Households’ Liquidity Preference, Banks’ Capitalization and the Macroeconomy: A Theoretical Investigation

ABSTRACT

In this paper, we build a simple model on the role of households’ liquidity preference in the determination of economic performance. We postulate, for the sake of the argument, a purely ‘horizontalist’ environment, i.e., a world of endogenous money where the central bank is able to fix the interest rate(s) at a level of its own willing. We show that even in such a framework liquidity preference, while obviously not constituting anymore a theory for the determination of the interest rate, continues to be a key element for the determination of both the level and evolution over time of aggregate income and capital accumulation. In our model, this happens because of the working of a mechanism so far unexplored in the literature, i.e., the endogenous variations of banks’ policy of profits’ distribution in response to changes in the liquidity preference of the public.

KEYWORDS:

• Liquidity preference
• endogenous money
• finance dominance

JEL CODES:

• B26
• B50
• E12
• E44

Acknowledgements

Thanks to two anonymous referees for their extremely useful comments and suggestions. Remaining errors are our own responsibility.

Disclosure Statement

No potential conflict of interest was reported by the author(s).

Notes

1 In this paper, we obviously refer to the Keynesian view of unconventional monetary policies (see Kregel 2014; Lavoie 2016; Lavoie and Fiebiger 2018), according to which central banks’ asset purchases aim at controlling interest rates, long-term ones in particular, and possibly lowering them to minimum levels. This view is perfectly consistent with the theory of endogenous money that, by rejecting the mainstream money multiplier, clearly explains the irrelevance of quantitative easing itself in stimulating banks’ credit via its effects on banks’ reserves (Rochon 2016; Lavoie and Fiebiger 2018).

2 In this paper, we don’t employ the expression ‘long run’ in association with the steady state equilibrium of the system. The reason is that labor productivity (technology) and population (labor force) are taken as fixed. The time horizon we take into consideration is not ‘long’ enough to allow these magnitudes to vary.

3 Tily (2006), for instance, makes reference to Victoria Chick’s studies and notes that ‘[bastard] Keynesian liquidity preference function is wrongly derived as a portfolio choice in the face of risk rather than a precautionary and speculative behavior in the face of uncertainty [… .and that it] has detracted from the fact that Keynes’ schedule is a demand schedule that shifts according to the ‘mass psychology’ of the public’ (Tily 2006, p. 661).

4 Of course, the real effects of liquidity preference variations would be permanent in a model with growth hysteresis. However, this would be true for any possible shock.

5 This terminology is due to Palley (2017).

6 This ‘early’ horizontalist perspective is also incorporated in a post-Keynesian model proposed by Fontana and Setterfield (2009), in an attempt at building a teachable post-Keynesian model to be contrasted with the 3-equation model of the new-Keynesians and the more traditional IS-LM scheme.

7 Before Lavoie (1996), see also Townsend (1937) and Chang, Hamberg, and Hirata (1983) as contributions discussing liquidity preference as relevant factor for the determination of interest rates’ spreads over assets with different maturity.

8 In our model, the central bank behaves passively by adjusting its holding of corporate bonds (which is what some central banks did during the pandemic crisis). In a more complete model with a Treasury (see for instance Godley and Lavoie (2007), chapter 5), the central bank would also adjust its holding of government securities. In both cases, this is done to maintain full control of the interest rate(s).

9 In a recent debate, Lavoie and Zezza (2020) on the one hand, and Sardoni (2020) on the other, while partially disagreeing on the relation between savings, investment and interest rate(s), agree on explaining the macroeconomic role of liquidity preference with its effects on the interest rate on corporate bonds.

10 According to Basel III agreement, this applies to the TIER 1 component of banks’ own funds, which is set to be equal to 4.5 per cent of banks’ risk-weighted portfolios.

11 See Bundesbank’s definition of banks’ own funds at https://www.bundesbank.de/en/tasks/banking-supervision/individual-aspects/own-funds-requirements/own-funds/own-funds-622952.

12 The scheme proposed in Table 1 is essentially the same as the balance sheet in Godley and Lavoie (2007), chapter 11. In our case, however, commercial banks and the central bank are consolidated, and therefore we do not see commercial banks’ reserves held at the central bank. To avoid any misunderstanding, it is worth stressing that commercial banks’ own funds and reserves are two completely different things. The former are commercial banks’ ‘perpetual’ debts towards their owners that constitute banks’ passive liquid buffer against losses and risks. The latter are commercial banks credits towards the central bank and are constantly mobilised in banks’ daily operations.

13 Carlin and Soskice (2014) argue that the mark-up lowers with higher own funds because commercial banks are better equipped to deal with riskier loans, expand their credit supply and the lending rate falls. Mark-ups and lending rates might also be affected by people liquidity preference and/or central bank’s open market operations. Let us assume people (money managers) and/or the central bank want to increase the share of bonds in their portfolios. Ceteris paribus, this will lower the return on bonds and induce commercial banks to hold less of them and expand their credit supply to the private economy. Once again, the lending rate (mark-up on the policy rate) would fall too.

14 This is clearly a radical Keynes’ departure from the Keynes of the General Theory, where – as Le Heron (2020, p. 144) reminds us – the view of an exogenous short-term rate of interest was already there, but the long-term rate of interest was said to be a highly psychological phenomenon’, a magnitude ‘more recalcitrant’ to be controlled by monetary authorities.

15 Of course, Kaldor does not ‘coincide’ exclusively with the view expressed in the 1985-quoted-text above. Yet, that view is, say, a ‘strong’ one and may justify the use of such simplifying label.

16 Following Palley (2013b), if we look at the US economy, the shares of total financial profits over GDP and non-financial profits have significantly increased since the 1970s. In the years just before the outbreak of the last financial crisis, they accounted for almost 4 percent of US GDP and 44 percent of non-financial profits. If we look at commercial banks only, commercial banks’ profits suddenly returned to represent about 15 percent of non-financial profits from 2010 to 2014 after the considerable decline experienced in 2008 and 2009 (see Lapavitsas and Mendieta-Munoz 2017). According to data from the Federal Reserve Bank of St. Louis, commercial banks’ net income accounted for 0.61 percent of US GDP, on average, from 1984 to 2019. This implies that commercial banks’ retained profits could stand up to half percentage point of US GDP, a non-negligible amount indeed. See https://fred.stlouisfed.org/series/USNINC#0.

17 Next-to-come Basel IV will tighten such rules even further by introducing the so-called ‘output floor’. This is a minimum level of banks’ own funds that banks will have to hold in proportion of their assets once these are weighted according to external standardized risk assessment criteria rather than ‘discretional’, internal ones. Available estimates suggest that most banks will have to raise their own funds (Schneider et al. 2017).

18 The argument we are going to develop holds regardless of the specific value taken by $\eta$. In particular, the following results are valid even when $\eta =0$.

19 Our analysis mainly refers to commercial banks. Nonetheless, it can be equally extended to other types of credit institutions such as cooperative banks and credit unions. Following McKillop et al. (2020), for instance, in most European countries also cooperative banks are subjected to Basel III regulation as they are systematically relevant’ financial institutions. And when cooperative banks are small players that offer a narrow range of products and benefit of simplified rules, such simplifications are often compensated by higher capital requirements.

20 Adrian and Shin (2009), for instance, noted that in the immediate aftermath of the 2007–2008 financial shock, commercial banks’ lending partially compensated for the dry-up of credit via market-based intermediaries.

21 Once again, this is not just a matter of complying with bank regulations. Banks are very peculiar corporations; they are also rentiers: they adjust own funds to go on making money out of thin air, exactly in the same way as a landlord that from time to time must spend some money to keep her plot of land in decent conditions to be able to go on renting it out. The privilege of making money out of thin air has a price.