III Currency hierarchy

Evolving international monetary and financial architecture and the development challenge: A liquidity preference theoretical

A liquidity preference theoretical perspective

Jorg Bibow1

Introduction and overview

This chapter investigates the peculiar macroeconomic policy challenges faced by middle-income countries opening up their financial system to the vagaries of todays monetary (non)order and globalised finance (conventionally referred to as‘emerging economies’). It reviews the evolution of the international monetary and financial architecture against the background of Keynes’ original Bretton Woods vision highlighting the U.S. dollar’s hegemonic status. Keynes’ liquidity preference theory informs the analysis of the loss of policy space and widespread instabilities in emerging economies that are the consequence of financial globalisation. While any benefits promised by mainstream promoters remain elusive, heightened vulnerabilities have emerged in the aftermath of the global crisis.

Keynes’ liquidity preference theory in a global setting

Keynes’ (1936) ‘The General Theory of Employment, Interest and Money’ delivered two pivotal blows to the mainstream (neo)classical thought of his time, one concerning labour markets, the other concerning financial markets.

On the mainstream view, employment is determined in labour markets and unemployment arises because workers are asking for too much. Work would be readily available to anyone willing to work at a lower (market-clearing) wage, unemployment is therefore always voluntary. Exemplifying a more general warning to economists to not blindly apply microeconomic thinking to macroeconomic issues, Keynes identified a fallacy of composition in this argument: whereas individual workers might be able to price themselves into employment, wage cuts across the economy are prone to yield deflation and instability instead. Any macroeconomic employment gains are unlikely to arise other than through raising a country’s external competitiveness (a ‘beggar-thy- neighbour’ zero-sum game) which, at the global (supra-macro) economy level, still constitutes said fallacy of composition.The global economic calamity of the Great Depression playing out at the time illustrated Keynes’ point rather well.

At the macro level, the crucial employment constraint overlooked by the mainstream theory of employment is the level of‘effective demand’, which depends on entrepreneurs’ sales expectations in general and perceptions of profit opportunities on real investment projects in particular. Moreover, in ‘monetary production economies’, money cannot be ‘abstracted from’ and only added on later as an after-thought to the ‘real analysis’. Instead, being far from ‘neutral’, money must be part of the analysis from the start, affecting motives, decisions, and employment outcomes.

The financial system comes to the fore here as either facilitating or potentially constraining economic activity and employment, capital accumulation and development. In this spirit, Keynes’ second important theoretical advancement, was to take issue with mainstream thinking on money and interest prevailing at the time. He rejected both the ‘quantity theory of money’ and the ‘loanable funds theory of interest’.

The former is preoccupied with the medium-of-exchange role of money and naively posits a proportionality between the monetary facilitator of market exchanges and the price level; with causality supposedly running from money to prices. Already in his ‘Tract on Monetary Reform’, Keynes (1923) found that the quantity theory of money was useless for policy purposes. In the General Theory, he highlighted that the quantity theory of money was not only out of touch with the realities of bank money and organised securities markets, but also rendered useless as a theory by ruling out effective demand as the key determinant of employment by assumption.

Hopelessly trapped in an agricultural (‘corn economy’) worldview that has the ‘not consumed’ (i.e. saved) corn becoming the investment of the next period, loanable funds theory was no better, Keynes found. For in monetary production economies real capital gets produced and therefore requires, like any other economic activity, advance finance rather than prior saving. Hence those engaged in economic activity need to first find the money - to then spend, produce, or acquire assets.They need to either convince those who hope money to hand it over, or those who can produce money to do so — at a price of course: ‘the’ rate of interest.

This key insight underlies Keynes’ ‘liquidity [preference] theory of the rate of interest’: interest rates are determined by the financial system as the price that, at the margin, balances desires of those who want to become more liquid and of those willing to become less so, including the producers of liquidity, the banking system. Not saving decisions are at issue here, but portfolio decisions concerning the form in which wealth is held and finance raised, with the banking system providing ‘liquidity par excellence’: money. In other words, economic activity and employment, capital accumulation and development are conditioned by the liquidity provided by the financial system but do not depend on - or are somehow ‘financed by’ - saving; as loanable funds theory would have it (Chick 1983, Bibow 2009a).

Modern mainstream macroeconomics may have written money and the quantity theory of money out of the play — replaced by an independent central bank setting a policy interest rate with a view of hitting its inflation target (by following some ‘Taylor rule’ while chasing Wicksell’s ‘natural rate’). Yet, upholding loanable funds theory, the mainstream still has the financial system channelling saving flows into investment, with banks churning deposits into loans. Applied globally, financial globalisation was promised to enable poor countries to invest more and catch up faster - by borrowing richer countries’ ample saving resources. The ‘Washington Consensus’ advice for developing countries aspiring to catch up to advanced ones then seems straight forward: to liberalise, privatise, and open up their economies to the market forces of wisdom ruling in today’s (hyper-)globalised world (Fischer 1997, Summers 2000, Rodrik 2012).

Liquidity' preference theory,applied in a global setting, offers a rather different perspective on the supposed virtues of financial globalisation. The point about money is, as Keynes emphasised, that money (the ‘money rate of money interest’) sets the floor below which other rates of return on assets in general will not fall. In other words, the terms of liquidity' provision as determined by' the financial system condition the production of new capital assets and hence employ'ment and development. The question is whether liquidity production should better be organised locally or globally.

For countries lacking capabilities to produce real capital assets, access to global finance appears to offer an alternative to the payment for imports solely by means of exports. But under globalised finance returns on assets, denominated in different national currencies or not, will also compete globally and be subjected to the whims of arbitrage, hedging, and speculation. In fact, national currencies themselves, as financial assets constantly assessed by' global financial market players, will be subject to the same forces too. And some currencies may be considered safer and more liquid than others.

‘Disciplined by’ financial market players, representing the international powers of wealth (mainly located in rich countries) acting freely across borders, national authorities will see their options and ‘policy space’ shrink accordingly. For those with sufficient faith in the invisible hand (or vested interest in the global rule by' the powers of wealth) this outcome may seem attractive (Hayek 1977). Bolstered by his own immense practical experience, in addition to superior theoretical insight, Keynes was sceptical that globalised finance would necessarily foster development and the general good (Bibow 2009a, 2017).

Keynes illustrated the importance of money and finance in monetary production economies in terms of his ‘own rates’ analysis, featuring the concept of the ‘liquidity premium’ and yielding a structure of asset prices (Bibow 2009a, Kaltenbrunner 2015, De Paula et al. 2017).

Keyrnes distinguishes different types of assets as possessing the following attributes in different degrees: yield q, carrying cost c, and a liquidity' premium I. To determine the expected returns on different types of assets over a period of time, in addition, the expected percentage appreciation or depreciation relative to some standard of value — normally the national money - is required.

The total expected return on an asset, or its ‘own rate of (money) interest’, is the sum of these four elements (1): R, = qt — q + /, + awhere the resulting (net) yields are default-risk adjusted and incorporate the cost of financial intermediation. An equilibrium requires the demand prices of all different types of assets to be such that their total expected returns are all equal. In such a general portfolio equilibrium, all assets are held and wealth holders have no incentive to reshuffle their portfolios at the current structure of asset prices — at least for a nanosecond.

Money appears in a pivotal position in this general portfolio allocation approach. First, money is the standard of value or unit of account. Second, Keynes identifies money as the asset with the highest liquidity premium. Having a certain (money) value under (almost) any circumstances makes money an attractive store of value in a world of fundamental uncertainty. The strength of the desire to hold money is not constant irrespective of circumstances though. Rather, as an indicator of our trust in the future, it is subject to abrupt change.

In this regard, bank money is par excellence ‘liquid’ in the eye of the (nonbank) public, while central bank money provides the ultimate settlement asset and liquidity par excellence from the banks’ perspective. Treasury bills and other money market instruments may be more or less close substitutes. The liquidity premium is not an actual yield but a notional reward, an amount of actual yield wealth holders are willing to forego for having money instead of less liquid assets at their disposal — ‘for the potential convenience or security given by this power of disposal’ (Keynes 1936, JMK 7: 226).

Money may also provide an actual yield on top of its liquidity premium: the short-term interest rate traditionally set by the central bank as the expression of its monetary policy stance. Competition will align the yield on bank money (and close substitutes) with the set policy rate. (The yield on central bank money — if nonzero - will depend on the central bank’s particular operating procedures.)

Keynes’ own-rates analysis highlights that monetary policy stands at the very centre of the structure of asset prices. Its influence on economic activity, as seen from this perspective, arises because money’s own rate of interest, its liquidity premium plus any cash yield (together with typically negligible carrying cost) sets the floor below which the own rates of interest on other financial instruments and assets in general cannot decline.

Financial instruments traded in financial markets provide alternative ‘liquid’ stores of value that typically promise higher yields. Investments that are final and permanent commitments by society are thereby made fluid for the individual fleeting‘investor’. The liquidity of markets can be compatible with stable prices of debts and assets at times. But market conventions rooted in imagination can dissolve rapidly, prices become unhooked and volatile, and market liquidity totally evaporate at times of stress. At no time is there any guarantee that prices will reflect some true and unique underlying real reality — as the mainstream view with its ‘efficient market theory’ of finance suggests. Asset market play is self-referential; asset prices restless and prone to excess volatility, bubbles and crashes; liquidity and leverage disposed to sponsor mania and fragility - as the experienced global financial market player John Maynard Keynes understood all too well (Minsky 2008, Carvalho 2016).

Financial conditions as determined by the financial system together with entrepreneurs’ expected rates of return on potential projects (‘marginal efficiencies of capital’) determine the demand prices for capital goods, while the economy’s cost structure (wages etc.) determine their respective supply prices. The production of capital goods ceases at the point at which their demand prices drop below their supply prices.There is no guarantee that by some law of nature this point will be at full employment.The financial system, determining the terms on which money is made available to the economy, can err in its allocative role, sponsoring wasteful activities. Under monetary policy guidance and regulated to some degree, it can also go astray regarding macro stability, and usher deep economic crises.

Under globalised finance the portfolio equilibrium condition depicted above will be a worldwide structure of asset prices expressed in some common standard of value. For reasons that will be elaborated upon below, the U.S. dollar has served in that role since World War II, with the U.S. Federal Reserve (Fed) setting the anchor rate for global finance and the floor below which the own rates of interest on other assets cannot decline, globally (Ocampo 2001, Terzi 2006).

In principle, national central banks may set their policy rates at different levels. But they will now all be seen by the markets with reference to the U.S. dollar anchor. Unless exchange rates are stabilised by the authorities, their expected rates of appreciation or depreciation will be part of the д-terms of assets denominated in some national currency. Different national monies may carry different and time-varying liquidity premiums in the judgement of global market players, depending on the perceived relative potential convenience or security based on their respective power of disposal.

The current regime of globalised finance and U.S. dollar hegemony contrasts starkly with Keynes’ envisioned ideal post-war global monetary order - which we will briefly revisit in the next section.

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