Source: Stephen Rousseas,"Post Keynesian Monetary Economics",p.54-64, 1992.

No matter what form the model took, the intersection of the IS and LM curves uniquely determined the equilibrium rate of the rate of interest at which the money and goods sectors were in simultaneous equilibrium, with a simultaneous equilibrium in the labor market thrown in for good measure in the pre-Keynesian version of the General Theory. The rate of interest, in other words, was market determined.

If, however the psychological factors that underlie the IS and LM curves in a world of uncertainty make them, in fact, interdependent, the usefulness of the rate of interest as an equilibrating force quickly dissipates in a haze of indeterminateness. One way out of this conundrum, within a Post Keynesian framework, is the emphasis from liquidity preference theory to credit-money and the role of banks. The best way of doing so is to apply Michal Kalechi's theory of markup pricing to the loan rates charged by banks for bank credit .6

Markup theory assumes an economy in which there are large concentrations of market power. As applied to the nonfinancial sector of production, oligopolies operate at a planned level of excess capacity and the degree of monopoly power in each industry allows a markup over unit prime costs. In the financial sector the interest rate is to be seen as the "price" of the financial "goods" provided by that sector. A markup theory of bank loan rates, as in the case for prices in the production sector, rejects the demand-supply analysis of competitive market behavior inherent in the IS-LM determination of the equilibrium rate of interest. An increase in demand relative to supply does not automatically transform itself into an increase in the loan rate. An "equilibrium" approach to the rate of interest charged by banks is not applicable to the financial sector.

It will be necessary, however, to translate the terms of, markup pricing for real goods into their equivalents for the financial sector and adjust the relative importance of the various components of markup theory. The markup equation for nonbank firms, p = k(u), can be rewritten for commercial banks as i = k(u), where i is the interest rate on loans, k the degree n of monopoly or market power exercised by individual banks or in the aggregate, by the banking industry as a whole, and u the unit prime of variable costs incurred by banks.

The total costs nonbank firms consist of certain fixed or overhead costs (including depreciation) and the prime costs which vary with the level of output. Prime costs are the sum of the costs of labor (wage costs) and cost of raw and intermediate goods (circulating capital) that enter the production process. By their very nature, fixed costs per unit of output fall along a hyperbolic curve as output increases. Unit prime costs, often controlled by forward contracting, are relative constant over the range of less than full capacity utilization that follows from the built-in planned excess capacity of oligopolistic firms. The degree of monopoly, or gross profit margin, which has been relatively stable over the long run, represents the markup over prime costs that determines the price of goods consistent with the profit goals of firms.

Demand and supply have little, if anything, to do with th oligopolistic commodity prices. An increase in demand, unless viewed as a permanent phenomenon, will elicit an increase in output cutting into the planned excess capacity of oligopolistic firms with no effect on prices in the short run. Price changes, given the degree of monopoly, are therefore due to changes in unit prime costs- either in the cost of labor or in the cost of materials- and serve the purpose of maintaining a firm's gross profit margin.

Banks, like nonbank firms, are in business to make a profit. The industry itself is dominated by a few large banks of national and international character. Their business is also to produce a product- financial services- which incurs certain costs. They are, however oligpolistic price setters in "retail" markets while being quantity takers in competitive "wholesale" financial markets. And unlike the case for nonbank firms, the wages of labor are included in fixed costs. The raw materials, therefore dominates prime costs. The raw materials, or inputs, of a bank are the deposits it is able to attract and its ability to borrow funds- both of are necessary ingredients for its final product, loans. Both have cost attached to them: the interest paid on deposits and the interest paid by banks on borrow funds. And both are determined in highly competitive markets, although attempts are being made to reduce the uncertainty attached to the "raw materials" costs through forward contracting, e.g. negotiable CDs (Certificates of Deposits) of various maturities at stated interest rates and severe penalties for violating the terms of the CD instruments. Other costs include required reserves banks must hold against their deposits and the insurance fees levied against such deposits the Federal Deposit Insurance Corporation (FDIC).

The revenues of a bank are largely derived from the "prices" charged against bank loans, or the patern of interest rates, and the interest income from holdings of short-term investments (Treasury Bills-TBs). The interest rates, or prices, of loans are determined by a markup over the "cost of funds" determined by the degree of monopoly or the profit margin of the bank. The equivalent of "excess capacity" in the banking system can be viewed as the excess reserves banks hold and their holdings of such secondary reserves as highly liquid TBs- which can be qdickly converted to loan assets virtually on demand either by refusing the Treasury's rollover, or in secondary markets of considerable "depth, breadth, and resiliency. " Planned excess capacity in the case of banks, however, would seem to play a lesser role than in the case of nonbank firms to the extent that banks, generally, keep excess reserves at a minimum. This is a general picture that needs now to be fleshed out with a more detailed explanation of the various price-determining components of the banking system.

The lending rates of banks are based on the "cost of funds" and the "interest rate spread" needed to achieve a bank's profit goals. The interest rate spread is simply the margin, or markup, between bank costs and what banks charge for their loans. A rough measure of the spread can be made by comparing the "prime rate"- an administered "price" set by banks supposedly for their best customers-and the Federal Funds rate, which can be taken as a proxy for costs of funds. Up to the Volcker policy shift of October 1979, the federal Funds rate, was a policy target of the central bank; after that it was free to find its own market level with the central bank concentrating on keeping a variety of monetary aggregates within certain defined upper and lower limits. Federal funds consist of very short term interbank borrowings of excess reserves. Table 3.1 lists and the prime rate and the Federal Funds rate from 1955 to 1990. The last column gives the PR/FF ratio, or the prime rate as a markup over the Federal Fund rate. As can be seen more clearly in Figures 3.4 and 3.5, there was some variability in the markup during the immediate postwar years of 1955 to 1964. It was less variable and at a lower overall level between 1966 and 1973, followed by a sharp rise during the 1973-76 OPEC crisis. From 1978 to 1981 the markup ratio remained virtually constant, with a rise in 1982-84 as banks increased their gross profit margin to offset an increase in problematic domestic loans and loans to Third World countries. For example, the percentage of problem loans to total loans outstanding for the largest bank in the United States, the Bank of America, rose from 0. 69 percent in 1978 to 4.50 percent in 1982. At other large banks, the percentage rose, for the same time period, from 0.81 percent to 2.56 percent and from 2.1 percent to 5.6 percent.

Part of the explanation for the recent increase in the gross profit margin is to be found in the Depository Institutions Deregulation and Monetary Control Act of 1980, which has increased the amount of interest banks can pay on deposits and has set off a competitive scramble for high interest rate deposits. In the process banks have been forced into making riskier domestic loans at higher interest rates to cover the increased cost of bank funds. Another part of the explanation is the enormous exposure of the larger banks in their loans to Mexico, Brazil, Argentina, and Chile (to mention only the most conspicuous ones) which are in virtual default. For both reasons, if future profit margins were to be threatened by increased domestic and foreign loan defaults banks might well attempt to restore their profit margins. By increasing their markup over prime costs. The general increase in k then be due to bad domestic loans being made under pressure to reach for higher returns at greater risk to cover the increased costs of funds, and to bad loans to Third World countries. Individual Banks, under normal circumstances circumstances, are not, free to set k at whatever level they wish. Their attempts to maintain k at a level consistent with the desired profit levels are subject to to certain constraints. A fall in profits may be the result of outside events that take an individual bank by surprise and over which it has limited control, or of mistakes in the handling of its loan portfolio, or simply of bad management. But the unilateral attempt of an individual bank store its profits by raising k may put it so out of line with other banks as to threaten it with a loss of business. When misfortune hits the banking industry as a whole, however, the tendency will be to raise k in order to maintain the profit margin of the industry as a whole. At any rate, the markup ratio after the 1984 adjustment has been remarkably stable, as shown in Figure 3.5.

It is interesting to note from Table 3.1 and its accompanying figures that the markup ratio increases from peak to trough and diminishes as the economy moves toward its next cyclical peak, especially between the years 1955 and 1978. The stickiness of the prime rate and the greater flexibility of the market-determine Federal Funds rate would account for the phenomenon. It would appear, however, that in more recent years banks have learned to adjust their prime rate more synchronously with changes in the Federal Funds rate.

Generally, k can be taken to be relatively stable, at least over the business cycle and, more recently, as a result of a quicker and roughly proportionate response of loan rates to changes in the internal cost of bank funds. Interest rates are therefore deterinined by a stable markup process over unit prime costs, and changes in interest rates are consequently dependent on changes in unit prime costs, or the cost of funds to banks. According to an excellent summary study of bank practices by Paul Meek of the Federal Reserve Bank of New York,7 banks mobilize funds for lending purposes by issuing domestic CDs and by paying the needed interest rates in foreign markets to attract Eurodollar deposits. CDs and Eurodollar deposits are in addition to regular deposits and are used by asset-driven commercial banks to expand their loans as a means of achieving their profit objectives. Their measure of internal cost of funds, applied to the domestic loan portfolio, is the rate adjusted upward for reserve requirement costs and the cost of deposit insurance; and for foreign loans, use is made of the London interbank offering rate (LIBOR) fo 3-month maturities. These estimates of the internal cost of funds are then applied against the lending and investment operations of a bank.

The next step is to determine the lending rate. Within the major banks the Money Desk is responsible for selling CDs, buying Federal Funds and other sources of borrowed funs- at a cost. The Money Desk is simply the equivalent of a purchasing agent in a nonbank firm, and its "purchases" are made in highly competitive markets. The Asset-Liability Committee (ALCO, on the other hand, is responsible for managing the types and maturities of bank assets and liabilities in keeping with the profit goals of a bank. It is in terms of ALCO decisions that the Money Desk engages in its borrowing operations. ALCO determines the interest rate spread between the bank's overall lending rate and its cost of funds, i.e., it oversees the maintenance of the gross profit margin of the bank.

Fixed lending rates are determined for 60- to 90-day loans in terms of a markup over the CD rate for corresponding maturities. A base rate is set for a bank's most creditworthy customers in keeping with the bank's profit target and then scaled up for other borrowers according to the degree of credit risk involved. Term loans are scaled up from the prime rate for best customers with the cost to the borrower fluctuating with the movement of the prime rate over time. Still other loans, from 30 to 180 days, are set at a markup over the adjusted CD or LIBOR rates for comparable maturities. Although there are a variety of interest rates, depending on the nature, maturity, and risk of different categories of loans and borrowers, they are all determined on a markup basis.

The forces affecting the cost of funds in terms of the interest rates paid on deposits were stable under Regulation Q, which set the maximum legal rates payable on differe kinds of deposits. Changes in the cost of borrowed funds were therefore attributable to changes of central bank reserve requirements, the discount rate, and the effect of open market operations on the Federal Funds rate. When the CD crisis of the 1960s forced the central bank to allow a series of large increases in the rate payable on negotiable time deposits (Regulation Q), the cost of funds took a sharp leap upward- as did interest rates as a markup over the cost of bank funds. All along, however, Eurodollar CDs were not subject to Regulation Q. And with the passage of the Depository Institutions Deregulation and Monetary Control Act of 1980, Regulation Q will have been completely abolished by 1986. This act also authorized thrift institutions to pay higher interest rates on their deposits and to compete with commercial banks by offering checkable deposits. In addition, high paying checking deposits were introduced by the money market and mutual funds of banks and brokerage houses. The cost of funds is in the process of becoming totally uncapped.

Yet another factor in the rise and volatility of bank prime costs was the October 1979 "monetarist" decision of the central bank, under Paul Volcker, to shift from targeting interest rates to targeting the money supply. The shift involved a turn from controlling the Federal Fund rate to an attempt to result, the costs of borrowed funds (the competitively determined "wholesale" interest rates) were left to seek their market-determined levels- in contrast to the "retail" interest rates which make up the 'product prices" confronting borrowers as a markup over the "raw material costs " of bankers. These "wholesale" interest rates attained unprecedented heights. The more restrictive actions of the Federal Open Market Committee (FOMC) have therefore had a profound effect on the cost of bank funds, with lending rates following suit on a mark up basis. Banks have therefore been forced to achieve their earnings targets by adjusting their lending rates in response to FOMC actions- usually within a week. As the cost of funds in general goes up, the increase is now much more rapidly transmitted to the price of loans. Expectations of future FOMC operations have become a critical factor in ALCO decision making. And with interest- rates now becoming a more significant part of the total costs of nonbank firms, prime costs in the nonfinancial sector have increased, leading to a markup df goods prices and, as in 1981-82, to a positive rate inflation along with massive unemployment.

Given the structural changes that have taken place in the banking industry (in part due to the Monetary Control Act of 1980) and the Monetaris policies of the central bank, the base of interest structure (as a markup over the "cost of funds") has probably taken a permanent shift upwards, on a long-term basis- even if the central bank should modify its "pragmatic" monetarism and return to a Keynesian policy of targeting interest rates.

More generally, what all this adds up to is that the notion of a market-clearing equilibrium "interest" rate- whether in the old "productivity-thrift" the or the "bastard" Keynesian IS-LM approach, or a market-determined short-run rate- is a theoretical fiction used to provide determinate theoretical solutions. Within arcane models bearing no relation to the real world. In the universe of economics, interest rates are not the equilibriating force of textbooks. They are essentially a markup over competitive prime costs in a broadly conceived financial sector that is bound to exhibit an even greater concentration of economic power, especially in the banking industry, as the recent, hasty deregulation of the financial sector leads to an even higher level of bank failures, the forced merger of those that do survive with the giants of the banking industry, and the entry into the banking industry of nontraditional types of institutions. In the meantime, the impact of structurally higher and uncapped interest rates all along the liquidity spectrum on what Keynes called the sector of "Industrial Circulation" will be pronounced since interest rates in their varied manifestations will play an even more significant role than before in determining investment, profits, and the process of capital accumulation and growth in a capitalist society.

7. Paul Meek, U. S. Monetary Policy and Financial Markets (New York: Federal Reserve Bank of New York, 1982), pp. 11, 22, and especially pages 44-51 of Chapter 3 on "Commercial Banks-Managers of Risk."
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