Revisiting Financing Blue Economy

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Blue Economy has suffered a definitional crisis ever since it started doing the rounds almost around the turn of the century. So much has it been plagued by this crisis, that even a working definition is acceptable only contextually, and is liable to paradigmatic shifts both littorally and political-economically. 

The United Nations defines Blue Economy as: 

A range of economic sectors and related policies that together determine whether the use of oceanic resources is sustainable. The “Blue Economy” concept seeks to promote economic growth, social inclusion, and the preservation or improvement of livelihoods while at the same time ensuring environmental sustainability of the oceans and coastal areas. 

This definition is subscribed to by even the World Bank, and is commonly accepted as a standardized one since 2017. However, in 2014, United Nations Conference on Trade and Development (UNCTAD) had called Blue Economy as

The improvement of human well-being and social equity, while significantly reducing environmental risks and ecological scarcities…the concept of an oceans economy also embodies economic and trade activities that integrate the conservation and sustainable use and management of biodiversity including marine ecosystems, and genetic resources.

Preceding this by three years, the Pacific Small Islands Developing States (Pacific SIDS) referred to Blue Economy as the 

Sustainable management of ocean resources to support livelihoods, more equitable benefit-sharing, and ecosystem resilience in the face of climate change, destructive fishing practices, and pressures from sources external to the fisheries sector. 

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As is noteworthy, these definitions across almost a decade have congruences and cohesion towards promoting economic growth, social inclusion and the preservation or improvement of livelihoods while ensuring environmental sustainability of oceanic and coastal areas, though are markedly mitigated in domains, albeit, only definitionally, for the concept since 2011 till it has been standardized in 2017 doesn’t really knock out any of the diverse components, but rather adds on. Marine biotechnology and bioprospecting, seabed mining and extraction, aquaculture, and offshore renewable energy supplement the established traditional oceanic industries like fisheries, tourism, and maritime transportation into a giant financial and economic appropriation of resources the concept endorses and encompasses. But, a term that threads through the above definitions is sustainability, which unfortunately happens to be another definitional dead-end. But, mapping the contours of sustainability in a theoretical fashion would at least contextualize the working definition of Blue Economy, to which initiatives of financial investments, legal frameworks, ecological deflections, economic zones and trading lines, fisheries, biotechnology and bioprospecting could be approvingly applied to. Though, as a caveat, such applications would be far from being exhaustive, they, at least potentially cohere onto underlying economic directions, and opening up a spectra of critiques. 

If one were to follow global multinational institutions like the UN and the World Bank, prefixing sustainable to Blue Economy brings into perspective coastal economy that balances itself with long-term capacity of assets, goods and services and marine ecosystems towards a global driver of economic, social and environmental prosperity accruing direct and indirect benefits to communities, both regionally and globally. Assuming this to be true, what guarantees financial investments as healthy, and thus proving no risks to oceanic health and rolling back such growth-led development into peril? This is the question that draws paramount importance, and is a hotbed for constructive critique of the whole venture. The question of finance, or financial viability for Blue Economy, or the viability thereof. What is seemingly the underlying principle of Blue Economy is the financialization of natural resources, which is nothing short of replacing environmental regulations with market-driven regulations. This commodification of the ocean is then packaged and traded on the markets often amounting to transferring the stewardship of commons for financial interests. Marine ecology as a natural resource isn’t immune to commodification, and an array of financial agents are making it their indispensable destination, thrashing out new alliances converging around specific ideas about how maritime and coastal resources should be organized, and to whose benefit, under which terms and to what end? A systemic increase in financial speculation on commodities mainly driven by deregulation of derivative markets, increasing involvement of investment banks, hedge funds and other institutional investors in commodity speculation and the emergence of new instruments such as index funds and exchange-traded funds. Financial deregulation has successfully transformed commodities into financial assets, and has matured its penetration into commodity markets and their functioning. This maturity can be gauged from the fact that speculative capital is structurally intertwined with productive capital, which in the case of Blue Economy are commodities and natural resources, most generically. 

But despite these fissures existing, the international organizations are relentlessly following up on attracting finances, and in a manner that could at best be said to follow principles of transparency, accountability, compliance and right to disclosure. The European Commission (EC) is partnering with World Wildlife Fund (WWF) in bringing together public and private financing institutions to develop a set of Principles of Sustainable Investment within a Blue Economy Development Framework. But, the question remains: how stringently are these institutions tied to adhering to these Principles? 

Investors and policymakers are increasingly turning to the ocean for new opportunities and resources. According to OECD projections, by 2030 the “blue economy” could outperform the growth of the global economy as a whole, both in terms of value added and employment. But to get there, there will need to be a framework for ocean-related investment that is supported by policy incentives along the most sustainable pathways. Now, this might sound a bit rhetorical, and thus calls for unraveling. the international community has time and again reaffirmed its strong commitment to conserve and sustainably use the ocean and its resources, for which the formations like G7 and G20 acknowledge scaling up finance and ensuring sustainability of such investments as fundamental to meeting their needs. Investment capital, both public and private is therefore fundamental to unlocking Blue Economy. Even if there is a growing recognition that following “business s usual” trajectory neglects impacts on marine ecosystems entailing risks, these global bodies are of the view that investment decisions that incorporate sustainability elements ensure environmentally, economically and socially sustainable outcomes securing long-term health and integrity of the oceans furthering shared social, ecological and economic functions that are dependent on it. That financial institutions and markets can play this pivotal role only complicates the rhetorics further. Even if financial markets and institutions expressly intend to implement Sustainable Development Goals (SDGs), in particular Goal 14 which deals with conservation and sustainable use of the oceans, such intentions to be compliant with IFC performance Standards and EIB Environmental and Social Principles and Standards. 

So far, what is being seen is small ticket size deals, but there is a potential that it will shift on its axis. With mainstream banking getting engaged, capital flows will follow the projects, and thus the real challenge lies in building the pipeline. But, here is a catch: there might be private capital in plentiful seeking impact solutions and a financing needs by projects on the ground, but private capital is seeking private returns, and the majority of ocean-related projects are not private but public goods. For public finance, there is an opportunity to allocate more proceeds to sustainable ocean initiatives through a bond route, such as sovereign and municipal bonds in order to finance coastal resilience projects. but such a route could also encounter a dead-end, in that many a countries that are ripe for coastal infrastructure are emerging economies and would thus incur a high cost of funding. A de-risking is possible, if institutions like the World Bank, or the Overseas Private Investment Corporation undertake credit enhancements, a high probability considering these institutions have been engineering Blue Economy on a priority basis. Global banks are contenders for financing the Blue Economy because of their geographic scope, but then are also likely to be exposed to a new playing field. The largest economies by Exclusive Economic Zones, which are sea zones determined by the UN don’t always stand out as world’s largest economies, a fact that is liable to drawing in domestic banks to collaborate based on incentives offered  to be part of the solution. A significant challenge for private sector will be to find enough cash-flow generating projects to bundle them in a liquid, at-scale investment vehicle. One way of resolving this challenge is through creating a specialized financial institution, like an Ocean Sustainability Bank, which can be modeled on lines of European Bank for Reconstruction and Development (EBRD). The plus envisaged by such a creation is arriving at scales rather quickly. An example of this is by offering a larger institutional-sized approach by considering a coastal area as a single investment zone, thus bringing in integrated infrastructure-based financing approach. With such an approach, insurance companies would get attracted by looking at innovative financing for coastal resiliency, which is a part and parcel of climate change concerns, food security, health, poverty reduction and livelihoods. Projects having high social impact but low/no Internal Rate of Return (IRR) may be provided funding, in convergence with Governmental schemes. IRR is a metric used in capital budgeting to estimate the profitability of potential investments. It is a discount rate that makes the net present value (NPV) of all cash flows from a particular project equal to zero. NPV is the difference between the present value of cash inflows and present value of cash outflows over a period of time. IRR is sometimes referred to as “economic rate of return” or “discounted cash flow rate of return.” The use of “internal” refers to the omission of external factors, such as the cost of capital or inflation, from the calculation. The biggest concern, however appears in the form of immaturity of financial markets in emerging economies, which are purported to be major beneficiaries of Blue Economy. 

The question then is, how far viable or sustainable are these financial interventions? Financialization produces effects which can create long-term trends (such as those on functional income distribution) but can also change across different periods of economic growth, slowdown and recession. Interpreting the implications of financialization for sustainability, therefore, requires a methodological diverse and empirical dual-track approach which combines different methods of investigations. Even times of prosperity, despite their fragile and vulnerable nature, can endure for several years before collapsing due to high levels of indebtedness, which in turn amplify the real effects of a financial crisis and hinder the economic growth. Things begin to get a bit more complicated when financialization interferes with environment and natural resources, for then the losses are not just merely on a financial platform alone. Financialization has played a significant role in the recent price shocks in food and energy markets, while the wave of speculative investment in natural resources has and is likely to produce perverse environmental and social impact. Moreover, the so-called financialization of environmental conservation tends to enhance the financial value of environmental resources but it is selective: not all stakeholders have the same opportunities and not all uses and values of natural resources and services are accounted for. 

Infrastructure and Asian Infrastructure and Investment Bank. Some Scattered Thoughts.

What is Infrastructure?

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Infrastructure, though definitionally an elusive term, encompasses an economic standpoint consisting of large capital intensive natural monopolies. The term attains it heterogeneity by including physical structures of various types used by many industries as inputs to the production of goods and services. By this, it has come to mean either social, or economic infrastructure, wherein, in the former, are schools, hospitals etc, while in the latter are energy, water, transport, and digital communications, often considered essential ingredients in the success of the modern economy. Conceptually, infrastructure may affect aggregate output in two main ways: (i) directly, considering the sector contribution to GDP formation and as an additional input in the production process of other sectors; and (ii) indirectly, raising total factor productivity by reducing transaction and other costs thus allowing a more efficient use of conventional productive inputs. Infrastructure can be considered as a complementary factor for economic growth. How big is the contribution of infrastructure to aggregate economic performance? The answer is critical for many policy decisions – for example, to gauge the growth effects of fiscal interventions in the form of public investment changes, or to assess if public infrastructure investments can be self-financing.

Let us ponder on this a bit and begin with the question. Why is infrastructure even important? Extensive and efficient infrastructure is critical for ensuring the effective functioning of the economy, as it is an important factor determining the location of economic activity and the kinds of activities or sectors that can develop in a particular economy. Well-developed infrastructure reduces the effect of distance between regions, integrating the national market and connecting it at low cost to markets in other countries and regions. In addition, the quality and extensiveness of infrastructure networks significantly impact economic growth and affect income inequalities and poverty in a variety of ways. A well-developed transport and communications infrastructure network is a prerequisite for the access of less-developed communities to core economic activities and services. Effective modes of transport, including quality roads, railroads, ports, and air transport, enable entrepreneurs to get their goods and services to market in a secure and timely manner and facilitate the movement of workers to the most suitable jobs. Economies also depend on electricity supplies that are free of interruptions and shortages so that businesses and factories can work unimpeded. Finally, a solid and extensive communications network allows for a rapid and free flow of information, which increases overall economic efficiency by helping to ensure that businesses can communicate and decisions are made by economic actors taking into account all available relevant information. There is an existing correlation between infrastructure and economic activity through which the economic effects originate in the construction phase and rise during the usage phase. The construction phase is associated with the short-term effects and are a consequence of the decisions in the public sector that could affect macroeconomic variables: GDP, employment, public deficit, inflation, among others. The public investment expands the aggregate demand, yielding a boost to the employment, production and income. The macroeconomic effects at a medium and long term, associated with the utilization phase are related to the increase of productivity in the private sector and its effects over the territory. Both influence significantly in the competitiveness degree of the economy. In conclusion, investing in infrastructure constitutes one of the main mechanisms to increase income, employment, productivity and consequently, the competitiveness of an economy. Is this so? Well, thats what the economics textbook teaches us, and thus governments all over the world turn to infrastructure development as a lubricant to maintain current economic output at best and it can also be the basis for better industry which contributes to better economic output. Governments, thus necessitate realignment of countries’ infrastructure in tune with the changing nature of global political economy. Infrastructure security and stability concerns the quantity of spare capacity (or security of supply). Instead of acting on the efficiency frontier, infrastructure projects must operate with spare capacity to contribute to economic growth through ensuring reliable service provisions. Spare capacity is a necessary condition for a properly functioning system. To assure the level of spare capacity in the absence of storage and demand, the system needs to have excess supply. However, no rational profit-seeker will deliberately create conditions of excess supply, since it would produce a marginal cost lower than the average cost, and to circumnavigate this market failure, governments are invested with the responsibility of creating incentives ensuring securities of supply. This is seeding the substitutability of economics with financialization. 

So far, so good, but then, so what? This is where social analysts need to be incisive in unearthing facts from fiction and this faction is what constitutes the critique of development, a critique that is engineered against a foci on GDP-led growth model. This is to be done by asking uncomfortable questions to policy-makers, such as: What is the most efficient way to finance infrastructure spending? What are optimal infrastructure pricing, maintenance and investment policies? What have proven to be the respective strengths and weaknesses of the public and private sectors in infrastructure provision and management, and what shapes those strengths and weaknesses? What are the distributional consequences of infrastructure policies? How do political forces impact the efficiency of public sector provision? What framework deals best with monopoly providers of infrastructure? For developing countries, which have hitherto been plagued by weaker legal systems making regulation and enforcement more complicated, the fiscally weak position leads to higher borrowing costs. A most natural outcome is a systemic increase in financial speculation driven by deregulation transforming into financial assets. Contrary to common sense and what civil society assumes, financial markets are going deeper and deeper into the real economy as a response to the financial crisis, so that speculative capital is structurally being intertwined with productive capital changing the whole dynamics of infrastructure investment. The question then is, how far viable or sustainable are these financial interventions? Financialization produces effects which can create long-term trends (such as those on functional income distribution) but can also change across different periods of economic growth, slowdown and recession. Interpreting the implications of financialization for sustainability, therefore, requires a methodological diverse and empirical dual-track approach which combines different methods of investigations. Even times of prosperity, despite their fragile and vulnerable nature, can endure for several years before collapsing due to high levels of indebtedness, which in turn amplify the real effects of a financial crisis and hinder the economic growth. 

Role of Development Banks and AIIB

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Where do development banks fit into the schema as regards infrastructure investment? This question is a useful gamble in order to tackle AIIB, the new kid on the bloc. As the world struggles to find funds to meet the Sustainable Development Goals (SDGs), development banks could be instrumental in narrowing the gap. So, goes the logic promulgated by these banks. They can help to crowd-in the private sector and anchor private-public sector partnerships, particularly for infrastructure financing. However, misusing development banks can lead to fiscal risks and credit market distortions. To avoid these potential pitfalls, development banks need a well-defined mandate, operate without political influence, focus on addressing significant market failures, concentrate on areas where the private sector is not present, monitor and evaluate interventions and adjust as necessary to ensure impact, and, finally, be transparent and accountable. All of these are the ideals, which more often than not go the other way. China-led Asian Infrastructure Investment Bank (AIIB), despite having no track record still enjoys the highest ratings on par with the World Bank. This has fueled debates ranging from adding much-needed capital augmenting infrastructure to leniency in observing high standards of governance, and possibly ignoring environmental and societal impacts.

The AIIB was officially launched in Beijing on January 16th, 2016, with 57 founding members, including 37 in Asia and 20 non-regional countries. Being the largest shareholder of the AIIB, China has an initial subscription of $29.78 billion in authorized capital stock in the AIIB out of a total of $100 billion, and made a grant contribution of another $50 million to the AIIB Project Preparation Special Fund on January 16th, 2017. India is the second-largest shareholder, contributing $8.4 billion. Russia is the third-largest shareholder, contributing $6.5 billion, and Germany is the largest non-regional shareholder (also the fourth largest shareholder), contributing $4.5 billion. While being open to the participation of non-regional members, the AIIB is committed to and prioritizes the ownership of Asian members. This is reflected in the capital structure requirement and the requirements for the composition of Board of Governors in the AIIB’s Article of Agreement (AOA), which requires no less than 75 percent of the total subscribed capital stock to be held by regional members unless otherwise agreed by the Board of Governors by a Super Majority vote. The AOA also requires that 9 out of the AIIB’s 12 members be elected by the Governors representing regional members, and 3 representing non-regional members. The prioritization of Asian-members’ ownership of the AIIB does not necessarily mean that the AIIB’s investment is restricted only to Asia. According to its AOA, the AIIB aims to “improve infrastructure connectivity in Asia,” and it will invest in Asia and beyond as long as the investment is “concerned with economic development of the region.” The bank currently has 64 member states while another 20 are prospective members for a total of 84 approved members. 

The AIIB’s EU/OECD members potentially could have some positive influence over the institutional building and standard setting of the young institution. The European Commission has recognized that an EU presence in China-driven institutions would contribute to the adoption of best practices and fair, global standards. Adherence to such standards will be promoted by the AIIB entering into partnership with existing Multilateral Development Banks. It has also been argued that joining the AIIB would give the European countries access to the decision-making process within the AIIB, and may even allow the European countries to play a role in shaping the AIIB’s organizational structure. As an example of EU/OECD members’ activism in monitoring the AIIB’s funds allocation, both Denmark and the UK, who are AIIB’s OECD members, proposed that contributions to the AIIB would qualify as official development aid (ODA). After a thorough review of AIIB’s AOA, mandate, work plan and other available materials, the OECD’s Secretariat of the Development Assistance Committee (DAC) recommended including AIIB on the List under the category of “Regional development banks,” which means the OECD would recognize the AIIB as one of the ODA-eligible international organizations. Once approved, the Secretariat of DAC will be able to “monitor the future recipient breakdown of the AIIB’s borrowers through AIIB’s future Creditor Reporting System and thereby confirm that the actual share of funds going to countries on the DAC List of ODA Recipients is over 90%.” That is to say, if approved, there would be additional external monitor to make sure that the funds channeled through the AIIB to recipient countries are used properly. 

The AIIB’s initial total capital is $100 billion, equivalent to about 61 percent of the ADB’s initial total capital, 43 percent of the World Bank’s, 30 percent of the European Investment Bank’s (EIB), and more than twice of the European Bank for Reconstruction and Development’s (EBRD). Of this $100 billion initial capital, 20 percent is to be largely paid-in by 2019 and fully paid-in by 2024, and the remaining 80 percent is in callable capital. It needs to be noted that according to the AOA, payments for paid-in capital are due in five installments, with the exception of members designated as less developed countries, who may pay in ten installments. As of any moment, the snapshot of AIIB’s financial sheet includes total assets, members’ equities and liabilities, the last of which has negligible debt at the current stage since the AIIB has not issued any debenture or borrowed money from outside. However, to reduce the funding costs and to gain access to wider source of capital, the AIIB cannot rely solely on equity and has to issue debenture and take some leverage, particularly given that the AIIB intends to be a for-profit institution. In February 2017, the AIIB signed an International Swaps and Derivatives Association (ISDA) Master Agreement with the International Finance Corporation (IFC), which would facilitate local currency bond issuance in client countries. Moreover, AIIB intends to actively originate and lead transactions that mobilize private capital and make it a trusted partner for all parties involved in the transactions that the Bank leads. In the long term, the AIIB aims to be the repository of know-how and best practices in infrastructure finance. 

It is widely perceived that the AIIB is a tool of Chinese foreign policy, and that it is a vehicle for the implementation of the Belt and Road (One Belt, One Road) Initiative. During a meeting with global executives in June 2016, the AIIB President Jin Liqun clarified China’s position, saying the AIIB “was not created exclusively for this initiative,” and that the AIIB would “finance infrastructure projects in all emerging market economies even though they don’t belong to the Belt and Road Initiative.” It is worth pointing out that despite the efforts on trying to put some distance between the AIIB and the Belt and Road Initiative, there is still a broad perception that these two are closely related. Moreover, China has differentiated AIIB projects from its other foreign assistance projects by co-financing its initial projects with the preexisting MDBs. Co-financing, combined with European membership, will make it more likely this institution largely conforms to the international standards” and potentially will steer the AIIB away from becoming solely a tool of Chinese foreign policy. This supports China’s stated intention to complement existing MDBs rather than compete with them. It also means that the AIIB can depend on its partners, if they would allow so, for expertise on a wide range of policy and procedural issues as it develops its lending portfolio.

Although AIIB has attracted a great number of developing and developed countries to join as members and it has co-financed several projects with other MDBs, there is no guarantee for any easy success in the future. There are several formidable challenges for the young multilateral institution down the road. Not all the infrastructure investment needs in Asia is immediately bankable and ready for investors’ money. Capital, regardless it’s sovereign or private, will not flow in to any project without any proper preparation. Although Asia faces a huge infrastructure financing gap, there is a shortage of ‘shovel-ready’ bankable projects owing to the capacity limitations. The young AIIB lacks the talent and expertise to create investor-ready bankable projects, despite that it has created a Project Preparation Special Fund thanks to $50 million by China. The AIIB aims to raise money in global capital markets to invest in the improvement of trans-regional connectivity. However, infrastructure projects are not naturally attractive investment due to huge uncertainties throughout the entire life cycle as well as unjustified risk-profit balance. Getting a top-notch credit rating is just a start. The AIIB has to find innovative ways to improve the risk-adjusted profitability of its projects. This issue itself has been a big challenge for many MDBs who engage in infrastructure financing for a long time. It is uncertain if the AIIB could outperform the other much more matured MDBs to find a solution to tackle the profitability problem in infrastructure financing. The highest rating it has received from ratings agencies could pose a challenge in itself. The high rating not only endorses the bank’s high capital adequacy and robust liquidity position, but also validates the strong political will of AIIB’s members and the bank’s governance frameworks. A good rating will help the AIIB issue bonds at favorable rate and utilize capital markets to reduce its funding costs. This certainly will contribute to AIIB’s efforts to define itself as a for-profit infrastructure investment bank. However, there is no guarantee that the rating will hold forever. Many factors may impact the rating in the future, including but not limited to AIIB’s self-capital ratio, liquidity, management, yieldability, risk management ability, and its autonomy and independency from China’s influence. 

Banking and Lending/Investment. How Monetary Policy Becomes Decisive? Some Branching Rumination.

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Among the most notoriously pernicious effects of asset price inflation is that it offers speculators the prospect of gain in excess of the costs of borrowing the money to buy the asset whose price is being inflated. This is how many unstable Ponzi financing structures begin. There are usually strict regulations to prevent or limit banks’ direct investment in financial instruments without any assured residual liquidity, such as equity or common stocks. However, it is less easy to prevent banks from lending to speculative investors, who then use the proceeds of their loans to buy securities or to limit lending secured on financial assets. As long as asset markets are being inflated, such credit expansions also conceal from banks, their shareholders and their regulators the disintermediation that occurs when the banks’ best borrowers, governments and large companies, use bills and company paper instead of bank loans for their short-term financing. As long as the boom proceeds, banks can enjoy the delusion that they can replace the business of governments and large companies with good lending secured on stocks.

In addition to undermining the solvency of the banking system, and distracting commerce and industry with the possibilities of lucrative corporate restructuring, capital market inflation also tends to make monetary policy ineffective. Monetary policy is principally the fixing of reserve requirements, buying and selling short-term paper or bills in the money or inter-bank markets, buying and selling government bonds and fixing short-term interest rates. As noted in the previous section, with capital market inflation there has been a proliferation of short-term financial assets traded in the money markets, as large companies and banks find it cheaper to issue their own paper than to borrow for banks. This disintermediation has extended the range of short-term liquid assets which banks may hold. As a result of this it is no longer possible for central banks, in countries experiencing capital market inflation, to control the overall amount of credit available in the economy: attempts to squeeze the liquidity of banks in order to limit their credit advances by, say, open market operations (selling government bonds) are frustrated by the ease with which banks may restore their liquidity by selling bonds or their holdings of short-term paper or bills. In this situation central banks have been forced to reduce the scope of their monetary policy to the setting of short-term interest rates.

Economists have long believed that monetary policy is effective in controlling price inflation in the economy at large, as opposed to inflation of securities prices. Various rationalizations have been advanced for this efficacy of monetary policy. For the most part they suppose some automatic causal connection between changes in the quantity of money in circulation and changes in prices, although the Austrian School of Economists (here, here, here, and here) tended on occasion to see the connection as being between changes in the rate of interest and changes in prices.

Whatever effect changes in the rate of interest may have on the aggregate of money circulating in the economy, the effect of such changes on prices has to be through the way in which an increase or decrease in the rate of interest causes alterations in expenditure in the economy. Businesses and households are usually hard-headed enough to decide their expenditure and financial commitments in the light of their nominal revenues and cash outflows, which may form their expectations, rather than in accordance with their expectations or optimizing calculations. If the same amount of money continues to be spent in the economy, then there is no effective reason for the business-people setting prices to vary prices. Only if expenditure in markets is rising or falling would retailers and industrialists consider increasing or decreasing prices. Because price expectations are observable directly with difficulty, they may explain everything in general and therefore lack precision in explaining anything in particular. Notwithstanding their effects on all sorts of expectations, interest rate changes affect inflation directly through their effects on expenditure.

The principal expenditure effects of changes in interest rates occur among net debtors in the economy, i.e., economic units whose financial liabilities exceed their financial assets. This is in contrast to net creditors, whose financial assets exceed their liabilities, and who are usually wealthy enough not to have their spending influenced by changes in interest rates. If they do not have sufficient liquid savings out of which to pay the increase in their debt service payments, then net debtors have their expenditure squeezed by having to devote more of their income to debt service payments. The principal net debtors are governments, households with mortgages and companies with large bank loans.

With or without capital market inflation, higher interest rates have never constrained government spending because of the ease with which governments may issue debt. In the case of indebted companies, the degree to which their expenditure is constrained by higher interest rates depends on their degree of indebtedness, the available facilities for additional financing and the liquidity of their assets. As a consequence of capital market inflation, larger companies reduce their borrowing from banks because it becomes cheaper and more convenient to raise even short- term finance in the booming securities markets. This then makes the expenditure of even indebted companies less immediately affected by changes in bank interest rates, because general changes in interest rates cannot affect the rate of discount or interest paid on securities already issued. Increases in short-term interest rates to reduce general price inflation can then be easily evaded by companies financing themselves by issuing longer-term securities, whose interest rates tend to be more stable. Furthermore, with capital market inflation, companies are more likely to be over-capitalized and have excessive financial liabilities, against which companies tend to hold a larger stock of more liquid assets. As inflated financial markets have become more unstable, this has further increased the liquidity preference of large companies. This excess liquidity enables the companies enjoying it to gain higher interest income to offset the higher cost of their borrowing and to maintain their planned spending. Larger companies, with access to capital markets, can afford to issue securities to replenish their liquid reserves.

If capital market inflation reduces the effectiveness of monetary policy against product price inflation, because of the reduced borrowing of companies and the ability of booming asset markets to absorb large quantities of bank credit, interest rate increases have appeared effective in puncturing asset market bubbles in general and capital market inflations in particular. Whether interest rate rises actually can effect an end to capital market inflation depends on how such rises actually affect the capital market. In asset markets, as with anti-inflationary policy in the rest of the economy, such increases are effective when they squeeze the liquidity of indebted economic units by increasing the outflow of cash needed to service debt payments and by discouraging further speculative borrowing. However, they can only be effective in this way if the credit being used to inflate the capital market is short term or is at variable rates of interest determined by the short-term rate.

Keynes’s speculative demand for money is the liquidity preference or demand for short-term securities of rentiers in relation to the yield on long-term securities. Keynes’s speculative motive is ‘a continuous response to gradual changes in the rate of interest’ in which, as interest rates along the whole maturity spectrum decline, there is a shift in rentiers’ portfolio preference toward more liquid assets. Keynes clearly equated a rise in equity (common stock) prices with just such a fall in interest rates. With falling interest rates, the increasing preference of rentiers for short-term financial assets could keep the capital market from excessive inflation.

But the relationship between rates of interest, capital market inflation and liquidity preference is somewhat more complicated. In reality, investors hold liquid assets not only for liquidity, which gives them the option to buy higher-yielding longer-term stocks when their prices fall, but also for yield. This marginalizes Keynes’s speculative motive for liquidity. The motive was based on Keynes’s distinction between what he called ‘speculation’ (investment for capital gain) and ‘enterprise’ (investment long term for income). In our times, the modern rentier is the fund manager investing long term on behalf of pension and insurance funds and competing for returns against other funds managers. An inflow into the capital markets in excess of the financing requirements of firms and governments results in rising prices and turnover of stock. This higher turnover means greater liquidity so that, as long as the capital market is being inflated, the speculative motive for liquidity is more easily satisfied in the market for long-term securities.

Furthermore, capital market inflation adds a premium of expected inflation, or prospective capital gain, to the yield on long-term financial instruments. Hence when the yield decreases, due to an increase in the securities’ market or actual price, the prospective capital gain will not fall in the face of this capital appreciation, but may even increase if it is large or abrupt. Rising short-term interest rates will therefore fail to induce a shift in the liquidity preference of rentiers towards short-term instruments until the central bank pushes these rates of interest above the sum of the prospective capital gain and the market yield on long-term stocks. Only at this point will there be a shift in investors’ preferences, causing capital market inflation to cease, or bursting an asset bubble.

This suggests a new financial instability hypothesis, albeit one that is more modest and more limited in scope and consequence than Minsky’s Financial Instability Hypothesis. During an economic boom, capital market inflation adds a premium of expected capital gain to the market yield on long-term stocks. As long as this yield plus the expected capital gain exceed the rate of interest on short-term securities set by the central bank’s monetary policy, rising short-term interest rates will have no effect on the inflow of funds into the capital market and, if this inflow is greater than the financing requirements of firms and governments, the resulting capital market inflation. Only when the short-term rate of interest exceeds the threshold set by the sum of the prospective capital gain and the yield on long-term stocks will there be a shift in rentiers’ preferences. The increase in liquidity preference will reduce the inflow of funds into the capital market. As the rise in stock prices moderates, the prospective capital gain gets smaller, and may even become negative. The rentiers’ liquidity preference increases further and eventually the stock market crashes, or ceases to be active in stocks of longer maturities.

At this point, the minimal or negative prospective capital gain makes equity or common stocks unattractive to rentiers at any positive yield, until the rate of interest on short-term securities falls below the sum of the prospective capital gain and the market yield on those stocks. When the short-term rate of interest does fall below this threshold, the resulting reduction in rentiers’ liquidity preference revives the capital market. Thus, in between the bursting of speculative bubbles and the resurrection of a dormant capital market, monetary policy has little effect on capital market inflation. Hence it is a poor regulator for ‘squeezing out inflationary expectations’ in the capital market.