Political economy of finance, note #4
This post is part of a series of notes (which begins here) for a two-week intensive course on the political economy of finance that I taught at Al Akhawayn University in Ifrane, Morocco. Each note looks at a political-economic concept and an institutional structure. The notes are the skeleton of the course, fleshed out in the classroom with lectures, analytical techniques, discussions and supplementary texts.
My approach to Political Economy of Finance, in keeping with the perspective of the Money View, focuses on the patterns of cash flows created by credit relationships. Practical bankers, in both private and public institutions, have to learn how to pay their debts on time. Some of them have bothered to write down how they do it, and using those texts we can construct a theory of money, which also turns out, I argue in this course, to tell us a lot about the underlying social relationships. It thus provides the basis for a political-economic perspective on finance in capitalism.
In trying to communicate this to students, I have found it helpful to be able to visualize these patterns of cash flows, coherently and correctly but simplified. This purpose of this note is to share and introduce those visualizations.
To organize these thoughts, I have had to go fishing in my memory, placing myself back in Perry Mehrling’s lecture hall and my graduate student days (though I understand it much more intuitively now!). I am always, I think, building on that foundation; in this particular lesson I am sticking very close to the model.
Capital asset finance
The first graph illustrates what is perhaps the most basic financial problem: how to pay for a capital asset. Capital assets have this problem: they generate cash inflows, but only after a big cash outlay, and only slowly, over a long period of time. A hotel is a nicely tangible example: it must first be built and furnished, and only then can rooms be rented out to generate cash income. This first graph, and all the graphs below, use the format of a cash-flow diagram, commonly used by engineers but, oddly, rarely used in monetary theory. Positive cash flows point up, negative cash flows point down:
In the case of a hotel, the negative cash flow is the initial outlay, the positive cash flows are the subsequent yields from operation. The quantities are simplified, with an important structure: total cash flow is zero. The cash inflows, that is, are exactly enough to pay for the cash outlay. But, crucially, they don’t come at the right time—the positive cash flow comes later, but it doesn’t come at all unless the outlays have been paid. If there is no hotel, then there are no rooms to rent out.
This difficulty with timing is the kind of problem that finance can solve. In general, the solution is something like this:
The borrower takes out a loan, which creates a big positive cash flow at the beginning, when the loan is disbursed, and smaller negative cash flows after, when it is paid back. In this idealized scenario, the loan exactly covers the initial cash outlay, and the future cash flows yielded by the capital asset exactly cover the loan payments. (In reality, things don’t line up so perfectly, but when a shortfall arises, it turns out that that too can be financed. Usually.)
Credit is also a capital asset
The loan (which might be a bond, or another financial instrument) solves the borrower’s cash-flow problem, but what about the bank (or the bond investor) that does the lending? This graph focuses only on the loan, but shows both sides of the transaction. On the left are the cash flows from above, loan and repayment, as seen by the borrower. On the right, the same transactions as seen by the bank:
If we are interested in understanding the system of credit relationships as a whole, we have to think about transactions from both sides at once. The borrower’s inflows are the bank’s outflows, and vice versa. Comparing the bank’s situation with the very first graph above, an important point might jumps out. To make it as clear as possible:
The bank now faces the same timing problem as the borrower: the loan requires a big cash outlay at the beginning, but only generates cash inflows later, and only in small amounts. In other words, a loan is also a capital asset, at least in terms of the cash flows it creates. Or in still other words: credit moves the cash-flow problem from the borrower to the bank; it does not solve it. The bank must find its own source of cash, which it will have to pay back later:
Banks are specialists in credit
The bank has the same problem as the borrower, but it solves it differently. By specializing in credit—by making many loans to many borrowers—the bank can arrange its lending so that it has inflows every day. This final graph is perhaps a bit more opaque than the others, but hopefully the point comes across:
Here then is the business of banking: to build a portfolio of credit in such a way that inflows cover outflows, day after day.