The of Shadow Banking

Eloy Fisher PhD Candidate at The New School

October 7, 2013

Abstract

This paper presents a theoretical overview of the political econ- omy behind shadow banking. Neither new or original, what is modern in shadow banking are its broader institutional implications and how it bore witness to the dramatic changes experienced by global capi- talism in the last century. Intimately tied to the political economy of capitalist dynamics, shadow banking is nested in the discontinu- ous distributive tension between workers and firms. These politics are a wedge in the operation of the shadow financial system, as govern- ment policy internalizes, guides and participates in dealings mediated by financial intermediaries. This government agency (especially in spending and borrowing) is itself a result of endogenous, differential pressures between workers’ desires to push for re-distributive stabi- lization and firms’ tolerance of increased worker bargaining power. We present a broad theoretical overview to motivate a formal politi- cal economy model of the shadow banking sector (stylized around the operation of market mutual funds, or MMMFs) using insights from Mehrling, Pozsar, Sweeney and Neilson’s model. Our simula- tions suggest the leading push of distributive dynamics that nest the operation of shadow banking.

JEL Codes: E12, E62, E63, H5, H6, P16.

1 Keywords: Political Cycles, Debt and Public , Shadow Bank- ing, The Political Economy of Finance, Kaleckian Macrodynamics, Political Macroeconomic Models.

2 1 Introduction.

Shadow banking (a term used interchangeably with shadow financial system) is “ funding of lending” [19] which generally takes place outside the regular banking system [3]. This definition high- lights the activities of financial intermediaries that use short-term money market funding, sourced on global dollar markets, to fund long-term invest- ment projects - namely capital loans. Both banks and other types of insti- tutions (a broad array of financial agents allowed to take client deposits to invest in different types of projects) engage in these activities. Estimates differ on the size of the shadow banking sector - some pin a figure around 65 trillion dollars worldwide as of 2011, from a “mere” 26 trillion in 2002 [5]. This eye-staggering growth was direct consequence of advances in securitization (which sought to minimize risk by packaging and pooling assets in structured products), a favorable regulatory climate and a macroeconomic environment of low interest rates. With the above in mind, this document describes the operation of the shadow financial system through an approach which not only underscores the inter-linkages between the sources and the target of this funding, but also the political economy of profits and wages that lies behind the dense web of financial intermediaries who participate as dealers, investment banks or special purpose vehicles (or SPVs, for short) to price funding and risk, depending on the assets and liabilities they hold on their balance sheets. However, these assets and liabilities originate in the relationships between firms and workers, and the rolling clout of special circumstances around government action and policy. With this in mind, we will argue that the financial operation of the shadow financial system is not a mere mechanical outgrowth of advances in securitization and risk management, but the natural result of tensions at the core of capitalist political development. Indeed, the 2008 financial crisis and other, perhaps less momentous events (like the 2011 debt ceiling crisis) turned sour the earlier enthusiasm with regards to shadow banks, managed money as would put it - the lot of hedge funds, mutual funds and the much-maligned investment

3 banks, whose top performers became extinct in the immediate aftermath of the crisis when they shed their skin to become bank holding companies. However, perhaps the important link in shadow banking is the operation of money manager mutual funds (or MMMFs, for short), who came to dominate an ever-growing share of financial flows after the elimination of ceilings on demand deposits in 1982. According to the Investment Company Institute (or ICI, for short), MMMFs comprise 17% of total assets held in mutual funds worldwide, behind equity and bond mutual funds. Unlike the latter two funds, MMMFs are deemed very safe and liquid investments: MMMFs sell shares to investors, and lend those funds (via repurchase agreements, or repos) to banks or dealers who demand liquidity for overnight operations. At a general level, MMMFs deposit their cash on investment banks or broker accounts, who in turn provide MMMFs with collateral - usually, high quality debt, whether commercial or sovereign in nature. The collateral provided is worth more than the deposit - the difference between the par value of the collateral provided and cash deposit is commonly known as the haircut. Under the terms of the repo, the bank repurchases the collateral at a higher price - or the difference between the initial selling price and the repurchase price is the repo rate, or interest rate on the loan. If the borrower fails to pay the repurchase price, the lender gets to keep the collateral at par value. Given these terms, the shares of these MMMFs are backed by high quality debt, namely high quality commercial paper, Treasury bills and sovereign bonds. Their operation in the United States is closely regulated by the Investment Company Act of 1940 and subsequent amendments, legislation which describes what constitutes safe investment assets for these entities. Furthermore, unlike other types of mutual funds, these MMMFs keep a net asset value (or the value of its assets minus its abilities) greater than 1, as their assets are highly liquid and risk-free - at least in theory. Herein lies the caveat: these MMMFs are viable entities as long as mar- kets provision liquidity and are able to price risk adequately, an ability that market participants woefully overestimated in the run-up to the crisis. For

4 this , how markets are organized institutionally and they interests they represent are of utmost importance to the operation of the shadow financial sector in general, and particularly to MMMFs (who at the receiving end of government deficits, trade large amounts of sovereign United States debt). For this very reason, we need to know not only how these MMMFs operate within the wider net of the shadow financial sector, but are the drivers of debt capital markets and the conflicting interests behind government policy. These questions can be tackled from two analytical vantage points: for one, this shift towards shadow banking is neither new or original. After this introduction, the next section claims that shadow banking is steeped deep into the political economy dynamics of despite the ever-changing vagaries of the world economy - this has long being argued by heterodox writers of both Marxist and Post-Keynesian persuasion. Marx himself took interesting notes on the appearance of quasi-banking, highly leveraged fi- nancial institutions (namely, the “Cr´editMobilier” of the mid-XIX century, heir to John Law’s General Private Bank a century before) whose operation was analogous to many shadow banks. His analytical innovation, however, stressed the political economy behind its operation. Marx highlighted not only the intimate political linkages of the “Cr´edit...”with the government of Napoleon III, but its overall function within French capitalism. Out of the Keynesian tradition, Hyman Minsky traced much later the development of what he coined money manager capitalism, a system “in which the proximate owners of a vast proportion of financial instruments are mutual and pension funds” [20]. In a later note, L. Randall Wray [28] updated Minsky’s definition, as “capitalism characterized by highly leveraged funds seeking maximum total returns (income flows plus capital gains) in an environment that systematically under-prices risk”. Their views stress the discontinuous changes in the institutional and political fabric of capitalism which provides for the rise of these institutions. In this section we also discuss how politics drives a wedge in the shadow financial system, as government policy provides needed guidance and col- lateral in dealings undertaken by financial intermediaries. We claim that government agency in deficit spending and borrowing is the result of endoge-

5 nous, differential pressures between workers’ wages and firms’ profits. It is our view that this tug-of-war is of central importance to fully understand the role of shadow banking in modern capitalism. Out of both analytical approaches, the third section presents the stylized facts we use to build the political economy model of the shadow banking sector, using insights from Mehrling, Pozsar, Sweeney and Neilson’s work on shadow banks [19] and data from the United States. Section four presents our mathematical model and a social-accounting matrix which fully describes our model. Section five presents our baseline results and alternative scenarios. Finally, Section six concludes.

6 2 Shadow banking in the political economy of capitalism.

2.1 Marx and Minsky: The role of shadow banks in capitalism.

In journalistic undertakings and personal exchanges with Friedrich Engels, discussed the appearance of the Cr´editMobilier system in France. Sanctioned by the French government of Napoleon III and with direct involve- ment of cabinet members and influential personalities of the Second Empire, the Societ´eG´en´erale de Cr´editMobilier was founded by the P´ereire brothers, a resourceful duo who had in their earlier years toyed with Saint-Simonian ideas - to Marx’s derision. Their company issued shares to select investors (later it was opened to the public) who wished to partake in long-term in- vestments in “mobile” property - namely, railways, industrial production (in contrast to real estate investments) or in stock market listings of these com- panies. Marx and other contemporary commentators described this venture as a “swindle” [26] given the obvious lack of safeguards. Yet, regardless of the tone he used to describe the “Cr´edit...”,Marx was intrigued by its financial operation and its political muscle. For one, the P´ereirebrothers’ venture was opposed by none other than baron Rothschild, the premier financier of his time, whose political leanings sided with the dethroned Bourbon king, Louis Phillipe. More importantly for Marx, the “Cr´edit...” served an important role in French capitalism. Its increasingly leveraged positions fueled the boom in industry and economic activity beyond potential capacity, especially as France lagged behind other industrial powers in this regard. As Marx rec- ognized in notes that would later become the third tome of Capital, this financial institution would only come to prominence in a country like France, “where neither the credit system nor large-scale industry was developed to the modern level. In England and America this kind of thing would have been impossible” [18]. A long quote below by Marx describes his views,

7 notes eerily familiar to modern ears:

[A] second director of the Cr´editmobilier [...] decamped leaving massive debts of about 30-40 million [francs]. This splendid in- stitution’s latest report [...] reveals that, although the net profit still amounts to 23%, it has nevertheless fallen by about a half compared with 1855. According to Mr P´ereire,the fall is due 1. to the [order...] by which Bonaparte forbade the Cr´editto skim the cream off the excessive speculation then going on in France; 2. to the fact that, by an oversight, this ‘ordre de la sagesse suprˆeme’extended only to soci´et´esanonymes, thus laying the Cr´editopen to highly improper competition [...]; 3. to the crisis during the last 3 months of 1856. True, the Cr´editsought to exploit that crisis [...] but was obstructed in this ‘patriotic’ work by the narrow selfishness of the Banque de France and the syn- dicate of Paris bankers headed by Rothschild; [...] P´ereireseems to be exerting severe pressure on Bonaparte. Should the latter shrink from giving his authorisation, a middle course would seem to be envisaged, namely to turn the Banque de France into the instrument of the Cr´editby loftier means, i. e. new draft leg- islation. [...] it further transpires that the Cr´edit’sbusiness is still vastly disproportionate to its capital and that it has used the capital loaned by the public exclusively to further its gambles on the Bourse. As a quasi-state institution of Bonaparte’s on the one hand, the Cr´editmobilier declares that it is called upon to maintain the prices of funds, shares, bonds, in short, of all secu- rities on the national Bourse, by advancing the money borrowed from the public to companies or individual stock-jobbers for their operations on the Bourse. As a ‘private institution’, on the other hand, its main business consists in speculating on the rises and falls in the stock-market. P´ereire reconciles this contradiction by something [others] might well call ‘social philosophy’ [17].

However, the new draft legislation (namely, Marx’s term for a state-

8 sponsored bailout) to buttress the finances of the society never came to pass. The embattled “Cr´edit...”finally went bankrupt in 1867. Although characteristically sardonic, Marx’s views on the “Cr´editMo- bilier” are not anachronistic - the way he saw it, industrial capitalism required a structured banking sector to finance industrial operations (with intimate ties to the State), a view later developed in depth by Rudolf Hilferding [10]. Marx and Hilferding rightly sensed how these financial institutions used their proximity to the political establishment and their financial muster to kick the can down the road, especially when the productive kernel of capitalism fal- tered, to support prices of securities and lengthen the boom cycle by debt layering. It was only in places where the position of industrial capital became precarious (or where industrialization was led directly by the government) where speculation prevailed over enterprise via financial institutions. Under these circumstances, expected cash flows from investment (which fed eco- nomic growth) took a back seat to the constant valuation of assets under the piecemeal management of the ”whirlwinds of optimism and pessimism” (as Keynes would say in Chapter 12 of the “General Theory...”) of large financial intermediaries. As Keynes himself would later suggest, this was a recipe for disaster. Hyman Minsky framed this issue similarly. The starting point for Minsky was the recognition that economic stability was a direct result of government involvement, not of more docile animal spirits. Higher government deficits backstopped the system, sovereign debt provided a safe asset to park accu- mulated cash resources. With higher deficits, the financial sector did not need to increase its portfolio diversity or push for other types of safe as- sets to meet this demand. But as Wray [28] notes, this New Deal backstop was an “aberration” (dare I say, political) in the evolution of financial capi- talism (which reared its head during Marx’s time) into the money-manager capitalism of late. The funding subterfuges of financial capitalism became necessary as the demand for capital for industrialization made it more expensive - banks syn- dicated loans to these purposes, efforts which lead to the concentration of capital under the control of holding companies. But as the world shed the

9 last vestiges of the New Deal order, it quickly took up the mantle of money- manager capitalism. Aberrations can never survive, and several factors led to the demise of the New Deal order. Internally, the political coalitions between capital intensive industries and worker interests which spearheaded the post-War era slowly weakened, as international trade resumed and competition from abroad sapped competitive advantages in heavy industries for the United States [7]. Externally, the collapse of the Bretton Woods system in 1971 cre- ated a global dollar market. Floating exchange rates, coupled with dollar’s exceptional privilege, strengthened the need and the supply of liquidity to international markets. With the elimination of Regulation Q, these global dollar markets sourced the already familiar MMMFs - initially, President Reagan’s deficits backstopped their operations. But as the United States entered a period of lower deficits (and inter- est rates) with President Clinton, the demand for safe, high-yielding assets outstripped supply. With the advent of securitization, synthetic assets were created to guarantee investor deposits. Low interest rates provided by the now (in)famous Greenspan put contributed to reduced Treasury rates, and fueled the need for “safe” substitutes. As argued by Gorton and Metrick [9], the booming global market in dollars outstripped the capacity of the Federal Deposit Insurance Corporation (or FDIC, for short) to allow institu- tions with large cash holdings to seek safe harbor, especially as the 1990s saw government surpluses - indeed, “the regulatory changes were, in many cases, an endogenous response to the demand for efficient, bankruptcy-free collat- eral in large financial transactions [...]”. At the international level, Mehrling, Pozsar, Sweeney and Neilson [19] provide an explanation:

[...] In today’s world so many promised payments lie in the distant future, or in another currency. As a consequence, mere guarantee of eventual par payment at maturity doesn’t do much good. On any given day, only a very small fraction of outstanding primary debt is coming due, and in a crisis the need for current cash can easily exceed it. In such a circumstance, the only way to get cash

10 is to sell an asset, or to use the asset as collateral for borrowing. In the private market, the amount of cash you can get for an asset depends on that asset’s current market value. By buying a guarantee of the market value of your assets, in effect you are guaranteeing your access to cash as needed; if no one else will give you cash for them, the guarantor will. [...] That, in effect, is what all the swaps are doing, or at any rate what they are trying to do. Because the plain fact of the matter is that all the swaps in the world cannot turn a risky asset into a genuine Treasury bill.

Given these , therefore, we need to shift gears to two related venues, the ability and operation of the private sector to package and dis- tribute these “safe” assets, and the drivers behind the issuance of debt - and hence, government deficits. The first requires grounding on how this shadow financial sector works, and how it conducted business until very recently, es- pecially in the United States. The second venue prompts an explanation of how these deficits come to be, and what interests lie behind them. To these issues we turn next.

2.2 Politics and government in the mechanics (and crises) of the shadow financial system: Mainstream and heterodox perspectives.

Without a doubt, the origin of the shadow financial sector is both a natural outgrowth of an worldwide, liquid dollar market that took root after the demise of Bretton Woods. Nonetheless, it is also a consequence of government action - especially of deficits and the role of government expenditure, as these provide needed securities for the international financial system. Much has been written around the de-regulatory climate and its intel- lectual garb which became conventional wisdom after the late seventies (for some examples, Wray [28], Wray and Nersisyan [30], Skidelsky [24]). As argued above, New Deal coalitions withered and private markets were left

11 to their own devices. On the intellectual side, ideas that promised the self- correcting tendencies of financial markets and their alignment with the needs of the real economy ruled the roost for most of these two decades. As Wray [28] notes, at their intersection was the repeal in the United States of the Glass-Steagal Act in 1999 (and specifically the provision that separated retail and investment activities in banks), the Commodities Future Modernization Act of 2000 (which excluded a number of financial instruments from regula- tory oversight) and the Employee Retirement Income Security Act of 2000 (which expanded the scope of instruments that pension funds could invest in). As Wray writes:

Some of these changes responded to innovations that had al- ready undermined New Deal restraints, while others were appar- ently pushed-through by administration officials with strong ties to financial institutions that would benefit. Whatever the case, these changes allowed for greater leverage ratios, riskier practices, greater opacity, less oversight and regulation, consolidation of power in ‘too big to fail’ financial institutions that operated across the financial services spectrum (combining commercial banking, investment banking and insurance) and greater risk [28].

This de-regulation had clear consequences - alongside its forces came pres- sures to bid up the prices of capital assets. And while the 20th Century bore witness to a slow shift from expected cash flows to the value of collateral to gage loan viability, this pace accelerated in this new century - and against Minsky’s ominous warning that these developments only added increasing fragility to the economic system. For example, this movement towards speculation is explained by Wray and Nersisyan’s analysis of loan composition in the United States before the crisis [30]: using data of the FDIC for the top three banks in the United States, they find that while real estate loans remained fairly constant around 22%, small residential loans increased from 13.5% to 17.2% between 1992 and 2008 - as % of total assets. Meanwhile, commercial and industrial loans decreased from 21.6% to 10.3% for the same period. These figures show the

12 marked shift towards a financial system geared towards asset appreciation (and speculation), not investment. Meanwhile, the shadow financial sector experienced spectacular growth in the same period, as recognized by Claessens, Pozsar, Ratnovski and Singh [5]. The need for safe dollar assets and low interest rates allowed for experimen- tation in securitization via off-balance-sheet intermediation. As dealers and banks received cash from institutional investors (and especially MMMFs), they loaned these funds to SPVs, who in turn packaged different types of securities into tranches, set apart by their combination of safe and riskier assets. In turn, these SPVs (held by these investment banks and dealers off their balance sheets given favorable regulatory treatment with respect to bankruptcy proceedings and taxes) became a source of profits and revenue, as they packaged securities served as collateral in their dealings with MMMFs and other institutional investors. During the financial crisis, especially after the Lehman shock in Septem- ber 2008, there was a run on these packaged assets: they quickly lost their value given precarious fundamentals. The first indication of a problem oc- curred in the repo market tying banks to MMMFs and other institutional investors. As asset value quickly drained away from banks’ balance sheets, haircuts on repos increased. As Gorton and Metrick [9] recognized “deposi- tors [namely MMMFs] in repo transactions with banks feared that the banks might fail and they would have to sell the collateral in the market to recover their money, possibly at a loss given that so much collateral was being sold at once.” As haircuts increased, banks had to finance larger amounts of their normal cash operations by other means, which hiked borrowing rates. MMMFs were also hit directly, as investors cashed their shares given the turmoil around the valuation of what was once regarded as quality debt. The forced liquidation of their assets put downward pressure on the value of these holdings - for one, there was a run out of private debt MMMFs into sovereign debt MMMFs, until the temporary guarantee program on MMMFs sponsored by the government stopped the ebb of funds. The above panic is in curious contrast to what happened during the debt ceiling crisis of April-July 2011 when Congress refused to approve the Trea-

13 sury’s request to issue more debt to meet projected fiscal obligations; then MMMFs suffered a different type of blowback. As argued by Krishnan, Mar- tin and Sarkar [15], the crisis affected private debt prime funds (which invest in commercial paper, certificates of deposit and repos) earlier and to a greater extent than sovereign, non-prime funds, which only saw sharp outflows after mid-July, when the situation turned critical for the leading banks and finan- cial institutions - not so long after they sent a strongly worded warning to the political leadership in Washington. The authors argue that the outflow effect was not as stark given the simultaneity of this crisis with an ever-worsening European situation. Given the above contexts, with regards to MMMFs, we can distinguish the operation of two mechanisms at work within the shadow financial sector, one financial and another political. As intermediaries, shadow banks react to systemic economic conditions which affect their financial counterparts - that happened during the 2008 crisis in their dealings with brokers and banks. However, as asset managers (especially of sovereign debt), they must also react to political calculations which affect the price of that debt. If the United States had (willingly) defaulted on its debt, it would have opened a downward price spiral, increasing the costs of borrowing and forcing the government to stop many of its activities. This would have undoubtedly created massive political unrest. Under these constraints, how is then the value of this government debt determined in capital markets? Indeed, the debt ceiling debates did not happen in a vacuum: the hardline push of house Republicans in denying the request of the Treasury happened amidst debates of how much government spending was adequate in the after- math of the 2008 crash to help stimulate the economy. For one, Republicans (and some moderate Democrats) argued that government spending failed to jumpstart economic activity, and only raised costs for businesses. Democrats, in turn, argued that President Obama’s stimulus project (or the American Recovery and Reinvestment Act of 2009) was not enough, and more spend- ing was needed in critical sectors. Indeed, almost immediately after the 2011 debt ceiling crisis, the Obama Administration proposed the American Jobs Act, but in its aftermath, garnered little support - especially with the politi-

14 cal fallout of the Standard and Poor’s downgrade that took place soon after the debt ceiling crisis was resolved. For this reason, any view which links sovereign debt and financial markets must also include perspectives on what interests and political tensions lie behind debt and deficits. At a theoretical level, the political economy of government debt and deficits features in treatments by both mainstream and heterodox commen- tators. With regards to the mainstream, Buchanan and Wagner’s classic work [4] posited deficit illusion of voters, who seek the benefits of govern- ment spending but do not wish to pay for these goods via higher taxes or inflation. Moreover, Persson and Svensson [22], Alesina and Tabellini [2] and Tabellini and Alessina [27] argue that high debt burdens can tie the hands of successor governments who inherit a constrained fiscal space for spending, and this may lead to overindulge debt beyond ’optimal’ levels. A more sophisticated version of this argument appears in a paper by Aghion and Bolton [1] where the authors contend that left-leaning govern- ments will increase debt levels to finance public expenditures geared to their own constituencies - especially if they harbor certainty in that their oppo- nents will win the next election. On the other hand, conservative-leaning politicians will favor debt reduction regardless, this to minimize the proba- bility of decreasing the value of savings apportioned by their better-off con- stituents (assumed to be held in bonds). If default is deemed as an strategic decision by either party, leftists will be perceived more likely to default than conservatives. With this in mind, conservatives will issue more debt to cre- ate the perception of debt unsustainability and influence election outcomes to their advantage. Finally, a less realist view of debt and deficits is picked up by later au- thors from Rogoff’s seminal paper on political budget cycles [23]. For Rogoff, deficits are a byproduct of a government’s competence in efficiently delivering public goods with existing tax resources. Very much like the above authors, Rogoff assumes that voters will be myopic in their assessment of public con- sumption goods with respect to investment goods. Yet, Rogoff assumes that competent policymakers will deliver these goods without the added burden of deficits (and hence, tax increases over the same period). Over the long-run,

15 voters will favor high competency incumbents who deliver a higher level of public good provision and investment, rather than untested challengers or outright incompetent politicians. The limitations of the above models are obvious: with respect to Rogoff’s work and its extensions, deficits can hardly be construed as a competency problem. Politicians enact spending policies to cater for votes, and doing so is their core competency in a democratic political system. With respect to the rest of the models, while they rightly recognize the strategic use of debt and deficits (and voters myopia in its assessment), these documents generally are critical of expansionary activity to sustainably stabilize economic activity. More importantly, their use of normal distributions to describe a median income and an median voter does not capture how the functional distribution of income and the endogenous political forces behind their determination can change the direction, priorities and overall effectiveness of government spending. This critique is developed by heterodox writers. Espoused forcefully by Michal Kalecki in his famous 1943 paper and in his writings about public finance, this alternative view proposes a different take on the drivers and sustainability of deficits and debt. In his political cycle model, Kalecki [11] thought that government expenditures, at least initially, were knowingly ben- eficial to both to workers and businesses. Spending would jumpstart effective demand, accumulation and growth, and in doing so increase wages and prof- its. The conflict between businesses and workers later on the cycle would be political in nature. For one, higher deficits led to tighter wage markets and increased worker bargaining power, which decreased worker discipline. Also, it shifted the locus of expectations from the private to the public sec- tor, and in doing so, relinquished a powerful tool at their reach to determine economic activity. For this reason, as political tolerance waned, businesses would object to full employment policies and promote austerity to regain the upper hand. Kalecki does not share the mainstream’s critique of deficit spending. For him, an increase in government deficit has no adverse effect on output - objections to deficits are political, not economic, positions. He recognized

16 that state borrowing does compete with private interests for loanable funds, but Kalecki argued that as the state pays to individuals, that money returns to the banks in the form of deposits. Interest rate stability would depend not on budget policy, but “on proper banking” action:

The interest rate will tend to rise if the public do not absorb the government securities, by the sale of which the deficit is financed, but prefer to invest their savings in bank deposits. And if the banks, lacking sufficient cash basis (notes and accounts in the ), do not expand their deposits and do not buy gov- ernment securities instead of the public doing so, then the rate of interest must rise sufficiently to induce the public to invest their savings in government securities. If, however, the central bank expands the cash basis of the private banks to enable them to ex- pand their deposits sufficiently while maintaining the prescribed cash ratio, no tendency for a rise in the rate of interest will appear [13].

Kalecki subscribed to the functional finance argument proposed by Abba Lerner [16], whereas government deficit management should achieve a public purpose - in stark contrast to the sound finance narrative that proposed to keep budgets balanced. As Lerner himself suggested, if the domestic interest rate is too high, then government had to provide bank reserves to lower it, as Kalecki argued in the quote above. As Wray [29] writes:

If government issues too many bonds, it has by the same token issued too few reserves and cash. The solution is for the treasury and central bank to stop selling bonds, and indeed, for the central bank to engage in open market purchases (buying treasuries by crediting the selling banks with reserves). That will allow the overnight rate to fall as banks obtain more reserves and the public gets more cash.

However, Wray goes further:

17 Essentially, [Lerner] says that government ought to let banks, households and firms achieve the portfolio balance between “money” (reserves and cash) and bonds desired. It follows that government bond sales are not really a “borrowing” operation required to let the government deficit spend. Rather, bond sales are really a part of , designed to help the central bank to hit its interest-rate target. (The emphasis is ours).

On that last point, Wray is undoubtedly right to recognize that bond sales are also an instrument of monetary policy, and not a mere recourse to deficit finance. However, this dual nature of government action is a source of political friction within social groups in a polity. While there is an interesting debate around the fiscal space enjoyed by sovereigns who issue debt on their own currency (as noted by scholars who subscribe to what is commonly known as , or MMT for short), we must underscore, like MMT theorists, that these sovereign privileges assume institutional and political trappings. While close financial substitutes, crediting bank reserves and bond issues may serve different political constituencies with conflicting attitudes towards government action undertaken by either the Treasury, the Central Bank or both. All the above may ultimately lead to differential results in interest rate management and/or stabilization policy. Furthermore, the characteristics of the security offered itself frames the market in which is traded. For example, participants in the primary market for debt in the United States have intimate dealings with the Treasury (and must subscribe to a set of prerequisites to that purpose, see Dupont and Sack [6]for an overview). Meanwhile, participants in secondary markets en- gage in over-the-counter transactions across the global dollar market under the welter of intervention by the Federal Reserve. With respect to the dollar, primary and secondary markets are deep, broad and liquid - despite the dif- ference in sizes (the primary market gathers a mere two thousand registered participants, of which a select few are the most active dealers). But other countries are not so lucky: In the United States, political con- siderations around debt are rendered moot by the exceptional privilege of the

18 dollar as gatekeeper of the world market. But for marketable debt securities auctioned by other polities, primary market auctions may serve urgent and very concrete political aims: if a government needs to spend its way to keep power amidst fractious politics, recruiting primary auction participants may prove to be a slow, protracted affair, especially if international market par- ticipants understand the underlying reason and directly ask for higher yields (as political appeasement involves a degree of unpredictability well beyond some of the most speculative profit-making opportunities). Derivatively, this will come next to less spending, as higher debt yields slam the brake on the more ambitious plans for social appeasement. Under these constraints, instead of waiting (and restraining spending as markets weight the political uses of these debts to generate employment, inflation and/or growth, or a combination of the three), a government un- der political pressure buys time when it nudges a compliant Central Bank to finance these deficits at the best available price but at the cost of possi- bly generating inflation over the longer term. If markets are able to test a government’s willingness (and the people’s tolerance) to resort to inflation, itself a politically costly endeavor, it may exact a heavy price on government borrowing. Finally, there is the issue of who owns this debt and to what purpose. For one, debt assets held by Central Banks become cash liabilities issued under its authority. This cash becomes sources of funds for those eager to spend. However, what if the debt asset also deals as a deposit of value for other social groups? Given their dual function, who owns these assets and to what purpose will cause friction and conflict. Keynes himself [14] argued along similar lines when he wrote:

A poor community will be prone to consume by far the greater part of its output, so that a very modest measure of investment will be sufficient to provide full employment; whereas a wealthy community will have to discover much ampler opportunities for investment if the saving propensities of its wealthier members are to be compatible with the employment of its poorer members.

19 In the quote above, Keynes took a strange supply-side view. To keep employment humming along in a wealthy country, he stated that scientific discoveries provide for available investment opportunities if saving behavior remains unaltered. Yet, this supply-side view encounters difficult hurdles to bypass as societies cannot rely on the goodwill of innovation to provide needed impetus for investment. Later in the “General Theory...”, Keynes argued that fiscal policy, pur- sued as to reduce economic inequality, would increase the propensity to con- sume in a society. Surprisingly, Keynes never went the extra mile in that book to posit why such a policy, centered around who ultimately leads gov- ernment fiscal action, would prompt a political showdown between wealthier savers and poorer consumers, all which would make this compatibility hard to achieve (although two years later, Keynes did refer with this issue in an open letter to President Roosevelt). At the core of this conflict is a simple fact: debt capital assets act as collateral for the wealth of a number of ren- tiers, who use these assets as guarantee (and trampoline) to higher returns in other interest-bearing activities, which are themselves not solely determined by prospective cash flows out of investment opportunities in innovation and the like, but in the circulation of profits. To these stylized facts we turn next.

20 3 Stylized facts.

As departure point for the stylized facts in our model, we use Mehrling, Pozsar, Sweeney and Neilson’s [19] analytical approach. Their model ab- stracts from traditional banking to devise a bare construction “in which shadow banking is the only system”. Given the centrality of the MMMFs, we propose a simpler version of their approach, where MMMFs take the role of the shadow banking sector. However, our vantage point incorporates the political economy not only of financial intermediaries (where MMMFs act directly between businesses and government), but of firms, government and workers.

Government Money Market Funds (MMFs) Firms taxes treasuries treasuries shares shares capital ΩG ΩMMF profits Table 1: Balance sheets for the government, money market (mutual) funds (or MMFs for short, we drop an M for convenience) and businesses (ΩG represents the net worth of the government, ΩMMF is the net worth of money market funds.)

The first balance sheet included in Table 1 above is the government’s account at the Treasury. While taxes are not the sole source of revenue for a government, we assume that the Treasury will hold a positive net worth

ΩG regardless of the amount of debt outstanding - this net worth is not a mere economic residual, but an institutional balancing factor, determined by political governance and decision structures. 1

1Many countries around the world keep a legal and political backstop to their financial obligations: Perhaps the most famous is the 14th Amendment (Section 4) of the United States Constitution which reads that the “validity of the public debt of the United States, authorized by law, including debts incurred for payment of pensions and bounties for services in suppressing insurrection or rebellion, shall not be questioned”. During the debt-ceiling debate this clause was raised as final recourse if an agreement was not reached, although no explicit strategy was articulated with regards to how did this “unquestioning acceptance” could be enforced. On that count, the Supreme Court did rule on a case (Perry v. United States, 1935) that “[i]n authorizing the Congress to borrow money, the Constitution empowers the Congress to fix the amount to be borrowed and the terms of payment. By virtue of the power to borrow money ’on the credit of the United States,’ the

21 Next, we have MMFs which keep government debt as assets and issue “shares” (or “deposits”, as Mehrling, Pozsar, Sweeney and Neilson would put it) to investors - the residual is the MMFs net worth ΩM MF . Finally, firms accumulate profits and save MMF shares as assets to finance capital investment. As standard Kaleckian models, we assume that businesses earn what they spend, so their net worth is zero by construction. In Mehrling, Pozsar, Sweeney and Neilson’s construction, prices are set by dealers who quote in two-side market. There are two types of dealers, those who keep matched books (or whose long positions are completely offset by their short positions) and those who do not. Unlike the first, who do not supply market liquidity at all, those who do not keep matched books engage in constant price revaluations that require a quick sense of how much liquidity is needed by the market - this involves a degree of risk. Unlike their model, prices in our stylized system (concretely, yields on private and government securities and returns on assets) are a byproduct of political conflict between profits and wages. In this sense, MMFs try to keep matched book positions but the value of these investments is affected by class dynamics. Government securities pay a yield on shadow banking sector holdings, as higher yields on debt securities held by the central bank will not turn into a direct, payable expense. This yield is given by function set according to a privately held debt to GDP ratio. This debt premium is not rationalized as a function of debt levels (and a possible default), but on the bargaining power of private markets over the government’s prospects of using debt resources to fulfill political ends in political stabilization. As governments spend more, private markets will demand an ever higher premium if the government is hesitant to pursue the monetization of its debt (and inflation) beyond currency needs, given the political costs involved, especially if workers’ income is constrained.

Congress is authorized to pledge that credit as an assurance of payment as stipulated, as the highest assurance the government can give, its plighted faith. To say that the Congress may withdraw or ignore that pledge is to assume that the Constitution contemplates a vain promise; a pledge having no other sanction than the pleasure and convenience of the pledgor. This Court has given no sanction to such a conception of the obligations of our government (the emphasis is ours).

22 Figure 1: Quarterly series of after-tax corporate profits (with inventory val- uation and capital consumption adjustment) as share of real (blue line) and change (in percent) of assets of MMF (2000-2013). Source: Federal Reserve of St. Louis http://research.stlouisfed.org/.

Meanwhile, returns on deposits loaned to the shadow banking sector can be best understood as a function of the overall profits - this is seen in Figure 1 above. More profits in the economy will push up the value of most assets in an economy, and hence lure investors into shadow financial assets for a quick return - indeed, the change in assets in MMFs tracks loosely after-tax corporate profits. As Minsky explained, in money manager capitalism the “total return on the portfolio is the only criteria used for judging the per- formance of [...] managers of these funds, which translates into an emphasis upon the bottom line in the management of business organizations” [20] - namely, profits. Their operation adds further complexity to distributive dynamics: as Kalecki explained [11, 12], higher profits do not translate into more output if demand stagnates. Moreover, the reaction of financial intermediaries, also trapped in the tug-of-war dynamics of distribution, is not as clear-cut, given their indirect linkages to both parties. They keep stakes both in using gov- ernment debt as collateral (and in doing so, allow for increasing government expenditures) but also benefit from higher profits. This story can be seen in Figure 2 below with respect to the United States,

23 which plots gross corporate profits (red line, as share of real output) and FIRE (Finance, Insurance and Real Estate, for short - in blue) value added as share of total gross corporate value added. For the two immediate decades after the war, both series remained stable in their respective contributions. In the late sixties both series took off, and rose together until the dot-com bust and the 2008 crisis slowed the contribution of FIRE to the total, when many institutions were rescued by government-issued collateral. However, as the last few quarters show, both profits and FIRE value added series have resumed their upward climb. One can argue that the fate of the financial sector, although not exclusively reliant on the fate of corporate profits, feels its warm embrace.

Figure 2: Quarterly series of gross corporate profits as share of real Gross Domestic Product (red line) and FIRE (Finance, Insurance and Real Es- tate) value added as share of total corporate gross value added (1947-2013). Source: Federal Reserve of St. Louis http://research.stlouisfed.org/.

This leads us to the role of government policy. As deficit expenditures push up employment and demand, increased worker bargaining power and employment wanes the political tolerance of firms. For this reason, the gov- ernment is trapped in a political cycle that oscillates between the narratives of sound and functional finance, as politicians play a delicate balancing act between the economic clout of businesses and financiers, and the majoritarian

24 political clout of workers. Workers and businesses demand stabilization up to a given threshold, when their interests diverge. As the economy slows down again, their inter- ests align anew. Additionally, the interests behind government expenditures do not unwind solely around the needs of stabilization, but on the govern- ment’s capacity to provide “safe” assets as collateral for the shadow financial sector via the issue of debt. This adds a wrinkle to the standard Kaleckian cycle, as wealthy savers will be torn on how to seek government collateral while keeping a lid on government expenditures. This careful balancing act does sum up recent political debates regarding austerity and spending. Democratic capitalist polities with responsive gover- nance structures with respect to worker and business interests are caught in a debate on who to bailout around a political zero-sum game. Government stabilization is paid mainly by borrowing (and not through higher taxes) to avoid disgruntling political constituencies that differ in reach and scope - although what can be taxed without fear of effective political repercussion can differ considerably from place to place. As government borrows it finds willing lenders amongst financial intermediaries, who then complain that this borrowing will nudge politicians to continue spending and increase the clout of workers over firms - without a doubt, it is Kalecki’s political , but with a twist. However, there were more recent warnings: Economists like Wynne God- ley [8], struck similar tones many years ago, and more recently, George Soros [25] argued similarly. As Thomas Palley presciently wrote in 1997 with re- spect to Europe:

Financial capital may still be able to discipline governments through the bond market. Thus, if financial capital dislikes the stance of national fiscal policy, there could be a sell-off of government bonds [...] This would drive up the cost of government borrowing, thereby putting a break on fiscal policy. Furthermore, there are problems in talking about [the European Monetary Union] and the national economic interest. This is because economies are

25 constituted by different groups which have different interests, and policies that benefit one group may harm another. This consider- ation applies forcefully to the issue of EMU, since its institutional design may advantage capital over labor or vice-versa” [21] (the emphasis is added).

The conflicting interests of stabilization to directly prop the wages of workers, and indirectly, via the needs of financial intermediaries, to require government securities as collateral raises the question of who manages govern- ment policy and to what purpose. Under these constraints, the government cannot be everything to everyone - it is either geared to those who want to ex- pand spending to support wage income directly, those who wish to restrain it to prop the clout of profits or those who need it to keep the financial system operating under increasingly strained political circumstances. Indeed, this complex matter is at the heart of the political economy of modern shadow banking. Despite these complications, we strive to keep the nuts-and-bolts of our model as simple as possible. We shy away from international and exchange rate dynamics to focus in the political dynamics between workers, financial firms and businesses. At its barest construction, it could well apply to a large, capitalist democratic economy like the United States, whose sheer size puts it at the epicenter of the worldwide dollar-based system. The simpli- fied transaction flow matrix in Table 2 further below explains how stocks of assets and flows of income are distributed across different actors (workers, businesses, MMFs and government - divided further into a Treasury and a Central Bank) - to this we turn next.

26 4 The theoretical model.

We present a closed economy model over the short-medium term where work- ers, businesses and government interact in the real sector, and businesses and government transact through a “shadow financial sector” (modeled specifi- cally after a money market fund) which settles financial claims between the latter two groups. All the relationships explained in this section are presented in the social-accounting matrix included further below. Workers consume their after tax wages. Firms invest their profits and save the rest to buy equity stakes in a money market fund. They accumulate after-tax profits and buy shares of these funds swayed by the equity returns on these assets - their investment is endogenously determined as a residual between their earnings and their spending in MMF shares. Government is financed via taxes on consumption and issues short-term treasury bills to make up the difference in spending, its expenditures are set via a countercyclical policy rule that checks wage earner clout in the econ- omy. A central bank provides cash for workers and firm spending, and buys government debt as an asset. Finally, the central bank follows an interest rate stability rule, whereas bonds are bought to credit cash reserves to facilitate consumption and investment. The shadow financial sector churns business equity investment into as- set purchases of government debt. They pay an equity return to business investors, itself a function of the overall profit share in the economy - if ag- gregate profit shares are high, these will push up money market returns and increase demand of MMF equity.

Aggregate demand: National output Y equals worker consumption Cw, capitalist consumption Cπ investment expenditures I and government spend- ing G:

Y = Cw + I + G (1)

We deal with each of these demand components in turn:

27 Workers: Workers consume their after-tax wages:

Cw = (1 − τ)ψY (2)

Where τ is the tax rate, and ψY is the wage share of output.

Firms: Investment expenditures are a residual between after-tax profits earned by firms, interest income of their holdings of financial equity iS and purchases of financial equity S˙.

I = (1 − τ)(1 − ψ)Y + iS − S˙ (3)

The change in the holdings of financial equity S˙ is a function f of the return on assets of the economy i and of investor confidence in the stability of the money market sector (as represented by ). :

S˙ = f(i+, ) (4)

The return of assets i is itself a positive function h of overall (after- tax) profit levels (1 − τ)(1 − ψ)Y - we posit that higher profits accrue to the valorization of assets across the economy (as wages are consumed by workers):

i = h[(1 − τ)(1 − ψ)Y +] (5)

The Treasury: Government spending G is a negative function g of G0, a jump variable which is positive if a fiscally active government is in power (and 0 if otherwise), the wage share ψ and the yield on government debt r:

− − G = g(G0, ψ , r ) (6)

The yield on government debt r is a positive function j of the govern- ment’s holding of private debt:

D  r = j MMF (7) Y

28 ˙ Where DMMF is government debt held in money market funds (MMF). As argued above, if the government issues short-term debt to finance its deficit, and firms recognize the political perils of debt monetization, their stronger bargaining power will force out higher yields of government debt. This leads to the government’s net deficit position with respect to private investors as the main driver of the government’s overall deficit:

˙ DMMF = G − τY + rDMMF (8)

Where τY is effective tax rate of output (as profits and wages are taxed equally). The last term is the debt payable to private investors, as the public sector as a whole does not pay interest on its overall debt, but only on the debt held by the private sector - in our model, money market funds.

The Central Bank: The Central Bank buys government debt to issue currency. With this in mind:

˙ ˙ H = DCB (9)

Where H˙ is the supply of cash liabilities issued by the Central Bank and ˙ DCB is Central Bank lending to the government. The total supply of cash to workers and firms is:

˙ ˙ ˙ H = Hw + Hπ (10)

At each point in time, the Central Bank facilitates consumption and investment spending by workers and firms respectively - hence:

˙ Hw = CW = (1 − τ)ψY (11) ˙ ˙ Hπ = I = (1 − τ)(1 − ψ)Y + iS − S (12)

The above policy undertaken by the Central Bank (with cooperation of the Treasury) seeks to keep interest rates stable at r0 via function w by adjusting currency needs and bond issues to that purpose:

29 ˙ ˙ ˙ ˙ ˙ r0 = w(D − DCB + H) = w(DMMF + H) (13)

Money Market Funds: Our shadow banks, the MMFs, issue equity shares and buy government debt as collateral for their interest generating opera- tions. MMFs accrue interest income to firm’s asset holdings. As dealers of the system, they price both firms’ savings and the value of government trea- suries used as collateral - this will be further explained when we close the dynamical section in the last paragraphs of this section.

The : Using equations (2)-(7) above and replacing to solve for the multiplier in (1), we get:

! G − S˙ Y ∗ = (14) 1 − (1 − τ)[ψ + (1 − ψ)] − h[(1 − τ)(1 − ψ)Y ]S

Employment and labor markets: With regards to the labor market and wage dynamics, the labor force N is assumed to be constant over the short-run:

N = N¯ (15)

The change in employment E˙ is a function x of the gap between actual output Y and potential output Y¯ 2 and a negative function of exogenous labor productivity.

! Y + E˙ = x , ξ− (16) Y¯ L Based on the above, the change in the employment rate L is:

 Y + − E˙ p Y¯ , ξL L˙ = = (17) N¯ N¯ 2While we could make potential output Y¯ a function of investment, we keep it constant - at this time, we are only interested only in short to medium-run dynamics.

30 The change in the wage share of the economy is a positive function z of the employment rate and a negative function of η, a parameter that gauges the clout and push-back of capitalists in their bargaining against wage increases:

ψ˙ = z(L+, η−) (18)

The dynamical system: Our dynamical model is described by equations (4), (8), (17) and (18). However, for equation (8) we consolidate the public sector accounting of the Treasury and the Central Bank. For this we use the inverse equation (13) and assume no central bank profits, therefore:

˙ ˙ −1 DMMF = G − τY + rDMMF − H − w (r0) (19)

−1 Where w (r0) is the inverse function of equation (13). However, as cash serves the purposes of consumption of workers and investment by firms, we replace H˙ with equations (11) and (12):

˙ −1 DMMF = G − τY + rDMMF − (1 − τ)ψY − I − w (r0) (20)

−1 Where w (r0) is the inverse function of (13). To sum up, the four state equations for the system are:

˙ ∗ ∗ −1 DMMF = G − τY + rDMMF − (1 − τ)ψY − I − w (r0) (21) S˙ = f(i, ) (22)

 Y ∗  x Y¯ , ξL L˙ = (23) N¯ ψ˙ = z(L, η) (24)

∗  G−S˙  Where Y = 1−(1−τ)[ψ+(1−ψ)]−h[(1−τ)(1−ψ)Y ]S ,I = (1 − τ)(1 − ψ)Y + ˙ DMMF  iS − S,G = g(G0, ψ, r), r = j Y and i = h[(1 − τ)(1 − ψ)Y ]. In the next section we proceed to simulate and analyze a linear (where possible) specification of this dynamical system.

31 Public Sector Output Costs Workers Business Treasury Central Bank Money Market Funds Total Output Uses CW IGY

Incomes Wages W ΩW Profits Π iS ΩΠ Government τY τW τΠ −rDMMF ΩG Interest rDMMF ΩMMF

Flow of Funds Financial Equity −S˙ S˙ 0 Government Debt D˙ −D˙ −D˙ 0

32 CB MMF ˙ ˙ ˙ Cash −HW −HΠ H 0

Total YΩW ΩΠ ΩG ΩMMF

Table 2: Social Accounting Matrix (SAM) for our model economy. CW stands for worker consumption expenditures, I for business investment, G for government expenditures. W is the total wage bill, and Π total profits. τW is the tax bill out of wages (where τ is the effective tax rate on consumption), τΠ is the tax bill out of profits and τY is the tax bill out of total output. rDMMF is the the yield on government debt. iS is the interest-bearing money market fund (MMF) assets held by firms. ΩW workers’ net worth (which is assumed zero), ΩΠ the firms’ net worth (which also assumed zero by construction), ΩG is the government’s net worth and ΩMMF is the money market funds’ net worth. i is money market rate of interest, r are interest payments on government debt and r0 is the central bank ˙ ˙ ˙ rate. D is the government deficit, which is financed by central bank lending DCB and money market funding DMMF . ˙ ˙ ˙ S is the change in financial equity. H are cash liabilities supplied by the central bank for worker consumption HW ˙ and investment HΠ . 5 Simulation and analyses

5.1 Specification for simulations and calibration

The concrete specification of the simulation dynamics is:

 D   D  D˙ = G − δ ψ − δ δ MMF − τY ∗ + δ MMF D MMF 0 1 2 3 Y ∗ 3 Y ∗ MMF   ∗ ∗ ∗ ˙ 1 − (1 − τ)ψY − (1 − τ)(1 − ψ)Y + δ4(1 − τ)(1 − ψ)SY − S + δ5 r0 ˙ ∗ S = δ4(1 − τ)(1 − ψ)Y − 

 Y ∗  δ6 Y¯ − ξL L˙ = N¯ ˙ ψ = δ7L − η ! G − S˙ Y ∗ = 1 − (1 − τ)[ψ + (1 − ψ)] − δ4(1 − τ)(1 − ψ)S

We calibrate the above specification with the following values G0 =

XiL 1.25, τ = 0.35,  = 0.005, N = 0.0175, η = 0.3125, r0 = 0.08 and parameters δ6 δ1 = 0.825, δ2 = 1, δ3 = 0.25, δ4 = 0.004, δ5 = 0.02, YN¯ = 0.005, δ7 = 0.325. For our initial conditions we use DMMF (0) = 0,S(0) = 1,L(0) = 1 and ψ(0) = 0.70.

33 5.2 Baseline simulation

Figure 3: (Starting in the top-left panel, in clockwise fashion) Simulations for 300 time steps for debt DMMF , financial equity S, wage share ψ and the employment ratio L; time series of ψ and S and a scatter plot between ψ, DMMF and S. The baseline model has several interesting features. Higher wage shares are correlated with higher deficits (or lower negative deficits) as increased output strengthens worker clout and their re- distributive demands. Wage shares act as floors and ceilings that allow and restrain the demand of financial holdings - this is better seen in the time series plot: high (low) profit (wage) shares accelerate the demand for MMF assets. 34 5.3 Alternative scenarios (as deviations from the baseline)

5.3.1 Scenario 1: An increase in the tax rate

Figure 4: (Starting in the top-left panel, left-to-right) Time series for 300 time steps for debt/primary balance DMMF and financial equity S, profit share deviations from baseline scenario and the volatility of privately held sovereign debt due to a 2 percentage point increase in the tax rate.

Although counterintuitive at first, we see how a increase in the tax rate feeds unstable dynamics to the system, especially via the increase in financial assets in the economy, which also drive the issue of collateral by the sovereign. The reason is hinted in the top-right panel, whereas the profit rate increases. Indeed, the model taxes both wages and profits alike, so any increase in taxes will differentially hurt wages more than profits, especially if profits can be saved into financial assets, which are a leakage of the circular flow (and are not taxed). Nonetheless, as profits increase, volatility in private held debt (which is used as collateral) increases.

35 5.3.2 Scenario 2: Decrease in the central bank interest rate

Figure 5: (Starting in top-left panel, left-to-right) Time series for 300 time steps for deviations from baseline in S for scenario 1 and 2, overall volatility of financial assets and time series for 300 time steps for deviations from baseline in the profit share for scenario 1 and 2 due to a six percentage point decrease in the central bank interest rate. This scenario highlights another channel by which distributive conflict takes place - the control of central bank interest policy. Whereas profits have greater flexibility to shoulder higher tax burdens (when compared to wages, as explained in scenario 1) given the model setup, lower interest rates take on a different dynamic around the accumulation of financial assets (top-left panel). This accumulation undergoes a more volatile dynamic than scenario 1 (top-right panel). In the bottom-left panel, we see that lower interest rates, acting as a floor on asset prices, deepen the tension between profits and wages. This conflict takes place in the private holdings of sovereign debt: as interest rates decrease, bond prices increase and their yields, the real interest rates, decrease. Higher bond prices and lower yields increase the government policy space, lower the costs of political stabilization biased to workers and facilitates debt as financial collateral. However, as both the interest payments on this debt and worker clout increase, firms pressure the government to pull back. 36 5.3.3 Scenario 3: Sensitivity of government to increases in wage share (and debt yields).

Figure 6: (Starting in the top-left panel, left-to-right) Time series for 300 time steps for financial assets S and wage share deviations from baseline scenario for a 25% reduction in δ1, or the sensitivity of government spending with respect to worker clout.

A dampened fall-back reaction of government action due to increased worker clout pushes the conflict between wages and profits to the forefront, as seen in the top-right panel. Lower profit shares decrease the demand for financial assets as seen in the top-right - the same applies to reduced sensitivity of government spending to increased sovereign yields.

37 6 Conclusion

This paper presented a theoretical overview of the political economy be- hind the development of shadow banking. Despite its ominous name, many features of modern shadow banking are neither new or original and have been discussed by theorists interested in their broader implications. On that note, the most enduring of these assessments, like those offered by Marx and Minsky noted not only how these financial institutions worked, but how the broader, institutional characteristics of markets and governments which nested their operation experienced dramatic changes. Shadow banking is intimately tied to the political economy of capitalism. The discontinuous distributive tension between wages and profits, itself an important source of political conflict in the social fabric of capitalism, pro- vides a rich theoretical backdrop of how these institutions survive amidst endogenous pressures within and outside government agency. This type of politics drives a wedge in how the shadow financial system operates next to firms and workers, as government policy provides needed guidance and collateral in dealings undertaken by financial intermediaries. Government spending and borrowing is itself the result of endogenous, differential pres- sures between workers’ desires to push for re-distributive stabilization and firms’ uneasiness to go to the extra mile, as demand beyond a certain point undermines their clout. This tug-of-war is of central importance to fully understand the role of shadow banking in modern capitalism. As hinted by the theoretical model and the simulations, government action is crucial to check the power of wages despite the pressures to sway voters through increased spending. This deficit spending serves multiple functions: for one, it appeases voters but also, pro- vides collateral. In the end, governments will tread a careful balancing act to minimize this tug-of-war, although biased towards smoother profit dynamics and the accumulation (and valorization) of financial assets. Moreover, given the flexibility of profits to quickly set up shop in the fi- nancial corners of the economy, increased taxes tend to hurt workers if these are not nested into a comprehensive policy objective. Furthermore, the use

38 and control of central bank rates also becomes an important tool for these shadow financial institutions, who welcome price asset floors through ac- commodative interest policy. However, these accelerate the political conflict between workers and firms, as lower interest rates and increased profit shares prompt worker push-back. Shadow financial institutions are involved in this conflict inasmuch as they demand government-issued collateral for their operations, and given their demand, may ease or constrain government agency. Indeed, as most of these revenues accrue to profits, shadow (and normal) financial institutions keep their allegiances to firms, and help brake government action if it tests given thresholds - but it is in their interest that government issues debt to spur economic activity and accumulation. While the model offers a simplified view of these political dynamics, its insights are not lost in the context of recent United States history. For one, we must see that serious opposition to deficits is not really about the ca- pacity of the federal government to pay its financial obligations, or due to an intellectual failure to communicate these ideas: it is an objection of the government’s political role in strengthening the clout of some social groups - Upton Sinclair said best: “It is difficult to get a man to understand some- thing, when his salary depends on his not understanding it.” The above dynamics allow us a better understanding of recent history, like the (now) recurring debt ceiling showdowns and government paralysis. For one, the best scenario for firms and finance would be that where gov- ernment spends to foster capital accumulation, an episode which took place with President Reagan’s deficits during the eighties and came with sweeping regulatory changes that favored profits over wages. However, profit-oriented policies sap demand and growth from the economy over the medium-term, and prompt push-back from organized labor - while this push has been gen- tle at best, it cannot be underestimated. It has been a major political force in the Obama administration, especially with the passage of the stimulus bill, and has nudged changes in social policy and healthcare - all which have prompted violent opposition from business groups. Indeed, it was the (shadow and otherwise) financialization of the econ-

39 omy which had led to these entrenched political differences. The so-called Greenspan put set the tone of President Clinton’s administration (and pro- vided a floor on asset prices when the economy slid into ) and hid these tensions behind amidst ever increasing inequality. In- deed, that Great Moderation is now an ironic misnomer of a period which planted the seeds of the financial fragility we are currently experiencing. These complexities do not add up to simple solutions: for one, policies that seek to regulate and restrain the operation of shadow financial institu- tions as to temper their operation and firewall their linkages to the real econ- omy could strengthen economic fundamentals. However, these policies can- not be undertaken nationally, given the global reach and mobility of finance and capital. Additionally, institutional reforms which rely on automatic sta- bilizers (like job-guarantee programs and social insurance mechanisms) over discretionary policy might minimize the overt political conflict between firms and workers, without denting prospects of economic growth - although these must take into account local economic contexts. Entrenched political impasses are not immutable or permanent: these can be shrewdly overcome by a reform agenda that seeks to address not only the but also the political economy behind these differences - it remains to be seen if this agenda will come after a regrettable breaking point.

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