profits, and that the government budget is balanced) will be `100, which will accrue to the capitalists collectively (whence Kalecki’s aphorism that “the workers spend what they earn while the capitalists earn what they spend”). But each capitalist may not necessarily be earning what they have decided to spend. And what is more, each capi­talist, not knowing what other capitalists are investing, would have no idea of what they would be earning ex post while ­deciding their own investment ex ante. Hence, in deciding how much to spend each capitalist will be constrained by their budget. But if the state undertakes an additional inv­estment of `100 by ­borrowing from the banks to start ­with, then this amount will accrue to capita­lists as profits, which the state has the power to tax away and return to the banks, so that it does not have to face any budget constraint.

Monetary policy or easing the availability of finance by deliberately inducing economic agents to underestimate risk, only “eases” this budget constraint faced by the capitalists, but does not do away with it. A continuous easing of the budget constraint in this manner by continuously inducing an underestimation of risk makes the financial system fragile, it makes the boom eventually unsustai­nable, and the crash when it comes ­becomes even more devastating.

State spending, we have seen, not only provided an exogenous stimulus for growth but also a countercyclical ins­trument that kept up a high level of acti­vity. In fact, state spending (for military purposes), as Rosa Luxemburg had noted (1963), was a source of demand that could be manipulated to suit the needs of the capitalist economy. The same was true of encroachments into pre-capitalist markets. Pre-capitalist markets, as the economic historian S B Saul (1960) had noted, were “markets on tap” under the colonial order. Easing of finance, however, is neither an exogenous stimulus for growth, and precisely for that reason, nor a manipulable instrument for keeping up the level of activity. It is hardly surprising then that neo-liberal capitalism, lacking such a manipulable exogenous stimulus, suffers from an ­immanent tendency towards stagnation.

Notes

1      The proposition that a capitalist economy without any exogenous stimulus would settle at a state of simple reproduction was established in Kalecki (1962). See also Patnaik (1997).

2      There is of course, as Chandrasekhar (2016) notes, a reduction of risk through a bundling of claims on different assets and in banks’ selling different bundles to different buyers, so that securitisation per se even without any camouflaging of risk can prolong the boom. But this has strict limits. Prolonging the boom beyond these limits necessarily requires a camouflaging of risk. The distinction here is between a genuine reduction in the risk premium and an imposed reduction in risk premium through subterfuge. The former prolongs the boom in the normal course. But anything beyond that requires the subterfuge.

3      I use the term “state” to cover all central banks, which must be seen as state organs. 

References

Azad, Rohit, Bose Prasenjit and Dasgupta Zico (2017): “‘Riskless Capitalism’ in India,” Economic & Political Weekly, Vol 52, No 31, 5 August.

Chandrashekhar, C P (2016): “Financial Development and Growth under Capitalism,” Economic Challenges in the Contemporary World, Mausumi Das, Sabyasachi Kar and Nandan Nawn (ed), Delhi: Sage Publications.

Kalecki, M (1943): “Political Aspects of Full Employment,” reprinted in Kalecki (1971).

—    (1962): “Observations on the Theory of Growth,” Econmic Journal, Vol 72, No 285, March.

—    (1971): Selected Essays on the Dynamics of the Capitalist Economy 1933–71, Cambridge: CUP.

Keynes, J M (1946): The General Theory of Employment, Interest and Money, London: Macmillan.

Kornai, J (1986): “The Soft Budget Constraint,” Kyklos, February.

Lewis, W A (1979): Growth and Fluctuations 1870–1913, London: Routledge.

Luxemburg, R (1963): The Accumulation of Capital, London: Routledge Paperback.

Minsky (1975): John Maynard Keynes, London: Palgrave Macmillan.

Patnaik, P (1997): Accumulation and Stability ­under Capitalism, Oxford: Clarendon Press.

Rogoff, Kenneth (2016): The Curse of Cash, Princeton: Princeton University Press.

Saul, S B (1960): Studies in British Overseas Trade, Liverpool: Liverpool University Press.

Steindl, J (1976): Maturity and Stagnation in Ame­rican Capitalism, New York: Monthly Review Press.

Updated On : 16th May, 2019

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