Financialization versus Development? A money view of the 2015 UNCTAD Report

The BIS and the IMF have each weighed in from the center, representing the perspectives of central banks and central Treasuries respectively.  (Interestingly, they don’t agree, see here for a recent sample of the debate.)  Now comes the periphery.  The new Trade and Development Report of the United Nations Conference on Trade and Development is titled “Making the international financial architecture work for development.”

A central theme of the report concerns the effect of financial globalization on the developing economies.  What these economies need, according to the authors, is finance of infrastructure and of small and medium-sized enterprises.  What they get is speculative short-term capital flow, first inward and then inevitably outward, boom and then bust.

This is an old story, and an old complaint.  What is new is the rise of market-based finance (so-called shadow banking), the global stress test of this new system in the financial crisis of 2008-2009, and the subsequent aggressive expansionary measures of the core central banks.  Each one of these new developments in the developed world has raised a new challenge for developing economies.

What the authors would most like to see is a complete restructuring of the international financial architecture:  a very substantial expansion and “democratization” of official multilateral credit institutions, and a replacement of dollar reserve currency hegemony with a true global currency (the SDR) and a true global central bank.  In this ideal, private financial markets with their inevitable focus on short-term private gain would be replaced by public financial intermediaries with their ability to focus instead on long-term economic development.  Various development banks already exist, of course; the problem is that their resources are very much too small to meet the need.

That’s the ideal but, and this is what makes the report interesting, the authors apparently realize that this ideal is not in the realm of the possible.  Dollar hegemony, and financial globalization, are the essential facts on the ground, and developing countries thus face the problem how best to interface with an international financial architecture that is apparently inherently inimical to their interests.

This recognition of the problem is a positive first step, according to me, engaging with the world as it is rather than as we might prefer it to be.   But it is not clear to me that the authors yet adequately appreciate the actual workings of the international financial architecture, and as a consequence they fall short in their recommendations for how best to interface with it.

Dollar hegemony, for example, is understood in the report mainly as “exorbitant privilege”, a phrase that apparently is intended to invoke the memory of French Minister of Finance Valery Giscard d’Estaing back in the pre-euro 1960s.  Reserve-currency countries (unnamed, but presumably including the US and perhaps also today the Eurozone?) stand accused of “issuing a reserve currency to bolster narrow national concerns at the expense of broader global interests” (p. IX), imposing insufficient discipline on themselves and providing insufficient elasticity for everyone else.

Regular readers of this blog will recall my enthusiasm for the 1967 Depres-Kindleberger-Salant riposte to the French j’accuse.  DKS pointed out that the United States was essentially operating as bank of the world, providing liquid asset reserves by borrowing short and illiquid capital funding by lending long.  True, the US was borrowing at a lower rate than it was lending, just as it is today with the developing world.  (“This is one of the factors that make the IMS highly inequitable” (p. IX).)  But that was not some kind of nefarious plot to emiserate Europe, only a consequence of the financial underdevelopment of Europe.  In the 1960s, Europe tapped dollar capital markets, and held some of the proceeds in liquid dollar claims, because of inadequate European capital markets and European liquidity provision.  Much the same could be said of the developing world today.

In this regard, the deep suspicion of financial development that is evident throughout the report might rather be considered part of the problem than part of the solution.

In part, the suspicion of financial development is clearly a consequence of past boom-bust experience, and in this respect it is entirely legitimate.  Regular readers of this blog will recall my enthusiasm for Ralph Hawtrey’s phrase “the inherent instability of credit”, and my unhappiness with the tendency in economics to focus attention on equilibrium models where this inherent instability is ruled out by assumption.  (This bifurcation is a central aspect of the difference between the BIS view and the IMF view, mentioned above, but that is a matter for another time.)  “Money will not manage itself,” as Bagehot told us long ago, “and Lombard Street has a great deal of money to manage.”

But the authors don’t want to manage money, they want to eliminate it, and replace it with an official bureaucratic structure of resource allocation.  (Perhaps it is just some authors, not all of them?  The report very much shows evidence of multiple points of view, incompletely synthesized.)  This seems to me less legitimate, and indeed possibly part of the problem.  Throughout the report, there is a constant contrast of “productive” versus “speculative” credit, the former good and the latter bad.  I am on record questioning whether there is any bright line test that would ever allow us to distinguish reliably between these two categories–entrepreneurship is inherently speculative.  In their zeal to stamp out speculative credit, in order to avoid financial instability, the authors risk overreaching by calling essentially for stamping out most of private credit.  If markets don’t work, then definitely you don’t want to use markets, but inherent instability is not sufficient reason.

The fundamental conceptual problem, so far as I can see, is an illegitimate separation of the real economy from the financial economy (a separation familiar in standard economic theory, to be sure, but no less illegitimate for that!)  To be sure, in many underdeveloped economies, an essentially non-monetary traditional sector survives, and even the modern sector often proceeds without much of a (domestic) financial infrastructure.  But, according to me, this is part of the problem not part of the solution.  The monetary and financial system is not just another sector, to be encouraged or discouraged according to developmental priorities, but rather the essential infrastructure for all sectors of a decentralized market economy.

Having said that, it is important to emphasize that there is no guarantee at all that the natural working of the decentralized market economy will lead to any social optimum.  Indeed, as I have emphasized above, the natural workings of the system are inherently unstable, and thus require deliberate, active, and above all informed management. Fear of finance, as the purported enemy of “real” development, is an obstacle to our understanding of how the system actually works, and hence also an obstacle to development itself.

In this regard, it has to be said, the developed world is not offering a very attractive example for the developing world to follow, to put it mildly!  The rise of shadow banking, global financial crisis, multiple rounds of quantitative easing–who could blame the periphery for saying “Thanks, but no thanks!”

According to the report, the essential problem of the developed world is income inequality, which is leading to a structural shortfall of aggregate demand.  Given political constraints that prevent incomes policy from directly addressing inequality, or fiscal policy from directly addressing the demand shortfall, the developed world has depended entirely on monetary expansion, deliberately blowing asset price bubbles in an attempt to get the economy going again.  Against this policy background, it is entirely understandable that the developing world would want to find ways to dis-engage and protect themselves.  “Thanks, but no thanks!”

The problem is that you can’t dis-engage and protect yourself, no matter how much you want to do so.  Indeed, given inadequate resources of the official development banks, and the contraction of private bank lending as a consequence of crisis and regulation, developing economies have become more reliant, not less, on the market-based finance system that emerged originally in the developed world.  In this respect, it is disappointing that the report spends so little time (pages 96-104) coming to grips with the “shadow banking system”, but it is a start.  First step done, next step yet to come.  We’re all trying to figure out how the emergent new system works, and how its inherent instability can best be managed.






4 comments on “Financialization versus Development? A money view of the 2015 UNCTAD Report

  1. Walker Todd on said:

    Good job analyzing the problem, as usual for Prof. Mehrling. He and I might disagree on solutions (I would oppose trying to create any new government-run international development banks, and I would favor gold [so did Harry Dexter White, don’t forget] over the SDR as an international currency, for example), but I agree with his analysis (apparently, so do the BIS and IMF reports) of what is the problem to be solved. As Prof. Mehrling has explained previously in his blogs, better than anyone else I have read, official connivance in promoting the shadow banking sector (e.g., U.S. subsidies to money market mutual funds through the NY Fed’s reverse repo operations) is laying the building blocks for the next big financial disaster. Official connivance in failing to obstruct the further rise of non-exchange-traded derivatives within the banking and shadow banking sectors generally points in the same direction.

    The alternative solution that Prof. Mehrling does not mention is a reasonably good one: Don’t nationalize (or internationalize) the governance structure for development finance; instead, for national development efforts, at least, simply clean out the domestic banking system and start over. This is what actually was done in the USA in the 1930s via the operations of Jesse Jones and the former Reconstruction Finance Corporation. Banking was cleaned out, and there were no US banking crises for the next 40 years. After 2008, when a similar clean-out was needed desperately, it simply was not done. Instead, we got Dodd-Frank, a sort of halfway house on the road to real reform, and the financial sector by and large is up to its old tricks. We also need measures like the repeal of the 1999 repeal of the Glass-Steagall Act and the repeal or wholesale reform of anti-consumer, anti-household provisions in the wildly misnamed Bankruptcy Reform Act of 2005. No politician who will not advocate these last two measures is worth supporting.

    For international development finance, the recommendations of the old Meltzer Commission (ca. 2000) are worth considering. The World Bank (the only global development bank worth supporting, IF it can be reformed properly) should be given specific mandates to accomplish, and the IMF should be reminded pointedly and often that it should not be a development bank. Regional development banks need wholesale reform, also.

    Still, please do not overlook the valuable contribution to the financial sector reform effort of Prof. Mehrling’s blog postings. He stands out in his willingness to grapple with the most difficult topics of that reform effort with knowledge and candor. — Walker Todd, Chagrin Falls, Ohio

  2. Nicolas Hofer on said:

    Dear Perry,
    thank you for yet another enlightening blog post.

    You write:
    “The monetary and financial system is not just another sector, to be encouraged or discouraged according to developmental priorities, but rather the essential infrastructure for all sectors of a decentralized market economy.”

    A subsequent question that fails to come up regularly when dealing with “development” isn’t asked in your blog post either:
    under what legal and fiscal infrastructure requirements can a “monetary and financial system” spring up at all?

    Is a “monetary and financial system” not inherently dependent on claims (“swap of IOUs”)? What good does a balance sheet entry of a claim do, when the claim (whether created “voluntarily” by private contract or “ordered” by public law) is not reliably enforceable for the claimant by due process of law?

    You write:
    “To be sure, in many underdeveloped economies, an essentially non-monetary traditional sector survives,”
    Exactly! Is this non-monetary sector not relying upon traditional solidarity and other non-formal relationships (incl. bribes, blackmail,…), a sector that is at large completely unaware of the mere existence of formal, enforceable claims?
    You continue:
    “and even the modern sector often proceeds without much of a (domestic) financial infrastructure.”
    Is the reason for this not the virtual non-existence of a legal infrastructure that would allow for “swaps of IOUs” or rather rely on claims to be effectively enforceable for the claimant?

    Should “development” not start at the most fundamental basics of the very legal infrastructure that is indispensable for having a “monetary and financial system” in the first place?

    Well, … since some of the authors want to do away with money anyway, they might as well just continue to ignore the prerequisites for a “monetary and financial system” to function in the countries they try to develop.

    As you so eloquently put it once: “there is no theory of markets” [in standard general equilibrium theory]. You might want to add now: neither is there a theory of how to build markets in the first place. Markets that completely depend on claims and counterclaims specifically on the continuous frictionless creation and destruction (settlement) of these claims.
    If you cannot rely upon (the enforceability of) claims, don’t wonder no one uses them: “even the modern sector often proceeds without much of a (domestic) financial infrastructure”.

    Thank you and all the best

  3. Charles D Porter on said:

    This “comment” furnished solely for purpose of “checking” the two boxes appearing below the “Post Comment”-button.

  4. Thanks Perry for yet another insightful post. I agree with most of it, yet I would like to add one observation.

    You write:

    “The fundamental conceptual problem, so far as I can see, is an illegitimate separation of the real economy from the financial economy (a separation familiar in standard economic theory, to be sure, but no less illegitimate for that!) To be sure, in many underdeveloped economies, an essentially non-monetary traditional sector survives, and even the modern sector often proceeds without much of a (domestic) financial infrastructure. But, according to me, this is part of the problem not part of the solution. The monetary and financial system is not just another sector, to be encouraged or discouraged according to developmental priorities, but rather the essential infrastructure for all sectors of a decentralized market economy.”

    I fully agree on that!

    But what is that essential infrastructure, the monetary and financial system, actually made up of, and how can it be created when it is not there yet, and instead a traditional non-monetary sector prevails? Is it enough to set up a few foreign banks from scratch, or is there more to be done to get a fully functioning credit and monetary infrastructure up and running,?

    I would like to suggest a very simple insight that we westerners often take for granted, because we are so used to habitually dealing with it all our lives that we notice it only when it is missing: any financial instrument we know comes into existence by way of contract, and will be trusted in and be negotiable – transferable to someone else we do not necessarily know personally, and who does not know the debtor personally – only when that contract will be legally enforceable. And that is a service which has to be provided in a unified way, by a state by way of reliable civil courts.

    As a matter of fact, ANY balance sheet entry is an enforceable legal title, either a legally enforceable property right, or a claim or an obligation (liability), as institutional economist John R. Commons noted in his 1934 “Institutional Economics”.

    This enforceability – any debtor being liable for his monetary obligations – is an essential part of private (property and contract) law, and presupposes a state who can provide the bureaucratic infrastructure (including registries for property and businesses, civil courts, etc.) and reliable personell to accomplish that in an impersonal, uncorrupt way. Without such prerequisites, impersonal exchange of negotiable debt instruments (financial markets) cannot flourish, and people instead have to fall back on informal, personal relations for their transactions, which – from a western point of view which implicitly presupposes law and the necessary state infrastructure to guarantee and enforce it – then are perceived as “corrupt” or “nepotistic”.

    As strange as that may sound to us westerners, the existence of such a reliable state and legal infrastructure cannot be taken for granted. As people like Benito Arruñada (in his book “Institutional Foundations for Impersonal Exchange”) have demonstrated, it exists only in a small number of countries in the world, and its buildup has been dis-, rather than encouraged, by western economics during the past 40 years which focused on taking down rather than on building up state infrastructure. Yet, economic theories do not only abstract from the actual practical workings of the financial system which is the core topic of the money view. They also abstract from the legal and state infrastructure without which such a financial system can not exist. And it seems to me that so far, the money view also still abstracts from that legal infrastructure, taking it mostly for granted and thus, not notices when that foundation is simply not there or very weak (as in many developing nations with a huge “informal sector”).

    We all know there are many weak and failed states out there – but which economic theory systematically connects weak states with a weak financial system and points to the fact that without a strong state reliably enforcing private law, there can be no secure credit, hence no negotiable debt, hence no financial markets on any meaningful scale? Has not the state often rather been seen as a hindrance to, rather than as a prerequisite for, a functioning credit and financial system during the past 40 years – and understandably so, during the cold war and “conflict of systems”?

    Moreover, as Francis Fukuyama found in his recent big 2-volume comparative and historical study of state building (Vol. 1: “Origins of Political Order”, 2011; Vol. 2: “Political Order and Political Decay”, 2014), which he wrote with the explicit purpose to get more clarity about the problem of “development”: building a reliable and non-corrupt state infrastructure is no small task but rather difficult to achieve, because, as Fukuyama points out comparatively by way of a broad range of examples, it basically runs counter to “natural” human inclinations, and any state is always in danger of being repatrimonialized.

    What makes things even more difficult is that a state presupposes an efficient monopoly of force, while private law and the market presuppose such a monopoly but also run counter to it, private property and markets being the most essential form in which monopolized force and sovereignty is DEcentralized. There is a constant tension between the market principles of private law (property and contract) and the state principle of public law (taxation, setup of state infrastructure, etc.), and to build such a contradictory system is not a simple task. You mention the hybridity of the credit system – being both private and public – as one of the biggest obstacles to understanding money.

    That hybridity, that dialectic is at the very heart of the legal system of western civilization, in the contradiction of the principles that private law and public law are based upon: freedom, equality and consent in private law which form the basis for markets, un-freedom, hierarchy and command in public law which forms the basis of the state, without which there can be no private law. I like to call this the private-public-law dialectic.

    As Edmund Burke once put it,

    “To make a government requires no great prudence. Settle the seat of power, teach obedience, and the work is done. To give freedom is still more easy. It is not necessary to guide; it only requires to let go the rein. But to form a free government, that is, to temper together these opposite elements of liberty and restraint in one consistent work, requires much thought, deep reflection, a sagacious, powerful, and combining mind.” (Edmund Burke, “Reflections on the Revolution in France”, 1790)

    That is the problem that europeans historically solved by way of constitutional law, creating republican states out of absolutist ones by essentially dividing up and thus, controlling the state monopoly of force while retaining it to guarantee the private/public legal order, but subordinating it to the rule of law.

    It is this task of state building that we westerners have long forgotten about because we accomplished it centuries ago. We therefore can take the state and legal system for granted. But “developing nations” cannot: they are facing this task of state building in their attempt to build the basis of the monetary and financial system – “the essential infrastructure for all sectors of a decentralized market economy” as you put it so well.

    Unfortunately, they have not been receiving much useful advice from western economists for this, who basically abstract not only from the financial and monetary system, but also tend to underconceptualize the specific legal and state infrastructure / bureaucracy that is needed to build one.

    After decades of failed attempts at “development aid”, “institutions” have now become a hot topic for the international institutions. But the essential connection of the legal and institutional foundations of capitalism, its monetary and financial system (any credit, any financial instrument is a contract) and “development” still remains underconceptualized in both orthodox and heterodox economics, imho. Neoclassical institutional economists talk about property rights (often, de facto, only about rights of possession), but still miss the connection to the financial system and its central role for the economy as a whole. Chartalists emphasize taxation and the state’s power but take for granted reliably enforceable private law (property and contract). The money view emphasizes markets, but conceptualizes the state as kind of a “big business”, thus underconceptualizing public law and constitutional law as the mediator between private (freedom) and public (command) law.

    That, imho, leaves us with the task of providing today’s monetary economics that is so badly needed to understand what is really going on in the world of markets, with systematic and explicit legal and institutional foundations that make it a useful tool for guiding strategies of development. Property rights are traditionally a liberal topic, but most of the time, they are not systematically connected to the financial system by way of accounting, which is really accounting for legally enforceable rights (assets, i.e. property rights and claims) and obligations (i.e. liabilities, debt).

    With Katharina Pistor’s project of a legal theory of finance, and the corresponding project of legal institutionalism, the process creating such a foundation has started. This, imho, is a much needed development, and will also help to make explicit for the money view the legal and state infrastructure real monetary economies empirically rest upon. We at have tried to make a small contribution to this with two presentations at the recent Symposium on property rights organized by WINIR, the World Interdisciplinary Network for Institutional Research, which can be viewed at our blog.

    I fully agree with what you say:

    “Fear of finance, as the purported enemy of “real” development, is an obstacle to our understanding of how the system actually works, and hence also an obstacle to development itself.“

    But to put in place a financial infrastructure, the state and legal infrastructure has to be put in place first. “Fear of the state and the law”, therefore, is not just an obstacle to development as such. It is, first and foremost, an obstacle to developing a monetary and financial infrastructure.

    Thanks, and all the best-
    Wolfgang Theil