The essays in this volume explain how financial inflation shifts banking and financial markets towards more speculative activity, changing the financial structure of the economy and corroding the social and political values that underlie welfare state capitalism. The essays begin with an article that was published in the Financial Times that highlights the problems of excess debt, which emerges when financial inflation exceeds the rate at which prices and incomes are rising.
Subsequent essays examine the consequences of this for money and international financial, and for financial and accounting techniques such as financial innovation, goodwill and leverage. Among them are critical essays on the role that finance theory has played in covering up the problems caused by finance. These include a portrait of the pioneer of modern finance theorist Fischer Black. Further essays discuss the role of finance in economic inequality, fostering a new political, social and economic divide between the asset-rich and the asset-poor as the housing market (and asset markets in general) become the new 'welfare state of the middle classes'.
A final group of essays looks at how financial inflation finally broke down and financial crisis broke out. A previously unpublished essay examines the limitations of central banks in securing financial stability, while two concluding essays discuss the role of international business in transmitting the crisis around the world, and how developing countries become affected by the crisis.
About the Author
Jan Toporowski is Reader in Economics and Chair of the Economics Department at the School of Oriental and African Studies, University of London. He studied Economics at Birkbeck College, University of London and at the University of Birmingham. Jan Toporowski has worked in fund management, international banking and central banking.
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Why the World Economy Needs a Financial Crash
And Other Critical Essays on Finance and Financial Economics
By Jan Toporowski
Wimbledon Publishing CompanyCopyright © 2010 Jan Toporowski
All rights reserved.
Why the World Economy Needs a Financial Crash
An unrecognised merit of Rosa Luxemburg's The Accumulation of Capital (London Routledge and Kegan Paul, 1951) is that its theory of international finance is of startling relevance today.
In this book, which could still be read with profit by many City economists, Rosa Luxemburg analysed the process of capital accumulation (i.e. economic development) in colonial territories around the turn of the century. Lacking their own sources of finance, the major capital projects of those times were paid for by floating shares and stocks on the London Stock Exchange or international loans.
Inevitably, the engineers and sponsors of the development schemes tended to be over sanguine about their projects' future profitability. Too often costs exceeded projected expenses and initial borrowings proved insufficient, so that, even if completed, the projects were over-loaded with debt repayments and interest. Non-payment of these would precipitate a financial crisis on the part of both lenders and borrowers. The resulting crash would so devalue the claims of the lenders on the project as to enable it eventually to be completed, or continue in operation. In this way, many banks and financiers were ruined, but the projects themselves (like railway construction in Britain) were rarely altogether abandoned. Thus, the accumulation of capital proceeded, developing the relatively backward parts of the world and the developed countries themselves, using the money hoards of rentiers to pay for investment, and then defaulting to avoid meeting the claims of those rentiers.
Fortunately, since those times, another less catastrophic means of devaluing the claims of rentiers on economic development came to prevail. This was inflation, which devalued rentier claims, while tending to maintain the value of development projects and their revenues upon completion.
The relevance of all this to the Third Word debt crisis is immediately obvious. However, the old solution of ruining the rentiers (in this case the international banks and their creditors) no longer seems to be available. The position of the international banks is reinforced by central banks' implicit, if not explicit, willingness to act as lenders of last resort in order to avoid precisely that financial crash which would resolve the debt problem by devaluing it all. The banks themselves have reinforced their claims in the Third World by the use of floating rate interest, which has increased the value of interest charges since the l970s. Moreover, by denominating their claims in currencies such as the US dollar and West German D-mark, that have tended to keep their value relative to commodities and other currencies, the banks have prevented their claims from being devalued by inflation.
Nevertheless, the decision of debtor countries such as Poland, Nigeria, Peru and Argentina to limit debt service payments to a minority share of their export earnings testifies to the urgent need of those countries to be released from the grip of rentier claims that are paralysing their trade and development. However, this solution is merely a way of easing the current payments problem by taking out more debt. Undiminished by devaluation, the acceleration in the growth of these claims must eventually crush either the rentiers, or the countries themselves.
There are three other possible solutions. One is the US Treasury Secretary James Baker's proposal to lend more money to debtor countries to enable them to maintain essential trade and minimise forced rescheduling.
Another solution is for real interest rates to fall drastically. While this could alleviate the problem somewhat, it is unlikely to come to pass. This is because of the way in which unregulated international markets operate, and the gradual integration into those markets of domestic financial markets in the OECD countries, a trend that the authorities in them seem powerless to reverse. Commercial banks operate in unregulated markets by drawing in funds whose supply is elastic, and directing them to borrowers whose demand for funds is relatively interest- inelastic. This enables banks to maximise their margins (until competition squeezes them out and forces banks to seek other relatively interest-inelastic borrowers). But it also tends to lever up interest rates in ostensibly free and competitive markets.
Both the Baker solution and lower interest rates are really ways of tinkering about with the problem, and offer solutions that at best will merely postpone the inevitable. A much more effective solution would be to devalue rentier claims by a short, sharp bout of inflation, preferably in the US.
However, in present circumstances, this is even less likely than lower interest rates, because of the stranglehold that deregulated financial markets are increasingly coming to have on government monetary policy in the OECD countries. Any government which appears even to tolerate inflation, let alone tries to engineer it, is increasingly likely to find its finances paralysed by financial markets and their dread of the systematic devaluation of their claims.
Thus the only practical conclusion that can be drawn under present circumstances is of the need for a financial crash. Obviously, such a crash would have an adverse effect on most of those in the City of London now preparing with enthusiasm for the Brave New Financial World after the 'Big Bang'. It would also temporarily dislocate much economic activity and have a disastrous effect on many whose incomes and wealth are based on financial assets. The Government policy, already over-dependent on the continuatiion of the present bull marke through its reliance on asset sales to finance current expenditure, would also suffer a severe reverse in its attempts to promote services as an alternative to stagnating industrial activity. In addition, a financial crash would dramatically sour the attractions of a 'share-owning democracy' and make untenable the notion of private pension schemes as alternatives to state provision.
Those drawing their main incomes directly from City activities are relatively few. There are many more in Britain and abroad who would stand to gain from a revival of trade, investment and production which are currently suffering progressive paralysis from the burden of rentier claims. The devaluation of those claims is a necessary, if insufficient condition for the quickening of real economic activity and perhaps even the survival of the capitalist system.CHAPTER 2
Money in Globalised Times
'Gladstone, speaking in a parliamentary debate on Sir Robert Peel's Bank Act of 1844 and 1845, observed that even love has not turned more men into fools than has meditation upon the meaning of money. He spoke of Britons to Britons. The Dutch, on the other hand, who in spite of Petty's doubts possessed a divine sense for money speculation from time immemorial, have never lost their senses in speculation about money.'
K. Marx, A Contribution to the Critique of Political Economy, New York: International Publishers 1970, p.64
Modern finance is about 'convenience money', that is, having a store of liquid assets that allows firms and households to meet unplanned expenditures, or unexpected declines in income, without the bother of having to sell possessions (labour or inanimate property) or borrow in an emergency. Such convenience money is part of accumulated wealth. As globalisation has linked up local and national markets for wealth, so too it has changed the kind of money that we use.
As every textbook reminds us, to the point of tedium, money is a social convention which makes trade easier because prices are set in amounts of the money-commodity ('unit of account'), and because the proceeds from selling commodities may be held as money until the desired commodity comes into the market ('store of value'). Under capitalism, financial markets concentrate large amounts of money (savings, or 'interest-bearing capital' in Marx) which can then be used to finance trade and production, in exchange for a portion of the profit from that trade or production. Since the twentieth century, such money capital is mostly used to generate profit from operations in financial markets, buying financial assets and selling them later at a higher price. Money therefore has primarily followed the development of trade and the expansion of markets. In recent times, however, movements of money capital in and out of different currencies has disturbed the effectiveness of money in facilitating trade.
The Evolution of Money
Before the nineteenth century, when markets were mostly local and small, locally produced coins were adequate for the needs of trade. In the great trading basins of the Mediterranean or navigable rivers such as the Volga or the Danube and elsewhere, as markets became more integrated, coins minted in different trading cities, each with different values, circulated alongside each other. The practical need to be able to calculate their value in terms of each other was resolved by valuing them according to the amount of precious metals (gold or silver) contained in the coins. A coin containing twelve ounces of gold was considered double the value of one containing six ounces of gold. Establishing the proper relative value of gold in relation to silver was more difficult.
In 1717, faced with a shortage of silver coinage for English trade, the ratio of silver to gold was fixed on the recommendation of the Master of the Mint, Sir Isaac Newton, by Crown proclamation at 21 silver shillings to the gold guinea. But this over-valued gold to such an extent that, for the next century, hardly any silver was brought to the London Mint for coining. Britain in effect went onto a gold standard. Nevertheless, at the end of the nineteenth century there were many serious monetary economists, such as Alfred Marshall, who advocated the return to the use of gold and silver currency, or bimetallism, if only because Britain's most important colony, India, remained on a silver standard until 1893.
As international trade developed in the eighteenth century, paper claims, and bills of exchange came to be used for payment. These had the advantage over coins or bullion (bars of precious metal) that they were more secure, and afforded possibilities of delayed payment, that is credit. The person who received such a bill in delayed payment could always bring forward its payment by selling it at a discount, that is at less than its value on maturity, to one of the banks specialising in this discount trade in London, Amsterdam or New York. From this emerged paper money, issued by local banks to reduce the circulation of gold in circumstances where the security of gold held in public hands was always precarious. However, by the middle of the nineteenth century it was considered prudent by most respectable bankers and economists that issuers of paper money should only put into circulation as much paper money as they had gold. Otherwise, it was feared that by increasing the amount of currency available to buy goods, an unlimited issue of paper money would give rise to inflation and speculation, or profiteering from the increases in prices of goods or property. Such inflation and speculation occurred in the United States after independence, in France after the 1789 Revolution, and in Britain during the Napoleonic Wars.
Gradually, paper money and coins of precious and industrial metals replaced gold in domestic circulation in more or less standardised units: pounds shillings and pence in Britain, dollars and cents in the US. But, like a dim echo of the times when coins issued by different mints circulated alongside each other, the gold 'content', or value against gold, of domestic currencies was supposed to represent their international value. This is what was meant by the gold standard, which most wealthier countries adopted after 1870. Under this system, trade and finance flourished. This apparent prosperity had nothing to do with any intrinsic qualities of gold, but everything to do with the ease with which international payments could be made with claims against accounts held in financial centres. There, claims, on being presented, would be paid with paper money such as Bank of England pound notes that were convertible into gold.
Indeed, the system even had its apparently bizarre but rational aspects: the Tsarist government of Russia would ship gold to a particular financial centre, such as Paris, for example. Increased gold reserves made banks lower interest rates in order to encourage borrowing. The Russian government would then raise a loan at the lower rate of interest, before taking its gold off to another financial centre, where it would raise another loan made cheap by the influx of Russian gold. In the 1920s the British Treasury official, Sir Ralph Hawtrey argued that a shipload of gold bullion should be sent New York in order to cause the US dollar to appreciate in the foreign exchange markets against sterling.
Inevitably, the whole system collapsed under the weight of debts contracted under it because of its apparent 'soundness', as well as those debts contracted to pay for the First World War. By the 1930s, the inability to make international payments and capital transfers of a stable value was irrevocably associated with economic depression. Economists since then have not ceased to argue about what it was precisely that governments did wrong to bring this catastrophe upon their citizens. The Great Depression of the 1930s confirmed a belief, among even the most practical bankers and financiers, in a 'natural' order in which cross-border payments and capital transfers can be made easily and at minimum cost throughout the world. By implication, the only obstacles to the unrestricted flows of international money are supposed to be politically inspired regulations: the national (or state, in the US) jurisdictions that have replaced brute force in securing commercial or financial claims.
It was in this context that the statesmen and economists gathered at Bretton Woods in the United States in 1944 to reconstruct an international trading and financial system. Most of them had the gold standard in the back of their minds as their bench-mark for their task. However, the US by then had over eighty-percent of the capitalist world's gold reserves, much of it delivered in payment for Wartime support or as security on loans. They agreed on an indirect gold standard, in which all other currencies were to be convertible at a fixed rate against the US dollar, and that dollar was made convertible against gold at a fixed rate of US$35 per fine ounce.
In order to keep to their fixed exchange rates, most governments limited access to foreign currency by residents of their countries. By obliging residents to exchange their foreign currency for domestic currency, central banks could obtain more foreign currency with which to intervene in the foreign exchange market. In addition, foreign capital transfers were limited, and foreign exchange to buy imports was often rationed. In London, and subsequently in Hong Kong and Singapore, free markets in foreign currency emerged. But these provided payments and transfer facilities mostly for multinational companies and international banks.
In any case, the system was bound to fail. Under the Bretton Woods system the US could pay for its balance of payments deficits by issuing dollars. These dollars were permanently in demand as foreign currency reserves for banks in other countries. The dollars that were returned for exchange in the US for gold merely drained gold from the United States. On August 15,1971, the US government ceased the sale of gold from its reserves on demand.
Free Markets and Globalisation
In the 1970s the world moved to a system in which various currencies circulated alongside each other in free markets, operating in London and Singapore for example, but accessible only to non-residents of those countries. Most governments still restricted the foreign exchange transactions of their residents by capital controls; that is, through the regulation of cross-border payments and capital transfers. The absence of any intrinsic common feature against which to measure their value, now that gold was no longer in use, meant that since the 1970s the exchange value of currencies has increasingly been determined in foreign currency markets, more or less beyond government control. This made capital controls, i.e., the regulation of cross-border payments and capital transfers, increasingly easy to evade. In the 1970s, the governments of the United States of America and the United Kingdom eliminated these controls, making it much more difficult for other countries to keep their foreign exchange markets stable. Effectively the two countries with the largest credit-creation capacity could now throw unlimited dollar or sterling credit into other countries' foreign exchange markets. Western European countries deregulated cross-border capital flows at the beginning of the 1990s, ostensibly in preparation for European monetary union.
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Table of Contents
Introduction; 1. Why the World Economy Needs a Financial Crash; Part I. The Economics of Financial Inflation; 2. Money in Globalised Times; 3. Neo-liberalism and International Finance; 4. Financial Innovation: Better Machines for Financial Inflation?; 5. The Inflation of Goodwill; 6. Leverage and Balance Sheet Inflation; 7. Inflation in Financial Markets; 8. Asset Inflation and Deflation; Part II. The Culture of Financial Inflation; 9. Twentieth-Century Finance Theory: The Frauds of Economic Innocence (in memoriam J. K. Galbraith); 10. Fischer Black’s ‘Revolution’; 11. Economic Inequality and Asset Inflation; 12. The Wisdom of Property and the Culture of the Middle Classes; Part III. Financial Crisis; 13. Everything You Need to Know about the Financial Crisis but Couldn’t Find Out Because the Experts were Explaining It; 14. The Limitations of Financial Stabilisation by Central Banks; 15. International Business and the Crisis; 16. Developing Countries in the Crisis Transmission Mechanism; Epilogue; Notes; Index
What People are Saying About This
'Jan Toporowski is the best-kept secret in British economics. His insightful essays combine insight into current market mechanisms and macroeconomic dynamics with a keen appreciation of the historical sources of the ideas being debated in today’s financial pages. This book explains Toporowski’s ground-breaking theory of financial inflation, which is the key to understanding why financial-market forces ultimately exploded. In sum, this book answers questions readers didn’t know they had about the 2007-08 financial crisis and about all the financial crises in the neoliberal era.' —Gary Dymski, Professor of Economics, University of California, Riverside
'Jan Toporowski offers a lively and engaging critical assessment of national and international financial problems. He writes clearly, in non-technical language, and explores the economic, historical, political, cultural and symbolic significance of finance. Anyone with a serious interest in the “great recession” that began in 2007 will benefit from reading this book.' —John King, Professor of Economics, La Trobe University
'In these essays Jan Toporowski demonstrates his characteristic ability to combine analytical insights with policy relevant commentary on a range of topics associated with financial inflation and with banking and financial crises. Directed at a non-technical audience, the discussions offer a lesson in rigor, clarity and conciseness. The breadth of knowledge is impressive and the resulting analyses always telling and thought provoking. A book to be highly recommended.' —Grahame F. Thompson, Professor of Political Economy, The Open University and Visiting Professor at the Copenhagen Business School
'Offers a uniquely systemic and historically aware insight into the structural, institutional, socio-political and cultural origins of financial instability associated with the rise of global finance... A sharp and comprehensive critique of the financial orthodoxy that is behind many myths of contemporary economics and political economy.' —Anastasia Nesvetailova, Department of International Politics, School of Social Sciences, City University London