Money and capital in economic development

World Development.

87

Vol. 2. No. 3. March 1974, pp. 87-95.

Book Reviews

Money and Capital in Economic DeveloDment. ’ Institution, i973. Pp. 177. Index.)

This is a book which it is difficult to review (not to say read) because it is full of paradoxes. For while proclaiming criticisms of the neoclassical approach (chiefly as to monetary theory but in asides also to the prevalence of increasing rather than diminishing returns) it is couched throughout in the terminology and conceptual framework of that view. The aggregate production function is frequently invoked, even if not explicitly, by reference to optimizing and to second-best solutions, despite simultaneous rejection by the author of diminishing returns. These are not uncommon conflicts of expression amongst economists. The term ‘neoclassical’ appears to have no single generally accepted definition in the profession and this is not the place to develop one. McKinnon’s attack is essentially focused on certain monetarist views, basically the assumptions of perfect capital markets and of the perfect substitutability of financial and physical capital, ab least in the context of developing countries, whose fragmented structure and other sources of imperfection are briefly described in the early chapters. The question as he sees it is: ‘How can governments nurture domestic capital markets’, given the imperfections so evident everywhere. McKinnon begins his recipe with a review of standard monetary and growth theory, elegantly summarized. The basic model is a modification of traditional capital theory to allow for rising prices. Money balances compete with physical capital for the use of resources in the private sector. The equilibrium demand for money is given not only by the transactions need for cash and by speculation but also by the need to finance real capital formation in countries where institutional credit works indifferently well. There is also the need to hedge against inflation in such a way as to preserve the real value of money balances as opposed to investment in physical capital. $=H(Y,r,d--P*) where

6* = the expected rate of rise of prices. r = the expected return on physical capital, d = the market rate of interest.

The neoclassical concept of a substitution effect between money and physical capital, combined with the monetary growth model of Levhari and Patinkin, gives the neoclassical investment function .(of Friedman,

By R. I. McKinnon.

Johnson, growth

(Washington,

Tobin .fi ‘=dt

et al.).

D.C.:

This holds

The Brookings

that

in equilibrium

M = SY + (5 - 1) (iii - P) p

In contrast to Keynesian or short-run ‘fine-tuning’ objectives, fiscal policy is viewed primarily as a device for using public saving to control aggregate capital formation over the long run. It makes no difference in the neoclassical context whether the government does this by transactions in bonds or in the stock of physical capital since interest-bearing bonds are a perfect substitute for real capital in the portfolios of private savers. The condition for equilibrium is (d-P*)

plus the marginal

Hence the ‘full-liquidity’

convenience

yield of cash

= r.

rule (d - P’) = r

while the ‘golden rule’ capital is given by r optimizing rules gives

of accumulation = Y. Combining

of physical these two

Y = (d - P*) = r, with h; = 0 if d = 0. McKinnon’s criticisms of this neoclassical approach are: (i) that capital markets are imperfect (as witnessed by the dispersion of rates of interest and of returns to physical investment); (ii) that the relationship of real resources to the monetary system is insufficiently specified (iii) that there are fiscal constraints which prevent governments from adjusting the aggregate rate of capital accumulation. McKinnon argues that these omissions lead to biased conclusions regarding: (1) the substitution effect between real balances and investment; (2) the independence of monetary policy from the private rate of saving; (3) the use of inflation to increase savings; (4) the dominance of diminishing returns to capital. In his view this generates the paradox that while a ‘first-best’ policy calls for deflation under the fullliquidity rule, a second-best policy, which takes the capital scarcity and fiscal incapacity of the developing countries into account, is one of inflation. In the developing countries, governments are unable to use the fiscal method of raising domestic savings and this is why

88

WORLD

they have resorted to inflationary financing. Finally he concludes that the ‘basic assumptions of the model do not generate a determinate demand for money’. He disputes the neoclassical conception of a world in which ‘essentially there is full liquidity without money’. McKinnon, in the remainder of the book, sets out to devise a model which does generate a deierminate demand for money by recognizing the well-known imperfections in the capital market where there are risks of default and in which the rates of return on physical and financial assets differ. Cash balances are needed to intermediate between income and expenditure and the demand for money is a continuously increasing function of d - P’ His first step is to assert complementarity between ,money and physical capital in economies in which ‘government fiscal action cannot affect aggregate capital accumulation directly’. This he sets out in Chapter 6 developing a simple cash flow model of holdings of real cash balances in which the individual. being limited to self-finance, is both saver and investor. Under the formal constraint that al! investments are self-financed average cash holdings are positively related to the propensity to invest (save). Hence, so his argument goes, ‘public policy is limited to the selection of the real return on holding money’, viz. (d - P*). The circle is completed as in step one by asserting once again that d - P* does impinge on private saving, this generalizing the simple model of the firm-household to the economy as a whole. The author does not seem to realize that this requires a logical leap of some magnitude since a large fraction of private investment is financed corporately even in small poor countries, and some of it even from abroad. McKinnon then turns to examine empirical evidence in support of his thesis. But with no greater success in my view, although the, time series he has selected do show that a country’s money balances increase rapidly when the real rate of interest becomes positive and that in the countries selected for examination (Korea, Taiwan, Brazil and Indonesia), in the same years, more or less, it appears also to be the case that GNP grew faster. McKinnon attributes the one to the other. His mechanism is that a higher real return on money balances increases the savings rate in the private sector. Thus (he argues) higher real interest rates increase investment, though he offers no supporting evidence that there were actual changes in physical capita! formation as interest rates rose. Nor does he discuss the lag structure which must relate any such set of variables. What is weakest about his position is that his models and his ‘evidence’ are not on the same footing. The models described are without exception derived from the assumptions of a ‘closed’ economy, for reasons of ‘organizational convenience’, according to the author, but the basic paradox is that his empirical material is entirely drawn from ‘open’ ones. The same criticism applies to his simplifying assumptions about investment in small self-financing domestic enterprises. For McKinnon makes no adjustments to his models when he turns to look at the developing countries themselves, even though they are themselves far from ‘closed’ and their rates of capital formation far from being determined largely by tiny self-financing units. Like virtually all developing countries they are highly dependent on foreign trade and arc open to corporate investment, much of it from abroad. This puts quite a different gloss

DEVELOPMENT

upon the data tabulated. Further, while he makes much of the fiscal limitations facing governments, McKinnon gives little recognition to limitations facing them in monetary management. Despite their postwar dcvelopment of central banking, the supply of money in such countries remains passive and governments have had little control over their own money supply. For this supply is highly influenced not only by the current payments surplus but by aid and net capital flows. McKinnon recognizes that ‘in practice, exchange-rate policy, international flows of capital, and trade restrictions have all been critical ingredients in the success or failure of past efforts at monetary reform’. (p. 90) Yet the evidence he offers does not cover these other flows. The time series presented are of limited value in the light of these omissions. The stock of money is all too dependent upon the sign of and the manner of financing the foreign balance (viz. the extent to which there is an export surplus or deficit and the degree to which this is funded by long-term capital movements or is met by short-term flows or monetary movements). The magnitude of the foreign balance itself is affected not only by ‘real’ factors, such as import propensities and elasticities, but also by monetary ones related to capital movements whether overt (hot money flows) or merely in their through leads and lags, even if temporary impact, or through under-invoicing and over-invoicing of exports and imports, practices which themselves are a method of capital transfer, whose importance is said to have much increased with the rise of multinationals. That a rise in demand deposits plus currency (MI ), or these plus time and savings deposits (M2 ), should be due to a rise in the savings ratio, as McKinnon would have us believe, is implausible when foreign trade and capital flows are brought into the picture. It is true that Taiwan has always had high rates of interest but she has also had a large and steadily rising net inflow of aid and private capital and the author gives us no data as to the share of foreign financing in domestic capita! formation. In Korea and Indonesia official time series show that the leap in capital inflows is quite dramatic, once real rates are raised. McKinnon does not ask whether it could be that this has raised liquidity and eased the financing of industrial production, thus raising the savings ratio indirectly as income grows. For some of the growth of GNP could surely be due to higher use of capacity, to an easing of foreign exchange constraints, rather than to an immediately higher rate of domestic capital formation. The final paradox is that McKinnon himself advises developing countries to resist the temptations of foreign financing (the Siren’s Ca!l, as he terms it) in the last thirty pages of the book, when he, though without amending the logic of his closed economy model, admits the Rest of the World into the picture. He himself sees the paradoxical nature of the problem. He lists the dangers of capital transfers from the rich countries as a means of tackling the foreign exchange constraint, whether this capital comes in as government-togovernment assistance (often he implies a thinly disguised mercantilism, p. 175) or as direct investment by giant multinational corporations in their subsidiaries (often, he points out, subject to the enclave syndrome or to repatriations out of line with their correctly measured economic contribution, p. 171). He recommends that poor countries should follow the Japanese example, in