INTEREST SYSTEM AND FINANCIAL INSTABILITY
MOHSEN FARDMANESH
Instability and financial crises have been latent, if not manifest, features of modern capitalist economies. The contained crashes of the Tokyo and New York stock markets since October 1987 are recent reminders of this inherent problem. The reason why these situations do not evolve into a full-scale economic disaster similar to the great depression is, according to the economist Minsky, only due to the combined influence of governments and Central Banks. However, this approach overlooks the destructive role of interest in the system.
He argues that interest is the fundamental source of instability in a capitalist economy because it ascertains a firm’s payment commitments and liabilities irrespective of, and before observing, their income.
Both Minsky and Keynes consider the instability of the capitalist economy symptomatic, but they attribute this to different factors. Keynes ascribes it to the violent nature of the marginal efficiency of capital, and Minsky to the perverse changes in firms’ margins of safety. Both explanations, however, overlook the role of the interest system in this problem.
Theory of Financial Instability
Instability in a modern capitalist economy depends on the use of external funds for procuring physical assets and a successful “hedge finance” developing into a fragile “speculative finance.” Under this system, subsequent to the rise in interest rates or a decline in rates of actual profits, bankruptcies arise from the financial problems of firms.
Firms finance the physical assets needed for producing goods and services internally and externally. External financing of the physical assets creates, for a firm, further payment commitments against its anticipated receipts and liquid assets. By closing the gap between the two, which Minsky calls the firm’s margin of safety, the firm’s manager, in effect, sets the probability of its financial viability. The instability in a modern capitalist economy is rooted in a systematic decline in the margins of safety, Minsky argues.
Initially the margins of safety are such that the firm’s receipts are sufficient to meet their payment commitments in each period. Minsky calls viable debt financing of physical assets “hedge finance.” The use of external funds for real investment does not stop at the successful hedge finance however
The resulting expansive market sentiment increases investment, capital asset prices, and the pace of debt financing. The margins of safety grow narrower, and the viability of the debt structures becomes less dependent on long-term expected profits and expected capital gains.
Thus, the speculative content of finance increases, and the successful hedge finance develops into a fragile “speculative finance.” A rise in interest rates or a decline in rates of actual profits increases the firm’s payment commitments and liabilities relative to their receipts and the value of their physical assets.
Consequently, the firm’s debt-asset ratios rise rendering certain firm’s insolvent. Crisis in one part of the financial market echoes through the entire market. Perceived margins of safety are revised upward by both lenders and borrowers. Rapid devaluation of assets follows, debts become fragile, and the highly speculative debt structures collapse.
Interest as a Fundamental Source of Instability
The economist Lavoie’s formulation of Minsky’s financial instability hypothesis establishes that a fundamental source of financial instability in a capitalist economy is the institution of interest. The leverage ratio – the share of external finance in investment – is the indicator of financial fragility in this model. According to Lavoie, Minsky’s thesis depends on two events: that the economy “naturally” moves towards a more fragile financial system, and that, under such circumstances, interest rates eventually rise. Lavoie confirms the occurrence of these two phenomena with the two central equations of his model:
g’/g = r’/r + s/s + u’/u – v’/v + [x’/x] * x/(l-x)
p’/p = w’/w – a’/a + [s’/s] * s/ (l – s) where:
g = the rate of growth of capital
r = the retention ratio of the firm on gross profits
s = the share of profits in national income
u = the rate of utilisation of capacity
V = the technological capital-capacity ratio
X = the leverage ratio
p = the price level
w = the nominal wage rate
a = an index of productivity
Considering the first equation and assuming the technological capacity ratio is constant in the short run, Lavoie argues that in an investment boom the channels of retention ratio, profit margin and leverage ratio can be used for firms’ expansion. The channel of the capacity utilisation ratio can be used as well, but only to its technologically determined limit. With the use of the channel of leverage ratio for firms’ expansion, the economy moves towards a more fragile financial system in an investment boom.
Considering the second equation, Lavoie argues that the use of the channel of profit margin for firms’ expansion entails a period of inflation. He then claims that interest rates increase in an investment boom. Given the economy has moved towards a more fragile financial system, the rise in interest rates entails financial instability in line with Minsky’s thesis.
An increase in the leverage ratio is essential to this thesis. The reason why it renders the financial system more fragile is that it increases firm’s further payment commitments in definite amounts while their future receipts remain uncertain. It is, thus, the institution of interest – the fixed nature of the firms’ future payment commitments and their independence from the firms’ future receipts – rather than a higher share of external finance in firms’ investments – which ultimately brings about the collapse of more leveraged debt structure.
In addition, the interest system assures the providers of funds the principal and fixed interest earning irrespective of the performance of the funded projects. Consequently, when the entrepreneurs follow the expansive (speculative) market sentiment in a boom situation, the providers of funds, especially the (thinly capitalised) financial intermediaries, tend to freely finance speculative projects, rendering the financial system more fragile.
General Acceptance of Interest
In the light of the above, it is surprising that almost all economists accept the institution of interest implicitly. Even Keynes, who did have critical views of this institution, did not totally reject it or count it as a fundamental source of instability in a capitalist economy. He rejected the classical – the loanable hinds – theory of interest, and put forward the liquidity preference theory of interest. “The rate of interest” he concludes “is not the price which brings into equilibrium the demand for resources to invest with the readiness to abstain from present consumption. It is the price which equilibrates the desire to hold wealth in the form of cash with the available quantity of cash.”
Avoiding Interest
Nonetheless, in his policy recommendations, the concluding chapter of the general theory, Keynes states that there are no “intrinsic reasons for the scarcity of capital” and, hence, for interest to exist in the long run: “except in the event of the individual’s propensity to consume proving to be of such a character that net savings in conditions of full employment comes to an end before capital becomes sufficiently abundant.” He proposes to correct such an event by means of communal saving (socialisation of investment) through the agency of the state.
Keynes is concerned with a rise in the rate of interest primarily because it entails a lower rate of investment and hence involuntarily unemployment. While he considers that a rise in the rate of interest may play an aggravating and even an initiating role in causing instability in a capitalist economy, Keynes suggests “that a more typical, and often predominant, explanation of the crisis is, not primarily a rise in the rate of interest, but a sudden collapse in the marginal efficiency of capital”.
Even though a drop in the marginal efficiency of capital, caused by a deficiency in effective demand or by an adverse supply shock, may initiate the instability process, the actual problem lies in the interest system. It is the independence of the cost of finance – interest rate – from the productivity of the respective debt-financed capital assets, and the determination of the interest rate before observing the yield, that is, the institution of ‘interest’, which renders a drop in the marginal efficiency of capital destabilising.
If the interest rate were based on the performance of the funded projects, it would always be set less than, or equal to the marginal efficiency of capital, and a drop in the latter would no longer destabilise the financial system.
Instability Inherent to Capitalist Economies
Keynes and Minsky consider instability and financial crises as natural features of modern capitalist economies. Their explanations as to what causes this inherent problem, however, overlooks the fundamental role the institution of ‘interest’ plays in causing the destabilising discrepancy between firms’ payment commitments and liabilities on the one hand, and their receipts and assets on the other hand.
Lavoie’s formulation of Minsky’s financial instability hypothesis demonstrates that an increase in the leverage ratio, which reflects a rise in speculative finance, is the crucial factor in Minsky’s explanation. As argued above, the crisis is rooted, not primarily in a rise in the share of external finance in a firm’s investments, but in the fixed nature of the firm’s future payment commitments and their independence from the firms’ future receipts. It is, thus, the institution of interest rather than a higher leverage ratio which ultimately brings about the collapse of more leveraged firms. A review of the general theory indicates that a decline in the marginal efficiency of capital is the prominent factor in Keynes’ explanation of instability in modern capitalist economies.
As discussed in the previous section, even though a fall in the marginal efficiency of capital may start the instability process, the root of the problem is to be found in the interest system. If the interest rate were based on the performance of the funded projects, it would be set less than, or equal to the marginal efficiency of capital, and a fall in the latter would no longer destabilise the financial system.
To sum up, the ultimate destabilising factor in a capitalist economy is the institution of ‘interest’, because it determines firms’ payment commitments and liabilities independent of, and prior to, observing their receipts.
Edited By Asma Siddiqi
Institute Of Islamic Banking And Insurance London
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