The Kalecki-Steindl Theory of Financial Fragility By Jan Toporowski, SOAS University of London, and the Research Centre for the History and Methodology of Economics, University of Amsterdam
The title of this paper is quite a mouthful, thanks to the names of two famous economists, Polish Michal Kalecki, who worked for years in the London School of Economics and Oxford and Cambridge universities, and Josef Steindl, an Austrian economist who later lectured at Oxford. Toporowski finds a link between their theories on how income inequality leads to excessive savings by the upper classes, which in turn leads to stagnation, and how that is combated by an economy that relies on asset price inflation.
The paper starts with Kalecki’s analysis of workers’ savings, which he sees as a “leakage” from the system, in the sense that “money spent by capitalists on wages does not return to capitalists in the form of sales of wage goods”. Steindl took the identity savings equals investment and expanded it to obtain another identity, viz., that retained profits are equal to firms’ retained expenditure less household savings. (To simplify things, the government deficit and external trade is left out of the picture.) Steindl said that if investment falls below the level of household savings, firms find themselves paying out more in costs, and payments to holders of their financial obligations, than they receive in income. Firms will then borrow to make up the deficit, and the rise in their indebtedness will tend to reduce investment further. When investment falls, it doesn’t immediately affect the upper classes who do most of the savings. Writes Toporowski, “Their continued saving prevents the money that firms throw into circulation, in the process of production, from returning to firms as sales revenue equal or greater than their costs of production and financing. In order to cope with this unexpected financial deficit firms continue to reduce their investment, driving the economy into recession, until household saving falls below the level of investment.” The process continues until public sector projects or replacement investment (depreciation) leads to a rise in investment. Toporowski says that this is what happened to industry in the US and Britain in the 1960s.
But capitalism soon found a way out, through asset price inflation. The removal of restrictions on credit and the inflow of money into pension funds set off a long financial boom. The excess demand for securities by pension funds led to companies substituting providing that equity by issuing capital and substituting it for debt, thus reducing interest costs and boosting profits. Excess and cheap capital was also responsible for a wave of mergers and acquisitions. Why indulge in the uncertainties of industrial investment, if financial engineering can provide faster and fatter profits?
The tendency of firms to tap the markets turned banks towards fee-related businesses such as derivatives, to make bets in the markets and to make loans to more risky customers, such as the subprime mortgages in the US. The rise in asset prices also led to a change in savings behaviour. Households, too, started to borrow against the inflated assets on their balance sheets. Says Toporowski, “The more common use of debt or asset sales to pay for current expenditure has brought down saving rates in the household sectors of the United States and Great Britain to negligible or negative levels. This in turn has removed the household saving threshold which firms’ investment must exceed in order to provide the business sector as a whole with a financial surplus.” In other words, asset price inflation got rid of the leakage of household savings.
That is why the end of booms in the West is now marked, not by industrial crises as in the past, but by financial crises.
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