On the nature and role of financial systems in Keynes’s entrepreneurial economies

ABSTRACT

In his debate with Bertil Ohlin, Keynes observed that entrepreneurs, when deciding to invest, have to be sure they will access the amount of finance necessary to initiate the investment process and that they will be able, when the time comes, to fund their debts in ways that are adequate to the profile of assets they are purchasing. In this statement, Keynes outlines the functions of financial systems in Entrepreneurial Economies, the type of economies he hypothesizes we live in. In entrepreneurial economies, investing firms have to be able to get hold of the necessary amount of means of payment required to purchase or order investment goods and to build balance sheets where in- and outflows of cash are broadly matched within reasonable margins of safety. This means that financial systems’ primary role in Keynesian economics is not to allocate savings or capital but to allocate liquidity and to allow investors to build liquid balance sheets. The article develops this proposition, presenting Keynes's basic concepts on the matter and showing how modern financial systems perform their role.

KEYWORDS:

• Entrepreneurial economies
• financial systems
• Keynes's economics
• liquidity preference

JEL CLASSIFICATIONS::

• E02
• E12
• E44

Notes

¹It was, of course, the dominance of the NCS among macroeconomists for many years that allowed Milton Friedman later to lead the monetarist counterrevolution with the motto “Money Matters!”.

²Keynes's side of the debate is reproduced in volume 14 of his Collected Writings. Ohlin's contributions were published in the March, June, and September 1937 issues of the Economic Journal.

³The Stockholm School included Scandinavian economists who modernized Wicksell's theories, such as, notably, Erik Lindahl, Gunnar Myrdal, and Bertil Ohlin.

⁴Two examples should suffice to illustrate the point. Blinder (1989) contained a chapter intended to “take issue with some fashionable views of why money has real effects, and to suggest a new theory, or rather resurrect an old one—the loanable funds theory” (p. 17). Stiglitz and Greenwald (2003) state “the theory that we develop can be thought of as a generalization of the loanable funds theory” (p. 45). In both cases, the authors were advancing what they judged to be the ‘Keynesian’ view.

⁵“Classical” in the sense used by Keynes in the GT.

⁶Gurley and Shaw's surplus and deficit units are not the same thing as savers and investors because the value of savings that is spent on investment by savers themselves is included in the amount of savings but is not included in Gurley and Shaw's surplus. Surplus and deficits are defined in terms of external resources, that is, of what remains after surplus units spend in consumption and investment, and deficit units need to spend in consumption and investment.

⁷Keynes tried unsuccessfully to work with the difference between actual and expected incomes in the Treatise by considering the possibility of windfall profits and losses. The point may seem trivial at first sight, but it relates to a larger concern, how to deal with expectations and, even trickier, how to deal with disappointed expectations.

⁸“Now, ex-ante investment is an important, genuine phenomenon, inasmuch as decisions have to be taken and credit or ‘finance’ provided well in advance of the actual process of investment; though the amount of the preliminary credit demanded is not necessarily equal to the amount of investment which is projected. There is, however, no such necessity for individuals to decide, contemporaneously with the investment-decisions of the entrepreneurs, how much of their future income they are going to save. To begin with, they do not know what their incomes are going to be, especially if they arise out of profit. But even if they form some preliminary opinion on the matter, in the first place they are under no necessity to make a definite decision (as the investors have to do), in the second place they do not make it at the same time, and in the third place they most undoubtedly do not, as a rule, deplete their existing cash well ahead of their receiving the incomes out of which they propose to save, so as to oblige the investors with ‘finance’ at the date when the latter require to be arranging it. Finally, even if they were prepared to borrow against their prospective savings, additional cash could not become available in this way except as a result of a change of banking policy. Surely nothing is more certain than that the credit or ‘finance’ required by ex-ante investment is not mainly supplied by ex-ante saving” (Keynes, 1937b, pp. 663–664).

⁹Keynes certainly did not convince Robertson, who saw in the demand for finance “a far longer stride back than he yet realizes towards the orthodox view” (Robertson, 1988, p. 12). Hicks, in his famous 1937 article, “Mr Keynes and the Classics,” had already concluded that Keynes had taken “a big step back to Marshallian orthodoxy” with the simple recognition of the role of money as a means of payment (Hicks, 1967, p. 134). Robertson and Hicks apparently shared the same view, that “Mr Keynes was so taken up with the fact that people sometimes acquire money in order to hold it that he had apparently all but entirely forgotten the more familiar fact that they often acquire it in order to use it” (Robertson, 1988, p. 12).

¹⁰Keynes made the distinction between the finance motive and “the demand for active balances which will arise as a result of the investment activity whilst it is going on,” which is precisely the increase in the transactions demand for money induced by the investment activity.

¹¹One should note that using the velocity of circulation in this sense does not imply giving any causative influence to this variable. It is an index describing a certain pattern of motion, not necessarily an explanatory variable.

¹²The role of the interest rate in Keynes's view is precisely to change prices of nonmonetary assets, that is, interest rates, to make the demand for money equal to the supply of money: “The function of the rate of interest is to modify the money-prices of other capital assets in such a way as to equalise the attraction of holding them and of holding cash” (Keynes, 1937a, p. 250).

¹³Keynes's inability to stick to his own labeling may have helped to confuse Ohlin and others. At one point in the debate, Keynes used the term credit to mean the demand for money: “In what follows I use the term “finance” to mean the credit required in the interval between planning and execution” (Keynes, 1937b, p. 664n1, emphasis added). In the same article, Keynes distinguishes between finance and funding needs as satisfied by “the markets for new short-term loans and for new long-term issues” (ibid.). In other points, Keynes seems to conflate both meanings of finance as in: “For ‘finance’ constitutes, as we have seen, an additional demand for liquid cash in exchange for a deferred claim. It is, in the literal sense, a demand for money” (Keynes, 1937a, p. 248). In this statement we have finance in the meanings of both demand for money and issuance of debt.

¹⁴“Occasionally he may be in a position to use his own resources or to make his long-term issue at once; but this makes no difference to the amount of ‘finance’ which has to be found by the market as a whole, but only to the channel through which it reaches the entrepreneur and to the probability that some part of it may be found by the release of cash on the part of himself or the rest of the public” (Keynes, 1937b, p. 664).

¹⁵One could think, however, that this impact on interest rates could be avoided or minimized by having these securities absorbed by financial institutions financing their purchases with deposits created by banks.

¹⁶Why would borrowing from banks not push the interest rate up? Kregel (1992) argues, based on some of Keynes's early writings on bank behavior, that banks would use inactive deposits, deposits held temporarily by income earners before a final decision is made whether to buy consumption goods or assets. Banks would see an opportunity to transform these temporarily inactive deposits into active balances by lending them to satisfy short-term borrowers. The interest rate would not rise because the opportunity cost of these deposits for banks would be zero.

¹⁷The use of the expression revolving fund of finance by Keynes added to the already deep misunderstanding that characterized his exchange with Ohlin (see Keynes, 1937b, p. 666). Since Ohlin (and Robertson) understood finance to mean borrowing from banks, the idea of a revolving fund of finance being replenished by the mere act of spending seemed absurd since debts created by borrowing would only be extinguished when those debts were liquidated. If one thinks of resources available to make loans, banks could not make new loans until the first borrower had settled the debts incurred with them. But Keynes was actually talking about money circulation. One takes money out of circulation to hold until a purchase is made and money comes back into active circulation. This works as if it were a revolving fund of finance, but it is not itself a revolving fund. If one remembers the meaning of finance in Keynes's works, the statement is simple, almost trivial. If one takes finance to mean borrowing, it is certainly impossible to see how anybody could make such silly mistake as the one attributed to Keynes. In fact, only the disbelief that Keynes could have made a mistake like that can explain Asimakopulos's attempt to explain the operation of a revolving fund of credit (not of finance in Keynes's sense) through special assumptions about the consumption multiplier (see Asimakopulos [1983, 1986], Kregel [1986], and Davidson [1986]). Keynes proposed an analogy to clarify his argument, but ended up muddling even further the already difficult dialogue he was sustaining with Ohlin.

¹⁸The frequent use of the expression credit-money by some Keynesian economists in this context, something one does not find in Keynes's works anyway, may also add to the confusion by stressing the credit-generating aspect of the operation of the finance demand rather than the monetary circulation aspect. It is the lack of liquidity that worried Keynes because in a monetary economy it is money that is required to purchase goods, not savings or credit. Extending credit is one way to satisfy the demand for money but it is not the only one, even if it is the more important. The problem at this point is not debt creation (and the related issues of solvency, cash in- and outflows, etc.) but money creation so that the demand for money to hold in advance of investment expenditures does not generate pressures on the existing pool of liquidity that would cause interest rates to rise.

¹⁹“The fundamental speculative decision of a capitalist economy centers around how much, of the anticipated cash flow from normal operations, a firm, household, or financial institution pledges for the payment of interest and principal on liabilities” (Minsky, 1975, pp. 86–87).

²⁰Minsky's well-known taxonomy of portfolio profiles where he distinguishes between hedgers, speculators and Ponzi investors is an attempt to typify funding strategies.

²¹“In a world with borrowing and lending, it is sensible for anyone or any organization with payment commitments to keep some money—the item in which its commitments are denominated—on hand as an insurance policy against unfavorable contingencies …. The ability of an asset to yield cash when needed and with slight variation in the amount is called its liquidity” (Minsky, 1986, p. 180). The relationship between money contracts and money is, of course, the cornerstone of Davidson's interpretation of Keynes's theory. See Davidson (1978).

²²“The margins of safety can be identified by the payment commitments on liabilities relative to cash receipts, the net worth or equity relative to indebtedness (the margin of stock market purchases), and the ratio of liabilities to cash and liquid assets, that is, the ratio of payment commitments to assets that are superfluous to operations. The size of the margins of safety determines whether a financial structure is fragile or robust and in turn reflects the ability of units to absorb shortfalls of cash receipts without triggering a debt deflation (Minsky, 1986, pp. 79–80).

²³This is similar to what is called funding liquidity by Brunnermeier and Pedersen (2009).

²⁴It may happen, for instance, that in highly inflationary economies lenders prefer to accept inflation-proof assets instead of more liquid alternatives that would provide weaker protection against rising prices.

²⁵I am using the expression “excess” savings to mean savings that are not used by the saver himself to fund his own investments, in accordance with the definition of surplus proposed by Gurley and Shaw (1955) explained before.

²⁶“The ultimately liquid assets of an economy consist of those assets whose nominal value is independent of the functioning of the economy. For an enterprise economy, the ultimately liquid assets consist of the domestically owned government debt outside government funds, Treasury currency, and specie” (Minsky, 1982, p. 9).

²⁷We are tangentially touching here a very important question for Keynesian economists, that is, the meaning and degree of endogeneity of money in entrepreneurial economies. This subject has long divided Keynesian, and even post Keynesian, economists, opposing so-called horizontalists, who propose that the money supply is fully endogenous, resulting in a horizontal money supply curve in the interest rate/money quantity space, and the “liquidity preference group,” for lack of a better term, which includes this author. One cannot explore the question in this article, other than suggesting that while horizontalists usually emphasize constraints on the action of central banks, the liquidity preference group tends to emphasize bank behavior. A more extended discussion of this point may be found in Cardim de Carvalho (2015, chap. 4).

²⁸If idiosyncratic elements cannot be canceled out or eliminated, a financial intermediary may not be able to perform this function and alternative ways to fund the investment may have to be found, such as, in some cases, having public entities perform the intermediation. In some of these cases, the development of the derivatives market, particularly through over-the-counter contracts, offered another solution.

²⁹Kaldor's reference to “perfect” markets is somewhat unfortunate because it suggests that “complete” markets and an efficient auctioneer are the answers one needs to deal with illiquidity problems. Many financial deregulation initiatives were actually justified on these grounds. Nothing would be lost if the analogy to “perfect” markets of Walrasian microeconomics was dropped and secondary markets were analyzed exclusively in terms of material and institutional characteristics.

³⁰As Jan Kregel reminds me, market makers, on the other hand, often operate with funds provided by the banking system, exemplifying a peculiarity of the financial sector in comparison with other sectors of the economy: the interrelationship of its participants.

³¹Not even legal tender itself is intrinsically liquid, as one can learn from hyperinflationary situations where sellers tend to prefer to suffer eventual legal penalties to selling goods in exchange for an instantaneously depreciating currency.

Additional information

Notes on contributors

Fernando J. Cardim de Carvalho

Fernando J. Cardim de Carvalho is a senior research scholar, Levy Economics Institute of Bard College and emeritus professor of economics at the Institute of Economics, Federal University of Rio de Janeiro (Brazil). The author thanks, without implicating, Jan Kregel for his observations on an earlier version of the article and an anonymous referee. Financial support from the National Research Council (CNPq) is gratefully acknowledged.