Financial Economy

Evolutions at the Edge of Crises

Smita Roy Trivedi, Sutanu Bhattacharya

• Publisher: Routledge India
• Year: 2018
• ISBN:
  9781351233217
• Edition: 1
• Topic: Économie
• Subtopic: Macroéconomie

This book examines how contemporary financial economy evolved as the predominant economic system, and why unabated accumulation of financial capital takes place in such systems. It reviews the mechanics of accumulation of wealth by tracing the historical roots of financial capital. Traversing the evolutions of capitalist systems since the 1850s till recent times, Financial Economy provides a lucid and logical explanation of the phenomenon. It uses a new methodology based on economic circuit of stocks and flows following the early ideas of the French economists of the 18th century and the contemporary Circuit school. It provides an alternative framework for studying economic systems design, keeping aside the orthodox neoclassical analysis of equilibrium market exchange. Further, it highlights the global financial circuit, the state of the current digitalised economy with electronic money transfers, consumer's decision-making and expected future earnings, and questions the relevance of some fundamental concepts of economics as well as economic policies. Using a notion of sequential economy, it also shows how present economic activities are treading upon the future.

This book will interest students and researchers of advanced macroeconomics, political economy, heterodox economics, economic history, and evolutionary economics. The historical account of the evolutions of capital, interest, and corporate structures will also be of interest to general readers.

1 Introduction

The principal aim of this book is to examine how the contemporary financial economy evolved as the predominant economic system, and why unabated accumulation of financial capital takes place in it. The book intends to explain the mechanics of accumulation of financial capital in economic systems by tracing out the historical roots of financial evolutions at the edge of crises. The secondary aim is, keeping aside the orthodox neoclassical analysis of equilibrium market exchange, to bring into focus an alternative framework for studying economic systems designs in terms of economic stocks and flows, following the circuit analysis of the French physiocrats. In a nutshell, the objective of this study is threefold – tracing out the evolutions of capitalism through crises in the historical contexts, developing for this an alternative methodology of economic circuits, and establishing logically the accumulation of wealth as a systemic phenomenon in capitalist systems.

The rationale behind this book could be seen in the context of the historical crises and the turning points of the capitalist economy. The economic scenario in the last few decades has seen sweeping changes in the financial sector. The investments and production capital in the real sector is stagnating, but a continued growth of financial capital has been taking place almost in the form of an explosion. Another paradoxical feature is that alongside this phenomenal growth in financial assets and increasing dominance of the financial sector, we see recurrence of financial crises in the system.

There are several other paradoxical features of contemporary economic growth, like the service sector growth paradox, productivity paradox, which remain unexplained in the conventional analytical framework of economics. A striking fact is that never in the recorded economic history before the industrial revolution has such high economic growth and accumulation of wealth alongside widening inequality been seen. The huge financial wealth of the top global corporations and high net worth individuals (HNIs) has now dwarfed many national economies. In a recent study, Piketty has highlighted the growing accumulation and concentration of wealth and inequality as global phenomena. Analysing a large volume of data he has sketched out the evolution of inequality since the beginning of the industrial revolution in Western European society (Piketty 2014). Our question, vis-à-vis Piketty’s study, is how to give a logical explanation for this statistical phenomenon.

In this context, an ‘inquiry into the nature and causes of the wealth’ creation in economic systems needs a review. But how do we make this review? Neoclassical economics does not provide a satisfactory framework for understanding the creation and accumulation of wealth in economic systems as it is beyond the scope of the equilibrium market exchange framework. The circuit approach of studying economic systems in terms of economic stocks and flows, as developed in this book, gives an alternative methodology for probing the structural foundation of economic systems and seeing how wealth and debt in various forms of stocks can accumulate through various circuit flows.

The central theme of the book is tracing out the evolutionary stages of Western capitalism. We mark three stages of evolution. First, we see the nascent stage with corporate industrial production in the West after the industrial revolution (1850–1930) with some scant replications of corporate production systems in the colonies. Second is the matured stage of the corporate production economy of the West with creditisation of money (1945–70). At this stage, corporate production systems also evolved in other national economies, especially in the newly independent developing countries. The final stage we mark as the current stage of financialisation and globalisation since the 1990s, now creating a single global economic circuit.

We must mention that the evolutions which we are considering here are the organisational evolutions that emerge out of the necessity created by the crises in economic systems. The source of the crises is the continuous accumulation of financial capital in the systems. This view of organisational evolution is clearly in contrast with what Marx pointed out as ‘forces of production’, what Weber pointed out as the ‘protestant ethics and the spirits’ of capitalism, and what Schumpeter tried to highlight as technological ‘innovations’. Our focus is on the organisation of capitalism, which evolved in the West and established its global supremacy. We call this organisation an economic circuit. The continuous accumulation of financial capital in economic circuit causes crises and leads to its subsequent organisational evolutions.

The central point in this evolutionary process is what the current theory of monetary circuit calls the ‘paradox of profits’. Profits generate through buying cheaper and selling dearer. This is evident in all trading activities, whether on goods or on financial commodities that we see in recent times. In industrial production activities, this simple fact got somewhat camouflaged in what the classical and neoclassical economics call value addition by the manufacturing process. But the fact remains – money to be received through sale of the goods produced must be more than the money paid out as its cost of production. A justification for this may be given as ‘value addition’, but in effect it is also buying cheaper and selling dearer.

The paradox of profits is quite simple. Profits could be realised by one individual in a process of buying cheaper and selling dearer, but there would be an equal amount of loss to those who sold cheaper or bought dearer. Therefore, in an economy as a whole, aggregating the gains or losses of all individuals, there are no profits. Yet, profits are not only the facts of reality, but also reflect accumulated wealth in economic systems. How do we then resolve this riddle?

Economic studies have lived with many paradoxes. We begin with a brief look at some of the paradoxical phenomena in our present economic landscape. From the narration of these paradoxes in Chapter 2 we get a clue – possibly the continuous accumulation of financial capital in economic systems could be a key factor behind these apparently paradoxical phenomena. This leads to a deeper question – how financial capital evolves and accumulates in economic systems? In Chapter 3 we probe the historical roots of the evolution of financial capital, as distinct from physical (production) capital. At the foundation of our analysis we need conceptual clarity in using these two terms. We make an attempt to trace out the evolution of the concepts and connotations of the term ‘capital’ in economic literature with reference to the ideas of financial and physical capital. Without a clear demarcation between physical capital as a means of production and financial capital as financial resources, the concept of capital remains elusive.

Traditionally, classical and neoclassical economic studies have considered capital in its physical dimensions only – the capital goods as the produced means of production. Only recently financial capital as a separate entity has come into focus in the studies of financial economics. However, the concept of financial capital is still somewhat amorphous, without a clear definition demarking as well as relating it with production capital in an overall analytical framework.

Intertwined with the evolution of capital as a monetary fund, interest on money evolved as another key economic entity. However, its legitimisation as an economic phenomenon took some time and so, in the early economic literature, the concepts of capital and interest were used in various contexts with varied connotations. In Chapter 4 we trace out the advent of the phenomenon of interest in human history, its evolutions in different forms and, later on, the recognition of money interest in economic literature. The implications of interest rate are of fundamental importance in this study. It links the future with the present, presuming an everlasting growth in the future over the present, without which a positive interest rate cannot be sustained. Therefore, it gives a way of discounting the future to the present, and thus acts as an instrument of creating financial claims in the present, treading upon the future. Further, by our economic construct, firms charge, on one hand, interest on the debt finance and, on the other, depreciations on the physical assets created out of it. The dynamic implications of this economic construct of charging twice for capital (in two forms) for the economy in aggregate have not been examined in economic studies. Yet, it is a clear source of accumulation of financial capital by the firms and thereby creating a mismatch in the longer run between the further debt financing required by the firms for physical capital and the finance that would be available with the banks through repayments of loans with interest by the firms.

Accumulation of financial capital as a stock can only be traced out properly in terms of stock-flow relations in economic systems. Unfortunately, this cannot be done with the aid of the neoclassical methodological framework of equilibrium market exchange. In Chapter 5 we point out why neoclassical economics disappoint us in this respect and propose an alternative methodology of circuit theory of viewing economic systems in terms of economic flows and stocks. As the background of this circuit methodology we trace out its historical roots in the French physiocrats’ circuit formulations, and then in its recent revival in the theory of monetary circuit. The current theory of monetary circuit reveals an important fact – there cannot be monetary profits within a closed economic circuit. The circuit theorists mark this as the ‘paradox of profit’ and have tried to resolve this paradox in many ways. However, that money profit cannot arise in a closed circuit is the theoretical underpinning of our study – an economic circuit must earn monetary profits through monetary flows from outside and for that matter it must be an open circuit. So here, we construct not a pure closed monetary circuit, but an open economic circuit with flows of production, trade, and finance, as well as creation of their corresponding stocks. We must mention that in this circuit methodology we consider the actual flows and stocks of economic entities. The neoclassical abstract concepts of demand and supply reflecting the desires, say consumption demand or investment demand, of the economic agents do not fit into the circuit methodology.

Using the circuit approach of stock-flow relations we examine the evolution and operation of the corporate economic circuit and its accumulation of financial capital in three stages of evolution – the nascent corporate production circuit in the West (1850–1930); the matured corporate production circuit of the West (1945–70) with similar circuits operating in the national economies of the developing world; and then a single global corporate financial circuit now shaping since the 1990s. We discuss the circuit operations and implications as well as the crises leading to the next turn of evolution in these three phases in Chapters 6 through 9.

The nascent corporate production circuit began in Western Europe in the 1850s. This is marked as the beginning of the ‘Age of Capital’ (Hobsbawm 1975). In Chapter 6 we give briefly a historical account of the organisational evolution of company as a business entity – from the earlier joint stock companies to the formation of limited liability companies. Then we develop the chart of the nascent economic circuit with corporate production and discuss its operations through the flows and the creations of stocks. The circuit operated with the Gold Standard money and achieved its golden era of realising money profit and accumulation of financial capital through colonial trade with the rest of the world. But soon it reached its limits. The Gold Standard money that ensured a ‘golden era’ turned into the ‘golden fetters’, as Keynes had famously expressed it, and came the crisis of the 1930s. Facing this crisis, the corporate production circuit needed an organisational evolution.

Before going into discussing the next stage of evolution, in Chapter 7 we have made some detailed analysis of the operations of economic circuit at the nascent stage with the help of its rudimentary formulations. The sectoral accounts of the flows and the formation of the stocks in the balance sheets are presented here. Since the rudimentary production circuit remains at the foundation of capitalist economic systems, the internal dynamics and economic growth (endogenous and exogenous) of the rudimentary economic circuit are examined here at some length.

The organisational evolution that became a necessity to remove the ‘golden fetters’ and to recover from the depression of the 1930s took place in the next stage. This organisational evolution was reflected in three forms – institution of central banks and endogenous credit money creation by banks; government fiscal systems incorporating Keynesianism; and Bretton Woods arrangements of international monetary systems. In Chapter 8 we begin with a brief account of these institutional changes in the mid-1940s as the background of the organisational evolution of the matured corporate production circuit in the West. This economic circuit was replicated also in the developing countries. So we had several country-specific circuits at this stage. However, it was the economic circuit of the developed West that attained maturity. We have examined here the chart and the operations of economic circuits with credit money and foreign trade with the rest of the world. The matured corporate industrial production economy of the West continued to grow through its net exports to the rest of the world with the consequent incidence of growing balance of payment and fiscal deficits there. For the developed economies of the West, the period 1945–65 was the golden period of economic growth with apparently unhindered accumulation of financial capital through creditisation and trade. However, it did not last long. Another crisis was again brewing since the early 1970s with stagnating demand in the real sector and declining labour productivity. We conclude this chapter with analysing the cause of this new crisis and the consequent necessity for another organisational evolution.

However, this organisational evolution did not come easily. During the period 1970–90, the world economic systems were in some turmoil. Afterwards, the organisational evolutions of this stage came to adapt to the information and communication technology (ICT) revolution that started in the mid-1980s. The ICT revolution neither generated from within the economic systems nor should be interpreted simply as innovations in production technology to be reflected in raising productivity. We discuss in Chapter 2 that some economic studies have tried empirically to find its reflections in productivity and got paradoxical results, known as the Solow paradox (Triplett 1999).

The ICT revolution has created a new environment for business. It has made possible, on one hand, instantaneous financial transactions or virtual money flow through account or claim transfers across the world and, on the other hand, globalisation of economic activities through business process outsourcing. Thus, it has given birth to a global financial web. To adapt to this change, the earlier economic circuits with corporate production of goods and services have undergone a complex organisational evolution. Now a single global economic circuit has emerged, in place of the earlier country-centric economic circuits.

In Chapter 9 we examine the operation and implications of the global economic circuit. The organisational evolutions at its background are quite complex – there is now a new generation of financial commodities like derivatives and structured securities created by financial architecture; the process of securitisation creating special purpose vehicles (SPVs); new financial markets – future and option trading exchanges – and their regulatory bodies; new entities like hedge funds, private equity funds, or foreign institutional investments; and corporations and conglomerates dealing in diversified financials, their global networks, and their operations through the corporate havens. Besides these, we see changes in the role of the banks and governments and the coming legislation of new rules and regulations for companies and banking, as well as changes in government tax and subsidy polices. There are also changes in the business accounting norms and practices, like allowing marking to market of the financial assets and off-balance sheet transactions. A reasonable discussion on all these would require almost a book. We therefore keep a brief discussion on some of these aspects in the Appendix, so as not to lose sight of the forest for the trees.

We begin Chapter 9 with a discussion on leveraging as an important operational aspect of the financial economy and then present the chart of the global economic circuit combining the real and financial circuits as the final stage of evolution in our study. We mention, first, that the global circuit is now a single economic circuit which is engulfing the earlier country-specific circuits. This is the essence of economic globalisation. Within the global circuit the earlier paradigms of country-specific concerns – like foreign and domestic countries and their interdependent production and trade structures, outsourcing by one country to another and its implications for them, etc. – really do not make much sense any longer, although these are traditionally some important areas of economic studies. However, these issues exist as globalisation is not complete yet. The global circuit has not yet engulfed the entire world of economic activities. There are still some local economic activities with financial transactions and savings which are not directly linked to the global circuit. So the global circuit still has an avenue to expand by linking these activities through financialisation. We see its reflections in the financialisations that are now taking place in the developing countries, particularly in the so-called emerging ones. In this context we have examined and kept in the Appendix a note on financialisation in the Indian economy as reflected in growing rentier income shares in India’s gross domestic product (GDP).

The second aspect of the global circuit is of particular significance. Within itself the global circuit appears to be a closed single circuit. It may be seen in the chart that we have kept no link to outside the circuit. Therefore, as happens in all closed economic circuits, there should be the paradox of profits, since every gain must be accompanied by an equal amount of loss within the circuit. Nevertheless, we make an important point here that the global financial circuit, although a single one, is not a closed circuit. It has its opening to the future, now created by securitisation, through which it treads upon the future economic activities and brings them to the present for inflating the current financial transactions and profits. This is, in fact, leveraging banked upon debt financing. In all debts the debtors bear the liability to be met in the future, which are the claims of the creditors on the future. In other words, debts mean the debtors have sold their future to the creditors. In addition, by securitisation of financial assets as the store of such claims, the creditors get the opportunity to give further loans and thereby leverage their claims on the future.

It may sound unacceptable if we say that in the financial economy it is now the future that determines the present. Our common understanding is the other way around – from our present activities emerges the future. But the financial economy has reversed it. When the future is expected to grow, one can take loans to be repaid in the future out of the growing earnings and use it in inflating the consumption or investment activities at present.

We have examined the operational implications of the global economic circuit. The most important ones are: the growing concentration of wealth and income of giant corporations and HNIs; rising capital intensity in spite of growing unemployment; stagnating growth of production in the real sector and shifting production towards high-end products shrinking the production of wage goods or basic items of consumption; and, above all, the growing indebtedness of the governments and the households (excluding HNIs).

Because of the nature of its economic construct it is inevitable that the global economic circuit can now operate only through accumulation of the corporate sector’s and HNIs’ wealth or net worth on one hand and the matching accumulation of government and household net debts on the other. We have commented that, theoretically, if it were possible to calculate and construct a balance sheet of the global financial economy, the four stocks would have been balanced – the net government debt and household debts (excluding HNIs) as liabilities and the net worth of the corporate sector and the HNIs as assets.

How long can these assets and liabilities keep on ac...

Table of contents

• Cover
• Title
• Copyright
• Contents
• List of figures
• List of tables
• Preface
• List of abbreviations
• 1 Introduction
• 2 Paradoxes of crisis and growth: the landscape
• 3 The twin concepts of capital: historical roots
• 4 Financial breeding: legitimisation of interest on money
• 5 Critique of neoclassical economics and revival of the idea of circuit analysis
• 6 The circuit construct: nascent corporate production economy
• 7 Rudimentary formulation of the circuit
• 8 Matured corporate accumulation: the creditisation phase
• 9 The financial circuit: leveraging the growth
• 10 Concluding note: the present as the future
• Appendix: Notes on some financial aspects
• Bibliography
• Index