theories of financial disturbance

Theories of Financial Disturbance

Krzysiowi

Rozum otwiera okna pamieci

… we should clearly trace the lines of tradition – positive as well as negative– from the older generations of economists in order to prevent our literaturefrom falling any more than necessary into Babylonic barbarism.

(Gunnar Myrdal, Monetary Equilibrium, p. 31)

Theories of FinancialDisturbanceAn Examination of Critical Theories of Financefrom Adam Smith to the Present Day

Jan ToporowskiResearch Associate, School of Oriental and African Studies,University of London, UK, University of Cambridge, UK and University of Amsterdam, The Netherlands

Edward ElgarCheltenham, UK • Northampton, MA, USA

© Jan Toporowski, 2005

All rights reserved. No part of this publication may be reproduced, stored in aretrieval system or transmitted in any form or by any means, electronic, mechanical or photocopying, recording, or otherwise without the prior permission of the publisher.

Published byEdward Elgar Publishing Limited Glensanda House Montpellier Parade Cheltenham Glos GL50 1UAUK

Edward Elgar Publishing, Inc. 136 West Street Suite 202 Northampton Massachusetts 01060 USA

A catalogue record for this book is available from the British Library

ISBN 1 84376 477 6 (cased)

Printed and bound in Great Britain by MPG Books Ltd, Bodmin, Cornwall

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Contents

Debts and discharges vii

Introduction 1

PART I A PREMONITION OF FINANCIAL FRAGILITY

1. Adam Smith’s economic case against usury 132. The vindication of finance 26

PART II CRITICAL THEORIES OF FINANCE IN THE TWENTIETHCENTURY: UNSTABLE MONEY AND FINANCE

3. Thorstein Veblen and those ‘captains of finance’ 454. Rosa Luxemburg and the Marxist subordination of finance 525. Ralph Hawtrey and the monetary business cycle 616. Irving Fisher and debt deflation 757. John Maynard Keynes’s financial theory of under-investment I:

towards doubt 798. John Maynard Keynes’s financial theory of under-investment II:

towards uncertainty 88

PART III CRITICAL THEORIES OF FINANCE IN THE TWENTIETHCENTURY: IN THE SHADOW OF KEYNES

9. The principle of increasing risk I: Marek Breit 10110. The principle of increasing risk II: Michal Kalecki 10911. The principle of increasing risk III: Michal Kalecki and Josef

Steindl on profits and finance 11912. A brief digression on later developments in economics and

finance 13113. The East Coast historians: John Kenneth Galbraith, Charles P.

Kindleberger and Robert Shiller 13814. Hyman P. Minsky’s financial instability hypothesis 14315. Conclusion: the disturbance of economists by finance 152

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Notes 155Bibliography 172Index 189

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I wish to record my thanks to the librarians of the Perry Library of South BankUniversity, the British Library of Political and Economic Sciences; thelibraries of the School of Oriental and African Studies and the Szkola GlównaHandlowa; and the British Library, and Tish Collins of the Marx MemorialLibrary, for their assistance in my research for this book. The generosity of theAmiel-Melburn Trust, the Leverhulme Foundation, and the EuropeanCommission’s research network on Financial Integration and Social Cohesionhas helped to defray expenses associated with broader research, of which thisis one outcome. Especial thanks are due to Anita Praz·mowska for her uniqueencouragement of my efforts to overcome the obstacles that academicemployment today throws in the path of intellectual endeavour. Thatemployment, however, also brought into the orbit of my discussions sometalented and enthusiastic students on whom I was able to try out many of theideas in this book. When those ideas became serious I was able to discuss themmore knowledgeably with David Gowland, Leslie Fishman, Peter Howells,Jesper Jesperson, Julio Lopez-Gallardo, Tracy Mott, Geert Reuten, ZviSchloss, Nina Shapiro, Geoff Tily, Tadeusz Kowalik and Randy Wray. I amgrateful to Mary French-Sokol for advice on Jeremy Bentham and hiswritings; to Ian King and Claudia Jefferies for their assistance in translatingMarek Breit’s 1935 article from German; and to David Cobham, GaryDymski, Susan Howson, John King, Andy Denis, Alfredo Saad-Filho, WarrenSamuels and Geoff Harcourt for comments on an earlier draft and variouschapters in the book. Especial thanks are due to Victoria Chick, who has beenthe most consistent and sympathetic critic of my work. She and GeoffHarcourt generously gave time and trouble to look at my drafts in the franticcrisis-ridden months as this book was being completed. None of theindividuals listed here saw the book as a whole and, therefore, they bear noresponsibility for its overall content and conclusions.

At a crucial stage in the emergence of the book, in September 2001, I wasinvited to give a series of lectures at the Faculty of Economics of theUniversidad Nacional Autónoma de México. The opportunity to discuss theideas in this book with Noemi Levy-Orlik, Alicia Giron, Guadalupe Mantey,Eugenia Correa and their students made an invaluable contribution towardsclarifying my arguments. Later on, aspects of the book were discussed at apresentation for Economics staff at the Open University. At around this time,

Debts and discharges

a draft containing the results of my investigations in classical politicaleconomy floated off to appear in the annual History of Economic Thought andMethodology, Volume 22-A, as ‘The Prudence of Projectors’. Completion ofthe book was made possible by the shelter generously provided by JohnWeeks, Machiko Nissanke and the Economics Department at LondonUniversity’s School of Oriental and African Studies. The book owes morethan is apparent to the enthusiasm and interest of all these individuals. Theauthor takes responsibility for the remaining errors. The enthusiast for newideas, and novel approaches to old ideas, is especially prone to overlookmistakes in pursuit of some immanent conception that inspires research. I hopethat the remaining blemishes are small enough to be overlooked in that greaterconstruction, and that the kindness of many friends is reflected in its qualities.

The most personal debt is owed to Anita Praz·mowska and MiriamPraz·mowska-Toporowska. Their tolerance of literary dementia and support indifficult times deserves more gratitude than can be expressed here, and amonument more beautiful than anything a mere economist can create.

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Introduction

The macroeconomic consequences of finance are a neglected part of financialeconomics. This may be in part because the professional duty of central bankeconomists condemns them to measuring the efficacy of monetary policy, andthat of economists employed in banks and financial institutions condemnsthem, at worst, to advertising their employers’ wares and, at best, to projectingasset prices, calculating optimal portfolios, and anticipating the policy of thecentral bank. Such neglect comes in spite of the domination of the markets bylarge collective investing institutions (pension funds, insurance companies andinvestment funds) that has emerged in the second half of the twentieth century.Although such institutions are more amenable to study than individualinvestors, their activities in many cases have shown that their bureaucraticrationality in the face of their ignorance is little advanced on that whichKeynes criticised 75 years ago:

The ignorance of even the best-informed investor about the more remote future ismuch greater than his knowledge, and he cannot but be influenced to a degree whichwould seem wildly disproportionate to anyone who really knew the future, and beforced to seek a clue mainly here to trends further ahead. But if this is true of thebest-informed, the vast majority of those who are concerned with the buying andselling of securities know almost nothing whatever about what they are doing. Theydo not possess even the rudiments of what is required for a valid judgement, and arethe prey of hopes and fears easily aroused by transient events and as easilydispelled.1

This judgement is perhaps severe, in view of the huge academic andprofessional investment in methods of calculating optimal investmentportfolios since those words were written. But, as I have argued in The End ofFinance, when the markets are being inflated, it does not take much rationalityto make money. Such calculation, by keeping attention focused on marketoutcomes and their shifts over time, fails to pay due attention to the sequencesof transactions outside the markets that bring about such outcomes.Calculating optimal portfolios provides reassurance in the face of theignorance that Keynes described. This practice narrows down the scope ofrisk, or unpleasant surprise, to a fall in asset prices.

Behind this preoccupation with obvious phenomena is a particular metho-dological predilection, the rise of formalism in economics.2 Formalism isloosely associated with the conversion of economic analysis into mathematical

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models. However, while mathematics has a place in economics, it cannotsubstitute for the study of how markets work. Keynes rightly criticised IrvingFisher for confusing what an equation told him would happen with whatwould happen in the real world.3 It is not enough to have an equation relatingtwo variables: it is necessary also to have an explanation of how the twovariables are brought into such a relation-ship in the economy. When such a relationship includes a presumption of equilibrium, which financial modelsneed for technical reasons of determinacy, the outcome is a presumption ofstability, which may not exist in the real world.4 Finance literature allows for instability of variables, and even extended ‘departures from equilibrium’as in New Keynesian-type information cascades, or behavioural finance. But these models provide different time paths for variables, rather thanshowing the mechanisms by which financial instability is conceived andpropagated.

1. EQUILIBRIUM, REFLECTIVE AND CRITICAL FINANCE

By and large, mainstream economics has adhered to two doctrines concerningthe way in which finance operates in modern capitalist economies.Equilibrium finance, most notable in Walrasian general equilibrium andTobin’s ‘q’ theory of investment, postulates that financial markets and theeconomy in which they operate are either in simultaneous equilibrium, or aredetermined by an immanent equilibrium, so that deviations from thatequilibrium are eventually eliminated. As Tobin observed:

If the interest rate on money, as well as rates on all other financial assets, wereflexible and endogenous, then they would simply adjust to the marginal efficiencyof capital. There would be no room for discrepancies between market and naturalrates of return on capital, between market valuations and reproduction cost. Therewould be no room for monetary policy to affect aggregate demand. The realeconomy would call the tune for the financial sector, with no feed-back in the otherdirection … Something like this occurs in the long run, where the influence ofmonetary policy is not on aggregate demand but on the relative supplies of moneyand real assets, to which all rates of return must adjust.5

In general equilibrium the relationship between the real economy and thefinancial system is a state of static, mutually determined equilibrium. Any orall variables in the economy may then cause change. By contrast, reflectivefinance regards the conditions in the financial markets as being determined bycircumstances in the real economy, that is, outside the financial sector. Thisview was nicely expressed by the French monetary economist Suzanne deBrunhoff in her exposition of Marx’s theories of money and credit:

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… the financial cycle is only a reflection of the economic cycle; monetary andfinancial movements reflect non-monetary and non-financial internal andinternational disturbances. But they reflect them in their own way because of theexistence of specific financial structures.6

An early exponent of ‘reflective finance’ was Joseph Schumpeter, whodescribed in The Theory of Economic Development a system in which credit ismore or less automatically advanced to entrepreneurs.7 Schumpeter allowedfor breakdown of the financial system, for example in crises of internationalcapital withdrawal, which he had noted already before the First World War.8

But in Schumpeter’s view these are ‘unfortunate accidents’ rather than anysystematic tendency.9 In his later work on business cycles he explicitlyrejected any notion that money or credit may initiate economic instability,although he allowed that it may transmit disturbances in particular parts of aneconomy to others.10 The efficient markets hypothesis and numerous stockpricing theories (for example the arbitrage pricing model) are latter-dayexamples of such ‘reflective’ views of finance. In both cases, any instabilitythat finance may suffer cannot be anything more than temporary ‘corrections’,while a new equilibrium establishes itself, reflecting underlying changes in thereal economy.

Critical finance may be defined by contrast with these doctrines as anapproach to finance which does not presume that finance is benign, but showshow, notwithstanding the virtues of its intermediary function, finance maysystematically disturb the functioning of the modern capitalist economy andaggravate fluctuations in the real economy. By finance is meant here themarkets for credit and securities (stocks and bonds) which dominate theeconomies of the English-speaking industrialised countries, and which arestarting to predominate in those parts of Europe and Asia where bank financewas more common in the past. This book argues that critical finance theorieswere published through the twentieth century, from Veblen at the beginning ofthat century to Minsky at its end. The coherence of essential elements of theseideas is all the more remarkable in view of two notable features of this work.The more obvious feature is that some of the thinkers who put forward similarideas (for example Thorstein Veblen and John Maynard Keynes) did not knoweach other’s work, suggesting the kind of coincidence that Joan Robinsonthought of as characterising objective, ‘scientific’ insight.11 Don Patinkin andthe sociologist Robert Merton thought that such ‘multiple discovery’ was thehall-mark of scientific advance.12

The less obvious feature is a confusion over the origins of ideas that arose with the publication by Hyman P. Minsky of his book John MaynardKeynes. In this Minsky associated himself with the ‘Post-Keynesians’: ‘JoanRobinson, G.L.S. Shackle, Nicholas Kaldor, Sidney Weintraub, PaulDavidson, Robert Clower and Axel Leijonhufvud are prominent among the

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dissidents who affected my thinking.’13 These theorists were largely exponentsof a monetary Post-Keynesianism. This may be distinguished from Minsky’sown ‘financial Post-Keynesianism’, which is discussed in Chapter 15 of thisbook, and which, in his book, he argued was implicit in Keynes’s views onfinance. In Manias, Panics and Crashes, Charles Kindleberger put forward theview that, ‘in its emphasis on the instability of the credit system’, Minsky’sargument ‘is a lineal descendent of a model, set out with personal variations,by a host of classical economists, including John Stuart Mill, Alfred Marshall,Knut Wicksell and Irving Fisher’.14 In fact Minsky’s ideas owed more toFisher, which Minsky was happy to acknowledge, and to Veblen, whomMinsky does not mention in his writings.15 At the same time, not allKeynesians shared their master’s disequilibium approach to finance. JoanRobinson stands out as an early critic of Kalecki in this regard, for fear that hisviews on finance may be a cover for the determination of investment bysaving.

Allowing for changes in the way in which the scope and structure of thefinancial markets has evolved through recent centuries, ideas of criticalfinance, as this book shows, have recurred repeatedly, from the earliest timesin the pre-classical discussions of finance by François Quesnay and AdamSmith. This is not because they are some Hegelian Geist at work on the mindsof disparate men and women, but because the thinkers observed the wayfinance initially provides welcome liquidity and then disrupts the functioningof capitalist enterprise from the earliest combination of capitalism and financeat the end of the sixteenth century to its hubris at the end of the twentiethcentury. This was most notable in the case of the 1929 crash, and recently inthe case of the Third World debt crisis and subsequent emerging market crisesat the end of the century. Because of the time that has elapsed, financialdisturbances appear less obvious, but arguably were no less real, in thedecades before the First World War. In this book it is argued that, followingthe establishment of the classical consensus that finance merely intermediatessaving and investment, there were essentially two waves in which systematicgeneralisations about the principles of critical finance (as defined above) weredeveloped. The first of these lasted from the turn of the twentieth century untilthe middle of that century. The second began in the 1970s. In between therewas an interlude in which critical views of finance were concerned with theinterpretation of past history rather than present possibilities, and in which thethought of the pre-eminent critic of finance in the twentieth century, JohnMaynard Keynes, was reinterpreted as a monetary theory of capitalism. It israther obvious that the historiographic interlude coincides with what came tobe known as ‘financial repression’ that accompanied the Keynesian boomafter the Second World War.

This book is therefore a study in the history of economic thought. As it

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Introduction

shows, the exposition of such history is rarely innocent. Journalists, politiciansand less reflective economists seek out in the commonplace events of every-day life incidents that will illustrate particular, more obvious, views. Morethoughtful economists from Adam Smith onwards have reconstituted thehistory of economic thought not as it was, a succession of rhetoricalinterrogations of events largely obscured by history, ennobled by algebra andthe passage of time, but as the emergence from obscure backwardness of morelearned views. These views then conclude with those ideas that the historianof economic thought deems to transcend their origins and to illuminate thecircumstances in which the history is written. This author is no exception.Those readers who know my previous work will readily identify in thesechapters hints of the approach adopted in my previous books. This means thatI have not done full justice to the totality of the ideas of many of the writersdiscussed here. This is most notable in the cases of Adam Smith, Karl Marx,John Maynard Keynes, Michal Kalecki and Josef Steindl. Any apologies dueto them may perhaps be excused by the higher purpose of the book, to intro-duce the reader to neglected aspects of their work and, in the case of MarekBreit, to a writer whose work, though relevant, is virtually unknown today.

2. OMISSIONS

My wilful distortion of the works of these great writers is compounded byseveral omissions. Apart from Schumpeter, mentioned above, some explana-tion is also necessary for the exclusion from this study of the work of thefollowers of the Swedish monetary economist, Knut Wicksell. This is a school of thought whose subtlety of analysis of cumulative processes ofdisequilibrium in the economy, also involving finance, was unmatched in itstime. However, there are two reasons why their analyses are beyond the scopeof a book examining how economists have postulated disturbance of theeconomy by finance. First of all, the fundamental disequilibrium driving thebusiness cycle in the Swedish view is an inequality of saving with investment,brought about by a difference of the ‘natural’ rate of interest (the rate of profiton new investment) and the money rate of interest set by a banking system thatis, in the work of Myrdal, a proxy for the whole range of costs of credit forvarious terms and risks offered in the financial system. The ‘natural’ rate isdetermined by the scarcity of capital, technology and technological innova-tion. According to the Swedish view, the fluctuation of this ‘natural’ rate awayfrom the ‘money’ rate, and interest rate policy by the monetary authorities thatdoes not match the money rate of interest to the ‘natural’ rate, accounts fordisturbances in the economy. Like Hobson’s theory of excessive saving, theWicksellian view has important implications for finance. But finance does not

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play an autonomous role in disturbing the economy. It merely transmits theinitial imbalance between saving and investment. Myrdal’s book MonetaryEquilibrium, for example, is not about equilibrium or disequilibrium in themoney markets or finance. It is about how monetary policy can bring about anequilibrium of ex ante or intended saving, with investment in the economy.Adam Smith put forward a cogent case against usury which, in a crediteconomy, would drive the rate of interest up to induce under-investment (seePart I below). However, the Swedish school did not suggest at any stage thatthe financial system would naturally produce excessive interest rates, as Smithdid. Indeed, Wicksell himself emphasised that:

The main principal and sufficient cause of cyclical fluctuations should rather besought in the fact that in its very nature technical or commercial advance cannotmaintain the same even progress as does, in our days, the increase in needs –especially owing to the organic phenomenon of increase of population – but issometimes precipitate, sometimes delayed. It is natural and at the same timeeconomically justifiable that in the former case people seek to exploit thefavourable situation as quickly as possible, and since the new discoveries,inventions and other improvements nearly always require various kinds ofpreparatory work for their realization, there occurs the conversion of large massesof liquid into fixed capital which is an inevitable preliminary to every boom andindeed is probably the only fully characteristic sign, or at any rate one which cannotconceivably be absent … If again, these technical improvements are already inoperation and no others are available, or at any rate none which have beensufficiently tested or promise a profit in excess of the margin of risk attaching to allnew enterprises, there will come a period of depression; people will not venture tothe capital which is now being accumulated in such a fixed form, but will retain itas far as possible in a liquid, available form.16

Hence ‘Wicksell held a “real” theory of the business cycle, in the sense that hebelieved that the cycle arose because of changes in the natural rate.’17

Wicksell’s is therefore not a theory of financial disturbance but a theory inwhich the banking system is the transmission mechanism for cumulativedisturbances arising out of changes in the productivity of capital.

The second reason for excluding Wicksell and his followers is that themodern view of how finance disturbs the economy is built on the idea that, inthe process of financial intermediation, assets are created which cannot beconverted into means of payment, or credit is extended to the point where theliquidity that households and firms use to manage their economics affairs isinsufficient to manage all financial liabilities (see Part II below). But, inWicksell’s view, financial innovation moved from commodity money to a‘pure credit’ economy of a banking kind.18 His Swedish and Austrian followerstherefore did not develop a view of finance in which financial and productiveassets have differing liquidity. The differential liquidity of assets was the basisof Keynes’s financial and monetary economics.19

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There are other omissions which will perhaps be contested by partisans ofthe authors concerned. Karl Polanyi, in his book The Great Transformation,presents an intriguing picture of the emergence of the ‘market system’ ofeconomy, underpinned by the gold standard and a nexus of haute financelinking the main capitalist countries until the failure of that standard after theFirst World War. The collapse of finance that it occasioned reveals thesuperficial and frail nature of the apparently ‘self-regulating’ market system.But, like Hobson’s analysis of finance in Imperialism: A Study, Polanyi doesnot reveal any mechanisms of disturbance emanating from finance. Both ofthem show finance as the dominant feature of capitalism at the end of thenineteenth century. But for all the acuteness of their criticism of finance as asocial and political institutions, Hobson and Polanyi have finance broughtdown with the economy by the violence of the social and political changes thateconomic forces and financial developments unleash. This does not make theiranalyses less correct. They merely lack the detail this author and the readermay expect to find in an analysis of financial disturbance of the economy.

Similarly, their remaining partisans will contest the exclusion from thisbook of the respective theories of C.H. Douglas (‘Major’ Douglas) and SilvioGesell. Along with Hobson and Polanyi, they saw finance as a critical flaw inthe modern capitalist system. They, ‘following their intuitions, have preferredto see the truth obscurely and imperfectly rather than to maintain error,reached indeed with clearness and consistency, and by easy logic, but onhypotheses inappropriate to the facts’.20 Indeed, Gesell’s advocacy of stampedmoney, along with Irving Fisher who is included in this volume, would seemto recommend him for inclusion. Perhaps their devotion to political advocacyof their views, through journalism and pamphleteering (although Gesell’swork, like that of Hobson, goes significantly beyond such instant interven-tions), left their analyses lacking certain systematic qualities which arenecessary to sustain an academic argument. These systematic qualities may be a consistent critique of the economic theories of contemporaries orpredecessors, or a comprehensive explanation of how their insight may changeour understanding of the capitalist economy.21 Nevertheless, for the thinkingindividual the study of the work of brave ‘heretics’, and consideration of thestrengths and limitations of their arguments, provides much greaterunderstanding of modern finance than the commonplace truisms that are thefoundation of textbook wisdom.

For a somewhat different reason I have excluded theories of policy-inducedfinancial disturbance. These were a familiar staple of Austrian and Germanmonetary theory, as expounded for example by Hayek. Their equivalentstoday are the views of latter-day (post-Friedman) monetarists and newclassical theorists, who see in the inappropriate management of interest ratesor the money supply the roots of economic disturbance. With the exception of

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Hayek, they reveal their true allegiance by their assumption that withoutgovernment intervention the economy would naturally fall into equilibrium.

3. THE THEORY OF CAPITAL MARKET INFLATION

The origins of this book lie in a somewhat belated ‘literature review’ for mybook The End of Finance. At a number of points in this book, I allude to thetheory of capital market inflation. It is appropriate therefore to give a briefoutline of the theory in this introduction.

The theory emerged from this author’s attempt to make sense of what washappening in the financial markets during the final decades of the twentiethcentury. Each successive boom in the financial markets promised higherinvestment, economic growth and prosperity, only to deliver a boom led byluxury consumption and lagging investment (notwithstanding fringes ofspeculative over-investment), followed by financial instability and crisis. Inthe course of a seminar at University College, London, around the beginningof the 1990s, the distinguished French economist Alain Parguez referred toKeynes’s analysis as ‘a theory of capital market inflation’. There aresuggestive allusions in Keynes, for example his suggestion in the Treatise onMoney, that excess liquidity in the stock market gives rise to excessiveproductive investment, and his urging in his Chicago University HarrisFoundation Lectures that the financial markets be flooded with cheap credit toinduce investment.22 Further clues were found in the writings of Keynes’sfollowers and critics (principally Hyman P. Minsky), not to mention thefinancial disturbances of the latter three decades of the twentieth century thatthis author experienced at first hand, to give intellectual and empirical supportto a new approach to finance in an economy where investment is dominatedby companies’ external finance and its consequent liabilities, and consumptionis dominated by wealth effects arising out of credit inflation.

The theory of capital market inflation examines the consequences of aninflation of the stock market. Such an inflation has been induced by the policyof diverting pension fund contributions from the payment of current pensionsto ‘funding’ the purchase of stock market assets, the income from which issupposed to pay the future pension of the contributor. The general benefits ofthis are supposed to be an increase in saving and investment, leading to fastereconomic growth. In practice, the effect of a greatly increased demand forlong-term financial securities leads to the over-capitalisation of companies.Companies’ excess capital is used to repay debt or to build up stocks of liquid(financial) assets, as an insurance against companies’ extended financialliabilities. Rising asset values in the capital market, and its greater liquidity,engender a festival of corporate balance sheet restructuring (mergers and

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شرح لكيفية حدوث الازمات الاقتصادية و علاقتها بالاقتصاد الحقيقي وفق كاينز و غيره

Introduction

takeovers and so on). Governments find that they can make their debtdisappear by privatisation, that is, the issue of company stocks whose proceedsare used not to increase the productive capacity of the companies issuing thesecurities but to repay government debt and finance fiscal deficits.

Capital market inflation induces financial fragility in the economy in twoways. First of all, by encouraging equity (common stock) finance rather thandebt, it deprives the capital market of the regular, predictable and stabilisinginflows of funds as companies and governments repay their debt. The liquidityof the market becomes much more dependent on future inflows of speculativefunds. In the case of the recent capital market inflations of the United Statesand Britain, driven largely by the inauguration of mass funded pensionschemes, the decline of these inflows is more or less inevitable as the schemesmature because employment ceases to rise, or because schemes that starttogether tend to mature together. The other means by which financial fragilityis promoted by capital market inflation is through the disintermediation ofbanking systems. The best loans of banks have traditionally been togovernments and large corporations. When these customers find that they canraise funds more cheaply in the capital market, banks are only able to retainthose customers’ financial obligations in their bank balance sheets by buyingthem in securities markets at prices which give banks negligible or negativemargins over their cost of funds. Banks are thereby induced to lend into morerisky markets where they can charge higher rates on their loans.

Finally, capital market inflation renders governments’ monetary policy lesseffective because the greater liquidity of big corporations makes their expen-diture on investment (the chief motor force of business cycles) less vulnerableto rises in the bank interest rates that are influenced by central bank rates ofinterest. The borrowing by households and small and medium-sized concernsis less responsive to changes in short-term interest rates. Accordingly, a higherchange in interest rates is necessary to induce a given change in aggregateexpenditure in the economy.

The theory of capital market inflation is a macroeconomic theory in at leasttwo senses of the word. First of all, it is an explanation of how the balancebetween income and expenditure, that is, aggregate saving, and theinstitutional channels through which that saving occurs, determines the valueof assets in the financial markets.23 This contrasts with the commonly heldbelief that the value of financial instruments is derived from estimates of thefuture earnings of the real or productive assets that are financed with thoseinstruments. Indeed, so widespread is this view that it was held by most of theauthorities discussed in this book, including Veblen, Keynes, Kindlebergerand Minsky. However, this is quite evidently a microeconomic view.

More importantly, the theory of capital market inflation is a macroeconomictheory because it identifies the mechanisms by which a process of inflation in

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the capital markets determines the way in which the rest of the economyoperates. By contrast, general equilibrium models do not identify any centralsubset of markets in the economy determining the rest of the economy. In ageneral equilibrium, by definition, all markets are in equilibrium and changesin any market can be transmitted to the other markets by the process ofreconfiguring the other markets to bring about a new general equilibrium.Once a sufficient number of variables is fixed, the interactions of supply anddemand in each market brings the whole system into equilibrium.24 In thisrespect, general equilibrium models are really just interconnected micro-economic models in which change could be inaugurated by a shift anywherein the underlying structure of technology or consumer tastes. Thedistinguishing feature of macroeconomics is its identification of crucialvariables, such as money, government economic policy, or, in the case of thetheory of capital market inflation, finance. Such crucial variables affect theefficient working of the rest of the economy in a way that mereinterdependence of markets on variables set in other markets does not. Byextension, reflective theories of finance, as defined above, deny the possibilityof functional determination by finance of the real economy, since it is the latterthat is supposed to determine financial conjunctures. The classical theory ofinterest, which identified the rate of profit as the determinant of the rate ofinterest, is an outstanding example.

As indicated earlier, this book does not claim to give a comprehensiveaccount of the theories of the authors cited in the book. This would take toolong, and would distract the reader from the main purpose of the work, namelyto explain how successive authors argued that finance disturbs, or ifunregulated would disturb, the economy. Readers wishing to have a compre-hensive account of these authors are recommended to read their works. Thisbook’s claim on the attention of the reader is not as history of economicthought, but to complement the economics literature summarised in ‘A briefdigression on later developments in economics and finance’ below. In thatliterature, finance appears in its intermediary function, for which we should allbe grateful because without it the modern economy would be lost. But, as aconsequence of this emphasis on efficient intermediation, the possibility thatthe financial system may unbalance and disorganise the economy, as well aslubricate it, has been lost sight of by many academic economists. Amongacademic and practising economists, and the well-educated and economicallyliterate non-economists, an increasing unease arises out of the contradictionbetween the claims of academic experts that inflated financial markets aremore efficient, and the apparent economic instability and financial insecuritythat accompany such inflation. It is to thinking and reading individuals amongthose classes that this book is addressed.

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PART I

A Premonition of Financial Fragility

The credit system develops as a reaction against usury … The initiators of themodern credit system take as their point of departure not an anathema againstinterest-bearing capital in general, but on the contrary, its explicit recognition.

(Marx, Capital Volume III, pp. 600–601)

1. Adam Smith’s economic case againstusury

The relationship of finance with the rest of the economy has been argued oversince the emergence of money and the concentration of trade in particulargeographical locations and at times that did not coincide exactly withproduction and consumption. The trade in money that this concentrationrequired lies at the origin of finance. Social attitudes towards it were focusedon the distribution of gains or losses arising out of that trade. In the past, thoseattitudes were obviously influenced by religious proscriptions against usuryand, among the less religious, by Aristotle’s argument that the mere trade inmoney is sterile. Aristotle’s view reached the highest point of its sophisticationin Marx’s analysis of circuits of capital, showing how the application ofmoney capital (or what Marx termed ‘fictitious capital’) to production releasesfrom labour the surplus that is the real basis of interest and gain from money.Modern finance is inextricably bound up with the emergence of capitalism andcorporate requirements for money that exceed the pockets of entrepreneurs.The emergence of capitalism changed the terms in which that argument wasconducted. This, however, has not been very well reflected in histories ofeconomic thought about finance. These have tended to follow the view of John Stuart Mill, and the financial interest that influenced classical politicaleconomy. According to this view, arguments against usury follow fromreligious prejudice or, in the case of Aristotle, misunderstanding of thefunctionsof money and finance.1 Classical political economy is supposed tohave brought enlightenment by removing religious considerations fromeconomic questions and subjecting them to rational (logical and empirical)enquiry. Such enquiry reveals the fundamental harmony of finance witheconomic progress in general, and capital accumulation in particular, aconclusion that still forms the basis of modern finance theory.

However, closer examination of the arguments of classical politicaleconomy about usury shows that the more favourable attitude towards financethat emerged was not the triumph over prejudice and misunderstanding that itnow appears. The economicarguments of those who advocated restrictions onusury and finance are now widely overlooked, even where they raised issuesthat concern many citizens, politicians, businessmen and bankers today. Thereis therefore a scholarly reason for reviewing Adam Smith’s argument about

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A premonition of financial fragility

usury, and the response of classical and subsequent political economy to thatargument. Modern theories of finance explain interest by reference toindividual abstinence, myopia, intertemporal choice of income, or capitalproductivity. But, as Marx pointed out, the origin of interest lies in usury2 andnot in those metaphysical fictions with which Senior, Böhm-Bawerk, Wickselland Fisher tried to give interest and finance a logical rather than a historicalfoundation. Once the historical nature of interest and finance is understood,their consequences in the capitalist economy become much clearer. Thecritical theories of finance that are discussed in this book all arise out of somerecognition that finance emerges out of history, even if that recognition ismore explicit in the case of, for example, the historical school of criticalfinance (see Chapter 13) than in the case of more analytical theorists. Only ina historical context can the possibility emerge that finance may have untowardconsequences that are not due entirely to the failure of individuals to behaverationally. Hence a critical account of finance has to start with usury.

For approximately a century and a half after their dramatic deflation, theSouth Sea and Mississippi Bubbles of 1710–20 had discredited finance. Withthe exception of government bond markets and a few chartered companies, therapid rise and fall of fortunes associated with the South Sea Company inBritain, and the Mississippi Company in France, had made the joint stocksystem of corporate finance almost synonymous with fraud and financialdebauchery.3 The joint stock system of finance was seen as seriously flawed,and an indictment of the theories on credit money of the schemes’ instigator,John Law. During those 150 years, classical political economy rose andflowered. Not surprisingly finance then came to be considered for its fiscal andmonetary consequences. This preoccupation left its mark on twentieth-centuryeconomics in an attitude that the fiscal and monetary implications of finance,eventually its influence on consumption, are more important than its balancesheet effects in the corporate sector. This attitude is apparent even in the workof perhaps the pre-eminent twentieth-century critical finance theorist, JohnMaynard Keynes.

1. ADAM SMITH AND COMPANY FINANCE

However, during this long slumber of finance, a premonition of its disturbingpotential may be found in the work of the founder of classical politicaleconomy, Adam Smith. By and large, Smith shared his contemporaries’disapproving attitude towards the stock market system of corporate finance. Inthe last quarter of the eighteenth century, the theft and pillage by the East IndiaCompany, culminating in the scandalous trial, from 1788 to 1795, forcorruption and cruelty, of the first Governor-General of India, Warren

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Adam Smith’s economic case against usury

Hastings, could only confirm the unfavourable opinion on finance that hadbeen formed in the wake of the South Sea Bubble.4

The prospect of embezzlement, and deception with fraudulent intent, hasalways haunted financial markets. Such markets are based on the trust withwhich a depositor or financing partner places his money in the hands of afinancial intermediary. Theft and deception are merely the obverse or denialof that trust. But they do not amount to an explanation of how the financialsystem can disturb an economy in a systematic way any more than, in the morecontemporary example of the ‘New Keynesian theory’ of Joseph Stiglitz, thelack of information which a lender may have on a borrower’s intent amountsto a complete account of financial disturbance.5 To explain how the financialsystem may destabilise an economy, it is necessary to provide acomprehensive view of how finance works in the real economy. In An Inquiryinto the Nature and Causes of the Wealth of NationsAdam Smith put forwardthe elements of a critical finance view of the economy (that is, an explanationof how the monetary or financial system can disturb the economy) more as apossibility than a reality in his own time.

The first of these elements was an explanation of how entrepreneurs, or‘projectors’, as he called them, tend to exaggerate their business prospects.True to his method of reducing economic explanation to moral sentiment,Smith saw this tendency to view future business outcomes favourably asarising out of a natural self-regard affecting all men:

The over-weening conceit which the greater part of men have of their own abilities,is an ancient evil remarked by philosophers and moralists of all ages. Their absurdpresumption in their own good fortune has been less taken notice of. It is, however,if possible, still more universal. There is no man living, who, when in tolerablehealth and spirits, has not some share of it. The chance of gain is by every man moreor less over-valued, and the chance of loss is by most men under-valued, and byscarce any man, who is in tolerable health and spirits, valued more than it is worth… The establishment of any manufacture, of any new branch of commerce, or ofany new practice in agriculture, is always a speculation from which the projectorpromises himself extraordinary profits. These profits sometimes are very great, andsometimes, more frequently, perhaps, they are quite otherwise …6

Accordingly, in making business plans, there is a bias towards exaggeratingfuture returns. Actual returns in business, that is, the productivity of labour,are, according to Smith, determined by the location of the business, itstechnology, trade and competition in that line of business. Those returns, heargued, were lower in manufacturing countries where there exists free tradeand a high degree of competition in the various trades, and higher inindustrially backward countries where trade was restricted.7

The second element of Smith’s implied critical finance involved banks.These were supposed to play an important part in financing trade. Indeed,

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Smith was an early and principal advocate of the Real Bills Doctrine: the viewthat banks could issue bills of exchange without inflationary consequences,providing those bills financed traders’ stocks and were repaid from the salesproceeds of those stocks.8 It was vital, Smith argued, that banks should fulfilthis trade-financing function efficiently and without overcharging for theircredit or services. Otherwise, the benefits of trade and industrial progresswould be lost. In contrast to his well-known views in support of free trade andlaissez-fairein business, Smith advocated the regulation of banks in generaland, in particular, limits on the rate of interest that could be charged by banks.The interest chargeable for loans had been regulated in England since the timeof Henry VIII and, before his break with the Roman Church, by ecclesiasticalCanon Law. By Smith’s time the ceiling on interest was fixed at 5 per cent.Smith was a firm supporter of the usury laws. In the course of justifying suchgovernment regulation, Smith outlined what he considered to be the likelyconsequences of allowing interest rates higher than the rate that is ‘somewhatabove the lowest market price, or the price which is commonly paid for the useof money by those who can give the most undoubted security’:9

If the legal rate of interest in Great Britain, for example, were fixed so high as eightor ten per cent. the greater part of the money which was to be lent, would be lent toprodigals and projectors, who alone would be willing to give this high interest.Sober people, who will give for the use of money no more than a part of what theyare likely to make by use of it, would not venture into the competition. A great partof the capital of the country would thus be kept out of the hands which were mostlikely to make a profitable and advantageous use of it, and thrown into those whichwere most likely to waste and destroy it. Where the legal rate of interest, on thecontrary, is fixed but a very little above the lowest market rate, sober people areuniversally preferred, as borrowers, to prodigals and projectors. The person wholends money gets nearly as much interest from the former as he dares to take fromthe latter, and his money is much safer in the hands of one set of people than inthose of the other. A great part of the capital of the country is thus thrown into thehands in which it is most likely to be employed with advantage.10

Smith’s argument here is clearly over the limit that should be placed by theusury laws on the possible interest charged. But, given that the purpose of theusury laws was to prevent banks charging interest above the legal ceiling, it isan obvious implication that, without such a ceiling, banks would charge higherrates of interest. As Smith pointed out, the composition of business would thenchange in favour of ‘prodigals and projectors’ who are willing to pay higherinterest and would waste finance on their schemes.11

Smith distinguishes this bank-induced instability in the economy from whathe called ‘the over-trading of some bold projectors’ whose speculation ‘wasthe original cause of … excessive circulation of money’.12 With this, the term‘over-trading’ entered the business and economic lexicon. Essentially, itmeant using bank credit to finance stocks of commodities and finished goods

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built up by traders in the expectation of higher prices. Smith believed that dueadherence to the Real Bills Doctrine would avoid such speculative creditinflation.

Smith’s interest rate argument may be visualised in the form of a graph intwo dimensions. On the horizontal axis the users of credit may be lined up inorder of their expected return on their borrowing, gross of the interest paid ontheir borrowing. On the extreme left of the axis will be the prudent borrowersoperating established businesses in which competition holds down the grossreturn on their borrowing to the minimum. Moving right along the axis, theexpected return rises because businesses are less well established, earningputative returns exaggerated by monopolies, the vanity of projectors, and thedesperation of prodigals. The vertical axis represents the expected gross returnon the capital borrowed. In its essentials, Smith’s argument is that usury lawsare necessary in order to hold down the rate of interest below the gross returnwhich the most prudent businessmen can obtain. If the rate of interest isallowed to rise above this level, then the most prudent businessmen drop outof the market for credit. The population of borrowers in the market is thenreduced to less prudent businessmen whose expected returns are (just) inexcess of the new, higher, rate of interest. If the rate of interest rises stillfurther, the less prudent borrowers drop out and are replaced by even lessprudent borrowers.

Therefore, as the rate of interest rises, so the population of borrowerschanges from the more cautious to the less prudent. This analysis amounts toa theory of financial fragility in the sense of providing a complete explanationof how an economy becomes more prone to financial collapse. The ‘quality’of borrowing is reduced when the prudent cannot afford to borrow and creditis advanced increasingly to those trading on their confidence, as the rate ofinterest rises in the absence of a legal ceiling. In correspondence DavidCobham has suggested that there is no reason why banks, which can properlydistinguish good borrowing from bad, should not lend at lower rates of interestto prudent borrowers. However, in Adam Smith’s time they would only havebeen able to do this if they could re-finance or discount their loans more or lessat the same rate, since this was the banks’ way of regulating their cash flow.13

If the discount, or re-financing, rate rose, they would have been obliged tofollow suit with their lending, or face the possibility of losing money on loansmade at lower rates of interest when these loans came to be discounted.

2. THE CRITICAL VIEW OF QUESNAY

There is an intriguing personal coincidence between the view of Adam Smithand the founder of the Physiocrat school of political economy, François

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Quesnay, on usury as well as on the more widely known matter of free trade.Adam Smith had met François Quesnay in Versailles in 1766, in the course ofthe Scot’s European tour with the Duke of Buccleuch, and he had readextensively the work of the Physiocrats. Smith and Quesnay were both highlycritical of mercantilism, whose proponents opposed usury in the form of highinterest rates on the grounds that it restrains commerce and diminishes theprofit that may be obtained from trade. With the decline of mercantilist ideas,opposition to usury had been questioned. William Petty had argued that theusury laws did not allow lenders to charge a proper premium for risk.14 ButDavid Hume, also a critic of mercantilist ideas, pointed out the great benefitthat he believed France to obtain from the suppression of credit:

The French have no banks: Merchant bills do not there circulate as with us: Usuryor lending on interest is not directly permitted; so that many have large sums in theircoffers: Great quantities of plate are used in private houses; and all the churches arefull of it. By this means, provisions and labour still remain cheaper among them innations that are not half so rich in gold and silver. The advantages of this situation,in point of trade as well as in great public emergencies, are too evident to bedisputed.15

While Smith’s argument against usury may be traced through the criticismof it by the English classical political economists, that of Quesnay fell intosuch obscurity that even Joseph Schumpeter, in his monumental History ofEconomic Analysis,ignored it. Despite a high regard for the Frenchphysician’s contribution to systematic political economy in his TableauÉconomique, Schumpeter declared that ‘his theory of interest may be said tobe almost non-existent’.16 The account here is based on an unpublished paperby Edwin Le Heron entitled ‘Problématique réelle et analyse monétaire chezFrançois Quesnay’.

François Quesnay developed his views on the regulation of interest duringthe 1760s, after the publication of the first version of the Tableau Économique.This put forward diagrammatically the circulation of net product of theeconomy through the various sectors of the economy, and argued that land andagriculture was the source of value and wealth. According to Quesnay, creditwas needed to finance productive agricultural activities. However, credit wasalso used in non-productive (‘sterile’) activities in the form of savings devotedto private enrichment: speculation, usurious loans, government bonds, tradingin luxury goods. He called this activity ‘circulating finance’:

The wealth built up so to speak by stealth in the State and which we call circulatingfinanceis pecuniary wealth accumulated in the capital, where through intermedi-ation in public securities it is employed in a speculative traffic or in financing finance[finance contre finance] and buying marketable securities at a discount, withconsiderable profits for those with plenty of money to devote to such commerce.

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The great pecuniary fortunes which seem to manifest the wealth of the State arereally signs of decadence and ruin because they are created to the disadvantage ofagriculture, navigation, foreign trade, the products of labour and the revenues of theCrown.17

Quesnay argued that this disadvantage arises because the demand andsupply of money for sterile circulating finance determine the rate of interest.The government, in his view, should set a rate of interest in accordance withthe productivity of the land, and direct finance towards agriculture.18 This lastwas important because otherwise a lower rate of interest might give a falseimpression of greater wealth.19 Such measures would of course be resisted bythose engaged in circulating finance:

The lenders of money at interest, who cover themselves with the mantle ofcommerce as the authority for the arbitrary rate of interest on money, would not beslow in objecting that subordinating the rate of interest strictly to conform with theproductivity of land would destroy commerce … The counter-arguments, suggestedby the greed of the money-lenders in opposition to natural justice, are under thepretext of claimed advantages of commerce, of which they have only confused anderroneous ideas.20

Both Smith and Quesnay aroused the ire of their followers by insisting onthe need to regulate the rate of interest. The opposition to Smith’s view isdetailed below. The criticism of Quesnay came much earlier and, indeed,coincided with Smith’s meeting with Quesnay in 1766. The EncyclopédisteAnn Robert Jacques Turgot, who was to become Contrôleur-général ofFrance, that is, head of the French government administration, was in that yearwriting his Réflexions sur la formation et la distribution des richesses.Although he followed Quesnay in regarding agriculture as the only source ofvalue, he criticised Quesnay for opposing usury. Turgot was against theregulation of the rate of interest for reasons which were to become familiarthrough the political economy of the classical English school. Saving providedcapital for productive enterprise. According to Turgot, restrictions on the rateof interest would discourage saving, encourage luxury consumption, andprevent equilibrium arising between saving and investment in agriculture andindustry. Turgot’s argument was important, because Smith read his Réflexionsand was familiar with his work. Henry Higgs, whose oratory so impressedKeynes, wrote that ‘Adam Smith need not have waited for Bentham to converthim from Quesnay’s opinion in favour of usury laws if he had carefullystudied Turgot’s admirable argument against them.’21

Both Smith and Quesnay therefore argued for controls on finance and, inparticular, for limits on the rate of interest because both of them discerned a tendency for the money markets or the market for loans to be taken over by interests of non-productive or speculative economic activities. The

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fundamental difference between them was over what they regarded asproductive activities. For Smith it was manufacturing. For Quesnay it wasagriculture.22 Trade was important for both of them, because it developedefficient markets for productive activities. So it was with a view to thepromotion of manufacturing and agriculture respectively, and trade, that thetwo political economists directed their arguments for the restriction of usury.In France control of usury lived on, even after the usury laws were formallyabolished at the time of the Revolution. To this day, even after control ofcentral bank interest rates has been handed over to the European Central Bank,the Banque de France publishes fortnightly the ‘usury rates’ (taux d’usure),which constitute the ceiling on interest which may be legally charged.23

3. ADAM SMITH AND THE NEW KEYNESIANS

It has been suggested by no less an authority than Mark Blaug that AdamSmith’s exposition of the likely consequences of abolishing this legal ceilingon the rate of interest is an anticipation of late twentieth-century views on‘imperfections’ in financial markets:

Remarks such as this have been seized on in recent years as signs that Smithrecognized the problem of asymmetric information and moral hazard in creditmarkets, which make capital rationing a normal, and even typical feature of suchmarkets.24

Samuel Hollander has also observed that ‘Smith’s justification for a legalmaximum interest rate in some respects resembles the rationalization of creditrationing by Stiglitz and Weiss.’25

As will be apparent from the discussion below, Blaug’s view is moreappropriate to Bentham’s critique of Smith, and Keynes’s analysis ofuncertainty, than to Smith himself. The theory of asymmetric information,associated with the US economists Ben Bernanke, Frederic S. Mishkin andJoseph Stiglitz, emerged during the 1980s in response to the manifestabsurdities of the ‘market efficiency’ theory (manifest at least to anyone whohas worked in the financial markets and experienced at first hand the largeshare in their daily diet of rumour and misinformation). The theory of marketefficiency holds that financial markets are information exchanges thatefficiently value stocks according to publicly available information. Thetheory spawned a rash of econometric studies relating ‘market efficiency’ tothe variance of stock prices around their mean. But the main significance ofthe theory, outside the sphere of academic calculation, was to justify financialderegulation. By contrast, the theory of ‘asymmetric information’ suggests thebanks cannot be fully aware of the purposes to which their credit will be

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applied, and the true returns from those purposes. The banker offering a loanin effect loses control over the money once he has handed over the loan to theborrower, who has a financial interest in minimising the risks of the businesswhich the loan will finance. In this situation, contracts cannot be ‘complete’.Underlying it is a fundamental uncertainty, a lack of knowledge on the part ofboth the supplier of finance and the user of finance, about the future returns ofbusiness. Only over a period of time working with a client can a bank orfinancial institution acquire reliable information about that client’s credit-worthiness. The possibility of raising finance at a rate of interest below thatappropriate to the risks of the business being financed is supposed to give rise to ‘moral hazard’. ‘Moral hazard’ is a term drawn from the business ofinsurance, where it refers to the careless behaviour that may arise becausethose insured know that they can obtain monetary compensation in the eventof loss. Any contraction of lending, or raising of interest rates, is supposed tolead to ‘adverse selection’, as new lending is concentrated on entrepreneurswith risky projects, and expecting correspondingly higher rates of return.Credit rationing is supposed to arise when bank capital ratios fall, or whencredit is extended to sectors in which it was previously constrained by creditceilings. Banks are supposed then to make loan decisions in ignorance of truefuture returns on the loan. Rationing credit is the banks’ way of limiting theircommitment of funds to activities whose true risk is unknown. Credit isfrequently rationed using collateral values or the borrower’s liquidity asproxies for the ‘riskiness’ of the loan. The collateral may consist of assets,financial or otherwise, whose value decreases when the rate of interest rises,for example if the market yield (rate of interest or dividend rate divided by themarket price of the security) of long-term securities rises with a rise in theshort-term or bank rate of interest. In this way, when collateral values arereduced by higher interest rates the quality of loans in bank balance sheetsdeteriorates.26

Ben Bernanke has suggested that the Great Depression was exacerbated by bank failures, which destroyed the information that banks had about their borrowers. This was then supposed to have raised the real cost ofintermediation, giving rise to credit rationing and driving businesses intoinsolvency.27 Joseph Stiglitz and Andrew Weiss put forward a celebratedformalisation of a system of lending under such asymmetric information in which credit rationing arises.28 Stiglitz went on to use his position as Chief Economist at the World Bank during the 1990s to denounce prematurefinancial liberalisation in developing countries. He argued that a rapidexpansion of credit facilities before the establishment of developed economicinfrastructure in other sectors can only lead to financial speculation andcollapse.29

In arguing that the theories of perfect financial intermediation invoked in

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favour of financial liberalisation take no account of the limitations of humanknowledge, Stiglitz, Mishkin and Bernanke area really echoing Fisher’singenious explanation of credit cycles (see Chapter 6). They thus placethemselves into a mainstream academic tradition established by AlfredMarshall, who argued that ‘the economist studies mental states’.30 Thetradition goes back ultimately to the moral philosophy of Adam Smith, andtakes in Keynes and the majority of his followers, among whom Stiglitz,Mishkin and Bernanke count themselves. This tradition holds that adequateexplanation has been advanced when economic phenomena have been reducedto universal aspects of human perception, inclination and reasoning. In thecase of Stiglitz, Mishkin and Bernanke, these universal features of humanexistence are uncertainty about the future, the borrower’s preference for gainat the expense of the lender, and the lender’s ignorance of the borrower’s trueintentions. Indeed, the theoretical foundation for their work can best bedescribed as the microeconomics of imperfect information as an aspect ofhuman perception.

However, the problems of financial instability are far from universal humanpredicaments, but arise in the specific historical circumstances when thefinancial liabilities that are the counterparts of the assets of capitalist corpora-tions are inflated. The significant portion of the financial intermediation thattakes place in such an economy is not between individuals, but betweencorporations. At the very least these may be expected to behave in a morerational and circumspect manner than individual human beings. Max Weberhad put this forward as one of the fundamental principles of corporateorganisation:

Business management throughout rests on increasing precision, steadiness, and,above all, the speed of operations … Bureaucratization offers above all theoptimum possibility for carrying through the principle of specializingadministrative functions according to purely objective considerations. Individualperformances are allocated to functionaries who have specialized training and whoby constant practice learn more and more. The ‘objective’ discharge of businessprimarily means a discharge of business according to calculable rulesand ‘withoutregard for persons’. ‘Without regard for persons’ is also the watchword of the‘market’ and, in general, of all pursuits of naked economic interests.31

Max Weber went on to write that ‘Every bureaucracy seeks to increase thesuperiority of the professionally informed by keeping their knowledge andintentions secret.’32 But this was more in connection with political andreligious administration than the business management referred to earlier.That, in principle, may be expected to operate along more rational lines thanthe individuals undertaking financial transactions who appear to be the agentsexperiencing ‘asymmetric information’ in the theories of Stiglitz, Bernankeand Mishkin. The writings of the microeconomists of imperfect information

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are replete with references to ‘individual’ borrowers or investors, so-called‘principal–agent problems’ of the individual landlord–tenant, or employer–employee type.33

The confusion between individuals and corporations is crucial becausewhereas the former are prone to individual failings, as Max Weber argued,corporations are organised in order to overcome individual limitations. This ismost obvious in the case of Adam Smith’s explanation of how the division oflabour in the factory extends the productive capability of the individualsconcerned. Indeed, while Adam Smith had few illusions about the distortedperceptions and frailties of individuals, his political economy was aboutorganising human relations and institutions in such a way that improves theoutcome of human actions.34 The capitalist corporation cannot get rid of theuncertainty concerning other corporations’ activities and intentions, and theirconsequences in unpredictable business cycles. But it can protect itself fromtheir adverse consequences through liquidity preference (maintaining stocksof liquid assets), securing lines of credit, ‘hedging’, insurance and so on.Asymmetric information undoubtedly exists, but affects corporations andfinancial institutions differently from the way in which it affects individuals.Among corporations and financial institutions, some are more badly affectedby ‘asymmetric information’ and ‘adverse selection’ than others. For example,venture capitalists and individual speculators seem to experience greaterlosses than department stores and betting shops. The question is not whether‘asymmetric information’ exists, but how capitalist institutions accommodateit, and what rational rules they use to cope with uncertainty, lack ofinformation and so on.35

To give him his due, this is the essence of Stiglitz’s criticism of theestablishment of US-style financial institutions in other countries.36 He is at hisstrongest here precisely because this criticism recognises that financialinstability and crisis are features of particular forms of capitalist financialorganisation, rather than universal limitations of human perception andreasoning. Similarly, Bernanke, in his study of the consequences of bankfailure in the 1930s depression, recognised that banks hold far moreinformation on credit risks than an individual may possess.37 However, his wasa study of bank lending to small companies. While such companies may be theclosest modern equivalent to Smith’s myopic and self-aggrandising merchantsand ‘projectors’, they were arguably marginal to the course of the GreatDepression, which was precipitated and extended by the failure of largecorporations and the decline in their capital spending.

In fact, there is a very easy way of overcoming the worst aspects ofasymmetric information in the relationship between corporations and financialinstitutions. A recent study by David Cobham suggests that large dominantshareholdings can eliminate some of the problems associated with

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‘asymmetric information’.38 This is found in the German type of capitalismwhere banks hold shares, in some cases controlling shares, in the companiesthat borrow from them. This eliminates differences between the bank and theborrower over the credit-worthiness of the borrower by making the bank a co-manager of the company borrowing from it. Paradoxically, this system wasnot the result of some ‘natural’ evolution towards the most information-efficient form of corporate organisation. Nor was it as universal as Hilferding,Lenin and their followers came to believe. It was in fact the result ofsuccessive collapses of capital markets in continental Europe from 1873onwards, and the great inflation of the 1920s which destroyed the bondmarkets that are the core, even today, of stock market activity. It is curious thatthis apparently more information-efficient variant of capitalism was theincidental outcome of financial crisis and an initially frankly socialist, utopianideology of Saint-Simon.39 Even more curiously, the inflation of internationalfinance in the final decades of the twentieth century has put seemingly more ‘information-efficient’ financial variants at risk. There has been anincreasingly widespread adoption of the ostensibly less ‘information-efficient’financial systems, based on capital markets whose high turnover underminesdominant and responsible shareholders. The recent emphasis on ‘asymmetricinformation’ as a source of financial instability remains unclear not only aboutthe relationship between individual and corporate forms of activity, but alsohow these are affected by changes in capitalist institutions and the politicalregulation of markets. Its advocates are at their best in criticising utopianfinancial reforms in developing and post-communist economies. But basingthemselves on one rather obvious aspect of financial transactions, theiraccount is less systematic than that of authors who have more developedtheories of capitalism and its evolution. Arguably it is also less systematic thanthe view put forward by Smith.

Hollander makes the important point that Stiglitz and Weiss put forward asystem in which banks ration credit and set the rate of interest because they donot know what the true returns to borrowers will be, whereas Smith argues thatthe State should set the maximum rate of interest.40 Moreover, Smith did notconfuse human characteristics with those of institutions, although in his time,legal limitations on joint stock companies prevented the widespread use ofcorporate systems of industrial and commercial organisation and finance.Moreover, while Smith had no illusions about the limited understanding ofbankers, credit rationing does not arise because of this. According to themicroeconomists of imperfect information, credit is rationed to borrowersbecause bankers cannot distinguish between more prudent and less prudentborrowers. Smith’s bankers ‘rationed’ credit because they were limited by theamount of cash in their tills.41 Those bankers lent to the best borrowers in themarket on the terms available. However, they could not bring into the market

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the most prudent borrowers who have left it because they cannot afford to paya high rate of interest. Nor can they lend at a rate of interest below that atwhich they may have to borrow. In discussing the appropriate sphere of jointstock corporate activity, Smith hinted at a much more rational form of‘asymmetric information’, in which the boundary between uncertainty andknown risk or certainty is drawn according to the nature of economicoperations, rather than the limitations of human perception:

The only trades which it seems possible for a joint-stock company to carry onsuccessfully, without an exclusive privilege, are those, of which all the operationsare capable of being reduced to what is called a routine, or to such a uniformity ofmethod as admits of little or no variation.42

Smith suggested four ‘trades’ as suitable for such endeavours: banking,insurance, canals and water supplies. In the case of manufactures (theprototype of the modern corporation, according to economics textbooks)Smith was sceptical, but uncertain:

The English copper company of London, the lead-smelting company, the glass-grinding company, have not even the pretext of any great or singular utility in theobject which they pursue; nor does the pursuit of that object seem to require anyexpense unsuitable to the fortunes of many private men. Whether the trade whichthose companies carry on, is reducible to such strict rule and method as to render itfit for the management of a joint stock company, or whether they have any reasonto boast of their extraordinary profit, I do not pretend to know … The joint stockcompanies, which are established for the public-spirited purpose of promoting someparticular manufacture, over and above managing their own affairs ill, to thediminution of the general stock of the society, can, in other respects, scarce ever failto do more harm than good. Notwithstanding the most upright intentions, theunavoidable partiality of their directors to particular branches of the manufacture,of which the undertakers mislead and impose upon them, is a real discouragementto the rest, and necessarily breaks, more or less, that natural proportion which wouldotherwise establish itself between judicious industry and profit …43

This is the closest that Adam Smith came to suggesting that manufacturinginvestment is best limited to that which can be undertaken by individuals outof their own wealth, and that undertakings that depart from known routines ofproduction and distribution are vulnerable to waste and fraud. However, thisis not due to ‘asymmetric information’, leaving the fortunes of outsideinvestors at the mercy of ‘inside’ managers who really know what ishappening. Rather it is due to the ‘partiality’ of entrepreneurs, naturallyinclined to exaggerate the success of their undertakings, a partiality whichmisleads them and everyone else.

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2. The vindication of finance

1. JEREMY BENTHAM’S DEFENCE OF USURY

Within years of the publication of The Wealth of Nations, Jeremy Benthamtook issue with Smith over his views on usury. Bentham was an ardententhusiast for Adam Smith’s laissez-fairepolitical economy, which comple-mented his own liberal political and legislative ideas. He read The Wealth ofNationssoon after it was published, and re-read it. According to the editor of Bentham’s economic writings, Werner Stark, ‘a most thorough study ofSmith’s illustrious treatise was the mainspring of all Bentham’s economicknowledge’.1 Bentham acknowledged that ‘as far as your track coincides withmine, … I owed you everything’.2 Perhaps for this reason he was outraged bySmith’s argument for regulating the rate of interest. Travelling in Russia, heheard a rumour that the administration of William Pitt the Younger wasplanning to cut the legal rate of interest down from 5 per cent to 4 per cent.This turned out to be a false rumour, but it proved to be the catalyst forBentham to bring his thoughts together in a pamphlet entitled The Defence ofUsury. The pamphlet was in the form of a set of rhetorical letters to AdamSmith, making clear that it was Smith rather than Pitt to whom Bentham’sreproaches were addressed.

The Defence of Usurymounted a serious political case against the usuryLaws. The literary critic Hazlitt considered it to be Bentham’s most perceptivework.3 In Bentham’s view, banking is like any other business and it was nobusiness of the government to regulate the ‘hire of money’ any more than thehire of horses (Letter IX). The laws, he argued, did not discourage prodigality,since this could usually and equally be financed from savings or the sale ofassets (Letter III). The laws were widely evaded, and this tended to discreditthe law in general (Letters VII and VIII). Its roots lay in muddled thinking: theAristotelian notion that money is unproductive; the prejudice of borrowers, asopposed to lenders; and anti-Semitism (Letter X).4 Furthermore, limitinginterest reduces the ‘parsimony’ which augments the ‘capital’ that is the basisof trade (Letter XIII, p. 198).

But Bentham reserved his most furious economic arguments for a defenceof ‘projectors’. Their speculations, he argued, were the foundation ofeconomic progress, and it was wrong to deny them finance on any terms thatthey were willing to pay. The usury laws themselves did not concentrate

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The vindication of finance

finance on good projects, but merely deprived all projects of finance (LetterXIII). A notable omission is the absence of any mention that the level ofinterest rates may itself discourage ‘projectors’. Bentham argued as if onlygovernment limitations on interest rates could hold back projectors. In thisway Bentham established finance as the partner of capitalist enterprise, ratherthan, according to mercantilist thought, a usurious parasite on that enterprise.Marx, who thought that ‘the polemic waged by the bourgeois economists ofthe seventeenth century (Child, Culpeper and others) against interest as anindependent form of surplus value merely reflects the struggle of the risingindustrial bourgeoisie against the old-fashioned usurers, who monopolised thepecuniary resources at that time’ concluded that, with Bentham, ‘unrestrictedusury is recognised as an element of capitalist production’.5 This is not reallysurprising. Bentham himself was the author of a new model prison, thePanopticon, for whose construction he singularly failed to raise money orinterest from the government. But it made him identify with ‘projectors’ to apersonal degree.

Bentham’s argument in favour of industrial speculation was to attractKeynes’s attention. In the ‘Notes on Mercantilism etc.’ in his General Theory,Keynes noted Smith’s preference for ‘cheap money’ and Bentham’s defenceof projectors. In a footnote, Keynes wrote:

Having started to quote Bentham in this context, I must remind the reader of hisfinest passage: ‘The career of art, the great road which receives the footsteps ofprojectors, may be considered as a vast, and perhaps unbounded, plain, bestrewedwith gulphs, such as Curtius was swallowed up in. Each requires a human victim tofall into it ere it can close, but when it once closes, it closes to open no more, andso much of the path is safe to those who follow.’6

The quotation clearly recommends itself to Keynes for Bentham’s apparentrecognition of the economic problem of uncertainty, whose analysis was to besuch a distinctive part of Keynes’s thought. If there was such a recognition onthe part of Bentham, its scope was narrower than may appear from Keynes’scitation, in a footnote to and semi-detached from the discussion of thefinancing of projectors. Bentham in fact continued:

If the want of perfect information of former miscarriages renders the reality ofhuman life less happy than this picture, still the similitude must be acknowledgedstill nearer and nearer to perfection; I mean the framing the history of the projectsof time past, and (what may be executed in much greater perfection were but afinger held up by the hand of government) the making provision for recording, andcollecting and as they are brought forth, the race of those with which the womb offuturity is still pregnant …7

Bentham therefore has in mind less the uncertainty of the human condition

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that was the cornerstone of Keynes’s philosophy, and more the uncertaintyover the outcome of industrial innovations. His view here is arguably muchcloser to that of Hayek’s entrepreneur, carefully seeking to avoid the errors ofothers in his market, and trying to avoid ending up as the exemplar of error toothers.8

Bentham and Keynes had in common an outstanding ability to throw offbrilliant observations on the margins of their discussions. Bentham realisedthat he had drifted away from his defence of usury, to which he returned withrenewed vigour, leaving his philosophical and political economic intuition,like so many of his other insights, dangling inconsequentially in his text.

Bentham’s Defence of Usuryis therefore essentially a plea for commercialfreedom to be extended to banking; an argument that the usury laws wereineffective and that they constrained saving, and therefore investment; and anaccount of the economic benefits of projectors. He did not deal with the mainburden of Adam Smith’s argument in support of the usury laws, namely that arise in the rate of interest would cause a decline in the quality of credit assound competitive businesses with lower rates of profit reduce their demandfor credit.

This context has to be borne in mind when considering the evidence that Adam Smith may have been won round by Bentham’s arguments. On 4 December 1788, George Wilson wrote to Bentham as follows:

Did we ever tell you what Dr. Adam Smith said to Mr. Wm Adam the Counsel M.P.last Summer in Scotland? The Doctor’s Expressions were ‘That the Defence ofUsury was the Work of a very superior Man; and that tho’ he had given Him somehard hard knocks, it was done in so handsome a way that he could not Complain’and seemed to admit that you were in the right.9

In early July 1790, Bentham wrote to Adam Smith outlining his plans for anew edition of the Defence of Usury.

I have been flattered with the intelligence that, upon the whole, your sentimentswith respect to the points of difference are at present the same as mine … If, then,you think proper to honour me with your allowance for that purpose, then and nototherwise, I will make it known to the public, in such words as you give me, thatyou no longer look upon the rate of interest as fit subject for restraint …10

Adam Smith was on his death-bed. He was to die on 17 July. Inacknowledgement he sent Bentham a dedication copy of The Wealth ofNations, ‘a present’, Bentham was to write,

I had the melancholy consolation of receiving from Adam Smith at the same timewith the news of the loss which, as a citizen of the world, I had sustained by hisdeath … a token of that magnanimity which, it were to be wished, were always the

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accompaniment of the inevitable war of opinions, as carried on by writing andthinking men.11

From this ambiguous evidence, Smith’s biographer John Rae concludedthat the Defence of Usury

had the very unusual controversial effect of converting the antagonist against whomit was written … It is reasonable to think that if Smith had lived to publish anotheredition of his work he would have modified his position on the rate of interest.12

More recently, Stephen Pressman wrote that ‘After reading Bentham’s book,Adam Smith was persuaded that his support of usury laws was in error, andthat there should be no government regulations on interest.’13

However, the editor of Bentham’s economic writings, Werner Stark, cameto a more ambiguous conclusion that ‘It must be an open question whether Raeis on firm ground.’ Since Bentham did not deal with Smith’s main argumentin support of the usury laws, the exclusion from credit by higher interest ratesof sound competitive businesses, it must be seriously doubted whether Smithwas convinced by Bentham. Smith had not been persuaded by Turgot’sarguments in favour of usury. These were more systematic than Bentham’s. Itis all the less likely, then, that Bentham’s additional pleading won him over.14

Schumpeter, who was by no means convinced of the validity of Smith’s theory of interest, dismissed ‘an entirely unjustified attack from Bentham’ onSmith’s ‘moderate and judicious argument about legal maxima’ on interest.15

Pesciarelli has suggested that Smith had the opportunity to change his viewsin revising the Wealth of Nationsfor its second and third editions, in 1789 and1791. He made substantial revisions of his Theory of Moral Sentimentsat thistime, and so would not have been deterred by the infirmities of his last yearsfrom correcting an earlier view which he might now have believed waswrong.16 Hollander also doubts that Bentham’s pleading made Smith changehis mind.17

2. THE BANKER’S VIEW OF HENRY THORNTON

Bentham’s argument against Smith was essentially political, namely acriticism of restraint on commercial endeavour. Even his editor was obliged toadmit that Bentham’s economic argument was weak, his ‘most outstandingshortcoming’ being ‘the complete absence of a theory of interest’.18 In theevent, this did not matter. Within a few years, the economic and monetarycircumstances that Smith and Bentham had described were transformed by theFrench Revolution and its wars, the wars against Napoleon Bonaparte, and his commercial blockade of Britain. In 1797, following a deflationary outflow

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of currency from the country in the wake of the assignatcollapse in France,the convertibility of banknotes against gold was suspended, and was notresumed until 1819. The banknote issue was inflated to pay for the wars, andthe focus of monetary discussions shifted to questions of price stability andconvertibility. Directly involved in these monetary and financial disturbanceswas the banker Henry Thornton. From 1782 to 1815 he was also a Member ofParliament, where he gave evidence to three committees of Parliament that, in 1797, investigated the suspension of the Bank of England’s obligation toconvert its notes into gold.19 Thornton went on to write an extensive explana-tion and defence of paper money entitled An Enquiry into the Nature andEffects of the Paper Credit of Great Britain, which was published in 1802.Together with two Speeches to the House of Commons on the Bullion Reportof 1811, which recommended the resumption of gold payments by the Bankof England, and some notes on Lord King’s Thoughts on the Effects of theBank Restrictionin 1804, these works exhaust the published writings of athoughtful and public-spirited banker. After many years of neglect, his workwas revived and republished in 1939, in a volume edited by Friedrich vonHayek that is, arguably, among Hayek’s greatest achievements. Later scholarsof economic thought were to find in his works ideas on money (the differencebetween nominal and real interest rates, interest premiums for expectedinflation, forced saving, and the precautionary demand for money) which hadbeen attributed to Wicksell, von Mises, Fisher, Keynes and Lucas. Like Smith,he had no doubt that bankers have the measure of their clients. However,Thornton went further and argued that this gives bankers the most profoundunderstanding of credit which, shared among themselves, could maintain itsbalanced expansion:

The banker also enjoys, from the nature of his situation, very superior means ofdistinguishing the careful trader from him who is improvident. The bill transactionsof the neighbourhood pass under his view; the knowledge, thus obtained, aids hisjudgement; and confidence may therefore be measured out by him more nearly thanby another person, in the proportion in which ground for it exists. Through thecreation of banks, the appreciation of the credit of numberless persons engaged incommerce has become a science; and to the height which this science is now carriedin Great Britain we are in no small degree indebted for the flourishing state of ourinternal commerce, for the general reputation of our merchants abroad, and for thepreference which in that respect they enjoy over the traders of all other nations …20

The Revolutionary and Napoleonic Wars had brought considerableprosperity to Britain, although this was arguably the result of its government’shigh expenditure on prosecuting hostilities, rather than the superlativeintelligence of its bankers. This prosperity inspired the presumption of a‘natural’ equilibrium in economic activity found in Thornton’s writings (‘thenatural state of things’, he called it) that has endeared him to those, like his

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editor Hayek, for example, who believe that the market capitalist economy isthe Mecca of economic civilisation. On one occasion Thornton even arguedthat any reduction in the Bank of England’s paper money issue would havevirtually no impact on commercial activity, because businessmen and bankerswould develop new forms of credit, trade credit in particular, to overcome anyshortage of circulating medium: ‘I cannot conceive that the mercantile worldwould suffer such a diminution to take place, without substituting a circulatingmedium of their own …’21 In Paper Credithe pointed to the variety of meansof payment and credit instruments in commercial use, whose only prerequisitewas ‘confidence’ that an exchange could eventually be effected for Bank ofEngland notes. This, together with his sceptical remarks about the efficacy ofchanges in the Bank of England’s note issue, is entirely consistent with theview, championed by Post-Keynesian economists after Kaldor, that the moneysupply is ‘endogenous’. This means that the supply of money is largelydetermined by the demand for it. Thornton criticised Smith’s Real BillsDoctrine on the grounds that lending against collateral could itself beinflationary if the value of the collateral were rising or if the term of the billwere extended.22 Bankers themselves would naturally be aware of this, andwould want to limit their lending:

It is certainly the interest, and, I believe, it is also the general practice, of banks tolimit not only the loan which any one trader shall obtain from themselves, but thetotal amount also, as far as they are able, of the sum which the same person shallborrow in different places; at the same time, reciprocally to communicateintelligence for their mutual assistance; and above all to discourage bills ofaccommodation … Thus a system of checks is established, which, though certainlyvery imperfect, answers many important purposes, and, in particular, opposes manyimpediments to wild speculation.23

In Thornton’s view, an excessive note issue might stimulate a short-termincrease in economic activity, but must inevitably lead to higher prices.24

Indeed, his Paper Creditcan be understood as an extended argument that theBank of England’s note issue since 1797 had not been excessive, and the risein prices experienced since 1797 was due to poor harvests, trade disturbancesand the exigencies of the war, an interpretation of events that would appeal tothe advocates of endogenous money. This defence of the Bank perhaps thencaused McCulloch later erroneously to describe Thornton as a Director of theBank of England.25 In Thornton’s view, reductions in the note issue bore mostheavily and immediately on the banking system. With fewer Bank of Englandnotes, which they could get from deposits, discounting, or by exchanging otherbankers’ notes (the Bank of England’s monopoly of issuing banknotes wasrestricted to the London area until 1844), banks would be vulnerable towithdrawals of deposits (runs) and would seek to conserve their gold coins andBank of England notes by refusing to lend, or discount merchant’s bills. This

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would precipitate ‘commercial distress’ and stock market crisis as merchantsand businessmen would find themselves unable to finance stocks or work inprogress, and investors would be forced to sell stocks:

the Suppression of the Bank of England’s Paper, to any considerable extent, must,unless some other Paper is substituted, in my Opinion, pull down the Price ofExchequer Bills, of India Bonds, and other Government Securities, which will besold by those who possess them, in order to secure a sufficient Quantity of BankNotes to carry on their payments, and which a Variety of Bankers will be selling atthe same Time, each endeavouring, though in vain, to possess himself of the notesheld by the others. It must produce, therefore, Discredit to the Government, aconsequent Distrust in the Minds of the Public, who will not understand the Causeof this Depreciation of the Stocks; it must produce, at the same Time, CommercialFailures, and an Appearance of Bankruptcy, even in Times when the Individuals inthe Nation, and the Nation itself, might be rich and prosperous …26

However, such disturbances are caused by deliberate manipulations of thenote issue by the monetary authorities. In this respect, Thornton may beclassed with later thinkers, such as Hayek, Lucas, Wicksell and Wojnilowerwho, even if they did not believe in general equilibrium, attributed financialdisturbances to the implementation of inappropriate policies by the monetaryauthorities.

However, his reputation as a monetary economist has obscured what isarguably Thornton’s most widely accepted idea, even though most individualswho have held it would be unable to identify his authorship of it. This is theidea that a low rate of interest gives rise to an excess demand for credit. Theclassical political economists rapidly took up this assertion to invert AdamSmith’s argument that high rates of interest induce deteriorating credit, and toconclude that low rates of interest lead to ‘speculation’.

Thornton put forward this argument by postulating that the rate of profit onmercantile activity varies according to the economic circumstances of acountry. But it is not just the rate of profit that determines the demand forcredit. That demand arises from a comparison of the rate of profit with the rateof interest that must be paid to borrow the (circulating) capital necessary toobtain that profit. The 5 per cent rate of interest laid down by the usury laws,or 4 or 6 per cent, may be appropriate in times of peace. But ‘the temptationto borrow, in time of war, too largely at the bank, arises … from the high rateof mercantile profit. Capital is then scarce, and the gain accruing from theemployment of it is proportionately considerable.’ Curiously Thorntonhimself was more concerned about the effect of an excess demand for crediton the liquidity of banks, rather than on prices, which worried later economistsmore: ‘It is, therefore, unreasonable to presume that there will always be adisposition in the borrowers at the bank to prescribe to themselves exactlythose bounds which a regard to the safety of the bank would suggest.’27

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Thornton was also concerned that British merchants and foreign stock-holderswould find more remunerative employment for their capital abroad than inBritain. The outcome of this was to oblige the Bank of England to limit theloans it granted to merchants to a fixed weekly total, an early example of creditrationing.28 Thornton therefore argued for the removal of the ceiling on the rateof interest.

Thornton had one other argument against the usury laws that is notable asan example of how two economists may draw mutually contradictoryconclusions from the same fact. In his evidence before the Lord’s Committeeof Secrecy Appointed to Enquire into the Causes which Produced the Order inCouncil of 26 February 1797 (this was the Order in Council under which theBank of England ceased to pay gold in exchange for its banknotes), Thorntonwas asked: ‘Has not the low Price of the Funds and other Governmentsecurities, by affording an higher Interest than Five Per Cent., operated as anHindrance to Mercantile Discounts?’ Thornton answered, ‘It undoubtedly hasoperated in that Manner very effectually.’29

His eventual conclusion was that the usury laws operated against creditstability by removing the possibility of raising interest rates to keep capital inthe country and discourage the demand for credit. Jean-Baptiste Say was toconclude otherwise, that usury laws were necessary to prevent precisely sucha diversion of credit from industry and agriculture.

3. RICARDO AND THE ABOLITION OF THE USURY LAWS

Although, like Bentham, Ricardo formed his views on political economy fromhis reading and re-reading of Smith’s The Wealth of Nations, he owed hismonetary thinking more to his practical experience as stockbroker during thewartime inflation. As is well known, he advocated a return to the goldstandard, but on the basis of the convertibility of high-value banknotes forgold bullion as a way of maintaining stable prices and trade equilibrium. In his Principles of Political EconomyRicardo criticised Smith for believing that the market rate of interest followed the legal rate, whereas in fact theactual market rate of interest varies from the legal rate, sometimes quitesubstantially, and the legal rate was widely evaded: ‘During the present war,Exchequer and Navy Bills have been frequently at so high a discount, as toafford the purchasers of them 7, 8 per cent., or a greater rate of interest for theirmoney. Loans have been raised by government at an interest exceeding 6 percent …’ while the legal rate remained fixed at 5 per cent.30 Hollander haspointed out that rates of interest on British government loans had exceeded thelegal rate as early as the late 1770s, as a result of the large amount of loans

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required to prosecute the American War.31 The market rate of interest, in itsturn, was ultimately determined by the rate of profit which, in Ricardo’seconomics, would tend to fall with capital accumulation. By implication, sotoo, eventually, would the market rate of interest. Indeed, the attempt to repealthe usury laws was introduced in 1818 precisely at a time when the market rateof interest was below the legal rate.

In his evidence to the House of Commons Select Committee on the usury laws, which he gave after the publication of his Principles of PoliticalEconomyin 1817, Ricardo reiterated his view that the laws were widelyevaded, including by the government. There would be no commercialdisadvantage in their abolition. Indeed, by restricting the competition to lend,the laws actually raise the rate of interest which borrowers are obliged to pay.There would be no injury to ‘mercantile interests’ if the laws were abolished,and it would help to discourage the export of capital.32 There is a curiouscoincidence between the views expressed by Ricardo and those of JeremyBentham. The two men were friends, with a correspondence dating back to 1811. There is ample evidence in the volumes of Ricardo’s Works andCorrespondencethat he knew of Bentham’s papers and pamphlets on legisla-tive reform. But Ricardo’s comments on Bentham’s economic writings arerestricted by and large to Bentham’s proposal for using circulating annuitiesas a currency and his papers on currency, arguing that the increase in papermoney was the cause of rising prices.33 In particular, there is no mention inRicardo’s writings or correspondence of Bentham’s Defence of Usury. Theconnection was to be made after Ricardo’s death by his disciple John RamsayMcCulloch.

Ricardo also attempted to deal with another argument for regulating the rate of interest, that of Jean-Baptiste Say. Say had put forward in his Traitéd’Économie politiquea version of François Quesnay’s ‘crowding-out’argument: agriculture, manufacture and commerce would be driven out of the credit market if ‘a borrower may be found ready to pay’ a higher rate of interest, especially the government. The ‘profit on stock’ would rise as merchants increased prices to pay higher interest, to the detriment ofconsumption and more productive activities.34 Ricardo’s answer to this was:

To the question: ‘who would lend money to farmers, manufacturers, and merchants,at 5 per cent. per annum, when another borrower, having little credit, would give 7 or 8?’ I reply, that every prudent and reasonable man would. Because the rate ofinterest is 7 or 8 per cent. there, where the lender runs extraordinary risk, is this anyreason why it should be equally high in those places where they are secured fromsuch risks? M. Say allows, that the rate of interest depends on the rate of profit; butit does not therefore follow, that the rate of profits depends on the rate of interest.One is the cause, the other the effect, and it is impossible for any circumstances tomake them change places.35

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Ricardo was not so much refuting Say as (unconsciously) reiteratingBentham’s earlier argument that loans at higher rates of interest reflectedobjectively higher profit opportunities, with correspondingly higher businessrisk.

Henry Thornton and David Ricardo were crucial in putting forward theideas that were to persuade legislators that, for the sake of sound banking andmonetary policy, as well as in the interests of commercial freedom, the lawslimiting the rate of interest should be abolished. However, in doing so theychanged the elements which constituted Adam Smith’s argument bynarrowing the scope of the demand for credit and changing its nature. AdamSmith envisaged merchants and industrialists borrowing money, with the latterin particular prone to exaggerate the success of their enterprises. Smith alsodiscussed the financing of enterprise through banks and joint stock issues.Thornton and Ricardo, London banker and stock-broker respectively,envisaged the demand for credit as essentially that of the individuals andinstitutions who did business with them in their professional lives, namelymerchants and financial investors, the Treasury, the country banks whopresented their bills to Thornton for re-discount against Bank of Englandnotes, international bill brokers and bullion dealers. The demand for industrialcredit appears from beyond the orbit of their practical work as a demand forfinance to undertake works with an objectively known rate of profit in a worldof certain prices and incomes.36 Adam Smith may have been more realistic inhis treatment of business motives and prospects, but Thornton and Ricardobetter represented the business optimism and social confidence of theemerging financial markets of London.37 By contrast, the anti-bullionistspokesman of the Birmingham manufacturers, Thomas Attwood, whoexpressed the manufacturers’ fear of credit instability under the bullionistsystem of currency regulation, was represented as ‘a provincial bankerlabouring under a financial monomania’.38

4. THE EMERGENCE OF MONETARY POLICY

Say’s point about higher interest, charged to consumers in higher prices,crowding out productive enterprise, was soon stripped of its regulatoryimplications by the bullionist critics of the Real Bills Doctrine. Thorntonargued that speculative inflation was all the more likely if interest rates werekept low.39 Among the bullionists, John Ramsay McCulloch distinguishedhimself by bringing back into the discussion Smith’s views on usury and theRicardians’ opposition to them. In 1828 he published an annotated edition ofAdam Smith’s The Wealth of Nations. In Volume II of this edition, afterSmith’s sentence ‘If the legal rate of interest in Great Britain, for example,

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were fixed so high as eight or ten per cent. the greater part of the money whichwas to be lent, would be lent to prodigals and projectors, who alone would bewilling to give this high interest’, McCulloch added the following note:

It is singular that Dr. Smith should have advanced so untenable a proposition. Thereis evidently no reason whatever for supposing that if the usury laws were repealed,and men allowed to bargain for the use of money as they are allowed to bargain forthe use of land, houses, &c. they would be less careful and attentive to their interestsin the former case than in the latter. The prudence and success of persons engagedin new and unusual undertakings are always considered doubtful; and they werenever able to obtain loans on such easy terms as those who are engaged in ordinaryand understood branches of industry. It is, however, unnecessary to enlarge on thissubject, as it has been most ably discussed, and every objection to the unconditionalrepeal of the usury laws, on the grounds of its encouragement of projectors,satisfactorily answered by Mr. Bentham, in his letter to Dr. Smith, in his Defence ofUsury. I shall give, in a note on the Usury Laws in the last volume, some accountof their practical operation during the late War, and of the efforts that have beenmade to procure their repeal.40

McCulloch never wrote his note on the usury laws. By this time economiccircumstances were evolving in a way that was to ensure their eventualabolition, irrespective of the merits of projectors. The resumption of convert-ibility in 1819, at the pre-war price of gold, was facilitated by a deflationaryreduction of the note issue by the Bank of England and speculation whichdrove down the price of gold. Thereafter the Bank of England needed aninstrument to facilitate the stabilisation of its gold reserves. This instrumentwas to be the bank rate, that is, the rate at which the Bank of Englanddiscounted the best-quality bills, which was supposed to discourage discount-ing in London for banknotes convertible into gold at the Bank. In 1811, HenryThornton had suggested that raising the rate of interest would attract gold toLondon.41 Beginning in 1833, the scope of the Usury Acts was limited untiltheir final repeal in 1854. But regulating gold deposits was not the onlypossible use of interest rates that was envisaged as the usury laws were beingabolished. In 1839, an outflow of gold from the country to the Continent andAmerica caused problems with reducing the quantity of paper money incirculation. The Bank of England raised its bank rate above the 5 per centmaximum laid down in the usury laws to 6 per cent. This was as much toreduce the outflow of gold reserves as to check the expansion of credit, byreducing the number of bills presented to the Bank of England for discount, sothat its note issue could be diminished without refusing to discount. (In theevent, the inflow of gold failed to materialise, and the Bank of England wasforced to borrow gold in Paris and Hamburg.) Avoiding a refusal to discountwas important for maintaining the liquidity of banks. The Bank of Englandhad on three occasions, in 1793, in 1799 and 1811, refused to discount, out ofa desire to limit the amount of banknotes that were issued at discount. On all

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three occasions, the government’s Treasury forced accommodation by issuingExchequer Bills, which the Bank of England could not refuse to discount, andwhich were therefore acceptable as means of payment among merchants andtheir banks. In 1825, the Bank of England refused again, but gave way andresumed discounting at the height of the crisis.42

According to Keynes, in 1839 ‘the new-fangled notion was invented thatbank rate had an independent influence through its effect on “speculation”’.43

The resulting tendency of money market interest rates to fluctuate with thebusiness cycle was noted by the banker Samuel Lloyd, Lord Overstone, in his1837 pamphlet Reflections … on the causes and consequences of the pressureon the Money Market. Overstone was to be very influential in the thinkingunderlying the 1844 Bank Charter Act, designed to limit the issue of papercurrency. Using a loanable funds model, the classical political economistsattributed changes in money market interest rates to changes in the demand forloans, relative to supply. ‘In speculative times’, during a boom, interest ratesrise, while ‘in the intervals between commercial crises, there is a tendency inthe rate of interest to a progressive decline from the gradual process ofaccumulation’, so that only in equilibrium is the rate of interest determined bythe rate of profit.44

5. JOHN STUART MILL AND SPECULATION

‘Speculation’ played an important part in the explanation of ‘commercialcrisis’ that prevailed among the classical political economists of the nineteenthcentury. A separate category of financial disturbance, bank ‘runs’, whichThornton had analysed, caused bank collapses but did not, apart from the lossof deposits, transmit such distress into the rest of the economy. The notion ofspeculation placed the starting point of commercial crises in speculative tradein the real economy, which they believed could be facilitated by easy financeof speculative stocks through credit or paper money. This view, echoingSmith’s earlier explanation of ‘over-trading’, was summed up by that greatsynthesiser of classical political economy, John Stuart Mill as follows:

The inclination of the mercantile public to increase their demand for commoditiesby making use of all or much of their credit as a purchasing power, depends on theirexpectation of profit. When there is a general impression that the price of somecommodity is likely to rise, from an extra demand, a short crop, obstructions toimportation, or any other cause, there is a disposition among dealers to increasetheir stocks, in order to profit by the expected rise. This disposition tends in itselfto produce the effect which it looks forward to, a rise in price: and if the rise isconsiderable and progressive, other speculators are attracted, who, so long as theprice has not begun to fall, are willing to believe that it will rise. These, by furtherpurchases, produce a further advance: and thus a rise in price for which there were

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originally some rational grounds is often heightened by mere speculative purchases,until it greatly exceeds what the original grounds will justify. After a time thisbegins to be perceived; the price ceases to rise, and the holders, thinking it time torealize their gains, are anxious to sell. Then the price begins to decline: the holdersrush into the market to avoid a still greater loss, and, few being willing to buy in afalling market, the price falls much more suddenly than it rose. Those who havebought at a higher price than reasonable calculation justified, and who have beenovertaken by the revulsion before they had realized, are losers in proportion to thegreatness of the fall, and to the quantity of the commodity which they hold, or havebound themselves to pay for.

If there were no such thing as credit, this could hardly happen with respect tocommodities generally … But … when people go into the market and purchase withmoney which they hope to receive hereafter, they are drawing upon an unlimited,not a limited fund … This is … what is called a commercial crisis.45

John Stuart Mill was perhaps the last of the nineteenth-century politicaleconomists to take issue with Smith’s argument against usury. Mill had nodoubt that it was ‘next to the system of protection, among mischievousinterferences with the spontaneous course of industrial transactions.’46

Predictably he commended ‘the triumphant onslaught made upon it byBentham in his “Letters on Usury,” which may still be referred to as the bestextant writing on the subject.’47 Like his friend Bentham, Mill saw the originsof restrictions on usury as being in a ‘religious prejudice against receivinginterest on money’, and defended ‘projectors’ as entrepreneurs engaged inindustrial progress. However, Mill now put forward what came later to beknown as a ‘loanable funds’ theory of capital to criticise restrictions on usury.In his view the rate of interest was naturally determined ‘by the spontaneousplay of supply and demand’. Attempts to hold the rate of interest below thislevel would give rise to excessive demand for credit, which would be satisfiedonly at excessive rates outside the protection that the law provides forcommercial contracts.

If the competition of borrowers, left unrestrained, would raise the rate of interest tosix per cent, this proves that at five there would be a greater demand for loans thanthere is capital in the market to supply. If the law in these circumstances permits nointerest beyond five per cent, there will be some lenders, who not choosing todisobey the law, and not being in a condition to employ their capital otherwise, willcontent themselves with the legal rate: but others, finding that in a season ofpressing demand, more may be made of their capital by other means than they arepermitted to make by lending it, will not lend at all; and the loanable capital, alreadytoo small for the demand, will be still further diminished. Of the disappointedcandidates there will be many at such periods who must have their necessitiessupplied at any price, and these will readily find a third section of lenders, who willnot be averse to join in a violation of the law, either by circuitous transactionspartaking of the nature of fraud, or by relying on the honour of the borrower. Theextra expense of the roundabout mode of proceeding, and an equivalent for the riskof non-payment and of the legal penalties, must be paid by the borrower, over and

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above the extra interest which would have been required of him by the general stateof the market. The laws which were intended to lower the price paid by him forpecuniary accommodation, end thus in greatly increasing it.48

On the supply side, Mill’s argument depended on a presumption that‘competition will limit the extra demand [for higher interest] to a fairequivalent for the risk’.49

Mill further argued that the usury laws exacerbated commercial crises. Herehe reinterpreted Smith somewhat:

Adam Smith rather hastily expressed the opinion that only two kinds of persons,‘prodigals and projectors’, could require to borrow money at more than the marketrate of interest. He should have included all persons who are in any pecuniarydifficulties, however temporary their necessities may be. It may happen to anyperson in business, to be disappointed of the resources on which he has calculatedfor meeting some engagement, the non-fulfilment of which on a fixed day would bebankruptcy. In periods of commercial difficulty, this is the condition of manyprosperous mercantile firms, who become competitors for the small amount ofdisposable capital which, at a time of general distrust, the owners are willing to partwith. Under the English usury laws, now happily abolished, the limitations imposedby these laws were felt as a most serious aggravation of every commercial crisis.Merchants who could have obtained the aid they required at an interest of seven oreight per cent for short periods, were obliged to give 20 or 30 per cent, or to resortto forced sales of goods at a still greater loss.50

In fact Smith put forward a policy of mercantile support that was even morefavourable to merchants in distress. His Real Bills Doctrine, combined withthe usury laws, offered the possibility of flexible credit against future sales ata rate of interest that would not rise because of additional demand for credit.Arguably this would relieve commercial distress much more effectively thanMill’s loanable funds model in which, without an increase in saving, the rateof interest would rise at the first signs of ‘pecuniary difficulties’.

Mill’s association of paper money with speculation was a life-longconviction expressed in one of his first articles ‘Paper Currency – CommercialDistress’, which he published in 1826. Here he echoed Smith to decry ‘theuniversal propensity of mankind to overestimate the chances in their ownfavour’ and looked forward to a time when ‘sober calculation may graduallytake the place of gambling’.51 However, the ‘speculation’ of which Mill andthe classical political economists wrote was a merchant’s pursuit, whereas the‘projectors’ of Smith, and Bentham, were industrial capitalists in speif not infact. Karl Niebyl has pointed out that in their considerations of credit, theclassical political economists regarded enterprise as an essentially mercantileactivity.52

In this regard Marx was an exception. Anticipating Minsky’s Ponzi financeanalysis, he noted that, in times of crisis, ‘everyone borrows only for the

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purpose of paying, in order to settle previously contracted obligations …’ andonly subsequently, ‘in time of renewed activity after a crisis, loan capital isdemanded for the purpose of buying and for the purpose of transformingmoney-capital into productive and commercial capital’.53

The opponents of bullionism (the doctrine that prices would be stable ifpaper currency were limited to the amount of gold reserves) pressed the caseof manufacturers keen to have more elastic credit facilities. They argued thatthe price level determined the quantity of currency, and not vice versa, andattributed the industrial depression after 1815 to the return to the gold standardand its effects on credit. The preference of anti-bullionists, for example theBirmingham banker Thomas Attwood and his brother the Member ofParliament Matthias Attwood, was for a paper currency which they envisagedworking much like the system Thornton examined in the early chapters ofPaper Credit.54 But it was not until the twentieth century, in the work of RalphHawtrey, that these anti-bullionist ideas were developed into a systematicargument about disturbance of the economy by the credit system.

Mill’s analysis of speculative crises was to be entrenched in twentieth-century economics by Alfred Marshall. In The Economics of Industry, whichhe published with his wife Mary Paley Marshall, he put forward a credit cyclewhich, in its essentials, was Mill’s speculative cycle. The main innovation wasthat an over-supply of credit, rather than paper money, was now held to beresponsible for inflationary, speculative booms and crises.55 A faint echo ofSmith found its way into The Economics of Industry, in a forecast that the rateof interest is destined to fall over time, in accordance with the law ofdiminishing marginal returns. The analysis of ‘credit fluctuations’ then foundits way into Marshall’s Money Credit and Commerce, where he reiterated theclassical doctrine that ‘prompt action by the Bank of England in regard to therate of discount’ may check speculative excess.56 However, he noted thedifficulty of doing this if the bank rate is being used to regulate gold reserves,and was best done where currency is inconvertible.57 Thus, through Marshall,the classical doctrine of raising the money rate of interest to check speculationwas transmitted into the twentieth-century work of Hawtrey and latermonetarists.

6. A PRELIMINARY CONCLUSION

The discussion around Adam Smith’s views on usury, and the reaction of laterclassical political economists to those views, provides intriguing anticipationsof current ideas of saving, uncertainty, risk-adjusted interest rates, loanablefunds, capital rationing, asymmetric information, Ponzi finance and financialfragility. That in itself makes it worthwhile re-visiting this debate. But a

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crucial and hitherto neglected element of the debate was Adam Smith’spremonition of financial fragility, the decline in the ‘quality’ of credit withhigher interest rates. The prevailing currency school in classical politicaleconomy replaced the notion that high interest rates concentrate credit on thefinancing of speculative projectors with the notion that high interest ratesdiscourage speculation.

Smith’s argument on usury was never refuted in its own terms (of highinterest rates excluding prudent borrowers and thereby shifting the demand forcredit towards speculators and so on). It simply got left behind, because thesituation changed: the conduct of the Revolutionary and Napoleonic Warsrequired the suspension of convertibility, with the result that the expansion ofpaper currency was associated with price inflation; and the terms of thediscussion changed: Bentham and Ricardo emphasised that freedom to set theterms of loans was an essential element of normal commercial freedom. Eventhat freedom proved to be elusive. With the Bank of England influencingmoney market rates through its discounting policy, cyclical movements inmoney market interest rates linked high interest rates with the bursting ofspeculative bubbles. This was not inconsistent with Smith’s argument: thefinancial collapse following a speculative bubble was, as Marx implied, just aslikely because of a decline in the quality of credit as interest rates rose. Smith’sargument came to be replaced by the categorical reassurance taught to studentstoday that ‘those who find it easiest to borrow are those whose financialposition is basically sound’.58 ‘Commercial distress’ came to be regarded byclassical political economy as being due to speculation, which is naturallysqueezed out by higher rates of interest. Monetary and credit problems cameto be viewed as the consequences of inappropriate monetary policy on the partof the authorities. The banking and financial system, while vulnerable to runsand collapses, nevertheless makes exchange more efficient and raises financefor industry and commerce. But the responsibility for financial fragility in theeconomy was placed firmly with merchant speculators and the monetaryauthorities. Out of this comes the modern view that Smith’s advocacy of legalregulation of interest was a reversal along an otherwise direct path to laissez-faire that must have occurred to him ‘in an incautious moment’,59 an‘aberration … inconsistent with Smith’s basic theory of sensible economicbehaviour’.60 Smith’s reluctance to recognise Bentham’s superior wisdom issupposed to illustrate how ‘the able economist … seldom admits or corrects amistake’.61 Even his most recent biographer, Ian Simpson Ross, recognisingthat Bentham was unlikely to have convinced Smith, opines: ‘It is aninteresting speculation that, had Smith lived beyond 1790, he might havealtered his stand on reducing interest and equating projectors with prodigals’,especially since ‘the message about the detrimental effects of most economiclegislation intensified in the third edition’ of 1791.62

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In a different context, the philosopher Bernard Williams said of analyticalphilosophy that ‘when you had taken the problems of philosophy apart, you’dfind that many of its traditional questions had not been solved but haddisappeared’.63 It would be tempting to see the dispute in political economyabout usury as just such an intellectual debate that went out of fashion, andwas replaced by a newer way of looking at the issues. However, the newer wayof looking was itself precipitated by events: the inflation of the NapoleonicWars and the deflation that followed, and the inconvenience of the usury lawsfor the burgeoning business of finance. These events did not resolve thequestions raised by Smith about finance, but served as the pretext for settingthem aside. Those questions were then transmitted to modern generations ofstudents as an uncharacteristic questioning of the wisdom of laissez-faire. ButSmith’s argument in favour of usury laws was not about the wisdom ofunregulated markets, but the respective roles of finance and enterprise in amarket economy. The issues that he raised were to be revived, albeit in a guisemore suited to their circumstances, in the twentieth century.

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PART II

Critical Theories of Finance in the Twentieth Century: Unstable Money and Finance

This social character of capital is first promoted and wholly realised throughthe full development of the credit and banking system … The distribution ofcapital as a special business, a social function, is taken out of the hands of theprivate capitalists and usurers. But at the same time, banking and credit thusbecome the most potent means of driving capitalist production beyond its ownlimits, and one of the most effective vehicles of crises and swindle.

(Marx, Capital Volume III, p. 607)

3. Thorstein Veblen and those ‘captainsof finance’

Because his work marks the first break with classical political economy overfinance, Veblen may be regarded as the first theorist of modern finance.Finance was crucial to his vision of how the modern capitalist economyoperates. He dismissed the neo-classical version of economics not onlybecause it was ahistorical, but also because it derived its so-called ‘laws’ fromaxioms about barter. It was not only the ‘neo-classicals’ who were guilty ofthis. The Swedish monetary economist and near contemporary of Veblen,Knut Wicksell, derived his notion of a ‘natural’ rate of interest explicitly fromconsiderations of exchange and capital productivity in a barter economy.1

The earlier classical political economy was less relevant, in Veblen’s view,because its monetary analysis was based on commodity money. Yet thecritical feature of the modern capitalist economy is the predominance of credit.Credit, in Veblen’s view, infuses virtually every transaction in the capitalisteconomy with a different meaning and different consequences to those whichsuch transactions may have in the barter economy that is the staple of classicaland neo-classical economics.2 In this respect, Veblen was arguably the firstPost-Keynesian. He criticised Tugan-Baranovsky for arguing that money wasa negligible factor in economic crises. ‘He thereby commits himself to theposition that these crises are phenomena of the material processes of economiclife (production and consumption), not of business traffic … Substantially thesame is true of Marx, whom Tugan follows, though with large reservations.’3

1. CRITICAL FINANCE IN THE THEORY OF BUSINESS ENTERPRISE

In three seminal chapters of his book The Theory of Business Enterprise,published in 1904, Veblen put forward a number of ideas which have sincebecome standard in mainstream and critical finance. Among them is the firstcapital asset pricing model, deriving the present value of capital assets fromthe discounted stream of expected future income. In a striking anticipation ofHawtrey’s and Keynes’s later views, Veblen made clear that economic crisesare a monetary phenomenon (‘The shrinkage incident to a crisis is chiefly a

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pecuniary, not a material, shrinkage.’4) Moreover, he argued that expectationsof future income are projections into a future which cannot be known, and aretherefore the outcome more of sentiment and confidence than rationalcalculation. The following remark could just as easily have been made byKeynes:

It will be noted that the explanation here offered of depression makes it a malady ofthe affections. The discrepancy which discourages business men is a discrepancybetween that nominal capitalization which they have set their hearts upon throughhabituation in the immediate past and that actual capitalizable value of theirproperty which its current earning-capacity will warrant. But where thepreconceptions of the business men engaged have, as commonly happens, in greatpart been fixed and legalized in the form of interest-bearing securities, this maladyof the affections becomes extremely difficult to remedy, even though it be true thatthese legalized affections, preconceptions, or what not, centre upon themetaphysical stability of the money unit.5

However, in contrast to Keynes and most subsequent economists, Veblendid not see credit inflation as in any way adding to productive capacity:‘borrowed funds do not increase the aggregate industrial equipment’.6 Instead,the funds are used to secure better control of markets and existing industrialcapacity:

All these advances afford the borrower a differential advantage in bidding againstother business men for the control and use of industrial processes and materials,they afford him a differential advantage in the distribution of the material means ofindustry; but they constitute no aggregate addition to the material means of industryat large. Funds of whatever character are a pecuniary fact, not an industrial one;they serve the distribution of the control of industry only, not its materiallyproductive work.7

Veblen combined this model with the social philosophy of emulation,which he had already made famous in his earlier book The Theory of theLeisure Class, into the first financial cycle theory. Borrowing in anticipationof future profits gives an enterprise a competitive advantage over otherenterprises in its business. Such a ‘credit extension’ from securities markets orbanks induces emulation among competitor firms. The effect of such lendingagainst collateral is to increase the value of the collateral. The gains expectedfrom their credit extensions become cumulative rather than cancelling eachother out because they raise the value in the financial markets of the collateralagainst which credit is obtained. In this way a credit boom is engineered: ‘Theextension of credit proceeds on the putative stability of the money value of thecapitalized industrial material, whose money value is cumulatively augmentedby this extension itself.’8 However, the foundations of the credit boom lie notin any increase in productive capacity, or income and corporate sales revenue,

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but in the expectations of the financiers that Veblen viewed as increasinglyrunning industry, and the way in which the financial markets value thecollateral on which they lend. Competitive lending is both the result of higherexpectations of gain and itself enhances that gain through increases in marketvaluations of assets, and hence expectations of future gains. Such gains, heargued, depended on the ability of business to raise prices faster than wages.9

But the difficulty with this is that it limits the market for output. Here Veblenendorsed Hobson’s under-consumptionist theory of depressions.10 Inevitably,when the enhanced expectations of gain are confounded, the boom breaks intoa financial crisis:

the money value of the collateral is at the same time the capitalized value of theproperty, computed on the basis of its presumptive earning-capacity. These twomethods of rating the value of collateral must approximately coincide, if thecapitalization is to afford a stable basis for credit; and when an obvious discrepancyarises between the outcome given by the two ratings, then a re-rating will be had inwhich the rating on the basis of earning-capacity must be accepted as definitive,since earnings are the ground fact upon which all business transactions turn and towhich all business enterprise converges. A manifest discrepancy presently arises inthis way between the aggregate nominal value (capital plus loans) engaged inbusiness, on the one hand, and the actual rate of earning-capacity of this businesscapital, on the other hand; and when this discrepancy has become patent a period ofliquidation begins.11

on the consequent withdrawal of credit a forced rerating of the aggregate capitalfollows, bringing the nominal aggregate into approximate accord with the facts ofearning-capacity … the shrinkage which takes place in reducing the aggregaterating of business capital from the basis of capital goods plus loans to the basis ofcapital goods alone, takes place at the expense of debtors and nominal ownersindustrial equipment, in so far as they are solvent … apart from secondary effects,such as a heightened efficiency of industry due to inflated values, changes of therate of interest, insolvency, etc., the main final outcome is a redistribution of theownership of property whereby the creditor class, including holders and claimantsof funds, is benefited.12

The rate of interest, Veblen argued, could influence the course of thebusiness cycle, but only where business committed itself to interest rates thatthen fell in a recession, and where the costs of converting to a lower rate ofinterest were too high.13 Moreover, lower interest rates in a depression wouldtend to raise the present value of existing industrial establishments relative tonew capacity, discouraging new investment.14

With the rise of stock market credit, the possibilities of credit extensions aregreatly increased. Large industrial corporations are kept permanently in a stateof ‘over-capitalization’ in relation to earning capacity by means of ‘stock-watering’. Additional stock is issued and the proceeds are not used to increaseproductive capacity. This excess capital corresponds to ‘good-will’, or

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‘franchise’, that is, intangible sources of future earnings. Such capital is valuedon the stock market at a price that fluctuates inversely with the ‘long-periodfluctuations of discount rates in the money markets’. Adjustments of creditvalues to the true earning capacity of industry then take place through changesin stock prices.15 The main function of this more sophisticated credit is acontinuous process of mergers, acquisitions and balance-sheet restructuringsin which the company promoter and investment banker benefits from anartificially induced turnover of credit: ‘This syncopated process of expandingcapital by the help of credit financiering, however, is seen at its best in thelater-day reorganizations and coalitions of industrial corporations …’.16 This,he argued, was what distinguished the instability of actual corporate financingfrom the kind of ‘speculation’ that Henry Crosby Emery at the time wassuggesting offered certainty and financial stability to business.17

By ‘heightened efficiency’, Veblen meant ‘heightened intensity of applica-tion and fuller employment of industrial plant’.18 His insistence that ‘creditextensions’ are not spent on additions to the material prerequisites ofproduction would suggest that the ‘credit inflation’ corresponds to increasedholdings of liquid assets by companies, rather than mere ‘good-will’.However, Veblen does not appear to have thought through such implicationsof balance-sheet identities. His suggestion that ‘heightened efficiency’ inindustry is a largely insignificant by-product of credit extension furtherhighlights the absence of a systematic exposition of the credit cycle, asopposed to the description of pertinent symptoms, which he evidently hugelyenjoyed writing.

Nevertheless, excluding this anomaly, his account would be not toodifferent from contemporary theories of ‘rational bubbles’.19 However, themore recent theories are rooted in equilibrium values reflecting the best of allpossible outcomes in production and distribution. Reversion to such values isthe basis of most recent theories of financial instability, and their scope islimited by the financial markets themselves. By contrast, Veblen’s cycles areexplanations of how finance disturbs the rest of the economy. As numerouscommentators, such as Heilbroner, have pointed out, Veblen reachedintellectual maturity at the time of ‘robber baron’ capitalism in America, whenfinance was a critical tool of plunder, as a means of gain as well as a way tolaunder illicit gains.20 In June 1893 there had occurred ‘one of the severestcrises in the history even of American credit’, as Ralph Hawtrey described itwith characteristically English condescension. Banks throughout the USA,with the exception of those in Chicago, suspended cash payments. Bankfailures were followed by a major crisis in industry and trade.21 As itproceeded, the economic depression was marked by a wave of industrialconsolidations, mergers and takeovers, leaving the American banks and stockmarkets preoccupied with corporate restructurings. Veblen drew much of his

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data from the testimony of witnesses before the Industrial Commissions of theUS Congress, which held hearings in the 1890s into the financial andindustrial excesses of American corporations. Veblen therefore regardedfinance as a tool of what he called ‘capitalist sabotage’, which set the ‘captainsof finance’ against the honest ‘engineers’ seeking industrial efficiency. In acapitalism dominated by finance, the absentee owners of industry are obligedto limit production to get the highest possible profit that ‘the market can bear’,and to disturb markets with their shifting coalitions between variouscorporations and industrial interests. Veblen argued that the ‘captains offinance’ and absentee owners owe their incomes and their control of industryto the legal conventions surrounding the laws of contract and propertyestablished in the eighteenth century. In the wake of the Russian Revolution,he looked forward to the day when more rational attitudes would prevail andthe ‘engineers’ would overthrow ‘the captains of finance’.22 He was to bedisappointed. After a slow start, the ‘New Capitalism’ of 1920s Americaflourished, motivated by the stock market boom.

2. VEBLEN’S LATER THOUGHTS

In 1923, Veblen published his last book, Absentee Ownership and BusinessEnterprise in Recent Times: The Case of America. In this he broadly reiteratedthe analysis that he had put forward in The Theory of Business Enterprise,albeit now expressing considerably less optimism concerning the possibilitythat the ‘engineers’ may take over from the ‘captains of finance’ (whom henow dubbed ‘captains of industry’). He also qualified, in a characteristicallyoff-hand way, his earlier view that cost minimisation by employers wouldrender workers unable to raise their wages above subsistence level. This hadbeen the basis of Hawtrey’s later dismissal of Veblen for establishing histheory of profit ‘on the Ricardian theory of a subsistence wage’.23 In a footnoteVeblen suggested that the limitations of aggregate demand in a capitalisteconomy make enterprises engage in ‘salesmanship’ in order to expand their market. This has the effect ‘of establishing a conventional need forarticles which have previously been superfluities’. The ‘(moral) subsistenceminimum to be provided out of wages will be raised, without a correspondingincrease in the workman-like efficiency of the wage-earners’.24 The some-what misogynous examples he gave of ‘moral’ necessities, rather than the‘requirement of subsistence or physical comfort’, were ‘furs, cosmetics orhigh heels’.25

But the main change he now introduced into his analysis concerned financeand its role in the economy. Whereas in The Theory of Business Enterprisefinancial instability was a major factor agitating the economic stagnation of

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capitalism, in his later work, financial disturbances disappeared. In 1913, inlarge part because of earlier financial instability, the US Congress hadestablished the Federal Reserve system. This set up a network of wholesalebanking markets and an official mechanism for discounting bank assets,ensuring that banks could not run out of liquidity. Veblen saw this as acentralisation of the credit system, underwriting the fortunes of investmentbanking.26 As a result, credit expands to take control of all business, with theaim of ‘recapitalising’ it and loading it with financial liabilities:

Stability, greater security from unforeseen or undesigned contingencies, will enabletrading in credits and capitalisation on a thinner equity; which signifies a largervolume of fixed charges payable to the makers of credit, on the resultant increasedvolume of outstanding obligations; which means that the custodians of credit areenabled to take over the assets of the business community with increasingly greaterexpedition; which in turn will increase the stability of the business as well as themeasure of control exercised by the keepers of credit over the conduct of businessand industry at large.27

However, this over-capitalisation of companies occurs using debt instru-ments (bonds or bank loans). This, in turn, gives rise to high equity gearing(ratio of debt to equity), Veblen’s ‘thinner equity’, which would nowadays betaken as indicating financial fragility, that is, a enhanced possibility offinancial collapse if the ‘fixed charges’ could not be paid. But Veblen saw itin rather more conventional terms that would have been familiar to Thorntonor John Stuart Mill, as a cause of price inflation in the real economy:

Directly or indirectly, the resulting credit instruments go to swell the volume ofcollateral on which the fabric of credit is erected and on which further extensionsare negotiated. These credit extensions in this way enable the concerns in questionto trade on a thinner equity. That is to say, such business concerns are therebyenabled to enter into larger commitments and undertake outlays that are morelargely in excess of their tangible assets than before; to go into the market with apurchasing-power expanded by that much – or a little something more – beyondtheir available possessions, tangible and intangible. Which goes to enlarge theeffective purchasing-power in the market without enlarging the supply of vendiblegoods in the market; which will act to raise or maintain the level of prices, and willtherefore enlarge the total of the community’s wealth as rated in money-values,independently of any increase of tangible possessions; all of which is ‘good fortrade’.28

This inflation is at the expense of industry:

It foots up to an inflation of the total volume of wealth in hand as rated in terms ofprice, with no corresponding increase of tangible possessions; whereby theinvestment bankers and their clients come in for an increased share of wealth inhand, at the cost of the general body of owners and workmen.29

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Although Veblen did not mention Hilferding, Lenin, Bukharin or Varga, theoutcome is their system of finance capital, but devoted to usury (expanding‘the capitalisation of overhead charges’ of credit) rather than ‘the socialisationof capital’:

Eventually, therefore, the country’s assets should, at a progressively acceleratedrate, gravitate into the ownership, or at least into the control, of the bankingcommunity at large; and within the banking community ownership and controlshould gravitate into the hands of the massive credit institution(s) that stand at thefiscal centre of all things.30

The stability of the system proved to be illusory. Veblen died in 1929,weeks before the ‘captains of finance’ overthrew themselves. In later years thecommon view was that the 1930s reforms of banking and finance (theGlass–Steagall Act of 1932, the extension of the powers of the FederalReserve system and the establishment of lender of last resort facilities)rendered Veblen’s theories of finance irrelevant.31 This leaves open thepossibility that recent deregulation may have renewed their currency. There isno doubt that his explanations suffered from a lack of consistency and system.This was a common feature of economic analysis in his time, and mayarguably be found also in the contemporary work of writers such as Hobson,and even Keynes and Schumpeter. Paul Sweezy later pointed out the seriousanalytical omission in Veblen of a theory of aggregate demand.32 This had theresult that he brought in arguments for particular purposes, and seems to haveignored them otherwise. A notable example is his treatment of companybalance sheets, in which the counterpart of excess capital is strangely absent,except as further claims on the cash flow of companies. The issue of excesscapital liabilities would normally add to the cash reserves of a company orwould be used for investment. The conventional view is that increasedreserves stabilise corporate finances. Further explanation is required to makeovercapitalisation consistent with financial instability, under-investment andindustrial stagnation, as he suggested.

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4. Rosa Luxemburg and the Marxistsubordination of finance

Rosa Luxemburg is best known for her attempt in her book The Accumulationof Capital to show that capitalist accumulation requires external markets inorder to overcome a tendency to stagnation. These external markets formedthe basis of her theory of imperialism, which was taken over by Lenin andsubsequent Marxists. However, in chapter XXX of that book, on ‘InternationalLoans’, Rosa Luxemburg examined the role of finance in capitalaccumulation. This analysis was perhaps peripheral to her argument. But it hassufficient critical elements to warrant a place for Luxemburg among thepioneers of critical finance, while the fate of that analysis among Marxistsreveals how the most important school of radical political economy in thetwentieth century came to an attenuated view of finance as a factor in capitalistcrisis.

1. ROSA LUXEMBURG’S CRITICISM OF INTERNATIONAL BANKING

For Luxemburg, the context of the system of international loans was crucial.Advanced capitalist countries faced crises of ‘realisation’, that is, inadequatedemand to allow profits to accrue. At the same time, developing countrieslacked the markets for commodity production to take place on a capitalistscale. She argued that international loans are crucial in providing finance sothat dependent and colonial countries can buy the equipment to develop theireconomic and industrial infrastructure, reaching political independence buttied into financial dependence on the older capitalist states:

In the Imperialist Era, the foreign loan played an outstanding part as a means foryoung capitalist countries to acquire independence. The contradictions inherent inthe modern system of foreign loans are the concrete expression of those whichcharacterise the imperialist phase. Though foreign loans are indispensable for theemancipation of the rising capitalist states, they are yet the surest ties by which theold capitalist states maintain their influence, exercise financial control and exertpressure on the customs, foreign and commercial policy of the young capitaliststates … such loans widen the scope for the accumulation of capital; but at the sametime they restrict it by creating new competition for the investing countries.1

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Rosa Luxemburg and the Marxist subordination of finance

The raising of the loans and the sale of the bonds therefore occur inexaggerated anticipation of profits. When those hopes are dashed, a crisis ofover-indebtedness breaks out. The governments of the dependent and colonialterritories are obliged to socialise the debts, and make them a charge on theirtax revenues. However, by this time the loans have served their primarypurpose, which is to finance the export of capital equipment from theadvanced capitalist countries, thereby adding to their profits and capitalaccumulation. With the crisis, capital accumulation comes to a halt, beforenew issues of bonds and loans finance capital exports to another country andcapital accumulation is resumed.

The financial crisis is overcome mainly at the cost of destroying theagricultural economy of the developing countries:

While the realisation of the surplus value requires only the general spreading ofcommodity production, its capitalisation demands the progressive supercession ofsimple commodity production by capitalist economy, with the corollary that thelimits to both the realisation and the capitalisation of surplus value keep contractingever more.2

Ultimately the peasants have to pay the additional taxes and are destined tosee their markets taken over by mass capitalist production. Luxemburg gavean extensive account of international loans in Egypt as an example. Here,

the transactions between European loan capital and industrial capital are based uponrelations which are extremely rational and ‘sound’ for the accumulation of capital,because this loan capital pays for the orders from Egypt and the interest on one loanis paid out of a new loan. Stripped of all obscuring connecting links, these relationsconsist in the simple fact that European capital has largely swallowed up theEgyptian peasant economy. Enormous tracts of land, labour and labour products,accruing to the state as taxes, have ultimately been converted into European capitaland have been accumulated … As against the fantastic increase of capital on the onehand, the other economic result is the ruin of peasant economy together with thegrowth of commodity exchange …3

Similarly, in Turkey,

railroad building and commodity exchange … are fostered by the state on the basisof the rapid disintegration, ruin and exploitation of Asiatic peasant economy in thecourse of which the Turkish state becomes more and more dependent on Europeancapital, politically as well as financially.4

Luxemburg’s analysis of finance did not win the favour of contemporaryMarxist economists. In his pamphlet, ‘Imperialism, the Highest Stage ofCapitalism’, written in 1916, Lenin did not even mention Rosa Luxemburg,but based his economic explanation of imperialism on his critical reading of

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Hobson’s Imperialism, and his view of the role of finance on Hilferding’sFinance Capital. Hilferding’s book had been published in 1910, three years before Luxemburg’s, and put forward a more benign view of finance.Hilferding generalised from the experience of banking in Germany, where‘universal’ banks organised the capital markets and thereby came to own oftencontrolling stakes in large companies. He argued that banks were a crucialfactor in the emergence of monopoly capitalism and the cartelisation of thecapitalist economy. In Hilferding’s view, the banks not only financed theindustrial expansion of capitalism into dependent and colonial territories, butalso restrained competition between capitalists and financed their cartels. Ifcrises arose, they were due to disproportions in production and class struggles.By stabilising the markets and finances of the capitalists in their cartels, bankswere able to shift the costs of those crises onto non-cartelised capitalists.Because it concentrates control over industry, finance capital facilitates theeventual socialisation of the means of production.5

2. THE MARXIAN REFLECTIVE VIEW OF FINANCE

In his insistence that capitalist crisis can only be due to disproportions inproduction, or struggles between the classes involved in it, Hilferding wasundoubtedly the more orthodox Marxist. Marx’s views on money and financedo not constitute a consistent analysis, largely because in his time finance wasonly just emerging into economic pre-eminence. Recent research by AnitraNelson and Riccardo Bellofiore suggests that those views themselves appearto have been mangled in the course of Engels’s editing of Marx’s notes intothe widely accepted versions of the second and third volumes of Capital.6

However, in at least two respects Marx was in advance of the conventional,Ricardian thinking of his time. First of all, Marx distinguished explicitlybetween the rate of interest and the rate of profit: in the classical politicaleconomy of David Ricardo, the rate of interest and the rate of profit werevirtually interchangeable.

Second, and related to his distinction between the rate of interest and therate of profit, Marx distinguished between real, or productive, capital and the ‘fictitious’ capital of financial assets.7 Real capital is the stock of plant,equipment and materials out of which goods will be produced. Fictitiouscapital is the structure of financial claims on that capital. This is crucial for theprocess of equalising the rate of profit across industries. It is through themarket for fictitious capital that money capital may be advanced to particularindustries, and through that market, money may be taken out of particularindustries and firms and transferred to others.

The scope and significance of finance in Marx’s analysis is clearly laid out

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in chapter thirty-six of volume III of Capital. With the title ‘Pre-capitalistRelations’ it may seem an odd chapter in which to find Marx’s conclusions onthe role of finance in capitalism. But it does conclude Part V of the volume, apart that is entitled ‘Division of Profit into Interest and Profit of Enterprise.Interest-Bearing Capital’. Moreover, the chapter has the added merit ofauthenticity: in his Preface, Engels wrote that ‘The greatest difficulty waspresented by Part V which dealt with the most complicated subject in theentire volume.’ After fruitless attempts to complete various chapters in it,Engels confined himself to ‘as orderly an arrangement of available matter aspossible’. Of these chapters, the manuscript of ‘the “Pre-capitalist” chapter(Chapter XXXVI) was quite complete’.8

The chapter discusses the historic emergence of credit from medievalsystems of usury. Marx wrote that

The credit system develops as a reaction against usury. But this should not bemisunderstood, nor by any means interpreted in the manner of the ancient writers,the church fathers, Luther or the early socialists. It signifies no more and no lessthan the subordination of interest-bearing capital to the conditions and requirementsof the capitalist mode of production.9

Marx viewed the battle against usury as a ‘demand for the subordination ofinterest-bearing capital to industrial capital’.10 In this way, capital ceases to bethe fragmentary wealth that is at the unhindered disposal of individualcapitalists, but is socialised to be reallocated where the highest return may beobtained.

What is crucial here is the use of the word ‘subordination’. It clearlyindicates the view that finance and credit are led by developments in produc-tive industry.11 As Engels succinctly put it in a letter to Eduard Bernstein in1883, ‘The stock exchange simply adjusts the distribution of the surplus valuealready stolen from the workers …’ (Marx and Engels, 1992, p. 433). InVolume III of Capital such adjustment is supposed to facilitate convergence,among firms and different activities, on an average rate of profit, whosedecline then sets off generalised industrial crisis in capitalism.12

Although this could not have been foreseen at the time when Marx waswriting, the development of the capitalist system went not towards the‘subordination’ of finance to industrial capital, but towards the subordinationof industrial capital to finance. Hence the sluggish development of industry incapitalist countries that have come to be dominated by rentier capitalism, mostnotably the UK and the USA from the 1880s through to the 1930s, and fromthe 1980s onwards.

This development is central to the theory of capitalist crisis. In Marx,economic depressions are supposed to arise from a decline in the industrialrate of profit. Marx, however, recognised that excessive expansion of credit

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may also give rise to crisis when confidence in that credit falls and demand forcash settlements rises. In Volume III of Capital, he suggested two kinds ofsuch crisis. One was an internal banking crisis,

when credit collapses completely and when not only commodities and securities areundiscountable and nothing counts any more but money payment … Ignorant andmistaken bank legislation, such as that of 1844–1845 can intensify this moneycrisis. But no kind of bank legislation can eliminate a crisis.13

The other kind of crisis that was familiar to Marx was the drain on gold forinternational payments attendant upon a balance of payments deficit. Thisresults in the successive ruin of first importers and then exporters:

over-imports and over-exports have taken place in all countries (we are notspeaking here about crop failures etc., but about a general crisis); that is over-production promoted by credit and the general inflation of prices that goes with it.14

However, more modern crises of finance capitalism appear to be set off bydisturbances in the financial system, which then spread to industry bydevastating the balance sheets of industrial corporations. Notable examples ofthis are the 1929 Crash and the Japanese economic crisis after 1991. ForMarxists these raise very fundamental questions concerning the scope ofMarx’s analysis, that is, the degree to which it indicates salient features of thecapitalism of his time, and the degree to which that analysis remains true ofcapitalism everywhere at all times. This is not a dilemma peculiar to Marxists.It is one that affects adherents of all ‘defunct economists’. Perhaps most of allit affects those ‘practical men who believe themselves to be quite exempt fromany intellectual influences’ and who therefore do not yet understand that their‘obvious’ ideas were invented by some defunct economist to enlightencircumstances that have since passed away.

Marx made one further assumption that today would be consideredcontroversial. This concerns the manner in which capitalist finance operates.One paragraph below his statement that capitalist finance is subordinated toindustry, Marx wrote the following:

What distinguishes interest-bearing capital – in so far as it is an essential element ofthe capitalist mode of production – from usurer’s capital is by no means the natureand character of this capital itself. It is merely the altered conditions under which itoperates, and consequently also the totally transformed character of the borrower,who confronts the money-lender. Even when a man without fortune receives creditin his capacity of industrialist or merchant, it occurs with the expectation that hewill function as a capitalist and appropriate unpaid labour with the borrowedcapital. He receives credit in his capacity of potential capitalist. The circumstancethat a man without fortune but possessing energy, solidity, ability and businessacumen may become a capitalist in this manner – and the commercial value of each

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individual is pretty accurately estimated under the capitalist mode of production –is greatly admired by apologists of the capitalist system. Although this circumstancecontinually brings an unwelcome number of new soldiers of fortune into the fieldand into competition with the already existing individual capitalists, it alsoreinforces the supremacy of capital itself, expands its base and enables it to recruitever new forces for itself out of the substratum of society. In a similar way, thecircumstance that the Catholic Church in the Middle Ages formed its hierarchy outof the best brains in the land, regardless of their estate, birth or fortune, was one ofthe principal means of consolidating ecclesiastical rule and suppressing the laity.The more a ruling class is able to assimilate the foremost minds of a ruled class, themore stable and dangerous becomes its rule.15

This Schumpeterian vision comes close to the perfectly efficient inter-mediation view of finance. It is still the view that prevails in contemporaryeconomics. The more fundamental critic of capitalism, in this regard, turns outto have been Michal Kalecki, who concluded that the key factor in capitalaccumulation was the ‘free’ capital owned by the entrepreneur. He wrote:

The limitation of the size of the firm by the availability of entrepreneurial capitalgoes to the very heart of the capitalist system. Many economists assume, at least intheir abstract theories, a state of business democracy where anybody endowed withentrepreneurial ability can obtain capital for a business venture. This picture of theactivities of the ‘pure’ entrepreneur is, to put it mildly, unrealistic. The mostimportant prerequisite for becoming an entrepreneur is the ownership of capital.16

Hints at a more complex view of finance by the founders of the Marxistschool emerge in their correspondence, in particular the later letters, whichshow a lively sensitivity to the way in which finance acquired economicimportance as the nineteenth century progressed. In a letter in 1881 to theRussian economist and translator of Capital Nikolai Danielson, Marx notedhow an influx of gold reserves can insulate the financial system from theindustrial crisis: ‘if the great industrial and commercial crisis England haspassed through went over without the culminating financial crash at London,this exceptional phenomenon was only due to French money’.17 In a later letterto the German social democrat leader August Bebel, in 1885, Engels notedhow inflated financial markets would drive down interest rates. In the absenceof higher returns from industry, money markets would stay liquid, but theirliquidity would not induce industrial investment, a premonition of laterEnglish theories of liquidity preference:

The chronic depression in all the decisive branches of industry also still continuesunbroken here, in France and in America. Especially in iron and cotton. It is anunheard-of situation, though entirely the inevitable result of the capitalist system:such colossal over-production that it cannot even bring things to a crisis! The over-production of disposable capital seeking investment is so great that the rate ofdiscount here actually fluctuates between 1 and 11/2 per cent per annum, and for

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money invested in short-term credits, which can be called in or paid off from day to day (money on call) one can hardly get 1/2 per cent per annum. But by choosingto invest his money in this way rather than in new industrial undertakings the money capitalist is admitting how rotten the whole business looks to him. And thisfear of new investments and old enterprises, which had already manifested itself in the crisis of 1867, is the main reason why things are not brought to an acutecrises.18

Finally, in 1890, looking back on his early years as an industrialist, Engelsbemoaned the distorted view of industry that prevails in the financial marketsand their self-regarding nature. He admitted that financial crises may occurthat have little or no foundation in industrial reverses. Finance may develop inits own way, but is an arena for the struggle between various industrialinterests. But ultimately the financial system must reflect production ‘taken as a whole’. Engels’s letter to the Swiss journalist Conrad Schmidt, dated 27 October 1890, stands out as a succinct statement of the Marxian ‘reflective’view of finance:

The money market man only sees the movement of industry and of the worldmarket in the inverted reflection of the money and the stock market and so effectbecomes cause to him. I noted that in the ’forties already in Manchester: the LondonStock Exchange reports were utterly useless for the course of industry and itsperiodical maxima and minima because these gentry tried to explain everythingfrom crises on the money markets which were generally only symptoms. At thattime, the object was to explain away the origin of industrial crises as temporaryover-production, so that the thing had in addition its tendentious side, provocativeof distortion. This point has not gone (for us, at any rate, for good and all), addedto which it is indeed a fact that the money market can also have its own crises, inwhich direct disturbances of industry only play a subordinate part or no part at all –here there is still much, especially in the history of the last twenty years, to beexamined and established …

As soon as trading in money becomes separate from trade in commodities it has(under certain conditions imposed by production and commodity trade and withinthese limits) a development of its own, special laws and special phases determinedby its own nature. If, in this further development, trade in money extends in additionto trade in securities and these securities are not only government securities but alsoindustrial and transport stocks and shares, so that money trade conquers the directcontrol over a portion of the production by which, taken as a whole, it is itselfcontrolled, then the reaction of money trading on production becomes still strongerand more complicated. The money traders have become the owners of railways,mines, iron works, etc. These means of production take on a double aspect: theirworking has to be directed sometimes in the immediate interests of production, butsometimes also according to the requirements of the shareholders, in so far as theyare money traders. The most striking example of this is the American railways,whose working is entirely dependent on the stock exchange operations of a JayGould or a Vanderbilt, etc., these have nothing whatever to do with the particularrailway concerned and its interests as a means of communication. And even here inEngland we have seen struggles lasting for tens of years between different railway

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companies over the boundaries of their respective territories – struggles in which anenormous amount of money was thrown away, not in the interests of production andcommunications, but simply because of a rivalry which usually only had the objectof facilitating the stock exchange dealings of the shareholding money traders.19

In his critique of Luxemburg, Lenin’s associate Nikolai Bukharin rebukedher for exaggerating the need for external markets and her neglect of financeas a centralising element in monopoly capitalism.20 In line with Hilferding’sanalysis of finance as coordinating monopoly capitalism, Marxist critics havelargely followed the founders of their school of thought to adhere to a‘reflective’ view that, if financial crisis occurs, it is because correctly ‘reflects’critical developments in production: a fall in the rate of profit, increased classstruggle, disproportions and so on. Even after the 1929 Crash, the Hungarian–Soviet economist Eugene Varga provided a Marxist orthodoxy according towhich ‘the cause of the cyclical course of capitalist production is theaccumulation of capital’ resulting in excess industrial capacity.21 The collapseof the long-term capital market was caused by such excess capacity.22 Morerecently, Suzanne de Brunhoff went as far as any Marxist critic has gone inwriting that

the financial cycle is only a reflection of the economic cycle: monetary andfinancial movements reflect non-monetary and non-financial internal andinternational disturbances. But they reflect them in their own way because of theexistence of specific financial structures.23

However,

the capitalist form of production is unable to give an entirely functional character tothe conditions under which it functions; the credit system preserves a relativelyautonomous development. The resurgence of the monetary system in times of crisisis a sign of that autonomy, since the demand for money is completely outside themovement of real production. But the financial crisis also reduces the ‘fictitious’mushrooming of credits and restores the monetary basis of credit.24

But this is because stock prices and credit can fluctuate with a degree ofindependence of real capital, and inversely with the rate of interest.25

Karl Polanyi, in his pioneering study of the social and institutional roots ofeconomic and financial collapse in the 1930s, wrote that

Marxist works, like Hilferding’s or Lenin’s studies, stressed the imperialistic forcesemanating from national banking, and their organic connection with the heavyindustries. Such an argument, besides being restricted mainly to Germany,necessarily failed to deal with international banking interests.26

In this regard Rosa Luxemburg was exceptional. Her analysis of the

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international loans system in the period preceding the First World War mayhave been incidental to her main argument about capitalist accumulation. Butthe view she portrayed of a financial system that visits repeated catastropheson the traditional economy, in the course of incorporating it in the moderninternational capitalist economy, anticipates much of the experience ofdeveloping countries since the 1970s. The elements of critical finance in herwork survive better than the model of accumulation in which they wereframed.

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5. Ralph Hawtrey and the monetarybusiness cycle

If thoughtful individuals, well read in contemporary economic theory in the1920s, had been asked at that time which economist was most likely torevolutionise twentieth-century monetary economics (and indeed had alreadystarted doing so), it is likely that, without hesitation, they would have giventhe name Ralph Hawtrey, rather than that of his rival, which we would nowgive, John Maynard Keynes. J.C. Gilbert recalled studying monetary theoryfrom Hawtrey’s Currency and Credit at the London School of Economics inthe 1920s, and Hicks was told by Austin Robinson that this was the standardwork used in the Cambridge Tripos at that time.1 Forty years later, his standinghad been reduced to that of one of the ‘also-rans’ of monetary theory. Forexample in Roll’s standard textbook A History of Economic Thought, hemerits only one mention as a theorist of credit policy.2 Schumpeter remarkedthat ‘Throughout the twenties, Hawtrey’s theory enjoyed a considerablevogue. In the United States, especially, it was the outstanding rationalizationof the uncritical belief in the unlimited efficacy of the open-market operationsof the Federal Reserve System that prevailed then.’3 But this was largelybecause Hawtrey’s ideas were taken up by Allyn Young at HarvardUniversity, who was an occasional advisor to Benjamin Strong, the influentialGovernor of the Federal Reserve Bank of New York from 1922 to his untimelydeath in 1928. As late as 1947, Lawrence Klein referred to Hawtrey asKeynes’s ‘rival for the leadership of British monetary policy’.4 But CharlesGoodhart’s scholarly study of The Evolution of Central Banks does not evenmention Hawtrey.

Much of the obscurity into which his work has fallen is the outcome of thenotoriety that became attached to his name because of his authorship and hisprolific and sophisticated advocacy in the Great Depression of the 1930s ofwhat was known as the ‘Treasury view’. This opposed fiscal stimulus, becauseit would ‘crowd out’ private sector investment, and urged ‘prompt and largecuts in wages’ and, less notoriously, devaluation and credit expansion,alongside Keynes’s advocacy of these measures, as policies for economicrevival.5 Hawtrey’s fiscal pessimism and regressive distributional valuescontrasted inevitably with Keynes’s more optimistic view. In the progressiveKeynesian consensus that followed 1945, even serious scholars have been


inclined to dismiss Hawtrey’s work. This is despite the methodologicalsophistication of his disequilibrium analysis of banking and finance which,unlike that of Keynes, does not obscure that disequilibrium by presenting it inequilibrium terms.6

Patrick Deutscher has recently suggested a number of reasons why hisanalysis fell into disuse. His emphasis on stock-holders’ responses to interestrate changes seemed relevant to an earlier, mercantile capitalism, rather thanan industrial capitalism based on fixed capital investment. But his earlier workdoes contain a theory of fixed capital investment. Deutscher says that his ideaswere disadvantaged by his absence from an academic milieu. But other, latercontemporaries, such as Michal Kalecki and Paul Sweezy, also workedoutside an academic milieu and did not suffer obscurity as a result. Third,Deutscher argues, because Hawtrey was widely perceived to have lost thepolicy argument of the 1930s, it was assumed that ‘the facts falsified histheories’. This was indeed a serious disadvantage for Hawtrey. But it was tosome degree remedied when the monetarist counter-revolution brought hisideas back into favour, albeit now with superficially Keynesian elements ofexpectations, rather than stock-holding, as the crucial monetary transmissionmechanism. Fourth, Hawtrey’s ‘aversion to formalism prevented him fromworking fully within the framework of mainstream economics and obscuredhis theoretical contributions’.7 But this is precisely what made him such apopular author in the 1920s. This aversion certainly did not diminish theauthority of economists such as Joseph Schumpeter and Gunnar Myrdal, andeven added a certain bohemian notoriety to the reputation of John KennethGalbraith. Finally, Deutscher argues that Hawtrey was ‘dated and madeobsolete’ by the Keynesian revolution.8 Much the same could be said of DavidRicardo and Keynes’s teacher Alfred Marshall, and many students today aretaught little more than Ricardo and Marshall in their economics courses. Hisreputation indeed never recovered from the exposure of his regressiveeconomic values, through his association with the ‘Treasury view’ that issupposed to have shaped the ‘hungry ’thirties’. Moreover, as macroeconomicsdeveloped, his approach, in which everything hung on the short-term rate ofinterest, proved to be methodologically untenable. It was Hawtrey’smisfortune that the monetary transmission mechanism from short-term interestrates has become such conventional wisdom in contemporary economics thathis immense contribution to the establishing of this transmission mechanismas the key relationship in economic dynamics is overlooked today.

In the final analysis, it was the inability of his ideas to make the transitionfrom the interwar ruins of the era of finance that flourished, in the unstablekind of way that he perceived, before the First World War. In the era ofplanned public sector stabilisation of economic disturbances, after the SecondWorld War, there could be little relevance in a monetary theory of the business

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Ralph Hawtrey and the monetary business cycle

cycle. But his most serious failure as an economist was also that aspect of hiswork which was his greatest achievement from the point of view of this studyin critical finance. His underlying economic philosophy that money andfinance, left to themselves, will disturb the capitalist economy remains worthyof re-examination in our present era of finance.

1. UNSTABLE MONEY

Hawtrey himself was not discouraged by the success of his youngercontemporary, and the apparent anachronism of his own analysis. Towards theend of a life that spanned the final decades of the gold standard, and thebeginnings of the emergence of finance at the end of the twentieth century, hereiterated his view as follows:

To unstable money are to be traced nearly all our economic troubles since 1918: theunemployment of the inter-war period; the over-employment and scarcity of laboursince the Second World War; the labour unrest incidental to perpetual wagedemands; the hardships and dislocation caused by the declining value of smallsavings, annuities and endowments; the vexation of continual price rises even forthose whose incomes on the whole keep pace with them; the collapse of the pricesof Government securities through distrust of the unit in which they are valued.9

By ‘unstable money’, Hawtrey meant considerably more than instability ofthe purchasing power of money, due to fluctuations in prices. ‘Unstablemoney’ meant for him a complex way in which monetary and financialinstitutions destabilise the economy in which they operate. However,monetary theory was the starting point of Hawtrey’s analysis, and it is for hismonetary theory of the business cycle that he was best known in his time.Hawtrey’s theory is different in a very fundamental way from other monetarybusiness cycle theories. In the monetary business cycle theories of Hayek, and,in the latter part of the century, Friedman, Lucas and, most recently,Wojnilower, monetary disturbances in economic activity are induced byincorrect economic or, more strictly, monetary policy decisions. For Hayekand Friedman, the economy is disturbed when the authorities expand credit bymore or less than the amount required to finance the level of investment andeconomic activity desired by the private sector.10 For Lucas, unexpectedchanges in the money supply disturb economic equilibrium.11 In Wojnilower’sanalysis, ‘credit crunches’, or withdrawals of loan facilities in response to theauthorities’ reregulation and monetary tightening, cause financial crises.12 Thestarting point, whether explicit or implied, is that in a ‘natural’ economy, thatis, without intervention by the authorities, the economy would proceedwithout financial crisis.

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Hawtrey’s starting point was different. He recognised that the institutionalforms through which the capitalist system evolved have been conditions inwhich money and finance disturb the economy. The roots of his analysis werein his historical studies of monetary and financial arrangements and, inparticular, the efforts of central banks to ease the constraints of the goldstandard on the credit system in the century before the First World War, and the attempts to resurrect that standard after that war. This is epitomised in the content and title of the last book that he prepared for publication in 1962, a third edition of A Century of Bank Rate. The central banks’ interest in more flexible currency policy arose out of a necessity to avoid the financial crises that the ‘cross of gold’ periodically inflicted upon the economybecause of changes in the global supply of gold, and shifts in its distributionamong trading countries. For Hawtrey, therefore, the monetary and financialsystem disturbs the economy naturally, and requires appropriate economicpolicies to limit the resulting instability. Of the authors cited in the previousparagraph, only Friedman, perhaps and certainly not consciously, with his idea of a constitutionally ordained rate of monetary expansion to stabilise the economy, comes anywhere near to Hawtrey’s critical approach tofinance.13

Hawtrey was largely self-taught in economics. So it is unlikely that theSwedish originator of credit cycles, Knut Wicksell, influenced Hawtrey,although both reflected in their respective analyses a more general sense that money markets do not ‘naturally’ complement a general economicequilibrium.14 Wicksell postulated a ‘natural’ rate of interest that keeps theeconomy in equilibrium by equalising saving with the demand for it forinvestment purposes. However, in a money economy, the actual or money rateof interest is determined in the money markets by the demand for and supplyof money by banks. Since this is subject to change according to the cashposition of banks, the actual rate of interest differs from the natural rate. If themarket rate of interest is above the ‘natural’ rate, ‘forced’ saving causes pricesand production to fall until equilibrium is reached between the two rates ofinterest. If the market rate of interest is below the ‘natural’ rate, saving is toolow and prices and production rise until again equilibrium is restored, withstable prices and production and equality between the two rates of interest.15

The centrality of the notion of equilibrium in Wicksell’s work is confirmed,and criticised, by Gunnar Myrdal in his Monetary Equilibrium, chapter III.Myrdal and his Swedish contemporaries, Erik Lindahl and Erik Lundberg,developed the elements of a monetary business cycle, based on Wickselliancumulative disequilibrium process. However, they stopped short at showingthat non-equilibrium interest rates change prices and the level of economicactivity. Hawtrey went further and showed how banks can systematicallygenerate and propagate disequilibrium in the economy. Similarly, Irving

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Fisher had published a theory of a credit cycle, which was brought to theattention of Hawtrey, probably by Keynes, before the writing of Good andBad Trade. But this too, as Keynes was to point out, failed to show systematicgeneration of economic disturbances.16 Alfred Marshall, the doyen of Englisheconomists at the end of the nineteenth century, had put forward a credit cycleas early as his first excursion into systematic economics with his wife, MaryPaley Marshall, in The Economics of Industry. In this, rising prosperitystimulates an expansion of credit which raises prices until speculation isstopped.17

But Marshall too was likely to have been only an indirect influence onHawtrey. He had not taught Hawtrey at Cambridge, where the latter hadstudied mathematics and had picked up a basic economics education from SirJohn Clapham, a distinguished economic historian who also wrote prolificallyon banking and financial history. It is perhaps this early influence that isapparent in Hawtrey’s inclination throughout his work to explain by referenceto the working of markets and institutions rather than to some immanentintellectually derived equilibrium.18 His analysis bears more than a passingresemblance to the criticisms of the Birmingham Banking School in the firsthalf of the nineteenth century, in particular Thomas Attwood, who criticised(albeit unsystematically) the instability of the gold standard, and questionedthe wisdom of allowing ‘the pressure of the metallic standard to fall upon thepoor’ as well as ‘the industrious, the useful and the valuable classes of thecommunity’.19

In his first book, Good and Bad Trade, published in 1913, Hawtreyexamined a credit cycle mechanism, but without any equilibrium beingbrought about by the markets. Capital investment by traders and entrepreneursis undertaken in expectation of a rate of profit which he defines in labour valueterms. If this rate of profit is greater than the market rate of interest, thenentrepreneurs will invest and expand production. But if it is less, theninvestment and production will be reduced. Investment and productiondecisions involve commitments for longer periods of time, during whichcurrency is drawn out of banks and into the cash economy in which themajority of the population in Hawtrey’s time still operated. During a boom,therefore, companies find themselves drawing down their balances in banks.To stem the drain on cash, banks raise their interest rates. Because these taketime to influence current investment and production, banks find themselvesraising interest rates by successive amounts until investment and productionare brought down to levels that will conserve, and even increase, the cash inbank tills. At this point interest rates are too high, and depression sets in untilfalling interest rates have their (delayed) effect on output and trade. In anycase, in contrast to Wicksell’s analysis, no equilibrium is ever reached: ‘thereis an inherent tendency towards fluctuations in the banking institutions which

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prevail in the world as it is’.20 Hawtrey later criticised the quantity theory ofmoney over its presumption of stability:

The banks, by restricting credit, can start the vicious circle of deflation, or, byrelaxing credit, can start the vicious circle of inflation. Either process, once started,tends to continue by its own momentum. In the one case there will ensue acumulative shrinkage of demand, curtailment of output and decline of prices; in theother a cumulative expansion of demand, increase of output and rise of prices.

Credit is thus inherently unstable.21

In practice it seldom, perhaps never, happens that a state of equilibrium is actuallyreached. A period of expanding or contracting credit, when it comes to an end,leaves behind it a legacy of adjustments, and before these are half completed a newmovement has probably already set in.22

Hawtrey’s distinctive innovation was to lay out this, already in his timeestablished explanation of investment on the basis of a theory of credit andinterest rates, and a theory of trade that are very modern, in the sense ofexplaining investment and trade in the sophisticated mechanisms of a finance-dominated economy, rather than in reduction to the elements of a ‘natural’economy. In Good and Bad Trade, he compared the functioning of an ‘island’economy without money with economies using money, and then credit. Heused this not to establish ‘natural laws’ or relationships, but to show that acredit economy will not converge on a stable equilibrium, but will continue tobe disturbed by the changing liquidity of the banking system (chapter VI ofGood and Bad Trade is entitled ‘A Monetary Disturbance in an IsolatedCommunity with a Banking System’). In his later expositions of his theory, hedropped even this primordial artifice. But it served its purpose to show that, inhis view, economic instability is associated with the emergence of money andcredit. (In his later years, he made the following admission: ‘I thought that thealternations of good and bad trade must be of interest to all who concernedthemselves with public affairs. The method of exposition starting with asimplified model, and dropping the simplified hypotheses one after another,was intended for this wider circle.’23)

In his next book, Currency and Credit, first published in 1919, Hawtreyextended this analysis. By ‘currency’ he meant metallic money and the notesissued by the central bank, while credit meant essentially deposits with thecommercial banks. Currency of course circulates around the economy. But an‘unspent margin’ is paid into banks or held as what would now be calledmoney balances. Somewhat confusingly, Hawtrey includes in the ‘unspentmargin’ all credit available in the economy.24 But this was to show that histheory is consistent with the quantity theory of money: ‘given all the othereconomic conditions, the price level is proportional to the unspent margin’.25

If the theories are consistent, then it is only by ignoring the main conclusions

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of Hawtrey’s analysis, described in his words above, that fluctuations inmoney and credit are the cause of economic instability, rather thanproportional changes in prices. It was more than just a factor in instability.When spent, credit is transformed into income, and income then determinesexpenditure, for which he used the term ‘effective demand’ that later becameassociated with Keynes’s critique of the ‘classics’ who adhered to Say’s Law.26

However, he insisted that ‘in the long run’ income is equal to expenditure.27

Hence ‘saving’ was not a problem which he admitted to his system. But hisinsistence that credit creates incomes marked an important step away from thequantity theory of money.28

According to Hawtrey, the amount of currency in bank tills determines theamount of credit that banks may advance. However, they cannot induceborrowers to borrow from them. All that they can do is to vary the rate ofinterest on their loans in the hope of attracting borrowers, or discouragingthem if the commercial banks wish to conserve their currency, or raise the cashratio which is crucial for their ability to pay currency on demand againstdeposits. But the amount of currency that the banks have in their tills dependson four factors. First the amount of banknotes issued by the central bank andthe amount of gold bullion in the country which, under the gold standard rules,determined the note issue of the central bank. After the First World WarHawtrey advocated cooperation between central banks to stabilise credit andthe foreign exchange markets. He represented the British Treasury at theGenoa Conference on international monetary cooperation in 1922.29 Later on,following the collapse of the gold standard and the onset of the GreatDepression of the 1930s, Hawtrey advocated open market operations (thepurchase of government bonds) as a way of improving the liquidity of thebanking system, and low interest rates as a means of reviving trade.30 A secondinfluence on the liquidity of the banking system that is rarely mentioned indiscussions of Hawtrey is the distribution of income. In Hawtrey’s time, onlythe rich, and businesses using credit, had bank accounts which they used forpayments. Hawtrey was a pioneer in monetary economics in recognising thatthe use of bank accounts in payments was a way of economising on currency.A corollary of this was that the more workers were employed in an enterprise,the more currency they took out of the banking system.31

The third and, in Hawtrey’s original view, the most important factorinfluencing the liquidity of the banking system was the amount of activity inthe economy, which determined the proportion of currency issued that wascirculating outside the banks. Here the crucial part was played by retail orwholesale ‘traders’ who financed their stocks with bank credit. If interest ratesincreased, traders were induced to economise on their use of credit byreducing the stocks of goods that they held. They could not do this byincreasing sales (since that is a decision for their customers), but they could

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reduce orders to producers. Lower orders and falling prices would reduce therate of profit. Output employment and income would be reduced.Unemployment would then last for as long as it took wages to fall until the rateof profit was restored. With a given amount of currency in the economy,production and exchange at lower wages and prices would cause anaccumulation of cash in bank tills. Banks would then lower the rate of interestto stimulate borrowing.32

A fourth factor increasingly preoccupied Hawtrey during the interwarperiod: international trade under the gold standard meant periodic shipmentsof gold bullion between trading countries.33 Under the gold standard, a fall ingold reserves due to excessive imports obliged the central bank to reduce thenumber of its banknotes in issue. This was sometimes done by the sale ofgovernment bonds. Such open market operations would drain the currencyfrom banks, causing them to cease lending and raise their rate of interest toattract currency deposits and discourage borrowing. More commonly, thecentral bank would raise the rate of interest at which it discounted bills, knownin Britain as the bank rate, allowing the central bank to issue less paper moneyin exchange for a nominal amount of bills. The First World War had adevastating effect on the distribution of gold reserves around the world,concentrating them in the creditor countries, principally the USA. Thebelligerent countries restricted their gold payments and for six years afterhostilities ceased British governments and their advisers wrestled with theproblem of how to return to full gold convertibility with prices, wages and acurrency issue inflated by war expenditure. Britain’s return to the goldstandard at the pre-war parity was finally achieved in 1925, setting off a litanyof complaint by manufacturers, reiterated periodically through the rest of the century, that they were being priced out of their export markets by theexchange rate. With the collapse of the US market, following the 1929 Crash, the gold standard was blamed for the trade crisis, both because of thehigh value of sterling that it required in relation to other currencies andbecause of the high bank rate required to maintain sterling’s parity with gold.In 1931, Britain finally abandoned the gold standard. But Hawtrey remainedconvinced that the 1930s Depression was caused by the earlier high interestrates.

2. UNSTABLE FINANCE: THE CLASH WITH KEYNES

The vicissitudes of the currency, at a time of economic instability anddepression, confirmed Hawtrey’s conviction that money causes economicfluctuations, a view that was to be echoed by a later generation of monetaristeconomists.34 In the case of the US stock market speculation, Hawtrey, like

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Keynes, associated it with a boom in fixed capital investment attendant upona fall in the long-term rate of interest. However, in an interesting anticipation(of which both parties were unaware) of Kalecki’s principle of increasing risk and the later theories that companies use stock markets to re-financesuccessful fixed capital investment,35 Hawtrey pointed out that ‘Resources fornew investment are derived mainly from profits … a large proportion of thecapital has been supplied not by issues in the market at all, but by thelimitation of dividends and the retention of a large proportion of profits in theform of reserves.’36 Hawtrey argued that there was virtually no net increase incapital issues by industrial and commercial companies. With rising profits,companies could obtain a higher return by lending money to brokers ratherthan placing it on deposit with banks. Brokers’ loans, or ‘call money’, fuelledthe speculation on the stock market until the Federal Reserve raised itsrediscount rate from 3.5 per cent in three stages in the first half of 1928 inorder to reduce the speculation, but also to stop an outflow of gold from theUSA. It was finally raised to 6 per cent in August 1929. Meanwhile, the rateof interest on ‘call money’ had risen from 4.24 per cent at the beginning of 1928 to 9.23 per cent in July 1929, just before the Crash. When pricescollapsed, the effect on speculators’ incomes was to reduce their spendingpower. The collapse was made worse by the failure of the Federal Reserve toreduce interest rates sufficiently after the Crash.37 The subsequent depressioncould only be effectively combated by a policy of cheap credit and openmarket operations in the principal gold-holding country, the USA, to forcecurrency into circulation by buying in bonds.

By 1931, Hawtrey was urging ‘that the fall of wages should overtake the fall of prices’, which he thought would be sufficient to give a country acompetitive advantage in trade.38 The problem with this was that if allindustrial countries reduced wages together, none would gain any advantage.In a rather confused passage he concluded that ‘decisive action still rests withthe banking system – that is to say, with the central banks of the world’.39 Henevertheless returned with an emphasis that seems almost visceral: ‘As tounemployment, that need not increase greatly provided workpeople all overthe world are willing to acquiesce at short intervals in prompt and large cuts in wages.’40 This and his opposition to deficit spending by the Britishgovernment (the notorious ‘Treasury view’) made him reviled by Liberals andSocialists alike.41 There was a greater consistency to his analysis than theywould often allow. His opposition to fiscal stimulus in Britain was not one ofprinciple, but was consistent with his belief that such action was eitherunnecessary, if sufficient credit was available in the financial system tofinance the government’s deficit, or would threaten the gold and foreigncurrency reserves held by the central bank. These would be depleted by theincrease in imports that would come with an economic recovery in Britain.

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Only the USA had sufficiently strong gold reserves to be able to sustain aneconomic recovery.42

In addition to his hint of later developments of Kalecki’s principle ofincreasing risk, Hawtrey appears to have become convinced by the 1929 stockmarket crash that the stock market is not permanently in that state ofequilibrium so beloved of later financial economists. He argued that therelevant measure of supply and demand was the placing of new issues andtheir purchase by investors out of their saving. Echoing Wicksell’s analysis ofthe capital market, Hawtrey saw the balance between supply and demand in itas made up by the borrowing of brokers, or their repayment of loans:

The new issues will not be exactly equal to the savings. If they exceed the savingsin any interval of time, the excess has to be held by the dealers in the investmentmarket (stock jobbers) and they have to borrow money for the purpose. If the newissues fall short of savings, the dealers in the market receive more money than theypay out, and are enabled to repay bank advances.43

In addition to their later polemics about fiscal activism, Hawtrey andKeynes conducted an extensive correspondence on economic and monetarytheory. The account of this that is given below is necessarily selective. A fulleraccount is given by Patrick Deutscher in his book R.G. Hawtrey and theDevelopment of Macroeconomics. Deutscher’s two chapters on Keynes andHawtrey confirm that much of the difference between them was termino-logical, or was perceived as such by them. An inordinate amount of theircorrespondence consists of detailed explanation of terms which theythemselves had invented. Keynes and Hawtrey had disagreed when the latterpresented evidence to the Macmillan Committee on Finance and Industry in1930, of which Keynes was a member. Their initial differences overterminology crystallised into a fundamental divergence concerning theimportance of the short-term rate of interest in the economy. In Volume I ofhis Treatise on Money Keynes dismissed the idea that low interest ratesstimulated ‘speculation’ in commodities. He quoted with approval ThomasTooke’s refutation nearly a century earlier of Joseph Hume’s view that lowerinterest rates encouraged such excess: ‘It is not the mere facility of borrowing,or the difference between being able to discount at 3 or at 6 per cent thatsupplies the motive for purchasing or even for selling’, but the differencebetween the expected rate of profit on the speculation and the rate of intereston the borrowing that finances it.44 Keynes went on to argue that the stocksheld by traders did not vary, as Hawtrey argued, inversely with their workingcapital, and were in fact much more modest than Hawtrey supposed.Moreover, Keynes argued, the interest cost of stocks was ‘perhaps the leastimportant’ of their expenses, by comparison with the deterioration in theirquality, warehouse costs and the risk of price changes.45

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Keynes’s criticisms were echoed by his disciple Nicholas Kaldor, who citedthe 1959 Radcliffe Report on the Working of the Monetary System to disposeof Hawtrey with the argument that ‘stocks of commodities are extremelyinsensitive to interest rates’.46 This was a characteristic oversimplification ofHawtrey’s view that traders’ desired rather than their actual stocks vary withthe rate of interest. In the fourth, 1950, edition of his Currency and CreditHawtrey inserted on page 69 a paragraph arguing that, in response to anincrease in short-term interest rates, ‘it is very easy for the trader to reduce theaverage quantity of goods held in stock, and so his indebtedness to the banker’.But this would always depend on the volume of demand. In his earliest work,he stated that ‘traders’ attempts to reduce stocks to economise on interestcharges will be frustrated by reduced demand in a recession’.47 Stocks wereimportant for Hawtrey not so much because they varied with the businesscycle, but because attempts to reduce them transmitted to industry, andeventually consumers, the effects in lower orders of higher interest rates. Itwas Hawtrey who gave Keynes the idea that a fall in investment relative toplanned saving would result, initially at least, in a rise in stocks of unsoldgoods.48 Such a fall in investment, in Keynes’s analysis, would be associatedwith a rise in rates of interest relative to the marginal efficiency of capital, i.e.the prospective return on the investment of new capital.49 In such circum-stances, higher stocks would be associated, temporarily at least, with a higherrelative rate of interest. In his contribution to the symposium in the EconomicJournal on ‘Alternative Theories of the Rate of Interest’ Hawtrey againreferred to the possibility that excessive stocks may be expected, but the tradermay be unable to prevent them from accumulating. Kaldor’s view, echoingKeynes’s early criticism, thus did not take into account the qualifications thatHawtrey made in his analysis of the business cycle to his view of stocks as amonetary transmission mechanism. Kaldor’s alternative view of money, thetheory that money supply is ‘endogenous’ or determined by the level ofactivity in the economy, is largely consistent with Hawtrey’s view that creditsupply is elastic as long as banks have sufficient reserves.50

Hawtrey responded by criticising Keynes’s oversimplified idea that thelong-term or bond rate of interest moves up and down with the money rate ofinterest:

There is no fixed relation between the average short-term rate and the long-termrate, and expectations regarding the short-term rate depend on circumstances. Suchexpectations, when they extend beyond a few months, are extremely conjectural.The short-term rate also may exceed the long-term rate.51

Hawtrey seems to have persuaded Keynes to moderate his optimism that thelong-term rate of interest would respond readily to changes in the short-termbank rate. By this time, Hawtrey’s studies had revealed to him the relative

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stability of the long-term rate of interest.52 Hawtrey concluded that long-termfinance for investment from the stock market was rationed, rather thanregulated, by the interest or dividend yield on securities:

the volume of capital outlay is remarkably insensitive to the rate of interest, and inpractice equilibrium is preserved in the investment market, at any rate over shortperiods, rather by a system of refusing to float more enterprises than the market canabsorb than by varying the rate of interest.53

However, underlying their difference over which was the crucial rate ofinterest, the long-term, or the short-term one, lay a profounder difference overwhich was the crucial variable transmitting changes in the rate of interest tothe economy as a whole. For Keynes it was investment in fixed capital. ForHawtrey it was stocks. It was Hawtrey rather than Keynes whose theory wasconsidered to be disproved by empirical studies conducted by Jan Tinbergenand, in Oxford, P.W.S. Andrews and his associates. These concluded thatinterest rates had very little effect on business investment in either stocks orfixed capital.54 But, in retrospect and unacknowledged, Hawtrey may havewon the battle for the hearts and minds of the economics profession. Theinterpretation of Keynes that took over after Keynes’s death was essentially a Hawtreyan one, of a credit economy (monetary production economy)regulated by fiscal policy and monetary policy concentrating increasingly onshort-term interest rates and control of the money supply.55 A generation ofeconomists were taught their ‘Keynesian’ economics in a form, popularised byJohn Hicks and Paul Samuelson, of an IS/LM model of equilibrium in thegoods market and the money market, an equilibrium that was between moneymarket rates of interest and equilibrium between saving and investment.56 Animportant difference is that, in the last quarter of the twentieth century in themain industrialised countries, what Hawtrey termed ‘currency’, that is, notesand coins, ceased to be important for anything other than marginal or blackmarket transactions as only a small minority of poorer citizens remainoperating without a bank account. Another important difference is thatmonetary conditions are now thought to influence investment in fixed capitaldirectly, rather than through changes in stocks.

In putting forward this Hawtreyan credit economy in the form of aKeynesian ‘short-period’ equilibrium it was also conveniently forgotten thatHawtrey presented an explanation of economic instability in a credit economybefore the emergence of finance/capital markets as determining fluctuations ina capitalist economy. Arguably, Hawtrey’s view of the capitalist economy wasessentially the banking economy that Britain was for most of the nineteenthcentury. This has to be borne in mind when examining the work of thetwentieth-century economists who took up his ideas selectively, principallyMilton Friedman.

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Hawtrey’s analysis of emerging capitalism reliant on banks for finance stillhas relevance to the developing countries and newly industrialised countries,where finance has yet to mature. In those countries, the credit system faces asimilar constraint to that analysed by Hawtrey under the gold standard. How-ever, in place of gold, credit is limited by the inflow of convertible currencies,chiefly the dollar. Credit in the developing and semi-industrialised countries istherefore obliged to expand and contract with fluctuations in foreign currencyinflows and reserves. The system is supposedly regulated by the central banksusing Hawtrey’s recommended instruments of open market operations and theshort-term rate of interest. With outflows of foreign currency reserves, interestrates are raised, and credit is contracted in the kind of deflationary crisis thatwas familiar to Hawtrey, and has come to be familiar to us from events inMexico in 1995, East Asia in 1997–98, Russia in 1998 and Turkey in 2001.Modern times have, however, added a dimension that was not available at thetime of the gold standard, when Hawtrey developed his analysis. At that timefor countries on the gold standard the exchange rate was fixed, and the onlyway out was to suspend the convertibility of central banknotes against gold.The inflexibility of these arrangements was recognised in the Bretton Woodsarrangements allowing a change in the exchange rate under exceptionalcircumstances. After the breakdown of these arrangements, depreciation of theexchange rate came to be widely used as a means of obtaining competitiveadvantage in export markets, but also to economise on foreign currencyreserves: for a given amount of domestic currency which investors andimporters wish to convert into foreign currency, the central bank has to supplyless foreign currency out of its reserves. In developing countries, where creditis increasingly influenced by the amount in foreign currency reserves, depre-ciation has therefore come to be a means of economising on bank reserves.These were problems which the main capitalist countries struggled withduring the 1930s. In the limit, under a currency board system, credit is onlydetermined by such reserves, depreciation is not allowed, and the only way ofsupporting the exchange rate is in the gold standard way, by offering a higherrate of interest for foreign currency deposits with the central bank. The cur-rency board therefore corresponds to a modern kind of gold standard with allthe dangers of banking and economic instability which Hawtrey had exposed.

This issue, with implications for banking at the end of the twentieth century,had been raised by the American economist Alvin Hansen, who went on tobecome a distinguished exponent of Keynes’s views in the USA. Before hisconversion by Keynes, Hansen had adhered to Hawtrey’s views on themonetary business cycle. However, he noted that Hawtrey’s business cyclearose because the expansion of credit is followed by a drain of reserves fromthe banking system, and banks have no other way of regulating their reservesthan by raising their interest rates.

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In one other respect Hawtrey looked forward to later theoreticaldevelopments. In his earlier-cited criticism of Keynes’s General Theory,Hawtrey argued that Keynes was wrong to overlook the internal liquidity ofindustrial and commercial companies in his analysis of the speculativedemand for money:

It is curious that Mr. Keynes seems to limit the scope of the function L2(r) to anindividual disposing of saving (current or past) out of income … It is reasonable tosuppose that the omission of redundant cash accumulated by business concerns isaccidental, and that he would include the idle working capital of a business in theidle balances.57

Anxious to rehabilitate his ‘traders’’ role in transmitting the effects of creditexpansions and contractions to the rest of the economy, Hawtrey himselfoverlooked the fact that businesses possess liquidity over and above theirworking capital. This is the liquid reserves out of which they finance theirfixed capital investment or which they hold as security against excess financialliabilities. The analysis of the economic consequences of such internal financewas developed from the 1930s onwards by Marek Breit, Michal Kalecki andJosef Steindl as the principle of increasing risk, relating the business cycle tocorporate finance in the modern form of finance capitalism.

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Michal

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6. Irving Fisher and debt deflation

The views of Veblen’s near-contemporary Irving Fisher on finance havetended to be obscured by the blow that his reputation suffered after hispronouncement, on the eve of the 1929 Crash, that ‘stock prices have reachedwhat looks like a permanently high plateau’.1 Shortly after the Crash, hepublished a book entitled The Stock Market Crash – And After, in which heargued that the stock market boom that preceded the Crash was justified bystructural improvements that had taken place in the US economy during the1920s. Mergers and acquisitions, he felt, allowed economies of scale to takeplace, along with scientific breakthroughs and innovations. The ‘scientificmanagement’ movement of Taylorism, improved layout of manufacturingplants, and a greater cooperation of trades unions in industrial managementwere also destined to increase the productivity of business, and the earnings ofstock-holders.2

However, Fisher was a much more thoughtful commentator on economicdevelopments than Galbraith’s selective quotations, and Fisher’s initialresponse to the Crash, would suggest. When he had reconciled himself to theloss of his sister’s wealth under his management in the Crash, Fisher reflectedon a possible connection between the financial inflation that had caused himthis loss, and depression that followed. In 1931, in the course of his lectures atYale, he first enunciated his theory of debt deflation. He wrote up hisreflections and analysis on business in his book Booms and Depressions.3 Byway of highlighting his distinctive views on the subject, he distilled his mainconclusions from that book into a paper on ‘The Debt Deflation Theory ofGreat Depressions’, which was published in a memorable first issue ofEconometrica.4

Fisher’s paper is extraordinary, not only for the originality of his theory, but also because it belies the commonly held view that, as a mathematicaleconomist, he was somehow a ‘fellow-traveller’ of the neo-classical,equilibrium school of economics. He had already advanced a credit cycletheory in his 1907 book, The Rate of Interest. However, these cycles were notcaused by the autonomous operations of the credit system, but by the limitedoutlook and perceptions of borrowers and lenders. This causes them to makefuture financial commitments without knowing what the future price level willbe, with the result that the real value of debts can change. Such changes then


cause fluctuations in investment as well as redistributing wealth betweenborrowers and lenders:

periods of speculation and depression are the result of inequality of foresight …imperfectionof foresight transfers wealth from creditor to debtor, or the reverse,inequalityof foresight produces over-investment during rising prices, and relativestagnation during falling prices. In the former case society is trapped into devotingtoo much investment of productive energies for future return, while in the contrarycase, under-investment is the rule.5

In 1933 he pointed out right at the start of his paper that equilibrium is animaginary state of affairs: ‘Only in imagination can all … variables remainconstant and be kept in equilibrium by the balanced forces of human desires,as manifested through “supply and demand”.’6 Business cycles are part of economic dynamics which occur because of ‘economic dis-equilibrium’.Therefore no two cycles are the same.

Fisher argued that cycles occur because of inconsistencies at any one timebetween a whole range of variables, such as investment, the capital stock, andindustrial and agricultural prices. But serious ‘over-speculation’ and crises arecaused by the interaction between debt and ‘the purchasing power of themonetary unit’:

Disturbances in these two factors … will set up serious disturbances in all, or nearlyall, other economic variables. On the other hand, if debt and deflation are absent,other disturbances are powerless to bring on crises comparable in severity to thoseof 1837, 1873, or 1929–1933.7

This identification of two crucial monetary and financial variables with avirtually all-pervasive destabilising effect on a (credit) economy was to bedeveloped in the 1970s by Hyman P. Minsky in his financial instabilityhypothesis. ‘A capitalist economy … is characterised by two sets of relativeprices, one of current output and the other of capital assets.’ The first of thesedetermines money incomes. ‘The second determines assets and, liabilities.“The alignment of these two sets of prices, which are based on quite differenttime horizons and quite different proximate variables, along with financingconditions, determines investment.” In turn investment determines theevolution of an economy over time.’8 This distinction between the pricesystem of the financial markets and the price system in the markets for goodsand services is a crucial distinction between the respective analyses of Fisherand Minsky, and that of Keynes. Bertil Ohlin, an early sympathetic critic ofthe General Theory, pointed out that ‘Keynes’s construction … seems toregard the rate of interest as determined “outside” the price system, or at leastas having almost no connection with the system of mutually interdependentprices and quantities.’9

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Irving Fisher and debt deflation

Fisher argued that debt deflation was set off by over-indebtedness. This inturn was often set off by over-borrowing, due to too low interest rates raisingthe temptation ‘to borrow, and invest or speculate with borrowed money’.Commonly this is associated with ‘new opportunities to invest at a bigprospective profit’. Thus over-borrowing may be induced by inventions andtechnological improvements, war debts and reconstruction loans to foreigncountries. But ‘easy money is the great cause of over-borrowing’ and Fishermentions ‘the low interest policy adopted to help England get back on the goldstandard in 1925’ as a factor.

Once over-borrowing takes hold, borrowers try to reduce their debt byincreasing sales of their assets. This distress selling causes prices to fall.Falling prices in turn raise the real value of money (‘a swelling of the dollar’)and in turn the value of debts denominated in nominal terms. A paradoxicalsituation develops, in which the more borrowers try to reduce their debt, themore it grows. The result is a process whereby debt reduces the velocity ofcirculation of bank deposits, causing a fall in the level of prices, falling profitsand bankruptcies. Falling output and employment in turn lead to pessimismand hoarding which further slows down the velocity of circulation.

This was Fisher’s explanation of the 1930s economic depression. Twopossible solutions to the depression were possible. The ‘natural’ one occurswhen, ‘after almost universal bankruptcy, the indebtedness must cease to grow greater and begin to grow less’. The recovery that followed would enabledebt to start growing again, opening the way for the next bout of over-borrowing. However, waiting for such a spontaneous recovery involved‘needless and cruel bankruptcy, unemployment, and starvation’. A far betterway is to reflate the economy. Fisher mentioned the open market policiespursued by the Federal Reserve under President Hoover as reviving prices andbusiness in the summer of 1932. He also suggested that deficit spending couldhelp.

After the Second World War Fisher’s analysis failed to attract mainstreaminterest in the economics profession. A rather obvious reason is the crucial rolein it of falling prices (‘swelling of the dollar’). In the main industrialisedcountries with sophisticated financial systems, prices have not fallen since theSecond World War. If anything, they have risen. Fisher’s analysis wasovershadowed by Keynes’s more sophisticated explanation of depression, andlanguished in obscurity until Minsky discovered it in the 1940s and made it thestarting-point of his reinterpretation of Keynes.

More crucially, Fisher himself shifted his point of view later in the 1930stowards a more purely monetarist explanation of the Depression. In a publiclecture at the Cowles Commission annual research conference at ColoradoCollege on 10 July 1936, Fisher argued that, among all the factors contributingto the Depression,

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one cause towers above all the other, the collapse of our deposit currency. Thedepression was a money famine – a famine, not of pocket-book money but of check-book money … our deposits subject to check. In 1929, our check-book moneyamounted to 23 billion dollars. In 1933, before our ‘bank holiday’ it was only 15billions …10

It was this monetarist explanation of the Depression that was subsequentlyreiterated by Milton Friedman in his monetarist Monetary History of theUnited States 1867–1960.

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7. John Maynard Keynes’s financialtheory of under-investment I: towards doubt

As an exponent of critical finance John Maynard Keynes requires a degree ofreinterpretation. Hyman P. Minsky recognised that Keynes’s analysis of howfinance disturbs the capitalist economy needs to be retrieved from the neo-classical makeover of his views that appears in economics textbooks. (Forexample, in the Hicks–Hansen IS/LM system, finance is reduced to the moneymarkets of an economy.) On closer examination, it turns out that his viewsmay not have been evolving in quite the direction which Minsky perceived inthem.1 The interpretation given in this and the following chapter is perhapsmore consistent with that of Keynes’s contemporaries, most notably his friend,rival and correspondent on monetary and policy issues, Ralph Hawtrey.2

Keynes’s purpose, as he made clear in the closing paragraphs of his GeneralTheory, beginning with the question ‘is the fulfilment of these ideas avisionary hope?’ (and continuing ‘the power of vested interests is vastlyexaggerated compared with the gradual encroachment of ideas … it is ideas,not vested interests, which are dangerous for good or evil’3), was to change theideas of policy-makers, academics, and the educated public. This rhetorical,ad hominem aspect of his exposition accounts for much of the incoherencewhich his critics observed, and continue to find, in his analysis. His style, hischampioning at various times of ideas which were not necessarily consistentwith each other, and his own notorious apostasy from views previouslyadvocated, make Keynesian exegesis a particularly fruitful, if treacherous,endeavour and afford a modicum of validity to different interpretations.4

1. KEYNES’S EARLY VIEWS ON FINANCE

Keynes’s early views on finance were little distinct from the views of hisCambridge teacher Alfred Marshall. Marshall’s views on the role of credit inthe business cycle, as expressed in his early book (co-authored with his wifeMary Paley Marshall) The Economics of Industry, and in his later work MoneyCredit and Commerce, is another instance of his broadly equilibrium approach


to finance. An ‘easing’ of credit, the willingness of banks to lend more atinterest rates below prospective rates of profit in particular lines of business,stimulates business activity and inflationary speculation. The need to sellspeculatively purchased or produced goods to repay debts (or avoid losses), orhigher interest rates, then brings the boom to an end. Such speculative boomsare propagated internationally by the rise in imports that occurs with increasedbusiness activity. Marshall’s views on this remained largely unchanged fromthe earlier views of John Stuart Mill (see Chapter 2 above), and changed littleover the span of Marshall’s own work. Indeed, the account he gave in MoneyCredit and Commerce, which he first published in 1923 but drafted muchearlier, is much the same as the accounts given in his Principles of Economicsand Economics of Industry.5 Since the span of that work coincided with manyof the dramas and crises in the financial markets that inspired Veblen’scritique, it was not surprising that Marshall had views on financial speculation.But these turned out to be common wisdom, in their time and ours: suchspeculation drove stock market values away from equilibrium values deter-mined in the real economy by profits and saving, and gave windfall profits totraders in securities with ‘inside’ information, at the expense of ‘outside’amateurs. All this he felt, naturally enough, was morally deplorable. But it wasdeemed to be an aberration, so that its broader economic consequences werenot considered.6

Recent research by Michael Lawlor has revealed that, in addition toMarshall, the other influence on Keynes’s early thought on finance was thework of a now obscure American lawyer who dabbled in financial economics,Henry Crosby Emery. In Cambridge before the First World War, Keyneslectured on ‘Modern Business Methods’ and ‘The Stock Exchange and theMoney Market’. Curiously, he listed Veblen’s Theory of Business Enterpriseas reading recommended to his students. But his lectures drew most heavilyon Emery’s book Speculation on the Stock and Produce Exchanges of theUnited States.7

Emery put forward a theory that, in its essentials, was to be advanced duringthe 1970s as market efficiency theory. This reflects perhaps less the way in which economists ignorant of the history of economic thought acquirespurious originality by rediscovering the ideas of ‘defunct economists’, andmore the way in which certain attitudes prevail during particular financialconjunctures. Emery was concerned to show that the sophisticated secondaryand futures markets in the USA of the 1890s were performing a useful service.This was to provide arguments against attempts in the USA and in Germanyto legislate against what were regarded as speculative abuses in those markets.Emery was especially concerned with the futures contracts with whichspeculators made their profits and hedged their speculative positions. Heargued that speculation had always accompanied trade, hence suggesting that

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Keynes’s financial theory of under-investment I

limitations on speculation were likewise limitations on trade. However,speculation he held was ‘limited to commodities of an uncertain production’and financial securities ‘in the face of the many and hidden causes affectingvalue, involving the same uncertainties as the purchase of commodities underthe new conditions of a world market’.8 Speculators were therefore necessaryto provide certainty of future values to traders and industrialists faced with arisky and uncertain future. Indeed, speculation was essential to provideliquidity and establish equilibrium prices. This warranted raising such activityto a fourth factor of production, after land, labour and capital. He detailed hisanalysis in a chapter with the suggestive title ‘The Economic Function ofSpeculation’. In his chapter on ‘Some Evils of Speculation’ he argued thatthose evils were largely moral, while the benefits were largely economic:

Even in the case of ‘gambling stocks’ there is no need for the bona fide investor tobe injured. His investment may be made elsewhere. The direct losses in the matterof these securities are borne by those speculators among the public who are foolishenough to tamper with such fraudulent schemes. Hence the economic evil is notgreat. The moral evil which results from the fact that such operators go unrebukedis of far greater consequence.9

Bourgeois propriety was maintained by making fraud the only pretext forregulation, because the benefits of arbitrage for all markets were so muchgreater.

Emery’s explanation of how business involves commitments to futurevalues, and how financial markets deal with uncertainty and risk, would havebeen philosophically congenial to the young Keynes, who had just completedhis Treatise on Probability. But Emery was not the only influence on Keynes.Frederick Lavington, a former bank employee, came to study economics atCambridge in his late twenties, and attended Keynes’s Political Economy Clubuntil his untimely death in 1927. He had an insider’s knowledge of thescandalous manipulations in the London Stock Exchange that followed theBoer War. He attended Keynes’s lectures, and himself lectured at Cambridgeduring the 1920s. Lavington’s conclusion on speculation was considerablymore critical than that of Emery:

there are considerable numbers of expert speculators who, in effect, deal throughthe Jobber with less well-informed members of the public and use their superiorknowledge of securities or of moods of the public to transfer wealth from theseother parties to themselves. The unskilled speculators and investors with whom theydeal obtain some protection from the Jobber, and can, if they choose, obtain almostcomplete protection by acting only on the advice of a competent broker; but thefacts show that they do not avail themselves fully of this safeguard. In so far as theexpert speculator levies his toll from the speculating public without still furtherexciting their activities his operations are not without some advantage to society, forthey tend to discourage the public from a form of enterprise which can rarely yield

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any net social advantage. In so far as he deals with investors he takes from them theadvantage of price movements without giving any adequate return, and the directeffect of his operations is a net social loss.10

However, even in the Indian Summer of Edwardian capitalism before theFirst World War, Keynes showed an awareness of the crucial role thatfinancial relations played in the generation of economic instability. In 1913,he presented a paper to the Political Economy Club with the provocative titleof ‘How Far are Bankers Responsible for the Alternations of Crisis andDepression?’. In this paper Keynes put forward an explanation of how banksmay make an economy fluctuate between over-investment in an economicboom and under-investment in a recession. Banks, he suggested, hold the ‘freeresources’ or savings ‘of the community’. These are lent out for businessinvestment. But without control over the investment process, banks cannotprevent over-investment. When this requires even more credit to sustain it,banks call in loans and raise interest rates until loans are repaid regularly andpromptly again. Thus it is not a shortage of cash, as Fisher and Hawtreysuggested, that causes banks to reduce their lending, but the illiquidity of loanscommitted to excessive investment.11 At this stage, Keynes’s thinking wasclearly still rooted in something like a loanable funds analysis (banks aretrying to equilibrate saving and investment indirectly by regulating theliquidity of their loans). The notion of an increasing illiquidity of investmentwas a feature of Austrian capital theory, but in Keynes’s case was probablymore the influence of Jevons. The latter’s The Theory of Political Economywas the first economics book that Keynes read, and he had recently reviewedthe fourth edition of that book.12 The fundamental flaw in the analysis isKeynes’s failure to grasp the principle of banking reflux. As investmentproceeds, and even if it turns into over-investment in relation to saving or ‘freeresources’, the payments made, with money borrowed or owned, for invest-ment equipment delivered, is credited to their bank accounts as additional ‘freeresources’ by the suppliers of investment equipment. In this way, the creditsystem inflates itself automatically in the course of an investment boom. Onlywhen the investment boom breaks, and producers find themselves withequipment financed with bank credit, which they are unable to repay from thereduced proceeds of their output, do the banks find their loans becomingsystematically illiquid. But the problem then arises in the real economy, andnot in the banking system.

2. MANAGING THE CREDIT CYCLE

The development of Keynes’s earlier thinking on the role played by finance in the capitalist economy came later and, as mentioned above, came as a

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by-product of his monetary analysis. In his Treatise on Money, whose proofshe revised in the wake of the 1929 Crash, Keynes, like Marshall and Fisher,distinguished between the financial circulation of money and its industrialcirculation in order to refine the quantity theory of money. This was necessaryfor his argument that saving may not always equal investment. But the ‘creditcycle’ which he put forward in the first volume of the Treatise turned out tobe a Wicksellian cycle in which saving and investment diverge cyclically, asthe actual rate of interest deviates cyclically from the ‘natural’ rate of interest. His interest was in the effect of this cycle on investment, prices andmonetary circulation.13 A ‘bull’ market in securities could coincide with over-investment, but only because the actual rate of interest would be below thenatural rate of interest.14

As is well known, by the time he came to writing his General Theory,Keynes’s views had changed. But there was a core that had not changed.Already in the Treatise on MoneyKeynes had recognised that it was not theshort-term, or money, rate of interest that affects the level of economicactivity, but the long-term, or bond, rate of interest. Early on in the Treatisehedisputed Hawtrey’s claim that changes in the short-term rate of interest wouldinfluence the inclination of traders to speculate on the prospects of profit orhigher prices.15 In the second volume of the Treatise Keynes included achapter on ‘The Control of the Rate of Investment’.16 He introduced here thedistinction between short-term and long-term rates of interest. Keynes citedresearch published by the American economist Winfield William Riefler,whose conclusion he quoted:

The surprising fact is not that bond yields are relatively stable in comparison withshort-term rates, but rather that they have reflected fluctuations in short-term ratesso strikingly and to such a considerable extent.17

Keynes then provided tables comparing the average bank rate and the yield on unredeemable government stocks (‘consols’) from 1906 to 1929 to arguethat there are similarly synchronised movements of short-term and bond rate in the UK. ‘It is rarely the case that bond yields will fail to rise (or fall) if the short-term rate remains at an absolutely higher (or lower) level than the bond yield even for a few weeks.’18 This clearly implied a yield curve ofrelatively constant slope which moved up and down along its whole length in response to changes in the money market rate of interest. The relativestability of the slope of the yield curve was a crucial element in his analysis of monetary policy. However radically he changed his views on money inwriting the General Theory, he retained basically the same view of the yieldcurve.19

In the TreatiseKeynes argued that the relatively stable relationship betweenshort-term and long-term rates was due to arbitrage by banks and financial

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institutions, which would shift the composition of their portfolios towardsbonds if the money market rates became too low. Rising bond prices wouldthen reduce bond rates more or less correspondingly. Conversely, highermoney market interest rates would cause these institutions to prefer the moreliquid assets with higher returns, and the bear market would reduce bondprices and increase their implied yield.20 Keynes appears to have beeninfluenced here by the ideas of Frederick Lavington.21 Richard Kahn, Keynes’sclosest research associate in the 1930s, suggested in the 1950s that the yieldcurve was formed by banks’ regulating their liquidity by buying and sellinggovernment bonds, that is by the ‘liquidity preference’ of banks.22 Keynesbelieved that while the effects of changes in money market rates of interest onworking capital were likely to be small,

the direct effects of cheap money operating through changes, even small ones, inthe bond market … is probably of more importance … In the modern world, thevolume of long-term borrowing for the purposes of new investment depends mostdirectly on the attitude of the leading issue houses and underwriters [in the marketfor long-term securities].23

Hence Keynes’s remedy for persistent under-investment was for the centralbank to buy long-term securities until the long-term rate of interest had fallensufficiently low to stimulate new investment. This, he believed, would beeffective because, in practice, only a small proportion of outstanding stock isactually turned over in the secondary market where the yield for securities isdetermined.24 Furthermore, if the central bank supplied

banks with more fund than they can lend at short-term, in the first place the short-term rate of interest will decline towards zero, and, in the second place, the memberbanks will soon begin, if only to maintain their profits, to second the efforts of theCentral Bank by themselves buying securities.25

Keynes admitted that buying of securities by a central bank may requirethem to be purchased ‘at a price far beyond what it considers to the long-period norm’, so that, ‘when in due course they have to be reversed by salesat a later date, [they] may show a serious financial loss’. But, Keynes went on,‘this contingency … can only arise as the result of inaccurate forecasting bythe capitalist public and of a difference of opinion between the Central Bankand long-term borrowers as to the prospective rate of returns’.26

There is another difficulty which Keynes did not mention, perhaps becauseat this stage he still regarded the supply of central bank credit as having a fairlyimmediate impact on interest rates. Flooding the markets with more funds thanbanks can lend short term merely reduces the excess demand for funds in thewholesale money markets. Usually this excess demand would be supplied bythe central bank. If it is reduced, then less will be supplied by the central bank

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at the request of banks and money-brokers (discount houses in Keynes’s time).This would reduce the effect of the attempt to increase the supply of money.Even after any excess demand in the money markets may have beenextinguished, the fear of capital loss in the market for longer-term securitiesmay effectively prevent banks from buying such securities.

Keynes reinforced this view in three lectures which he contributed to aseries organised by the Harris Foundation, at the University of Chicago in July1931. Here he contrasted the experience of the USA during the 1920s, whereinvestment activity was high, in spite of high interest rates, with the relativelylower investment activity in the UK. He argued that a decline in investmenthad started as early as 1929, and, ‘according to my theory, was the cause ofthe decline in business profits …’27 The fall in investment was due to excessiveinterest rates, in relation to business profits. The very high interest rates in theUSA brought gold into that country from the rest of the world, causing creditcontraction in other countries.28

In these lectures, Keynes gave a revealing summary of the reflux theory ofprofits, and its connection to finance, that he had enunciated in his Treatise onMoney:

The costs of production of the entrepreneurs are equal to the incomes of the public.Now the incomes of the public are, obviously, equal to the sum of what they spendand of what they save. On the other hand, the sale proceeds of the entrepreneurs areequal to the sum of what the public spend on current consumption and what thefinancial machine is causing to be spent on current investment.

Thus, the costs of the entrepreneurs are equal to what the public spend plus what they save; while the receipts of the entrepreneurs are equal to what the publicspend plus the value of current investment. It follows ... that when the value ofcurrent investment is greater than the savings of the public, the receipts of theentrepreneurs are greater than their costs, so that they make a profit; and when, onthe other hand, the value of current investment is less than the savings of the public,the receipts of the entrepreneurs will be less than their costs, so that they make aloss …29

Keynes then reverted to an imbalance in the real economy as an explanationfor economic disturbances: ‘The whole matter may be summed up by sayingthat a boom is generated when investment exceeds saving, and a slump is generated when saving exceeds investment.’30 Public works should beundertaken and confidence needed to be restored to lenders and borrowers, toraise investment and hence profits. Ultimately, ‘the task of adjusting the long-term rate of interest to the technical possibilities of our age so that thedemand for new capital is as nearly as possible equal to the community’scurrent volume of savings must be the prime object of financial statesman-ship’.31

Keynes recognised that this could not be done through the banking system,

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‘for prima facie the banking system is concerned with the short-term rate ofinterest rather than the long’. It had to be done by a combination of loweringthe short-term rate of interest, open market operations, and restoring ‘theattractions of non-liquid assets’.32

3. THE FAILURE OF MONETARY POLICY

The reflux theory of profits of the Treatise on Money, outlined in Chicago, waspoorly received by his academic colleagues. Keynes abandoned it followingdiscussions with his Cambridge acolytes, grouped informally in theCambridge ‘Circus’ (see Chapter 12 below). More important, from the pointof view of the development of his financial theory of investment, was theapparent failure of low interest rates to generate the predicted recovery ofinvestment. In 1932 the Bank of England reduced its bank rate to a historiclow which, however, failed to revive economic activity. On 30 June 1932 bankrate was cut to 2 per cent (it had been as high as 6 per cent when the Bank hadsuspended gold payments in 1931). Interest on overnight loans in the moneymarket fell to below 0.75 per cent. But the stock market revival was halting.In a rarely noted example of central bank open market operations designed toimprove the liquidity of the market for long-term securities, the Bank alsoentered the market to buy government securities, before a conversion later thatyear of 5 per cent War Loans to 3.5 per cent. Similar measures of monetaryexpansion were undertaken in the USA and Europe. The net effect was toincrease the liquidity of the banking system, with only a limited recovery inreal investment,33 an outcome that was widely regarded as confirming a causallink between liquidity preference in the financial markets and under-investment in the real economy.

In June 1933, in an article published in the American Economic Review,Edward C. Simmons criticised Keynes’s ‘scheme for the control of thebusiness cycle’ by influencing the long-term rate of interest throughmanipulation of the short-term rate. Simmons argued that the relationshipbetween the short-term and long-term rates of interest had been unstable inrecent years, from 1928 to 1932, and therefore Keynes’s ‘scheme’ would notwork. Keynes replied by pointing out that the relationship between long- andshort-term interest rates was by no means as unstable as Simmons suggested: ‘even in these abnormal years the directionsof changes in the two rates werethe same’. Furthermore,

I am not one of those who believe that the business cycle can be controlled solelyby manipulation of the short-term rate of interest … I am indeed a strong critic ofthis view, and I have paid much attention to alternative and supplementary methodsof controlling the rate of interest.34

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Keynes went on to argue that the influence of the short-term rate on thelong-term rate, while not

infallible … is not so negligible as one might have expected … My proposals forthe control of the business cycle are based on the control of investment… I havebeen foremost to point out that circumstances can arise, and have arisen recently,when neither control of the short-term rate of interest nor even control of the long-term rate will be effective, with the result that direct stimulation of investment bygovernment is the necessary means. Before a very abnormal situation has beenallowed to develop, however, much milder methods, including control of the short-term rate of interest, may sometimes be sufficient, whilst they are seldom or nevernegligible.35

By the mid-1930s, therefore, Keynes was entertaining doubts about theability of the monetary authorities to control investment, and hence thebusiness cycle, by acting upon the short-term rate of interest. As recently as1930, he had confidently asserted that

A central bank, which is free to govern the volume of cash and reserve money in itsmonetary system by joint use of bank rate policy and open market operations, ismaster of the situation and is in a position to control not merely the volume of creditbut the rate of investment, the level of prices and in the long run the level ofincomes …36

Keynes was now working on the drafts that were to become his GeneralTheory of Employment Interest and Money. In the course of his preparation,he had to uncover the reasons for the ineffectiveness of monetary and financialpolicy in bringing the economy to a more ‘normal’ situation, where suchpolicy couldbring about the desired levels of investment and employment. Hedid this by moving away from a business cycle methodology, in which theeconomic situation in a given period is explained by its antecedents in theprevious period, or periods, towards short- and long-period equilibria. Thecharacteristics of these equilibria were to be determined by generalisedproperties of commodities and individual human agents, with the short-termequilibrium dominating, but subsequent equilibria emerging through financingand capital commitments.

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8. John Maynard Keynes’s financialtheory of under-investment II:towards uncertainty

In the General TheoryKeynes abandoned the view expounded in the Treatiseon Moneyof the capitalist economy made unstable by credit cycles and re-casthis analysis as an explanation of under-employment equilibrium, reflecting thestagnationist trend in the capitalist economies during the 1930s. This emphasison equilibrium was to challenge those economists who expected an imminentreturn to full employment. But it also placed an ambiguity at the heart of hiswork, inviting, on the one hand, a search for the market ‘rigidity’ (‘sticky realwages’) that was preventing the realisation of a full employment equilibrium,while retaining, on the other, the elements of his critique of a capitalism madewayward by its financial system.1 The General Theoryalso contains, alongsidethe analysis of an under-employment equilibrium created by the financialsystem described below, a theory of a capitalist economy brought to under-employment by its use of money. This latter theory became the staple of laterKeynesian explanations of economic disturbance and stagnation. Expoundinga monetarytheory of economic disturbance in the context of a financial oneincreased the scope for the interpretative ambiguity that has dogged Keynes’seconomic thought.

On his way to a more generalised theory that would incorporate factorscapable of producing the ‘abnormal’ under-investment not amenable tofinancial or monetary policy, Keynes advanced a theory of ‘own’ rates ofinterest. This is distinctive in being peculiar to the General Theory, althoughKeynes refers to Sraffa as having originated it.2 It advanced a monetaryexplanation of under-employment, as opposed to the financial theory of under-investment in the face of uncertaintywith which he ended the General Theory.

1. FROM OWN RATES OF INTEREST TO SPECULATION

The theory of ‘own rates of interest’ was drafted at the end of 1934, when itformed chapter 19 of the first draft of the General Theory. The first title of thatchapter, ‘Philosophical Considerations on the Essential Properties of Capital,

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Keynes’s financial theory of under-investment II

Interest and Money’, reveals Keynes’s attempt to step back from his policyfocus on a transmission mechanism from the financial markets to companyinvestment, to take in more general characteristics of economic activity. Thechapter eventually appeared as chapter 17 in the published book with its title‘The essential properties of interest and money’ unchanged from the first draft.In an attempt to escape capital productivity theories of interest, an essentialfeature of the ‘classical’ economics which he now sought to overturn, Keynesput forward the idea that all commodities may be deemed to have their ‘own’rate of interest. This is the net benefit from holding them over time. Keynesargued that this net benefit consists of the yield or net output of the commodity(income and appreciation in money terms), minus its carrying cost (cost ofstorage), plus its liquidity premium (the ‘power of disposal over an asset’).Included in this was also supposed to be a ‘risk premium’, that is, the holder’s‘confidence’ in the expected yield of the commodity. Because money cannotbe easily produced (it ‘has both in the long and in the short period, a zero, orat any rate a very small, elasticity of production’), and has a negligibleelasticity of substitution, its own rate of interest, the money rate of interest, isthe standard against which other own rates are measured. If the own rates ofother reproducible commodities are higher, more of those commodities will beproduced for gain, gradually reducing their ‘own’ rate of return until there isno advantage in production, as opposed to holding money:

Thus, with other commodities left to themselves, ‘natural forces’, i.e., the ordinaryforces of the market, would tend to bring their rate of interest down until theemergence of full employment has brought about for commodities generally theinelasticity of supply which we have postulated as a normal characteristic of money.Thus, in the absence of money and in the absence – we must, of course, alsosuppose – of any other commodity with the assumed characteristics of money, therates of interest would only reach equilibrium when there is full employment.3

This analysis gave rise to long discussions with Hawtrey and Robertsonover the meaning and significance of ‘own’ rates of interest. Keyneseventually concluded:

I admit the obscurity of this chapter. A time may come when I am, so to speak,sufficiently familiar with my own ideas to make it easier. But at present I doubt ifthe chapter is any use, except to someone who has entered into, and is sympatheticwith, the ideas in the previous chapters; to which it has, I think, to be regarded asposterior. For it is far easier to argue the ideas involved in the much simpler way inwhich they arise in the chapter on liquidity preference.4

However, even Keynes’s partisans have been considerably more critical ofthe chapter. Alvin Hansen described it as ‘a detour which could be omittedwithout sacrificing the main argument’.5 More recently, Fiona MacLachlan

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has written that it ‘is undoubtedly muddled and it appears that Keynes wasgrasping at ideas that he had not successfully sorted through in his own mind’.6

It was Hicks who put his finger on the essential inconsistency in Keynes’sanalysis in this part of the General Theory. There is no evidence that he hadbeen involved in Keynes’s discussions on this chapter when they were beingdrafted, although the parallels with Hicks’s own thinking are apparent, andHicks was lecturing in Cambridge from 1935 to 1938. They correspondedafterwards, but the correspondence was quickly taken up with theinterpretation that Hicks put forward of the General Theory in his seminalarticle ‘Mr. Keynes and the Classics’. However, their correspondence startedwith Hicks’s review of the General Theory. In particular, their earlier lettersfocused on Keynes’s liquidity preference theory of money. At one point,Hicks wrote up his criticisms, of which the bulk was a section headed ‘Theown rates of interest’. Here he concluded:

After a great deal of thought, I have become convinced that the argument of yourchapter 17 gets tied up because you do not distinguish sufficiently betweeninvestment that does employ labour and investment that does not. If the monetarysystem is inelastic, a mere increase in the desire to hold stocks of coffee, whichitself does nothing directly for employment, may raise the rate of interest, and thusactually diminish employment on balance – at least apart from the effect onanticipations, and hence on the production of coffee. Similarly, in a coffee world, arise in the desire to hold stocks of money will raise the coffee rate of interest (if thesupply of coffee is imperfectly elastic) and this will similarly tend to lessenemployment.7

Hicks was evidently here trying to recover the stable relationship betweenthe rate of interest and investment that was a feature of his exposition in ‘Mr.Keynes and the Classics’, a draft of which Hicks enclosed with his letter toKeynes. But it is nevertheless a curious intervention, because Hicks himselfhad earlier sketched out some of the ideas that Keynes was to put into hisGeneral Theoryin a paper which Hicks read at the London Economic Club in1934. This appeared the following February in Economicaas ‘A Suggestionfor Simplifying the Theory of Money’. The paper is today known mainly as one of the first expositions of a ‘portfolio’ theory of money. Here hepresented ‘a sort of generalized balance-sheet, suitable for all individuals andinstitutions’. This had on the assets side the whole range of commoditiesavailable in a modern capitalist economy, including perishable and durableconsumption goods, money, bank deposits, short- and long-term debts, stocksand shares and ‘productive equipment (including goods in process)’.8 Eshaglater indicated that ‘the relationship between the rate of earnings on differentcategories of assets and their degree of marketability’ could be traced back toLavington, Thornton and Giffen.9

It was Nicholas Kaldor who may arguably be said to have made the best

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sense out of the chapter in his 1939 paper on ‘Speculation and EconomicActivity’. Kaldor’s paper sought to make Keynes’s theory of ‘own rates ofinterest’ consistent with not only the liquidity preference theory of money,presented in chapters 13 and 14 of the General Theory, but also Keynes’sanalysis of speculation in chapter 12 of that work. Kaldor argued that ‘ifKeynes had made the theory of the own rate of interest, suitably expanded, thecentre-piece of his exposition in the General Theory, a great deal of thesubsequent interest controversy might have been avoided’.10 In his view thetheory was an explanation of speculative behaviour. However,

in the real world there are only two classes of assets which satisfy the conditionsnecessary for large-scale speculation. The first consists of certain raw materials,dealt in at organised produce exchanges. The second consists of standardised futureclaims to property, i.e. bonds and shares. It is obvious that the suitability of thesecond class for speculative purposes is much greater than that of the first. Bondsand shares are perfect objects for speculation; they possess all the necessaryattributes to a maximum degree. They are perfectly standardised (one particularshare of a company is just as good as any other); perfectly durable (if the paper theyare written on goes bad it can be easily replaced); their value is very high inproportion to bulk (storage cost is zero or a nominal amount; and in addition they(normally) have a yield, which is invariant (in the short period at any rate) withrespect to the size of the speculative commitments. Hence their net carrying cost cannever be positive, and in the majority of cases is negative.11

George Shackle and Victoria Chick have drawn attention to a complemen-tary interpretation, which was advanced by Hugh Townshend, a formerstudent of Keynes’s, in response to a review article by Hicks on the GeneralTheory. Townshend argued that the rate of interest is not determined byconditions of supply and demand in some notional market for new loans, asHicks’s loanable funds interpretation of the General Theorysuggested, but inthe market for existing loans. There, as Keynes had argued, values areessentially conventional: ‘the influence of expectations about the value ofexisting loans is usually the preponderating causal factor in determining thecommon price’.12 Since the values of longer-term securities can changeovernight, no equilibrium between the supply of funds and the demand fornew loans is possible. Accordingly, both Shackle and Chick have put forwardTownshend’s view as a methodological critique of general equilibriuminterpretations, rather than as a theory of financial disturbance.13

In chapter 12 Keynes made a fundamental distinction between the purchaseof securities for resale at a higher price, which he termed speculation, andenterprise, buying securities for long-term income. He lamented the predomi-nance of speculation over enterprise, which he believed reduced companies’productive investment in plant, machinery and technology to incidentaloutcomes of a ‘casino’, mere ‘bubbles on the whirlpool of speculation’. But he

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concluded that there is no other effective way of providing additional financefor productive investment.14

In that same chapter, Keynes put forward his theory of stock prices, thefamous beauty contest, in which speculators buy and sell stocks according tohow they believe that the other speculators or participants in the market willon average evaluate those stocks in the future:

professional investment may be likened to those newspaper competitions in whichthe competitors have to pick out the six prettiest faces from a hundred photographs,the prize being awarded to the competitor whose choice most nearly corresponds tothe average preferences of the competitors as a whole; so that each competitor hasto pick, not those faces which he himself finds prettiest, but those which he thinkslikeliest to catch the fancy of the other competitors, all of whom are looking at theproblem from the same point of view. It is not a case of choosing those which, tothe best of one’s judgement, are really the prettiest, nor even those which averageopinion genuinely thinks the prettiest. We have reached the third degree where wedevote our intelligences to anticipating what average opinion expects the averageopinion to be. And there are some, I believe, who practise the fourth, fifth andhigher degrees.15

Market evaluations are a ‘convention … that the existing state of affairs will continue indefinitely, except in so far as we have specific reasons toexpect a change’.16 It is impossible to resist ‘average opinion’ in favour of more rational, long-term considerations: ‘For it is not sensible to pay 25 for an investment of which you believe the prospective yield to justify a valueof 30, if you also believe that the market will value it at 20 three monthshence.’17

2. CONCENTRATING ON UNCERTAINTY

The reason for this dependence on subjective evaluations and their coagulationinto conventional market values is uncertainty. Like the entrepreneur decidingwhether to install new equipment, the speculator cannot know the future valueof his investment. He can only make judgements with a greater or lesserdegree of ‘confidence’ according to the ‘weight’ of the evidence he has avail-able to him. Accordingly, speculators’ ‘confidence’ veers between optimismand pessimism. Furthermore, expectations in their turn are determined moreby recent experience than the more distant past.18 Such confidence thereforetends to become over-optimistic as a boom matures, and over-pessimistic as arecession is prolonged.

Uncertainty about the future is the key to understanding the adherence oftraders to conventions and past experience. It also explains an apparentinconsistency that arises in Keynes’s ‘Notes on the Trade Cycle’ in the

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General Theory, where he expounded his view of an expectations-drivenbusiness cycle. He argued that ‘a serious fall in the marginal efficiency ofcapital also tends to affect adversely the propensity to consume …’ through ‘asevere decline in the market value of Stock Exchange equities’. The marginalefficiency of capital was defined by Keynes in subjective terms as ‘theexpectationof yield’ in relation to ‘the current supply price of the capital-asset’.19 He then proceeded to argue that changes in securities’ prices affect theconsumption of rentiers, ‘the class who take an active interest in their StockExchange investments’. The fall in consumption ‘serves to aggravate stillfurther the depressing effect of a decline in the marginal efficiency of capital’.No mention is made here of Keynes’s earlier justification of the stock marketas a source of finance for business investment, and its implication that suchfinance would be less readily available, and certainly more expensive, if stockprices are falling. Hence Shackle’s later opinion that chapter 12 may ‘appearat first reading as a strange intruder into the main current of thought’ of theGeneral Theory. Shackle believed that opinion on the stock market may beless self-regarding, and more symptomatic of general business confidence.20

Later, in response to criticism of his monetary analysis from Bertil Ohlin,Keynes stated that entrepreneurs who cannot finance investments out of theirown savings do so by borrowing from banks. This then became an additional,‘finance’, motive for augmenting the demand for money.21 In this view,business investment depends more on the rate of interest than on stock marketprices.

It was Keynes’s theory of the speculative demand for money which gavehim the clue as to how finance may lead to a permanent regime of under-investment. The speculative demand for liquidity, as Keynes called it, was themoney held by traders in the securities markets awaiting profitable investmentopportunities in those markets. As Keynes put it, it has ‘the object of securingprofit from knowing better than the market what the future will bring forth’.22

In this respect it is a counter-tendency to the conventions established by the‘beauty contest’ in the stock market. Only if the speculative demand formoney is held in check will increases in the supply of money reduce the rateof interest.23 But even this may not be enough to overcome businessuncertainty about the prospective yield on investments. Once this yield falls,then even a low interest rate may be insufficient to stimulate investment: ‘ahigh rate of interest is much more effective against a boom than a low rate ofinterest against a slump’.24 Keynes thus identified the limits to the manipula-tion of economic growth by monetary policy. This lay in the volatility of theprospective yield on investments:

Thus the remedy for the boom is not a higher rate of interest but a lower rate ofinterest. For that may enable the so-called boom to last. The right remedy for thetrade cycle is not to be found in abolishing booms and thus keeping us permanently

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in a semi-slump, but in abolishing slumps and thus keeping us permanently in aquasi-boom.

The boom which is destined to end in a slump is caused, therefore, by thecombination of a rate of interest, which in a correct state of expectation would betoo high for full employment, with a misguided state of expectation which, so longas it lasts, prevents this rate of interest from being in fact deterrent. A boom is asituation in which over-optimism triumphs over a rate of interest which, in a coolerlight, would be seen to be excessive.25

Hence, in contrast to his resignation in the face of ‘speculation’ in chapter12, Keynes concluded his analysis by urging the ‘euthanasia of the rentier’ andthe socialisation of investment.26 This was because of the dependence ofcapitalist investment on the conjuncture in the financial markets. Thisdependence on finance put expectations of yield at the forefront of investmentconsiderations. It required the lowering of the rate of interest to raiseinvestment to the point where full employment was achieved:

the scale of investment is promoted by a low rate of interest, provided that we donot attempt to stimulate it in this way beyond the point which corresponds to fullemployment. Thus it is to our best advantage to reduce the rate of interest to thatpoint relatively to the schedule of the marginal efficiency of capital at which thereis full employment.27

In the long run, however, this dependence of investment on finance wasalready in the process of being overcome: ‘the euthanasia of the rentier, of thefunctionless investor, will be nothing sudden, merely a gradual but prolongedcontinuance of what we have seen recently in Great Britain, and will need norevolution’.28

Keynes reiterated this explanation of under-investment a short time later inhis paper ‘The General Theory of Employment’. The socialisation ofinvestment was essential because, in the course of the 1930s, Keynes hadcome to doubt that it was possible to maintain adequate levels of investmentby fixing the conjuncture in the financial markets. This was because of thenature of the investment decision in the face of ignorance of the future, that is,uncertainty.29

Thus the General Theorywas not only Keynes’s considered view on howthe economy worked as a whole, and hence the book may be viewed as across-section of the ideas which he had in his mind in the mid-1930s. It wasalso a critique of the way in which long-term securities markets financecompanies. But, above all, it is argued here, the General Theoryis a responseto the failure of monetary policy to influence those markets in such a way asto allow them to do more effectively what the conventional wisdom of his timeand ours tells us that they do superlatively, namely finance investment.Although ‘Keynesian’ policy is now universally associated with aggregate

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demand management through fiscal policy, in his book Keynes onlymentioned fiscal policy in passing as an influence on the marginal propensityto consume.30 His preferred fiscal stimulus was through public works. Hisessential message, which he later declared to be his original contribution in theGeneral Theorywas the introduction of uncertainty and expectations asfactors preventing the long-term rate of interest from falling to stimulateinvestment up to its full employment level.31

In his ‘Notes on the Trade Cycle’, chapter 22 of the General Theory,Keynes appeared to turn away from a financial explanation of economicdisturbance:

we have been accustomed in explaining the ‘crisis’ to lay stress on the risingtendency of the rate of interest under the influence of the increased demand formoney both for trade and speculative purposes. At times this factor may certainlyplay an aggravating and, occasionally perhaps, an initiating part. But I suggest thata more typical, and often the predominant, explanation of the crisis is, not primarilya rise in the rate of interest, but a sudden collapse in the marginal efficiency ofcapital … Liquidity-preference, except those manifestations of it which areassociated with increasing trade and speculation, does not increase until after thecollapse in the marginal efficiency of capital.32

Keynes went on to argue that movements in the stock market had a morepronounced ‘wealth’ effect on consumption:

Unfortunately a serious fall in the marginal efficiency of capital also tends to affectadversely the propensity to consume … With a ‘stock-minded’ public, as in theUnited States today, a rising stock market may be an almost essential condition ofa satisfactory propensity to consume; and this circumstance, generally overlookeduntil lately, obviously serves to aggravate still further the depressing effect of adecline in the marginal efficiency of capital.33

Keynes then concluded by arguing that the financial markets tend toconcentrate, rather than disperse, volatile expectations of returns frominvestments with a longer time horizon than the markets have. This isaggravated by the effect of changes in stock market values on consumption:

Thus, with markets organised and influenced as they are at present, the marketestimation of the marginal efficiency of capital may suffer such enormously widefluctuations that it cannot be sufficiently off-set by corresponding fluctuations in therate of interest. Moreover, the corresponding movements in the stock market may,as we have seen above, depress the propensity to consume just when it is mostneeded. In conditions of laissez-faire the avoidance of wide fluctuations inemployment may, therefore, prove impossible without a far-reaching change in thepsychology of investment market such as there is no reason to expect. I concludethat the duty of ordering the current volume of investment cannot safely be left inprivate hands.34

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In the General Theoryand beyond, Keynes made use of two explanationsof under-investment. One was a financial theory of under-investment, due toexcessive long-term interest rates. This fits in neatly with his consistentadvocacy, from the Treatiseonwards, of open market operations to bringdown the long-term rate of interest in order to stimulate investment.35 Theother lay in the nature of investment, which requires the capitalist entrepreneurto take a view on an uncertain future. When the experience of the 1930srevealed the difficulties of guiding investment through monetary policy,Keynes put forward uncertainty in the process of investment decision makingas an additional explanatory variable. As Susan Howson and Donald Winchput it:

[In 1936], Keynes’s major policy goal was still the stability of the economy at ahigh level of employment; but the perspective on the instruments and the difficultiesof achieving this goal reflected five years of thought plus the experience of theslump. Given that investment was the motive force of the system, employmentpolicy had to regulate investment. An appropriate monetary policy directed at long-term interest rates, as in the Treatise, would provide the right long-termenvironment. In contrast to the Treatise, however, where monetary policy wasexpected to do all the work, it might not, given the state of entrepreneurialexpectations, provide the solution to short-term instabilities. For that, fiscalregulation might be necessary, particularly if the monetary authorities found itinexpedient to operate in long-term securities markets rather than relying on Bankrate. Open market purchases of Treasury bills or other short-term securities couldonly affect long rates indirectly, and it was long-term rates – very much subject to‘the state of news’ – that affected the bulk of investment.36

3. LIMITS OF INTEREST RATE POLICY

Until he died, Keynes held to the view that the rate of interest was crucial forinvestment, but that its influence was modified at low levels. As late as 1945,in his Notes for the National Debt Enquiry, Keynes wrote:

The rate of interest … is one of the influences affecting the inducement to invest.Experience shows, however, that whilst a high rate of interest is capable of havinga dominating influence on inducement to invest, it becomes relatively unimportantat low levels, compared with the expectations affecting the inducement.37

As part of a fiscal regime to maintain a high level of investment, Keynesrecommended keeping down the long-term rate of interest by open marketoperations with a permanent tap issue.38

Keynes’s profound insights, as well as his inconsistencies, ensured thatsubsequent discussion of the relationship of finance to the real economy took place in the shadow of his analysis. There is no inconsistency between

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a strictly financial theory of under-investment, and a more essentialistuncertainty theory of under-investment. But Keynes’s more philosophicalfollowers, notably George Shackle, have tended to emphasise the principles ofuncertainty in his theory. Keynes’s more financially rooted followers andcritics, the remnants of the Swedish School and Minsky, have tended toemphasise the limits imposed on investment by the financial markets.

Minsky in particular criticised Keynes for his failure to include ‘the price ofcapital assets in his statement of the liquidity-preference function’ and hencestating his argument solely in terms of the rate of interest.39 This was to beremedied by Keynes’s perhaps most thoughtful colleague and advocate, JoanRobinson. In The Accumulation of Capitalshe postulates that, with bondsassumed to be irredeemable to remove the effects of different terms tomaturity, their yield is differentiated according to the perceived risk of defaultof the issuer. When confidence is high, the spread around the current moneymarket rate of interest is reduced:

The yield of a bond at any moment reflects both the general level of interest ratesand the particular credit of the particular concerns (those most respected andreliable enjoying the lowest yields). We may select the very best concerns aboutwhose ability to honour their obligations there is the least possible doubt, as amarker, and call the yield of their bonds thebond rate of interest. Others have higheryields in varying degrees. The relative yields fan out in times of insecurity and lieclose together in periods of general prosperity when profits are easy to earn andfears of default are far from everyone’s thoughts.40

The implied yield curve is flat during an economic boom and acquires apositive slope during a recession. However, there is a notable absence of anyinfluence of Keynesian ‘liquidity preference’ which would lead one tosuppose that longer-term stocks would pay a margin over the short-term rateof interest as a ‘liquidity premium’ against the possibility of illiquidity.

Further on, Robinson attributes high bond rates to active interest rate policyby the monetary authorities:

Generally speaking, the wider and less predictable are fluctuations in the level ofinterest rates, the higher, on the average, the level will tend to be, for it isuncertainty about future interest rates which gives rise to a reluctance to hold bondsand keeps up their yields … Thus we must add to the list of causes of stagnation towhich capitalist economies are subject, stagnation due to a chronic tendency forinterest rates to rule too high, relatively to the rate of profit, to permit accumulationto go on.

At this point a footnote is added ‘This is one of the main contentions ofKeynes’s General Theory.’ 41

Eprime Eshag’s pioneering research at the end of the 1950s, reiteratedrecently by David Laidler, confirms that ‘there was nothing of great

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significance which could be regarded as wholly original in Keynes’s formalanalysis of the rate of interest. What he did, in effect, was to develop andelucidate the ideas known at Cambridge prior to the appearance of the GeneralTheoryin 1936.’42 In particular:

the excessive importance attached by Keynes to changes in the quantity of moneyand in the rate of interest in determining the volume of investment has beendistinctly harmful in practice. The general impression given by Keynes’s work onthe rate of interest is that changes in the rate of interest, which in practice rangefrom a fraction of 1 per cent to 1 or 2 per cent at a time, can produce a verysignificant direct impact on the volume of investment and on the level of economicactivity. The prevalence of the notion that the level of investment and income canbe significantly influenced by changes in the rate of interest within the rangementioned above, accompanied by corresponding variations in the quantity ofmoney, which is found not only among the orthodox economists and bankers, butalso among some leading Keynesian economists, can be traced, in the case of thelatter group, partly at least, to the influence of Keynes … In this respect, Keyneswas still operating under the influence of the classical economists and Marshall.43

Eshag here revealed the influence on him of Kalecki. In fact there was moreto Keynes’s analysis of capitalism than just the theory of money and an almostclassical theory of investment. Keynes’s analysis of money and investment inthe context of a capitalist economy dominated by finance produced a financialtheory of under-investment to explain the decline into economic depression atthe start of the 1930s. For a while he believed this to be amenable to treatmentby expansionary monetary policy. With the failure of this policy in the 1930s,he shifted the grounds of his critique to the way in which finance makesinvestment depend on uncertainty and expectations, as well as on the rate ofinterest. Whereas Marx looked forward to a capitalism that had ‘subordinated’finance, it was Keynes’s signal achievement to reveal in certain essentials acapitalism that has yet to emancipate itself from usury.

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PART III

Critical Theories of Finance in the Twentieth Century: In the Shadow of Keynes

Wartime financing in Britain and the United States resulted in a large increasein the holdings of government and bank liabilities by households, firms, andnon-bank financial institutions. As a result, the financial system of the 1930swas replaced by a robust financial system in the first postwar decade. Theeconomic problems … were not of the type contemplated by Keynes in TheGeneral Theory… As the sixties progressed, eminent economists – especiallythose associated with government policy formulation – who in their ownminds were disciples of Keynes, were announcing that endogenous businesscycles and domestic financial crises were a thing of the past, now that thesecrets of economic policy had been unlocked.

(H.P. Minsky, John Maynard Keynes, p. 15)

9. The principle of increasing risk I:Marek Breit

The working lives of Marek Breit, Michal Kalecki and Josef Steindl spannedthe middle decades of the twentieth century, from the 1930s up to the 1980s.Marek Breit was a Polish economist, too briefly active in his profession duringthe 1930s, who was tragically killed during the German occupation of hiscountry. Josef Steindl, an Austrian economist, worked in Britain during theSecond World War, and continued to write until 1990. They had in commonthe experience of working with the Polish economist Michal Kalecki, and theirshared commitment to what the latter enunciated as the principle of increasingrisk.

1. FROM FREE BANKING

The idea behind the principle originates in the work of Marek Breit. He camefrom a Jewish background in Cracow, and studied at the JagiellonianUniversity in his home town. His only book, Stopa Procentowa w Polsce(TheRate of Interest in Poland), published in Cracow in 1933, has all theappearance of a doctoral thesis. Given his background, Breit could hardly haveaspired to appointment in Poland’s notoriously conservative universities. Inthe year of the book’s publication he moved to Warsaw, where EdwardLipinski later recruited him to the Institute for Research in Business Cyclesand Prices (Instytut Badania Konjunktur Gospodarczych i Cen). Kalecki wasalready working at the Institute. Breit’s main task was writing reports on creditmarkets in Poland. But the development of his ideas at this time clearly showsthe influence of Kalecki’s monetary and business cycle theories. In 1936, Breitand the third outstanding economist at the Institute, Ludwik Landau, openlycriticised the deflationary policies of the Polish Finance Minister, EugeniuszKwiatkowski, under whose patronage the Institute had been established.Kwiatkowski demanded their removal, and the two were sacked. Lacking theinternational connections that brought Kalecki (and Oskar Lange) out ofPoland on Rockefeller Foundation Fellowships, Breit remained in Poland andwas killed in 1940.

In the English-language economics literature, an important essay by Alberto

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In the shadow of Keynes

Chilosi1 is the only extant discussion of Breit’s monetary analysis. In Breit’sown country, Tadeusz Kowalik’s erudite history of modern Polish economics2

discusses Breit, but the bulk of the discussion is devoted to the financial modelof the socialist economy which he wrote with Oskar Lange in 1934.3 Inpersonal discussion, Kowalik reported Kalecki’s view that Breit’s early workwas neo-classical. In his maturity Kalecki would have objected to Breit’sclassical conviction that the rate of interest influences the volume ofinvestment. Kowalik has also written that Breit was influenced by Wicksell.4

Breit was indeed neo-classical in Keynes’s meaning of the term, in that he didnot consider actual saving and investment to be equal. In the more commonsense, of someone who adheres to laissez-faireand marginalist doctrines,Breit’s book was certainly neo-classical. But the conclusion of his only paperpublished outside Poland, in German in 1935 as ‘Ein Beitrag zur Theorie desGeld- und Kapitalmarktes’ in the Zeitschrift für Nationalökonomie, containsintriguing hints at Kalecki’s later scepticism about the influence on investmentof the conditions of credit. Common to all his work is a clearly Schumpeterianmonetary analysis and view of capitalist production as a process rather than aseries of discrete production decisions. In his book, Breit went even furtherand subjected Wicksell and Schumpeter to a more profound critique, and heeventually rejected their business cycle views, implicitly if not explicitly. Theoriginality of this thinker and the obscurity of his work, in a world increasinglydominated by English-language discussion, warrant a more extensiveexamination of his analysis.

Although published in 1933, Stopa Procentowa w Polscewas in fact writtenin 1930. This is important, because it reveals the source of Breit’spreoccupation in the book with inflation. During the first half of the 1920s,Poland had experienced hyperinflation, which was finally brought to an endby the Grabski reforms of 1926, which introduced a new currency linked tothe US dollar. By the time the book was published, Poland was in the severeeconomic depression that brought financial deflation to the forefront of Breit’spreoccupations in the articles that he published after 1933.

The book begins in orthodox Austrian fashion, arguing that the rate ofinterest establishes a natural equilibrium between saving and the amount ofresources that society wishes to devote to the establishment of more produc-tive ‘roundabout’ methods of production. Breit argued that this equilibrium is prevented by government intervention, ‘étatism’, which distorted thisequilibrium in three ways. First of all, the government engaged directly inunprofitable ventures. Second, government banks in Poland supported privateenterprise with cheap credit. Finally, the government imposes interest rateceilings below the equilibrium rate of interest. However, governments canonly effectively reduce short-term rates of interest, because long-term rates aredetermined in the credit markets. This creates a further disparity between

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short-term rates and the long-term rate of interest.5 All this was of coursecommon ground for Austrian critics of government monetary intervention,such as Hayek, as well as recent financial liberalisers. It undoubtedly explainswhy Kalecki reacted so unfavourably to the new arrival from Cracow at theInstitute.

Breit’s critique of government intervention in the credit market, whichwould otherwise naturally bring about an equilibrium between saving andinvestment in the economy,6 indicates Breit’s inclination, at least at the time when he was writing the book, towards a ‘general equilibrium’ view offinance. In fact, his monetary analysis reveals means by which the bankingand financial system may itself disturb the economy. Among these arecentrally allocated credit quotas and interest ceilings. These, he argued, areresponsible for the misallocation of credit in the economy, leading toinefficient investment in the economy.7 This is well known today from thework of Hayek and financial liberalisers such as Ronald MacKinnon andMaxwell Fry. In a paragraph that would have complemented rather wellHawtrey’s analysis, of which he seemed to have been unaware, Breit pointedout that credit rationing and interest ceilings (Poland had reintroduced a usurylaw in June 1924) led to fluctuations in the reserves of smaller private bankson the fringes of the banking system. This is because they were unable toreduce the demand for credit by raising the rate of interest, and were thereforeobliged to ration credit. Such rationing in turn caused shifts in the prudencewith which these banks viewed the investment projects of entrepreneurs.When banks had strong reserves they tended to be careless about lendingmoney. When they had weaker reserves, banks tended to be over-cautious.8

Hence, and in contrast to Adam Smith’s view, Breit associated low rates ofinterest with poorer-quality loans. The artificial scarcity of loans at such ratesdiscouraged their repayment.9

Along with Hayek and recent financial liberalisers, Breit emphasised thatstate control of credit created monopolistic distortions. The intervention of thestate in interest rate policy and through its ownership of large banks in Polandat the time brought about an excess demand for credit and disintermediationof savings from the formal banking system.10 At the end of his book, he putforward a credit cycle model that, in its essentials, is the same as the one thatHayek put forward a short time afterwards in London.11 This credit cycle neednot detain the discussion here, since it is driven not by the autonomousfunctioning of the financial system, but by ‘misconceived’ state direction ofcredit or interest rates. However, Breit took this analysis much further thanmore recent critics of state intervention in banking, and made it into thefoundation of his monetary analysis.

Breit divided the money supply into two parts. The first of these was the‘money supply arising from the normal circulation of the static economy’, and

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the second was ‘additional money supply whose sources lie in the dynamicshifts of the modern money-credit economy’. This additional money supply isalso called ‘inflationary credit’.12 The first, consisting of ‘normal means ofpayment’, is clearly a notion drawn from Schumpeter’s analysis of money inhis Theory of Economic Development, as also is Breit’s terminology fordescribing capitalist activity as making ‘combinations’ of factors ofproduction.13 The second category of money supply, inflationary credit, wasalso common currency in the German monetary theory that was the foundationof his analysis.14 The whole of chapter three in his book is devoted to theexplanation of inflationary credit.

Inflationary credit is credit to which no additional commodity productioncorresponds, although it may exist in the future if additional production isundertaken with it. According to Breit, it arises because of the monopolisticpower of banks. This monopoly power allows them to issue additional creditwithout loss of their reserves. The most obvious monopoly is that of centralbanks, which are given a formal monopoly of rights of banknote issue bygovernments.15 This additional money supply brings the money rate of interestbelow its ‘natural’ level. Breit criticised Schumpeter and Wicksell for seeingthe source of that money rate of interest in the supply of and demand formoney in the wholesale money markets, whereas its true origins lie in theinternational bank cartel that accepts into its members’ reserves the additionalmeans of payment that they issue.16 Thus Breit attributed credit disturbancesnot only to inappropriate monetary and credit policies by the government, butalso to an absence of competition among banks, which would limit theirinflationary credit creation.17

Breit at this time was clearly close to a view known as ‘free banking’.18 Itsmost articulate spokesmen, such as Henry Meulen, who was active during thefirst four decades of the century, and more recently Hayek, argued that banksnaturally evolved towards an ideal system that limited credit creation to non-inflationary dimensions.19 Breit did not mention any of this literature, nor is itdiscussed by the authors he cited: Böhm-Bawerk, Cassel, Hahn, Kock, Mises,Spiethoff, Wicksell or Schumpeter. The ‘free banking’ school attributedmonetary disorders to the appropriation by the state and its agencies of controlover credit creation.20 Breit, however, stands out from the ‘free banking’school. He saw that bank cartels could arise among banks in the same way thatthey arose among other commercial concerns, even just through the operationsof the inter-bank market: ‘It is generally known that within states, bankscreating accounts have for a long time combined in cartels, setting their con-ditions of credit on the same basis (“Konditionenkartell”).’ This inflationarycredit expansion exposes central banks to the possibility of falling foreigncurrency reserves. Accordingly central banks join in an international cartel tomaintain stable exchange rates. ‘This involves the co-operation of the whole

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credit-creation system on a world scale … With such a wide monopoly, thereare no external obstacles to the inflationary moves of the world-wide bankcartel.’21

In fact this cooperation by banks is an essential feature of their managementof their liquidity and asset quality.22 Breit’s exposition of the inflationaryimplications of such cooperation is a more profound dilemma of institutionaldesign than he may have realised.

2. PERCEPTIONS OF RISK

By the time that Breit’s inflationary fears had been put into print, the financialsituation he was observing had changed dramatically. The Polish economywas beset by depression. Like other ‘producers’, the Institute where he cameto work cut the prices of its publications in an effort to promote their sale. Asa result of expansionary monetary policy by the central bank, the Polishbanking system was able to maintain its liquidity. In his book, Breit hadargued that the long-term loans market comes into operation once the short-term loans markets is ‘satiated’.23 But the extension of the long-term loanmarket in Poland and elsewhere at this time was distress lending rather thanthe financing of new investment opportunities. Short-term loans could not berepaid and banks were forced to roll them over, if they were not to admit themas bad loans, while the state banks were obliged to extend long-term loans tobusiness to prevent industrial collapse.24

At the Institute for Research in Business Cycles and Prices Michal Kaleckiintroduced Breit to the new principles of aggregate demand that were to makeGerman monetary theory obsolete in the 1930s. A distinctive feature of theseprinciples, in Kalecki’s version published by the Institute, was the refluxtheory of profits, which showed how the retained profits of companies weredependent upon capitalists’ own expenditure and the fiscal deficit of thegovernment.25 This was a crucial breakthrough for Breit, modifying, if notentirely replacing, his earlier Austrian notion of profits based on the presumedgreater productivity of ‘more roundabout’ theories of production.

In 1935 Breit published a theory of the structure of interest rates in a paperthat appeared in the German Zeitschrift für Nationalökonomie. The paper hasa significance that goes far beyond the now relatively obscure debates inGerman monetary economics of the 1930s. The paper amounted to a substan-tial critique of the Cambridge (and Oxford) doctrine of liquidity preferencethat came to dominate monetary economics following the publication ofKeynes’s General Theory, a doctrine that is represented in the paper by two ofHicks’s early papers in monetary theory. Breit criticised the notion that thiswill give rise to an ‘equilibrium’ term structure of interest rates in credit

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markets. The grounds of his critique are that any actual structure of interestrates will also affect the financing preferences of non-financial corporations.The influence of the rate of interest on investment is therefore mediatedthrough these balance-sheet effects. But the aspect of the paper that has mostcurrency in today’s monetary and financial economics is Breit’s examinationof the effects of risk and uncertainty upon entrepreneurial investment andfinancing arrangements. Some of this corresponds to Keynes’s distinctionbetween lender’s and borrower’s risk, in chapter 11 of his General Theory.However, Breit’s exposition of how credit markets and financing contractsaccommodate risk and uncertainty by raising interest rates and rationing creditis much closer to that of the New Keynesians.26

Important differences between more modern approaches and that of Breitshould be emphasised. These relate in particular to the New Keynesians andto Tobin, whose ‘q’ theory is supposed to include corporate balance sheets ina portfolio theory of money and credit.27 The modern approach limits thepossible influence of the financial markets by adhering to the Miller–Modigliani doctrine that the compositionof a company’s financial liabilities(as opposed to their cost) cannot influence its investment activity. Tobin andthe New Keynesians provide determinate solutions in general equilibriummodels in which real rates of interest determine corporate investment andhence macroeconomic outcomes. By contrast, Breit used the marketrates ofinterest actually available to an individual entrepreneur. He was therefore ableto bring his analysis closer to industrial reality. Breit also highlighted the factthat the absence of a positive solution may lead to the extinction of the marketfor long-term securities. In this respect his is a disequilibrium model. Itobviously arose out of the European reality of his time. Recent difficulties inreviving activity in Japan since the 1990s suggest that Breit’s analysis mayalso be close conceptually, if not historically, to our reality as well, and maybring additional considerations to bear on dilemmas of contemporarymonetary policy.28

The model in Breit’s paper relates financial risk to the amount of borrowingthat is undertaken by an individual firm. The larger the amount the firmborrows, the greater the charge on its own capital if the return on the investedloan falls below the interest charged. ‘Financial risk’ therefore increases withthe size of the loan, relative to the entrepreneur’s capital. Accordingly, abovea certain size of loan, the lender takes into account this financial risk bycharging a risk margin on top of the basic lending rate of interest. This marginincreases with the excess of the loan. This article established the distinctionbetween internal funds, the savings of the business, and external fundsborrowed or raised from a financial intermediary. Those internal funds aredrawn from the retained profits that in turn are determined largely bycompanies’ own expenditure on investment (see Chapter 11 below).

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This possibility that excessive external financing of business increasesenterprises’ risk is what distinguishes the analysis of risk in Breit, andsubsequently also in Kalecki, Steindl and Minsky, from that of Hicks orKeynes. In an early paper on monetary theory, to which Breit referred, Hickshad argued that holders of financial assets assess the future value of theirassets probabilistically, with uncertainty being reflected in the dispersion of possible future values.29 In his General TheoryKeynes had called this‘lender’s risk’, and distinguished it from ‘borrower’s risk’, namely the pos-sibility of an adverse outcome to the investment project for which finance isbeing raised, and for which the borrower is liable. Keynes merely hinted thatthe lender’s risk may be reduced ‘where the borrower is so strong and wealthythat he is in a position to offer an exceptional margin of security’ and that,during a boom, ‘the popular estimation of both these risks, both borrower’srisk and lender’s risk, is apt to become unusually and imprudently low’.30

Breit’s paper is mostly concerned with how entrepreneurs decide betweenlong-term and short-term loans in financing their ‘new combinations’. On theone hand, long-term finance involves additional risk for the lender, incommitting himself to a company that may get into financial difficulties,which would affect the resale value of long-term securities. The long-termlender therefore charges an additional premium for such finance. On the otherhand, short-term finance involves what Breit called ‘transformation’ costs, orcosts of rolling over short-term obligations (including the possibility of higherinterest rates in the future). Given the external finance that is required, it is thebalance between the short-term rate of interest plus these transformation costs,and the long-term rate with its risk premium that determines whether theentrepreneur will seek finance in the long-term or the short-term market. In hispaper, Breit concluded that business investment rather than conditions incredit markets held the key to improving business cash flow, and hence itsprospects. This could be assisted by public works, which would have a similareffect on business liquidity. With this Breit rejected his Schumpeterian andWicksellian origins, in which the rate of interest and the ‘natural’ productivityof (marginal) ‘new combinations’ were the key determining variables in thebusiness upswing.31 But once the credit market lost its significance forinvestment, Breit was close to arguing a ‘reflective’ view of finance:

it is not the difference between the high capital market interest rate, and the lowmoney market interest rate, that is responsible for the reduction in investmentactivity. Instead, both the low volume of investment and the divergence of interestrates represent different symptoms of the same economic processes which operateat a much deeper level. It has also been shown that the divergence in interest ratesis associated neither with intensity of the tendency towards liquidity in theeconomy, nor with the unequal division of demand [for credit] between the marketsfor long and short-term loans … It has been shown that the apparently low short-term interest rate is by no means low in an economic sense. Instead (together with

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transformation costs) it is excessive in comparison to the profitability of newenterprise. Above all, we have been able to refute the idea that the impulse whichproduces a new wave of prosperity must come directly from the credit market. Inour reasoning, the fall in the rate of interest, and the increase in demand do notnecessarily have to precede, either logically or in time, the growth in intensity ofreal economic processes. In certain cases, of course, both phenomena run inparallel. But in other ones, (for example, with the emergence of new combinationsin production, or with counter-cyclical state investments), the fall in the rate ofinterest and the increasing liquidity of the markets are shown to be the consequenceof increasing investment activity, whose rise is quite independent of the situation inthe credit market.32

The publishing life of Marek Breit spanned no more than four years, and hiswriting life in economics no more than six. However, these were years whenthe economy that he was studying most directly swung between inflation andsevere economic depression. In analysing both he identified banking andfinance as crucial and relatively autonomous factors driving the inflationaryand deflationary processes in the economy. Ultimately he criticised creditcycle theories and the notions of liquidity preference in financial markets thatwere emerging in England, that were to culminate in Keynes’s GeneralTheory. Working with Kalecki, he came to a view that emphasised theliquidity of business balance sheets as the key to the fixed capital investmentthat drove the economic cycle.

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10. The principle of increasing risk II:Michal Kalecki

Kalecki rapidly took up and extended the essential concept of financial riskthat Breit had put forward. The first version of Kalecki’s ‘Principle ofIncreasing Risk’ appeared in English in 1937.1 In his hands this analysisbecame a theory of investment, an explanation for the size of firms, and areason why increasing the supply of credit in financial markets would notincrease investment, as suggested by the equilibrium loanable funds theory.2

Along the way he echoed (unconsciously) Fisher in criticising Pigou’s realbalance effect.

1. RISK IN CORPORATE FINANCE

Kalecki suggested that a constant prospective return on investment is morerealistic than the decreasing returns favoured by most economists. Given sucha return, and the current rate of interest with increasing risk margins, theamount of investment that a firm can undertake is limited by the amount of itssavings. A similar risk constraint would apply to funds raised from the stockmarket, through a rising cost of funds on bond issues. In the case of shares,existing shareholders would resist the watering-down of their stock byadditional stock issues, and corporations would be faced with rising costs ofselling more than an ‘optimum size of issue’.

In the 1954 version of this paper, Kalecki dropped the static analysis ofinvestment decisions based on internal savings, and turned his principle ofincreasing risk into a theory of the size of the firm under the revised title of‘Entrepreneurial Capital and Investment’.3 He argued in general terms that ‘theexpansion of the firm depends on its accumulation of capital out of currentprofits’,4 and discussed the limitations of capital market finance. Bond issuesreduce the return on share capital if the investment is unsuccessful, while shareissues reduce the control of the controlling shareholders. The latter may bepartially overcome by a holding company structure (floating off 49 per cent ofa subsidiary). But the problem remains that, if the venture is unsuccessful,earnings per share will be reduced. Finally Kalecki suggested that portfoliodiversification by rentiers will limit the amount of new shares in a company to


which financial investors will be willing to subscribe. He pointed out that allof these difficulties may be overcome through the accumulation of internalsavings from profits, that is, entrepreneurial capital. This provides a cushionof reserves to reduce the financial risk of capital subscribers and will even‘widen the capital market for the shares of that company since, in general, thelarger a company is the more important will its role in the share market be’.5

Readers versed in modern finance theory will immediately recogniseKalecki’s analysis of the limitations of external finance for investment as an argument that the capital market is ‘imperfect’; that is, it does notautomatically supply finance at the current price of finance, including the riskpremium of the project not the firm, for all projects with returns in excess ofthat price. In the capital markets of the second half of the twentieth century (orat least from the 1960s onwards), Kalecki’s constraints on capital finance havebeen barely detectable. However, this is not because the capital markets havebecome more perfect, but because of the inflation of those markets withpension fund savings. This inflation has greatly enlarged the possibilities ofcapital-market-financed company growth. Where such growth has taken place,it has not been due to increased productive investment, as the loanable fundstheory would predict. Rather it has been through waves of merger andtakeover activity that have increased industrial concentration and made capitalmarkets less stable.

Kalecki also intervened in the debate around Keynes’s notion of an under-employment equilibrium with an argument that Fisher would have recognised.Arthur Pigou criticised this notion on the grounds that were wages and pricessufficiently flexible, then unemployment would result in falling wages andprices. The resulting increase in the real value of wealth, especially moneyholdings, in relation to current production would cause an increase inexpenditure, which would bring the economy back to a full employmentequilibrium. This is known today as the ‘real balance effect’. Kalecki pointedout that, unless those savings were held in government debt or gold, theincrease in the real value of savings due to falling prices would mean anincrease in the real value of private sector debt. This would lead to corporatecollapse, a crisis of confidence and industrial decline.6

Kalecki’s real debt deflation view was evidently a relatively recent con-clusion. Earlier, in a review of a book on monetary economics by the Germaneconomist E. Lukas, Die Aufgaben des Geldes, Kalecki had put forward adisequilibrium view of how the financial markets work, without mentioningthe possibility that falling prices would entail a rise in the real value ofcorporate debt. The review also reveals how limited was the influence ofKeynes in the work of the Polish economist whose correspondence with JoanRobinson is testimony to his resistance to Keynes’s approach to macro-economics.7 Lukas’s support for Nazi employment policies is noted without

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comment. Kalecki reserved his detailed criticisms for Lukas’s exposition ofthe loanable funds theory that had been popularised in the English-speakingworld by Dennis Robertson, and which formed the rationale for opposition togovernment expenditure on public works to alleviate mass unemployment.Robertson had equated bank credit with saving and argued that saving wouldnormally evoke equivalent investment; he held this view well after it hadapparently been discredited by Keynes (Robertson, 1928 and 1949). Kaleckiwrote:

The author [i.e., Lukas] takes for granted the popular view that the buying ofsecurities by the saver automatically creates a demand for new capital equipment.Thus the increase in saving, as such, is not considered to have a ‘deflationary’effect. If, however, savers buy, for example, bills, instead of bonds, a correspondingamount of purchasing power is shifted from the capital to the money markets andmeets there a part of the demand for credits.8

Thus credits granted by monetary authorities fall off and ‘the purchasing power incirculation’ shrinks pro tanto. As a result the fall in the demand for new capitalequipment which occurs is not compensated for by the increase of effective demandin other parts of the economy. This description is, of course, inadequate. Theprocess concerned is much more complicated. A shift of a certain amount (whethercoming from new or old savings) from the capital to the money market tends toraise the long-term rate of interest, and thus reduce the volume of investment, butin general not just by the amount initially shifted.9

Kalecki here showed how, even with supply and demand equal in the bondand the money markets, an increase in saving may transmit a deflationaryimpulse to the real economy through the normal and even efficient functioningof the financial system. At this time he still followed Keynes in regarding thelong-term bond market as the market for finance of industrial investments, sothat a shift of funds away from that market would cause a rise in long-termbond yields and an increase in the financing costs of new industrialinvestments, effectively discouraging such investments. The more interestingargument is, however, the way in which Kalecki may be said to have stoodHawtrey and Robertson on their heads, by showing how an increase in short-term saving can reduce the money supply. The buying of bills or, moregenerally, a rise in bank deposits, would merely result in a correspondinglylower demand from commercial banks accommodating credit from the centralbank. An increase in saving thus induces a reduction in the money supply ofthe central bank. The money market rate of interest would not fall because alower demand for central bank credits is met by a reduced supply of them atthe current rate. The failure of the short-term rate to fall means that there isno incentive to switch savings back to the long-term bond market to obtain anew equilibrium there at the lower yield that would encourage higherinvestment.

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Kalecki’s model here suggests a structure of financial markets in whichshort-term interest rates are more stable than long-term rates, because centralbanks ‘accommodate’ changes in the demand for money in the moneymarkets. In fact the reverse is the case: long-term rates tend to be more stablethan short-term rates. This had been widely noted by Harrod in The TradeCycle, for example, and Hawtrey in A Century of Bank Rate. A large part ofthe debt of the British government had been consolidated at the end of theeighteenth century into irredeemable stocks, known as Consolidated Funds, or‘consols’, bearing a rate of interest of 2.5 per cent or 4 per cent of nominalvalue. The yield on consols therefore varied with the price of the stock, but itsperiod to maturity did not fall over time, as it would for a stock with a finiteredemption date. That yield was therefore a variable price for a stock ofconstant immaturity, a pure yield unaffected by imminent repayment. With nodefault risk, because interest was payable by the British governmentindefinitely, the yield on consols was commonly taken as the standard currentreturn, on risk-free long-term stocks and the ‘benchmark’ for returns in long-term stocks.10 Relatively stable yields on consols over more than a hundredyears were convincing evidence of the comparatively limited movement oflong-term interest rates. The discussions of consol yields by Harrod andHawtrey feature among the very few references that Kalecki made in his workto other economists, and in his writing about the long-term rate of interest, heused the yield on consols as the base for the long rate.

2. THE YIELD CURVE

Kalecki first wrote about this difference between the two ends of the yieldcurve in 1938, when preparing his Essays in the Theory of EconomicFluctuations for publication. He added a brief chapter on ‘The Long-term Rateof Interest’. The purpose of the chapter was to show that the long-term rate ismore stable than the short-term rate. He explained why this is the case byarguing that interest arbitrage between the two ends of the curve will notmaintain a constant slope of the curve, but that the slope will vary as changesin the short-term rate of interest move the short end of the curve above orbelow a more constant long end of the curve.

In the course of an economic boom,

an increase in investment causes the banks to sell bills and bonds in order to be ableto expand advances … The Central Bank, in buying bills reduces very much thepressure of sales … But the effect of the Central Bank’s buying is partlycounterbalanced by the fact that with increasing activity the demand for notes ‘incirculation’ rises. At any rate there is an inherent tendency in the system for strongfluctuations in the discount rate, which in fact often makes itself felt.11

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The reason why interest arbitrage will not equalise the two rates, with dueallowance for factors such as risk, uncertainty, illiquidity, inflation and so on,is that the current short-term rate of interest is not the short-term equivalent oropportunity cost of the long rate. That equivalent or opportunity cost is theaverage short-term rate expected over the term of the bond. Kalecki used as his representative financial investor ‘a capitalist with a “non-speculativeoutlook”’. This may well be a reference to Keynes’s recent distinctionbetween ‘speculation’, that is, investing for capital gains, and ‘enterprise’,investing for future income, in the stock market in chapter 12 of his GeneralTheory. If Kalecki too had such a distinction in mind, then it would be entirelyconsistent with his methodological predilection for assuming rationality on thepart of capitalists, rather than speculative fervour or existential indecision inthe face of uncertainty. Kalecki wrote as follows:

Consider a capitalist with a ‘non-speculative outlook’, who faces the alternatives of holding his reserves in bonds or deposits. There is the advantage of a stable and generally higher income on the side of bonds: on the other hand, deposits are constant in value, while the price of bonds, in the case of emergency which may necessitate their sale in the indefinite future cannot be foreseen, and the risk of loss is always present. Thus it is clear that the stimulus to keep bonds is themargin between the present long-term rate and the anticipated average short-termrate over a long period. Now it is very likely that the change in the present rate on deposits does not greatly affect the expectations of its average over a long period. Thus it is plausible that a deposit owner of the type considered may beinduced to buy bonds though the rate on deposits has increased more than the yieldon bonds.12

Kalecki may have developed this idea from his reading of Hawtrey’s ACentury of Bank Rate to which Kalecki referred as providing supportingevidence of the stability of the long-term bond rate. On page 147 of that book,Hawtrey cited evidence which the banker Samuel Gurney gave to aParliamentary Committee in 1848. When asked what would be the effect of‘dear money’, that is, high short-term interest rates, on long-term interest rates,Gurney replied that this ‘depends on how long dear money is expected to last’.If they were expected to last a long time, then long-term bond prices may fall,and the yields on those stocks rise in line with the rise in short-term interestrates. While it is unlikely that this account inspired Kalecki’s explanation ofthe relative stability of long-term interest rates (Kalecki’s interests wereconsiderably more contemporary), Gurney’s evidence in 1848 doescorroborate Kalecki’s view remarkably.

Kalecki drew two conclusions from the relative stability of long-term ratesof interest. First of all,

It excludes these theories of the business cycle which attribute the breakdown ofprosperity to the increase of the rate of interest. For the rate of interest can stop the

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boom only by hampering investment, and it is chiefly the long-term rate whichmatters in investment activity.13

This was a sweeping dismissal of monetary theories of the business cycle,such as those of Hawtrey and Hayek. His second conclusion was

that the boom ends in general before full employment is reached. When the systemcomes to the point of full employment, wages must rise sharply. But … this doesnot tend to reduce employment directly … wages and prices continue to climb up,the demand for bank advances steadily increases, causing a strong rise in the short-term rate and – at least after a certain time – an appreciable increase in the long-term rate. Only this can overcome ‘inflation’ by hampering investment and stoppingthe rise in wages and prices.14

This analysis was incorporated by Kalecki in papers which were thencombined for publication in his Studies in Economic Dynamics, which thenbecame his Theory of Economic Dynamics: An Essay on Cyclical and Long-Run Changes in Capitalist Economy, published respectively in 1943 and 1954,by which time Kalecki had dropped the reference to the ‘non-speculative’capitalist. However, he had expanded his reasoning about the yield curve fromhis ‘Lukas critique’, with a static model in which the bond yield moves aroundthe more stable short-term rate, due to the accommodating policy of centralbanks, to a more normal yield curve in which discretionary policy by monetaryauthorities moves short-term interest rates around the more stable bond rate.‘Call money’, the automatic credit granted to brokers in the stock market,would act as a further stabilising influence on bond yields, since such facilitieswould make brokers more ready to absorb excess supplies of bonds.

It is obvious that in a capitalist economy with markets for financial instru-ments kept stable by accommodating credit policies, the long-term bond yieldand money market interest rates (hence also the yield curve in general) areinelastic with respect to saving. Keynes too was concerned to show how thelong-term bond rate is inelastic. He attributed this to liquidity preference, thatis, the subjective unwillingness of savers to hold their money in financialassets without immediate assured liquidity. For Kalecki the reasons for theinelasticity of the yield curve in general were much more like the ones thatBreit had put forward (see previous chapter). These were rooted in theinstitutional arrangements surrounding the operations of the money market.Inflows of savings or liquidity into the money market or the banking system,whether from additional saving or from the long-term bond market, merelyreduce the credit supplied by the central bank. A switch of funds from thebond market to the money market would raise financing costs in the bondmarket, without reducing them in the money market. But, by implication, aswitch of funds from the money market or the banking system to the bondmarket has the capacity to reduce bond financing costs without increasing

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interest rates in the money market. Such a switch to the long-term securitiesmarket would be accommodated by the central bank.15

Kalecki put forward another reason why the financial markets would notautomatically bring a finance capitalist economy into equilibrium. This is the inelasticity of rentiers’ saving. In his Studies in Economic Dynamics,published in 1943, Kalecki suggested that, because of their high and stableincomes, rentiers always have positive saving, except when subjected tohyperinflation. In a closed economy, with no government, saving can bedivided up between rentiers’ saving and the financial accumulation ofcompanies (depreciation plus retained profits). Ex post saving, in Kalecki andKeynes, is equal to, and determined by, gross investment (see Chapter 9).When that investment falls, in a recession, so too does saving, and at the samerate as investment. If, however, rentiers’ saving does not fall as fast, then thefinancial accumulation of companies must fall more rapidly then the fall insaving and investment overall. In effect, as a rising proportion of companies’investment is externally financed, their financial risk is increased. Firms maytry to accommodate this by economising on their internal liquidity throughreducing investment still further. In this way they reduce the financial accumu-lation of firms as a whole, and increase firms’ external indebtedness stillfurther.16

Because of this inelasticity, rentiers’ saving tends to make recessions moreextreme, introducing a ‘negative trend’ into Kalecki’s business cycle model.However, when he revised his model, in the early 1950s, Kalecki pointed outthat this negative trend is offset by technological innovations which stimulateinvestment. He argued that it is the net overall effect of rentiers’ saving andinnovations that determines the long-run development of capitalism.17 Thisseems perhaps even more obvious at the beginning of the twenty-first centurythan it did when Kalecki wrote his analysis.

When Kalecki was preparing Essays in the Theory of Economic Fluctu-ations for publication, in 1938, George Shackle was one of Kalecki’s fewfriends in London and one of the small number of economists with whom hediscussed his ideas. Although they did not correspond, so that there is norecord of exchanges between them, Shackle kept a copy of the Essays andgave a glowing review in Economica to the Studies in Economic Dynamics.He also kept a copy of Kalecki’s paper ‘The Short-Term Rate and the Long-Term Rate’, which appeared in the Oxford Economic Papers in 1940. Shacklewas very methodical in his reading, annotating his books and papers carefullyin pencil and even noting the date when he read a particular work. He first readKalecki’s paper on 28 October 1940, and he appears to have been particularlytaken with Kalecki’s idea that only some fraction of the current money marketrate of interest enters into the expected rate of interest. He wrote at the bottomof the paper ‘One of Kalecki’s brilliant tours de force.’18

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But when Shackle came to look at the yield curve he came to differentconclusions that were much more in line with Kalecki’s analysis in the Lukasreview. Looking at the yields on different maturities of government bondsagainst money market rates on particular days between 1945 and 1947,Shackle found that the longer bond rates varied more than the short rates. Thishe attributed to the anchoring down of short-term interest rates by the Bank ofEngland’s cheap money policy at this time, while what he called the ‘violentmovements’ of the longer bond rates were caused, in his view, by fluctuationsin the uncertainty of financial investors.19

3. THE SAVING CONFUSION

Kalecki’s analysis of yield curve was a part of his realisation that the rate ofinterest could not be a factor in investment, and hence in the business cycle.These depended, in his view, on the rate of profit and the amount of‘entrepreneurial savings’, that is, the accumulated financial reserves ofbusinesses. His closest associate in Britain, Joan Robinson, did not agree.Together with Keynes she had been wedded to the more orthodox Marshalliannotion that, as the opportunity cost of fixed capital investment, the rate ofinterest had to be a factor in such investment. In 1952 she wrote ‘My chiefdifference from Mr. Kalecki is in respect of his treatment of finance as theshort-period bottleneck.’20 In 1951, she had sent him a manuscript with arequest for comments containing the caveat ‘It disagrees with your system innot taking Finance as the limit.’21

It is impossible to tell from their correspondence what this manuscript was.But Robinson has recently published her essay on ‘The Rate of Interest’ andthis paper gives some idea of her disagreement with Kalecki. In her essay sheput forward a view of the yield curve in ‘equilibrium’ depending on the degreeof uncertainty over capital values (affecting the bond yields) as opposed touncertainty over short-term interest rates (affecting money market rates). Theequilibrium between them is supposed to arise when investors will no longerengage in arbitrage between the two rates: ‘Operations such as this to someextent smooth out differences in demand for securities of different types andbring the various interest rates closer together.’22 An increase in the moneysupply ‘given the state of expectations’ would tend to push all rates down, butshort rates more than longer rates (Robinson was of course writing before therational expectations revolution narrowed the scope of expectations to themoney supply). An increase in investment raises money market rates and bondrates because of the increased demand for money for transactions in the realeconomy. But prices of company shares (common stocks) would tend to risein line with the increased optimism associated with higher investment. An

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increase in saving (‘thriftiness’) has an immediate impact on stocks and causesretailers to require additional money from the banking system and through thesale of bonds in a way that Hawtrey probably recognised at the time the paperwas published. But after excess stocks have been sold, and with a constantsupply of money, interest rates would eventually fall, most of all in the moneymarket, and the dispersion of yields on company shares would increase asshare prices fell due to falling sales. But she concluded that ‘This pattern ofinterest rates does not look very encouraging to investment … investmentmust be revised in the downward direction because of the surplus capacity andlow profits in the consumption trades and the high cost of industrialborrowing.’23

Joan Robinson’s insistence on the rate of interest as a factor in investmentdecisions, and her assumption that the monetary authorities would hold themoney supply constant, were bringing her very close to the ‘loanable funds’position (in which the rate of interest naturally equilibrates saving andinvestment), which she may have identified in Kalecki’s principle ofincreasing risk. Her objections to Kalecki’s ‘finance bottleneck’ centred on herworry that this was equivalent to the ‘loanable funds’ view that savingsgenerate their own investment and hence that Say’s Law holds. She was notthe only economist to make this inference. None other than Dennis Robertson,the rival of the Keynes circle at Cambridge and evangelist of the ‘loanablefunds’ gospel, quoted from Kalecki’s 1949 Review of Economic Studiespaper ‘A New Approach to the Problem of Business Cycles’ the followingsentence:

A reasonable interpretation of the inter-relation between the level of income andinvestment decisions should be based, I think, on the fact that with a high level ofincome there is correlated a high level of savings, and that the stream of newsavings stimulates investment because it makes it possible to increase investmentwithout increasing indebtedness.

Robertson was delighted to find coming from the pen of someone regardedas a heavyweight Keynesian words that could be used to confirm hisequilibrium analysis and his criticism of Keynes. ‘Induced savings of thepublic’ will find ‘a vent in real investment either directly or through themachinery of a normally functioning stock exchange’.24 ‘Highbrow opinion’he now remarked,

is like a hunted hare; if you stand in the same place, or nearly the same place, it canbe relied upon to come round to you in a circle. What then was my joy to find, acouple of years ago, that Mr. Kalecki, than whose no brow is higher, had beenstruck by this same thought that the induced saving might walk away and generateinvestment on its own … It is not so much investment which governs savings assavings which govern investment.25

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In his response to Joan Robinson, Kalecki insisted that what he had in mindwas not savings in general, but the savings of the entrepreneur. Risingindebtedness would tend to reduce investment, as would the fall in the rate ofprofit attendant upon higher saving:

If, with a given distribution of savings (between rentiers and entrepreneurs) thelevel of savings is reduced, then [an] entrepreneur will be ceteris paribus reducingthe volume of his investment decisions, because if he continued to invest at thesame level, he would tend to increase his indebtedness … Investment decisions area function not only of current entrepreneurial savings, but also of the change in thefactors determining the rate of profit … If the rate of profit is increasing, investmentwill be higher than when it is constant, and the entrepreneur will be able to securethe finance for that in such a case. It is assumed that at the end of each period theentrepreneur has undertaken all such investment plans which he consideredprofitable and for which he could obtain finance. What makes him undertakeinvestment in the next period is the new supply of his own savings, and the changein the rate of profit.26

Joan Robinson did not raise again the question of finance with Kalecki, anddropped references to her differences with him over this in her writings abouthim. Her subsequent references to Kalecki were characterised by even morewarmth and respect. But she did not take into her work his disequilibriumanalysis of finance. Its development was left to Kalecki’s colleague, JosefSteindl.

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11. The principle of increasing risk III:Michal Kalecki and Josef Steindl on profits and finance

Josef Steindl worked with Kalecki in Oxford during the Second World Warand was to regard him as the seminal influence on his work. Indeed, so greatwas Kalecki’s influence that, in comparing their work, it is difficult to identifywhere that influence gave way to Steindl’s own ideas. In his early papers, ‘OnRisk’ and ‘Capitalist Enterprise and Risk’, Steindl put forward the Breit–Kalecki principle of increasing risk, and suggested that it leads to ‘capital-wastage’ in small enterprises. However, in the second of the two papers hetouched upon an issue that was to become a distinctive theme in his later work.He suggested that in the joint stock system, ‘over-capitalization’ or the issueof stock in excess of ‘the cost value of real assets’ is used to give ‘inside’shareholders controlling the company a higher rate of profit and a greaterinfluence over the company vis-à-vis‘outside’ shareholders. In his first book,Small and Big Business: Economic Problems of the Size of Firms, written as acritique of the Marshallian theory of the ‘representative firm’, Steindl returnedto the principle of increasing risk as a factor limiting the effectiveness oflifting the financing constraint on small businesses. He also noted that ‘over-capitalization’ leads to the understatement of the rate of profit on the actualcapital of big companies.1

1. MONOPOLY CAPITALISM AND INFLEXIBLE SAVING

Steindl’s second book was his classic study of American monopoly capitalismin the six decades before the Second World War, Maturity and Stagnation inAmerican Capitalism. With the Wall Street Crash playing something of apivotal role in that period, consideration of the role of finance in economicstagnation was inevitable even though that consideration was overshadowedby the analysis of monopoly capitalism for which that book is best known.Having examined the boom that preceded the Crash, Steindl came to theconclusion that the equity market of the joint stock system can effectivelyenhance the entrepreneurial capital of big companies. With share prices


determined by expected earnings per share, an inflow of funds into the marketwill tend to elicit new shares from companies, taking advantage of the cheaperfinance.2 This would offset the investment-reducing effect of the falling rate ofprofit as real capital expands.3 Larger companies can issue shares morecheaply at lower yields. Therefore a capital market boom tends to encouragethe emergence of monopolies through ‘financial concentration’. In mergersand takeovers the lower-yielding shares of the larger company are issued inexchange for the higher-yielding shares of the company that is being boughtout. Furthermore, the inflow of funds into the equity market allows the furtherdevelopment of holding company structures in which new shares may beissued without diluting the control of the dominant shareholders. In this waythe 1920s stock market boom reinforced a tendency towards monopoly inAmerican capitalism and offset a declining rate of profit during that decade.However, after the Crash, the market for new shares evaporated.

According to Steindl, the key mechanism by which financial inflationcontributed to economic decline was through the monopolies that were createdby webs of holding companies. Because they could exact a higher profitmargin from their customers, monopolies were more willing to tolerate excessproductive capacity. But having unused capacity also discouraged investment.This, in turn, led to economic stagnation.

In his 1982 paper on ‘Household Saving in a Modern Economy’, Steindlreturned to the fundamental starting point of his analysis, and of the approachto finance of Kalecki and Breit, the principle of increasing risk. The paper putforward the principle as a macroeconomic issue affecting the balances of thevarious sectors (private households, the corporate sector, the public sector andthe overseas sector) in the flow of funds accounts. He started with theKeynesian saving identity. According to this, saving is by definition equal togross investment, plus the government’s fiscal deficit, plus the trade surplus.(This is further discussed below.) Steindl then distinguished between house-hold saving and corporate saving. An increase in household saving, with theother factors remaining constant, leads to an ‘enforced indebtedness ofcompanies’:

business will find that their profits have fallen below expectations, and theytherefore have to finance their current investment to a greater extent than foreseenby borrowing. This may then motivate them to reduce their investment in thefuture.4

The rising indebtedness of business would normally be offset by a risingtrade surplus, and a rising fiscal deficit, because they are net inflows of fundsinto the business sector. But the analysis overall represents a significantdivergence from Kalecki’s own analysis. Steindl made clear that householdsaving has an immediate impact on corporate retained profits and saving,

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Michal Kalecki and Josef Steindl on profits and finance

whereas in Kalecki’s model household saving affects rather the ‘trend’ ofeconomic activity.5

Finally, in an undated paper that appeared in the volume of his CollectedPapers that was published in 1990, Steindl returned to the much moreKeynesian theme of conventional valuations in the stock market. In hisTreatise on Moneydiscussion of how stock market activity affects bankdeposits, Keynes had argued that, when traders are buying and selling forcapital gains (i.e. speculating), stock prices depend on the balance between‘bullish’ expectations that stock prices will rise, and ‘bearish’ expectationsthat prices will fall. Steindl put forward a model in which such views arebrought to balance by price adjustments. If there is an excess of ‘bullish’sentiment, buyers will raise prices until they change the expectations ofsufficient ‘bulls’ to persuade them to become ‘bears’, or sellers of stockbecause they no longer expect further price increases. A ‘total frequencydistribution will show just how much funds are associated with each expectedprice’. He then introduced uncertainty in the form of the variance of priceexpectations that then affects the price elasticity of demand and supply in themarket. If expectations are closely concentrated, a small price change willmove a large volume of money between bulls and bears. If expectations arewidely dispersed, a large change in price is necessary to get stocks and moneycirculating in the market. However, this analysis only holds if the priceexpectations of individuals are independent of each other. In practice there are‘opinion leaders’ around whom expectations will ‘cluster’. Such clusters areunstable as new ‘opinion leaders’ emerge. This leads to a second type ofuncertainty, over ‘the variety of possible clusters of opinion and the frequencyof shifts between them’. Imitation may cause ‘agglomerations in one oranother direction’ so that the market becomes ‘bearish’ or ‘bullish’. Steindlsuggests the possibility of a ‘two-humped frequency distribution’ with marketopinion switching between two extremes, before concluding:

The most extreme loss of independence occurs in a crash. Here one opinion hascome to dominate and the other condition for steady state, the existence of a beliefin certain limits or standards, has also disappeared.6

2. PROFITS AND FINANCE

In their writings, Michal Kalecki and Josef Steindl put forward two theoreticalinnovations that, combined, form a theory of financial cycles with certainacknowledged similarities to the theory that Hyman P. Minsky fashioned outof the work of John Maynard Keynes, but that is arguably more complete thanMinsky’s theory. These innovations were the principle of increasing risk,which has been discussed in these chapters, and the theory of profits, to which

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Michal


some consideration must now be given, since it remains a crucial influence onthe course of business cycles in economies dominated by finance capital.

Kalecki’s theory of profits is perhaps the oldest element of his economicanalysis. It certainly pre-dates the principle of increasing risk, which he haddeveloped only after Breit’s paper of 1935. The theory was pithily summarisedby Kalecki’s Cambridge partisan, Joan Robinson, although not by Kaleckihimself, as ‘the workers spend what they get; the capitalists get what theyspend’.7 She added, by way of explanation, that ‘an increase in investmentincreases profits to whatever extent is required to raise saving out of profits tothe corresponding extent’, by which she meant that investment determinesprofits. The idea originally came to Kalecki as a result of his work on thenational income accounts in Poland in 1930. But its origins go back to theeconomic reproduction schemes in volume II of Marx’s Capital. It can also bedetected as the substance behind Austrian theories of ‘forced saving’ andWicksell’s macroeconomics, which had become influential among Polisheconomists in the interwar period.

The theory starts from the national income identity between total incomeand total expenditure in the economy in a given period (e.g. one year). Ifconsumption is deducted from the income and expenditure sides of theequation, then the remainder is the sum of taxes, and saving. This is then equalto the sum of government expenditure, gross investment and the balance oftrade surplus (exports minus imports). Transferring taxes over to the expen-diture side gives the well-known ‘Keynesian’ saving identity, that is, savingequals gross investment (i.e. expenditure on plant machinery and stocks, ratherthan financial investment), plus the fiscal deficit (i.e. government expenditureminus taxes) plus the trade surplus.

All that may be concluded from this is that the amount of saving in aneconomy will always finance whatever investment, or deficit spending by thegovernment, has taken place. By a small manipulation of this equation,Kalecki showed how profits are determined. For the sake of simplicity Kaleckiintroduced an assumption that there are only two classes in society: capitalists,who receive profits, and workers, who earn wages. The saving identitytherefore represents the saving out of profits andwages. If saving from wagesis deducted from the expenditure side of the equation, then the identityrepresents just the saving out of profits. Since profits can only be spent oninvestment, or they can be consumed, or they can be saved, adding inconsumption out of profits to the expenditure side gives an equation forprofits. Profits, therefore, are equal to the sum of gross investment, plus thefiscal deficit, plus the trade surplus, plus capitalists’ consumption minusworkers’ saving. Kalecki pointed out that this equation for profits is, of course,an identity derived from the national income identity between income andexpenditure. By itself it has no causal implication. But it is, in fact, the

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expenditure side which determines the income (profit) side, because capitalists‘may decide to consume and to invest more in a given period than in thepreceding one, but they cannot decide to earn more’.8

As a matter of empirical observation, of these elements, investment is themost important. The fiscal deficit, the trade surplus, and the balance betweencapitalists’ consumption and workers’ saving are balance items which wouldrarely exceed, say, 5 per cent of gross domestic product. By contrast, grossdomestic fixed capital formation, or investment expenditure, usually falls inthe range of 15 per cent to 33 per cent of gross domestic product.9 This has two important implications for economic activity. First of all, profits aredetermined largely by other capitalists’ or firms’ expenditure, rather than themark-ups that a firm impose on its cost of production. Even more importantly,this analysis shows that investment expenditure automaticallygenerates thesaving necessary to finance it:

if some capitalists increase their investment by using for this purpose their liquidreserves, the profits of other capitalists will rise pro tanto and thus the liquidreserves will pass into the possession of the latter. If the additional investment isfinanced by bank credit, the spending of the amounts in question will cause equalamounts of saved profits to accumulate as bank deposits. The investing capitalistswill thus find it possible to float bonds to the same extent and thus to repay the bankcredits.10

An important consequence of this is that the common view amongeconomists that the investment of firms in the economy is somehowconstrained by the amount of savings in the economy is at best only partiallytrue. It applied to the early capitalists of whom Adam Smith and DavidRicardo wrote, before the emergence of a ‘national’ economy in whichcapitalist enterprises are wholly integrated through markets, and, in particular,through the use of a common financial system. The saving constraint appliesstill to small and medium-sized businesses that have not been able toaccumulate financial reserves, and in developing countries. But for the bigbusinesses that account for the bulk of investment in an established capitalisteconomy, there is no saving constraint. There is instead the problem of the financial risk that is the subject of these chapters. Kalecki concluded that:

One important consequence of the … [reflux theory of profits] is that the rate ofinterest cannot be determined by the demand for and the supply of new capitalbecause investment ‘finances itself’.11

Kalecki thereby placed himself with Keynes as a pioneer of a ‘pure monetary’theory of interest, in which interest is no longer influenced, as in classicalpolitical economy, by the rate of profit on new investment. Moreover,

123Michal Kalecki and Josef Steindl on profits and finance


Kalecki’s conclusion that investment ‘finances itself’ in a financiallyintegrated capitalist economy removes the main argument that has beenrepeatedly adduced since the emergence of financial markets for inflatingthose markets, namely that such inflation is ‘necessary’ to increase businessinvestment.12

Kalecki’s reflux theory of profits has been associated with Keynes’s‘widow’s cruse’ analogy in the Treatise on Money. This association is worthexamining, because it highlights an important difference between the twotheorists concerning their respective views on the role of finance in thecapitalist economy. The association has been made, for example, by MichaelHoward in his book Profits in Economic Theory.13 In his Treatise, Keyneswrote:

There is one peculiarity of profits (or losses) which we may note in passing, becauseit is one of the reasons why it is necessary to segregate them from income, as acategory apart. If entrepreneurs choose to spend a portion of their profits onconsumption (and there is, of course, nothing to prevent them from doing this), theeffect is to increasethe profit on the sale of liquid consumption goods by an amountexactly equal to the amount of profits which have been thus expended. This followsfrom our definitions, because such expenditure constitutes a diminution of saving… Thus, however much of their profits entrepreneurs spend on consumption, theincrement of wealth belonging to entrepreneurs remains the same as before. Thusprofits, as a source of capital increment for entrepreneurs, are a widow’s crusewhich remains undepleted however much of them may be devoted to riotous living.When, on the other hand, entrepreneurs are making losses, and seek to recoup thoselosses by curtailing their normal expenditure on consumption, i.e., by saving more,the cruse becomes a Danaid jar which can never be filled up; for the effect of thisreduced expenditure is to inflict on the producers of consumption goods a loss of anequal amount. Thus the diminution of their wealth, as a class, is as great, in spite oftheir savings, as it was before.14

The similarity with Kalecki’s theory of profits arises from the commonnotion that ‘capitalists receive what they spend’. However, in contrast toKalecki, but like Marx in volume II of Capital, the reflux is of the money thatcapitalists spend on consumption, rather than investment.15 Moreover,Keynes’s reflux theory was in the context of an attempt to relate prices to thequantity of money in circulation. The implicit assumption underlying this wasthat the level of output remains constant, so that the change in capitalists’expenditure affects only prices. Keynes elicited criticism for this from DennisRobertson, Friedrich Hayek and Austin Robinson, who termed it ‘the widow’scruse fallacy’. Robinson questioned ‘If an entrepreneur, loaded with profits,decided on his way home to have a shoe-shine, was the effect solely to raise the price of shoe-shines?’16 Keynes’s editor, Donald Moggridge, wrotethat ‘As a “general theory”, rather than a statement of a particular limitingcase, it was inadequate.’17 The idea was, in any case, incidental to Keynes’s

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quasi-Wicksellian analysis in the Treatise. The course of his discussions withJoan Robinson, Austin Robinson and Richard Kahn, in the Cambridge‘Circus’ that was trying to bring systematic order into the medley of his ideas,directed Keynes elsewhere. This was towards the notion that changes ininvestment affect the economy through their influence on consumption inwhat became the orthodox Keynesian multiplier analysis.18

But, having dropped the reflux theory of profits, Keynes also lost with it theidea pressed by Kalecki, that capitalists’ expenditure on investment and theirown consumption reappears as profits, and hence that investment expenditureis, in general, not credit-constrained. The exceptions here are the earlycapitalist enterprises and small businesses that do not have the reserves toembark on investment, or Schumpeter’s ‘new combinations’.19 These are, in any case, marginal to the investment undertaken in mature capitalisteconomies by large corporations with liquid assets. In response to a verysimilar argument to Kalecki’s from Bertil Ohlin,20 Keynes introduced a new‘finance’ motive for demanding money because ‘Planned investment – i.e.investment ex ante– may have to secure its “financial provision” beforetheinvestment takes place; that is to say, before the corresponding saving hastaken place.’21 In later years this was to inspire among some Post-Keynesiansprecisely what Kalecki sought to dismiss, namely the notion that somehow themarket rate of interest, rather than income and expenditure, brings saving andinvestment into balance.22

3. THE LIQUIDITY PREFERENCE THEORY OF INVESTMENT

As has already been mentioned, Kalecki’s theory of profits is in effect a reflux theory of investment, since it is investment that provides the bulk of the expenditure which enables profits to be realised. If investment determinesthe major share of profits, what determines investment? Kalecki worked onthis question from the time when he published his first papers in economicsuntil the end of his life. His published analysis changed in successive versionsof his theory. But there was a common core to all of them, around the principle of increasing risk as a ‘liquidity preference’ theory of investment.Steindl showed this in his paper ‘Some Comments on the Three Versions of Kalecki’s Theory of the Trade Cycle’, which, despite its title, is really aboutKalecki’s investment theories. As is well known, Keynes had put forward inhis General Theorya liquidity preference theory of interest, according towhich the liquidity preference of financial investors, or rentiers, determinesthe rate of interest that they will demand in order to part with immediatepurchasing power when they lend money. Kalecki’s principle of increasing



risk, as developed by Steindl, suggests a liquidity preference theory ofinvestment.

According to this view companies are constrained in their investment infixed capital by the need to keep sufficient liquid reserves and assets to be able to meet future cash commitments. But firms have two ways of regulatingtheir internal liquidity, which is the basis of their ability to settle financialcommitments. The first of these is by borrowing or raising new capital. Thisexpands their future financial liabilities. The second way is by varying theirinvestment commitments. Given the extended gestation period of fixed capitalinvestment, varying investment commitments can only be done by postponing,or bringing forward, new investments. If a firm reduces its investment, it is left with a greater amount of liquid reserves for a given amount of outstandingfinancial liabilities. This increase in reserves will, of course, only be tem-porary if other firms pursue a similar course: as the investment reflux theoryof profits shows, the effect of lower investment will be to reduce profits forfirms as a whole. Nevertheless, because the costs of investment are charged,in the first instance, to the internal liquidity of the company, that is, its liquidreserves and liquid assets, the individual firm’s investment programme ismanaged in such a way as to maintain the internal liquidity of the firm.Furthermore, a rise in financial liabilities requires the firm to maintain a largerstock of liquid assets in order to meet future payments on those liabilities.

As for financing commitments, that is, the issue of capital liabilities bycompanies, in a financially developed capitalist economy this is determinednot so much by the financing requirements of fixed capital investments, assuggested by the finance theories of virtually all economists, most notablyTobin, but also Keynes and possibly even Minsky (see Chapters 12 and 14below). Rather it is determined by demand for financial assets, whichcompanies as a whole can be induced to issue by the simple expedient of risingprices for financial assets. If firms do not have sufficient investment projectsto absorb the finance that financial investors offer them, then rising securitiesprices (and the implied lower cost of finance) will eventually inducecompanies to issue new securities. The proceeds of these issues will then beused to reduce bank debt or to buy other securities. Of course, if the proceedsof new securities issued are used to buy other securities (in merger andacquisition activity, or management buy-outs), then this simply prolongs theboom in financial asset prices. Steindl recognised that a reduction ininvestment, relative to its financing, would result in additional ‘enforcedindebtedness’ of companies, which would then reduce investment. He did not,however, explore the possibility implied by his analysis that a rise infinancing, relative to investment, would eventually have the same effect.

A rise in saving represents a corresponding reduction in expenditure andincome for firms and hence, as Steindl noted, an increase in the indebtedness

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(or a reduction in the internal liquidity) of companies. However, a rise in‘ rentiers’ savings’ also represents an increase in the financial liabilities ofcompanies that issue additional capital or debt to absorb those increasedsavings. The increased financial liabilities will tend to depress investment.23

Companies with access to the capital market, that is, those companies in theadvanced capitalist countries that account for the vast majority of privatesector investment in those countries, therefore face a dilemma when theyundertake investment of uncertain profitability whose financing can drain theirinternal liquidity. They finance investment from internal liquidity, and thenissue new financial liabilities (stocks or bonds) to replenish internal liquidityagainst completed investments of proven profitability. This is the basis of what I have elsewhere called the ‘refinancing theory of capital markets’.24

Refinancing is required because firms are not ‘representative’: they havedifferent financial characteristics and operate in different markets. (Steindlundertook a pioneering statistical investigation of this in his book RandomProcesses and the Growth of Firms.) A given investment expenditure raisesthe profits of all firms in general. But the additional profits are distributedamong firms according to their relative size and their degree of monopoly,which allows them to raise prices in response to a given increase inexpenditure. Big businesses, which undertake the bulk of private sectorinvestment, also have the greatest market power and, therefore, get the bulk ofadditional profits spread among themselves.25

Hence a firm making an investment does not get back through the reflux (orKahn/Keynes multiplier) process all that it spends on investment. Firms ingeneral will need to refinance investments in order to replace the internalreserves spent on those investments. The refinancing of investments throughthe capital market makes companies vulnerable to the inflation of that capitalmarket. The money that a company obtains from the issue of capital marketsecurities is not ‘free’ liquidity, available for further investment. Some of ithas to be held back against the possibility that in future existing productivecapital may not generate the cash flow required to service the company’sfinancial liabilities. This financial uncertainty can be accommodated byissuing stock in excess of what is required to refinance existing completedinvestments. Moreover, if stock prices are rising, as they would normally in aboom, a remunerative alternative to fixed capital investment emerges. Thecompany’s excess capital, and a large part of its liquid assets, can be used tobuy stock issued by other companies for later sale at a profit. Rising stockprices are usually the result of financial investment or placements that are inexcess of the additional capital requirements of governments and companies.Using a company’s excess capital for corporate acquisitions is a way of takingthe excess liquidity that is causing the stock market boom out of the marketand then putting it back into the market as additional purchases of securities.



This then prolongs the boom in the stock market. Moreover, it makes apparentsense to hold financial assets against growing financial liabilities: in a periodof financial inflation they are more liquid than fixed capital investment, andtheir profits can be more quickly realised. There is a ‘wealth effect’ onconsumption, as the higher incomes of financial intermediaries and personalinvestors finance luxury consumption. This personal prosperity accompaniesa shift in the priorities of companies from production and investment towardscorporate balance sheet restructuring as a way of generating speculativeprofits. This was a feature of recent economic booms in the UK and the USA.These booms were also marked by slow investment in traditional technologiesalongside speculative investment in new technology. Such unbalanced growthwas analysed perceptively by Kalecki in his last model of the business cycle.26

In this way an investment boom, and the consequent rise in profits, give wayto even more rapidly rising financial liabilities and a fall in net (retained)profits. These eventually deter investment, causing gross profits to fall as well.Thus the principle of increasing risk implies two elements of financialdisturbance in an economy, namely rising financial liabilities and fallinginvestment, relative to external financing, and hence falling profits.27

Steindl first put forward this idea in his Maturity and Stagnation inAmerican Capitalism. He argued in section 2 of chapter IX that, overall, thesaving in an economy is relatively inelastic. The balance between this externalindebtednessof business and the gross profits which finance the servicing ofthat indebtedness has to be made up by additions to, or deductions from, theinternal liquidity of companies. Companies, in turn, regulate their internalliquidity by postponing investment projects. A reduction of investment, inaccordance with Kalecki’s reflux theory of profits, reduces profits. Steindlbegan his argument by arguing that rentiers’ savings are especially inelastic.28

He referred at this point to Kalecki’s argument that ‘the existence of rentiers’ savings causes a negative long-run investment, i.e., long-runshrinking of capital equipment … because this causes a continuous increase inentrepreneurs’ indebtedness towards rentiers, which depresses investmentactivity’.29 Steindl went on to argue that, to prevent rising indebtedness,reductions in saving therefore have to come from reducing the saving of theprofessional middle classes. This is unlikely since ‘the savers in these groupsare in relatively sheltered positions, and their income is not subject to verygreat pressure’.30 As a consequence, the pressure of the adjustment of savingto investment has to come about through a reduction in economic activity, andhence a fall in employment.

Whatever elasticity of outside savings there might be … is dependent onunemployment. If therefore the real capital accumulation decreases, and it becomesnecessary to reduce the rate at which outside savings accumulate in order to preventa growing disequilibrium [that is, rising indebtedness – JT], then a considerable

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increase in the degree of secular unemployment is practically the only means to thisend …

If an increase in the degree of secular unemployment cannot bring about asufficient reduction in the rate of outside saving … then, instead of leading to a new‘moving equilibrium’ the sequence of events conforms to the disequilibriumdescribed above. Internal accumulation is reduced proportionately more thanoutside saving, so that the gearing ratio [between external financial liabilities andassets – JT] increases. Further reduction of investment will fall more heavily oninternal accumulation than on outside savings, so that the gearing ratio increases.Real accumulation, internal accumulation, and the profit rate will thus continue tofall and the gearing ratio will continue to rise. The outstanding feature of thisdisequilibrium is that the gearing ratio in fact established is continuously out ofharmony with the ratio entrepreneurs wish to establish: this indeed is the reason forthe continuing disequilibrium. There is a growing relative indebtedness against thewish of entrepreneurs, one might say an ‘enforced indebtedness’.31

The counterpart of the inelasticity of saving of the rentiers and the middleclasses is a more extreme volatility of the financial accumulation of companies(depreciation plus retained profits).

Keynes had previously argued that changes in national income make savingadjust to investment automatically.32 Steindl showed how this process takestime, and makes the economy move cumulatively through successive phasesof disequilibrium, in which retained profits balance the inflexible response ofhousehold savers and rentiers to changes in investment. In effect it is a‘Wicksellian process’ of falling investment and profits that continues as longas household and rentiers’ saving leaves companies with inadequate retainedprofits to finance a stable level of investment. Steindl’s notion of risingindebtedness may also be contrasted with Hayek’s doctrine of ‘forcedsaving’.33 However, Hayek’s forced saving is the excess of investment overvoluntary saving, which then results in unplanned saving. In Kalecki andSteindl, the reflux of investment comes to profits, and external indebtednessincreases by the amount by which investment fell short of saving.

Steindl believed, like most economists, that the 1920s boom in the US stockmarket financed an investment boom, and that the fall-off in the growth of thatinvestment was due to the rise of monopolies, created by the corporaterestructuring that accompanied the boom. A reconstruction of Kalecki’s ideaswas put forward in some of their essentials by Hyman P. Minsky (see Chapter14), and in my book The End of Finance. But its elements were developed byKalecki and Steindl well before the rise of finance in the second half of thetwentieth century. A key role in their work was the idea that the saving ofrentiers, far from providing additional financial resources for companies asorthodox finance theory suggests, actually destabilises the financial accumu-lation and internal liquidity of companies. At the end of the twentieth centurythe rentiers were financial institutions: pension and insurance funds that, withthe proliferation of funded pension schemes through the 1980s and the 1990s,



directed their large financial surpluses into markets for corporate financialliabilities – a system in which rentiers’ saving has been not so much inelasticas upwardly elastic, with eventually devastating consequences for thecumulative financial liabilities of those funds as their surpluses were reduced.Although it is sound on the dynamics of financial deflation, Kalecki andSteindl’s work provides limited directions for the understanding of financialinflation. The two major financial inflations of the twentieth century, the1920s stock market boom in the USA and the financial boom of the finaldecades of the twentieth century, largely preceded or came after the period inwhich they developed their main ideas. Nevertheless, the essential conceptsfor understanding the economic fragility induced by financial inflation,namely the fall in investment attendant upon enforced indebtedness and risingexternal liabilities, may be found in their work.

Steindl’s most important work, Maturity and Stagnation in AmericanCapitalism, was published in 1952. It brought to an end the analyticalexposition of critical finance in the first half of the twentieth century. As amonograph concerned with a particular historic period through whichAmerican capitalism had passed, it also looked forward to the next,historiographic, discussion of critical finance that characterised the first twodecades of the second half of the century.

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12. A brief digression on laterdevelopments in economics and finance

It is useful to pause at this stage and summarily survey the directions in whicheconomics, and its junior academic discipline of finance, were to move afterthe 1930s. This is a convenient point at which to view these laterdevelopments because, as will be apparent, the essential ideas around whicheconomics and finance were to develop after the Second World War weremore or less all known and argued about by the time of that war. They allderive from a period when finance had been sidelined by the débâcle of 1929,and government spending, through a greatly enhanced public sector, stabilisedthe economy. The leading ideas in economics and finance came to be the ideasof economists who worked in or advised governments and governmentagencies when governments used the far-reaching influence on the economyof the public sector to manage the economy, albeit with increasingly mixedresults as finance re-emerged. However, those ideas are increasingly inade-quate for a proper understanding of the operation of an economy dominated byfinance, such as the main capitalist economies today. That understanding wascontained in the literature to which the rest of this book is devoted.

Finance, as an academic discipline, owes its main ideas to the monetaryeconomics of Anne-Robert-Jacques Turgot, David Ricardo, John Stuart Mill,Alfred Marshall and Dennis Robertson, the French/Swiss economic theoristLéon Walras, and John Maynard Keynes. From Turgot, Ricardo, Mill andRobertson, the finance discipline obtained the idea that there exists in afinance capitalist economy a ‘market for loanable funds’, or saving that isbrought into equilibrium with investment by the rate of interest. From Walras,finance theory has imported the notion that finance and its articulation with theeconomy are best studied in a system of general equilibrium. Includingfinance, this is a state of rest after all changes to the economic system haveworked themselves out. At the same time Keynes (especially the Keynes ofchapter 12 of the General Theory) reminds modern finance that stock priceswill deviate from this equilibrium. From Keynes, Hayek and Myrdal, modernfinance has extended the notion of general equilibrium to include makingexpected returns on investment coincide with actual ones.


On this basis, the Keynesian James Tobin developed his ‘q’ theory,according to which firms invest the funds supplied in the market for long-termsecurities, and the balance sheets of the different sectors of the economy adjustinto general equilibrium. Costless and perfect arbitrage and rational foresightallowed Merton Miller and Franco Modigliani to argue that the structure of acompany’s balance sheet does not matter: only its holdings of real(productive) assets matter. Harry Markowitz showed that in a world in whichthe capitalist economies experience business cycles that are not synchronisedwith each other, a portfolio of financial investments may be stabilised byholding financial assets in markets whose cycles are not correlated with eachother.

In this way, a view of finance emerged in which there are no problemscreated by finance. The central problem addressed by these theories is theconstruction of ‘optimal’ portfolios, or the rational choice of financialinvestments. The only obstacles are government regulation, which constrains‘rational’ investment choices, and the limited knowledge of investors. Theseare easily overcome by deregulation and studious devotion to increasinglymathematical financial modelling. Even as the financial system is provingitself to be increasingly unstable, the only concession made is that prices may‘rationally’ deviate from their ‘equilibrium’ values, but only while the market‘adjusts’ to equilibrium.

The economics taught in Western universities, practised in central banksand government departments, and evangelised throughout the world as theWashington Consensus, developed in a slightly different way. The economicmodels in which the supposedly Keynesian system of macroeconomics wasformalised, by John Hicks, Oskar Lange, Alvin Hansen and Paul Samuelsonin equilibrium models (the so-called IS/LM system), combined Hawtrey andRobertson with Keynes and Walras. The short-term rate of interest producesequilibrium in the money markets, taking into account a demand for moneyfrom the stock market. Simultaneously, that same short-term rate of interest issupposed to equilibrate the supply of ‘saving’ and the demand for it to financeproductive investment. Finance only appears as an equilibrium in the loanablefunds market and in a speculative ‘demand’ for money.

From this system of economic analysis, Milton Friedman and EdmundPhelps developed ‘adaptive expectations’ models of the economy. Here theeconomy tends naturally to an equilibrium that is disturbed by expectations ofprice inflation inspired by changes in the money supply. Robert Lucas andThomas Sargent then established that in this system only unexpected changesin the money supply would disturb the natural equilibrium in the economy. Atthe end of the twentieth century, the argument in macroeconomics fluctuatedbetween Hawtrey’s idea that inflexible money wages are responsible forunemployment, and notions that economic agents (in the real economy) cannot

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A brief digression on later developments

make ‘equilibrium’ decisions because of uncertainty and lack of complete and certain knowledge (so-called ‘asymmetric information’). In monetaryeconomics, the pre-Keynesian views of Hayek, Hawtrey and Wicksell prevail:the money rate of interest is held to determine the business cycle because ofthe statistical correlation between the (short-term) rate of interest and the cyclein the real economy. But the tracking of inflation and economic activity byshort-term interest rates could also arise because central bankers change theirinterest rates in anticipation of inflation, rather than because of any ‘monetarytransmission mechanism’ of short-term interest rates operating in the economyindependently of the central banks.

Outside the ‘mainstream’ of practising economists, Marxists and the ‘neo-Ricardian’ followers of Piero Sraffa clung resolutely to the notion that wagesand investment determine the course of the business cycle. In this view thefinancial system is a superstructure facilitating the centralised/monopolisticcontrol of industry, and directing capital to its most profitable uses (the‘socialisation of capital by capital’). Finance appears here in the service ofindustrial capital, reflecting deeper shifts in the relationship between wagesand profits, rather than as autonomously directing the capitalist economy. Inthe later 1980s, a number of Marxists became dissatisfied with a theory basedon a productive activity that has been in relative decline in the most advancedcapitalist countries, namely manufacturing, and an analysis that ignored thegrowing sophistication and apparently ‘global’ hegemony of finance.1 Theysought to break out of their severely Ricardian isolation by developing a‘circuit’ theory of credit money. This is a theory of money along Hawtreyanlines, except that credit is used to pay wages in advance of sale. However, thissmall step away from the economics of factories and manufacturing comesnowhere near examining a capitalism dominated by finance. The need for such an analysis, which Marx and Engels hinted at in their correspondencetowards the end of their lives, was realised by Keynes, Kalecki, Steindl andMinsky.

In the second half of the twentieth century another school of thoughtemerged and subjected the embrace of pre-Keynesian ideas by ‘mainstream’economics to a tenacious and sophisticated criticism. Calling themselves‘Post-Keynesians’, they explicitly deferred to the authority and the argumentsof Keynes in contesting the revival of pre-Keynesian theories and policies.Accordingly, their main criticisms were around the methodological andmonetary consequences of uncertainty (lack of certain knowledge about thefuture) and consequences for investment (real and financial) of expectationsand business ‘confidence’. For the Post-Keynesians, money, with finance asits hinterland, makes the big difference to the way in which the capitalisteconomy operates. Following Keynes, they referred to their analysis asdescribing a ‘monetary theory of production’. There are notable exceptions

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among the Post-Keynesians who recognised the singular importance offinance in Keynes’s work. Chief among them are Hyman P. Minsky, JanKregel, Victoria Chick and Martin Wolfson.

The Post-Keynesian critique is undoubtedly closer to Keynes’s views in the1930s than were the various Keynesian models advanced after his death. Butan understanding of the institutional background is necessary to understandquite why his views evolved in the direction that they took. Keynes introducedit, in his contribution to a 1933 Festschrift for Arthur Spiethoff, as an explicitcritique of equilibrium money and finance, with the words:

In my opinion the main reason why the problem of crises is unsolved, or at any ratewhy this theory is so unsatisfactory, is to be found in the lack of what might betermed a monetary theory of production … This is not the same thing as to say thatthe problem of booms and depressions is a purely monetary problem. For thisstatement is generally meant to imply that a complete solution is to be found inbanking policy.2

I have suggested in my chapters on Keynes that he advanced a monetarytheory of production because he initially regarded monetary policy as the keyto controlling a financial process of under-investment. Money then acquiredits nexus with uncertainty in his work with the failure of monetary policy tocontrol that financial process of under-investment during the 1930s. Themonetary theories of production advanced by recent Post-Keynesianscorrectly highlights the merely notional role of money in the neo-classicalsynthesis. However, outside the influence of Minsky, Post-Keynesians havetended to limit the contribution that finance makes towards inflating thesignificance of uncertainty in the contemporary capitalist economy byemphasising the way in which the rationale for money is its reassuranceagainst uncertainty. For example, Paul Davidson writes that:

In a world of uncertainty where production takes time, the existence of moneycontracts permits the sharing of the burdens of uncertainty between the contractingparties whenever resources are to be committed to produce a flow of goods for adelivery date in the future.3

The purpose of finance is merely to transmit saving (determined of courseby investment, in Keynesian and Post-Keynesian system) to investingentrepreneurs:

Since savers are interested in wealth only as a means of storing, transferring (andhopefully increasing) command of resources into the future, while entrepreneurialinvestors desire the services of scarce capital goods for their expected net moneyflow and not for their liquidity, portfolio balances (forms of wealth-holding)decisions and hire purchase of capital goods decisions will look out to differentmarkets and prices. The investment decision depends on the market demand price(value) relative to the flow-supply price of capital goods, while the portfolio

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decision depends upon the current spot price of securities relative to their expectedfuture spot price – and there is no important direct relationship between thesemarkets, other than the rate of interest (and the concomitant financial decisions).4

Davidson then explains:

The functions of the rate of interest are (1) in the portfolio decision to modify thespot price of securities relative to their expected future spot price in such a way asto equalise the attraction of holding securities as a deferred claim on cash comparedto holding cash directly and (2) in the investment decision to set a floor on the rateof discount used to evaluate the expected flow of net revenue from the hire purchaseof capital goods so that its present value can be compared to the flow-supply priceof capital goods. The existence of financial markets in which new securities can besold permits, but does not require, the transfer of immediate command [i.e.purchasing power – JT] from economic units who wish to spend currently less thantheir income to units who wish to command resources in excess of what theircurrent income permits.5

But there is more to finance than just supplying the rate of interest at whichfinancial resources may be obtained, and at which future incomes may bediscounted. It is the financial liabilities that companies (and households) havethat make their production and investment decisions so much more urgent and weighty. Without such liabilities, production or other trading activitiescould be abandoned in the face of uncertainty (or risk) at no loss. With such liabilities, activity has to be undertaken, even if it is only turning over assets or liabilities in financial markets that may expose the ‘entrepreneurialinvestor’ to financial risks or losses that can temporarily be postponed.Moreover, a view that distinguishes only intermediaries and entrepreneurialinvestors does not allow such investors any participation in the financialmarkets other than as debtors, or holders of financial liabilities. However, themodern business corporation aspires to make money out of financial assets,just as it seeks to make a marginal profit over the supply price of finance outof its more tangible assets. Indeed, the apparently greater liquidity, in a periodof financial inflation, of its financial assets makes them an even more attrac-tive investment for the modern corporation. Hence a ‘monetary productioneconomy’ that does not allow for the swelling of gains or losses from financialcommitments is like Hamlet with nothing rotten in the state of Denmark.Before Minsky, few Post-Keynesians considered that finance, rather thanmoney, is the critical element in modern capitalism. In the early 1970s, JanKregel, for example, could only hint at a greater role for finance:

The role of money in a monetary economy then exerts influence primarily byproviding finance for investment irrespective of the amount of personal savingobtaining in the economy (or, in the case of a fringe of unsatisfied borrowers, limitsthe amount of investment that can be carried out irrespective of saving).6

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None of the above-mentioned schools of thought ignored finance. But, withthe exceptions noted above, they included it in their models either in anequilibrium form, for example, in the ‘market’ for ‘loanable funds’ or savings,as the inspiration for a ‘speculative’ demand for money, or as a portfolio, orbuffer stock, demand for money. In this way, according to these theories,finance affects money, which affects the real economy. Money has come to beregarded as the main determinant of economic activity. Partly this is becausethe ideas of academic economists, developed at one remove from practicaleconomic activity, have usually been formed by theories formulated torationalise past economic events. Although this is a different process, it has thesame effect as the way in which, according to Keynes, more practical menbecome enslaved by the ideas of ‘defunct economists’.

In large part this preoccupation with money has come about for soundinstitutional reasons. It is the purpose of economists employed by thegovernment ‘to select those variables which can be deliberately controlled ormanaged by central authority in the kind of system in which we actually live’,as Keynes wrote in an early draft of his General Theory. With the passing ofthe Keynesian animus in public finance, central banks have come to beregarded as the only public agencies of consistently reliable integrity. In an eraof inflated, and hence unstable, financial markets, the central bank obtains apivotal position in financial markets that slip relentlessly out of control. As theexcessive liquidity of financial markets weakens the ability to control moneyand credit in accordance with textbook prescriptions, the scope of central bankactivity is increasingly limited to the ritual setting of rates for its discountfacilities and open market operations. Economists in the central bank, andthose in financial firms seeking arbitrage opportunities between the moneymarkets and other markets, are employed to forecast short-term interest ratesand the consequences of changes in those rates. The labour market isextraordinarily efficient in providing economists who will do what they arepaid to do, just as the tradition of deference in the profession and ourincreasing dependence on finance will always ensure a sympathetic receptionto their endeavours. Thus the activities of the central bank acquire a quasi-mystical power and authority that, in the view of most economists, makemoney and the rate of interest the key to human welfare and the (uncertain)economic outlook. In an economy dominated by uncontrolled finance,economists persuade themselves, the public and governments that all is underthe influence of the money variables which the central bank is believed to haveunder its control.

This is a significant change in the scope of the influence of money oneconomic activity from the view of classical political economy. As outlined inthe Introduction, from Adam Smith to John Stuart Mill it was believed thatmoney affects finance, which affects the real economy. The priority they

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attached to thrift and saving arose because, faced with the immaturity offinancial institutions, the finance of the firm by its own saving was thenrecognised as the main determinant of economic activity. In the second half ofthe twentieth century, a small group of thinkers, who were closer to theeconomic reality of their times than the conventional wisdom of their peers,maintained ways of thinking systematically about a capitalist economy inwhich the central relationship determining its activity is finance. They begantheir analyses with critical readings of Keynes. For, although he considered hismonetary theory to be his most important contribution to economics, and it isas a monetary economist that he is most widely known, his analysis describesa capitalism dominated by finance. The other inspiration has been Kalecki,whose theories highlighted more clearly than those of Keynes the instabilityof the capitalist economy, and the more general nature of financial risk.Keynes’s financial theories, and his ambiguous intellectual heritage, havealready been discussed. The reader who is curious about the world afterKeynes and beyond academic and technical conjectures is invited to find outabout these more ‘worldly philosophers’ in the final chapters of this book.

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13. The East Coast historians: JohnKenneth Galbraith, Charles P.Kindleberger and Robert Shiller

Apart from being near contemporaries writing on finance in the second half ofthe twentieth century, John Kenneth Galbraith and Charles P. Kindlebergerrepresent a common historiographic approach to the analysis of financialinstability in modern capitalism. Their inductive approach was echoed at theend of the century by Robert Shiller, a professor of economics at Yale Univer-sity. The latter suggests a geographical as well as intellectual proximity, and apersonal influence on the younger by the two older historians, CharlesKindleberger (at the Massachusetts Institute of Technology in Boston) andJohn Galbraith (at Harvard University in the Cambridge suburb of Boston).

1. KINDLEBERGER AND GALBRAITH

Galbraith’s The Great Crash 1929 and Kindleberger’s Manias, Panics andCrashes are essentially descriptions of the events preceding and accompany-ing particular financial crises. Sentiments of greed, euphoria, frustratedexpectations and panic move financial markets, set off by any change in theeconomy that arouses heightened expectations of return, leading to excess,fraud and collapse. Kindleberger cites Minsky’s theoretical analysis.1 But hisand Galbraith’s analyses are really studies in mass psychology (as is suggestedby the title of Kindleberger’s book).

The terms of Kindleberger’s analysis are really a taxonomy of the phases offinancial crashes, which he sees as characterising all kinds of financial cycles,whether they be an over-extension of bank credit, or a ‘bull’ market insecurities. If there is a common origin to financial cycles, it lies in monetaryincontinence at some initial stage of the credit boom. A ‘displacement’ in thereal economy raises expectations and thereby arouses a credit boom. Thisleads to ‘euphoria’ or ‘overtrading’, in which rising collateral and securitiesprices encourage speculative excess. Such excess naturally leads to the nextphase of ‘financial distress’ when frauds and financial over-commitmentscollapse and the gap between the over-optimistic expectations and the morepedestrian reality is revealed. The next phase, ‘revulsion’, in which investors

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try to get their money back out of the markets, naturally gives way to one of‘panic’, because of the inability of all holders of financial claims to realisethem at the same time. At this stage prices fall precipitately and asset marketsbreak down, unable to cope with the excess of sale orders.

Galbraith and Kindleberger both advocate the timely provision of lender oflast resort facilities by central banks, as a way of stemming the extension offinancial crisis to the real economy as the system of commercial credit breaksdown. However, Kindleberger admits that, on an international scale, thisrequires financial arrangements going beyond the kind of discretionarysupport that the International Monetary Fund can give outside its limited quotasystem.2

Galbraith does provide a more systematic account of the pathologicaleffects of finance with his emphasis on the unequal distribution of income andwealth as factors contributing to speculation and economic decline. Hehighlighted the fact that ‘the proportion of personal income received in theform of interest, dividends, and rent – the income, broadly speaking, of thewell-to-do – was about twice as great [in 1929] as in the years following theSecond World War’. A highly unequal distribution of income makes theeconomy ‘dependent upon a high level of investment or a high level of luxuryconsumption spending or both’. These kinds of expenditure ‘are subject,inevitably, to more erratic influences and wider fluctuations’. This, in turn,makes those expenditures and, as a result, the economy as a whole, moresusceptible to ‘crushing news from the stock market’.3

A recurrent theme in Galbraith’s discussions of financial instability after thepublication of The Great Crash(echoed in Minsky’s essay title ‘Can “It”happen again?’) is his view that a crash like 1929 will not happen againbecause the distribution of income has become much more equal. ForGalbraith, as for Minsky, the welfare state and ‘Big Government’ after theSecond World War are supposed to make sure that spending in the economycan never be as dependent on the vagaries of the stock market as it was in1929. As the conservative reaction against the post-war-managed capitalismset in during the 1980s, followed by a resurgence of financial instability,Galbraith’s optimism has a decidedly passéair about it. In a foreword to the1988 edition of The Great Crashhe underlined the strong link between theregressive redistribution of income, which governments again believed wouldunlock economic enterprise, and speculation. He pointed to:

the enactment earlier of tax reductions with primary effect on the very affluent –before 1929, those of Andrew Mellon; before 1987, more spectacularly, those ofsupply-side economics and Ronald Reagan. In both cases they were supposed toenergize investment, produce new firms, plants and equipment. In both cases theysluiced funds into the stock market; that is what well-rewarded people regularly dowith extra cash.

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This direct connection between tax reductions for the rich and stock marketinvestment had not, incidentally, been referred to in earlier editions of TheGreat Crash, which mention only the tax reductions with which PresidentHoover tried to revive the economy. Nevertheless, Galbraith’s distributionalargument bears illuminating comparison with John Hobson’s theory of over-saving. Hobson had argued that the unequal distribution of income, inparticular the concentration of rent, interest and dividend income among a richminority of the population who could not consume all their income, gave riseto over-saving.4 Ultimately, the rentier society that emerged, a way of lifedependent upon the inflation of financial markets through over-saving, led tothe neglect of industry and economic stagnation.5 For this reason, Hobsonended up, like Galbraith and Minsky in a later age, an advocate of taxation andthe welfare state as means of stimulating and stabilising demand in theeconomy.

However, even his most enthusiastic supporters admit that Hobson tendedto omit crucial detail and explanation from his analysis. Examining the courseand consequences of the 1929 Crash, Galbraith has been able to add a theoryof speculation to what is essentially Hobson’s view of over-saving caused byan increasingly inequitable distribution of income. But this is perhaps the mostsystematic interpretation of Galbraith. Even this afterthought may be less validthan it is acute: the first post-millennial administration of the Younger (GeorgeW.) Bush in the USA conspicuously failed to revive the stock markets with itstax reductions in 2001, although devotees of market efficiency can no doubtblame this on ‘insider knowledge’ of the attack on the World Trade Center inNew York on 11 September in that year.

2. ROBERT SHILLER: HISTORIAN

Like Kindleberger, Robert Shiller has put forward a taxonomy as anexplanation of the stock market bubble that he perceived in the USA at the endof the twentieth century. Despite an adherence to a school of ‘behaviouralfinance’, ostensibly offering a realistic analysis of how finance is used, ratherthan suggesting how its use may be ‘optimised’, Shiller’s view is essentiallyhistorical. However, his focus is considerably narrower than that ofKindleberger and Galbraith, with little consideration of how the financialeuphoria that he perceives is transmitted to the rest of the economy.6 This isbecause the ultimate purpose of his work is to explain how financial variablesmove over time. This may be so that the variables can be more expertlyforecast. In that case, Shiller betrays perhaps an unconscious fidelity to themethodology of Milton Friedman. According to this methodology, the purposeof science is to develop models that provide better forecasts, rather than to

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obtain insight into economic processes. This of course has been hugelyinfluential in finance theory because of the obvious connection betweenforecasting and speculation. Where Shiller’s concern is with public policy, itis a much narrower concern than that of Kindleberger and Galbraith.Essentially it is with the use of conventional instruments of monetary policyand institutional investment to stabilise financial markets. His distinctivepolicy recommendation, put forward in his most recent book, The NewFinancial Order, but advanced earlier in his book Macro Markets, is a morewidespread use of derivatives and insurance against macroeconomic ‘risks’.This is a return to a more optimistic, ‘optimising’, financial economics thattakes a rather more benign view of the markets.

Shiller may also be loosely classed as a historian because his measure ofwhat is happening in the financial markets, and the ‘bubble’ that he identifiesin it, is a historical one. He uses the price–earnings ratio (the ratio of theirmarket price to the profits per share) of US stocks to show that, in a historicalperspective, stock market prices at the end of the 1990s were too high. Thisthen defines a problem that is less one of the effects that this overvaluation hason the economy as a whole, and more one of when and by how much marketprices will come down again:

The extraordinary recent levels of U.S. stock prices, and associated expectationsthat these levels will be sustained or surpassed in the near future, present someimportant questions. We need to know whether the current period of high stockmarket pricing is like the other historical periods of high pricing, that is whether itwill be followed by poor or negative performance in coming years. We need toknow confidently whether the increase that brought us here is indeed a speculativebubble – an unsustainable increase in prices brought on by investors’ buyingbehaviour rather than by genuine, fundamental information about value. In short,we need to know if the value investors have imputed to the market is not reallythere, so that we can readjust our planning and thinking.7

The ‘planning and thinking’ is obviously that of the financial investor.He regards the bubble as being inflated by structural, cultural and psycho-

logical factors. Among these structural factors are ‘precipitating’ forces, suchas the ostensibly revolutionary new technology of the Internet, a change in thedemographic structure of the population changing the traditional patterns ofsaving and spending, the shift towards funded pension schemes, and thedeclining quality of increasingly sanguine professional investment advice.‘Precipitating events’ are similar to the ‘displacements’ of Minsky andKindleberger. A second group of structural factors ‘amplifies’ such events.Among these factors are ‘naturally occurring Ponzi processes’ in whichinvestor confidence is aroused by precipitating events, even when such events,in the face of an uncertain future, hardly constitute an objective basis forenhanced investor confidence.

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Among the ‘cultural’ influences, Robert Shiller highlights the role of thebusiness news media in creating an expectation of immanent wealth by trailingephemeral and insignificant market events and news as portents of fortune anddecline. Largely notional movements in price averages and occasionalglimpses into the business of industry and commerce are transformed intobogus market records and an exciting fabric of unspecified significance.Psychology enters into an ability of investors to persuade themselves that eachperiod’s unique economic and technological features promise unprecedentedfinancial rewards.8

Ultimately, however, and unlike Kindleberger and Galbraith, Shiller onlypays lip-service to the economic disturbances that speculative finance maycreate, with a mere aside about the misallocation of investment.9 He remainsconvinced of the wisdom of the markets when extended to offer individualsfuture claims on income, employment and housing outcomes.10

Along with law, monarchy, and lunatic, religious and military establish-ments, finance offers singular opportunities for ridiculous and anti-socialattitudes and behaviour. Among these activities, finance is unique in its ability to attract money, and hence to make those attitudes and behavioureconomically self-sustaining. The conceits and sophistries of finance thereforeoffer a rich literary seam for journalists, novelists, and moral and politicalcommentators, not least because of the serious demeanour that must alwaysmask its more human, less elevated pretensions. However, this seam does notamount to an economic analysis showing how finance disturbs the economy ina systematic way, as opposed to offering a refuge for disturbing ideas or avenue for the display of human folly. Charles Kindleberger and John KennethGalbraith use their tales of such extravagance to expound an analysis of howit contributed to economic recession. In a descriptive way, they argue that thestock market bubble of the 1920s gave rise to distortions in corporatemanagement structures, with excessive hierarchies of holding companies and subsidiaries, over-extended financial liabilities that drained corporateliquidity, and a banking system holding large amounts of bad loanscredulously entered into. This was aggravated by low investment even beforethe Crash. Kindleberger adopted a Fisherian explanation of the transmissionmechanism, arguing that the fall in security and commodities prices in 1930increased the real value of debt.11 With Robert Shiller, the historiographicschool offers an economics of finance that looks at its follies rather than theireconomic consequences, ‘just as [Bagehot’s] Lombard Streetis thepsychology of finance, not the theory of it’.12

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14. Hyman P. Minsky’s financialinstability hypothesis

Hyman P. Minsky, together with his contemporaries Galbraith andKindleberger, spent much of the second half of the century reflecting on ‘Can“It” Happen Again?’ (the title of a collection of his essays, 1982a). ‘It’ was thekind of economic depression induced by a financial crash that had occurredafter 1929. With his aphorism describing how modern capitalism works,‘investment determines output; finance determines investment’, Minsky maybe said to have started where Keynes left off, with the flow of finance toinvestment. Thus Minsky developed a balance sheet approach to therelationship between the financial markets and business that extendedKeynes’s analysis.1

1. MINSKY FROM KEYNES

Minsky’s fundamental criticism of Keynes was that Keynes did not take intoaccount the price of capital assets in determining the demand for them. Minskysuggested that this should be done by calculating the present value futureexpected yields, or cash flows, using the current money market rate of interestto discount future incomes and costs. This, Minsky argued, ‘is a more naturalformat for the introduction of uncertainty and risk preference of asset holdersinto the determination of investment than is the marginal efficiency schedule,which has been too casually linked by both Keynes and his interpreters to the productivity-based investment functions of the older, standard theory’.2

Minsky here was repeating the standard neo-classical (marginal capitalproductivity) interpretation of Keynes’s theory of investment, rather than thetheory of investment based on expectedreturns that may be found in theGeneral Theory. From the point of view of the theory that Minsky developed,using capital asset prices supports more directly a dynamic process determinedby the values in two separate systems of prices. One is for current output, andthe other is for capital assets. The latter determines investment, but also thefinancing activity of firms that exposes them to financial risk.3 This was a viewthat Minsky obtained from Fisher.

Taking Keynes’s analysis of expectations determining investment decisions


in the face of uncertainty, Minsky argued that transactions in the financialmarkets involve commitments to future payments (liabilities) or to futurereceipts (assets). He put forward a taxonomy of ‘financing structures’:commitments to make future payments covered by a certain income stream are‘hedge’ financing; commitments to make future payments which may or maynot be covered by future income are ‘speculative’ financing structures; whilecommitments to make future payments which can only be covered by issuingnew liabilities, such as borrowing, are ‘Ponzi’ financing structures. The last henamed after Charles Ponzi, who ran a pyramid banking scheme in Bostonearly in the century.4

For Minsky, the modern corporation is not just an organisation that earns itsmoney from production. In his work, the modern corporation is defined by abalance sheet whose liabilities it finances out of the cash flow from its assets.The cash flow of a company may be defined the net result of its tradingactivities, plus its net payments on financial commitments (payments receivedminus payments made), plusits net financing activity (issue minus repaymentsof securities and debt). The cash flow of a company will normally proceed ina relatively pedestrian way, in line with the expansion of its markets. Netpayments on financial commitments will tend to rise over a boom along withthe rise in interest rates and any increase in financial commitments. Acompany’s net financing activity increases most rapidly of all as investmentrises. Therefore, as an economic boom proceeds, Minsky argued, companybalance sheets ‘deteriorate’ as they take on more borrowing. Withexpectations of gain tending to rise with each increase in profits, hedgefinancing structures tend to become more speculative, and speculativefinancing structures tend to become infected by Ponzi elements. As debtaccumulates, a situation arises in which debts can only be serviced by the issueof new liabilities. As long as the financial markets are booming it is possibleto augment an inadequate cash inflow from trading activities with Ponzifinance, issuing new securities to finance current liabilities. When the finan-cial markets slow down their expansion, Ponzi-financed economic units areforced to sell their assets. These ‘distress’ sales cause asset prices to fall, atwhich point the financial markets, and businesses with excessive liabilities tothose markets collapse.

However, without a theory of the business cycle, this analysis requiresexogenous ‘displacements’ to initiate the credit boom. This was the unspecificappeal to ‘events’, favoured by Fisher and Kindleberger, as the interventionthat shifts the economy from stable functioning to heated expansion, or frommania to panic. These were supposed to be the real events behind the shifts in‘confidence’ that were a feature of nineteenth-century credit cycle theory (seeChapter 2 above). During the 1970s, Minsky dropped this rather artificialdevice, and adopted a Kaleckian business cycle, which has the advantage of

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showing how profits fluctuate with investment over the course of the cycle.This then enabled Minsky to put forward a combined cycle in whichfluctuations in the real economy stimulated and were aggravated by financialbooms and crises.5 However, Minsky’s borrowing from Kalecki was onlypartial. Kalecki’s reflux theory of profits was useful to Minsky because itsystematically determines the income flow that enables financialcommitments to be settled:

Profits are a critical link to time in a capitalist economy … They determine whetherthe past debts and prices paid for by capital assets are validated, and they affect thelong-run expectations of business-men and bankers that enter into investment andfinancing decisions … Profit expectations make debt financing possible and helpdetermine the demand for investment output. Investment takes place because it isexpected that capital assets will yield profits in the future, but these profits will beforthcoming only if future investment takes place … In the simple model wheregovernment and foreign trade are not taken into account, prices and outputs adjustso that profits equal financed investment.6

The reference to time and expectations here is clear evidence of Minsky’sstudies of the works of Keynes and Shackle.

Minsky suggests that rising investment leads to an increase in ‘investmentin process’, which raises ‘the demand curve for financing’. But the demand forfinance for ‘investment in process’ is also inelastic in relation to the cost ofthat finance. Moreover, as more investment leads to higher profits, the pricesof capital assets at any given rate of interest also rise. The ‘internal workingsof the banking mechanism or Central Bank action’ will result in a rise ininterest rates. Increases in short-term interest rates lead to a rise in long-terminterest rates.

This leads to a fall in the present value of gross profits after taxes (quasi-rents) thatcapital assets are expected to earn … These … lead to a fall in investment, whichlowers current and near-term expected profits … The fall in profits means that theability of business to fulfil financial commitments embodied in debt deteriorates. Inparticular when profits fall some hedge units become speculative units and somespeculative units become Ponzi units … The recursive process between profits andthe effective discount rate for business assets can continue even onto a ‘presentvalue reversal’; i.e., the supply curve of investment output can rise above thedemand curve for investment output so that investment, and with investment, profitscollapse. Once profits collapse, the cash flows to validate even initially hedgefinancing arrangements will not be forthcoming.7

Thus rising indebtedness and rising interest rates are the crucial factorswhich, in a finance–capitalist economy, bring about a recession in economicactivity. Minsky recognised that the rise of ‘external financing’ of investmentis the main factor in the increasing indebtedness of companies. But under the

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‘reflux’ principle of profits, as investment expenditures rise, there should alsobe a corresponding increase in internal funds, notably in the investment goodssector, available for investment (see Chapter 11 above). Moreover, for Minskyshort-term interest rates enter into the ‘supply function of investment’. Banksare supposed to be reserve-constrained, and the central bank is supposed toraise interest rates when credit expands.8 But, as Victoria Chick has pointedout, modern banks are not reserve-constrained, but can buy and sell reservesfreely among themselves and from the central bank.9 With financial inflation,the rising prices of long-term financial assets make it even easier to obtainreserves against improving assets. Moreover, it requires an explicit policydecision to raise interest rates during an economic or financial boom. In this respect, Minsky’s theory was echoed by Wojnilower, and anticipated byWicksell: monetary tightening precipitates a credit contraction (see Introduc-tion). This does not mean that commercial and central banks do not raiseinterest rates as the economic boom approaches its peak. They do, but, in asituation where all variables are changing at the same time, it is not possiblefrom this coincidence to infer that higher interest rates have caused a fall ininvestment and an economic recession, as most theorists suggest. Minsky’sview, though widely accepted, appears not to have been shared by Keynes:

we have been accustomed in explaining the ‘crisis’ to lay stress on the risingtendency of the rate of interest under the influence of the increased demand formoney both for trade and speculative purposes. At times this factor may certainlyplay an aggravating and, occasionally perhaps, an initiating part. But I suggest thata more typical, and often the predominant, explanation of the crisis is, not primarilya rise in the rate of interest, but a sudden collapse in the marginal efficiency ofcapital … Liquidity-preference, except those manifestations of it which areassociated with increasing trade and speculation, does not increase until after thecollapse in the marginal efficiency of capital.10

Minsky’s financial instability hypothesis is therefore less self-generatingthan it appears to be. In this situation, the increase in liquidity preference ofcompanies, which Steindl suggested would be their response to a rise in theirexternal financial liabilities (see Chapter 11 above), affords a more plausiblemechanism for breaking the financial boom. As firms hoard liquidity in orderto manage their financial liabilities, to reduce their risk of being unable to payinterest and principal on those liabilities, they reduce their investment.11 Thisthen precipitates the fall in profits and the consequent further fall ininvestment that ushers in economic recession.

To overcome financial instability, Minsky advocated government economicstabilisation policies with high-profile government spending and public sectorenterprise to stabilise investment, and a progressive and planned wages policyto stabilise consumption.12 From his earliest writings he urged the use ofmonetary policy to alleviate crises of over-indebtedness, through lender of last

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resort facilities and the lowering of interest rates in financial crises.13 Hebelieved that this last tactic had the power to rehabilitate financing structures.By reducing the servicing costs of corporate financial liabilities, lower interestrates could convert Ponzi financing structures into merely speculative ones,and speculative financing structures into hedge financing. However, invirtually every modern financial crisis the authorities themselves are uncertainas to the longer-term financial soundness of distressed economic units. Lenderof last resort financing has to distinguish between supporting sound buttemporarily illiquid financing, and supporting fraudulent or irretrievablyinsolvent operations. By 1986 Minsky was hinting that a more selectivecentral bank refinancing may be preferable.14

2. CRITICAL REACTION

Perhaps a more serious problem with Minsky’s theory is that the financialbooms at the end of the twentieth century were characterised more by equitythan debt finance, and even featured the issue of equity to pay off debt.15 Theconventional wisdom in the finance professions is that equity affordscompanies cheap and secure finance. Its expansion in recent stock marketbooms would therefore, in principle, stabilise rather than undermine corporatefinances.

Minsky’s view that financial instability is inherent in financial markets wasnot to the liking of general equilibrium theorists. At a conference in BadHomburg, in May 1979, critics sought to bring out inconsistencies in hisanalysis.16 The faults attributed to that analysis that were rhetorical(‘irresponsible … demagoguery’ in the view of Raymond Goldsmith17), oraddressed to the Kaleckian or Keynesian apparatus that Minsky employed indetermining the cash flows out of which payments to financial intermediariesare made, may be left aside here. The remaining criticisms may be reduced tothree points. The first was the cash flow concept of income that Minsky usedto identify the point at which corporate balance sheets start to deterioratebecause additional financing is required to pay current expenses. The secondwas that it is not necessarily the progress of an economic boom that causesdeterioration of corporate balance sheets or financial asset portfolios. Thismay occur simply because some outgoings may be ‘lumpy’ in relation toincome. Finally, it was argued that there are sufficient distinctions betweensystems of financial intermediation, and their lender of last resort support, tomake Minsky’s thesis of increasing financial risk as economic expansionproceeds less general than he supposed.18

These criticisms have to be assessed with care. Their implicit starting pointwas a general equilibrium model subjected to stochastic shocks, which would

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clearly have the balance sheet effects that Minsky envisaged, but not in asystematic or cumulative way. This is the classical model in which, accordingto Slutsky, random shocks create apparently cyclical disturbances.19 Indeed,providing refinancing facilities are available at all times, then deficient cashflows can always be overcome by additional borrowing. However, this is justa way of saying that all financial crises are caused by illiquidity rather thaninsolvency. By showing how assets depreciate with the onset of a crisis,Minsky showed that illiquidity can lead to insolvency. Since the 1930s, theliquidity of banking systems has not been in question, except in markets on theperiphery of the capitalist world affected by Hawtrey’s ‘unstable credit’. Inmore financially advanced countries, the accommodation of banks’ liquidityneeds by central banks and wholesale money markets ensures that banks donot fail, at least in their domestic business. However, this does not mean thatthey will advance money to illiquid companies, or should even be encouragedto do so. Furthermore, the social underwriting of bank balance sheets has nowbeen overtaken by increasing financing in long-term securities markets.Securing bank liquidity therefore still leaves at risk the liquidity of thecorporate sector, which is now increasingly dependent upon financing andrefinancing in markets for long-term securities that do not have assuredliquidity. Here the expansion of long-term financing during a stock marketboom can have disastrous effects on companies that use that boom to makeprofits out of balance sheet restructurings (changing their financial liabilitiesand engaging in merger and takeover activity) and on banks experiencingdisintermediation. But these are features of capital market inflation rather thanof Minsky’s theory.20

The most serious gap in Minsky’s analysis therefore emerged after he hadpublished his ‘financial instability hypothesis’. This gap concerns the modelof corporate financing that developed in the USA and the UK during the 1980sand the 1990s. As the economic and financial booms of the 1980s and the1990s proceeded, it was not corporate debt that increased, but equity (share orcommon stock) finance. From an orthodox finance point of view, such equityfinance stabilises corporate cash flows because dividend payments are, intheory at least, at the discretion of the company. Such an arrangement should,again in theory, prevent the ‘deterioration in company balance sheets’, thatMinsky viewed as the forerunner of financial crisis. This is because paymentsby a company on its equities could be matched to its income. However, thispresupposes that companies invest only in productive capital assets, such asplant and equipment. In fact with the financial booms of the last decades of thetwentieth century, companies were increasingly using their equity capital totake speculative positions in the financial markets that required furtherrefinancing to be profitable. Among large corporations, merger and takeoveractivity requires subsequent resale of subsidiaries to profit from rising equity

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prices. Among medium-sized corporations, high-interest debt must eventuallybe refinanced in a liquid equity market.

The increasing dependence of corporations on the liquidity of equitymarkets in fact arises when equity market liquidity is profoundly ephemeral.Such equity market liquidity not only loosens central banks’ control overmoney and credit in the economy. It is also less amenable to regulation byinterest rate policy (lower interest rates can rarely stimulate demand in afalling stock market). Lender of last resort facilities, by which Minsky andKindleberger set great store, are also less likely to place a safety net under theresulting financial fragility. This is because only the most reckless or desperatePonzi financiers are likely to borrow even at the lowest rates of interest torefinance assets whose market value is falling.21

3. AFTER MINSKY

It is too early to assess the influence of Minsky on economic theory, or on thepractice of financial regulation in his home country of the USA or in othercountries. However, in one respect he was a crucial figure. This was intransmitting Fisher’s view, that uncontrolled credit expansion can causefinancial collapse, to a generation of economic thinkers and policy makers atthe end of the twentieth century who had been taught that the only alternativeswere Keynesian fiscal stabilisation or monetarist faith in the naturalequilibrium of market economies. Among those younger thinkers were Post-Keynesian economists such as Jan Kregel, L. Randall Wray and MartinWolfson, all of whom were influenced by Minsky’s work. Martin Wolfsondeserves particular mention for his systematic examination of postwarfinancial cycles in the USA, in the light of Minsky’s analysis. Wolfson haspublished this in journal articles and a book, Financial Crises: Understandingthe Post-War U.S. Experience.22

Wolfson’s analysis developed out of the earlier Minsky theory, in the sensethat he proposes that a ‘surprise event’ precipitates financial crisis.23 Thissurprise event is rather more narrowly defined than Minsky’s ‘displacements’.For Wolfson it is a ‘surprise default’ by a major borrower, or a suddentightening of credit by financial regulators, that exposes financial fragility inthe system. These disrupt ‘normal financing patterns’, and interrupt ‘thesupply of credit’.24 As in Minsky, an inability to refinance existing financialcommitments, or an inability to do so without incurring losses, causes thefinancial crisis to spread.

Among financial commitments, an important part is played by whatWolfson calls ‘involuntary investment’. These are investment projects thathave already been started and need additional external financing in the future

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to complete, or unexpected increases in stocks, or inventories, that weresupposed to generate revenue but fail to do so because of a failure of demand.25

Such involuntary investment is a crucial mechanism for transmitting financialcrisis to the economy at large. Because it involves expenditure without anyimmediate and corresponding sales revenue, as would be the case withexpenditure on current production, in a system of continuous production,involuntary investment drains liquidity from businesses. This recalls Kalecki’sdistinction between investment and investment decisions, through which heargued that investment is a continuous process and that Keynes’s notion of a‘short period equilibrium’ would be continually destabilised by ‘cumulativeWicksellian processes’ affecting prices and production. The financing needsof investment projects begun in an earlier period mean that, throughinvestment, businesses submit themselves to financial risk. The larger thescale of the investment, relative to a firm’s reserves, the greater is that risk.

However, this can only be for the individual firm undertaking investmentbeyond its financial means. For firms as a whole, precisely because‘involuntary’ investment forces them to spend more than they would prefer,such investment is a stabilising factor in the ‘cumulative Wicksellian process’.Steindl and Kalecki had highlighted the ‘inelasticity of rentiers’ saving’ as thedriving factor in recessions and booms: if investment falls, then saving toofalls. But because rentiersdo not reduce their saving by as much as the fallinvestment, if at all, then the reduction in saving falls wholly on entrepreneurs’saving, that is, the retained earnings of companies. This then obliges firms toreduce their investment further, resulting in a further disproportionate fall inretained earnings until incomes in the economy have been reduced sufficientlyto obtain the fall in household saving needed to restore companies’ retainedearnings. In a boom, the inelasticity of rentiers’ saving makes any increase ininvestment return largely to companies as an increase in their retainedearnings.26 By stabilising investment, albeit at the cost of greater indebtednessin a recession, involuntary investment also stabilises corporate finances.

Wolfson therefore relies more on surprise events to unsettle growingindebtedness, which may be caused by deregulation or the emergence of newfinancing patterns. Financial disturbances then precipitate a wider economicdecline, but only if the economy is so predisposed by a falling rate of profit.27

Marx and empirical evidence are adduced to substantiate this falling rate ofprofit. In this respect, Wolfson regards the economic decline as resulting fromthe coincidence of these two factors. The analysis therefore largely overlooksthe mechanism that makes financial over-extension induce lower profits.Kalecki and Steindl suggested that lower profits occur because investment isreduced by rising financial liabilities, a growing liquidity preference ofcompanies that is implicit in the principle of increasing risk. Minsky hadpicked up the connection between investment and profits but, rooting his

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theory in the work of Fisher and Keynes, did not make the connection betweenliquidity preference and financial liabilities. This is because, in Keynes,liquidity preference is, first and foremost, a characteristic of financialinvestors that determines their demand for money and, through that, fixes thevarious rates of interest for financial instruments. It is those rates of interestthat, together with the expected profit, affect the real investment of companies.Wolfson therefore joins more conventional theorists like Wojnilower andTobin in concluding that stricter financial regulation can bring economicstability, and that the financial instability at the end of the twentieth centurywas because finance had ‘outgrown’ earlier regulation.28 Kalecki and Steindlviewed economic instability as much more inherent in finance capitalism, andtherefore did not give much credit to the ability of regulation to stabilise theeconomy. Minsky, from a more Keynesian perspective, argued for fiscalintervention to remedy that instability.

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15. Conclusion: the disturbance ofeconomists by finance

Capitalism in the twentieth century was dominated by finance, with theexception of that half of the century that was taken up by its world wars, theGreat Depression and its Keynesian aftermath. Even before, in the nineteenthcentury, finance seduced industrial capitalism by offering a vision of capitalistreproduction expanded by the resources generated by financial inflation,ostensibly held in check by controls on the issue of paper money. Theextensive and negative reaction of English political economy to Adam Smith’sviews on usury was symptomatic of the expansion of financial markets andtheir growing confidence in their ability to contribute to commerce andindustry. From Veblen through Keynes to Minsky, a series of critics of financeargued that economies do not operate in the benign way in which it appears inequilibrium economics. These critics can be divided into those like Veblen,Hawtrey, Kalecki, Steindl and Minsky, who took a general view of finance;those like Smith, Fisher and Breit, who saw the financial system as essentiallya banking system; and those like Keynes, Kindleberger and Galbraith, whohave identified the pathology of modern capitalism in its capital markets.

The institutional forms through which the capitalist system has evolvedhave been crucial factors in the development of critical views of finance. Themore conspicuously has the brilliance with which financial institutions haveflourished stood out from its environment, the more finance has put itselfforward as the remedy for the poverty of that environment. In part this isbecause the very dependence of financial inflation on credit inflows intofinancial markets requires a missionary devotion to expanding the scope andinfluence of financial institutions, and sources of credit. The high standing offinance before the First World War played a significant role in setting offVeblen’s critical reflections on finance. The institutional factor has also beena key element in the Marxist adherence to reflective finance, precisely becauseMarxism developed before the rise of finance and proceeded to generalisefrom a Central European model of banking finance. By the time of the 1930s, finance was an integral part of the economic theory. The ‘financialrepression’ that followed the 1929 Crash facilitated the emergence of a‘monetary’ view of the economy in which finance is absent, passive orsignificant only for monetary policy. In neo-classical economics this is

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Conclusion

epitomised by the IS/LM system, with later additions of equilibrium, orreflective finance extensions, such as Tobin’s ‘q’ theory.

This preoccupation with immanent general equilibrium may not havemattered during the period of ‘financial repression’ of the 1950s and 1960s,when governments in the capitalist world could stabilise their economies byfiscal and monetary policy, and public sector activity, with limited oroccasional interference from the financial markets. In any case, after theSecond World War, with a more passive financial system, critical financetheorists like Kindleberger and Galbraith could only expound their views as ahistory of capitalism’s past. Similarly, the analysis of American capitalism inthe early part of the century was the starting point of Steindl’s criticalapproach to finance. Even the last of the twentieth century’s analytical criticsof finance, Minsky, commenced his considerations with the historical question‘Can “It” Happen Again?’ (‘It’ being the disastrous slide into depression thatfollowed the 1929 Crash), before the rise of finance in the 1960s inspired hisreinterpretation of Keynes. Since the 1960s capitalism has come to bedominated by the conjuncture in finance, rather than by the circumstances ofthe money markets per se.

With that rise of finance, Minsky came to be the most widely knownexponent of an analytical approach to how finance disturbs the economy. Inhis later work, Minsky made sporadic use of ideas he found in the businesscycle theories of Michal Kalecki. The more systematic development of theseideas, and their application to finance, was undertaken by Josef Steindl. Thecrucial concept that he took over from Kalecki was the principle of increasingrisk, whose roots went back, through the work of Kalecki’s early colleagueMarek Breit, to Wicksell and German credit cycle analysis. The principlehighlighted the internal liquidity of companies, rather than external monetaryor financial conditions, as the key mechanism affecting investment and hencethe stability of business.

Initially criticised, or, in the case of Steindl, ignored the approach in thesetheories was vindicated during the last two decades of the twentieth century bythe financial crises that emerged in overfinanced developing countries, andeventually in banking and securities markets in the most financially advancedcountries. However, most economists, including the monetarist descendants ofHawtrey and the New Keynesians, have argued that these were policy failures,rather than intrinsic tendencies of financial markets. More mainstreameconomists ignored the institutional mechanisms that generate and propagatecrises, and concentrated instead on producing models that could imposepatterns on the movement of economic variables over time. In recent years, thesophistication of the mathematical and statistical techniques at their disposalhas increased enormously.

Curiously this increased sophistication has done little to develop an

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improved understanding of financial crisis and its role in economic dynamics.In large measure this is because, from a modelling point of view, such crisisinvolves too many shifts of structural parameters to be adequately summarisedin a determinate set of equations. For example, the effects of marginal changesin sales or profits may be quite marginal at a time of economic boom, whencompanies are relatively liquid. At times of low corporate liquidity or highindebtedness, marginal changes in sales or profits may have much moreextreme effects. Hence a deeper understanding of financial markets andinstitutions, their evolution in the context of the wider economy, and thechanging way in which their operations have been understood in the past, isindispensable for a proper understanding of financial disturbance. Withoutsuch understanding, technicians merely provide comfort or strengthen theresolve of the practical men of finance. Without understanding how past criseshave been understood, economists will follow practical men into future crises,as they have in the past, reassuring them, as they both fall over the precipice,that the previous crisis cannot recur. A cynic might argue that practical men infinance, and the sophists that fortify their resolution, are eminentlydispensable. But the thinking economist also has a civic duty to the morehumble dependants of finance, whose numbers are swelled by financialinflation, to explain the economic catastrophes that blight their lives andadvise on their avoidance. The starting point for the avoidance of financialdisturbance is a consideration of the ideas put forward in this book.

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INTRODUCTION

1. Keynes, Treatise on Money, Volume II (1930), pp. 360–61.2. See Backhouse and Laidler, ‘What was Lost with IS/LM’ (2003).3. Keynes, Review of Irving Fisher, The Purchasing Power of Money(1911).4. Chick and Dow, ‘Formalism, Logic and Reality: A Keynesian Analysis’ (2001). See also

Toporowski, ‘Mathematics as natural law’ (2002b).5. Tobin, ‘A General Equilibrium Approach to Monetary Theory’ (1969).6. de Brunhoff, Marx on Money(1976), pp. 100–101.7. Schumpeter, The Theory of Economic Development(1934), chapters III and VI.8. Ibid., p. 221.9. Ibid., pp. 220–22.

10. See Schumpeter’s 1927 paper, ‘The Explanation of the Business Cycle’ and his major 1939study Business Cycles.

11. Robinson, The Rate of Interest and Other Essays(1952), p. 159.12. Patinkin, Anticipations of the General Theory?(1982), chapter 1; Merton, ‘Singletons and

Multiples in Scientific Discovery’ (1961).13. Minsky, John Maynard Keynes(1975), p. vi.14. Kindleberger, Manias, Panics and Crashes(1989), p. 12.15. Kindleberger’s remark on the ancestry of Minsky’s financial instability hypothesis elicited

a vague comment from Minsky that ‘Karl Marx and John Maynard Keynes belong to the listof great economists who held that the capitalist economy is endogenously unstable’(Minsky, ‘The Financial Instability Hypothesis: Capitalist Processes and the Bahavior of theEconomy’ (1982b, p. 37, note 1). In a personal communication, Professor Julio Lopez-Gallardo told this author that in conversation Minsky expressed his high regard for the workof Veblen.

16. Wicksell, Lectures on Political Economy Volume II(1935), pp. 211–12. It is worth recallingthat, in Hayek’s and Myrdal’s view, Wicksell was not well served by translators of his workinto English (Myrdal, Monetary Equilibrium, 1939, p. 32). Bertil Ohlin’s translation of thispassage brings out even more the crucial role of non-monetary factors, albeit at the expenseof Wicksell’s analysis of corporate liquidity preference:

The main cause of the business cycle, and a sufficient cause, seems to be the fact that technical and commercial progress cannot by its very nature give rise to series which proceeds as evenly as the growth in our time of human needs – due above all to the organic increase in population – but is now accelerated now retarded. In the former case … a mass of circulating capital is transformed into fixed capital, a process which, as I have said, accompanies every rising business cycle: it seems as a matter of fact to be the one really characteristic sign, or one in any case which it isimpossible to conceive as being absent. (Ohlin, ‘Introduction’ to Wicksell’s Interest and Prices, 1965,pp. viii–ix)

17. Backhouse, The Penguin History of Economics(2002), p. 213.18. Wicksell, Lectures Volume II(1935), pp. 79–88.19. See below, Chapter 7. This insight into an essential difference between the Swedish and the

Cambridge Schools of monetary analysis was suggested to me by Victoria Chick.20. Keynes, General Theory(1936), p. 371.21. The perceptive reader may argue that these criteria would exclude much of the literature

contained in economic journals, in particular in their recent ‘empirical’ mood. Arguably,

Notes

such incidental insights clarify arguments, but rarely in themselves constitute systematicanalysis.

22. Alain Parguez recently confirmed to me that flooding the markets with cheap credit waswhat he meant by capital market inflation.

23. Toporowski, The End of Finance(2000), chapter 2.24. Chick and Dow in ‘Formalism, Logic and Reality’ (2001), provide a more weighty

methodological foundation for this view.

CHAPTER 1: ADAM SMITH’S ECONOMIC CASEAGAINST USURY

1. See, for example, Speigel’s article on usury in the New Palgrave: A Dictionary of EconomicTheory and Doctrine(1987).

2. See Volume III of Marx’s Theories of Surplus Value (1975), pp. 527–37.3. The most authoritative account of these schemes is given in Murphy (1997).4. References to Adam Smith’s condemnation of joint stock finance may be found in

Toporowski (2000), pp. 19–20, 139 and 144–5.5. Stiglitz and Weiss, ‘Credit Rationing in Markets with Imperfect Information’ (1981).6. Smith, Wealth of Nations(1904), Book I, chapter X, Part I, pp. 119–29. 7. Ibid., Book I, chapter X.8. Ibid., Book II, chapter II. See also Perlman, ‘Adam Smith and the Paternity of the Real Bills

Doctrine’ (1989).9. Smith, Wealth of Nations, Book II, p. 399.

10. Ibid., p. 400.11. Mathieu Carlson gives a similar interpretation of Smith’s views on usury in Carlson, ‘Adam

Smith’s Support for Money and Banking Regulation’ (1999). Similar interpretations byBentham and Keynes are discussed below.

12. Smith, Wealth of Nations, p. 336.13. Victoria Chick in ‘The Evolution of the Banking System’ (1986) has provided the essential

explanation of how the function of the rate of interest has changed with the evolution ofbanking systems.

14. Petty, Quantulumcunque Concerning Money(1695), p. 13.15. Hume, ‘Banks and Paper-Money’ (1752), p. 5.16. Schumpeter, History of Economic Analysis(1954), p. 234.17. Quesnay, François Quesnay et la physiocratie(1958), p. 580.18. Ibid., p. 847.19. Ibid.20. Ibid., p. 766.21. Higgs, The Physiocrats(1897), p. 93. 22. The Physiocrats’ belief in agriculture as the proper foundation for the modern state led them

to an intriguing fascination with China, in whose static institutions they discernedconformity with ‘natural laws’. This fascination was ably researched by Sophia Daszy´nska-Golinska in a sadly neglected gem in the treasury of the history of economic ideas, her LaChine et le système physiocratique en France(1922). However, Smith considered that Chinawas backward because of its ‘law and institutions’, in particular those restricting trade andmaking owners of ‘small capitals’ prone ‘to be pillaged and plundered at any time by theinferior mandarins’. As a result, he reported, the ‘common interest of money’ was as high as12 per cent (Smith, Wealth of Nations, 1904, p. 106).

23. I am grateful to M. Le Heron for pointing this out to me.24. Blaug, Economic Theory in Retrospect(1996), p. 55.25. Hollander, ‘Jeremy Bentham and Adam Smith on the Usury Laws’ (1999). 26. Mishkin, ‘Asymmetric Information and Financial Crises’ (1991).27. Bernanke, ‘Non-monetary Effects of the Financial Crisis in the Propagation of the Financial

Crisis’ (1983).

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28. Stiglitz and Weiss, ‘Credit Rationing in Markets with Imperfect Information’ (1981).29. Stiglitz, ‘Preventing Financial Crises in Developing Countries’ (1998).30. Marshall, Principles of Economics(1938), p. 16.31. Weber, From Max Weber(1948), p. 215. 32. Ibid., p. 233.33. Gary Dymski has pointed out that ‘New Keynesian models treat agents as simple entities and

the risks they take as axiomatic and pre-social’. He went on to argue that ‘asymmetricinformation’ cannot explain the US savings and loans associations collapse of the early1980s, the East Asian crisis in the 1990s, and the social problem of the ‘redlining’ of poorerdistricts, that is the treatment by banks of loan requests from particular poor areas asinherently risky. Dymski, ‘Disembodied Risk or the Social Construction of Credit-worthiness’ (1998).

34. This is the view of Harcourt, ‘What Adam Smith Really Said’ (1995).35. David Cobham has suggested to me that limited liability may even increase financial risk

because it sets limits on the losses which the owners of a company may sustain. This maymake them more inclined to go for high-risk ventures promising high rewards.

36. Stiglitz, ‘Preventing Financial Crises in Developing Countries’ (1998).37. Bernanke, ‘Non-monetary Effects of the Financial Crisis in the Propagation of the Financial

Crisis’ (1983).38. Cobham et al., ‘The Italian Financial System’ (1999).39. Toporowski, ‘Mutual Banking from Utopia to the Capital Market’ (2002a); Hu, National

Attitudes and the Financing of Industry(1979); Kindleberger, A Financial History ofWestern Europe(1993), chapters 6 and 7.

40. Hollander, ‘Jeremy Bentham and Adam Smith on the Usury Laws’ (1999).41. It is only with the arrival of the ‘pure credit’ economy, in which lending may be advanced

without ever running out of credit, that ‘rationing’ arises from bankers’ considerations ofpossible and unknown differences in the risks associated with their customers’ activities.This is further explained in Chick, ‘The Evolution of the Banking System’ (1986).

42. Smith, Wealth of Nations(1904), Book V, chapter 1, p. 390.43. Ibid., pp. 392–3.

CHAPTER 2: THE VINDICATION OF FINANCE

1. Stark, ‘Introduction’ (1952), p. 14. 2. Bentham, Defence of Usury(1787), p. 167.3. ‘His admirable little work On Usury, published forty years ago, is clear, easy and vigorous’,

Hazlitt, The Spirit of the Age(1904), p. 15.4. Bentham was much ahead of his time in condemning anti-Semitism.5. Marx, Theories of Surplus Value(1975), pp. 467 and 534.6. Keynes, General Theory(1936), p. 353.7. Bentham, Defence of Usury(1787), p. 180.8. Cf. ‘Competition is essentially a process of the formation of opinion: by spreading

information, it creates the unity and coherence of the economic system … It creates theviews people have about what is best and cheapest, and it is because of it that people knowabout what is best and cheapest, and it is because of it that people know at least as much about possibilities and opportunities as they in fact do.’ Hayek, ‘The Meaning ofCompetition’ (1946), p. 106.

9. Milne, The Correspondence of Jeremy Bentham(1981), Letter 633, pp. 19–20.10. Ibid., Letter 702, pp. 132–4, published in Stark, Jeremy Bentham’s Economic Writings

(1952), pp. 188–90.11. Stark, Jeremy Bentham’s Economic Writings(1952), p. 27.12. Rae, Life of Adam Smith(1895), pp. 423–4, cited in Stark, Jeremy Bentham’s Economic

Writings (1952), p. 27.13. Pressman, Fifty Major Economists(1999), p. 27.

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14. But cf. Higgs, The Physiocrats(1897), p. 94.15. Schumpeter, History of Economic Analysis(1954), p. 193.16. Pesciarelli, ‘Smith, Bentham and the Development of Contrasting Ideas on Entrepreneur-

ship’ (1989).17. Hollander, ‘Jeremy Bentham and Adam Smith on the Usury Laws’ (1999).18. Stark, Jeremy Bentham’s Economic Writings(1952), pp. 33–4.19. The House of Commons Committee of Secrecy on the Outstanding Demands on the Bank

of England, the Committee on the Restriction of Payments in Cash by the Bank, and theHouse of Lords Committee of Secrecy Appointed to Enquire into the Causes whichproduced the Order in Council of 26 February 1797.

20. Thornton, ‘An Inquiry into the Nature and Effects of the Paper Credit of Great Britain’(1802), pp. 175–6.

21. Thornton ‘The Evidence Given by Henry Thornton before the Committees of Secrecy’(1797), p. 282.

22. Thornton, ‘Inquiry’ (1802), pp. 252–3.23. Ibid., p. 176.24. Ibid., chapters VIII and XI.25. It was in fact Henry Thornton’s brother Samuel, who was a director of the Bank. See Hayek,

‘Introduction’ (1939), p. 15.26. Thornton, ‘Evidence’ (1797), p. 305.27. Thornton, ‘Inquiry’ (1802), pp. 254–5.28. Ibid., p. 258.29. Thornton, ‘Evidence’ (1797), p. 310.30. Ricardo, On the Principles of Political Economy(1951), pp. 296–7.31. Hollander, ‘Jeremy Bentham and Adam Smith on the Usury Laws’ (1999).32. Ricardo, ‘Minutes of Evidence’ (1818).33. See Volume III of Sraffa’s edition of Ricardo’s Works and Correspondence (1811).34. Cited in Ricardo, On the Principles of Political Economy(1951), p. 299. Hollander (1999)

has similarly observed that the government could ‘crowd out’ private industrial andcommercial borrowing by raising loans at a rate of interest higher than the legal maximumwhich private sector borrowers were obliged to observe.

35. Ricardo, On the Principles of Political Economy(1951), pp. 299–300.36. Harcourt, ‘What Adam Smith Really Said’ (1995).37. Niebyl, Studies in the Classical Theories of Money(1946), p. 75.38. The description is attributed to Benjamin Disraeli; Corry, Money Saving and Investment in

English Economics(1962), p. 83.39. Thornton, ‘Inquiry’ (1802), p. 253; see also Corry, Money Saving and Investment (1962),

pp. 52–5.40. McCulloch, ‘Supplemental Notes and Dissertations’ (1828), Vol. II, p. 138.41. Thornton, ‘Two Speeches of Henry Thornton’ (1811), p. 331.42. Hawtrey, The Art of Central Banking(1933), pp. 121–2. 43. Keynes, Treatise on Money Volume I(1930), p. 195.44. Mill, Principles of Political Economy(1867), Book III, chapter XXIII; see also Marx,

Capital Volume III(1959), pp. 512–14.45. Mill, Principles, Book III, chapter XII, pp. 318–19. 46. Ibid., Book V, chapter X, pp. 558–9.47. Ibid., p. 559.48. Ibid.49. Ibid., p. 560.50. Ibid.51. Mill, ‘Paper Currency – Commercial Distress’ (1826).52. Niebyl, Studies in the Classical Theories of Money(1946), pp. 74–5.53. Marx, Capital Volume III(1959), p. 513; see also Chapter 4 below.54. Corry, Money Saving and Investment in English Economics(1962), pp. 85–95; Laidler, The

Golden Age of the Quantity Theory(1991), p. 23.55. Marshall and Marshall, The Economics of Industry(1879), Book III, chapter 1.

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56. ‘It was Marshall, in his evidence before the Gold and Silver Commission in 1888, who firstintroduced bank rate into economic theory. He attributed the operation of the discount rateto its effect on “speculators” who, he supposed, were encouraged by easy borrowing to buyand hold commodities for a rise. He does not seem to have entertained the idea of anyoneother than a speculator holding commodities with borrowed money. And he assumed tooeasily that speculators would be amenable to the pressure of the short-term rate of interest.’Hawtrey, Capital and Employment(1937), pp. 112–13.

57. Marshall, Principles(1938), pp. 258–9.58. Hanson, A Dictionary of Economics and Commerce(1967), p. 420.59. Robbins, The Theory of Economic Development In the History of Economic Thought(1968),

p. 86.60. Stigler, The Citizen and the State(1975), p. 208.61. Ibid.62. Ross, The Life of Adam Smith(1995), pp. 359–60.63. Stuart Jeffries, Profile of Bernard Williams, The Guardian Review, 30 November 2002,

p. 22.

CHAPTER 3: THORSTEIN VEBLEN AND THOSE‘CAPTAINS OF FINANCE’

1. Wicksell, Interest and Prices(1898), p. 102.2. Veblen, The Theory of Business Enterprise(1904), p. 185.3. Ibid. 4. Ibid., p. 191.5. Ibid., pp. 237–8; see also pp. 196–9.6. Ibid., p. 100.7. Ibid., p. 104.8. Ibid., p. 106.9. Ibid., pp. 199–200.

10. Ibid., pp. 214–16 and 227, 255.11. Ibid., pp. 106–7.12. Ibid., pp. 113–14.13. Ibid., pp. 221–3.14. Ibid., p. 227.15. Ibid., p. 118.16. Ibid., p. 119.17. Ibid., pp. 122 and 165; see also Chapter 7 below.18. Ibid., p. 112.19. E.g. Blanchard and Watson, ‘Bubbles, Rational Expectations and Financial Markets’

(1982).20. Heilbroner, The Worldly Philosophers(1961), chapter VIII.21. Hawtrey, Currency and Credit(1934), pp. 365–6.22. Veblen, ‘The Captains of Finance and the Engineers’ (1921).23. Hawtrey, Capital and Employment(1937), p. 39.24. Veblen, Absentee Ownership and Business Enterprise in Recent Times(1923), pp. 392–3.25. Ibid., p. 393.26. Ibid., pp. 352, 362–3.27. Ibid., pp. 361–2.28. Ibid., pp. 356–7.29. Ibid., p. 348.30. Ibid., p. 362. By ‘fiscal’ Veblen referred to the levying of financial charges, rather than the

levying of taxes which we would now associate with this term. A printing error, which hasremained uncorrected since the first edition, also omits the ‘s’ at the end of the word‘institution’. It could, alternatively, have been placed at the end of the word ‘stand’. But the

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Notes

original printed text (‘the massive credit institution that stand at the fiscal centre …’) isungrammatical.

31. Dirlam, ‘The Place of Corporation Finance in Veblen’s Economics’ (1958).32. Sweezy, ‘Veblen on American Capitalism’ (1958).

CHAPTER 4: ROSA LUXEMBURG AND THE MARXISTSUBORDINATION OF FINANCE

1. Luxemburg, The Accumulation of Capital(1951), p. 421.2. Ibid.3. Ibid., p. 438; see also Aaronovitch, ‘Agriculture in the Colonies’ (1946).4. Ibid., p. 445.5. Hilferding, Finance Capital(1910), chapters 20 and 25.6. Nelson, Marx’s Concept of Money(1998); see also Bellofiore, Essays on Volume III of

Capital (1998).7. Marx, Capital Volume III(1959), chapter XXV.8. Ibid., pp. 4 and 6.9. Ibid., p. 600.

10. Ibid., p. 603.11. As in nearly everything that Marx wrote after the first volume of Capital, it is possible to

question the interpretation of his analysis because of the enormous scope that his notes leftfor editing. But this chapter suffered least from Engels’s editing, and it has not been mis-translated: In the original German, the sentence about the subordination of finance toindustrial production reads as follows: ‘Es bedeutet nichts mehr und nichts weniger al dieUnterordnung des zinstragenden Kapitals unter den Bedingungen und Bedürfnisse derkapitalistischen Produktionweise’ (Marx, Das Kapital Buch III, 1932, pp. 647–8). Suzannede Brunhoff prefers to use the word ‘adapt’ in place of ‘subordinate’ (de Brunhoff, Marx onMoney,1976, p. 77).

12. Marx, Capital Volume III(1959), Parts II and III. An essential guide to the interpretation ofthese parts was given by Josef Steindl in ‘Karl Marx and the Accumulation of Capital’ inSteindl, Maturity and Stagnation in American Capitalism(1952).

13. Marx, Capital Volume III, pp. 459 and 49.14. Ibid., pp. 491–2. See also Clarke, Marx’s Theory of Crisis(1994).15. Marx, Capital Volume III (1959), pp. 600–601.16. Kalecki, Theory of Economic Dynamics(1954), pp. 94–5. Kalecki went on to commend

Steindl’s treatment of this problem in Steindl, ‘Capital Enterprise and Risk’ (1945a).17. Marx and Engels, Selected Correspondence(1936), p. 384.18. Ibid., p. 441.19. Ibid., pp. 478–80.20. Bukharin, Imperialism and the Accumulation of Capital(1924), pp. 253 and 257.21. Varga, The Great Crisis(1935), p. 21.22. Ibid., pp. 39–47.23. de Brunhoff (1976), pp. 100–101, emphasis in the original.24. Ibid., p. 118.25. Marx, Capital Volume III (1959), pp. 467–9.26. Polanyi, The Great Transformation(1944), p. 283.

CHAPTER 5: RALPH HAWTREY AND THE MONETARYBUSINESS CYCLE

1. Gilbert, Keynes’s Impact on Monetary Economics(1982), p. 235; Hicks, EconomicPerspectives(1977), p. 118 and note 3.

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2. Roll, A History of Economic Thought(1960), p. 458.3. Schumpeter, A History of Economic Analysis(1954), p. 1121.4. Klein, The Keynesian Revolution(1947), p. 103.5. Hawtrey, Trade Depression and the Way Out(1931); Hawtrey, ‘Public Expenditure and the

Demand for Labour’ (1925).6. Victoria Chick takes a somewhat different view on equilibrium in Keynes in ‘Equilibrium

and Determination in Open Systems’ (1996). Her view would bring Keynes methodologi-cally closer to Hawtrey.

7. Deutscher, R.G. Hawtrey and the Development of Macroeconomics(1990), p. 243.8. Ibid. Susan Howson argues that his policy advice had fallen out of favour even during the

1930s, after the British government took up public works, which Hawtrey had opposed, andadopted cheap money with a 2 per cent bank rate, which he had advocated. Howson,‘Hawtrey and the Real World’ (1985).

9. Hawtrey, ‘Foreword’ (1961) to A Century of Bank Rate(1962), p. xxii.10. Hayek, Prices and Production(1935); Friedman, ‘The Resource Costs of Irredeemable

Paper Money’ (1986); Friedman and Schwartz, A Monetary History of the United States(1963).

11. Lucas, Studies in Business Cycle Theory(1981). 12. Wojnilower, ‘The Central Role of Credit Crunches in Recent Financial History’ (1980) and

the same author’s ‘Private Credit Demand, Supply and Crunches’ (1985).13. Friedman, ‘The Role of Monetary Policy’ (1968). 14. Laidler points out that Wicksell’s work was not available to English readers until the 1930s.

See Laidler’s Fabricating the Keynesian Revolution (1999), pp. 13–14.15. Wicksell, Interest and Prices(1898).16. See Keynes’s review of Fisher’s The Purchasing Power of Money, Keynes (1911), and

Keynes, ‘How Far are Bankers Responsible for Alternations of Crisis and Depression?’(1913). These are further discussed in Chapter 7.

17. Marshall and Marshall, The Economics of Industry(1879), Book III, chapters 1 and 2. Seealso Eshag, From Marshall to Keynes(1963), and Gootzeit, ‘Marshall’s vs Wicksell’sTheory of the Cumulative Process’ (1999).

18. Towards the end of his life, Hawtrey admitted that when he wrote his first book, in 1909, ‘Ihad read very little economics’ (Hawtrey, ‘Foreword’, 1961, p. viii) – not bad, one mustadmit, for someone who had by then been employed as an economist at the British Treasuryfor five years! Susan Howson informs me that Hawtrey said that he learned a great deal fromhis Treasury superior Sir John Bradbury, ‘whose knowledge of British financial institutionswas unparalleled outside the City of London at that time’. However, he only joined Bradburyin the Finance Division of the Treasury five years after starting at the Treasury (Howson,‘Hawtrey and the Real World’, 1985, pp. 144–5). Still, the standards of his superior mayaccount for Hawtrey’s fastidious admission in 1961 that his first book ‘exposed myignorance of the functions of bill-brokers’, with page number references where this wasrevealed (Hawtrey, ‘Foreword’, 1961, p. ix).

19. Cited in Corry, Money, Saving and Investment(1962), p. 85.20. Hawtrey, Good and Bad Trade(1913), p. 199.21. Hawtrey, Trade Depression and the Way Out(1931), p. 10.22. Hawtrey, Currency and Credit(1934), p. 58.23. Hawtrey, ‘Foreword’ (1961), p. ix.24. Hawtrey, Currency and Credit(1934), pp. 34–55.25. Ibid., pp. 34–5.26. Hawtrey, Good and Bad Trade(1913), p. 6.27. Ibid., p. 34.28. Realfonzo, Money and Banking Theory and Debate(1998), pp. 19–20. Laidler gives a more

monetarist interpretation in Fabricating the Keynesian Revolution(1999), pp. 112–20.29. See Howson, ‘Hawtrey and the Real World’ (1985) for references.30. Hawtrey, Trade Depression and the Way Out(1931).31. Hawtrey, Currency and Credit(1934), pp. 42–3.32. Hawtrey, Good and Bad Trade(1913), pp. 44–6.

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33. Ibid., chapter IX.34. E.g. Capie, Mills and Wood, ‘What happened in 1931?’ (1986), and Bordo, ‘Financial

Crises, Banking Crises, Stock Market Crashes and the Money Supply’ (1986).35. Anderson, Corporate Finance and Fixed Investment(1964); Toporowski, The End of

Finance(2000), chapter 1.36. Hawtrey, A Century of Bank Rate(1938), p. 49. Such views had also appeared in the Report

of the Macmillan Committee, to which Hawtrey had contributed.37. Hawtrey, The Art of Central Banking(1933), pp. 79–80.38. Hawtrey, Trade Depression and the Way Out(1931), p. 44.39. Ibid., pp. 44–5.40. Ibid., p. 83.41. ‘Soon after “Good and Bad Trade” appeared, F.H. Keeling, an intellectual Socialist,

reproached me with having recommended reductions of wages. I disavowed having madeany such recommendation, though I had contended that prompt and appropriate changes inwages, upward as well as downward, would counteract the injurious consequences of thecycle … Discussion elicited the fact that he was quite unaware that the supply of gold set alimit beyond which the wage level would cause increases in unemployment.’ Hawtrey,‘Foreword’ (1961), p. x.

42. Hawtrey, Trade Depression and the Way Out(1931), pp. 61–84. Later in life he argued thathis first book ‘puts forward changes in the wage level as an alternative to adopting aninconvertible paper currency, subject to a system of banking control which would effectivelyprevent fluctuations being generated in the country itself’. Hawtrey, ‘Foreword’ (1961), p. x.

43. Hawtrey, Trade Depression and the Way Out(1931), p. 8. See also A Century of Bank Rate(1938), pp. 62–3.

44. Keynes, Treatise on Money(1930), Vol. I, pp. 174–5.45. Keynes was speaking from his own experience of speculation in commodities. In 1936 he

even considered the possibility of using the Chapel of King’s College Cambridge, of whichhe was Bursar, to store a large quantity of wheat which he feared he may have to takedelivery. Harrod, The Life of John Maynard Keynes(1951), pp. 294–304; Keynes, CollectedWritings, Vol. XII (1983), pp. 10–11.

46. Kaldor, The Scourge of Monetarism(1982), p. 7. See also Kaldor, ‘Hawtrey on Short- andLong-term Investment’ (1938).

47. Hawtrey, Good and Bad Trade(1913), p. 62.48. Deutscher, R.G. Hawtrey and the Development of Macroeconomics(1990), pp. 108–9.49. Keynes, General Theory(1936), pp. 317–18.50. On their own, theories of monetary endogeneity may be a form of ‘reflective finance’, as

long as they ignore the other (more implicit) part of Keynes’s criticism of Hawtrey, namelythat the long-term rate of interest, rather than the short-term one, prevents the economy frommoving into a full employment equilibrium.

51. Hawtrey, Capital and Employment(1937), p. 191.52. Ibid., p. 114.53. Ibid., p. 188.54. Deutscher, R.G. Hawtrey and the Development of Macroeconomics(1990), pp. 224–8.55. Laidler, Fabricating the Keynesian Revolution(1999).56. Chick, Macroeconomics After Keynes(1983), pp. 3–4.57. Hawtrey, Capital and Employment(1937), p. 219.

CHAPTER 6: IRVING FISHER AND DEBT DEFLATION

1. Galbraith, The Great Crash(1980), p. 70. Laidler notes that ‘Because Fisher had publiclyexpressed his faith in the durability of the stock market boom in September 1929, hadpersisted in pronouncing the market’s subsequent temporary collapse well into 1930, andhad also found time in 1930 to publish a defence of Prohibition … it is not surprising that

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he found himself thus placed in the company of monetary cranks.’ Laidler, Fabricating theKeynesian Revolution(1999), p. 229.

2. Fisher, The Stock Market Crash – And After(1930).3. Fisher, Booms and Depressions(1932). 4. Note 4 of that article details the development of his theory and, prompted by Wesley

Mitchell, acknowledges that Veblen, in chapter VII of Theory of Business Enterprise,‘comes nearest to the debt deflation theory’.

5. Fisher, The Rate of Interest(1907), pp. 285–7. Fisher was nothing if not consistent in hisanalysis during this period. Exactly the same passage is reproduced on exactly the samenumbered pages in his 1911 book The Purchasing Power of Money.

6. Fisher, ‘The Debt Deflation Theory of Great Depressions’ (1933).7. Ibid.8. Minsky, ‘The Financial Instability Hypothesis’ (1978).9. Ohlin, ‘Some Notes on the Stockholm Theory of Savings and Investment’ (1937). This is

precisely why Schumpeter described Keynes’s theory as ‘a monetary theory of interest,according to which interest is not derived from, or expressive of, anything that has, inwhatever form, to do with the net return from capital goods’. In a footnote appended to thisremark, Schumpeter commented: ‘this is, speaking from the standpoint of theoreticalanalysis alone, perhaps the most important original contribution of the General Theory …’(Schumpeter, History of Economic Analysis, 1954, p. 1178).

10. Fisher, ‘The Depression: Its Causes and Cures’ (1936), quoted in Dimand, ‘Irving Fisher andthe Quantity Theory of Money’ (2000).

CHAPTER 7: JOHN MAYNARD KEYNES’S FINANCIALTHEORY OF UNDER-INVESTMENT I:TOWARDS DOUBT

1. Minsky, John Maynard Keynes(1975).2. E.g., in A Century of Bank Rate, Hawtrey (1962), pp. 196–8.3. Keynes, The General Theory(1936), pp. 383–4.4. His own acolytes recognised the enigmatic nature of Keynes’s writing: Hicks famously

detected ‘at least three theories of money’ in Keynes’s Treatise on Money(Hicks, ‘ASuggestion for Simplifying the Theory of Money’, 1935). In 1983, Geoffrey Harcourt andTerry O’Shaughnessy identified at least six different interpretations of the General Theory(Harcourt and O’Shaughnessy, ‘Keynes’s Unemployment Equilibrium’, 1985). GeorgeShackle aptly entitled his chapter on Keynes’s own search to overcome the ambiguities ofhis General Theory‘Keynes’s Ultimate Meaning’ (Shackle, The Years of High Theory,1967).

5. Marshall, Money Credit and Commerce(1924), Book IV. The section in chapter III of thatbook, dealing with ‘The ordinary course of a fluctuation of commercial credit’, has thefollowing footnote attached to its heading: ‘Much of this Section is reproduced fromEconomics of Industryby the present writer and his wife, published in 1879.’

6. Marshall, ‘The Folly of Amateur Speculators’ (1899).7. Lawlor, ‘On the Historical Origin of Keynes’s Financial Market Views’ (1994), p. 207.8. Emery, Speculation on the Stock and Produce Exchanges of the United States(1896),

pp. 109 and 112.9. Ibid., p. 184.

10. Lavington, The English Capital Market(1921), pp. 248–9.11. Keynes, ‘How Far are Bankers Responsible for Alternations of Crisis and Depression?’

(1913).12. Keynes, ‘Review of W. Stanley Jevons’ Theory of Political Economy(1912).13. Keynes, Treatise on Money(1930), Book IV. 14. Ibid., Volume 1, pp. 202–5.15. See above, pp. 70–71 and Keynes Treatise on Money(1930), Volume 1, pp. 194–5.

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16. Ibid., Volume 2, chapter 37.17. Ibid., Volume 2, p. 355.18. Ibid., p. 358.19. It was only in 1938 that Hawtrey published A Century of Bank Rate, in which he showed

clearly that, over the century in which bank rate had been operational, bond rates had beenmore stable than money market rates. The implied anchoring of the long end of the yieldcurve was then absorbed into the financial economics of Michal Kalecki. See Chapter 11.

20. Keynes, Treatise on Money (1930), Volume 2, pp. 357–61.21. Lavington, The English Capital Market(1921).22. Kahn, ‘Notes on Liquidity Preference’ (1972).23. Keynes, Treatise on Money (1930), Volume 2, pp. 364 and 368.24. Ibid., p. 361. ‘The rate of interest … is not causally determined by the value set by the

conditions of supply and demand for new loans at the margin. Rather are the demand andsupply schedules for new loans determined by the value set by the market on existing loans(of similar types).’ Townshend, ‘Liquidity Premium and the Theory of Value’ (1937).

25. Keynes, Treatise on Money (1930), Volume 2, p. 371.26. Ibid., p. 373.27. Keynes, ‘An Economic Analysis of Unemployment’ (1931b), p. 349.28. Ibid., p. 350.29. Ibid., p. 353.30. Ibid., p. 354.31. Ibid., p. 365.32. Ibid.33. Schumpeter noted that deposits rose in the London clearing banks and banks abroad, but ‘to

the last quarter of 1935, advances contributed next to nothing to this expansion of deposits’.Schumpeter, Business Cycles(1939), p. 959. Susan Howson pointed out that new capitalissues in the British capital market remained very low in the case of imperial and foreignissues, but domestic issues recovered until 1936, when they fell off again. Howson,Domestic Monetary Management(1975), pp. 104–6.

34. Keynes, ‘Mr. Keynes’s Control Scheme’ (1933a), p. 434.35. Ibid., p. 435.36. Keynes, ‘Credit Control’ (1931a), p. 424.

CHAPTER 8: JOHN MAYNARD KEYNES’S FINANCIALTHEORY OF UNDER-INVESTMENT II:TOWARDS UNCERTAINTY

1. This is further discussed in Chick, ‘Equilibrium and Determination in Open Systems: TheCase of the General Theory’ (1996).

2. Keynes, General Theory(1936), p. 223. According to Fiona MacLachlan, Keynes ‘borrowed’the idea from Piero Sraffa (MacLachlan, Keynes’s General Theory of Interest, 1993, p. 97).

3. Keynes, General Theory(1936), p. 235.4. Ibid., p. 519.5. Hansen, A Guide to Keynes(1953), p. 155.6. MacLachlan, Keynes’s General Theory of Interest(1993), pp. 96–7.7. Keynes, Collected Writings Volume XIV(1973b), pp. 78–9.8. Hicks, ‘A Suggestion for Simplifying the Theory of Money’ (1935), pp. 74–5.9. Eshag, From Marshall to Keynes(1963), pp. 65–6.

10. Kaldor, ‘Introduction’ (1960), p. 6.11. Kaldor, ‘Speculation and Economic Stability’ (1939), pp. 22–3.12. Townshend, ‘Liquidity Premium and the Theory of Value’ (1937).13. Shackle, The Years of High Theory(1967), pp. 246–8; Chick, ‘Hugh Townshend’, in The

New Palgrave(1987).14. In this regard, too, Lavington turns out to have been considerably more critical. In The

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English Capital Market, Lavington concluded that ‘the amount of capital annually passingthrough the securities market and applied to the extension of the business equipment of thecountry is comparatively small, and is probably in the neighbourhood of one quarter of thewhole’. The main contribution of the securities market to business was providing liquidityrather than capital. (Lavington, 1921, pp. 280–81.

15. Keynes, General Theory(1936), p. 156.16. Ibid., p. 152.17. Ibid., p. 156.18. ‘the present is a much more serviceable guide to the future than a candid examination of

past experience would show it to have been hitherto’, Keynes, ‘The General Theory ofEmployment’ (1937a).

19. Keynes, General Theory(1936), p. 136.20. Shackle, The Years of High Theory(1967), pp. 132–3.21. Keynes, ‘Alternative Theories of the Rate of Interest’ (1937b); see also Chick, Macro-

economics After Keynes(1983), pp. 198–200. 22. Keynes, General Theory(1936), p. 170.23. Ibid., p. 171.24. Ibid., p. 320.25. Ibid., p. 322.26. Ibid., pp. 375–7. With an error that is perhaps more acute than the correct original, Hobson

welcomed Keynes’s conversion to critical finance as follows: ‘His theory of interest enableshim to foresee the way of getting rid of the scarcity of capital and the income paid for itsuse. He predicts the “enthusiasm of the rentier, the functionless investor,” and assigns to theState the “socialization of investment” as “the only means of securing an approximation tofull employment.”’ Hobson, Confessions of an Economic Heretic(1938b), p. 213.

27. Keynes, General Theory(1936), p. 375.28. Ibid., p. 376.29. Keynes, ‘The General Theory of Employment’ (1937a); Shackle, The Years of High Theory

(1967), p. 136.30. Keynes, General Theory(1936), pp. 94–5.31. Keynes, ‘The General Theory of Employment’ (1937a).32. Keynes, General Theory(1936), pp. 315–16, emphasis in the original.33. Ibid., p. 319.34. Ibid., p. 320.35. Keynes, Treatise on Money (1930), Volume 2, pp. 371–3, General Theory(1936), p. 206.36. Howson and Winch, The Economic Advisory Council(1977), pp. 138–9.37. Keynes, ‘The National Debt Enquiry’ (1945), p. 390.38. Ibid. A tap issue is a bond issue that is sold into the market as required over an extended

period of time, rather than on a particular issue day.39. Minsky, John Maynard Keynes(1975), p. 69-70.40. Robinson The Accumulation of Capital(1956), p. 230.41. Ibid., p. 242. In her essay ‘The Rate of Interest’ (1952, p. 6) Joan Robinson wrote that

‘uncertainty of future capital value … due not to any fear of failure by the borrower but tothe possibility of changes in capital values owing to changes in the ruling rate of interest …is the main ingredient in Keynes’s concept of liquidity preference. He regards the rate ofinterest primarily as a premium against the possible loss of capital if an asset has to berealised before its redemption date.’

42. Eshag, From Marshall to Keynes(1963), p. 66; Laidler, Fabricating the KeynesianRevolution(1999).

43. Eshag, From Marshall to Keynes(1963), p. 68.

CHAPTER 9: THE PRINCIPLE OF INCREASING RISK I:MAREK BREIT

1. Chilosi, ‘Breit, Kalecki and Hicks on the Term Structure of Interest Rates’ (1982).

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2. Kowalik, Historia Ekonomii w Polsce 1864–1950(1992).3. Breit and Lange, ‘The Way to the Socialist Planned Economy’ (1934).4. Kowalik, Historia Ekonomii(1992), p. 161.5. Breit, Stopa Procentowa w Polsce(1933), pp. 3–5.6. Ibid., p. 214.7. Ibid., chapters IX and X.8. Ibid., p. 165.9. Ibid., p 155.

10. Ibid., pp. 151–4.11. Ibid., chapter X; Hayek, Prices and Production (1935).12. Breit, Stopa Procentowa(1933), pp. 7–10.13. Schumpeter, The Theory of Economic Development(1934), chapters I and III.14. See Ellis, German Monetary Theory(1934), pp. 317–25.15. Breit, Stopa Procentowa(1933), pp. 43–4.16. Ibid., pp. 41–51.17. Ibid., pp. 34–5.18. White, Free Banking in Britain(1984).19. Meulen, Free Banking(1934); Hayek, The Denationalization of Money(1976).20. Realfonzo, Money and Banking Theory and Debate(1998), pp. 148–50.21. Breit, Stopa Procentowa (1933), pp. 42, 46.22. Goodhart, ‘Why do Banks Need a Central Bank?’ (1987), and The Evolution of Central

Banks(1988), chapters 5 and 7.23. Breit, Stopa Procentowa (1933), p. 197.24. Breit, ‘Konjunkturalny rozwój kredytu dlugoterminowego’ (1935b).25. Kalecki, ‘O handlu zagranicznym i “eksporcie wewnetrznym”’ (1933b); see also Chapter

11.26. E.g. Stiglitz and Weiss ‘Credit Rationing in Markets with Imperfect Information’ (1981).27. Tobin, ‘A General Equilibrium Approach to Monetary Theory’ (1969); Tobin and Brainard,

‘Asset Markets and the Cost of Capital’ (1977). The inconsistencies in Tobin are exploredin Chick’s Macroeconomics After Keynes(1983), pp. 213–17.

28. Some of these more recent problems are discussed in Goodhart, ‘What Weight should begiven to Asset Prices in the Measurement of Inflation?’ (2001).

29. Hicks, ‘A Suggestion for Simplifying the Theory of Money’ (1935).30. Keynes, General Theory(1936), pp. 14–15.31. In a review of Breit’s paper, at the conference of the European Society for the History of

Economic Thought on 28 February 2004 in Treviso, Italy, Harald Hagemann pointed outthat Breit’s conclusion, in which he refers to ‘new combinations’ as precedinga fall in therate of interest and a rise in the liquidity of the financial markets, is consistent with aWicksellian view. This is correct, but Breit also mentions other factors, including publicworks, that could stimulate investment. Breit indicates that this investment itself is the causeof greater profits. Such profits, too, could be interpreted as a kind of Hayekian ‘forcedsaving’.

32. ‘nicht der Abstand zwischen dem hohen Stande des Kapitalmarkt- und dem niedrigen desGeldmarktzinsfußes daran die Schuld trägt, daß sich die Investierungstätigkeit verringert.Vielmehr stellen sowohl das kleine Investierungsvolumen, als auch die Zinsfußdivergenzverschiedene Symptome derselben viel tiefer verlaufenden wirtschaftlichen Vorgänge dar.Es zeigte sich weiter, daß die Zinsfußdivergenz weder mit der Intensität der Tendenz zurLiquidität der Wirtschaft, noch mit der ungleichmäßigen Verteilung der Nachfrage zwischenden lang- und kurzfristigen Märkten in Zusammenhang steht … Es zeigte sich, daß derscheinbar niedrige kurzfristige Zinsfuß in wirtschaftlichen Sinne keineswegs gering ist,vielmehr is er (zusammen mit den Transformationkosten), im Vergleich mit der Rentabilitätneuer Unternehmungen, übermäßig aufgetrieben. Am wichtigstenist aber, daß wir im Standewaren, die Auffassung zu widerlegen, daß der Stoß, der eine neue Aufschwungswellezeitigt, unmittelbar von Seiten des Kreditmarktes erfolgen müsse. Das Sinken des Zinsfußesund das Steigen der Nachfrage müssen nach unseren Ausführungen weder im logischen,noch im zeitlichen Sinne dem Anwachsen der Intensität realer wirtschaftlicher Prozesse

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vorangehen. In gewissen Fällen laufen zwar die beiden Erscheinungen parallel ab, inanderen dagegen (z. B. bein Entstehung neuer produktiver Kombinationen oder beinkonjunktureller Intervention durch staatliche Investierungen) erweisen sich das Sinken desZinsfußes und die Verflüssigung der Marktes nur als Folgeerscheinungen der zunehmendenInvestierungstätigkeit, daren Ansteigen ganz unabhängig von den Änderungen der Situationdes Kreditmarktes angebahnt wurde.’ Breit, ‘Ein Betrag zur Theorie der Geld- undKapitalmarktes’ (1935a), pp. 658–9.

CHAPTER 10: THE PRINCIPLE OF INCREASING RISK II:MICHAL KALECKI

1. Kalecki, ‘The Principle of Increasing Risk’ (1937).2. See Chilosi, ‘Breit, Kalecki and Hicks on the Term Structure of Interest Rates’ (1982); Mott,

‘Kalecki’s Principle of Increasing Risk’ (1985–86); and ‘Kalecki’s Principle of IncreasingRisk’ (1982).

3. Kalecki, Theory of Economic Dynamics(1954), chapter 8.4. Ibid., p. 92.5. Ibid., p. 94.6. Kalecki, ‘Professor Pigou on “The Classic Stationary State”’ (1944); see also Sawyer, The

Economics of Michal Kalecki(1985), chapter 5, and Sawyer, ‘Kalecki on Money andFinance’ (2001).

7. Joan Robinson wrote to Kalecki in September 1936: ‘you are making an attack on Keynes… Keynes’s system you say is unrealistic …’ (Osiaty´nski, 1990, p. 502). In his review ofKeynes’s General Theoryin that same volume of the Collected Works of Michal KaleckiVolume I(Osiatynski, 1990) Kalecki gave a full explanation of why in his view Keynes wasonly partially right.

8. Kalecki refers here to pages 408–10 of Lukas’s book. Kalecki means here that buying billsinstead of bonds causes demand for securities to shift to the money market, where banksmay sell bills to savers. ‘Savers’ do not, of course, operate directly in the money markets,but through intermediaries, e.g., banks, insurance companies or pension funds.

9. Kalecki, ‘Review of Die Aufgaben des Geldes’ (1938), p. 77.10. In fact consols were not so strictly irredeemable: at various times, the British government

contributed to sinking funds, dedicated to the repayment of its debt, and this affected theprice and hence the yield of these stocks.

11. Kalecki, Essays in the Theory of Economic Fluctuations(1939), pp. 111–12.12. Ibid., pp. 112–13.13. Ibid., pp. 114–15.14. Ibid., p. 115.15. See Hawtrey’s theory of stock market bubbles, discussed in Chapter 5 above, and the

theory of capital market inflation put forward in Toporowski, The Economics of FinancialMarkets and the 1987 Crash(1993a), chapter 6; Toporowski, ‘Monetary Policy in an Era of Capital Market Inflation’ (1999a), and Toporowski, The End of Finance(2000),chapter 2.

16. Kalecki, Studies in Economic Dynamics(1943), pp. 85–6.17. Ibid., p. 159.18. I am grateful to Mrs Catherine Shackle for giving me George Shackle’s copy of Kalecki’s

Essaysand a copy of the page of Kalecki’s paper with her husband’s annotations.19. Shackle, ‘The Nature of Interest Rates’ (1949).20. Robinson, The Rate of Interest and Other Essays(1952), p. 159.21. Osiatynski (ed.), The Collected Works of Michal Kalecki Volume II(1991), p. 538.22. Robinson, ‘The Rate of Interest’ (1952), p. 11.23. Ibid., p. 28. This last remark is inconsistent with the fall in the yield curve that Robinson had

just described.24. Robertson, ‘Some Notes on Mr. Keynes’s General Theory of Employment’ (1936).

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25. Ibid.26. Osiatynski (ed.), The Collected Works of Michal Kalecki Volume II(1991), p. 539.

CHAPTER 11: THE PRINCIPLE OF INCREASING RISK III:MICHAL KALECKI AND JOSEF STEINDLON PROFITS AND FINANCE

1. Steindl, Small and Big Business(1945b), p. 42.2. Steindl, Maturity and Stagnation in American Capitalism(1952), p. 142. 3. Ibid., p. 144, 153–4. 4. Steindl, ‘The Role of Household Saving in the Modern Economy’ (1982).5. Kalecki, Theory of Economic Dynamics(1954), p. 159.6. Steindl, ‘The Dispersion of Expectations in Speculative Markets’ (1990).7. Robinson, ‘Introduction’ to Kalecki, Studies in the Theory of Business Cycles(1969), p. ix.8. Kalecki, Theory of Economic Dynamics(1954), p. 46.9. See Toporowski, ‘Profits in the U.K. Economy: Some Kaleckian Models’ (1993b), and

‘Kalecki and the Declining Rate of Profit’ (1999b).10. Kalecki, Theory of Economic Dynamics(1954), p. 50.11. Ibid.12. Victoria Chick has shown how changes in financing structures allow investment to deter-

mine saving in ‘The Evolution of the Banking System and the Theory of Saving, Investmentand Interest’ (1986).

13. Howard Profits in Economic Theory(1983), pp. 161–3; see also Wood, A Theory of Profits(1975).

14. Keynes, Treatise on Money(1930), Volume 1, p. 139. See also Chapter 7 above.15. ‘paradoxical as it may appear at first sight, it is the capitalist class itself which throws the

money into circulation which serves for the realisation of the surplus value incorporated inthe commodities. But, nota bene, it does not throw it into circulation as advanced money,hence not as capital. It spends it as means of purchase for its individual consumption.’ Marx,Capital Volume II(1974), pp. 338–9.

16. Keynes, Collected Writings Volume XIII(1973a), p. 340.17. Ibid., pp. 339–40.18. The two Robinsons and Kahn argued that: ‘For the truth of the proposition that an increase

in I[nvestment] will lead to an increase in O[utput], the two following conditions appear tous to be sufficient, though not necessary:(a) That an increase in I will lead per seto a rise in the demand for consumption goods …(b) That the conditions of supply of consumption goods are not affected by a change in

I …’ Keynes, Collected Writings Volume XXIX(1979), pp. 43–4.19. Schumpeter, The Theory of Economic Development(1934), chapter II.20. ‘savings and investment are equal ex definitione, whatever interest level exists on the

market’, Ohlin, ‘Some Notes on the Stockholm Theory of Savings and Investment’ (1937).21. Keynes, ‘The Ex-Ante Theory of the Rate of Interest’ (1937c).22. E.g. Asimakopulos, ‘Kalecki and Keynes on Finance, Investment and Saving’ (1983). In

response to this, Jan Kregel highlighted the autonomy of investment decisions: ‘once themoney is spent on new investment it all comes back to the capitalist class in the form ofprofits anyway: it is not the money, it is the investment that is important’. Kregel, ‘Savings,Investment and Finance in Kalecki’s Theory’ (1989).

23. Kalecki, Theory of Economic Dynamics(1954), p. 139. Malcolm Sawyer has acutelysummarised the connection between investment and the principle of increasing risk asfollows: ‘The principle of increasing risk is based on the simple proposition that the greateris a firm’s investment relative to its own finance the greater will be the reduction in theentrepreneur’s income if the investment is unsuccessful.’ Sawyer, The Economics of MichalKalecki (1985), p. 103.

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24. Toporowski, ‘A Refinancing Theory of Capital Markets and their Valuation’ (1995).25. ‘Cartels warding off ruinous competition will earn profits, but for these profits to be realized,

investments must be made, since the total profits of capitalists equal the sum of theirconsumption plus their investments. If cartels can achieve profits while not investing theonly reason is the existence of non-cartelized industry, part of whose assets cartels directlyor indirectly appropriate. However, if the entire economy were made up of cartels, thenobviously they could not achieve large profits without making large investments …’Kalecki, ‘Stimulating the World Business Upswing’ (1933a), pp. 160–61.

26. Kalecki, ‘Trend and Business Cycles Reconsidered’ (1968).27. This can be illustrated as follows. Assuming, initially at least, a closed economy with no

government; total saving, S, can be divided into the retained profits of companies, Sc, andhousehold saving, Sh: S � Sc + Sh. Total saving in such an economy is also equal toinvestment, S = I, with the direction of causation being from investment to saving; that is,the amount that firms spend on investment determines how much saving takes place in theeconomy. Substituting I for S gives: I = Sc + Sh . Rearranging this gives an equation forretained profits: Sc = I – Sh. This reveals how crucial is household saving, relative tocompany investment, for corporate liquidity. If investment falls below the level ofhousehold saving (I < Sh), the net cash flow of companies, after business expenses andpayments for capital, is negative. Companies now have to borrow the excess saving fromhouseholds. This is what Steindl means by enforced indebtedness. With negative retainedprofits, the companies are now more inclined to reduce investment further. If householdsaving remains unresponsive to the fall in investment, retained profits will move evenfurther into deficit, and enforced indebtedness will rise further. Conversely, if investmentexceeds household saving, then the excess returns to companies as positive retained profitsfor the sector as a whole. Additional investment may now be undertaken without the needfor external financing.

More generally, this analysis highlights the importance of appropriate deficit financing bythe government so that, if investment falls off, a fiscal deficit removes the excess householdsaving and ‘returns it’, as additional expenditure, to the company sector. See Steindl, ‘TheRole of Household Saving in the Modern Economy’ (1982).

28. Steindl Maturity and Stagnation in American Capitalism(1952), p. 115.29. Kalecki, Studies in Economic Dynamics(1943), p. 86.30. Steindl, Maturity and Stagnation in American Capitalism(1952), p. 117.31. Ibid., pp. 118–19.32. Keynes, General Theory(1936), p. 84.33. Hayek, ‘A Note on the Development of the Doctrine of Forced Saving’ (1932).

CHAPTER 12: A BRIEF DIGRESSION ON LATERDEVELOPMENTS IN ECONOMICS AND FINANCE

1. See Lapavitsas and Saad-Filho, ‘The Supply of Credit Money and Capital Accumulation’(2000).

2. ‘A Monetary Theory of Production’ in The Collected Writings of John Maynard KeynesVolume XIII(1997a), emphasis in the original.

3. Davidson, Money and the Real World (1978), p. 149. See also chapter 9 in that book on ‘ThePeculiarities of Money’.

4. Ibid., pp. 248–9.5. Ibid. See also Downward and Reynolds, ‘The Contemporary Relevance of Post-Keynesian

Economics’ (1999).6. Kregel, The Reconstruction of Political Economy (1973), pp. 156–7.

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CHAPTER 13: THE EAST COAST HISTORIANS: JOHN KENNETH GALBRAITH, CHARLES P. KINDLEBERGER AND ROBERT SHILLER

1. Kindleberger, Manias, Panics and Crashes(1989), pp. 11–12; A Financial History ofWestern Europe (1993), chapter 15.

2. Kindleberger, Manias, Panics and Crashes(1989), chapter 10.3. Galbraith, The Great Crash(1980), pp. 177–8.4. Hobson, The Industrial System(1910).5. Hobson, Imperialism (1938a), pp. 92–3; Cain, ‘J.A. Hobson, Financial Capitalism and

Imperialism’ (1985).6. Shiller’s consideration of the effects of financial instability in a chapter appropriately

called ‘Speculative Volatility in a Free Society’ is largely the conventional wisdom in themarkets at the end of the twentieth century: unequal distribution of income, impoverishedpensioners, interruptions in trade and commerce; Irrational Exuberance (2000), chapter 11.

7. Ibid., p. 5.8. Ibid., pp. 142–6.9. Ibid., p. 230.

10. Ibid.11. Kindleberger, A Financial History(1993), p. 358.12. Keynes, ‘Review of Mrs. Russell Barrington (Ed.) The Works and Life of Walter Bagehot’

(1915), p. 538.

CHAPTER 14: HYMAN P. MINSKY’S FINANCIALINSTABILITY HYPOTHESIS

1. Harcourt, ‘Post-Keynesianism: Quite Wrong And/Or Nothing New’ (1982).2. Minsky, John Maynard Keynes(1975), pp. 99–100.3. Minsky, ‘The Financial Instability Hypothesis: A Restatement’ (1978). 4. Minsky, Stabilizing an Unstable Economy(1986), Appendix A.5. Minsky, ‘The Financial Instability Hypothesis: A Restatement’ (1978). 6. Ibid., p. 14. 7. Ibid., p. 17.8. Minsky, Stabilizing an Unstable Economy(1986), p. 195. 9. Chick, ‘The Evolution of the Banking System’ (1986).

10. Keynes, General Theory(1936), pp. 315–16, emphasis in the original. For an unusuallysceptical central bankers’ view, see Dow and Saville, A Critique of Monetary Theory(1988).Dow and Saville suggest that the only systematic influence that changes in interest rateshave on the economy, outside the financial system, is through the effects of those changeson exchange rates. This would suggest that shifts in interest rates would have negligible realeffects in a relatively closed economy, such as that of the USA or the Eurozone, or under afixed exchange rate regime.

11. See Toporowski, The Economics of Financial Markets(1993a), chapter 3. 12. Minsky, Stabilizing an Unstable Economy(1986). 13. Minsky, ‘Financial Crisis, Financial Systems, and the Performance of the Economy’ (1964). 14. Minsky, Stabilizing an Unstable Economy(1986), p. 327. 15. See Wray, ‘The Political Economy of the Current U.S. Financial Crisis’ (1994) and

Toporowski, ‘Monetary Policy in an Era of Capital Market Inflation’ (1999a), and The Endof Finance(2000), Chapter 2.

16. Kindleberger and Laffargue, Financial Crises: Theory, History and Policy(1982). 17. Ibid., p. 43.

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18. Ibid., pp. 39–47. In addition to Raymond Goldsmith, the other critics were John Flemmingand Jacques Melitz.

19. Slutsky’s theorem is discussed in Schumpeter, Business Cycles(1939), p. 180. The Slutskymodel is a serious critique of cyclical periodicity, but is no theory of economic dynamics.Cf. ‘how insipid the economists are who, when they are no longer able to explain away thephenomenon of over-production and crises, are content to say that these forms contain thepossibility of crises, that it is therefore accidental whether or not crises occur andconsequently their occurrence is itself merely a matter of chance.’ Marx, Capital Volume II(1974), p. 512.

20. See Toporowski, The End of Finance(2000). It may be noted here that recent developmentsin international bank regulation, essentially the Basle Accords, now also make banksdependent upon the liquidity of capital markets.

21. This implication of Minsky’s analysis of financing structures is further explained inToporowski, ‘Monetary Policy in an Era of Capital Market Inflation’ (1999a).

22. See also Wolfson, ‘Financial Instability and the Credit Crunch of 1966’ (1999). Volume 11,Number 4, 1999 of the Review of Political Economyin which the latter paper by Wolfsonappears, contains a ‘Symposium on Minsky’s Financial Instability Hypothesis and the 1966Financial Crisis’ in which various aspects of Minsky’s and Wolfson’s work are discussed.

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188

189

Aaronovitch, S. 160Adam, W. 28Adverse selection of borrowers 21, 23Agriculture 18, 19, 34Andrews, P.W.S. 72Arbitrage pricing model 3Aristotle 13, 26Asimakopulos, A. 168Asymmetric information 20–21, 22,

23–4Attwood, M. 40Attwood, T. 35, 40, 65Austrian school 6, 102, 105, 122

Backhouse, R.E. 155Balance sheet restructuring 8, 48, 50,

148–9Bank Charter Act of 1844 37, 56Bank of England 30, 31, 35–7, 40, 41,

86Banking School 35, 40, 65Banks 9, 20–21, 36, 86, 111, 164, 171

banking cartels 103, 104–5German banking 24, 54, 59Polish banks 102, 103US banks 48

Bebel, A. 57Bellofiore, R. 54, 160Bentham, J. 20, 157

cited by McCulloch 36and Ricardo 34, 35and Smith 26, 28–9, 41on uncertainty 27–8see alsoentrepreneurs; Keynes; Marx;

savingBernanke, B. 20, 21, 22, 23Bernstein, E. 55Bill discounting 17, 68, 85, 161Blaug, M. 20Böhm-Bawerk, E. 14. 104Bond markets 3, 24, 109, 165, 167

Borrowing 16–17, 20–21, 106, 114–15Bradbury, J.S. 161Breit, M. 74, 101, 152, 153, 166–7

Kalecki on 102, 103see alsocredit cycles; equilibrium;

investment; Kalecki Britain 9, 128, 148

interest rates in 33usury laws in 16, 26, 34, 36, 39

de Brunhoff, S. 2–3, 59, 160Bukharin, N. 51, 59Bullion Report of 1811 30Bullionism 33, 35, 40Bush, G.W. 140Business cycles 3, 6, 23, 62–3, 71, 74,

122, 132, 133, 144Fisher on 76Kalecki on 113, 114, 116, 125, 128Keynes on 92–4

Business management 22

Canon law 16Capital asset pricing model 45Capital exports 53Capital market inflation 8–10, 24, 110,

119–20, 126, 127–8, 135, 148, 167Carlson, M. 156Cartels 54, 169Cassel, G. 104Central banks 64, 84, 111, 114–15, 136,

145, 149Chick, V. 91, 146, 155, 156, 157, 161,

164, 166, 168Child, J. 27Chilosi, A. 101–2China 156Clapham, J. 65Clower, R. 3Cobham, D. 17, 23–4, 157Collateral, lending against 46Common stock, seeshare capital

Index

Index

Competition 157, 169Consols, seegovernment debtCorporations, large 9, 23, 47–8, 106,

125, 127, 135, 144, 148–9Corry, B. 161Cowles Commission 77Crash of 1873 24Crash of 1893 48Crash of 1929 4, 56, 59, 68, 69, 75, 119,

131, 139, 142Credit crunch 63Credit cycles 22, 46, 144, 153

Breit on 103Fisher on 65, 75–6Keynes on 82–4Kindleberger on 138–9Marshall on 80Mill on 37–8Veblen on 46–7, 48

Credit, or financial, inflation 8, 46, 50,82, 103–5, 120, 124, 130, 146, 152

Credit rationing 21, 24–5, 33, 72, 103Credit worthiness 21, 28, 41Critical finance theory 3, 4, 10, 48Culpeper, T. 27Currency board 73Currency school 41

Daszynska-Golinska, S. 156Davidson, N. 57Davidson, P. 3, 134–5, 169; see also

interestDebt crisis of 1982 4Deflation 66, 67–8, 73, 77, 102, 110,

128, 130Depression 6, 55–6, 65, 76

Depression of 1815 40Great Depression of 1930s 21, 23, 59,

61, 67, 68, 77, 98, 152Deutscher, P. 62, 70Developing countries 60, 73, 123Disequilibrium finance 4, 5, 128–9Disintermediation 9, 103, 148Disraeli, B. 158Distribution of income 139Douglas, C.H. 7Dow, J.C.R. 170Dow, S.C. 155, 156Dymski, G. 157

East India Company 14Econometric studies 20Efficient markets hypothesis 3, 20, 80,

140Egypt 53Emerging market crisis 73Emery, H.C. 48, 80–81Engels, F. 54, 55, 57–9, 133, 160; see

alsoentrepreneursEntrepreneurs 15, 23, 25,

Bentham on 26–7Engels on 57–8Marx on 56–7

Equilibrium in economics 2, 10, 62, 131,132

Breit on 102–3, 105, 106Hawtrey on 65–6, 70, 161Kalecki on 115Keynes on 87, 88, 91Steindl on 128–9Thornton on 30in Wicksell 64

Eshag, E. 90criticism of Keynes 97–8

Euphoria in markets 138, 142Exchange rates 170

Federal Reserve System, seeUnitedStates of America

Financial crisis 21, 37, 41, 148de Brunhoff on 59international 3, 52–3Keynes on 95, 146Mill on 37–6, 39Minsky on 144, 146–7Thornton on 32Veblen on 47Wolfson on 149–50

Financial fragility 9, 17, 40, 41, 50, 130,139, 146–7, 148

Financial inflation, seecredit inflation

Financial innovation 6Financial liberalisation 21, 103Financial ‘repression’ 4, 152, 153Fiscal policy 61, 94–5, 122, 139, 151,

169Fisher, I. 2, 4, 7, 14, 30, 83, 109, 143.

144, 161credit cycle in 64–5

190

Index

see alsobusiness cycles; credit cycles;interest; speculation

Fixed capital 6Flemming, J. 171Foreign currency reserves 69, 73Foreign exchange markets 67Formalism in economics 1–2, 62France 4, 18, 19

assignatcrisis 30French Revolution 29usury laws in 20

Fraud 14, 15, 25, 81, 138Friedman M. 63, 64, 72, 77, 132, 140Fry, M. 103Full employment 89, 94Futures contracts 80

Galbraith, J.K. 62, 75, 138, 152, 153Genoa conference of 1922 67Germany 24

banking in 24, 54, 59Gesell, S. 7Giffen, R. 90Gilbert, J.C. 61Glass–Steagall Act 51Gold convertibility 29–31, 33, 36, 68Gold standard 7, 64, 65, 67, 68, 77Goldsmith, R. 147, 171Goodhart, C.A.E. 61, 166Gould, J. 58Government bonds 32, 63, 83Government debt 9, 18–19, 112, 167Grabski, W. 102Gurney, S. 113

Hagemann, H. 166Hahn, A. 104Hansen, A. 73, 89, 132Harcourt, G.C. 157, 163Harris Foundation 85Harrod, R.F. 112Hawtrey, R.G. 40, 45, 48, 61, 79, 103,

111, 112. 113, 114, 117, 133, 148,152, 161, 164

disputes with Keynes 61, 70–72, 89on investment 65, 71–2on Marshall 159‘Treasury view’ of 61, 62, 69on Veblen 49on wages 69, 162

see alsoequilibrium; interest; investment; saving; Schumpeter

Hayek, F.A. von 7, 30–31, 32, 103, 114,124, 131, 155, 157

on ‘forced saving’ 30, 129, 166on uncertainty 28

Hazlitt, W. 26, 157‘Hedge’ financing 144, 147Hegelian Geist4Heilbroner, R.E. 48Henry VIII of England 16Le Heron, E. 18Hicks, J.R. 61, 72, 90, 91, 105, 132, 136Higgs, H. 19Hilferding, R. 24, 51, 54, 59History of economic thought 4–5Hobson, J.A. 5, 7, 51, 53–4, 140

on Keynes 165under-consumptionism of 47

Hollander, S. 20, 24, 29, 33, 158Hoover, H. 140Household borrowing 9Howson, S. 96, 161, 164Hume, D. 18Hume, J. 70

Imperialism 52–4Industrial Commissions of the US

Congress 49Industrial crises 58–9Industrial efficiency 48Industrial finance 24–5, 46, 54, 56–7,

111, 123, 134–5, 144, 158, 160Industrial innovations 115, 128Inflation 66, 102Insolvency 148Insurance companies 8, 9, 129–30, 141,

167Interest, rate of 2, 5, 7, 9, 39, 70, 133,

136, 158, 170classical theory of 10, 33–4, 123and credit rationing 24–5Davidson on 135Fisher on 75, 163Hawtrey on 67–8, 164Keynes on 76, 83–4, 85, 88–91, 143,

163Minsky on 145–6‘natural’ 5, 45, 64, 103Quesnay on 18–19

191

Index

relationship between short- and long-term rates 83–4, 86–7, 102–3, 107, 111–12, 113–14, 115

J.V. Robinson on 116–17Townshend on 164Veblen on 47Wicksell on 64

Intermediation 6, 10International Monetary Fund 139Investment 4, 5, 6, 9, 25, 47, 63, 102,

126, 127, 131, 149–50, 153, 168,169

Breit on 103, 107, 166Hawtrey on 65, 71–2Kalecki on 109, 116, 118, 123, 125,

150, 168Keynes on 82, 83, 85, 93–5Minsky on 145–6Robertson on 117J.V. Robinson on 116–17

Japan 56, 106Jevons, W.S. 82Joint stock companies 14

Kahn, R.F. 84, 125, 127, 168Kaldor, N. 3, 31, 90–91Kalecki, M. 4, 5, 69, 70, 74, 98, 101,

102, 107, 137, 151, 152, 153, 164,167

on capital ownership 57on company profits 122–4, 129, 145finance constraint 116–19influences Breit 105and Keynes 123–4, 167and Shackle 115–16and Steindl 119, 120–21, 160see alsoBreit; business cycles;

equilibrium; investment; Robinson, J.V.; saving

Keeling, F.H. 162Keynes, J.M. 2, 3, 4, 5, 6, 8, 9, 30, 45,

51, 62, 102, 121, 126, 127, 129,131, 136, 137, 150, 151, 152, 166,161

on Bentham 27on company profits 85, 124–5criticised by Ohlin 76critique of capital markets 91–2‘finance’ motive for demand for

money 125The General Theory of Employment,

Interest and Money87–96, 106Harris Foundation Lectures 85–6Hawtrey, disputes with 61, 70–72Notes to the National Debt Enquiry 96and Post-Keynesians 133–4Treatise on Money83–4, 96 124on uncertainty 1, 27–8, 92, 94, 165see alsobusiness cycles; credit cycles;

equilibrium; financial crisis; Hobson; interest; investment; Kalecki; Minsky; saving; Schumpeter; speculation

Kindleberger, C.P. 4, 9, 138–9, 141, 144,149, 152, 153, 155

King, P. 30Klein, L. 61Kock, K. 104Kowalik, T. 102Kregel, J. 135, 149, 168Kwiatkowski, E. 101

Laidler, D. 97, 161, 162–3Landau, L. 101Lange, O. 101, 132Lavington, F. 81–2, 84, 90, 164–5Law, J. 14Leijonhufvud, A. 3Lender of last resort 139, 146–7, 149Lenin, V.I. 24, 51

criticised by Polanyi 59on imperialism 52, 53–4

Lindahl, E. 64Lipinski, E. 101Liquidity 6, 9, 86, 114Liquidity preference 23, 57, 84, 86, 90,

95, 97, 108, 146, 151Lloyd, S. (Lord Overstone) 37Loanable funds theory of finance 37–9,

111Lopez, J. 155Lucas, R.E. 30, 32, 63Lukas, E. 110–11Lunacy 142Lundberg, E. 64Luther, M. 55Luxemburg, R. 52

on capitalist loans 52–3criticised 59

192

Index

MacKinnon, R. 103MacLachlan, F. 89–90Macroeconomics 1, 9–10, 62, 132–3,

136Manufacturing 15, 25, 34Markowitz, H. 132Marshall, A. 4, 22, 40, 62, 65, 79–80,

83, 98, 131on credit cycles 80, 163see alsoHawtrey; speculation

Marshall, M.P. 40, 65, 79Marx, K.H. 2–3, 5, 13, 98, 122, 124,

133, 155, 156, 160, 168, 171on Bentham 27on crisis 39–40, 41, 55–6, 57criticised by Veblen 45on interest 27on usury 14, 55see alsoentrepreneurs

McCulloch, J.R. 31, 34on Smith 35–6see alsoBentham; Smith

Melitz, J. 171Mellon, A. 139Mercantilism 18, 27Merton, R. 3Meulen, H. 104Microeconomic theories of finance 9–10,

22–3, 24Mill, J.S. 4, 50 131

on interest rates 38–9on paper money 39on speculation 37–8see alsofinancial crisis; Smith

Miller–Modigliani theory 106, 132Minsky, H.P. 3–4, 8, 9, 39, 76, 77, 107,

121, 128, 129, 135, 138, 139, 141,150–51, 153, 155, 171

on Keynes 97, 143, 145see alsofinancial crisis; interest

Mises, L. von 30, 104Mishkin, F.S. 20, 22Mississippi Company 14Mitchell, W.C. 163Moggridge, D. 124Monetary policy 7–8, 87, 96, 104, 146;

see alsoopen market operations;United States of America

Monetary transmission mechanism 62,133, 170

Money 2, 3, 13, 111,demand for 19endogenous supply of 31, 162financial circulation of 83, 121paper 39Schumpeterian analysis of

103–4significance in economics 136–7

Money market 58, 64, 111, 167Monopoly capitalism 119–20, 129Moral hazard 20, 21Mott, T. 167Myrdal, G. 5, 6, 62, 64, 131, 155

Nelson, A. 54Neo-classical economics 45New Keynesianism 2, 15, 106, 132–3,

153Niebyl, K.H. 39

Ohlin, B. 76, 93, 125, 155, 168Open market operations 61, 67, 68, 77,

84, 86Optimal portfolios 1, 132Over-capitalisation of companies 8,

47–8, 50, 51, 119, 127Over-trading 16–17, 37

Parguez, A. 8, 156Patinkin, D. 3Payments system 67Pension funds 8, 9, 129–30, 141,

167maturity of 9, 130

Perlman, M. 156Pesciarelli, E. 29Petty, W. 18Phelps, E. 132Physiocrats 17–18Pigou, A.C. 109Pitt, W., the Younger 26Poland 102, 105, 122

usury law in 103Polanyi, K. 7, 59Ponzi finance 39, 40, 141, 144, 145, 147Post-Keynesianism 133–5Pressman, S. 29Prodigals 16, 26, 39, 41Psychology of markets 142Public works 85

193

Index

Quantity theory of money 66, 98Quesnay, F. 4, 17–20, 34; see alsoSmith

Rae, J. 29Railway finance 58Rational bubbles 48‘Rational’ expectations 116, 132Reagan, R. 139‘Real balances’ effect 110Reflective finance theory 2–3, 10, 58–9,

162Rentier capitalism 55Ricardo, D. 33–5, 41, 54, 62, 123, 131Riefler, W.W. 83Risk 115, 123, 137, 141

lender’s and borrower’s risk 106–7Robertson, D.H. 89, 111, 124, 131

on saving 117–18see alsoinvestment

Robinson, E.A.G. 61, 124, 125, 168Robinson, J.V. 3, 4, 97, 122, 125, 165,

168differences with Kalecki 116, 188,

167see alsointerest; investment; saving

Roll, E. 61Ross, I.S. 41Russia 26

Saint-Simon, C.H. 24Samuelson, P.A. 72, 132Sargent, T. 132Saville, I.D. 170Saving 4, 5, 18, 19, 103, 114, 132, 141,

168Bentham on 26, 28Hawtrey on 63, 65–7inelasticity of 115Kalecki on 109–10, 111, 116–18,

122–3, 128, 150, 167Keynes on 85, 124J.V. Robinson on 116–17

Sawyer, M.C. 167, 168Say, J.-B. 34–5Schmidt, C. 58Schumpeter, J.A. 3, 5, 18, 51, 57, 62,

102, 107 125, 155, 164on Hawtrey 61on Keynes 163monetary theory of 103–4

on Smith and Bentham 29Securities markets 3, 58, 109, 111,

116–17, 148, 153, 164–5, 167Senior, N. 14Shackle, C. 167Shackle, G.L.S. 3, 91, 93, 97, 145, 163,

167Share or equity capital 109–10, 119–20,

147, 148–9Shiller, R. 138, 140–42, 170Slutsky, E. 148, 171Small and medium-sized businesses 119,

123, 125Smith, A. 4, 5, 6, 13–18, 19, 20, 35–6,

41–2, 103, 123, 156on banks 15–16criticised by McCulloch 35–6criticised by Mill 38–9on division of labour 23on manufacturing 15, 25meeting with Quesnay 18moral philosophy of 15, 22Real Bills Doctrine of 16, 17, 31, 39on trade 15–16

South Sea Company 14, 15Speculation 9, 16–17, 18, 21, 31, 128,

138Fisher on 76Keynes on 91–2, 162low interest rates induce 32, 70, 77Marshall on 80Mill on 37–8prior to 1929 69, 129, 130, 139, 142Thornton on 31–2

Spiegal, H.W. 156Spiethoff, A. 104Sraffa, P. 133Stamped money 7Stark, W. 26, 29Steindl, J. 5, 74, 101, 107, 119, 125–7,

151, 152, 153, 160on ‘enforced indebtedness’ 120,

128–9, 146, 150, 169on saving 120–21, 128–9see alsoequilibrium; Kalecki

Stiglitz, J. 15, 20, 21, 22Stock exchange 47–8, 55, 92–3, 95, 117,

126–8, 139, 164‘bull’ market in 83, 119, 121, 127

Stocks of goods 67–8, 70

194

Index

Strong, B. 61Swedish school 5, 6, 97Sweezy, P.M. 51, 62

Tableau Économique18Thornton, H. 30, 35, 50, 90

on equilibrium 30–31see alsofinancial crisis; speculation

Thornton, S. 158Tinbergen, J. 72Tobin, J. 2, 126, 151, 166

‘q’ theory of 106, 132, 153Tooke, T. 70Townshend, H. 91, 164Trade cycle, seebusiness cycleTugan-Baranovsky, M. 45Turgot, A.R.J. 19, 29, 131Turkey 53

Unemployment 63United States of America 9, 48, 170

dollar 73, 102Federal Reserve System of 50, 51, 61interest rate policy in 69, 85‘New Capitalism’ in 49, 129, 130‘robber baron’ capitalism in 48, 58stock markets in 80–81, 128, 148

‘Unspent margin’ theory of banking 66,82

Usury 13–14

Vanderbilt, C. 58Varga, E. 51

Veblen, T. 3, 4, 9, 80, 152, 155on ‘capitalist sabotage’ 49on credit 45error in 159–60on stock markets 47–8on uncertainty 46wage theory of 49see alsocredit cycles; financial crisis;

Hawtrey; interest

Walras, L. 131, 132War Loans 86Wealth effect 93, 95, 128Weber, M. 22, 23Weintraub, S. 3Weiss, A. 20, 21Wicksell, K. 4, 5, 6, 14, 30, 32, 45, 64,

65, 70, 84, 102, 104, 107, 122, 133,146, 153, 155, 161, 166

‘Wicksellian process’ 6, 129, 150see alsoequilibrium; interest

‘Widow’s cruse’ 124Williams, B. 42Wilson, G. 28Winch, D. 96Wojnilower, A.M. 32, 63, 146, 151Wolfson, M. 149–51, 171; see also

financial crisisWray, L.R. 149

Yield curve 83–4, 97, 105–6, 112–13,115, 167

Young, A. 61

195

theories of financial disturbance

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