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.