Development Macroeconomics: Alternative Strategies for Growth 180037111X, 9781800371118

Table of contents :
Contents
Acknowledgments
Introduction
1. Several central debates in development macroeconomics
2. Key principles of macroeconomics
3. Giving space to the public sector
4. The domestic economy and the rest of the world
5. A reform to remove the external constraint
6. Macroeconomic strategies to guide the economy
Conclusion
References
Appendices
Index

Citation preview

Development Macroeconomics

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Development Macroeconomics Alternative Strategies for Growth

Basil Oberholzer Economist, Swiss Federal Office for the Environment, Switzerland

Cheltenham, UK • Northampton, MA, USA

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© Basil Oberholzer 2020 All rights reserved. No part of this publication may be reproduced, stored in a retrieval system or transmitted in any form or by any means, electronic, mechanical or photocopying, recording, or otherwise without the prior permission of the publisher. Published by Edward Elgar Publishing Limited The Lypiatts 15 Lansdown Road Cheltenham Glos GL50 2JA UK Edward Elgar Publishing, Inc. William Pratt House 9 Dewey Court Northampton Massachusetts 01060 USA A catalogue record for this book is available from the British Library Library of Congress Control Number: 2020944684 This book is available electronically in the Economics subject collection http://dx.doi.org/10.4337/9781800371125

ISBN 978 1 80037 111 8 (cased) ISBN 978 1 80037 112 5 (eBook)

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Typeset by Servis Filmsetting Ltd, Stockport, Cheshire

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Contents vi

Acknowledgments

Introduction1 1 Several central debates in development macroeconomics 7 2 Key principles of macroeconomics 41 3 Giving space to the public sector 88 4 The domestic economy and the rest of the world 137 5 A reform to remove the external constraint 210 6 Macroeconomic strategies to guide the economy 256 Conclusion268 270 298 325

References Appendices Index

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Acknowledgments This book originates in the observation and experience that a proper macroeconomic perspective is largely missing in most current debates on development economics. It aims to make a contribution to fill this gap by starting from the basic principles of macroeconomics, combining alternative approaches, analyzing the resulting complexities, and deriving a development strategy. Many people have supported me towards the publishing of this book. First of all, I am indebted to Sergio Rossi and Edwin Le Heron who reviewed the manuscript and provided helpful remarks. Moreover, I am grateful to Jonathan Massonnet for providing me with important sources and very welcome advice. Further thanks go to the Edward Elgar Publishing staff for efficient support as well as to the many other people who helped me with detailed answers to my specific questions. All mistakes in this book are my own. Finally, I give special thanks to Eva Muthoni Kimonye for linguistic support and for the countless discussions on how macroeconomic conditions translate into the concrete challenges developing countries and their populations have to master in everyday life.

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Introduction When popular Michael Manley took office as the Prime Minister of Jamaica in 1972, the country suffered from high illiteracy, unemployment and poverty. In the two decades before, the private sector had proven not to be able to guarantee long-term economic and social development. The government was expected to initiate change and steer growth (Davis, 1986, p. 77). Immediately after his election, Manley started the program he had promised: among other measures, a minimum wage was established; his land reform redistributed farmland to small-scale farmers; education at all levels became free; adult education programs reduced illiteracy. Did the story end as a success? To finance the program, the government ran high budget deficits that were mainly financed by foreign capital flows. The government expanded, while support for the private sector was reduced. This prompted capital flight (Shams, 1989, p. 75). Capital leaving the country meant currency devaluation, inflation, and economic contraction. Violence spread over the country. Manley lost his election in 1980. This example is not unique. On the larger scale of a whole region, Latin America and Africa were hit by debt crises in the 1980s that triggered the same macroeconomic instability. Likewise, the Asian crisis hit East and South East Asian economies in 1997 after a period of continuous growth. In recent years, we have witnessed how the government in Venezuela has funded social programs to provide comprehensive health service and eliminate illiteracy since the beginning of this century. Nationalization of the oil industry and redistribution triggered capital flight out of the country. Currently, Venezuela is facing a currency crisis and hyperinflation. Meanwhile, Argentina’s export returns have declined in recent years due to falling commodity prices. Foreign debt is increasing, while the peso is depreciating. The central bank interest rate target peaked at over 80 percent in 2019 while the government had to request the International Monetary Fund’s assistance once again. Analogous observations can, for example, be made in Nigeria, where the low oil price entails trade deficits and foreign debt while inflation rates are double-digit. The country exemplifies the fear of a new debt crisis emerging on the African continent. These current and historical examples, taking place in different political and economic circumstances, were certainly triggered by additional ­1

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factors than the ones mentioned here. But the similar outcome confirms common features in all the stories. The core question suggesting itself is: what can a poor country in a globalized economy do to get on a successful development track? Given the examples described, one may ask further: does the path to successful economic policy even exist? Apparently, policies favoring social redistribution, active economic policies, and market intervention are punished by capital flight. Capital is mobile and hardly willing to contribute to fairer wealth distribution. Moreover, as will be seen in detail, growth-enhancing development strategies create balanceof-payments problems, external debt, and exchange rate fluctuations even if there are no speculative capital flows. One may thus be tempted to conclude that development and poverty reduction should be left to the market, while government intervention should be reduced. On the other hand, even countries with no exceptional economic policies are exposed to destabilizing global capital inflows and outflows. Even if one shares the controversial view that the fight against poverty is progressing well, it will be a long time before today’s poor people are relieved from their miserable living conditions. As will be seen, general living standards alongside poverty reduction have improved most in China in past decades. Its interventionist economic policy and a high share of public investment have yielded hitherto unseen economic progress. Other East Asian countries such as South Korea and Taiwan underwent a similar experience a few decades earlier (see Chang, 2006). These countries may have had several advantages compared to today’s developing countries in Latin America, Africa and Asia, with respect to institutional strength, historical legacy, and the state of the world economy. Global competition has since increased, goods markets and financial markets have been liberalized, and advanced economies are not no longer pushing global growth. One may argue that even if state-driven development has ever been successful, it can no longer be so in the current age of economic and financial globalization. Is this a case for a more self-regulating market-driven approach? It has been tried, by imposing market liberalization and fiscal discipline on Latin American countries after the debt crisis of the 1980s, and subsequently also in other world regions. Yet, the results in terms of domestic investment and growth were disappointing (MorenoBrid et al., 2004‒05, p. 347). The central issue remains the same. If developing countries want to improve their populations’ well-being, they need to adopt appropriate strategies. Countries strongly depend on foreign conditions via their trade and financial relations. Given that financial markets punish profitshrinking policies by capital flight, it is obvious that the scope of action of an individual country is minimized. If poverty is to be reduced in the

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Introduction ­3

foreseeable future, developing countries need to get back their sovereignty in economic policy. This requirement can only be fulfilled at a systemic level. Therefore, first, we need a consistent view of how macroeconomics works. Second, more clarity on what is meant by appropriate economic policy is necessary. Third, we have to assess the conditions that allow a country to implement such policies, even as a single small open economy in a globalized world. In short, we need to design a macroeconomic ­strategy for developing countries. This is what this book aims to do. It is structured as follows: Chapter 1 gives an overview of several central debates in development macroeconomics that have influenced the way the economics profession, particularly the economics mainstream, looks at development. Starting with selected data on global poverty, the dimension of the problem is presented. The evolution of global living standards is often considered as positive. But there are also critical voices arguing that progress in poverty reduction is overestimated, thus further stressing the urgency of action. And some data even report a deterioration of the global situation. In the subsequent section, the principal approaches to growth theory as the core macroeconomic discipline in development economics are briefly introduced. Thereafter, a summary of the Washington Consensus, the agenda of mainstream economists for developing countries for at least two decades, is provided. Even though criticism has become more pronounced particularly after the financial crisis of 2008, the Consensus’s ideas are still present in public debates. The subsequent sections therefore discuss its agenda topics of fiscal policy and the role of the state in general, trade liberalization and financial liberalization. Understanding these topics and the critical underlying assumptions is key to elaborating an alternative approach. Industrial policy, which has been promoted by some economists and in some countries but has been largely neglected by the Washington Consensus, is debated as well. Finally, the chapter turns to the meaning of institutions in a development context and the different approaches to the term. In Chapter 2, the foundation for the macroeconomic analysis of this book is laid. It starts at the very beginning by defining and justifying the key principles of macroeconomics. The principles are mostly opposed to the assumptions of neoclassical economics. This is why the chapter devotes considerable space to the examination of mainstream theory and its assumptions and conclusions. It is the identification of their weaknesses which leads to heterodox economics. First, it is argued that money plays an important role in economic activity and that its nature is endogenous. Second, money is associated to output and cannot be separated from it. Economic production is part of a monetary circuit or credit circuit, respectively. Third, the circuit reveals that economics is not just an exchange

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between the demand side and the supply side. More than this, the whole process from the issuance of a loan, via the payment of wages, the production process and sales of goods, to the repayment of the loan, must be considered. The principle of the monetary economy of production reveals the fundamental importance of Keynes’s (1936/1997, pp. 55, 161–162) conceptions of effective demand and uncertainty. Effective demand is one of the conditions to make a capitalist economy work. Fourth, there is another condition for an economy to prosper, which is profitability. No firm is going to invest if the expected profitability of the capital employed is insufficient. The combination of these principles forms a complex and dynamic system, which is the capitalist economy. In contrast to what neoclassical theory assumes, there is no predetermined optimal equilibrium. This economic system is modeled and simulated in a stock-flow consistent (SFC) model. This book does not adhere exclusively to a specific school of thought, but combines useful insights of both post-Keynesian theory in a broad sense on the one hand, and classical economics on the other hand. The reader strictly sticking to a specific school of thought may find the analysis eclectic. Yet, the pragmatism applied here hopefully helps to understand the complexity of economic development. While the analysis in Chapter 2 concerns the macroeconomy without any policy influence apart from monetary policy, Chapter 3 introduces the public sector. In neoclassical theory, there is usually little space for the government as an economic agent. The central bank and fiscal policy may be allowed to counteract deviations when exogenous shocks cause distortions in the otherwise efficient equilibrium. Additionally, the government is allowed a role to provide basic social services. However, the substantial contribution that the state can make to employment and long-term productivity growth is generally denied. Neoclassical proponents usually argue in three ways: active fiscal policy distorts market efficiency; the government faces financial constraints and hence cannot make expenditures as it wishes; too much economic activity of the public sector crowds out the private sector. The chapter reviews these arguments and reveals why they are inconsistent with a proper macroeconomic monetary analysis. The reason why the state can play an important role in economic development is its character as a macroeconomic agent. The government can shift and overcome constraints that private firms cannot. Its role in enhancing the economy’s productivity and effectiveness is essential. The state is a driver of economic growth. The previously constructed basic SFC model is extended by including the public sector. Model simulations show how different kinds of policy intervention ‒ that is, social spending, taxing and income redistribution, as well as public investment ‒ can make a ­substantial contribution to economic development.

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Introduction ­5

Chapter 4 drops the assumption of the economy as an isolated space. Countries are integrated with the global economy mainly via trade relations and financial flows. While global growth has an impact on the specific developing country considered, its own growth also affects flows of goods and finance across economic borders. The first section of this chapter therefore investigates the nature of those flows and the essential link between the monetary spaces of the economies, that is, the exchange rate. In particular, it analyzes the determining factors of nominal as well as real exchange rates, and thus provides a picture of the new complexities that are involved once the economy is opened up to the rest of the world. In another section, the instruments used by countries to control the exchange rate are discussed. They are more or less useful in achieving certain targets, but in many cases also entail new instabilities. Exchange rate pegging is an example of this. The central problem of an individual country’s integration with the rest of the world is the persisting imbalances: higher domestic growth means more net imports and thus tends to worsen the current account while increasing external debt. This brings about further consequences for the exchange rate, which itself impacts back on domestic economic performance. It is argued in detail how monetary and economic policy become largely ineffective when turning from a closed to an open economy. Economic growth is restricted by the balance-of-payments constraint. Moreover, to the extent that economic policy means market intervention and possibly income redistribution, capital tends to leave the country, thereby triggering further fluctuations up to currency crises. Some bad examples of this have been described above. The further extension of the SFC model to include the external sector confirms the quite limited space for economic policy and hence development strategies. Given this external constraint, developing countries might be condemned to doing nothing but to wait for a positive dynamic coming from the private sector. Yet, Chapter 5 shows that there are instruments for developing countries to get back their scope of action. A more thorough monetary analysis reveals the nature of international payments. In the current (non-)system of international payments, such payments are actually made twice, thus giving rise to twofold payments of interest on external debt, as well as the duplication of external debt itself. Bernard Schmitt’s (2014) analysis of this hidden crucial fault in the global monetary system reveals far-reaching consequences. The double payment not only involves exchange rate fluctuations but also depresses effective demand in countries with a current account deficit. The solution to the problem is based on Keynes’s (1942/1980) proposal for an international settlement institution, but goes beyond it by taking up important elements developed by Schumacher (1943a, 1943b) and Schmitt (2014). It can be unilaterally

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implemented by a single country. Taking account of the true nature of money as a means of payment, the reform designs a consistent system of international payments thanks to which countries can reclaim their scope of action. The reform removes the external constraint. In addition to monetary and economic policy becoming effective again, developing countries are provided with an additional instrument to direct domestic economic development, which is introduced in this chapter. It is important to mention that the reform also strongly reduces, if not eliminates, the detrimental impact of capital flight. In one last extension, the SFC model is complemented with the structural changes introduced by the one-country reform of international payments. The model is simulated and confirms the regained effectiveness of monetary and economic policy. Finally, there is space for macroeconomic strategies for developing countries. Chapter 6 consists of two sections. First, it combines the insights of the previous chapters in order to formulate a consistent strategy for developing countries. To improve living conditions of the poor, a successful approach must foster productivity in the domestic economy while reforming the way international payments are made. In other words, a development strategy needs to remove both the internal and the external constraints. Thereby, institutional limits of poor countries have to be taken into account. The design of the strategy leaves room for different variations depending on respective national contexts. In the second section of the chapter, a very long-run perspective is outlined. The instruments and reforms analyzed in this book may also point beyond poverty reduction. In more advanced economies, the question of the end of economic growth is urgently suggesting itself. On the one hand, there are signs of sluggish long-term economic growth. On the other hand, environmental destruction and planetary boundaries raise the demand to radically change the direction of economic development that was based on uncontrolled expansion in the past. It is argued that appropriate macroeconomic governance can also help to pave the way to a post-growth transition. This book provides an analysis of how appropriate macroeconomic strategies can be established. Readers who do not like formulas may be discouraged from continuing when seeing the successive extensions of the simulated models. First of all, it should be mentioned that the basic message can also be understood by skipping the model sections. However, it can confidently be said that the math of the formulas is quite simple. The interest is not in creating unnecessary and complicated things, but in giving an impression of complex system dynamics. Models should not be overestimated. But they detect mechanisms and effects which otherwise would simply go undetected.

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1. Several central debates in development macroeconomics To give an overview of several debates related to development from a macroeconomic perspective, this chapter briefly emphasizes them to provide the basis for the subsequent analysis. After starting with concentrated data on global poverty, the chapter presents the central growth theories as well as the core development debates of the past thirty years dubbed as the “Washington Consensus,” and then goes on to take a look at fiscal policy, international trade and financial flows, industrial policy and institutions. Depending on economic paradigms, these topics are considered differently. Moreover, not all of them are covered by the subsequent analysis of this book, but it will become clear what role – be it more or less prominent  – they play in a successful macroeconomic development strategy. Hence, while this overview aims to emphasize certain important issues, it also introduces others in order to present dominant thinking in development economics and, throughout the book, to show its gaps and shortcomings.

1.1  POVERTY: FACTS AND FIGURES Poverty is hard to grasp precisely in numbers. In international development debates, income per capita dominates as the main indicator to define poverty. For instance, the Millennium Development Goals set the target to halve the number of people living on less than US$1.25 a day between 1990 and 2015 (United Nations, 2015). This benchmark has been adjusted to US$1.90 per day, the amount below which about 10 percent of the world population currently live on according to the World Bank (2018a). As a similar indicator, Figure 1.1 compares gross domestic product (GDP) per capita across different world regions. Income in advanced countries is a multiple of what it is in the poorest countries, that is, in Sub-Saharan Africa or in the group of the least developed countries according to the United Nations (UN) classification. The value of Western Europe is much higher than appears in the figure because its average is reduced by lower incomes in Eastern Europe and Central Asia. ­7

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60 000 50 000 40 000 30 000 20 000

Least developed countries

Sub-Saharan Africa

South Asia

Latin America & Caribbean

East Asia & Pacific

Middle East & North Africa

Europe & Central Asia

0

North America

10 000

Source:  World Bank (2019b).

Figure 1.1  Average GDP per capita 2017 (current international dollars) The world is far from any automatic convergence of income levels. Economic growth in East Asia and the Pacific was the highest in the world throughout the past 60 decades in almost every year, as Figure 1.2 depicts. Growth was first driven by Japan, then by the so-called “Tiger” states of South Korea, Singapore and Taiwan, to be followed by the constant and high-speed growth rates of mainly China up to the present. In this sense it is valid to suggest a convergence process, as emerging countries in East Asia are catching up to North America and Western Europe, which are richer but featured lower growth rates during the same time period. A less impressive but partially analogous argument can be made for South Asia, as India has grown quite fast since 2000. However, catch-up is much slower given the still very low per capita income of the country. Latin America and the Middle East and North Africa regions generally grew at slightly lower rates than industrial countries. Sub-Saharan Africa featured hardly any long-term growth even though it is the poorest world region. Growth also tended to be lower for the least developed countries. Since there was strong population growth, per capita income has actually fallen there. However, poverty estimates using income as an indicator face serious

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Central debates in development macroeconomics ­9

800 700

North America

600

Europe & Central Asia

500

Middle East & North Africa East Asia & Pacific

400

Latin America & Caribbean

300

South Asia

200

Sub-Saharan Africa Least developed countries

100 0 1960

1970

1980

1990

2000

2010

Source:  World Bank (2019a), author’s calculations.

Figure 1.2  Economic output 1960–2017 (1960 5 100) measurement problems, such as the choice of an international standard basket of consumer goods or the construction of price indices and international purchasing power parities (see for example Edward & Sumner, 2018, pp. 488–490). Events such as the surge in food prices from 2005 to 2008 are hardly reflected in these data (Woodward, 2015, pp. 50–51). Moreover, these benchmarks measure poverty in absolute terms, thus ignoring the relative measure, that is, inequality in income and wealth. Yet, there is strong empirical evidence that inequality produces outcomes which make a society poorer with regard to people’s well-being. For example, more unequal societies reveal more violence, status consumption, more abuse of drugs, more stress and therefore more health problems than others (Wilkinson & Pickett, 2017). In this sense, inequality produces a kind of poverty which is invisible when referring only to income per capita. Even though this book touches upon the issue of income distribution in general, it does not particularly focus on it. Nonetheless, income per capita should be supplemented by further data to provide a more accurate picture of poverty. The United Nations’ Human Development Index adds life expectancy at birth and school education to income per capita (UNDP, 2019). Despite still being far from perfect, such indicators broaden the view. Indeed, as is argued by Dasgupta (1993, p. 115), life expectancy at birth is the best indicator to measure well-being. Figure 1.3 depicts the development of life expectancy in different world regions. We observe a slight convergence, as the poorer countries have been able to catch up whereas life expectancy in richer world regions grew slower. Yet, the difference between Sub-Saharan

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80 75 North America

70

Europe & Central Asia

65

Middle East & North Africa

60

East Asia & Pacific

55

Latin America & Caribbean

50

South Asia

45

Sub-Saharan Africa

40

Least developed countries

35 30 1960

1970

1980

1990

2000

2010

Source:  World Bank (2019c).

Figure 1.3  Life expectancy at birth in number of years, 1960–2016 Africa and North America is still 19 years. The dip in the curve of SubSaharan Africa can be explained by the AIDS crisis in Southern Africa which reduced life expectancy drastically before medical treatment was improved (see World Health Organization, 2018). Living conditions may also be described by economic life in a society and the share of the population working in the informal sector. The informal sector does not provide a regular income and is marked by low revenues, uncertainty, stress and precarious working conditions. It is a robust economic indicator because it does not depend on calculations of price indices and difficult international definitions. Moreover, it may also give hints about the productive structure of an economy. The proportion of workers in vulnerable employment, including own-account workers, is depicted in Figure 1.4. While the respective shares in advanced economies have remained constantly low, they have fallen strongly, by 27 percentage points, in East Asia and the Pacific during the last almost 30 years. However, in all other emerging and developing world regions, proportions have remained rather stable. In Latin America, South Asia and SubSaharan Africa, the decrease in vulnerable employment was only between 4 and 8 percentage points. In South Asia and Sub-Saharan Africa, about three-quarters of workers are engaged in vulnerable employment. This means that the large majority of workers depend on precarious day-to-day activities. Needless to say, there is an extensive debate on whether the fight against poverty is successful or not. The World Bank takes the benchmark of per capita income of US$1.90 as its bottom line and states that there has been

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Central debates in development macroeconomics ­11

90 80

North America

70

Europe & Central Asia

60

Middle East & North Africa

50

East Asia & Pacific

40

Latin America & Caribbean

30

South Asia

20

Sub-Saharan Africa

10

Least developed countries

0

1991

2005

2018

Note:  The values are the unweighted average of male and female vulnerable employment. Source:  World Bank (2019e).

Figure 1.4  Share of workers in vulnerable employment, 1991–2018 (%) a continuous decline in poverty, but admits that the speed of reduction is too low to meet the targets of the United Nations (World Bank, 2018a). The respective old and new benchmarks of US$1.25 and US$1.90 are argued to be equal and a mere adjustment due to changes in purchasing power parities. However, Lahoti and Reddy (2015) point to numerous methodological problems of such a single benchmark and even to its adjustment; they argue that the old and the new benchmarks therefore cannot be compared, which makes measuring the evolution of global poverty difficult. Moreover, the authors show that to cover just the most necessary food needs, at least US$5 a day are necessary (ibid., pp. 12–13). According to this cost-of-food benchmark, more than 80 percent in Sub-Saharan Africa and South Asia are poor. Additionally, this percentage of the poor population only decreases slowly, while the absolute number of poor people hardly declines at all and is clearly higher than in 1990 (ibid.). In a similar vein, the most recent report of the UN Food and Agriculture Organization (FAO, 2019, pp. 8–9) shows that both prevalence and number of ­undernourished people have been rising again since 2015. Hickel (2017, pp. 48–49) gives an example of how wrong estimates give a biased view: in India the World Bank claimed that according to the international poverty line the proportion of poor people was on a steady decline; while, in fact, the proportion of people living on less than 2100 calories a day had increased by a third between 1984 and 2011. Likewise, World Bank data state a continuous decrease of population shares living in slums at least since 1990 (World Bank, 2019d). However, a different perspective points to the fact that we have seen decades of growing

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informal settlements all over the southern world. Since the middle of the past century, the average growth rate of urban population has been higher than the growth rate of the total world population, while the slum population again has grown faster than cities in total, as argued by Davis (2006, pp. 17–19). Often, official numbers on slums are criticized by local experts for being too low (ibid., pp. 23, 26). Another measurement problem consists in the fact that not all goods are produced under market conditions. In that case, they are not priced and therefore are not included as part of GDP. In countries where markets expand to former non-market areas, official GDP estimates increase while real wealth ceteris paribus does not. Countries are probably rather heterogeneous in this regard, such that GDP per capita measures may be biased. Edward (2006) criticizes the official World Bank poverty benchmark by developing an alternative approach. He suggests an ethical poverty line by relating income per capita to life expectancy at birth. There is a range of per capita income where life expectancy increases considerably with every additional dollar of income. At a certain life expectancy, the slope decreases strongly, so that growing income only has a modest impact on life expectancy. This empirical observation represents a kind of a benchmark. Ethically, it can be justified that wealth distribution should be such that human years of life are maximized. Hence, people who do not reach the life expectancy benchmark because their income is too low, are considered as poor. The population above the benchmark is rich, because it has more income than necessary to achieve the benchmark and its abundant wealth does not raise life expectancy substantially further. Taking the ethical poverty line, which integrates the issue of inequality, the size of the global poor population is about three times what the World Bank estimates (ibid., p. 390). Global poverty trends as estimated by the multilateral organizations provide an ambiguous picture, whereas alternative calculations criticize them for still being too positive. On the one hand, general health conditions seem to have improved thanks to medical progress in the long term, as can be seen from increased life expectancy. With regard to economic data, however, we observe strong differences across world regions. Most poverty reduction, in percentage as well as in absolute numbers, took place in East Asia and notably in China, where the planning state plays a much more active role in the economy than almost elsewhere in the world. The share of Chinese in the world lowest decile of income declined from 58 percent to 11 percent between 1981 and 2010 (Woodward, 2015, p. 53). This is also reflected in growth rates of that region. Growth has also been high in South Asia, but progress in poverty reduction is much less as can, for example, be seen from the proportion of vulnerable employment. Latin America and the Caribbean are somewhere in the middle of these develop-

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Central debates in development macroeconomics ­13

ments, while Sub-Saharan Africa faces the lowest growth rates, lowest life expectancy and the largest informal sectors. Finally, the perspectives to end poverty are not promising: Woodward (2015, p. 58) estimates that if the progress of the past continues, poverty as measured by the US$5-a-day line will be eliminated in about 200 years. This book does not analyze the roots of poverty or the advantages and disadvantages between the continents such as the amount of natural resources available for development. Nor does it argue that, for instance, certain cultures and traditions are better able to steer poverty reduction than others. Instead, it suggests that different economic development strategies produce different outcomes. The poverty data above confirm this. In particular, this book argues that any successful development path requires consistent macroeconomic governance. The theoretical analysis may reduce poverty to a one-dimensional issue, which is exactly what has been criticized here. Indeed, the model, which serves as a supportive instrument for the analysis, mainly focuses on economic growth. However, it also includes wage development and “formal” employment. Therefore, it can provide useful indications for economic policy programs. Nevertheless, it should be kept in mind that the theoretical simplifications in this book in fact represent a complex phenomenon, which is poverty and miserable living conditions in all its various aspects.

1.2  THEORIES OF GROWTH When talking about developing countries, defining the term “development” is not easily accomplished. Different sciences have a different approach to it. Yet, their common bottom line is the reduction of poverty arising from material shortage, which causes physical and mental suffering. Even though development includes a large variety of different aspects, it has the removal of the material constraint at its core. Development problems are therefore, directly or indirectly, essentially economic in their nature. This applies to microeconomic issues such as rural development or education. At the macroeconomic level, those questions translate into the performance of aggregate economic activity and, hence, economic growth. While growth is not a guarantee to eliminate poverty in today’s developing countries, it is the crucial precondition. Development strategies cannot be successful if they do not steer economic growth. In Bresser-Pereira’s (2016, p. 341) words, “economic development is the main element of progress or human development, which also involves the increase in security, the increase of individual liberties, the reduction of inequalities, and the protection of the environment.” This chapter therefore gives a short overview of growth theories and

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relates them to the context of developing countries. Starting with the classics, Smith (1776/1976) introduced the notion of increasing returns to scale, which he explained by the division of labor, as the source of growth. By contrast, Ricardo (1821/2001, pp. 40–42, 71, 58) predicted economic stagnation due to land as the limiting resource in the production process, as well as rising wages. By extending production, less-fertile land is cultivated, thus signifying decreasing returns. Indeed, whether increasing production inputs gives way to increasing or decreasing returns decides the potential of economic growth. As a simple matter of fact, 200 years of continuous long-term economic growth show that increasing returns exist. However, this observation taken alone does not yet tell us anything about the factors driving returns to increase. In Smithian terms, division of labor may allow for increasing returns, thus entailing economic growth (see for instance Borland & Yang, 1992). But it remains unexplained under what conditions division of labor takes place effectively, as recognized by Young (1928). There are different ways to deal with this gap. The neoclassical model of growth, as developed by Solow (1956), starts with a standard aggregate production function whose inputs are capital and labor. Supply of labor is given by exogenous population growth. Likewise, capital accumulation is determined by an exogenous saving rate as a share of output. This model contains the assumption that all savings are automatically turned into investment. The production function is assumed to exhibit constant returns to scale, while the marginal returns to each production factor are decreasing (ibid., pp. 67, 70). Maximizing the production function yields an optimal capital‒labor ratio. As in any neoclassical model, returns-to-production factors adjust in a way to ensure full employment of labor and capital. This implies that when labor supply grows, growing output gives rise to increasing savings and hence a growing capital stock. There is a steady convergence to the equilibrium where the optimal capital‒labor ratio under given factor prices prevails. The growth rate at this steady state is called the natural growth rate. By several extensions, Solow (1956, pp. 70–73) shows that there may be more than one equilibrium and that convergence may be quite long-term. But in essence, an equilibrium capital‒labor ratio implies that growth of total output is determined by population growth and the saving rate. There may also be technological progress taking place at a certain rate in each period (Solow, 1956, pp. 85–86). It has two effects on growth dynamics: on the one hand, technological progress endows both production factors with higher productivity; output is higher, with inputs being the same. On the other hand, given the saving rate and labor supply, capital accumulation increases.

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After all, in the neoclassical growth model it is the saving rate, population growth and technological progress that determine economic performance (Thirlwall, 2002, p. 22): a higher saving rate yields a higher level of output per capita because of a higher capital‒labor ratio. However, it cannot influence the rate of economic growth since a higher capital‒output ratio is compensated by a lower marginal productivity of capital. Population growth has a negative impact on output per capita due the lower capital‒ labor ratio. However, since the latter raises returns to capital, population growth triggers higher economic growth. Technological progress finally raises both output per capita and the rate of growth of total output. The neoclassical model makes a prediction which is particularly important for developing countries: if tastes and technology are equal across countries, there is convergence in incomes per capita (ibid., 2013, p. 26). Poorer countries usually have a lower capital‒labor ratio, thus implying a higher marginal productivity of capital. This allows them to grow faster and hence to approach the income levels of industrialized countries. This explanation is to be distinguished from those catch-up effects where it is suggested that poorer countries can adopt technologies of advanced economies (see for instance Abramovitz, 1990, p. 2). While the former describes a move on the curve of the production function, the latter means a shift of the curve itself. Even though the Solow model is able to assign a role to important parameters such as savings, investment, technological progress and population growth, it exhibits quite fundamental shortcomings. First, there is no empirical evidence of long-term convergence in economies’ per capita incomes, at least not for capitalist economies (see for instance Baumol, 1986; Thirlwall, 2013, pp. 29–31). Be it the difference in the returns to capital, or catch-up via adoption of modern technologies, there seems to be no channel that automatically leads to convergence. Second, the neoclassical model is theoretically quite weak. It describes variables but does not give an explanation of the factors driving them. Neither is it clear what determines an economy’s saving rate and hence (according to the model) capital accumulation, nor is there any suggestion about where technological progress comes from. Exogeneity of those parameters circumvents the answer to important questions. This gap remains when the model is used for empirical exercises in growth accounting. By decomposing the aggregate production function, the respective contributions of capital accumulation and technical progress to economic growth per capita can be assessed (see for instance Solow, 1957). An explanation of what causes those factors to make a contribution to growth and how they are linked with other variables is missing. Facing this criticism, neoclassical economics moved on to the so-called

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“new” or “endogenous” growth theory in the 1980s. Investment is likely not only to raise the capital stock but also to increase productivity via the introduction of new technology. Hence, returns to capital are not necessarily decreasing. In Lucas (1988), productivity increases through human capital accumulation and learning by doing. Romer’s (1986, 1990) model is based on increasing returns to capital due to externalities arising from research expenditures. Other factors affecting the productivity of capital may be trade, macroeconomic performance and the political environment (Thirlwall, 2002, p. 31). Neoclassical economists reconcile this new development by testing whether there is convergence in per capita incomes after controlling for the additional effects, which may entail increasing returns to capital. Evidence of convergence can be found (see for example Barro, 1991). However, after ruling out factors accounting for divergence in incomes, it is no surprise that convergence is revealed. Moreover, the result of convergence is not helpful if the main factors driving growth are those that raise the productivity of capital; that is, a factor that does not contribute to convergence. New growth theory is thus not genuinely new, as argued by Thirlwall (2002, pp. 32–33). First, the observation of diverging incomes per capita across countries during the second half of the twentieth century is just too obvious to be discovered only by new growth theory. Indeed, structuralism as a distinct theory of economic development has pointed to widening income disparities between advanced and developing economies, or the center and the periphery, respectively. For instance, Prebisch’s (1950, pp. 8–15) classical developmentalism emphasizes a model where the center of the world economy produces industrial goods, while the periphery provides primary goods. Since long-run productivity growth largely goes along with industrialization, the productivity gap between the center and the periphery widens. At the same time, Prebisch (1950, p. 9) observed terms of trade evolving in favor of industrial goods from the 1870s until the 1940s. Hence, productivity gains in the center were not shared with the periphery. Quite the opposite: the periphery received fewer industrial goods in exchange against primary goods and thus was deprived of resources. Insufficient returns from foreign trade prevented the import of capital goods to foster industrialization in the periphery. Other analyses of causes of growth divergence, likewise ahead of the new growth theory, were made by Myrdal (1957), Hirschman (1958) and Emmanuel’s (1972) Marxian analysis of unequal exchange. New growth theory was not first, either, in discovering that capital may feature increasing returns. Instead of assuming technological progress to be exogenous, intuition tells us that there is causality in both directions between investment and technological progress: productivity growth

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triggers investment, while investment strengthens productivity via the establishment of new production plants and equipment. Indeed, this is what Kaldor (1957, p. 604) suggested by proposing a direct relationship between investment and output growth where the channel is technological progress rather than a move on the curve of the production function. Thus, foundations of heterodox growth theories may tell us more about growth dynamics. Yet, there are further shortcomings even in new growth theory, which also apply to Kaldor (1957). The neoclassical model is a supply-side framework where there is no role for demand (Thirlwall, 2002, p. 24). This has far-reaching implications. First, the model assumes that output is determined by the existing capital stock, labor input and technology represented by the production function. Hence, the capital stock is always fully employed, signifying full capacity utilization. The same applies to employment. The total labor force enters the production function at a wage level consistent with labor market clearing, so that there is no unemployment. Second, neoclassical theory assumes that agents save a share of their income, which is then automatically invested. According to the model, savings determine investment. The share of income not consumed today provides the foundation for output growth tomorrow. With output growth and technological change being exogenously given, economic growth becomes quite predictable. New growth theory adds uncertainty by making technological progress endogenous. However, the supply-side determination of the model and the causality from savings to investment remain. Heterodox growth theories, borrowing from both post-Keynesian and classical approaches, have more insights to share in this regard as well. The idea that savings cause investment can no longer be sustained once the monetary system is introduced to the analysis, as will be explained in the following chapter. Investment does not rely on preliminary savings, thus allowing for altered growth dynamics as revealed by Robinson (1969/2013). Moreover, in reality, production capacity is far from being permanently fully utilized. Whereas classical models converge to a socalled normal rate of capacity utilization in the long term while it varies in the short run, Kaleckian and neo-Kaleckian approaches tend to reject a natural convergence towards full utilization even in the long run (see for instance Blecker & Setterfield, 2019, pp. 281–282). To give a sketch of the real dynamics of the macroeconomy, let us take investment and employment as being determined by producers’ expectations. Investment grows if it is expected to be profitable. Employment is increased when sales in the close future are expected to increase. If these conditions are fulfilled, growing expenditures imply higher aggregate

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demand and thus higher capacity utilization. Investment then may well introduce new technologies and thereby raise productivity and economic growth in the long term. Yet, if the conditions are not satisfied, demand is in a slump. Economic activity stagnates and there is a lack of investment to enlarge long-run production capacity. Technological progress thus is also essentially influenced by demand conditions. As León-Ledesma and Thirlwall (2002) show, the so-called natural rate of economic growth, often referred to by heterodox growth theory and defined by Harrod (1939) as the rate at which capacity utilization and employment are constant, is influenced by the actual growth rate. This means that strong demand, by driving current economic activities, also shifts production capacity and thus the economy’s growth potential. It does so via the strengthening of investment and technological progress. Supply-side factors remain important, but they are neither exogenously given nor do they exclusively determine economic activity. Insufficient demand is an important barrier which prevents productivity growth and keeps developing countries stuck in poverty, as will be argued in the remainder of this book. Once the supply-side determination is given up and economic growth is considered as demand-driven, it becomes obvious that there is neither a guarantee nor a tendency towards a stable or even a positive growth path. Given that, depending on the strand of research within heterodox theories, profitability matters for investment and the wage level affects the level of demand, income distribution obviously becomes an important determinant of economic performance. Whereas the relevance of distribution is a common feature of most post-Keynesian models, including particularly Kaleckian and neo-Keynesian models, as well as classical approaches, it is not included in neoclassical foundations (see Blecker & Setterfield, 2019). Yet, the wage level, and hence the wage share in total income is a key variable affecting profitability and demand. Within heterodox economics, opinions differ on what pattern wages should follow. While post-Keynesians suggest that wages should grow in line with productivity to maintain demand and keep the wage share stable (see for example Cynamon & Fazzari, 2016; Stockhammer, 2015), classical economists support wage increases only to the extent that they do not jeopardize profitability, which may be better complied with if wages grow slower than productivity (see Shaikh, 2016, pp. 760–761; Shaikh, 2018, pp. 151–152). Finally, mainstream growth models are constructed as a closed economy. But once it is recognized that countries are embedded in the world and have trade and financial relationships, the issue of growth becomes more complicated. External liabilities and exchange rate fluctuations set limits to a country’s growth potential and require a more sophisticated development

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strategy to create a space where productivity can be strengthened while employment is ensured. Heterodox theories, building on Kaldor (1970a), emphasize the importance of export markets as the essential drivers of growth. On the other hand, economic growth raises the demand for imports, which gives rise to the so-called external constraint that requires a balanced current account (Thirlwall, 1979). Those limits to growth that any small developing country faces are a central issue of this book. The new developmentalism approach, making use of development economics and post-Keynesian macroeconomics, is an important more recent contribution in this regard, as it incorporates heterodox growth theory as well as the implications of the open economy (Bresser-Pereira, 2016, 2020). It distinguishes itself from classical developmentalism by its embrace of a more macroeconomic theory and its focus on middle-income countries (Bresser-Pereira, 2020, pp. 629–630). But new developmentalism also provides insights for developing countries, notably regarding its concern with the exchange rate and its implications for growth.

1.3  THE WASHINGTON CONSENSUS To find one of the very key milestones, if not the central one, that has influenced development economics to this day, we have to go back to 1989. John Williamson presented a paper with a reform agenda he considered to be consensus among the “people in Washington” (Williamson, 2004‒05, p. 195). Notably, Washington in this regard also includes the international financial institutions based there. The reform agenda included ten policy instruments and was targeted to Latin America. It has come to be known as the Washington Consensus. The ten points were the following (ibid., p. 196):   1. Fiscal discipline to avoid inflation.  2. Redirecting public expenditure priorities in favor of neglected fields with high economic returns such as health, education and infrastructure.   3. Tax reform combining a broad tax base with moderate marginal tax rates.  4. Financial liberalization with the ultimate objective of market-­ determined interest rates.   5. A competitive exchange rate to promote exports of non-traditional sectors.   6. Trade liberalization where quantitative restrictions are first replaced by tariffs, which are reduced step by step down to a uniform range of 10 to 20 percent.

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Liberalization of foreign direct investment (FDI). Privatization of state enterprises. Deregulation to ease entry and exit barriers for firms. Provision of property rights, particularly to the informal sector.

If the Washington Consensus did not itself lay the base for a new trend in development economics, it at least described the dominating paradigm in a concise form, and came to be the object of an intensive debate in the following decades. The debate concerns development economics and development policies, but also globalization in general, and neoliberalism as an economic and political dogma. The general intention of the program was the achievement of higher living standards and more productive economies in the Global South through enhanced competition. As will be understood in the following analysis, the Washington Consensus is based on the view of a supply-determined economy in line with the principles of the neoclassical growth model. According to the basic assumptions, efficient markets entail optimal resource allocation. Intervention of the public sector, barriers to trade and financial market regulation would only induce distortions and inefficiencies. Therefore, budget deficits should be small, and the role of the state should be reduced while trade, interest rates and financial flows should be liberalized. The Washington Consensus was criticized immediately after its formulation. International financial institutions are accused of applying the Consensus’s program to developing countries without taking care of the countries’ specific needs (see for instance Stiglitz & Schoenfelder, 2003). Moreover, the program is considered as being harmful to developing countries, because markets are liberalized while the idea of development is based on wrong ideas of markets and institutions (see Chang & Grabel, 2004‒05). Facing the criticism, the original agenda was extended. The intention was not to reverse, but “to complete, correct and complement the reforms” (Kuczynski & Williamson, 2003, p. 18). The update, called After the Washington Consensus, contains a new agenda consisting of four additional elements (ibid., pp. 320–321): fiscal policies should be complemented with a Keynesian element of anticyclical spending. Together with inflation targeting, flexible exchange rates and strict budget discipline of subnational governments, economies can be stabilized in crises. In addition, the revised agenda proposes second-generation institutional reforms including the political system, the civil service, the judiciary and the financial sector. Moreover, they involve a national innovation system, the modernization of property rights and bankruptcy laws, and the strengthening of prudential supervision (Marangos, 2012, p. 591).

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As Marangos (2012, p. 591) argues, these propositions are consistent with the role of the state in mainstream economics, which is “creating and maintaining effective institutions, providing public goods; internalizing externalities; correcting income distribution; providing decent infrastructure, a stable and predictable macroeconomic, legal, and political environment, and a strong human resource base.” Finally, the Consensus is to be amended by a social agenda aiming at a partial income redistribution. The fiscal system should become more progressive, while tax revenues should be spent for the empowerment of poor people by providing them with resources such as education, land and credit (Kuczynski & Williamson, 2003, p. 321). Even though the Washington Consensus still considers growth as always being in favor of the poor, the poor need resources to start with, thus requiring initial support (Marangos, 2012, p. 591). The Washington Consensus, including its amendment, has been the focal point of development macroeconomics to date, despite ‒ or perhaps precisely because of ‒ continuous criticism arguing for its failure (see Rochon, 2006a, p. 107). Its agenda was targeted to Latin American countries, but the recipes have been implemented in both developing and advanced economies. The Consensus’s components are thus still central issues in current debates.

1.4 FISCAL POLICY AND THE ROLE OF THE STATE Discipline in government budgets is the requirement listed first in the Washington Consensus. The justification given by mainstream economics is twofold. First, fiscal deficits are considered as the source of balanceof-payments crises, inflation and even hyperinflation (Williamson, 2003, p. 1476; Woo, 2006, p. 1). According to this view, government deficits, if used for the provision of consumption goods, induce savings to fall short of expenditures (Gemmell, 2004, p. 154). Therefore, growing demand pressure meets restricted supply-side conditions, thus giving rise to inflation. Inflation deteriorates the building of expectations and increases uncertainty, which harms investment and capital accumulation. To the extent that budget deficits are created to pay for imports, supply shortages in the domestic economy may be prevented. But this comes at the cost of current account deficits, currency depreciation and balance-of-payments crises. The second reason for fiscal discipline is given by the market-driven paradigm. The Washington Consensus aims at strengthening the private sector and competition. A stronger role of the market in economic decision relies even more on price stability to prevent price distortions (Kregel,

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2008, p. 548). The public sector thus should not be allowed to influence market prices by inflationary budget deficits. The Consensus criticizes the use of fiscal deficits as a macroeconomic policy tool, which is argued to involve instability. Therefore, it requires primary surpluses, even in recessionary periods (Câmara Neto & Vernengo, 2004‒05, p. 334). Primary surpluses exclude the payment of interest. Such tight restrictions strongly reduce the role of the so-called developmental state (see for instance Chibber, 2014; Williams, 2014). The requirement of constant surpluses is a drag on public investment. Even though mainstream theory, including the Washington Consensus, suggests efficiency of unregulated markets, economic fluctuations are an indisputable fact in capitalist economies. Public investment not only increases the productive potential of an economy in the long term, but also creates demand by making expenditures for investment goods. This contributes to employment and output, and hence enables the government to stabilize output (Câmara Neto & Vernengo, 2004‒05, p. 335). This potential powerful role of the state is constrained by the requirement of fiscal discipline. This is the point where heterodox economics criticizes the mainstream stance on fiscal policy as expressed by the Consensus. Not all fiscal deficits are alike. Keynesian analysis recommends the separation of the budget into a current budget and a capital budget (Câmara Neto & Vernengo, 2004‒05, p. 335). The former covers consumption spending, while the latter defines investment expenditures. The difference is obvious. In contrast to consumption, investment often generates future returns. And investment materializes in a real asset, which is part of the government’s wealth. Hence, while public debt arising from consumption is not sustainable in the long run, the capital budget may well include a certain level of debt. First, there is a possibility to repay debt out of investment returns. Second, a comprehensive consideration of public debt considers not only financial debt but also the real assets backing that debt. Net debt is thus lower or can even be negative, thereby denoting net public wealth (see Llorca, 2017, pp. 177–178). Additionally, public debt should also be considered in relation to a country’s output in order to judge its affordability. Higher output increases the resource potential out of which returns and tax revenue can be generated to repay debt in the future. Câmara Neto and Vernengo (2004‒05, pp. 339–340) point to another dilemma of fiscal discipline that applies to development economies being open towards the rest of the world. To keep the exchange rate stable and prevent capital flows out of the country, interest rates have to be at a sufficiently high level. High interest rates ceteris paribus means high interest payments. Therefore, the primary surplus needs to be considerably large for the deficit after interest not to be too large. Even though there is even-

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tually a deficit, it still does not contribute to domestic demand when interest has to be paid on foreign debt. In an open economy with high interest rates, the squeeze on public investment is thus particularly pronounced. The consensus view of fiscal policy is based on the observation of fiscal deficits going along with inflation and balance-of-payments problems. It is implicitly assumed that budget deficits cause macroeconomic instability, so that fiscal discipline is the cure to make the economy more stable. However, there is a causality in the opposite direction, which is at least as important. High economic growth implies high returns of firms and households who are taxed by the government. A sound tax base means higher tax revenue. Moreover, public enterprises enjoy higher profits. Fiscal surpluses are the consequence. On the other hand, bad economic performance shrinks the tax base and results in higher budget deficits. From this, it follows that eliminating fiscal deficits to prevent macroeconomic instability is not necessarily the best option. Cutting budgets means shrinking demand and hence further contributes to recession. Instead, considering fiscal policy as responsible for maintaining a high level of demand requires deficits in times of deteriorating economic performance (Arestis & Sawyer, 2010b, p. 334). Besides the question of whether or not fiscal deficits are allowed for developing countries, another issue is the role that can be attributed to the public sector in general. The same budget surplus or deficit can go along with either a high or low share of the public sector in economic activity. Laissez-faire economics assigns a minimized role to the government in order to prevent price distortions and inefficiencies in self-regulating markets. Alternative theories rely more on the idea of a developmental state, which fosters development via public investment and also directs private funds to politically defined priority sectors (see for instance Bagchi, 2004; Chibber, 2014). In this regard, public investment targets more than output stabilization. Its core is the long-run development of productivity and output growth in poor countries. Justification for state-driven investment can be found, on the one hand, in transformative economics and theories on economic planning where public intervention is required to speed up economic development and to fully utilize the existing productive resources (Kalecki, 1942/1986, p. 20; Kalecki,1966/1972, p. 117). On the other hand, Keynes (1936/1997, p. 378), who doubted that the private sector alone is able to ensure permanent full employment, suggested the “socialization of investment” where the government cooperates with the private sector and takes over the investment necessary to eliminate unemployment. A look at data shows the importance of the public sector in economies at different stages of development. Figure 1.5 plots public investment in

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12 10 8

Advanced economies Emerging markets

6

Low-income countries

4 2 0 1970

1980

1990

2000

2010

Note:  For the exact classification of advanced economies, emerging markets and lowincome countries, refer to IMF (2014, pp. 161–167). Source:  International Monetary Fund (2014).

Figure 1.5  Real public investment in percentage of GDP, 1970–2011 advanced economies, emerging markets and low-income countries from 1970 to 2011. Public investment as a percentage of GDP reveals a longterm decline in advanced economies. Emerging economies, containing among others the BRICS countries (Brazil, Russia, India, China, South Africa) face public investment double the size of their GDP, where no clear trend is visible in the long run. Low-income countries are between the two former country groups. After a drop in the share of public ­investment due to the debt crisis at the beginning of the 1980s it has increased again since, but has not reached the former high level. Even though not all investment is equally efficient and macroeconomically important, it is striking that the country group with highest growth rates ‒ that is, the emerging economies ‒ also features the highest relative public investment. At the same time, Figure 1.6 shows that public investment does not necessarily come with higher public debt. The figure reveals gross and net debt as a ratio to GDP of selected countries of the respective group of advanced, emerging and developing countries. Overall, it can be seen that both gross and net debt ratios tend to be higher in advanced economies than in emerging and developing countries. The reasons for this difference are not elaborated in detail in this book. But a sketch of it can be given by the macroeconomic principles and the basic model developed in the following chapter. Namely, lower growth rates caused by slowly progressing productivity, as observed in industrial countries, require a higher demand

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120

Gross debt Net debt

100 80 60 40

Pakistan

Indonesia

Kenya

Nigeria

Cameroon

Dominican Republic

Bolivia

Mexico

China

South Africa

India

Brazil

Russia

France

United Kingdom

Germany

Canada

0

United States

20

Source:  International Monetary Fund (2018).

Figure 1.6  G  ross debt and net debt as a percentage of GDP in selected countries, 2016/2017 stimulus to maintain full employment. The government is an important source of such a stimulus, be it via welfare programs or tax cuts. Advanced economies can usually sustain higher debt levels without interest rates going up or the exchange rate depreciating. Investors tend to have more confidence in industrial countries’ institutional strength and capacity to manage public debt than in the case of emerging and developing economies. In relation to fiscal discipline, mainstream economics such as the Washington Consensus also emphasizes the role of the public sector by recommending the privatization of state enterprises. The sale of public assets is, indeed, one of the central pillars of the Consensus. It is justified, on the one hand, by the more prominent role that should be given to the private sector, for “true” prices and market-driven factor allocation to work out in favor of efficiency and, eventually, growth and prosperity. On the other hand, it is also argued that privatization makes public firms as entities in themselves more efficient and productive (Brune et al., 2004, p. 196). However, even though empirical evidence on the economic benefits of privatization of public enterprises is mixed, privatization policy

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has been pursued with great intensity, as thousands of entities have been privatized since the 1980s (ibid., pp. 195–196). Moreover, selling public assets is argued to contribute to good fiscal performance. Even though this provides only a one-time return, privatized companies can be taxed and thereby contribute to state revenues. Data on Latin America show that tax revenues as a percentage of GDP have increased steadily since the 1990s (Economic Commission for Latin America and the Caribbean, 2018, p. 43). This may reflect the indirect impact of privatization. Criticism of privatization from academics and civil society points to the importance of public provision of basic services for the poor population in developing countries. When the Washington Consensus lost dominance during the “noughties,” privatization also featured a marked slowdown (see Chong & López-de-Silanes, 2005, p. 1). Besides ethical and social considerations, the role of the public sector is of cardinal importance to economic performance, as it can support employment in the short term and productivity growth in the long run. This aspect is neglected by neoliberal economic agendas recommending privatization of public assets. The analysis of this book emphasizes the issue of fiscal policy in detail and assesses the potential role that the public sector can play in a developing country. Therefore, the general objections of neoclassical theory against active government intervention concerning market distortions, financing constraints and the crowding-out of the private sector have to be emphasized. Thorough macroeconomic monetary analysis reveals their weakness. Our alternative view shows that an economy is far from automatically establishing optimal factor allocation, but may rather face demand and profitability constraints, and thus cannot generate full employment and long-term development of a country. Public intervention can thus be useful in influencing effective demand, employment, long-term capital accumulation, growth and poverty reduction. Beyond past and current trends in fiscal policy debates, this analysis shows the potential impact that the public sector can unfold to foster development.

1.5  TRADE LIBERALIZATION Opening countries to international trade flows has been one of the core issues of the Washington Consensus where the only potential disagreement is the speed with which trade should be liberalized (Williamson, 2003, p. 1476). To date, it is on the agenda of almost all mainstream development economists, and particularly of the World Trade Organization (WTO). Neoclassical economic theory finds a number of benefits arising from free trade, that is, the elimination of tariffs and other non-tariff barriers.1 First,

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opening domestic goods markets to the rest of the world increases the degree of competition. It is not only the most efficient firm in the domestic economy which dominates the market, but the most advanced producer globally. Inefficient firms are thus closed, while efficient ones can expand (IMF et al., 2017, p. 19). The more economies of scale there are, the more they can be exploited by trade (see Helpman & Krugman, 1989). Trade helps to transfer technology and knowledge across countries, particularly to developing countries. These spillovers increase the productive capacity of the world economy and also of each country. Producers can import inputs to production at a lower price instead of purchasing them in the domestic economy. Likewise, consumers get access to cheaper goods of a higher variety (IMF et al., 2017, p. 19). Overall, the argument in favor of free trade states that trade liberalization removes barriers and distortions and thus helps the economy to approach the optimal equilibrium point. The intuition is provided by David Ricardo’s (1821/2001, pp. 85–103) theory of comparative advantage. It recommends that countries should specialize in the production of goods they are best at. This would maximize the productivity and wealth of the economies. Taking Ricardo’s model of two countries and two goods, even if one country can produce both goods at lower cost than the other country, both countries should specialize in the respective good which they can produce at relatively lower cost. Free trade is required so that countries can exchange their goods against those they do not produce. This is the precondition for specialization. Critics of free trade point to potential costs that may arise from trade liberalization. Some sectors may benefit from cheaper input material, while others lose market shares in the domestic economy due to competing imports. Some sectors might therefore experience a loss in employment (OECD, 2005). Proponents of free trade argue that these are short-run adjustment costs that are more than compensated by gains in other sectors. In the same vein, it is claimed that potential benefits from protectionism are only short-term (Nash & Mitchell, 2005, p. 37). However, there is criticism of the free-trade paradigm that goes beyond transitional imperfections. As will be argued throughout this book, critical arguments essentially point to the fact that neoclassical theory is focused merely on exchange, while ignoring the production process. Yet, goods have to be produced before they can be exchanged. Domestic production needs to be sufficient for exports to pay for imports. Technological progress and productivity growth are the crucial factors driving production in the long run. However, the theory of comparative advantage does not say anything about this (Skarstein, 2007, p. 352). Today, free trade policies based on the theory of comparative advantage in fact suggest

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that advanced economies specialize in industrial goods, while developing countries focus on agricultural goods and primary goods in general. This corresponds well with Prebisch’s (1950, pp. 8–15) center‒periphery model. The problem is that industrial goods and agricultural goods involve different demand patterns in the course of economic development. Income elasticity of demand is higher for the former than for the latter, as stated by Engel’s law. This means that there are inherent limits to the demand for agricultural goods. Moreover, Kaldor’s growth laws (see Thirlwall, 1983, pp. 345–346), based on empirical evidence, show that economic growth goes along with growing manufacturing output, while the latter is also correlated with growth in labor productivity in and outside of the manufacturing sector. This includes Verdoorn’s law, which states that there is a significant correlation between output growth and productivity development (Arestis & McCombie, 2006, p. 3). This means that as long as production in developing countries is limited to agricultural goods, productivity growth is low (Skarstein, 2007, p. 353). As a consequence, advanced economies grow faster than poor countries. Even worse, industrialization also strengthens productivity in the agricultural sector such that, even here, advanced economies can be more productive than developing economies. Comparative advantage thus turns into an absolute advantage for industrial countries (ibid., p. 361), implying an absolute disadvantage for poor countries. Free trade and specialization in the primary goods sector according to the theory of comparative advantage is thus considered a “dead end for underdeveloped economies” (ibid., p. 347). According to many heterodox economists, tariffs and export subsidies should therefore be applied such that they maximize promotion of economic development (see for example Chang & Grabel, 2004, pp. 61, 66). This may amount to the violation of comparative advantage considerations in the short term by favoring productivity growth in the long run. However, protection is exactly what today’s industrial countries applied in their earlier stages of development (see Wade, 2003, p. 631). The trend to trade liberalization is evident, as Figure 1.7 shows. The examples of several advanced, emerging and developing economies reveal a cut in average tariffs on imports of manufactured goods, ores and metals since the late 1980s and early 1990s in all country groups. The higher the original tariff rates, the larger the reduction. The differences between countries have thus become smaller, whereas advanced countries already had quite low tariff rates before. Currently, tariffs in most countries are quite low, but still a bit higher in poorer countries. Tariffs also depend on a country’s specialization, which defines the sectors where protection is needed. Yet, average tariff rates of different sectors in larger

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90

1990–1994

80

2016–2017

70 60 50 40 30 20

Philippines

Sri Lanka

Kenya

Nigeria

Cameroon

Paraguay

Bolivia

Mexico

South Africa

China

India

Russia

Brazil

Japan

Germany

US

0

Canada

10

Source:  UNCTAD (2018).

Figure 1.7  A  verage tariffs on imports of manufactured goods, ores and metals (exact year depending on data availability) sets of countries confirm the conclusion from Figure 1.7 (see UNCTAD, 2017, p. 5). There is a large volume of empirical literature on the effects of trade liberalization. De Loecker and Goldberg (2014) show that it improves firm performance. On the one hand, input costs decrease; while there are demand effects on the other hand, possibly coming from lower prices and economies of scale. However, it is not clear whether trade liberalization improves firm performance through higher profitability within firms, or also via the actual reallocation of physical resources. Regarding actual impacts on productivity, Ahn et al. (2016) estimate that trade liberalization in advanced European countries between 1991 and 2012 increases total factor productivity. This result is confirmed by Amiti and Konings (2007), who estimate the impact on productivity in Indonesia from 1991 until 2001, where they find that the effect of reductions of input tariffs is much stronger than that of output tariffs. A similar study for India between 1986 and 1993 also finds a positive but quite weak impact on total factor productivity (Topalova, 2004). There is further research on additional aspects. Carrère et al. (2018) test for the impact of trade liberalization on employment and find mixed results. The change in employment depends on whether the sectors of

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comparative advantages favored by liberalization have efficient or inefficient labor markets. The question of whether free trade merely strengthens productivity or also improves living conditions of large shares of the population is positively responded to by Fajgelbaum and Khandelwal (2016), who argue that trade favors the poor due to lower prices of many goods in their basket. With a calibrated general equilibrium model for Nigeria, Shuaibu (2017) finds a positive but quite small effect of trade liberalization on poverty reduction. Dollar and Kraay (2004) argue that developing countries which open their economies to trade grow faster than the other developing countries, while the impact on the poor is also positive. Notably, the sample of the open countries in this study also includes China and India. Regarding the quality of products, Amiti and Khandelwal (2013) provide mixed evidence, finding that the quality of goods that are close to the quality frontier improves with trade liberalization, while quality improvement for the other goods is discouraged. However, not all of the literature presents positive results arising from free trade. Pacheco-López (2005) provides evidence of the effects of trade liberalization and particularly of the North American Free Trade Agreement (NAFTA) in Mexico by considering the time period from 1973 until 1999. Liberalization has increased the propensity of GDP to import more strongly than its propensity to export. This means that a given growth rate implies a deteriorated balance of payments.2 Consequently, the growth rate consistent with balanced trade is lower than before. The impact of NAFTA on growth is thus argued to be negative (ibid., p. 613). A similar outcome is attained by Pacheco-López and Thirlwall (2007), testing for the impact of trade liberalization on 17 Latin American countries between 1977 and 2002. For most countries, the trade-off between growth and balanced trade has deteriorated. Some of those countries grew faster, but only at the expense of a worsened balance of payments. Siddiqui (2015) argues that developing countries had lower growth rates after the trade liberalization period starting in the 1980s than before. Dowrick and Golley (2004) compare developing and advanced economies and find that openness to trade favored economic convergence of poor and rich countries in the 1960s and 1970s, but has not done so since the 1980s, when it was mostly to the favor of advanced economies. In an analysis of the trade liberalization reforms in Brazil in the early 1990s, Arbache et al. (2004) provide evidence of wages falling thereafter in both traded and non-traded sectors. The utility of free trade for economic development remains inconclusive. Empirical research often provides results without establishing a comprehensive theory. This book does not have a particular focus on trade regimes, but

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embeds trade into a whole macroeconomic framework. It will come back to the issues of exchange and production: the former cannot take place without the latter. Trade thus cannot be considered in isolation. Different macroeconomic issues are important for a development strategy to be successful.

1.6  FINANCIAL LIBERALIZATION What started as “interest rate liberalization” in the Washington Consensus was reformulated to “financial liberalization” to emphasize the topic in a broader way, as suggested by Williamson (2002, p. 1). The term covers the deregulation of financial flows in the domestic economy as well as internationally. Moreover, it points at more competition in the banking system. To date, the financial liberalization debate continues, particularly on aspects such as financial market development in developing countries. The rationale for financial liberalization is given by its proponents as follows (Arestis, 2004‒05, p. 254): the allocation of credit should be decided by market forces for investment to be made in a growthmaximizing way. First, the market equilibrium ensures that the efficiency of capital is maximized. Second, the process of allocation of savings to their use as investment takes place in the most efficient way. Third, market forces also determine the level of savings and investment in equilibrium in an optimal way, based on preferences of agents. Financial liberalization thus influences capital both quantitatively and qualitatively. The interest rate is determined by the equilibrium of savings and investment. Hence, the market prevents the rate from being too low, such that investment projects with low profitability, and therefore low efficiency, are ruled out. The average efficiency of capital thus is increased, which raises the productivity of the economy. Higher efficiency of capital again augments real returns to capital and therefore entails higher savings and higher investment. Financial liberalization includes two main components. On the one hand, it requires deregulation of the domestic banking system, thus reducing the influence of dominant state-owned banks and eliminating the political influence on interest rates. On the other hand, interest rates of a country can only be considered as really market-determined if they correspond to the conditions in the global financial system with respect to savings and investment. Hence, a country ‒ that is, the space defined by its currency ‒ should be open to foreign capital inflows and outflows. International financial liberalization allows savings and investment to equilibrate globally. If there is a relative squeeze in savings in one country, the interest rate is higher than in the rest of the world where savings are more abundant. The removal of barriers such as capital controls thus

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allows money to flow in and to align domestic interest rates with the international level. If this is not the case, according to the proponents of liberalization, investment in the domestic economy risks being inefficiently allocated because of the biased allocation signal of domestic interest rates. Abiad et al. (2008, pp. 4–6) give an overview of a set of specific liberalization measures: besides the removal of capital and interest rate controls, it concerns the abolition of credit controls such as prescriptions regarding what sectors should be provided with credit in what volume; the abandonment of entry barriers for financial institutions; withdrawal of state ownership in the banking sector; and establishing of internationally open debt and equity markets by offering tax incentives and by developing depository and settlement systems. Since the 1970s, when several Latin American countries were first to experience financial liberalization in the developing world, the conception has faced increasing criticism and was considered as a failure in terms of enhancing economic prosperity. For this reason, the debate was widened and concerned mainly the way liberalization is achieved; that is, the optimal path to liberalized financial markets. Liberalization proponents suggest that financial reforms should be sequenced (see Arestis, 2004‒05, pp. 255–256). For instance, liberalization of the real sector should be implemented before financial markets follow, so that different sectors can react to mutual allocation signals. Likewise, opening to foreign financial markets is only to happen after liberalization of domestic financial markets (ibid.). This is a condition for a country’s financial system to be able to absorb foreign capital inflows and outflows. Failure of former liberalization programs in developing countries was also attributed to the absence of banking supervision, and macroeconomic instability. In an unstable environment, efficient allocation of savings and investment is distorted. Hence, adequate banking supervision and stable macroeconomic conditions are a precondition for financial liberalization (ibid.). This includes a “liberalized and sound banking system” to deal with capital flows (Williamson, 2004‒05, p. 198). The rationale of financial liberalization is opposed by heterodox economics based on a different conception of money, interest rates and the functioning of markets. The basic assumption of financial liberalization is based on the idea of markets as being efficient and inherently stable. Yet, markets are more than the perfect equilibration of supply and demand (and from a proper macroeconomic perspective, even about something entirely different than equilibrium, as will be shown in the next chapter). First, there are obstacles such as imperfect information (see Stiglitz & Weiss, 1981). Asymmetric information between lenders and borrowers gives rise to risk premia on interest rates and credit rationing.

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Moreover, there are nominal rigidities entailing time lags. Financial markets react more strongly to news than goods markets, but their dynamic interaction involves non-linear convergence to equilibrium, if any. Even more importantly, there is the issue of uncertainty, this quite fundamental idea developed by Keynes (1936/1997, pp. 161–162). Uncertainty is absent in neoclassical economics. Where it is addressed, it is reduced to a perception of risk even though, in fact, it is something very different from the distribution of probabilities. Uncertainty, developed in more detail in this book, implies that the future is unforeseeable. Agents in the economy thus have to make assumptions, build expectations and rely on conventions (Arestis, 2004‒05, p. 257). In reality, as heterodox approaches state, the way production, investment and exchange take place is quite different from what neoclassical models suggest. Moreover, production requires money. Money is not something like savings, which have to be available for investment to take place, as mainstream economics argues. Instead, it is created out of nothing by the banking system, and needs to be associated with production in order to attain purchasing power. It will be shown that there is no need for the economy to converge to an equilibrium that guarantees stability. Regarding financial liberalization, the essential problem emanates from the fact that the banking system can create money without limits, which influences prices in financial markets and thereby can create instability. Speculative bubbles may burst and trigger financial crises. Most developing countries do not have well-developed voluminous financial systems. Therefore, foreign capital flows usually are a higher risk to macroeconomic stability than the isolated domestic banking system. Capital flows may consist not only of long-term foreign direct investment but also of short-run portfolio flows with possibly speculative intentions. Capital account liberalization thus exposes the countries to irregular and sometimes immediately reversing capital inflows and outflows. They affect risk exposure of the domestic banking system and of the whole economy via the impact on the exchange rate. While capital inflows may create financial bubbles, sudden outflows tend to trigger banking and financial crises. In particular, this concerns the phenomenon of capital flight, as mentioned in the Introduction to this book. A country with a liberalized capital account is exposed to financial fragility. Economic policy thus has to be in line with the demands of financial markets in order to prevent capital from flowing out of the country and triggering a currency crisis. Honohan and Klingebiel (2000, pp. 27–28) provide evidence of the high economic costs of financial crises after financial liberalization reforms, of which the Asian crisis in 1997 is perhaps the best-known one.

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The final objective of financial liberalization is efficient resource allocation, which is argued to increase economic growth, welfare and the efficiency of financial systems (see for instance Fischer, 1997). However, the argument that market-driven interest rates are growth-maximizing is based on the paradigm of the interest rate being determined by the equilibrium of savings and investment. Yet, post-Keynesian monetary theory argues that the interest rate is not needed to equilibrate savings and investment; instead, the short-term interest rate level is set by monetary policy (see for example Rochon, 1999, p. 14). The lower the interest rates, the more profitable the investment. Economic activity thus can be strengthened if interest rates are kept below the level determined by neoclassical market equilibrium. Such interest rate level setting by central banks, termed “financial repression,” was a common practice in developing countries in the 1950s and 1960s (Arestis, 2004‒05, p. 254). Moreover, selective credit and investment allocation was applied in countries where public banks dominated, in order to concentrate resources on specific sectors in favor of long-run technological development (see for instance, Chang, 2003, p. 262; Zhu, 2007, p. 267). Such development strategies are far from liberalized financial markets, but can be effective in fostering growth. There is considerable empirical research on whether financial liberalization achieves its objectives. Galindo et al. (2007), by investigating 12 developing and emerging countries in Latin America and Asia, find that financial liberalization improves the efficiency with which investment funds are allocated. The same outcome is presented by Hermes and Meesters (2015), conditional on the sufficient quality of bank regulation and supervision. However, such results are an expression of the exclusively profit-oriented character of private investment in contrast to public investment. The latter may target sectors with low profitability but great importance for the long-run development of an economy. Such investment does not drive efficiency in neoclassical terms, but instead drives productivity. With respect to the impact of financial liberalization on economic growth, Townsend and Ueda (2007) find ambiguous results for Thailand from 1976 to 1996. Estimates collected in a meta-study by Bumann et al. (2013) find mostly insignificant results; whereas Bekaert et al. (2009) provide evidence of a positive impact on growth for a set of 96 countries between 1980 and 2006. Likewise, Owusu and Odhiambo (2014) provide support that financial liberalization strengthened economic growth in Nigeria in the observed period from 1969 to 2008. By contrast, another study analyses the impacts of financial liberalization on industrialization in Malawi and concludes that firm concentration increased thereafter, entry of new firms fell, while financing constraints for small and mediumsized enterprises were not removed (Kabango & Paloni, 2011). In a review

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of studies on financial liberalization in Sub-Saharan African countries in the period from 1980 to 2004, Fowowe (2011) shows a wide range of results with regard to economic growth and concludes that the expected gains have not materialized. Additionally, there is evidence that capital account liberalization increases income inequality in an economy (Furceri & Loungani, 2018). The channels through which financial liberalization makes economies more prone to financial fragility and crises is examined by a voluminous literature. In two case studies on Mexico and South Korea, Kwon (2012) shows that fast-paced liberalization attracted short-term foreign capital, feeding stock markets rather than productive activity. In contrast to foreign direct investment, short-term flows triggered financial and currency crises in 1994 in Mexico, and in 1997 in South Korea. Using indices of financial instability and financial liberalization, Batuo et al. (2018) investigate 41 African countries between 1985 and 2010 and find that financial liberalization goes along with more financial instability. Yang et al. (2019) provide empirical support for the argument that financial liberalization involves surges and flights of capital, which may trigger financial crises as regards, notably, portfolio flows in emerging countries. This finding is confirmed by Arestis et al. (2006). This book provides a detailed theoretical analysis of the fundamental mechanisms of monetary and financial systems. Based on the key principles of macroeconomics, the meaning of domestic and international financial flows is assessed. We will see that the exposure of developing countries as small open economies to the rest of the world implies numerous complex interdependencies that a development strategy should take into account. To prevent macroeconomic instability including banking and currency crises, a proper monetary analysis is required.

1.7  INDUSTRIAL POLICY While liberalization of trade and financial flows is a top priority on the agenda of international financial institutions, industrial policy is largely as absent as it was in the Washington Consensus. As will be seen, mainstream economics is based on the assumptions that there is inherent convergence of the economy to equilibrium. State intervention causes deviations from equilibrium and thus creates inefficiency. Trade and financial liberalization contribute to efficient factor allocation. This is why many development agendas are limited to liberalization of markets. Yet, considering trade as an act of exchange without taking production as its base into account does not answer the question of what goods can actually be exchanged.

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Proponents of active industrial policy thus argue that a productive economic base is the foundation of any successful development. Productivity growth can best be strengthened by promoting those sectors that have the biggest potential of technological progress. In line with Kaldor’s growth laws (see Thirlwall, 1983, pp. 345–346), the manufacturing sector is the main contributor to overall productivity growth. Historically, successful development stories in general went along with a process of industrialization (Szirmai, 2012). Moreover, other sectors such as various services depend on manufacturing (see for instance Guerrieri & Meliciani, 2005). Manufacturing takes the role of a “learning centre of capitalism in technological terms” (Chang et al., 2013, p. 11), because manufactured goods are inputs in many other sectors and thereby allow for productivity spillovers. Additionally, manufactured goods generally have higher tradability than services and thereby can be exported in order to finance imports (ibid., p. 12). Industrial policy can be justified by further arguments (UNECA, 2016, pp. 41–46). First, many industries depend on other industries, which create demand for output. Those industries thus need to be set up simultaneously so that their returns can be guaranteed. The government can promote and facilitate this process by supporting several industries at the same time. Second, investment such as research and development (R&D) creates externalities so that there is no incentive for individual firms to invest, thus leaving the whole sector with underinvestment. Subsidies for investment may be effective. Third, quite different from standard theory, investment in the real world is fixed and long-term. Companies competing in the same emerging market might invest too many resources in such fixed structures and plants, such that total capacity is too large for market demand. The policy-maker can coordinate investment by setting up entry or investment barriers. Fourth, to enable technology transfer, the government can use instruments to ensure that foreign corporations establish R&D facilities and take measures such as hiring local workers. Fifth, the state has the most financial means to make long-term investment, which may not be profitable immediately. Sixth, risky sectors, which are important from a development perspective, benefit from a kind of insurance if the government is willing to support them. This can also involve restructuring or nationalization when a company is in trouble. Instead of specializing in a certain sector where a country has a comparative advantage, more active industrial policy focuses on infant industry promotion. Such policy targets certain sectors where output is supposed to grow. As long as an industry is not productive enough to compete in the world market, it is protected by tariffs and other measures such as licensing. The industry is supported until its unit costs are low

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enough to succeed in global competition without protection. Infant industry promotion was intensively used in the 19th and 20th centuries by today’s advanced economies, whereas in recent decades it has been an economic policy instrument particularly in East Asia (see for instance Lee, 1997; Skarstein, 2007, pp. 359–360). The main criticism of infant industry promotion is that protection from competition makes firms inefficient, since market pressure is absent. Even worse, protection may also outcompete more efficient sectors such that resources are allocated in the wrong firms (Sauré, 2007). To prevent such unintended outcomes, infant industry promotion has to go along with an incentive system of capacity-building, investment, worker training or R&D, while conditioning the support on sufficient productivity growth (UNECA, 2016, p. 39). Industrial policy became popular in development economics in Latin America right after World War II under the term “import substitution.” Developing countries should be enabled to produce manufactured goods on their own, instead of importing them and therefore depending on exports of primary goods and their volatile prices. Even though active industrial policy was replaced by liberalization of trade and financial flows, it exhibited higher growth rates than the following phase (Kregel, 2008, p. 542). The reason for the abandonment was external deficits due to growing domestic incomes and hence rising demand for imports. Yet, this external constraint, to be analyzed in more detail, nonetheless requires either substitution of imports through domestic production, or export promotion in order to improve the balance of payments (Nevile & Kriesler, 2011, p. 27). This requires investment in the respective sectors. A global overview confirms the weak position of developing countries with respect to their productive base. Annual value-added per capita in manufacturing is only a fraction of the corresponding value of advanced economies, as Figure 1.8 reveals. As a second significant difference between advanced and developing countries, the former have featured an average increase in manufacturing value-added over time, while the latter appear to be stuck at a very low level. Data seem to confirm the inability of development strategies, which are limited to trade and financial liberalization, to create a sound industrial structure. Mainly for Africa and Latin America, actual deindustrialization is observed (see for instance BresserPereira & Theuer, 2012; Page, 2012; UNECA, 2015, pp. 46–47). In the following analysis, industrial policy will not be investigated in all its details. Yet, there is a strong focus on the macroeconomic importance of state intervention in the form of active economic policy to develop an industrial base and foster productivity.

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7000 6000 Europe & Central Asia

5000

Latin America & Caribbean

4000

Middle East & North Africa North America

3000

South Asia Sub-Saharan Africa

2000 1000 0 1990

1995

2000

2005

2010

2015

Source:  World Bank (2019f), author’s calculations.

Figure 1.8  M  anufacturing value-added per capita 1990–2017 (constant 2010 US dollars)

1.8 INSTITUTIONS Institutional economics, initiated by Thorstein Veblen, is a term which appears in Hamilton (1919) for the first time. It focuses on economic ­activity as being driven by institutions that in real life are imperfect, evolving in real time and influenced by human behavior. Institutional economics criticizes the neoclassical equilibrium approach while favoring the view of indeterminate economic processes. By arguing that “the human economy . . . is embedded and enmeshed in institutions, economic and noneconomic,” Polanyi (1957, p. 250) established the view that the market itself is an institution as well (Polanyi, 1977, p. 6). The problem of economic analysis is the interaction of the technological and the social spheres creating frictions and requiring continuous institutional adjustment (Stanfield & Wrenn, 2005, p. 27). In contrast to institutional economics, neoclassical theory is essentially based on consumer preferences and production technology that generate an equilibrium to which the economy converges permanently and ­independently of institutional characteristics. However, institutions have received much more attention in mainstream economics during the past three decades. The so-called new institutional economics embeds institutional issues into the neoclassical framework. Acemoglu and Robinson

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(2012, pp. 79–83) mainly emphasize the need of “inclusive institutions”; these are institutions which guarantee private property rights and competition in the marketplace. In development economics, the institutions approach gained importance through the international financial institutions, which increasingly made loans conditional on governance criteria (see for example Kapur & Webb, 2000). This again reinforced the institutions debate within heterodox economics, where it has a long tradition. The term “institution” is not easy to define, and is sometimes characterized by entities, sometimes by forms, and sometimes by functions (see for instance Chang, 2007, pp. 18–19). Taking the first of these, institutions may be the budgetary institutions (governments), financial regulation institutions, wage- and price-setting institutions (companies and trade unions), central banks, religious institutions or the civil society. They may be expressed in forms such as democracy, independent judiciary, state ownership or the welfare state. Finally, institutions fulfill functions such as coordination of economic activities, income redistribution, technology promotion, enforceability of contracts and respect for private property. The difficulties in finding a clear definition of institutions reveals their diverse nature. This has led to criticism of the mainstream’s preference to hold the guarantee of private property rights to be the most important institutional requirement. There is no obvious argument why private property rights are always superior to public, open access and hybrid ownership patterns (Chang, 2007, pp. 22–23). As Goldberg (2015, pp. 58–59) argues, there is largely one single kind of capitalism in Western economic thinking. It assumes that the guarantee of private property rights and contract enforceability are essential for the functioning of a capitalist economy. However, particularly in emerging countries, these two “conditions” are violated quite often. Nonetheless, the cases of China and other fast-developing countries reveal an undeniable record of many decades of economic progress. Capitalist processes often mix with public intervention on the one hand, and traditional modes of production and institutions on the other hand. In China, land is usually owned by the communities instead of held in pure private ownership, which involves different economic relationships and the persistence of a certain subsistence agriculture (ibid., pp. 121–123). Kiiza (2007, pp. 291‒293) describes Botswana and Mauritius as two African success stories of economic development. Instead of adopting economic liberalism, developmentalism as a national ideology was institutionalized while promoting effective bureaucracy. There are certainly different forms of capitalism interwoven with various kinds of institutions. Good institutions are often associated with characteristics such as

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democracy, an independent judiciary and a small public sector, which all countries should adopt as a “global standard institution” in order to steer development (Chang, 2007, p. 20). However, as history and differences between countries show, there is a variety of differently combined institutions that are certainly economically more successful than a global standard institution would be in the same place. In the Global South, different forms of capitalist economies exist that create different institutions, while also being influenced by them. These phenomena are described by the term “the articulation of modes of production” (see for example Goldberg, 2015, pp. 77–79). In many mainstream development discourses, the above-mentioned institutions such as the guarantee of property rights are seen as preconditions for economic development (see for example Acemoglu et al., 2005, pp. 389–396). However, first, building institutions is costly. For example, in a poor country with limited resources it may be quite inefficient to develop sophisticated institutions to implement patent law, while reducing expenditures for health and education (Chang, 2011, p. 488). Second, many institutions may only be established or strengthened once economic productivity of a country allows for it. Reinert (2007, p. 64) argues that, historically, only societies with a sufficient level of manufacturing have achieved the “right” institutions. “Hundreds of years of accumulated experience show that today’s maxim ‘get the institutions right’ cannot be solved independently of ‘getting into the right kind of economic activities’” (ibid.). Hence, instead of the causality from institutions to economic development, the reverse causality from economic development to institution-building may be stronger (Chang, 2011, pp. 476–477). This book does not have a particular focus on institutional development. However, in the macroeconomic analysis and the subsequently developed propositions, institutions should be kept in mind. Economic policy and reforms can only be viable if they meet appropriate institutions in developing economies. Or, conversely, policy and reforms are only viable if they are appropriate for today’s institutions in poor countries.

NOTES 1. For an overview and examples of non-tariff barriers such as licensing, origin and agency restrictions, see Wade (1990, pp. 128–136). 2. See Chapter 4 for a detailed analysis of the implications of balance-of-payments constrained growth.

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2.  Key principles of macroeconomics The main schools of thought in development economics do not include money in a comprehensive way. The same applies to most growth models (see Blecker & Setterfield, 2019, p. 150). However, any production and any exchange in capitalist economies is tied to money. It is essential to perceive economies as fundamentally monetary. The consideration of money is, first, key to identifying economic effects properly, including not only real variables but also monetary ones. Second, if economic policy is to improve developing countries’ conditions, it has to intervene not in abstract models but rather in concrete reality. The reality is monetary and policy instruments are likely to be so as well. This chapter briefly introduces some essential principles of macroeconomics. It lays the base to finally show that while economic policy often has to deal with short-term demands, it can also use its instruments to have a long-term impact. In fact, short term and long term can be distinguished analytically, but hardly separated in reality. The chapter develops a stock-flow consistent model based on the macroeconomic principles. It shows the fundamental mechanisms of capitalist economies. The insights provided by model results lay the ground for further extensions of the model in subsequent chapters.

2.1 EXOGENOUS MONEY AND ENDOGENOUS MONEY The conception of money differs according to different economic schools of thought. We can broadly distinguish between theories and models considering money as exogenous, and those where money is treated as endogenous. In neoclassical economics, money is mainly perceived as an exogenous entity. During the gold standard system, gold represented money. Since then, commodity money has been replaced by virtual money created out of nothing, called “fiat money” (see for instance Ritter, 1995, pp. 134–135). The central bank decides on the money stock to circulate in the economy. In practice, it does so by determining the amount of money ­41

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reserves provided to commercial banks. These reserves enable the banks to grant loans to firms and households. Loans form someone’s income and hence get back to the banks in the form of deposits. Banks can relend the deposits, thus giving rise to further growth of loans and deposits. The final resulting amount of money is a multiple of the reserves provided by the central bank. Hence, conceptually speaking, it is the so-called money multiplier that defines the money stock coming into existence once reserves are given. The money multiplier is suggested to be empirically stable. Therefore, despite the ability of the banking system to create money out of nothing, it can still be said that the central bank is able to control the money stock (Friedman, 1959, p. 527). This is why in mainstream arguments and models, money is still characterized as a commodity, which is added to the economic process from outside as if it had ‒ as pointed out by critics ‒ fallen from heaven (see Davidson, 2006a, p. 146; Lavoie, 1984, p. 774). Hence the exogeneity of money. Neoclassical monetary theory was strongly influenced by the monetarist school led by Milton Friedman. It puts the quantity theory of money to the fore, stating that the quantity of money multiplied by the velocity of money is equal to nominal income in the economy, that is, real income multiplied by the general price level (Friedman, 1956). Causality is considered as one-directional. Hence, monetary policy defines the money stock exogenously. Since the money velocity is considered as stable, a higher quantity of money then is identical to higher nominal demand and hence a higher nominal income as stated in the quantity equation. Since real output of the economy is fixed by the existing productive capacity, the increase in the money stock can only transmit to the price level. Monetary policy therefore cannot have an impact on real variables but merely on nominal ones (Friedman, 1968, p. 11). Economic activity is dictated by supply-determined general equilibrium and is hence independent of money (Lavoie, 2006b). Thus, expansive monetary policy, implemented via an increase of the money stock, just gives rise to inflation. Moreover, inflation resulting from increased nominal demand in the course of monetary policy easing is considered as the only cause of inflation in mainstream economics. Most neoclassical economists adhere to Friedman’s statement that “inflation is always and everywhere a monetary phenomenon” (see for example Mishkin, 2007, p. 2). As a simple consequence coming from the fact that monetary policy cannot have real but only nominal effects, the central bank should focus on a single ­objective, namely price stability. As a second main consequence of exogenous money, economic activity is studied in purely real terms. Since money does not impact on real variables, it can simply be added after having assessed real economic

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effects. This procedure has significant implications for final conclusions, as Wicksell’s monetary analysis shows (see Rochon, 2004). In this particular neoclassical framework, agents make decisions on savings and investment in real terms. Savings provide the means to invest. No investment can be made when savings are insufficient. The higher (lower) the interest rate, the more (less) they are willing to save, while investment demand decreases (increases). The interest rate equilibrates savings and investment. It is called the “natural” interest rate (Wicksell, 1898/1965, p. xxv). Then, money is added to this real-term equilibrium. Treating money as a commodity means that it is scarce. Its price fluctuates with its relative abundance. Money supply has to be defined such that it matches the requirements of the real equilibrium between savings and investment. Hence, the central bank should fix the money supply such that the market interest rate matches the invisible natural interest rate. If the monetary market rate is lower (higher) than the natural rate, money supply is too high (low) and hence causes inflation (deflation). Since the 1960s when monetarism started to become influential, neoclassical economics has developed in several respects regarding money. New Keynesianism introduced nominal rigidities such as imperfect competition and wage rigidities. In the course of expansive monetary policy, increased nominal demand does not immediately raise the general price level due to the rigidities. Nominal demand therefore has an impact on real output (see for instance Ball et al., 1988). However, once all variables have adjusted to the new monetary conditions, output converges back to its original level (McGrattan, 1997, p. 286). In addition to new Keynesianism, new classical economics emerged around the development of the real business cycle models (see Plosser, 1989). These models are maybe the purest expression of the neoclassical principle that only real variables are relevant, while nominal ones do not have any influence. While the economy is basically always in general equilibrium determined by perfect competition, exogenous technology shocks can impact on the supply-side conditions of the equilibrium. The business cycle is thus created by exogenous shocks. The combination of new Keynesian innovations with real business cycle theory led to the emergence of the “new neoclassical synthesis” (Goodfriend & King, 1997). Monetary policy, and money itself, is given slightly more room due to time lags caused by nominal rigidities. However, there are still no long-term impacts as the latter are exclusively fixed by real variables such as ­production technology and consumer preferences. Another more recent development is the emergence of the “new consensus” in monetary policy. It accepts that the quantity of money cannot be set exogenously and therefore has come to consider the short-run interest rate level

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as the exogenous variable to be determined by the central bank (see Gnos & Rochon, 2007, p. 369). However, its theoretical background still remains rooted in the exogenous money conception. Namely, the main target is to set the policy interest rate such that it matches the natural interest rate (ibid., pp. 371–372; Woodford, 2001). The famous Taylor rule was developed to guide monetary policy towards the natural rate (see Taylor, 1993). Hence, even given these developments, monetary policy is still suggested to merely intervene in the economy in order to guarantee price stability. Any interventions going beyond this goal are considered as harmful because they distort the perfect market equilibrium, whereas judgments differ among different schools with respect to the time horizon of such distortions. Endogenous money is a very different concept. It was pioneered by economists such as Kaldor (1970b, 1982) and Moore (1988) and has been advanced mainly by post-Keynesian economics. According to this paradigm, money comes into existence whenever banks grant a loan to a borrower, given that the latter has been assessed as creditworthy. It is created ex nihilo (Rochon, 1999, p. 9). This fundamental fact has several important implications. First, money is created when firms plan production and therefore need to finance expenditures. It means that money is associated with output. This association explains why money is endogenous: its creation emerges out of the economic process (ibid., pp. 7–8). Additional reasons for credit demand may be financial investment or consumption expenditures. Second, since money requirements are associated with economic activity, demand for credit increases when output grows. In the opposite case of an economic slump, there is no demand for money and hence no money is created. Thus, money is driven by demand (Moore, 1988, p. 19). Third, the demand-led nature of money implies that the supply side of the money market ‒ that is, the central bank ‒ may change the conditions of money supply. But it cannot create a single unit of money if demand is missing. There is no identifiable supply function because money supply is itself driven by money demand, too (ibid.). The credit nature of money means that every unit of money is mirrored by a debt of the same amount. Once debt is paid back, money is destroyed. The endogeneity of money implies that since monetary policy only has a quite limited impact on economic activity, the impact on money creation is limited as well. The central bank is thus not able to control the quantity of money (Lavoie, 1984, p. 782). Banks create money upon demand while demanding reserves from the central bank according to their needs, corresponding to their volume of loans and deposits. The concept of the money multiplier in the monetarist sense becomes useless (Lavoie, 1984, pp. 777–778; Lavoie, 2003, pp. 523–524).

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Due to the inability to control money creation, monetary policy targets the level of interest rates instead of money supply. Hence, the short-run interest rate is the exogenous variable (Rochon, 1999, p. 14; Smithin, 2017, p. 270). It sets the conditions under which banks can demand reserves. The interest rate in the interbank market translates to the interest rates with which banks charge loans and reward deposits. Individual rates within the whole set of market interest rates differ according to time horizon and risk assessment. Monetary policy cannot fix individual market rates, but since it is able to determine the interbank target rate with high precision it also has a strong impact on the average level of market rates. Once the interest rate level is given, demand for credit determines the amount of money to be created. Within the theory of endogenous money, two main strands can be distinguished. The structuralist school takes business cycles as well as financial booms and busts into account. Developed in significant part by Minsky (1957), it argues that the more an economic boom advances, the more credit grows and the higher total risk exposure in the market gets. The central bank aims to limit financial risk in the economy and therefore increases the interest rate target. Commercial banks transmit restricted conditions to market rates. With regard to the relationship between interest rates and money, structuralism implies a rising interest level when money creation grows (see for example Dow, 2006; Palley, 1991, 1996; Pollin, 1991). In this context, banks can also limit credit supply due to increasing uncertainty in the market (see Le Heron & Mouakil, 2008). The interest rate curve is upward-sloped. The horizontalist school of thought argues that the central bank behaves in a fully accommodative way in the face of demand for reserves (Kaldor, 1982, 1985; Lavoie, 2006a; Moore, 1988). As Moore (1988) as a key contributor argues, the central bank can realize its interest rate target most efficiently if it fulfills any demand for reserves. Moreover, if it denied doing so, it would trigger a liquidity crisis with corresponding consequences in the banking system. Horizontalism argues that financial risk, as emphasized by structuralism, is taken into account when banks assess borrowers’ creditworthiness (Rochon, 1999, p. 10; Rochon, 2006b, pp. 171–173). Changes in the interest rates thus are not attributed to business cycles but to the level of individual borrowers. Exogeneity of the interest rate is stronger in horizontalism than in structuralism because once the general level is set by monetary policy, it does not change with the volume of money creation. The interest rate curve is horizontal. Despite some analytical differences, structuralism and horizontalism agree on the argument that the quantity of money cannot be controlled. Le Heron (2019) suggests a reconciliation between the two approaches

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by arguing that both of them are found in Keynes’s General Theory; in a “qualitative theory of money,” horizontalism applies to short-term rates and structuralism is relevant with regard to banks’ risk considerations and agents’ liquidity preference. The respective interest rate curves are in clear contrast to the vertical curve of the exogenous money approach where money supply is fixed first while the interest rate is the dependent variable (see for instance Davidson, 2006a, p. 143). Another essential difference distinguishes endogenous money theory from the neoclassical approach with regard to the relation between savings and investment. Whereas neoclassical analysis is done in real terms where savings are a precondition for investment, endogenous money reveals that causality goes in exactly the opposite direction. The creation of money through the issuance of a loan implies the simultaneous creation of a deposit of the same amount. For example, a firm may be granted a loan which is used to pay workers’ wages. The firm is a debtor, while workers own the deposit. In this sense, workers are the creditors of the firm. The banking system faces a loan on its asset side and a deposit on its liability side. Therefore, savings and investment are not two independent functions that need to be equilibrated by the interest rate as the Wicksellian analysis suggests. The endogenous nature of money reveals that savings and investment are always equal a priori. Thereby, the relationship between savings and investment is not merely an equality but even an identity, as they represent “the two opposite facets of the same reality” (Cencini, 2003a, p. 309). Loans and deposits are created simultaneously. A loan cannot exist without a corresponding deposit and vice versa. The identity of savings and investment does not require an interest rate to act as an equilibrating force. Thus, there are other forces to determine the level of the latter. With endogenous money, monetary policy is able to determine the short-run interest rate level and at least exerts a key influence on the long-term market rates. We now see why the causality from savings to investment, as claimed by neoclassical economics, is wrong. The fundamental reason for money to be created is demand for credit. It is thus investment financed by a loan, which is the driving force. Savings in the form of a deposit are the result of investment. Despite the simultaneity of creation of loan and deposit, it is logical that causality goes from investment to savings, that is, that loans create deposits (Moore, 1988, pp. 3–4; 1989, p. 55). This conclusion is not subject to argument but is mere logic arising from the nature of doubleentry bookkeeping. It would even be valid in the absence of a central bank (Lavoie, 2003, p. 506). Post-Keynesian economics as the school of thought that mainly

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c­ ontributed to the development of endogenous money theory rejects the notion of a natural interest rate (Smithin, 2013, pp. 244–246, 252). First, it cannot be observed. Its mere existence is thus rather hypothetical. Second, dividing economic analysis into two steps by first analyzing the economy in real terms and introducing money later is inappropriate. Economies are fundamentally monetary. Issuance of loans is at the root of any economic activity. Money is required to bridge the time from the planning of production, purchase of input materials and employment of workers until the sale of output (see for example Davidson, 2006b, pp. 139–142). Moreover, money is the measure of economic output and represents produced output in its numerical form (Rossi, 2001, p. 11). In modern capitalist economies, economic activity simply cannot take place without money. The only interest rate whose existence is given is the monetary interest rate observed in the market. In neoclassical theory, when the market interest rate is below or above the natural rate of equilibrium, supply of money is inappropriate, giving rise to a change in the price of money which is expressed in either inflation or deflation. However, the consideration of money as a commodity prone to scarcity and abundance is proven wrong by endogenous money analysis. Money is created out of nothing upon demand and hence can be neither scarce nor abundant. Rejection of the existence of a natural interest rate requires a different analysis of inflation. Monetarism and more recent neoclassical theories argue for inflation to be caused by demand, which itself is triggered by a growing supply of money. With endogenous money, however, money creation is a reaction to existing demand. This raises questions as to what actually causes inflation. An argument for reversed causality can be made when a higher level of wages as a result of wage bargaining gives rise to a higher general price level (see for example Davidson & Weintraub, 1973, p. 1117). Higher wages require firms to raise their outlays at the beginning of the production period. They have to request a larger loan from the bank. As a consequence, money is not at the origin of a higher price level. Instead, increased money creation is the result of a rising price level. Hence, following Arestis and Sawyer (2003a, p. 9), money is not at the root of inflation. So, what causes inflation? As long as production capacity is not fully utilized, economic output can react to growing demand by increasing the utilization rate. Hence, the general price level does not necessarily have to increase when demand grows. Similarly, unemployment can be considered as unused “labor capacity.” Wages therefore do not substantially increase as long as unemployment is high enough. Once the economy approaches full employment, wages start rising. Alternatively, the conflictive claim approach argues that prices may rise when firms react to higher demand

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(see Blecker & Setterfield, 2019, pp. 210–223). Whereas rising demand for consumption goods is considered a “demand pull,” higher wages appear as a “cost push” to production (see for example Vernengo, 2006, p. 471). In neoclassical theory, the economy usually produces at full capacity while there is no involuntary unemployment. In heterodox approaches, this need not necessarily be the case, as will be introduced below. For monetary policy, this means that expansive policy is inflationary to the extent that it leads to demand exceeding capacity in terms of either production plants or labor force. Yet, it is not that increased demand induced by monetary policy meets a fixed supply constraint as general equilibrium models suggest. Demand can also create supply (see for instance Colander, 2001; Oberholzer, 2017, pp. 81–86). Higher credit demand might give rise to higher consumption expenditures by households. They do not contribute to higher production capacity. However, firms may use loans to fund investment expenditures and hence to finance capital accumulation. While this increases demand regarding the production of investment goods, it also raises supply once investment goods are installed as production plants. If expansive monetary policy shifts production capacity itself, it does not inevitably lead to inflation.1 The theory of endogenous money concedes more room for monetary policy than does exogenous money. By stimulating investment, expansive monetary policy can indeed have an impact on output without necessarily raising the inflation rate. In contrast to the conception of money in neoclassical theory, therefore, money is not neutral. However, the interest rate level is far from being the only factor with a potential influence on economic activity. It has been argued above that demand is the essential determinant of money creation and hence of production. Opinions in heterodox economics about the significance of monetary policy effects on output thus differ (see for instance Rochon & Setterfield, 2011). The new consensus approach to monetary policy reflects a certain convergence between the respective exogenous money and endogenous money approaches. Yet, the convergence is less than it may seem. Despite the new consensus’s recognition of the impossibility to control money supply, its conclusions and recommendations for monetary policy are still clearly rooted in a neoclassical framework that considers money as exogenous. While post-Keynesian economics, relying on endogenous money, sets the interest rate at a level suggested by economic policy considerations, monetary policy’s task in the new consensus approach is to “shadow the fluctuating ‘real natural rate of interest’” (Goodfriend, 2007, p. 29). The comparison of exogenous money to endogenous money shows fundamental differences in favor of the latter. Endogenous money theory provides a much more detailed emphasis of money and its integration in

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the production process. It acknowledges the nature of credit money and its corresponding implications. In connection to the following principles, it becomes clear that they can only be appropriately explained once the endogeneity of money is recognized. This is why the analysis in this book relies on endogenous money.

2.2  MONETARY CIRCUIT AND CREDIT CIRCUIT A further quite fundamental principle to understand the workings of modern economics is the idea of the monetary circuit. The recognition of the endogeneity of money gives a flavor of the economic dynamics and the elasticity as well as instabilities that economic and financial systems involve. However, the economic process of production itself has not yet been explained. The understanding of the monetary circuit – an issue largely ignored by mainstream economics – is therefore key. The theory of the monetary circuit, or credit circuit, is introduced as a logical framework. The circuit approach lays the base to understand the principle of the monetary economy of production and its differences to the economy of exchange in mainstream economics. The theory of the monetary circuit was developed by a number of heterodox authors influenced by post-Keynesian economics (see for example Gnos, 2006; Graziani, 2003; Parguez & Seccareccia, 2000; Realfonzo, 2006). Graziani (2003, p. 25) summarizes some key aspects of the monetary circuit: money is an endogenous variable and its nature is credit money. Hence bank credit represents money. It is created through grants by a bank and destroyed once bank credit is paid back. The theory is thus based on endogenous money and rejects economic analysis in merely real terms, as well as the scarcity of money when perceived as a commodity. The monetary circuit can be divided into a sequence of steps. First, firms ask for loans from the banks. The loans are granted. Credit supply at this stage is called “initial finance” (Graziani, 2003, p. 27). The firms need the money to pay workers. As soon as the payment has taken place, money has come into existence. Firms are considered as a consolidated sector of production. Material inputs are internal flows within this sector. Due to this macroeconomic perspective, labor can be considered as the only input in production (ibid., p. 27). Not all representations of the monetary circuit exclude commodities (see for example Parguez & Seccareccia, 2000, p. 104). The more commodities individual firms have to purchase, the higher is the demand for credit. However, the simplification does not alter the logic behind the circuit. In the next step, production takes place. The banks’ balance sheet

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c­onsists of assets in the form of loans granted to firms, and liabilities consisting of workers’ deposits. The essence to understand is that money as bank credit allows firms to pay wages before having produced available output (Gnos, 2006, p. 93). There is no a priori constraint, by contrast to what the exogenous money approach suggests. After production, produced output is sold. Workers spend their wages while firms generate the return to repay their loans. Hence, eventually money is destroyed, and the monetary circuit is closed. The next period requires the issuance of another loan to start the circuit again. The theory of money emissions can be considered as related to the theory of the monetary circuit. Also known as quantum macroeconomics, it was initiated and predominantly developed by Bernard Schmitt with a number of additional contributors (Cencini, 2005; Rossi, 2003, 2009; Schmitt, 1960, 2012). Yet, it faces several conceptual differences compared to the monetary circuit theory. Specifically, the theory of money emissions argues that the monetary circuit is not a sequence of steps but an instantaneous event (Rossi, 2009, p. 40). Whereas in the monetary circuit theory money is a stock being created through loan issuance, exchanged between workers and firms and finally destroyed, in the theory of money emissions money is itself the flow. In a single instant when a loan is granted, money is the flow from the loan to the deposits (of workers). So money as a flow is to be distinguished from deposits as a stock. Hence, in monetary circuit theory, money is the object of payment, while it is the means of payment in the theory of money emissions (ibid., p. 38). In Cencini’s (1997, p. 274) words, “having played its role as a means of payment, money disappears leaving behind a book-keeping entry representing a positive amount of income deposited within the banking system.” The object of deposits is therefore not money itself but produced output. Money, itself a mere number, is only endowed with purchasing power because it is associated with economic production. Loans and deposits as the results of a monetary flow imply that the borrower is the debtor to the bank, whereas the depositor is the creditor of the bank. Or, in other words, once the borrower pays a worker, the latter immediately becomes the former’s lender with the bank acting as a financial intermediary. Any payment in a modern banking system thus involves a monetary intermediation as well as a financial intermediation: “the monetary intermediation concerns money as a flow, and is based on the principle that ‘loans make deposits’ . . . The financial intermediation concerns money as a stock (to wit, bank deposits), and is based on the principle that ‘deposits make loans’” (Rossi, 2009, p. 42). Therefore, any payment in modern banking systems is final. It should be noted, however, that this conclusion is far from any exogenous money approach implying

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that money needs to pre-exist for a payment to be exerted (ibid., p. 43). For if this was the case, any payment would only be a zero-sum game and could not explain the formation of income (Gnos, 2017, p. 24). Monetary intermediation and financial intermediation take place simultaneously to guarantee payment finality. They do not challenge the fact that money is created ex nihilo. With money instantaneously destroyed once it is created in quantum macroeconomics, the same is not true for deposits. Deposits, just as loans, actually exist for a positive time span. They represent a claim on produced output and hence represent income, and as such they are the monetary expression of produced output. Following Schmitt (2012, p. 82), “what can be found in banks is not a deposit of money, but a deposit of produced output.” For this reason, it is not money which moves in a circuit, but credit and deposits (still representing an identity) (see Rossi, 2009, p. 42). So as long deposits are not used to repay loans, this circuit indeed is not closed, in the sense that consumption does not destroy the created income. Following the theory of money emissions, it is credit rather than money which can be considered as moving in a circuit. Income, which has a positive duration in time, is created via production and destroyed via consumption. As these theories are not emphasized in more detail here, it may be mentioned that the theory of the monetary circuit and the theory of money emissions often lead to analogous results with regard to economic policy conclusions. The definition of payment finality in quantum macroeconomics will be useful to understand the analysis in Chapter 5. Now, what are the conditions for the monetary circuit or, respectively, the credit circuit to be closed? So far, the implicit assumption has been that workers spend all their wage income, with which they can afford to purchase all goods produced in the period of a circuit. Hence, by selling output, firms receive exactly the amount of income they had paid to the workers at the beginning. They are able to exactly repay the loan they were granted as initial finance. The banks’ balance sheet shrinks back to zero. This simplification is reasonable to start with, but it is not an appropriate description of reality. Under these assumptions, production is a zero-sum game for firms because they do not earn any profits. Once the assumptions are relaxed, new economic dynamics emerge. Let us enlarge the circuit by allowing for not only the production of consumption goods but also the production of investment goods. Obviously, the latter cannot be consumed by workers through expenditures of wages. Therefore, investment constitutes a difference between total output and production costs. As such, it represents firms’ profits. As Parguez and Seccareccia (2000, p. 108) argue, firms thus have to borrow from banks not only for wage outlays but also for investment expenditures. Firms

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­ roducing consumption goods make a profit according to the wage expenp ditures made by workers in firms producing investment goods. This profit is spent on the purchase of investment goods. So, the firms producing investment goods are compensated for their wage payments. In addition, they enlarge production capacity by acquiring investment goods produced in their own sector. This explanation is a sketch of Marx’s (1885/2008, pp. 367–370, 470–474) reproduction scheme, introduced to post-Keynesian economics by Kalecki (see for instance, Kalecki, 1939/1987, p. 75). This logic is a clear and direct confirmation of the fact that loans create deposits, and the causality in the investment-savings identity goes from the former to the latter because profits in this regard are synonymous to firms’ savings. Firms’ borrowing for investment expenditures creates profits of the same amount. In the end, there is no increase in firms’ debt, while the capital stock has increased. Under these assumptions, Kalecki’s famous statement that workers spend what they get, capitalists get what they spend (see for example Asimakopulos, 1988‒89; Weintraub, 1979) is confirmed. So far, interest payments have been excluded from the circuit analysis. As a next step towards an appropriate description of reality, they should be taken into account. From the point of view of a firm, interest payments are a component of production costs. It may therefore seem impossible to pay interest, because firms are granted a credit of x units of money but have to repay x plus interest. Hence, they owe more money than has been created. However, interest payments constitute banks’ profits. From a macroeconomic perspective, interest is part of the total profit sum, just as argued by Marx (1894/2004, p. 349). Interest forms an income of banks. As any income, it can be spent again. Hence, bank profits contribute to demand for goods (Zezza, 2004, p. 1). Parguez and Seccareccia (2000, p. 110) argue that banks issue debt on themselves in order to spend it. Interest payments of firms provide the corresponding reflux. This explanation is quite stylized and technical, but it shows how the payment of interest takes place without contradicting the logic of the circuit. However, it may be that profit consists not only of investment but also of consumption goods. Firm owners most likely want to enjoy consumption too. In particular, as rentiers they can afford luxury goods, which are out of reach for workers. Moreover, if investment was the only constituent of profits, the latter would be zero in a situation where there is no net investment. The determinants of investment behavior are still to be explained. However, it can already be said that private production with zero profit is incompatible with the way capitalist economies work. It is thus indeed not possible that a circuit only has wage goods as its final output. For, if this was supposed to be the case, production would break down. Hence, given

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that net investment is zero, there still have to be positive profits whose real form is consumption goods. This implies that workers’ wages are not sufficient to purchase all consumption goods. So, while it is clear that wages buy a part of consumption goods, where is the money to buy the rest of the consumption goods that represent profits? They belong to the firm owners. But whereas consumption goods for workers and investment goods can be purchased by money flows arising from the loans that were granted at the beginning of the circuit, no money is available to pay for profit goods because they were not financed by credit. The literature on monetary profit realization usually does not extend to the problem presented here where profits also consist of consumption goods. However, existing approaches nevertheless can contribute to the solution of this problem (for an overview, see Rochon, 2009). First, one may simply assume that no monetary realization of profits is needed because firm owners enjoy profits in kind through direct physical consumption. Alternatively, firms may borrow from banks to realize their profits. Rochon (2009, pp. 62–63) criticizes this approach by arguing that banks would not be willing to grant a loan for profits at the beginning of a circuit without knowing what the amount of profits will be. Instead, he argues that investment finance is provided by long-term loans not repaid within a single production period, that is, within a single circuit (ibid., pp. 73–74). Money is thus available to realize profits. However, this solution is dependent on the existence of positive investment and thus not applicable to a situation where there is no positive investment but still a profit. Other approaches suggest interrelations between different circuits simultaneously taking place in an economy (see for example Gnos, 2003). Outstanding loans in one circuit provide the money for profit realization in another circuit, being in a different phase of the circuit. Alternative explanations require surpluses in the current account or public deficits to provide the demanded sources of money. However, such an assumption does not answer the question concerning the closure of circuits of government and foreign economies (see Seccareccia, 1996, p. 405). For the remainder of the analysis, it is not of fundamental importance to have found a single definitive solution. Different propositions may apply in different situations of real-world economies. The simplest solution may still be that banks grant loans for profit realization. They do not do so at the beginning of a circuit where production plans are presented. Rather, borrowing takes place after completion of production, that is, when profits already exist. For banks, there is no longer uncertainty as to how small or large profits may be in the future. Loans being issued after production are thus not subject to any production, be it for consumption

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or investment. They are rather a kind of consumption credit. As with any loan for a consumer, creditworthiness is assessed by estimating the risk of debt failure. Firms have profit in the form of real assets serving as collateral. There is thus no more uncertainty for banks than there is with any loan prior to production at the beginning of the circuit. Even if there are profits and interest payments, the circuit can be closed, implying that the banks’ balance sheet shrinks back to zero. However, it may be that either workers or firm owners do not spend all their wages and profit income, respectively. Positive savings mean that firms cannot sell all goods and hence have to build inventories. As a consequence, they are not able to generate sufficient reflux for all loans to be repaid. Outstanding loans are mirrored by deposits arising from savings of firm owners or workers (or both). Under such circumstances, the credit circuit cannot be closed. Yet, all monetary payments are settled in the sense that depositors immediately become creditors of the debtors (Rossi, 2009, p. 42). Now, the question is how the positive savings of individual households are related to the total savings of the macroeconomy. It has been explained that investment determines savings. This rule applies from a ­macroeconomic perspective. Investment defines what share of total output is not devoted to consumption, that is, not devoted to being destroyed through consumption. Once firms have decided on the volume of output and the level of investment, savings and consumption are predetermined. From this point of time on, it is households’ decision on what share of income they are going to spend (Cencini, 2003a, pp. 311–312). But this decision can no longer affect magnitudes of total output. Workers’ and firm owners’ saving rates merely define what respective shares of consumption goods are purchased by households and by firms. For, ­ theoretically speaking, if households’ saving rate is positive, the goods that are not sold to them have to be purchased by firms themselves and be stored as inventories. This purchase is funded by the part of the loan that firms cannot finally repay (Rossi, 2009, p. 45). As explained, this loan is immediately financed by depositors due to the principle of double-entry bookkeeping. To sum up, firms’ investment decisions determine the total savings of the economy and can therefore be considered as macroeconomic savings (see Cencini, 2003a, p. 310). Households’ saving rates only affect the distribution of purchases between firms and households. We can define it as microeconomic saving. The recognition of this distinction will be shown in the model.

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2.3 MONETARY ECONOMY OF PRODUCTION, EFFECTIVE DEMAND AND UNCERTAINTY Even though reality is too complex to track all financial and monetary flows, the monetary circuit or credit circuit, respectively, provides a precise explanation of how money is integrated with production. Endogenous money and its connection with the circuit makes the emphasis of production an essential part of any economic analysis. Yet, this acknowledgement reveals a further fundamental difference between neoclassical and heterodox economics. The latter focuses its investigation on an economy of production, while the former is limited to an economy of exchange. The distinction between the two terms goes back to Keynes (1933/1973), where he criticizes neoclassical theory for analyzing a barter economy where money is added just for convenience to assess relative exchange values. The criticism goes along with the announcement of the elaboration of a “monetary theory of production” where the neutrality of money is abandoned (see also Gnos, 2009, p. 1). While the production process was already at the core of interest in classical analysis, it was Keynes and post-Keynesian economics adding the monetary approach that eventually give rise to the concept of the monetary economy of production to which the theory of the monetary circuit made important contributions (see for instance Fontana & Realfonzo, 2005; Graziani, 2003; Gnos, 2005; Rochon, 2005). The consideration of the whole circuit in monetary terms instead of investigating a real exchange economy leaves room for a lot more dynamics. Figure 2.1 shows the analytical differences between the respective Exchange: sale of output/expenditure of income

Loan issuance

Loan repayment

Figure 2.1  Exchange economy as a section of the economy of production

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approaches of a monetary economy of production and a real exchange economy. While the former investigates the whole circuit from loan issuance to loan repayment, the latter considers only a section of it, namely the moment when goods are sold and purchased. To provide an image, the exchange economy only considers the section within the square, whereas a monetary analysis and the importance of the production process require accounting for the whole circle. After having studied the different steps of the credit circuit, one may ask how an economic analysis can skip the issuance of a loan and the planning of production. In neoclassical theory, the level of output is fixed by a supply-side equilibrium (see for example Colander, 1996, pp. 28–29; Sawyer, 2002b). An aggregate production function defined by a certain given level of technology and corresponding factor inputs implies that production is predetermined. The economy is a perfect market equilibrium producing at full capacity. Deviations from this state are due to exogenous shocks and rigidities giving rise to time lags (see Greenwood et al., 1988; Svensson, 1986). Since technological factors determine supply, no space is left for expectation-building, changing production plans, and a production process requiring historical time. No money is thus needed to realize production. Economic activity in neoclassical analysis actually only starts when production is already given in real terms. Say’s law states that under profit maximization of producers and utility maximization of individuals, supply creates its own demand (Davidson, 2002, pp. 19–21). Production factors are remunerated in real terms according to their marginal product and markets always clear. There is no unemployment. And exchange is real: goods are exchanged against other goods (ibid., pp. 18–19). One commodity can be defined as money allowing for the measurement of the relative prices of all other commodities. In line with the definition of exogenous commodity money, “a commodity is regarded as money for our purposes if and only if it can be traded directly for all other commodities in the economy . . . money buys goods and goods buy money; but goods do not buy goods” (Clower, 1967, p. 5). Hence, as stated by Keynes (1933/1973, p. 408), in neoclassical theory money is used “as an instrument of great convenience, but transitory and neutral in its effect.” Exchange therefore is and remains real rather than monetary. The monetary economy of production differs in many fundamental regards from the economy of exchange. It is not only that the circuit approach is more comprehensive. In particular, the section common to both approaches ‒ that is, exchange ‒ is perceived differently. Whereas neoclassical theory emphasizes a relative exchange between commodities of which one serves as money, the circuit implies an absolute exchange.

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Quantum macroeconomics, having elaborated best on this issue, points to the fact that money is provided with purchasing power through production. Deposits are identical to output by representing it in its monetary form. When deposits are spent to purchase output in its real form, the latter is in fact exchanged against itself, thus being an absolute exchange (Cencini & Rossi, 2015, pp. 26–27; Schmitt, 1984, p. 347). Heterodox economics divides into different strands with respect to Say’s law. For example, Davidson (2002, pp. 21–25), relying on Keynes, argues that supply and demand are not necessarily equal. This implies that markets, including the labor market, do not necessarily clear (Davidson, 2015, pp. 11–13). Rejection of Say’s law is based on the argument that if it held, full employment would have to be the normal state of the economy, which it actually is not (see also Keynes, 1936/1997, p. 26). Others support Say’s law from a different angle. They insist on the identity of aggregate supply and aggregate demand. This identity is analogous to the investment‒savings identity and has already implicitly been introduced by the circuit approach. Production creates income. Hence, total supply is equal to the sum of demand components, that is, consumption and investment. Supply and demand describe two sides of the same entity, thus building not merely an equality but an identity. It was actually Keynes himself who identified this macroeconomic identity (Keynes, 1936/1997, pp. 61–65). In this sense, Say’s law is confirmed, since supply can never deviate from demand nor the other way round: “what Say’s law and Keynes’s identity tell us . . . is that supply and demand are jointly determined” (Cencini & Rossi, 2015, p. 42). The identity even holds when households decide not to spend all their income on consumption goods. As explained, a depositor immediately becomes the creditor of the debtor, with the bank playing the role of the financial intermediary. In fact, being a debtor comes down to selling financial claims to the creditor. Therefore, an income holder can either choose to spend money on consumption goods or on financial claims. But it is not possible not to spend it; that is, to hoard money units. Sales and purchases of each agent are equal, hence confirming the identity of supply and demand (ibid., pp. 46–48). Yet, both heterodox arguments agree that the neutrality of money as implied by Say’s law is erroneous. Moreover, the mainstream assumption of a static technology-determined supply is rejected. After having explained the issue of money, the circuit of the monetary economy of production, and the relationship between supply and demand, the question arises about what factors determine the level of output. The neoclassical assumption of full capacity utilization is grounded in the economy of exchange. In contrast, the circuit analysis clearly reveals that production depends on firms’ decisions regarding credit demand and employment of workers.

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Firms have to build expectations with regard to future sales and profits. They are only willing to produce if expectations are sufficiently optimistic. The principle of effective demand is one of the fundamental principles driving the macroeconomy to be found mainly in Keynes’s and Kalecki’s works but also, at least partially, in Marx’s works (see Hein, 2015). As defined by Keynes (1936/1997, p. 55), “the effective demand is simply the aggregate income (or proceeds) which the entrepreneurs expect to receive . . . from the amount of current employment which they decide to give.” When the economy is in a downturn, firms’ expectations, relying on past experience, deteriorate. If they are not able to sell all their goods, they adjust production plans and reduce employment in the subsequent circuit. The opposite happens in an upswing. Firms enjoy high sales and profits and therefore plan to scale up production in the future. Capacity utilization and employment can thus differ in each period. Effective demand implies dynamics that are endogenous to economic processes and thus is in stark contrast to the exogenous shocks used to explain economic fluctuations in real business cycle models. Moreover, volatility caused by variations in effective demand does not have to follow a regular pattern of ups and downs. In particular, there is no autonomous force that leads the economy out of a recession. As long as expectations are depressed, a country remains in a slump for an undefined time. Therefore, based on the insight that growth is demand-led, the assumption of permanent full capacity utilization has to be rejected. However, heterodox literature is inconclusive on whether the rate of capacity utilization floats freely or converges to a certain exogenous equilibrium rate in the long run. Post-Keynesian theory, and especially Kaleckian models, tends to consider capacity utilization rate as a completely free variable not following any equilibrium path (see for instance Lavoie, 2014, p. 360; Lavoie & Kriesler, 2007). Other heterodox authors, particularly classicals, refer to a “normal rate” of capacity utilization in the long term. Such an exogenous rate is supported mainly by the argument that high and low capacity utilization rates trigger investment and disinvestment, respectively, and thus adjust total capacity in such a way that the utilization rate converges towards the normal rate (Harrod, 1939, p. 19; Shaikh, 2016, pp. 594–594). However, both stances share the point of view that there is no autonomous convergence towards a degree of capacity utilization that corresponds to full employment (Shaikh, 2016, p. 745). And both agree on the fact that fluctuations in the rate of capacity utilization can have a lasting impact on absolute output and growth. In neoclassical theory, expectation-building is based on the assumption of perfect knowledge of the future. First, agents are assumed to act on

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rational expectations (see for instance Lucas, 1972). This means that they immediately adjust to all new information in the market and hence guarantee that true prices are discovered. Forecast errors are zero on average. Second, some models define a set of states with a certain probability of realization for each. Both features are based on the assumption of perfect knowledge of the true model. In the first case, knowledge is contained in new information; in the second case, it is incorporated in the defined set of possible states (O’Donnell, 2017, pp. 75–76). However, knowledge cannot be perfect for quite fundamental reasons. The building of expectations is a complex thing for which the understanding of Keynes’s (1936/1997, pp. 161–162) concept of uncertainty is necessary. Agents, be they firms or individuals, know that economic performance depends on how other agents in the economy behave. They build expectations about the future by guessing what other agents do. However, other agents do likewise, and include assumptions of the respective behavior of all other agents in their expectation-building (see ibid., p. 156). There is mutual dependence of all agents’ prospective behavior. Since everyone adjusts their own behavior to what they believe the other agents are doing, the economy is subject to dynamics, which cannot be calculated by any mathematical tool. The dynamics can be volatile, irregular and, particularly, self-enforcing due to permanent adjustment in agents’ expectations. Uncertainty is thus a conception fundamentally different from probability (see Keynes, 1937). Uncertainty also reveals why macroeconomics needs to be studied separately from neoclassical microeconomic theory and cannot be derived from the latter (Cencini, 2003b, p. 13). Due to mutual interdependencies, the behavior of individuals cannot just be aggregated to get macroeconomic results. However, this is exactly what mainstream economics does by assuming representative agents and aggregate maximization of profit and utility. This gives rise to the so-called “fallacy of composition” as pointed out by Keynes (see for instance McCombie, 2010, p. 120; Niggle, 2006, p. 376), the most famous example of which is the “paradox of thrift”: when every agent in the economy increases the saving rate, resulting macroeconomic savings are lower instead of higher. Saving deteriorates the business prospects of firms, which start cutting down employment and hence production and income. The saving rate may be higher but absolute savings are lower due to a recession. In the previous section, the point was made that it is investment which drives macroeconomic savings, while microeconomic savings, that is, households’ saving decisions, do not affect the level of output. This remains true as long as the analysis is limited to a single circuit. As soon as a sequence of production periods is considered, microeconomic savings

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become relevant too. Positive household savings give rise to inventory accumulation within firms. They are thus tantamount to a deterioration of effective demand. As such, they impact on firms’ expectations which, through uncertainty, may contribute to further cutbacks in production. However, this analysis is still far from the neoclassical view of savings causing investment where it is assumed that the former are a precondition for the latter to take place. While mainstream economics criticizes government intervention as a force that distorts the market equilibrium, the heterodox macroeconomic approach introduced here neither considers market outcomes as perfect nor does it rule out active economic policy. As stated by Weintraub (1975, p. 535), in a world of uncertainty, adjustment to an equilibrium is meaningless. Any equilibrium pattern is hypothetical. With the analytical result that the supply‒demand identity always holds, the notions of equilibrium and disequilibrium lose their relevance. In a situation with sluggish effective demand, economic policy may significantly improve economic performance without any constraining equilibrium requirements. This issue is discussed in Chapter 3.

2.4  PROFIT RATE The common statement that neoclassical economics is a supply-side approach, while in post-Keynesianism the economy is driven by demand, is too simplistic. As shown, supply and demand are identical and hence jointly determined. However, it is true that effective demand plays an essential role in post-Keynesian analysis for the assessment of economic activity. For the economy to run at high levels of output and employment, effective demand is necessary but not sufficient. A further important principle to be taken into account in any macroeconomic analysis is the profit rate. Its conception is often not emphasized at all by neoclassical theory. The latter assumes profit maximization in absolute terms but does not define profitability itself as a condition for economic activity.2 The profit rate is, broadly speaking, the ratio of profits to capital employed. Here, capital includes not only physical capital such as equipment but also financial capital comprising all outlays an investor has to make for production to start. Thus, it includes both fixed capital and wage costs. In capitalist economies, profits must be positive for providing an incentive to produce. However, it is not only the absolute magnitude that is relevant. Instead, profits have to be sufficient in relation to capital employed. The profit rate thus should meet at least a certain minimum level for the economy to prosper. Keynes (1936/1997, pp. 135–137) recognizes

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this requirement by setting the market interest rate as the lower-bound threshold. He defines the marginal efficiency of capital by comparing all expected future returns of an asset to the replacement costs of that asset. The marginal efficiency of capital is the discount rate, which sets the returns equal to replacement costs (ibid., p. 135). For any investment to take place, the discount rate has to be higher than the market interest rate. Otherwise, buying bonds or depositing wealth at a bank account is more profitable. Within heterodox economics, the profit rate is accounted for in some strands of post-Keynesian literature such as neo-Keynesian models (see for instance Robinson, 1969/2013) and neglected in others as, for instance, in Harrodian approaches (see Harrod, 1939; Fazzari et al., 2013; Ferri et al., 2011). In fact, the profit rate is most emphasized in classical economics in general and in Marxian economics in particular (Shaikh, 2016, p. 66). Specifically, Marxian analysis considers the profit rate to be the guiding force of any economic activity (Marx, 1894/2004, pp. 44–45). It has to be at a level considered as sufficient by capitalists for the economy to prosper and capital accumulation to take place (see for instance Husson, 2009, p. 186; Shaikh, 2016, p. 619). Any event that reduces the profit rate threatens economic performance. In Shaikh’s (2016, p. 616) words, “classical macroeconomics is neither supply-side nor demand-side: it is ‘profit-side’. Profit operates on both demand and supply, on their levels and on their growth paths.” Competition between different capitals in different sectors entails their constant search for the highest profit rate. A sector with a high profit rate attracts new capital until the abundance of the produced output in that sector leads to a falling rate of profit. In a sector with below average profit rate, the opposite happens. Hence, profit rates across sectors equalize (Marx, 1894/2004, p. 180). Both principles – the sufficiency of the profit rate and effective demand – are necessary conditions for an economy to grow and prosper. If the profit rate is high but effective demand is low, an individual firm may produce and generate a high share of profit in output (a high surplus value in Marxian terms) but cannot sell it. Inventories pile up. In the opposite case, high effective demand clears the whole goods market, or even more than that if firms have to release existing inventories. However, the low profit rate does not reward the efforts of the firms. If the profit rate is low, firms face a “production problem” and if they cannot sell output, they have a “realization problem” (Shaikh, 2016, p. 209). But as much as these two conditions are necessary, they are also opposed to each other and reveal a fundamental contradiction of capitalism. A high profit rate means that a relatively high share of output is profit

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income, while wage income is relatively low. As Keynes (1936/1997, pp. 91–92, 211) remarks, the propensity to consume out of a low income is higher than that to consume out of a high income. In general, firm owners generally save a higher share of income than workers. Therefore, a high profit rate tends to imply a high overall saving rate of households. Yet, a high saving rate implies a high amount of consumption goods remaining unsold, hence reducing effective demand. On the other hand, a low profit rate implies a high share of wage incomes and hence strong effective demand. But insufficient profitability can lead to a breakdown of production. Marx and Marxist authors argue that economic crises are preceded by wage growth (see Carchedi, 2018, p. 71). It can thus be said that, at least in the short run, the relationship between the profit rate and effective demand is a negative one. A high (low) profit rate lowers (raises) effective demand. A change in the profit rate has a stimulating as well as a limiting impact on economic growth. In contrast to the neoclassical assumption of supply-led growth, where output is always determined by existing production capacity, demand-led growth takes this relationship into account (see Nell, 2012, pp. 719–726). The debates on whether economic growth is profit-led or wage-led try to provide an answer to the situation of a certain economy as regards the positive or negative growth effect of a change in the wage share (see for instance Bhaduri, 2008; Bhaduri & Marglin, 1990; Blecker, 1989; Onaran & Galanis, 2012; Stockhammer & Onaran, 2013). However, since growth eventually requires both profitability and effective demand, this trade-off is limited. Profit, investment and capital accumulation are driving forces of economic growth. It entails, however, what Marx (1894/2004, pp. 209–211) called the “tendency of a falling profit rate.” Capital accumulation implies that the denominator of the profit rate ratio falls over time. A similar argument can be found with Ricardo’s (1821/2001) argument of decreasing returns to capital as well as in Keynes (1936/1997, pp. 136–137): the returns of investment decrease when investment increases. Consequently, the marginal efficiency of capital falls. Investment is made until the marginal efficiency of capital has declined to the level of the market interest rate. The same conclusion is provided by quantum macroeconomics based on a strictly monetary analysis (Cencini & Rossi, 2015, pp. 200–202). Neoclassical theory does not recognize this long-term development because the rate of profit is not considered as a relevant variable. Firms’ profit maximization targets absolute profits unrelated to capital employed. There are basically two options to respond to this tendential fall of the profit rate (Marx, 1894/2004, pp. 229–237). The first one is to lower wages. A lower share of wages in output restores the profit rate (see for instance

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Husson, 2013‒14, pp. 5–6). However, such action brings the consequence of dragged demand. The second way out of the falling profit rate is, as also observed by Ricardo (1821/2001, p. 79), an increase in productivity. Rising productivity means that, given capital intensity of production technology and given employment, output grows. Assuming that wages are stable, higher output feeds into higher profits. The numerator of the profit rate ratio grows and so does the ratio as a whole. In reality, testing for a fall in the profit rate is difficult since it may not be observed due to counteracting effects such as wage declines (or a slowdown in wage growth) or productivity growth. Nevertheless, a big volume of literature confirms both falling rates of profit and productivity growth in the long term in industrial countries since World War II (see for instance Duménil & Lévy, 2002; Husson, 2012; Shaikh, 2016, pp. 729–735; Tsoulfidis & Tsaliki, 2019, pp. 422–428). For developing countries, these facts are relevant in mainly two respects: first, capital accumulation is less advanced than in industrial countries; second, higher growth rates can be realized through catching up to rich countries by making use of already existing advanced technologies, thus enjoying high productivity growth rates. Even though firms have an interest in lower production costs through wage cuts, there are limits to such behavior. Let us imagine that firms succeed in strong wage reduction. As a consequence, the profit share in output is quite high, also implying ceteris paribus a high profit rate. Yet, this is a quite stylized situation that cannot remain in reality. An abovenormal profit rate triggers strong price competition. Firms cut prices in order to gain market shares. The average profit rate starts falling. Firms can afford price cuts until the rate of profit has come down to a level below which no competitor would be willing to maintain production any more. Shaikh (2016, p. 259) denotes this process as “real competition” and describes it as the central regulating mechanism of capitalism which “forces individual firms to set prices with an eye on the market, just as it forces them continually [to] try to cut costs so that they can cut prices and expand market share.” The chase after the profit rate is a dynamic and never-ending process. It is the force which drives real competition. It involves the search for profit across sectors leading to the equalization of profit rates as well as the maintenance of the profit rate over time. At the same time, it is real competition that regulates the profit rate. The profit rate may vary over time, but it does so within limits. The same is therefore true for real wages. This is a feature of capitalism often neglected in post-Keynesian analysis. In the long term, however, there may be persistent shifts of the share of wages in output. As capital accumulation advances, the maintenance of

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a sufficient profit rate may require that a larger share of output becomes profit income. It will be seen throughout the model that the connection between the interest rate and the profit rate is important. It follows from the convergence of the marginal efficiency of capital to the interest rate as suggested by Keynes (1936/1997, pp. 135–137) that a decrease of the interest rate makes investment in physical assets relatively more profitable and can induce output growth. In Marxian theory, interest payments feed capital income and hence are part of macroeconomic profits (Marx, 1894/2004, p. 349). However, it is only capital accumulated in non-financial firms which contributes to physical output and thus to the formation of profits. Hence, the net profit rate as the difference between the profit rate and the interest rate is the relevant variable for those firms with regard to the decision on planned production and investment.

2.5 STOCK-FLOW CONSISTENT MODELS: STRENGTHS AND LIMITATIONS This chapter has shown how the macroeconomic principles of endogenous money, the credit circuit, effective demand, uncertainty and the rate of profit are connected to the central issues of development economics such as economic growth, productivity and technology. In most of the literature, these are considered as long-term problems. However, the links established in this chapter show that the supposed long-run topics are so clearly integrated to the short-term issues that, in fact, the two cannot be separated. This will become clear once the model is presented. Stock-flow consistent (SFC) models have the strong feature of providing a truly macroeconomic approach combined with a monetary analysis. This type of model was largely developed by Wynne Godley (see Godley & Lavoie, 2012). It is based on the insight that all income and expenditures are equal or, to be more precise in the light of the macroeconomic principles, identical. As such, they necessarily sum up to zero. Hence, the economy is only perceived correctly if supply‒demand identities, investment‒saving identities, and households’ identity of income with expenditures and savings (the latter actually being a purchase of financial claims), can be shown to hold. SFC models strictly follow the principle of double-entry bookkeeping. Variables must sum up to zero on the balance sheet of each groups of agents such as firms, workers, banks, and so on. And they must sum up to zero on the balance sheet of each item such as investment, consumption, debt and deposits, wages, profits, and so on. The model is macroeconomic in the sense that it does not rely

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on ­micro-foundation in the neoclassical sense where each individual’s behavior is aggregated linearly such that macroeconomic outcomes can be directly traced back to individuals. The model presented here perceives agents as groups according to their economic functions. There is neither aggregate profit maximization nor utility maximization. Each group reacts in a specific way to changes in other variables without any predetermined equilibrium. Neither the supply side nor the demand side is fixed a priori. Hence, final results such as output, employment and debt can basically be of any value. This is in full accordance with the introduced macroeconomic principles. Endogenous money is modeled in a horizontalist framework providing credit to finance production. Any monetary analysis is incompatible with a real exchange economy. The model thus takes full account of the credit circuit and builds a monetary economy of production. Firms’ behavior is driven by uncertainty, effective demand, and the rate of profit. Each of the submodels a), b), c) and d) is based on the SFC modeling concepts in Godley and Lavoie (2012). However, to my knowledge, they are new and not derived from any other existing model. Starting from the basic model, every step of extension makes it a bit more complex by taking up certain elements of the recent development history of SFC models (see Le Heron & Marouane, 2015). Models are able to make sense of a huge number of interlinked variables. Partially, they allow to reduce that complexity. And partially, they give the chance to reproduce complexity to identify effects that remain undetected by a purely theoretical approach without a model. This is especially true for SFC models, which take uncertainty into account and show how a specific individual behavior gives rise to opposite macroeconomic effects. However, it should be stressed that models cannot replace a detailed theoretical analysis. Any model involves simplifications. Despite the endeavor to make it as realistic as possible, underlying assumptions may lead to deviations from real-world economics. Moreover, the model is calibrated with arbitrary values for parameters and starting variables. The magnitude of simulated effects may be unrealistic. However, the interest here is not in providing empirical results, as this would require even stronger assumptions. The complexity of the model can hardly be replicated by real data, which could end up with misleading results. The aim of the model is to identify the existence of many different positive and negative effects. The values are thus set according to economic theory. Despite arbitrary absolute values, relative comparison of different economic policies is still possible. Too-complicated modeling may impede both the understanding and the efficient use of a model without significantly better quality. For this reason, the model at hand tries to minimize the necessary assumptions. Additionally, I try to formulate the math in a

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way that is as simple as possible in order to have the focus on economics and not on complicated and unnecessary formulae. After all, despite limitations the model still fulfills the task of providing new insights and arguments for the formulation of consistent macroeconomic strategies for developing countries.

2.6 MODEL A): CENTRAL FEATURES OF MACROECONOMICS Model a) represents a baseline and introduces the fundamental macroeconomic principles discussed in the previous section, that is, how those basic principles and actors form a whole and give rise to the finally observed phenomena. To briefly summarize it in advance, it explains how profit expectations drive investment behavior. Investment by firms gives rise to employment of workers. Spending of labor and profit income creates demand and thus influences firms’ further investment decisions. Fixed investment enlarges the economy’s capital stock and hence production capacity. As long as profit expectations are positive and effective demand allows for optimism, firms increase the number of workers employed. Economic growth, however, is limited by several factors. First, there are potential short-term or medium-term constraints. Firms are only willing to invest if existing demand allows them to sell their whole output. Yet, if either workers or capitalists decide to save part of their wages or, respectively, profit income instead of spending it, firms start accumulating inventories of unsold goods. Moreover, they are not able to repay all the loans, since sales returns are insufficient. In such a situation, they start reducing staff, thereby lowering production and capacity utilization. Lower capacity utilization signifies that no more investment is needed. Lower investment, or even disinvestment, lowers employment again. A second constraint is increasing wages due to falling unemployment in the course of an economic boom. They limit profitability of capital and reduce firms’ willingness for further investment. Third, a long-term restriction is given by the profit rate. Investment introduces new technology and hence makes labor employed by capital more productive. While productivity gains tend to be higher when existing fixed capital is scarce, every additional investment increases productivity by less and less. This implies that while the capital stock keeps growing, the output potential of the economy does likewise but by a smaller amount. The profit rate as a ratio of profits to capital invested thus tends to decrease in the long run. Model a) consists of 37 endogenous variables and hence 37 equations. It describes the economy as existing of firms, workers, capitalists and

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the banking system.3 Capitalists own firms and banks. Even though they decide on investment of firms, investment is subsumed in the firms category. Capitalists as a category in this model signify their role as private persons who gain their income from firms’ and banks’ profits and spend it on consumption goods or save it. For simplicity, the model does not develop a sophisticated financial sector. So, financial investment, speculation and volatile prices of financial assets are excluded. The banking system is limited to loans and deposits. This is sufficient for the purpose at hand, particularly because financial markets in developing countries are usually not far developed. Production, Investment and Employment Let us first consider the economy’s output (gross domestic product, GDP) produced by firms, YF, which is determined by the level of employment, LF, multiplied by labor productivity, A:

YF 5 A*LF (1)

This equation should not be confused with a production function in a neoclassical sense. In this case it would imply that firms are producing without fixed capital. In fact, equation (1) is a simple and thus robust accounting equation telling us what output can be produced with a certain number of workers employed to the existing capital stock. The relation to the latter is introduced below. Output can be considered from both the production side and the income side. As they represent the same thing from two different points of view, they imply an identity:

YF 5 CF 1 IF 1 ΔINF 5 WF 1 rLN,21*LNF,21 1 PF 

where CF is the production of consumption goods, IF is firms’ investment, ΔINF reflects the change in inventories of produced goods, and WF is the total wage income of workers. The next term denotes firms’ interest costs on the loans, LNF, outstanding in the last period multiplied by the interest rate on loans, rLN, in that period. PF is the profit of firms. This composition of output complies with the analytical conclusion of both classical and Keynesian economics, namely that labor is the sole source of economic value or, respectively, the “sole macroeconomic factor of production” (Cencini & Rossi, 2015, pp. 23–24). Any costs of material inputs eventually decompose to wage costs. So wages are the only component of proper production costs from the macroeconomic perspective of this model, the other components signifying income from production profits

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and financial profits. Reformulation allows the determination of PF and ΔINF as two dependent variables:

ΔINF 5 YF 2 CF 2 IF (2)



PF 5 YF 2 WF 2 rLN,21*LNF,21(3)

So the change in inventories is given by the goods that are neither sold as consumption goods nor sold or used as investment goods. Profit is simply output minus production costs. Since wages only buy consumption goods, it is obvious that investment goods contribute to profits. They are owned and installed by firms in order to increase production. Consumption goods sold by firms are purchased partially by workers and partially by capitalists:

CF 5 CW 1 CCap(4)

Profit-led investment behavior is an essential characteristic of capitalism. As introduced above, the only reason for a conventional private firm to make investment expenditures is the expectation of a sufficient profit rate. Firms’ profit rate, prF, is defined as the ratio between profits and the sum of fixed capital, KF, and the wage bill:

prF 5

PF (5) KF 1 WF

Firms build expectations of the future profit rate by relying on past experience. So we simply say that the expected profit rate is the realized profit rate of the preceding period. For investment to be an option for a firm, the expected profit rate has to be higher than a certain minimum profit rate, prmin. The latter is equal to the return on savings deposits, rD. If the expected profit rate does not meet this minimum rate, it is more profitable to save any funds in the form of bank deposits. Since rD is not constant over time, prmin varies, too:

prmin 5 rD(6)

This broadly corresponds to the condition of a sufficient net profit rate in the Marxian tradition as well as to Keynes’s requirement that the marginal efficiency of capital at least has to be equal to the risk-free interest rate. (see for instance Husson, 2009, p. 186; Keynes 1936/1997, pp. 135–137; Shaikh, 2016, p. 619). The rate of capacity utilization, CUF, is the second factor that

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i­nfluences  investment decisions. It is not assumed to be equal to one because firms want to be able to accommodate short-run changes in demand. If CUF was above a certain reference threshold in the last period, firms invest so that they do not run out of spare capacity. If previous capacity utilization was below the threshold, they even disinvest because they have more spare capacity than needed in case demand should strongly increase in the future. Capacity utilization is simply defined as the ratio of effectively used capacity, KF, eff   , to total capacity, which is the total capital stock: KF, eff CUF 5 (7) KF Capacity utilization can vary over time. So far, the argument is in line with post-Keynesian, or neo-Kaleckian, theory criticizing the assumption of full capacity utilization in neoclassical theory. This is reflected in investment, which reacts to changes in capacity utilization (see Dutt, 1984, p. 28; Taylor, 1985, p. 387). However, the model also contains a strong classical element in this regard (see for example Shaikh, 2016, p. 363): when capacity utilization deviates from the normal rate, it triggers investment or disinvestment activity. Hence, the reaction of investment implies that capacity utilization tends to gravitate around a so-called normal rate, CUn. Taking together the two determinants, profit rate and capacity utilization, yields the investment equation given by:

IF 5 α1* ( prF,21 2 prmin) 1 α2* (CUF,21 2CUn) (8)

where the impact of each factor is given by corresponding weights α1 and α2, respectively. The configuration of the equation implies that it is not necessary for both terms to point to higher investment for the latter to actually increase. For instance, it might basically be that prF is very high but since spare capacity is just too large, investment nevertheless declines or even becomes negative. On the other hand, prF might be lower than prmin but investment is positive because CUF is far above CUn. This is not contradictory, as in the real world adjustments take place gradually. So, given fixed capital, an insufficient profit rate is unacceptable for firms in the long run but still contributes to the recovery of costs in the short run. If continued production worsens the profit rate further, it will be the dominating factor that effectively gives rise to a shutdown in production plants. Hence, both influence factors impact investment behavior, but with changing strengths, sometimes pointing in the same direction and sometimes being opposed.

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Quite simply, investment in every period is added to the capital stock. We simplify by abstracting from capital depreciation: ΔKF 5 IF (9)



The higher the capital stock, the more technology enters the production process, thus raising productivity. Moreover, a higher capital stock implies larger production capacity. This allows for economies of scale and hence raises productivity by reducing production costs. Following Kaldor (1957, p. 604), productivity grows with capital accumulation. Yet, in contrast to Kaldor, higher productivity in this model does not necessarily feed into higher output. The latter requires further conditions such as sufficient effective demand, which is to be introduced below. As argued above, workers’ efforts can be more effective by better technology. But there are limits to the amount of capital a worker can absorb. Hence, in Keynes’s (1936/1997, p. 136) terms, the marginal efficiency of capital declines when investment increases. Decreasing returns of investment are represented by the first term to define productivity A in equation (10). However, assuming that the economy is stagnating such that the capital stock remains constant, productivity can still increase. The amount of capital may not grow, but its quality still changes as old machines are replaced by new ones. This impact is covered by the second term in equation (10), which states that productivity increases each time a positive investment is made. When, in a stylized case, the capital stock achieves a peak in an economic boom and is reduced by disinvestment during the following recession before reaching the same peak again in the next boom, productivity is at a higher level at the second peak due to technological development. The new capital stock has partially replaced the old one. The second term is able to cover this effect. Taking the two terms together with a respective weight δ1 and δ2 attributed to each of them, the rate of productivity growth decreases only slowly and may follow a partially irregular pattern:

A 5 δ1* (KF) 0.5 1 δ2* a 0 IF   for all IF . 0 t21

(10)

With the technological change and productivity growth implied by capital accumulation, capital intensity, ci, of production grows. It defines the units of capital needed per labor unit and is given by the following formula:

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ci 5 ε* (KF) 0.5(11)

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with ε just denoting a parameter to align the respective values of the intensity ratio and of the capital stock, which belong to different units. The fact that capital intensity grows at a lower rate than the capital stock is quite natural. If they grew at the same rate, any additional machine would not allow to increase employment but would be needed to meet the higher capital intensity. The level of employment multiplied with the capital intensity yields the effectively used production capacity, that is, KF,  eff  : KF, eff 5 ci *LF (12)



Equations (11) and (12) imply that capital and labor are not perfectly substitutable as in a standard neoclassical model that would allow for permanent full employment of all resources. By contrast, given the production technology, a certain amount of labor requires a corresponding amount of capital stock, in analogy to a Leontieff function (see Blecker & Setterfield, 2019, pp. 10–15). Moreover, whether technical progress is Harrod-neutral, Hicks-neutral, Marx-biased or Solow-neutral depends on equations (10) and (11) (see ibid., pp. 80–82). Whereas productivity growth is always labor-saving since it allows the production of a unit of output with less labor input, it is capital-saving or capital-using depending on the changing capital intensity. At the early stages of high productivity growth, productivity increases more than proportionally to the capital stock, while at a later stage this relation deteriorates. One of the very essential issues not yet introduced is the determination of employment. Employment depends on the output that firms are planning to produce. Firms build expectations about what their future sales will be. This is where the fundamental principle of effective demand comes into play. High expected demand incentivizes firms to plan a higher output and, as a consequence, employ more workers. As in the case of investment, firms build their expectations based on past experience. Therefore, the higher the sales of the past period, the higher are expected sales. Realized demand of the past period is given by consumption and investment expenditures which are equal to total output minus the change in inventories. If additional inventories are accumulated, sales are smaller than output: CF,21 1 IF,21 5 YF,21 2 ΔINF,21



So effective demand is given by past sales plus the change in investment. Investment is determined by equation (8). If it is higher than investment last year, expected output is higher as well. Hence:

Effective demand 5 YF,21 2 ΔINF,21 1 ΔIF

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Employment now has to be determined at a level allowing firms to produce the output they expect to be purchased in the coming period. For this reason, required employment is lower, the higher labor productivity is. If the story was finished here, firms would raise employment constantly as long as effective demand is increasing (corrected by changes in productivity) and the model would reflect a case of so-called Harrodian instability (see Harrod, 1939; Fazzari et al., 2013; Ferri et al., 2011). This self-enforcing effect would take place even if production was not profitable. This is why we set a reasonable limit by complementing the effective demand factor by a profitability factor. If the profit rate is above its minimum threshold, firms increase employment by more than effective demand itself meaning that firms’ decisions become even more optimistic. On the other hand, if the profit rate is insufficient, it has a negative impact on the employment level. The equation thus is formed as follows:

LF 5

(YF,21 2 ΔINF,21 1 ΔIF) A

* (1 1 prF,21 2 prmin ) (13)

As with investment, the two factors of effective demand and high profit rate are necessary conditions, which both have to be fulfilled at least in the medium term. But again, employment may be growing for some time despite an insufficient profit rate because the lower profit rate still generates a certain cash flow in the short and medium term. However, if the profit rate keeps deteriorating, it will at some time become the dominating factor and give rise to lower employment. Labor Market, Consumption and Saving Firms’ demand for labor affects the labor market. The firms’ wage bill, WF, which is total labor income, results from the level of employment multiplied by the wage per unit of labor:4

WF 5 w*LF (14)

Wages are variable and consist of three components. The first one is an autonomous component, γ0, signifying a minimum wage below which nobody is willing to work. In the context of developing countries, this may for instance mean that with a wage below the minimum level a person is better off with subsistence farming or working in the informal sector. The second component reflects current labor market conditions in the sense that the level of employment has an impact on wages. As long as the economy is sufficiently far away from full employment, L, wages increase

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Key principles of macroeconomics ­73 1.6 1.4

wage

1.2 1 0.8 0.6 0.4 0.2 0

0%

20%

40%

60%

80%

100%

employment

Figure 2.2  Impact of the employment rate on the wage level (x 5 10) only slowly in employment. However, as soon as supply becomes scarce, wage growth takes off. As a consequence, inflation stemming from wage growth only becomes relevant once the economy is approaching full employment. The exponential impact of employment on wages, guaranteed by the exponent x . 1, is simulated with fictitious values in Figure 2.2. The third component accounts for the relative strength between firms and workers in wage bargaining. Â0 denotes total productivity growth since a certain reference point in time. Multiplying it with a baseline wage ‒ that is, the wage of the same reference period ‒ shows what the wage increase since the reference period should be if wages are to grow proportionately with productivity. After weighing the second and third component with the respective factors γ1 and γ2 we arrive at the wage equation (15). The higher γ2, the more bargaining power workers have, and hence the higher the share of productivity growth going to labor at a given level of employment:

w 5 γ0 1 γ1*a

LF L

x

b 1 γ2*w0*A^0(15)

The level of productivity reflects the potential capacity of an economy to produce wealth. If labor income is to obtain a constant share of total income, wages need to increase in line with productivity. We define a reference wage level based on this criterion. As such, it grows in line with productivity starting from the reference year introduced in equation (15):

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wref 5 w0* (11A^0) (16)

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The wage level determines the amount of consumption workers can afford. CW can be formulated as an accounting equation. Total income of workers is composed of actual labor income, WF, and the returns from savings deposits in case workers have been able to accumulate any. If not all of the income is spent for consumption, a part of it is saved:

CW 5 (1 2 sW) * (WF 1 rD,21*DW,21) (17)

where sW is the workers’ saving rate, rD is the interest rate on savings deposits that has already been introduced above with reference to the minimum profit rate. DW represents savings deposits of workers. Consequently, DW is accumulated by unspent income:

ΔDW 5 sW* (WF 1 rD,21*DW,21) (18)

The saving rate is related to the reference wage. The latter reflects the level of income and living standard that is generally considered as appropriate. When actual wages are higher than the reference wage, workers can cover their consumption needs and are still able to save a part of income. In the opposite case, workers consume more than they earn and hence get indebted:

sW 5 z* (w 2 wref) (19)

where z is the parameter defining the impact of the reference wage. However, as is the natural case in developing countries, poor households can hardly afford any savings. This is confirmed by empirical studies on household savings stating that average saving rates are quite low (see for instance Mirach & Hailu, 2014). Workers and the unemployed represent the poorest parts of the population, so their saving rate is reasonably quite close to zero. On the other hand, it is difficult for workers in developing countries to get access to loans, especially if they are spent for nondurables. For this reason, it is justified to simplify the model and set z to zero, however knowing that the model is basically able to capture the effects of positive or negative savings of workers. Important to note: the fact that workers consume all their income does not tell us anything about the saving rate of the whole economy. The latter is explained below. Consumption of capitalists can be calculated in analogy to workers’ consumption despite their income stemming from different sources. CCap is therefore given by:

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CCap 5 (1 2 sCap) * (PCap 1 rD,21*DCap,21) (20)

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Key principles of macroeconomics ­75

where sCap is the capitalists’ saving rate, PCap is “profits of capitalists,” meaning capitalists’ income coming from different sources of profits, and DCap is capitalists’ savings deposits. The change in DCap is simply:

ΔDCap 5 sCap* (PCap 1 rD,21*DCap,21) (21)

The saving rate of capitalists is an important feature of the model. Higher profit income may be due to the fact that profit of each capitalist is higher, or that there are more capitalists gaining their income from profits (or both). Saving thus does not start when absolute profits exceed a certain level. We rather assume that capitalists start saving once the rate of profit exceeds a certain threshold. So we say that as long as the profit rate corresponds to prmin or, respectively, to rD, capitalists gain an income that corresponds to their living standard such that savings are exactly zero. A change in this reference rate implies that the share of total output belonging to firms’ profits and interest income is going to change in the long run, too. Capitalists take this perception as their baseline of the long-term normal state. Hence, to the extent that the actual profit rate differs from the minimum rate, they consider their revenues as either above or below the normal. According to these deviations, capitalists decide on their saving rate. When the profit rate exceeds (falls short of) prmin, savings become positive (negative). Again, the profit rate of the previous period is taken as reference:

sCap 5 κpr21 2prmin 2 1(22)

where κ is a positive parameter defining the strength of the saving rate’s reaction to an increase in the profit rate. We have now assessed the saving rate of workers (assumed to be zero) and of capitalists. However, it would be wrong to derive the saving rate of the whole economy by aggregating household savings as just defined here. Moreover, a correct perception of the investment‒savings identity is key to properly understand macroeconomics. It has been explained that savings are not a precondition for investment. Rather, investment gives rise to savings of the same amount. So, the identity presents itself as follows:

SF 5 IF (23)

It has been shown above that investment is part of profits because it cannot be consumed by workers. And since it is not consumed, it is the macroeconomic savings of a given period. This fact is independent of workers’ or capitalists’ saving behavior in their role as households. This

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model thus confirms Kalecki’s (1954/1987, p. 139) analytical result that investment creates the corresponding savings, and thus finances itself. Since investment goods are not consumption goods, they are employed in firms and cannot be purchased by consumers. Even though they belong to profits, they cannot be distributed. Hence, as long as there is positive investment, there is always a part of profits that has to remain within the firm. Undistributed profits, PUF, are given by the formula:

PUF 5 SF 1 xF *LNF,21(24)

where the parameter xF implies that firms may also retain more than just SF in case they want to get hold of funds to pay back part of their debt, LNF. The higher the debt, the more profit firms should retain to pay it back. This leads us to the question of the determining factors of firms’ debt. Strictly following the logic of the monetary circuit, firms obtain a granted loan, which they use to pay the workers’ wages. To facilitate the explanation, let us distinguish between the part of total income belonging to workers and the rest of income consisting of profits. Once workers spend their income for consumption goods, firms earn the revenues to pay back debt. However, if workers do not spend all of their wage but decide to save part of it, firms accumulate inventories because they cannot sell all their produced goods. At the same time, they do not earn sufficient revenues to cover the whole loan. So, they end up with an increase in LNF. However, since firms usually grant only a part of produced output to workers, they appropriate part of this output in the form of profit. Let us now consider profit income separately. The formation of firm profits is presented in equation (3). Let us assume for a moment that interest rates are zero so that total wage income of workers is the only cost factor in production. Moreover, we set xF in equation (24) to zero for now. From this it becomes clear that profits are the sum of two components, that is: (1) the savings arising from investment that cannot be distributed as explained; and (2) the part of profits distributed to the firm owners, namely the capitalists. In this regard, the model structure is again analogous to Kalecki (1954/1987, p. 138). Capitalists spend profit income for consumption. Hence, firms get their bill settled. They distribute profits and receive the same amount of money through capitalists’ consumption. Yet, just as workers, capitalists may decide to save part of income as bank deposits. In this case, the firms distribute more profits than they can refund through consumption expenditures of capitalists. Again, they end up with a positive debt. And likewise, they cannot sell all their produced output. In reality, of course, interest rates are usually not zero. But it will be shown just below that this does not change the logic of the argument.

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Moreover, setting xF again to a value greater than zero does not change the macroeconomic logic, either. In this case, firms distribute less profit, but capitalists consume correspondingly less. In both cases where either workers or capitalists save, firms accumulate stocks. Stocks imply insufficient revenues, so that firms get indebted by the same amount. Therefore, total debt of firms is determined by the following factors:

ΔLNF 5 IF 2 PUF 1 ΔINF (25)

Basically, debt increases by the amount of investment because it is an expenditure for firms that cannot be sold for consumption. However, as long as the corresponding savings resulting from investment are retained by the firms as reflected by the second term PUF, there is no net increase in debt. But again, any increase in inventories implies a shortage of revenue of the same amount, independent of whether the income is saved by workers or capitalists. This shows that whenever an agent accumulates monetary savings in the form of deposits, someone else in the economy inevitably accumulates debt of the same amount. The identity of loans and deposits remains a fact. It is the consequence of double-entry bookkeeping. The model shows as well how the paradox of thrift (see Lavoie, 2014, pp. 18, 295–296) is effective when consumers start saving. Consumption decreases while inventories grow (see equation 2). Growing inventories deteriorate firms’ expectations of future sales and hence depress effective demand and employment (see equation 13). As a result, output decreases. Notably, the same mechanism exists with respect to firms’ savings. Firms are not always reluctant to accumulate debt. It is the very normal case that companies accept long-term debt to finance investment. However, once credit grows too large, firms start taking measures in order to deleverage their finance structure. Hence, they may want to pay back past loans, implying that xF in equation (24) is greater than zero. Alternatively, they might plan to retain savings for future uncertainties. In both cases, distributed profits are lower. It follows straightforwardly that capitalists receive less income to be spent. Firms will again not be able to sell all their output and are forced to build up stocks. In such a situation, firms achieve quite the opposite of the original intention, as their debt is supposed to decline but in fact increases. In all these cases, we clearly see that macroeconomic outcomes can be quite different from what individual agents ‒ be they workers, capitalists or firms as such ‒ try to achieve. Of course, there are circumstances where the economy can continue growing for a considerable time even though debt is piling up, such as in the run-up to the financial crisis in 2008 where

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middle-class debt was feeding profits while keeping up consumption (Stockhammer, 2012, pp. 14–15). It is now obvious what the difference is between SF on the one hand, and either workers’ or capitalists’ savings on the other hand. SF is the direct result of investment and hence identical with it. It denotes what the economy as a whole is actually able to save, which is everything that is not supposed to serve as a consumption good. In this sense, SF signifies macroeconomic savings. In contrast, positive savings resulting from positive saving rates by either workers or capitalists (or both) are a zero-sum game. They give rise to positive savings deposits but imply unpaid loans on the side of firms, too. Meanwhile, firms build inventories. Savers keep income in monetary form while firms have output in its real form at their disposal. There is no difference at the macroeconomic level because total output is not affected. Hence, capitalists’ and workers’ saving behavior can be considered as microeconomic saving. Over time, however, microeconomic saving is still able to exert an influence on the macroeconomy, namely through effective demand. The Banking System After the introduction of the main economic mechanisms of this model, the banking system remains to be defined. For the purpose at hand, it does not have to be very sophisticated. So the banking system is considered as a unique entity containing both the central bank and private commercial banks. It has become quite clear from the description so far that money is considered as endogenous. Banks satisfy demand for credit in an accommodative way as long as the borrower is considered creditworthy. The check for creditworthiness is not separately modeled in this horizontalist framework. It is assessed individually for each borrower. So at the macroeconomic level of this model, we can reasonably act on the assumption that the production of output is that of firms whose demand for a loan has been accommodated by banks after testing their creditworthiness. In a horizontalist system of endogenous money, short-run interest rates are exogenously set by the central bank. In our model, monetary policy is implemented in a so-called floor system (see for example Lavoie, 2014, pp. 223–225; Goodfriend, 2002). This means that the targeted interest rate is set equal to the deposit rate of banks at the central bank’s account. Further, we abstract from the term structure of interest rates so that there is no difference between short-term and long-term rates. It is therefore appropriate to take the target rate, rCB, as approximately equal to the deposit rate of savers. Banks earn their profits from the difference between deposit rate and lending rate. Parameter d is a fixed differential. These simplifications may not do justice to the real-world complexity of mon-

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etary policy implementation and banking business. But such modelling is sufficient to depict the basic logic of the banking system:

rD 5 rCB(26)



rLN 5 rD 1 d(27)

Banks’ profits, PB, are the difference between interest returns on loans and interest cost on deposits:

PB 5 rLN,21*LNF,21 2 rD,21* (DW,21 1 DCap,21) (28)

Banks do not have to make any fixed investment. Furthermore, we abstract from employment in the banking sector so that no wages have to be paid. Banks distribute all their profits or they may retain part of it:

PUB 5 xB*PB(29)

where PUB is banks’ undistributed profits and xB is a parameter deciding what proportion of profits is retained. If undistributed profits are greater than zero, they add to the banks’ equity:

ΔEQB 5 PUB(30)

As a result of the whole economic process, the banks’ balance sheet varies to the degree that loans are granted, paid back or remain unpaid, while deposits and equity grow and shrink accordingly. This equation is not required by the model since the number of equations is already sufficient to explain the 37 independent variables and thus to close the model. Nevertheless, it is useful to reveal the dynamics in the banking system: loans are equal to deposits because they represent an identity:

ΔLNF 5 ΔDW 1 ΔDCap 1 ΔEQB

The model is constructed such that the variable names imply that firms can only be indebted or balanced out towards the banks, while private households are either balanced out or deposit owners. However, all these variables can in principle also be negative. A negative value of LNF implies that firms have a positive claim towards the banking system, which means they own deposits. Likewise, negative values of DW and DCap mean that private households are indebted to the banks. And a negative value of EQB means negative equity and thus bankruptcy. Yet, the model at this

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stage rules out negative equity since banks’ profits are always positive due to the differential between loan rate and deposit rate. The model is constructed in a way that as soon as LNF turns negative, it is rewarded with the deposit rate instead of being charged with the loan rate. On the other hand, negative values of DW and DCap imply immediate charging with the lending rate. Capitalists’ profit income is the sum of the respective distributed parts of firm profits and bank profits:

PCap 5 PF 2 PUF 1 PB 2 PUB(31)

Banks only earn a positive profit if there are loans outstanding. The profit based on the interest rate differential implies the appropriation of a part of economic output by banks. Firms’ profits are diminished by interest costs. Through distribution of this profit, capitalists’ income increases. They can spend it on consumption. Interest payments thus mean a redistribution of profits.5 Just as in the case of firms, if banks decide not to distribute all profits, capitalists receive a lower profit income as shown in equation (31). They can spend less, such that firms have to accumulate inventories and end up with higher debt. Up to this point, the model does not say anything about the price level. The analysis based on our macroeconomic principles considers income and output as the same object and hence, in contrast to economic mainstream, does not treat nominal and real magnitudes as largely unrelated variables. Inflation is defined as determined by different factors, which have been identified in section 2.1 on endogenous money. Clearly, a change in the quantity of money in the monetarist sense is useless to explain inflation. Instead, the price level increases as a result of either demand pulls or cost pushes. There are two indicators of the state of demand pressure and hence market tightness. One is the rate of capacity utilization: the more it exceeds the normal rate, CUn, the more firms tend to raise prices. The second demand-pull indicator is inventories. Increasing inventories have a lowering effect on the price level because firms intensify competition to sell them. The wage rate and the interest rate each represent a cost-push i­ ndicator.6 The higher wages are, the higher are firms’ production costs. w denotes real instead of nominal wages. But when real wages rise, they usually go along with partially increasing nominal wages, and with an increasing general price level because firms try to resist wage demands by raising prices in an endeavor to restore the profit rate. Interest is part of production costs. Thus, the higher the interest rate, the higher firms set prices to compensate for higher costs. The higher outstanding loans are, the larger is the influence of an interest rate change on production costs. Changes in labor productiv-

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ity represent a further very important cost-push factor. Straightforward higher productivity implies lower production costs per unit of output, thereby reducing prices. An increase in productivity is tantamount to a negative cost-push. Since productivity growth is a long-term development, it may be considered as the most persisting impact factor. Taking account of these determinants of inflation, we define the general price level, PL, as:   PL 5

β1* (CU21 2CUref) 2 β2*ΔIN21 1 β3*w21 1 β4*LNF,21*rLN A

 (32)

with βi being parameters determining the influence of each factor. Obviously, inflation is an ambiguous issue. A policy measure may give rise to a change in the impact factors, which may influence the price level in opposite directions. It has to be admitted that this equation is artificial; it could be argued that the same variables do not determine the price level but the inflation rate itself. For the purpose at hand, the equation is nonetheless sufficient to illustrate possible inflationary effects. Combining equations (15) of the labor market and equation (32) gives a kind of Phillips curve revealing the trade-off between higher employment followed by higher wages and low inflation. Or, in more heterodox terms, it is a model of conflictive claims where higher wage claims meet the firms’ reaction of price increases to maintain the profit rate (see Blecker & Setterfield, 2019, pp. 257–260). Model a) is now a closed system able to reproduce the main macroeconomic effects. For completeness, we add the wealth equations for each category of agents to show how wealth is distributed in the economy. Wealth of firms, VF, wealth of workers, VW, wealth of capitalists, VCap, and wealth of banks, VB, are given by:

VF 5 KF 1 INF 2 LNF (33)



VW 5 DW (34)



VCap 5 DCap(35)



VB 5 LNF 2 DW 2 DCap(36)

Summing up wealth of all categories in the economy yields total wealth, Vtot. After netting out debt and deposits, only real wealth is left, naturally consisting of real accumulation of capital and inventories:

Vtot 5 VF 1 VW 1 VCap 1 VB 5 KF 1 INF (37)

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2.7 THE EFFECTS OF EXPANSIVE MONETARY POLICY Let us now turn to the results generated by this model. It is run for 100 periods, where one period is defined as a quarter of a year. The total time frame thus amounts to 25 years, ranging from 2001 until 2025. Definitions could also be different, but such a perspective gives an idea of the time horizon that I think is relevant to be envisaged by economic policies. At the beginning, the whole economy is in a kind of equilibrium. Starting values are calibrated and parameters are set according to reasonable economic theory.7 Once again, it should be said that these values are arbitrary and do not deliver precise numerical results. The model rather aims to identify economic effects and to allow for a comparison of different measures and hence different impacts. The initial equilibrium is one where the profit rate is equal to the minimum profit rate such that investment is zero. Capacity utilization is at its normal rate, saving rates are zero, and there is no change in inventories. As a consequence, there is no output growth while wages and employment are constant. However, as is the normal situation in developing countries, the economy is far from full employment. Now and also in the extended models in the following chapters, population growth is ignored as it would complicate things but not bring us closer to the core issues. Since no household saves, firms do not accumulate any debt, so that the banks’ balance sheet is zero at the end of each period. It does not matter whether one considers the economy as stagnating or following a certain hypothetical “equilibrium growth path.” The interest here is in how changes in certain variables lead to a deviation from this baseline. It is questionable where a growth stimulus can come from in such an environment. In neoclassical theory, the starting equilibrium of this model would be considered as a type of general equilibrium. Economic growth takes place to the extent that exogenous technology shocks increase supply in the long run. There is no major space for public intervention as the optimal general equilibrium is market-based (see for example Lucas, 2007, p. 8). Following this line of argument, there are few instruments which could contribute to output growth in an economy where the public sector is not allowed to intervene. There is also no means for developing countries to impact technology development. The role of monetary policy in neoclassical theory is recommended not to counteract economic fluctuations, but only to re-establish equilibrium (see Goodfriend, 2007, pp. 26, 29). Yet, the model shows that monetary policy as the only policy instrument in this economy is able to exert a long-run impact on the economy, although a limited one. Figure 2.3 exhibits the effect of a decrease in the

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0.40 0.35 0.30 0.25 0.20 0.15 0.10 0.05 0.00 –0.05

9 8 7 6 5

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Figure 2.3  E  ffect of a 1 percentage point decrease in the interest rate on investment, employment, productivity, output, profit rate and wage interest rate target, rCB, by one percentage point. First of all, a lower interest rate means that the minimum profit rate falls, too, such that the actual profit rate is now higher than prmin. As panel a) shows, investment thus increases. Higher investment generates effective demand and hence

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higher employment, which is plotted in panel b). In the face of increased employment and hence higher consumption, firms adjust their expectations upwards such that there is again positive investment in the following periods. Capital accumulation stimulates productivity growth as can be seen in panel c). Both higher productivity and higher employment contribute to output growth, depicted in panel d). The profit rate in panel e) first reacts by an increase, which is due to productivity growth in the course of capital accumulation. Productivity growth allows for higher profits per unit of capital employment as long as labor costs do not increase by too much (see equation 5). However, due to decreasing returns on investment, productivity grows slower than the capital stock. Moreover, panel f) shows that wages increase, caused by lower unemployment and wage bargaining corresponding to the second and third terms in equation (15), respectively. Slowing productivity growth and rising wages reduce the profit rate. Even though it soon falls below its initial level, investment is still profitable for firms because the minimum profit rate is constantly lower now. However, once the actual profit rate approaches prmin, investment converges back to zero. Growth in employment, output and wages comes to an end. Finally, people’s living standard has increased. In panel a) of Figure 2.4, we see that expansive monetary policy also has an impact on capacity utilization. It increases, and thus becomes an additional driving force of investment. Once investment and output growth fade out, CUF approximates its initial referential level again. On the other hand, firms accumulate inventories (see panel b) and hence – due to the logic of double-entry bookkeeping – an outstanding loan of the same amount. The reason for this can be found in positive savings of

Panel b) inventories

Figure 2.4  E  ffect of a 1 percentage point decrease in the interest rate on capacity utilization and inventories

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capitalists. Due to the emerging difference between the actual profit rate and the minimum profit rate or, respectively, the interest rate on deposits, capitalists enjoy profits which are considered to be above the long-term minimum rate. For firms, the increase in debt is not worrying as the increase in output is more than six times as much. This can be seen from comparison of the final level of inventories to the growth of output in panel d) of Figure 2.3. Moreover, firms’ capital stock backs debt as a real asset. It just pertains to the real world that a share of production plants is financed by debt. Even though the accumulation of inventories drags effective demand because it induces firms to adjust their production plans downwards, the effects of profitability and of higher capacity utilization dominate, such that output growth is positive. Let us have a look at the impact that expansive monetary policy has on inflation. The pattern of the general price level is exhibited in Figure 2.5. It clearly reveals the ambiguity of monetary policy effects on inflation. Right after the cut in the interest rate, the price-lowering impact factors dominate. Namely, the accumulation of inventories and initial strong productivity growth tend to lower the price level. Later, the price-raising effects of higher capacity utilization and especially wage growth become stronger. Inflation is supported by the slowdown in productivity growth implying a weakening price-lowering effect. The impact of the interest rate is counterintuitive at first sight. The interest rate itself is lower than at the beginning. However, since the model starts with zero debt and features growing loans, the impact of credit on the price level is still a positive one. We end up with a price level which is a bit higher than initially. 0.85 0.83 0.81 0.79 0.77 0.75 2001 2004 2007 2010 2013 2016 2019 2022 2025

Figure 2.5  E  ffect of a 1 percentage point decrease in the interest rate on the price level

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Needless to say, the numerical result depends on parameter calibration and the weighting of each impact factor. The outcome of the model is in line with the general observation that economic growth coincides with positive inflation. What is most important to note here, however, is that inflation is a temporary phenomenon before the price level stabilizes again. A higher output does not cause an accelerating rate of inflation. This implies that inflation is mainly present in transition phases such as growth processes, but is not a necessarily persistent result of economic policy. It has been shown in Figure 2.3 that wage increases reduce the profit rate and thus lower investment and overall GDP growth. Would it be useful to moderate wage growth in order to strengthen output growth? The answer is yes and no at the same time, and reveals one of the essential contradictions of capitalist economies already introduced above. It is true that lower wages raise the share of output belonging to capital, that is, profits. Higher profits entail optimistic expectations of firms and boosts their incentive to invest. On the other hand, however, the well-known impact of the propensity to consume on employment as argued by Keynes (1936/1997, pp. 91–92, 211) clearly applies here, too. Workers’ saving rate is zero while capitalists’ saving rate is positive when the profit rate is above the minimum rate. This means that the workers’ propensity to consume is higher than that of capitalists, such that redistribution of income from the former to the latter implies less consumption and hence less effective demand. The inventories curve in panel b) of Figure 2.4 would thus rise higher. Firms would reduce employment correspondingly, which again impacts negatively on sales. Once capacity utilization is sufficiently low, firms would start to disinvest. Finally, it needs to be said that the effects of a 1 percent decrease in the interest rate level are results obtained from a model starting from an initial equilibrium. We assume that the profit rate is initially at its minimum level so that there is no net investment. Workers’ consumption is also in a kind of equilibrium so that effective demand is neither depressed nor overwhelming. Any improvement in the profit rate thus leads to additional economic activity. However, the results do not suggest that expansive monetary policy may always be sufficient to raise output. In a situation where effective demand is too depressed, stimulation by the central bank might make little or no difference.

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NOTES 1. There is also the counterargument that expansive monetary policy may actually reduce the general price level. Interest on debt is part of firms’ production costs. Lower interest rates thus imply lower production costs (Sawyer, 2002a, p. 42). Moreover, if increasing demand raises capacity utilization, the cost of fixed capital meets a higher output such that each unit of output gets cheaper (Arestis & Sawyer, 2009, p. 42). 2. In fact, in the perfect market equilibrium with constant returns to scale, profits are zero (Bénicourt & Guerrien, 2008, pp. 185–186). 3. For an overview of all model variables, values of exogenous variables and parameters, see Appendix I. For the full set of model a) equations and the stock and flow matrices, see Appendix II. 4. For technical reasons, w-1 is taken in the model simulation, that is, the wage rate agreed between firms and workers one period ago setting the baseline for the current period. The interpretation of the equation is not affected at all by this formal adjustment. 5. Likewise, the deposit holders appropriate a part of profits through interest payment. In case workers exhibit a positive saving rate, they become partial rentiers. 6. The definition of demand-pull and cost-push also depends on the perspective of the analysis. While higher wages appear as a cost-push in production, they may be the result of a demand-pull when considering the labor market. It might be due to strong demand for labor that wages rise. 7. The values can be found in Appendix I.

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3.  Giving space to the public sector The introduction of the stock-flow consistent (SFC) model reveals the limits inherent to the economy if it is left to market forces. There is no autonomous force nor any other endogenous mechanism that keeps investment and effective demand at a constantly high level. The role of the government necessarily comes to the fore of the debate. It is discussed in this chapter.

3.1  THE STATE AS A MACROECONOMIC AGENT The state has the potential to be a macroeconomic agent in the sense that it can take a macroeconomic perspective and counteract effects caused by behavior of individuals in the private sector. Its most important characteristic distinguishing it from any private firm is its ‒ at least partial ‒ independence from the profit imperative. A private agent by and large acts on self-interest and therefore is only willing to produce output if resulting profits at least meet a certain minimum threshold in relation to capital employed. Profit rate and profit realization, hence effective demand, are the conditions for individuals to start economic activity. Due to uncertainty and the fallacy of composition, what is optimal for an individual is not necessarily optimal for the whole economy. By contrast, the government can focus on the macroeconomic optimum while putting its own profitability as a second priority. Even though the state acts within limits as well, it has the size and power to target macroeconomic variables. To achieve development objectives such as economic growth, employment or poverty reduction, it can sustain below-average profitability or even negative profits for a considerable time. In this sense, a sufficient rate of profit and effective demand are not preconditions for the government to act. Instead, insufficient profits and missing effective demand may provide exactly the motivation for public intervention aiming to remove these constraints. To increase investment, employment and production, the private sector requires sufficiently profitable conditions that influence agents’ expectations. It is via market intervention that the government is able to influence expectations of economic agents. When ­88

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private investment is in a slump, the public sector may raise its investment expenditures. In a case where effective demand is low, public consumption spending could restore it. And when the rate of unemployment is high, the government may raise employment through productive expenditures and goods production. These are measures to restore profitability and effective demand. In a meaning influenced by Keynes, the state can reduce uncertainty in the economy through the stabilization of economic conditions and agents’ expectations. As Cardim de Carvalho (1997, p. 41) puts it, “government is not just another guess-maker as to future trends but is, to a large extent, a builder of the future, through its power to mobilize resources and to influence aggregate demand.” For this purpose, “the government has at its disposal an arsenal of measures to act upon the overall level of activity” (ibid.). Once the potential of public intervention is identified, we are led to the issue of fiscal policy and its potential and mode of implementation. According to Musgrave (1959), fiscal policy serves the purposes of allocation, stabilization and redistribution. Regarding the first issue, there may be important goods and services, much needed by society, which are not provided by the market (ibid. p. 6). One may think of social services, transport systems, security or other public goods. Following the second objective of stabilization, fiscal policy aims to maintain “a high level of resource utilization” (ibid., p. 22). Stabilization of economic activity is a form of demand management (see for instance Arestis & Sawyer, 1998). The government counteracts a drop in output by government expenditures in order to guarantee private sector profits and effective demand. Thus, stabilization implies countercyclical behavior of policy action (see for example Drumond & Silva De Jesus, 2016, p. 182). Redistribution as the third issue emphasizes tax collection and government spending through which income is redistributed according to defined ideas of social security, equality and ethics. Beyond this, any state of income distribution implies a certain pattern of effective demand (Musgrave, 1959, pp. 17–18). Indeed, this may be considered as a fourth purpose of fiscal policy, and as such is of central interest: what does fiscal policy contribute to total economic output, employment and, in the context of developing countries, to the reduction of poverty? Fiscal policy may not just stabilize and redistribute a certain level of output and income; it can also contribute to economic development (see for instance Brahmbhatt & Canuto, 2012; Llorca, 2016, p. 122). The distinction between different characteristics and objectives of fiscal policy reveals possible categories according to which policy action can be classified. First, it applies to different time horizons. Stabilization of

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economic activity is a short-run task of economic policy, whereas the focus on economic development follows a long-term objective. Social transfers, provision of public goods and a fair income distribution (whatever a society or government considers it to be) are basically constant endeavors. The issues of resource allocation and income distribution hence are not attached to a particular time horizon. Following this classification, our interest here is mainly in the long-term impacts of fiscal policy. Economic development and hence poverty reduction and increase in living standards are at the core of the analysis. However, as argued with the macroeconomic principles, the short term and the long term cannot be separated. This is why we will start from the short term, that is, from concrete policy action in a monetary economy, and explore its impact in the long run. This automatically implies that stabilization and distribution also play their respective roles because effective demand is an issue of constant concern for any government. A second dimension of classification concerns the specific instruments of fiscal policy. There are the two sides of the government’s accounting of income flows, namely expenditures and revenues. Regarding the former, spending consists of expenditures such as government purchases (for example, military equipment) or social transfers such as pensions, healthcare, unemployment insurance and social programs (see Vasconcelos, 2014, p. 26). Further expenditures are necessary for the provision of public goods such as, for example, security and the law. These spending purposes can be summarized as consumption expenditures since their final objective is a kind of consumption good or service. As further expenditures, there are interest payments flowing from the government to the banking system in cases where the former is indebted. And finally, a government can also make investment expenditures. In contrast to consumption expenditures, investment spending allows the state to acquire or create assets, which enter the public balance sheet as positive values. To the extent that investment gives rise to fixed capital and hence production plants, production processes involve further expenditures such as the payment of material and labor inputs.1 Investment and expenditures for the production process can be considered as productive expenditures. On the income side, there are tax revenues that the government imposes on different agents in the economy. Moreover, productive expenditures can yield returns via cash flows from real assets. With regard to the type of fiscal policy, we will investigate the impacts of both government consumption expenditures and public investment and discuss how these instruments can be employed as part of a coherent macroeconomic development strategy.

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It will be seen throughout the analysis of the potential of economic policies that this approach to fiscal policy is a rather broad one. For example, if public investment is to play a substantial and systematic role in economic development, its meaning exceeds many of the issues conventionally associated with fiscal policy such as, for instance, short-term stabilization. Thus, public intervention, economic policy or, specifically, industrial policy are more often referred to, instead of the narrower term of fiscal policy. This is supported by the approach where fiscal policy is usually not considered as an isolated instrument but as part of a broader economic strategy.

3.2 MAINSTREAM ARGUMENTS AGAINST FISCAL POLICY Fiscal policy is not uncontroversial. Different economic schools of thought attribute different roles to the public sector. The Washington Consensus suggests that the state should limit itself to providing public goods and education, good institutions and legal environment, and internalizing externalities (see Marangos, 2012, p. 591). Apart from those mainly supply-side measures, the provision of social transfers is the one function of fiscal policy where most economists agree. Even though they strongly disagree about the amount and variety of the social services, it is uncontroversial that a social safety net should provide individuals at least with existential support. Any public intervention going beyond existence guarantees is subject to extensive debate. In particular, neoclassical theory attributes only a minor role to fiscal policy. The lines of argument are either that fiscal policy is either not desirable or not feasible, and cannot contribute to an improvement of economic performance and people’s well-being. There are three main critical points raised by mainstream economics. First, that too active a fiscal policy distorts the optimal general equilibrium realized by market forces. Second, it is said that the government can afford neither high-level government expenditures for consumption nor large public investment due to funding and financing constraints. Third, if the public sector becomes too active in the economy by providing goods and services as well as participating in production, it crowds out the private sector. Let us have a closer look at each of these arguments and briefly analyze their quality before developing an alternative view of public intervention through economic policy.

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Market Distortions Caused by Government Intervention Given the neoclassical view that economic activity is defined by a supplyside equilibrium determined by technology, full capacity utilization and full employment, the economy is basically always at its optimum point. Flexible prices and maximization of utility and profit absorb exogenous shocks immediately, such that the perfect-competition general equilibrium is always maintained. If one allows for nominal rigidities, transition to the equilibrium takes some time but is at least restored in the medium run. This is the background against which neoclassical theory explains the role for fiscal policy. As Mankiw and Weinzierl (2011, p. 221) argue, optimal fiscal policy follows “classical principles,” meaning that it provides public goods which cannot be supplied by the private sector, in a quantity such that the marginal utilities of public-goods consumption and private-goods consumption are equal (see also Eggertsson, 2011, p. 257). Thereby, the role of the government is assessed but also restricted. In an economy with fully flexible prices, this necessarily means that public and private consumption move in the same direction (Mankiw & Weinzierl, 2011, p. 232): if the utility functions of public and private consumption have analogous properties, a change in private consumption affects its marginal utility. Public consumption has to move in the same direction to re-establish the equality of marginal utilities. Hence, a decrease in private consumption should be met by a decrease in public consumption, and vice versa. There is neither space nor need for countercyclical fiscal policy. Any deviation of public consumption from the optimal position reduces households’ overall utility. When an exogenous shock happens, be it a change in productivity or in consumers’ preferences, individuals adjust their behavior. Under flexible prices, the optimal equilibrium is immediately established. It is with sticky prices that policy gets a certain role assigned. Monetary policy then reacts via a change in the interest rate, which makes households change the respective present and future consumption levels. Once again, the task of the central bank is to restore the equilibrium output that would obtain under flexible prices, whereas fiscal policy is not needed for stabilization of output (Mankiw & Weinzierl, 2011, pp. 226, 230). Yet, there may appear a situation where conventional monetary policy is not applicable because the target rate has reached the zero lower bound. In a case where so-called unconventional monetary policy, for whatever reason, is restricted in its monetary expansion, fiscal policy may also be applied. However, an increase in government spending is a signal for consumers that taxes will be raised by an equal amount in the future.

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Foreseeing future tax charge, households keep private consumption and investment unchanged. Moreover, even though government spending may raise total output via an increase in capacity utilization, it cannot achieve the flexible-price equilibrium because public goods are different from private goods so that the new allocation is only second-best (Mankiw & Weinzierl, 2011, p. 234). The Ricardian equivalence referred to here states that government expenditures have no impact on consumption because households take the inevitable future tax increases into account. As neoclassical economists admit, the Ricardian equivalence, which requires assumptions such as rational expectations and infinite planning horizons, is not supported by empirical evidence (Agénor & Montiel, 2008, p. 121). If the equivalence is abandoned, fiscal policy gets a more active role: depending on the sign of the exogenous shock, it should run a budget surplus or deficit so that households adjust their consumption choices in closer accordance with the flexible-price equilibrium (Mankiw & Weinzierl, 2011, pp. 241–245). Mankiw and Weinzierl’s (2011) neoclassical framework proposes a clear hierarchy of policy action. If economic activity deviates from its optimal equilibrium, then monetary policy in its conventional form or, if necessary, through unconventional instruments leads the economy to the optimum. Fiscal policy only applies when all opportunities of monetary policy are exhausted. Even then, its task is basically “to do what monetary policy would if it could” (ibid., p. 246). Since the financial crisis of 2008, neoclassical theory, or at least its new Keynesian version, has become less hostile to fiscal policy. Even though it is especially in a new Keynesian framework where the macroeconomic effects of fiscal policy may materialize too late due to time lags, it may help to stabilize output (Blanchard et al., 2010, p. 9). Whereas discretionary fiscal policy takes time to be implemented, automatic stabilizers such as social transfers and progressive income taxes can be key in a crisis as they imply transfers to be countercyclical. However, new Keynesianism considers fiscal rules as necessary to avoid procyclical public spending and debt ratios growing in the long term, hence to guarantee sufficient fiscal space in a recession (ibid., pp. 14–15). Discretionary fiscal policy including one-time expenditures that do not follow strict rules are distortionary and increase the output gap (Taylor, 2014). The general equilibrium approach features well-known shortcomings that also apply to the specific issue of fiscal policy. The supply-determined nature of the economy rules out dynamics triggered by changes in effective demand. The flexible-price equilibrium is taken as the optimum towards which policy action should be oriented. Hence, fiscal policy, if even, is only useful for stabilization of output and should thereby follow strict rules.

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The constraint on the supply side negates any impact of fiscal policy that goes beyond (re-)establishment of that optimum. Fiscal policy appears to be ineffective (Arestis & Sawyer, 2003b, p. 7). In the described neoclassical model, technology and productivity are exogenous variables and hence cannot be influenced by public intervention. Thus, the flexible-price equilibrium is a priori made the optimum outcome; that is, by taking productivity as exogenous. The neoclassical analysis makes a statement on where the economy is at the moment, but it does not say anything about where the economy may go in the future. Any improvement in economic performance that is not caused by a stochastic exogenous shock, but achieved by economic policy, is ruled out by assumption. Yet, as the macroeconomic principles have shown, inclusion of both supply-side and demand-side dynamics is absolutely key to the understanding of capitalist economies. It is much more appropriate to act on the assumption that productivity is an endogenous variable influenced by investment, capital accumulation and profit expectations, as our model does. Effective demand is thus an essential driving force of economic performance even in the long term (see Arestis & Biefang-Frisancho, 2000). This involves the consideration not just of relative exchanges, but of the whole credit circuit as part of the monetary economy of production. As a consequence, capacity utilization and employment fluctuate over time and there is no fixed general equilibrium to which the economy reverts. Another criticism regards the neglect of uncertainty. The assumption of rational expectations in the neoclassical sense is only meaningful, if all individual utility functions are summed up to an aggregate, actually giving rise to a single representative agent. The fallacy of composition is assumed away by the supply-side equilibrium. In the real world, the Ricardian equivalence cannot be held up because perfect foresight is not possible in a world of uncertainty. But even if this assumption is dropped, neoclassical economics assigns the role of perfect foresight to the government whose task it is to move the economy as close as possible to the flexible-price equilibrium (Mankiw & Weinzierl, 2011, pp. 241–245). However, despite the government having a specific role as a macroeconomic agent and as a “builder of the future” (Cardim de Carvalho, 1997, p. 41) as argued above, it is far from knowing the optimum of economic activity. Since the economy is not driven merely by exogenous shocks but also by a large number of endogenous forces, it is even a hypothetical question whether a single optimum equilibrium exists. Hence, the government is moving in uncertainty as well. There is no definite information in advance of a fiscal policy program regarding its effects on output and employment, nor is it clear within what time horizon

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the effects are going to materialize in the economy. Clearly, the effects of fiscal policy are delayed, but the same is true for monetary policy action. However, heterodox theory assigns a potentially important role to fiscal policy because a thorough macroeconomic monetary analysis reveals the impact it can have on maintaining or improving the profit rate of firms and effective demand. The Government Facing Financial and Institutional Constraints A second mainstream argument against too-active government intervention points to missing capacity of the public sector to provide goods and services. Missing capacity means insufficient knowhow and expertise on the one hand and, particularly, a lack of finance for investment and funds for consumption expenditures on the other hand. For example, it is said that the global infrastructure sector, covering areas such as transport, energy, water, waste management, and more, is facing an investment gap (see for instance UNCTAD, 2014, p. 140; UNEP FI, 2018). This means that currently existing infrastructure is not sufficient for infrastructure needs around the world. The public sector is argued not to be able to close this gap via public investment because its budget is constrained (see World Economic Forum, 2014, p. 14). The solution is considered to lie in private sector participation. The private sector can provide finance to close the investment gap. Additionally, it can take over existing assets from the government through privatization. Private sector investment and knowhow improve the operation of assets and hence the provision of goods and services (see for instance International Finance Corporation, 2012, pp. 6, 14). The public finance constraint argument appears more often in the environment of development institutions than in academia. However, its foundations reveal a direct connection to the exogenous money view. Basically, public finance can only be constrained if money supply is restricted. In such a world, the argument is valid. A government facing limited sources of money either has to borrow from the private sector or, alternatively, should try to include private firms in the investment and operation of goods and services. But, as discussed at length, money is not scarce. It is created when loans are granted. Hence, from a macroeconomic accounting perspective, there is no difference as to whether the government borrows from the banking system or from other private investors, or whether it is private agents themselves being provided with credit to make investments. In contrast to what the argument suggests, there is no a priori constraint on public spending. The government can borrow money and make the required investment. The same is basically true for government consumption expenditures.

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It is not just that the government can invest without being constrained; rather, it should do it. Taking again the example of infrastructure, it is considered key to raise living standards in developing countries and to make the economy more sustainable (Bhattacharya et al., 2015). For this reason, it is unquestioned that more infrastructure investment is required. If the private sector is able to provide necessary finance, one may wonder why investment does not take place to close the investment gap. A variety of reasons are given for the lack of private sector involvement in the infrastructure sector, such as insufficient preparation of infrastructure projects (see for example Nassiry & Nakhooda, 2016). Despite infrastructure being a complex issue, the private sector is able to set up businesses in other, even more complex fields. In fact, many goods and services of high social relevance are not supplied by the private sector because returns arising from a corresponding investment are far from the average profit rate expected by investors. Hospitals, schools, public transport systems, climate-change mitigation and adaptation projects, and other goods and services are essentially needed by societies in developing countries. However, in many cases demand for services is only sufficient if tariffs for usage are low, which make investment not profitable enough. Contrariwise, high profits imply high tariffs, which large shares of the population in developing countries cannot afford. On the other hand, profitable areas such as, for example, certain energy projects, private schools and hospitals, that are only accessible for customers belonging to high-income groups, have a much better chance to be implemented by private investors. Profitability is a precondition for private sector investment. Engaging private investors for investment in goods and services which have a social or environmental impact is only possible at large scale if this precondition is fulfilled. This is why development institutions aim to demonstrate the business case of sustainable investment (see for instance Mehta et al., 2017, p. 110). A business case signifies that an investment generates cash flows feeding investors’ returns. Since it is not guaranteed for many projects in developing countries, it is often argued that development finance or climate finance may support the creation of business cases to attract private capital (see for example Barnard, 2015, p. 8; Bhattacharya et al., 2015, p. 18). Such support actually means public subsidy, in some form or another, which is supposed to guarantee private profits. Hence, it is mistaken to argue that the public sector is not able to invest in socially necessary goods and services due to finance constraints. The fact that the private sector is reluctant to step in to fill investment gaps gives rise to the conclusion that the public sector is even more needed. The central strength of the state is its ability (depending on the

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political will) to produce output at a below-average profit rate, or even without any profits at all. Together with the recognition that money is endogenous, the conditions for the supply of the necessary goods and services by the public sector are fulfilled. Independence from the profit requirement also enables the government to direct consumption expenditures and investment towards the needs of the poor households. The ideal of providing basic goods and services as public goods can thereby be approached. The objection that the public sector faces a lack of knowhow and institutional capacity to implement successful projects may be correct in some respects and wrong in others. Yet, constraints in institutional capacity are a high, but not insurmountable, barrier. Chang (2011) gives an overview of the meaning of institutions for development and argues that the former are not a precondition for the latter. Instead, institutional improvements go along with economic development, whereas development is itself one of the conditions for strong institutions. Even though this is not the place for an extensive debate on the economics of institutions, which has been glanced at in Chapter 1, the lack of private sector engagement underlines the need for public intervention. Public investment and the production and provision of (public) goods can be supportive to the development of institutions and knowhow. While the public sector may have shortcomings, the potential of the private sector certainly faces constraints too, as explained here. Even though money creation is not exogenously limited, there can be economic constraints to the governments’ consumption and expenditures. The argument of the public finance constraint also criticizes fiscal policy for running budget deficits and accumulating debt. This is why those mainstream economists who admit a role to fiscal policy at all suggest restricting it by fiscal rules (see Blanchard et al., 2010; Taylor, 2014). Yet, investment requires finance which is, in any case, backed by credit. If the private sector is supposed to provide finance, it either has to borrow or it can raise funds out of past profits. Independently of the case, any investment implies debt of an equal amount. The logic of the monetary economy of production and the credit circuit makes debt a necessary condition of any economic activity. For the government, as a single agent in the economy, debt may still become a problem if it grows to such an amount that it gets out of control; as, for instance, when interest rates increase. The following section 3.3 deals with the question of debt affordability. Its limits are less of a concern in a closed economy but relevant once the open economy is considered, as it will be in Chapter 4.

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Crowding-Out of the Private Sector The third mainstream argument against fiscal policy says that public expenditures crowd out private output. Hence, its effect is at best a zerosum game. The explanations provided in economics textbooks, but also particularly with regard to development economics, follow different lines just to end up at the same conclusion. The explanation of the first crowding-out channel says that public investment or public deficit spending for consumption expenditures lowers public savings, raises the demand for money, and hence gives rise to higher interest rates (see for example Berg et al., 2009, p. 8). To finance budget deficits or investment, the government issues bonds. The growing supply of bonds lowers bond prices while raising bond rates. The latter are an important influencing factor of investment expenditures. Higher lending rates thus entail a decline in private investment. The second line of argument is based on the Ricardian equivalence and states that deficit spending for either public consumption or investment needs to be compensated by a future budget surplus (see for instance Arestis & Sawyer, 2010a, pp. 12–13; Mankiw & Weinzierl, 2011). In preparation for future tax increases, households reduce consumption expenditures. Hence, total output grows by government expenditures but it declines by the same amount via a reduction in private consumption. The third main argument concerns the labor market. To the extent that government expenditures raise demand for labor, wages increase, thereby making employment unaffordable for the private sector. The government may hire workers for public production or the provision of public goods. However, employment in private firms decreases accordingly until the original wage rate is reached again (see for instance Behar & Mok, 2013). There is no net gain for the overall economy, while the size of the private sector shrinks. The channels of crowding-out may involve further problems for the economy. To the extent that the private sector is more efficient and productive than the public sector, the crowding-out of the former deteriorates overall economic performance in the long term. Moreover, the government has the power to raise taxes and to run larger deficits. It is less constrained by market forces than the private sector. Growth of the public sector share of output reduces the degree of competition and efficient resource allocation. The economy is running the risk of losing one of its most important regulating mechanisms to develop productivity in the long term (see for instance Mankiw, 2008, p. 10). The first crowding-out argument can be criticized with regard to many aspects. In particular, it reveals fundamental flaws and ignores more than one macroeconomic principle. For the negative impact of public

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expenditures on the private sector through an increase in interest rates to materialize, the quantity of money must be constrained. Hence, the argument acts on the assumption of exogenous money that does not respond to any change in demand for it.2 It is based on explanations such as the loanable funds theory, which assumes that funds need to exist prior to their lending such that demand for funds determines the interest rate (see Smithin, 2017, pp. 266–267), or the IS-LM model where the money supply is even a vertical curve. However, even Hicks (1937, p. 157) as the founder of the model argued that the central bank can raise money supply in order to prevent interest rate hikes. To complete the logic, the exogenous money assumption should be replaced by endogenous money. The central bank and commercial banks reasonably accommodate demand for reserves and credit, respectively. Hence, the short-term interest rate is exogenous. To the extent that the central bank target rate determines the general level of the whole set of interest rates, no investment, be it public or private, can induce a change in it. Due to the double-entry bookkeeping in a monetary economy, a public deficit automatically generates the required savings on the side of those who receive government expenditures (Arestis & Sawyer, 2010b, pp. 339–340). The identity of investment and savings is preserved such that there is no pressure on interest rates. Possibly, growing supply in government bonds may indeed lower their price while raising bond rates. This would be due to the higher share of government bonds in total bonds, which requires better offering conditions to convince bond purchasers. However, the investment‒savings identity holding, this would imply higher prices and lower rates for non-government bonds, leaving the average interest rate unchanged (ibid., p. 340). There is no crowding-out of the private sector. As regards the second crowding-out argument, the Ricardian equivalence is itself not supported by empirical evidence. But even more important than its wrong description of consumers’ behavior, it reveals the constraints implicit in neoclassical assumptions, which make fiscal policy useless. The equivalence explains why an increase in public expenditures leads to an equal decrease in consumption. As a consequence, total output is fixed. Hence, the Ricardian equivalence is needed to restore the optimal equilibrium. Output is exogenously given by the general equilibrium determined by a certain production function, while capacity utilization is normally at unity. The output constraint is thus not affected by fiscal policy. The latter is not able to impact total capital accumulation. Since public expenditures are a zero-sum game, there is no way in which they could influence productivity growth. If neoclassical theory allowed for demand-led output growth triggered by changes in capacity utilization, capital accumulation and possible other

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factors, households’ adjustment of consumption would no longer be a zero-sum game for total output. Moreover, if public spending is able to promote economic growth, there is even less reason for households to fully compensate through a reduction in consumption. Still following the logic of the Ricardian equivalence, they then would know that total output grows in the future, giving way to a rising supply of consumption goods for every household. If the government plans to repay debt by running a budget surplus, its ratio to total output will be lower than the ratio of the current deficit to current output. For households, this means that even if they have to pay higher taxes in the future, there is still more income available for consumption. For this reason, they would not have to save the whole amount of the current public deficit for the tax payment in the future. To sum up, the Ricardian equivalence and the supply-side determined economy are two assumptions, which are conditional upon each other for the result of ineffective fiscal policy to hold (Rowthorn, 2020, p. 5). If the Ricardian equivalence is not valid, public expenditures actually have an impact on total output. If households do not compensate public spending by an equal reduction in consumption, there is indeed a demand stimulus, which triggers enhanced economic activity. It then may be that the economy grows sufficiently such that the increase in public spending does not reduce private sector output. Output is no longer predetermined by supply-side constraints. On the other hand, if fiscal policy is allowed to have an impact on economic activity – be it simply through a demand stimulus, be it via productive investment – the supply constraints are shifted outwards. Fiscal policy would induce changes in production capacity and productivity. As a consequence, the Ricardian equivalence would break down. Even if individuals were rational utility maximizers, they would not nullify the effect of public spending by a reduction in consumption. The reality is a world of uncertainty, and the economy is a dynamic system driven by profitability and effective demand. Consumers do not know what taxes the government is going to charge in the future, just as they do not know the future at all. All they do is build expectations. The state can influence expectation-building by making use of public intervention. If government spending takes the form of consumption expenditures, the resulting demand stimulus induces the private sector to raise production and to create additional production capacity through investment. The government can also direct spending towards productive expenditures. Both private and public investment create production capacity, which itself drives productivity through technology and efficiency. Appropriate fiscal policy and demand trigger an outward shift of the supply constraint

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such that the latter cannot be considered as an immutable barrier (Arestis & Sawyer, 2003b, p. 12; see also Arestis & Biefang-Frisancho, 2000). Neither the Ricardian equivalence nor the assumption of an economy predetermined by supply take fundamental macroeconomic principles into account. They are useless to argue in favor of ineffective fiscal policy. The only channel through which a crowding-out could potentially become effective is the labor market. There is one difference to the other crowding-out arguments which makes this concern of crowding-out partially valid. In contrast to what neoclassical theory suggests, money is not a commodity and hence cannot be scarce. Therefore, the interest rate does not increase when demand for money grows. The same is largely true for production capacity. Prices may increase when spare capacity converges to zero. However, total capacity is not a fixed variable. It increases when investment takes place. If productivity grows at the same time, production capacity rises even more. Abstracting from time frictions and resource constraints, there is basically no exogenous constraint to the development of capacity. It counteracts price increases. As explained with regard to the second crowding-out argument, increases in production capacity accommodate growing demand. Since there is no exogenous constraint to money nor to production capacity, public expenditures do not necessarily give rise to a crowding-out of the private sector. The labor market, however, is different in this respect. Even though the population, and hence the labor force, may be growing, it is constrained in the sense that it does not adjust to demand for labor. It is true that population growth is, among other factors, influenced by economic development. But such trends tend to materialize only in the very long term. In the shorter run, the pool of workers is given. Hence, to the extent that public spending exerts demand pressure, wage increases might reduce employment in the private sector. Yet, there are several important qualifications to be made to this argument. First of all, the existence of a supply-side constraint in the labor market does not mean that the constraint is binding at any moment. The crowding-out argument is based on the neoclassical assumption of full employment. However, any analysis that accounts for the characteristics of a monetary economy of production reveals that full employment is not the normal state of the economy. As long as there is unemployment, public spending can create jobs without raising wages. Even though some economic policies such as social transfers may under certain circumstances have an impact on the participation rate of workers in the labor market and thus on wages (Minsky, 1986/2008, p. 29), substantial wage growth takes place only when the economy reaches full employment. Moreover, the extent to which crowding-out effectively takes place at

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full employment also depends on other factors. A minor mitigating influence may come from a varying profit rate. Simple accounting tells us that a growing wage share ceteris paribus reduces the profit rate. Facing a wage increase at the full employment point, firms may decide to disinvest and reduce employment. Or they may accept a higher wage and a lower profit rate as the new normal state, especially if the latter had been relatively high previously. Even though the profit rate cannot go below a certain threshold, competition may allow it to vary within a range. A more important mitigating factor may be the impact of employment and high wages on productivity. As Kleinknecht (2015, p. 2) argues: first, firm-specific learning and knowledge gains strengthen productivity growth; second, productivity is also positively influenced by high wages because they force firms to innovate in order to remain profitable (Kleinknecht, 2015, p. 5; Rezai et al., 2013, p. 71). The more economic policy can keep employment and wages at high levels, the stronger is productivity growth according to this argument. With growing productivity, it is easier for firms to afford higher wages while sustaining a high profit rate. Thereby, the labor market constraint itself is not removed, but productivity growth contributes to an outward shift of production capacity. To the extent that high, or full, employment has a positive effect on productivity growth, crowding-out of the private sector via the labor market is dampened. Despite these possible dampening effects, the crowding-out argument by and large has validity once full employment is achieved. However, it is to be said that when the economy is at full employment, there is no need for fiscal policy to provide further demand stimulus. It may then be turned to objectives other than employment growth, such as redistribution of income or the provision of public goods. Alternatively, in a context of full employment, fiscal policy may be structured in such a way that it focuses on strengthening productivity growth rather than employment stimulus. Even though mainstream economics assigns only a quite limited space to fiscal policy, its importance is usually larger in reality. As Blanchard et al. (2010, p. 6) state, it is more widely used than the accompanying rhetoric may suggest. It is observed that the size of the government increases in the course of the development of an economy (Mourmouras & Rangazas, 2008, p. 3). Moreover, developing countries have larger government sectors than advanced countries had at similar stages of development (ibid., p. 4).

3.3  A FRAMEWORK FOR ECONOMIC POLICY The criticism of the mainstream arguments against fiscal policy have laid the ground for the sketch of an alternative framework for public

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intervention. As mentioned at the beginning of this book, we want to know what instruments of economic policy developing countries can apply in order to achieve a significant and lasting reduction of poverty. In an economy where a majority of people are engaged in the informal or subsistence economy, poverty is synonymous with very high unemployment. According to this definition, employment means the number of jobs in the formal sector. Obviously, no developing country complies in the least with the neoclassical assumption of full employment. Despite wages being low, no substantial investment in fixed capital takes place to raise production capacity, productivity, employment and output in the long term. It is the fundamental task of a macroeconomic strategy to lift people out of poverty by boosting economic activity. For an economic policy program to be successful, it has to be aware of credit, money, capacity utilization, investment, productivity and hence production capacity, employment and output as endogenous variables. By contrast to what neoclassical theory suggests, a demand stimulus is not useless due to supply-side constraints; public spending is not limited by exogenous money; and it is not necessary that economic policy crowds out private economic activity. Appropriate public intervention produces just the opposite effects: it triggers private investment; it contributes to productivity growth and production capacity; it raises employment, wages and living standards. It entails a crowding-in of the private sector. Economic policy is able to do so because it addresses the fundamental conditions that need to be met for production to take off. Private firms’ rate of profit and effective demand each have to be at a high enough level. This shows once again that economic policy also has to focus on the short run in order to be successful in the long term. The outline suggested here is quite close to what was introduced as industrial policy in Chapter 1. The Keynesian Multiplier and the Monetary System Obviously, the suggestion that a demand stimulus involves economic growth and crowding-in contains the idea of a multiplier effect of public spending on output. The idea goes back to Kahn (1931) and Keynes (1936/1997). It says that any investment gives rise to savings of an equal amount. However, consumers who receive the additional income arising from investment expenditures will save only part, and spend most of it. The respective shares are determined by the households’ saving rates. Expenditure again creates additional demand, thereby creating income of which a part is saved again. The process continues in convergence until total savings are equal to the initial investment spending. Final employment and output are higher than they were initially. Hence, “the multiplier

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tells us by how much their [the public’s] employment has to be increased to yield an increase in real income sufficient to induce them to do the necessary extra saving, and is a function of their psychological propensities” (Keynes, 1936/1997, p. 117). There are extensive debates about the size of the Keynesian multiplier. A demand stimulus can only yield positive results if the multiplier is at least one. This means that economic policy must be such that it prevents crowding-out and rather triggers crowding-in of the private sector. Empirical estimates for either advanced or developing countries differ and provide values of both above and below unity (see for instance Barro & Redlick, 2011; Freedman et al., 2009; Hemming et al., 2002). Studies on crowding-in and crowding-out effects at least broadly agree that there is no evidence of private sector crowding-out through rising interest rates nor via the Ricardian equivalence (see for instance Das, 2010; Hemming et al., 2002). However, overall literature provides mixed results with regard to crowding-out in general (for developing countries, see for example Bahal et al., 2015; Behar & Mok, 2013; Ranzani & Tuccio, 2017). This still leaves open space for crowding-out to be effective in the labor market. Yet, such econometric tests are based on assumptions that make their interpretation difficult. Measurement biases impede definite conclusions. For example, public sector expansion may be the response to a crisis that has led to private sector contraction. In such a situation, the negative correlation between public and private economic activity may lead to the conclusion that the public sector crowds out the private sector. However, the impact of fiscal policy may actually be a crowding-in, because it prevents the private sector from contracting even more. Some studies try to take this issue into account by including control variables. For instance, Behar and Mok (2013) and Feldmann (2010) aim to isolate the effect of public sector employment on private sector employment by controlling for economic growth, which is suggested to take business cycles into account. However, the logic of the multiplier argument requires that for the multiplier to be greater than one, public employment needs to have a positive impact on economic growth. Hence, the public sector variable and the growth variable are supposedly not independent. Once growth is covered by the control variable, the impact of public employment is investigated under the assumption that total output is fixed. Under this assumption, it is just necessary that an increase in public sector employment implies an equal decrease in private sector employment, that is, full crowding-out. Hence, any multiplier effects are ruled out by assumption. Structural models may allow for some improvements but basically have the same measurement problem (see for example

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Mitra, 2006). As another shortcoming of many studies, the impact of fiscal policy on investment, capital accumulation and productivity growth is likely to be a quite long-term and non-linear one. Yet, most studies are focused on the short run (ibid.). Given the empirical problems, the multiplier theory requires a sound theoretical base in line with macroeconomic principles. According to the idea of the multiplier, additional income spent involves employment, production and new income. Any new expenditure forms profits of the firms producing and selling the goods. The saving rate implies that part of income is saved and retained from renewed circulation. However, this requires that money can be hoarded. Yet, initial demand stimulus implies the creation of debt, which brings about – in line with the monetary or credit circuit – the production of goods. The sale of goods yields revenues for firms which are used to repay initial loans. Where not all goods are sold, firms sell bonds to receive the funds for debt repayment. In any case, there is no money left to be transmitted to the future (Parguez, 2008, p. 110). Any expenditure is a destruction of income. Hence, incomes cannot circulate (Bradley, 2008, p. 101). If spending income exerts additional demand in a certain sector, demand in the sector where income was formed through production decreases by the same amount. Hence, if a demand stimulus gives rise to additional income which is larger than the stimulus, it is not due to the circulation of money. Income increases only when output increases. For this to take place, firms have to employ additional workers and pay wages. For additional employment to be financed, additional loans have to be issued. Since there is no circulation of income, a demand stimulus cannot be multiplied. Economic activity involves both production and consumption, where the former means the creation of income while the latter implies its destruction. The multiplier idea assumes that consumption expenditures can create new income. This is not possible because “the purchasing power of money is spent only once: it disappears when goods are purchased” (Schmitt, 1960, p. 109, own translation). The value of any “dynamic multiplier” can only be unity (Bailly, 2008, p. 148; Schmitt, 1960, pp. 109–111). However, how can fiscal policy entail a crowding-in of the private sector? This is only possible if it triggers additional production which is larger than the initial stimulus itself. Yet, the basic idea of the Keynesian multiplier can be reconciled with the principles of endogenous money and the monetary production economy. Effective demand is the connecting element through its impact on agents’ behavior (Gnos, 2008, p. 191). Any demand stimulus raises firms’ sales and hence makes their expectations more optimistic. An improved stance of effective demand induces

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additional investment and output. Hence, even though the multiplier does not work via circulation of incomes, it is still visible as the ratio of total output after the fading-out of the demand stimulus to initial output. This adapted view of the multiplier is in line with the macroeconomic principles introduced in Chapter 1. It will be seen that the SFC model allows for multiplication effects precisely via changes in inventories and capacity utilization in the first instance, and employment and productivity growth in the second instance. Consumption and Investment Expenditures by the Government Our approach to economic policy is defined by the results it can achieve. In this sense, it is related to the concept of functional finance by Lerner (1943). Currently, several core aspects of functional finance receive a lot of attention under the term “modern monetary theory.” It says that countries with “sovereign currency” – where the term means the power of the government to issue money and to raise taxes, the latter guaranteeing the money to be used as a means of payment – can create any demand via government deficit financing (see Wray, 2015, pp. 1–8, 43–44). Since a government cannot be restricted by the money it has the power to issue, full employment can be ensured. Without discussing all aspects of the theory in detail, certain qualifications have to be made for our purpose. First, the extent to which full employment can be achieved depends on the type of fiscal policy. Second, developing countries are usually far from full employment in its formal sense. Public intervention can contribute to substantial improvements but, due to institutional weaknesses, not immediately prevent any unemployment (Wray, 2015, pp. 229–232). In general, permanent full employment would require a lot of fine-tuning, which can hardly be delivered by fiscal policy (Palley, 2015, pp. 17–18). Third, in the real world, government deficits are usually not completely irrelevant. These arguments will be made more explicit in this chapter and throughout the book, particularly when considering the open economy. Yet, it remains true that economic policy should be oriented towards targets with regard to output, employment and poverty reduction. It should follow “function rules” instead of budgetary rules, which are arbitrary and may constrain demand when it is needed most (Arestis & Sawyer, 2010b, pp. 331–334). As introduced above, fiscal policy can be classified according to the character of expenditures. The macroeconomic effect of consumption expenditures is a demand stimulus. If the government’s budget is balanced, the demand stimulus works through redistribution of income. Its strength and direction are ambiguous and depend on the initial state of income

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distribution. Income transfers funded by income taxes and spent as social services imply redistribution from rich to poor households. They may have an impact on effective demand due to differences in the propensity to save between rich and poor households. Due to non-existent saving among poor households in developing countries, effective demand is boosted by such redistribution. On the other hand, to the extent that taxes are imposed on capital incomes, whether on firms’ profits or on capitalists’ dividends, they reduce the profit rate and hence lower firms’ willingness to employ workers and make investment expenditures. Therefore, redistribution towards more equality in an economy increases effective demand while diminishing the rate of profit, whereas redistribution towards more inequality has the opposite effect. In the latter case, the direct demand stimulus arising from government spending is negative. However, it may trigger an indirect demand stimulus via increased investment expenditures made by firms due to increased profitability. The case of redistribution through fiscal policy is analogous to the question of whether an increase in wages has a positive or a negative impact on the macroeconomy (see for instance Stockhammer & Onaran, 2013). If, by contrast, government spending entails a budget deficit, the demand stimulus is unambiguous. It signifies a net increase in effective demand. Its positive multiplicative effect on output and employment works via growing consumption spending by private households if the budget deficit finances social transfers. Or it is effective by means of an increase in firms’ profit rate caused by a tax release or higher subsidy of inputs or sales. The extent to which the initial stimulus brightens firms’ expectations, and thereby has positive effects on employment and investment, depends on factors such as the investment propensity of firms, households’ saving rates, current capacity utilization and inventories, and the impact on productivity. Demand stimulus via deficit spending is not just unambiguous, it is also likely to be much stronger than the effect of pure redistribution with a balanced budget. If public spending is dedicated to productive expenditures, the macroeconomic implications are different. Reasonably, government investment is financed via deficit spending. Debt resulting from deficit spending is matched by a real asset of the same value. If investment was to be financed without creating debt, it would have to be covered by tax revenues, thus actually implying a budget surplus. The private sector would inevitably be in a corresponding deficit. This implies reduced profitability and actually would bring about a crowding-out of the private sector. Furthermore, since any productive expenditures are tantamount to the creation of additional income, they require the issuance of new loans. Just as in the case of private firms, the public sector makes use of the endogeneity of money in order to finance production.

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As any public expenditure, investment spending is a demand stimulus. In this respect, the impact on economic activity is analogous to public deficit spending for consumption. However, public investment also has a supply-side effect by enlarging production capacity of the economy. The effect on output, employment and poverty reduction is thus larger and more direct in contrast to government consumption expenditures where any supply-side reaction is expected to come from the private sector and thus is uncertain. It is not only the crowding-in effect of the private sector that produces additional output but also public sector output itself. The multiplier is thus likely to be larger.3 In addition, by creating state-owned production capacity, the government can directly employ workers and thereby improve the situation of poor households not just by income transfer but by income creation. The idea is related to Minsky’s proposition of the state as the “employer of last resort” (Vasconcelos, 2014, pp. 31–34; Wray, 2007). Whenever the private sector’s economic activity is insufficient so as to result in unemployment, the public sector can employ the unemployed in order to guarantee a constant stream of income and prevent output fluctuations. As argued above, there is no argument in favor of a crowding-out of the private sector. The condition for success, however, is that public intervention is applied in an appropriate way. The only sensitive area of crowdingout, namely the labor market, is naturally affected by public investment and employment. If the public sector set wages far above market rates, the overall wage level in the market would increase. The private sector’s profit share would squeeze and private employment would finally fall. Yet, as long as full employment is not reached, and if the government hires workers at the prevailing market wage rate, there is no crowding-out to be expected. And as mentioned, when full employment is achieved, there is no need for the public sector to increase production any further. The government can employ workers at a certain defined wage, which automatically becomes an effective minimum wage (Wray, 2007, p. 13; Wray, 2015, p. 222). This shows that public investment endows economic policy with a further powerful instrument to influence economic activity. By setting the (minimum) wage at an appropriate level in its role as a public employer, the government can exert an impact on income distribution and effective demand. If it considers the general wage level to be too low, an increase in public sector wages influences the overall wage level in the labor market. Growth in total labor income boosts effective demand. On the other hand, in a situation where private investment is in a slump, it may even be useful to lower the wage level in the public sector. Moreover, by setting the wage rate appropriately, the government can also broadly ensure price stability (Wray, 2015, p. 224). Even though developing coun-

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tries, and even advanced economies, may not be able to guarantee permanent full employment due to weaknesses in institutions and production capacity as well as a number of practical difficulties regarding fine-tuning and labor market economics (Sawyer, 2019, pp. 172–176), the notion of the employer of last resort still provides a useful framework. There are certain advantages of productive expenditures by the government compared to consumption expenditures. First, by stimulating not only the demand side but also the supply side of the economy, inflationary pressure is reduced. Fiscal policy merely consisting of social transfers may reduce participation of the labor force while exerting demand without contributing to additional production (Minsky, 1986/2008, p. 29). Second, consumption expenditures create demand. However, their success in stimulating economic activity depends on profitability in the private sector. If the latter is not given, spending may be ineffective. By contrast, public investment actively contributes to profitability by enhancing productivity via capital accumulation. Third, government investment creates assets, which can generate cash flows in the future. Public sector profits are a source for further government spending, for example by means of social transfers. Noticeably, if government profits were not distributed, a part of produced output would remain unsold. Hence, just as in the case of private profits explained in model a), retained government profits would ceteris paribus represent a drop in demand and might give rise to a negative multiplier. Public Finance and Debt For modern monetary theory, public debt is never a problem because the sovereign state can always provide the currency needed to finance expenditures. This would basically be true, if institutions of a country were rearranged in a way that the central bank is directly tied to the treasury to finance the latter’s deficits (see Lavoie, 2013, p. 13). Apart from this, the limits of monetary sovereignty will come to the fore, at the latest, once an individual country is considered in its relationship with the international economy (see for instance Epstein, 2019). For reasons that will be emphasized in more detail later, public debt should not exceed a controllable level. If too large a share of public expenditures is used for interest payments, redistribution from labor income to capital income takes place. While it increases inequality in society, it also implies a drag in effective demand in the long term. Moreover, increasing debt levels may reduce investors’ perception of a government’s creditworthiness and raise interest rates on bonds further. The evolution of the public debt to GDP ratio informs about the

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government’s future ability to serve and repay debt. Stability of the ratio means that the level of debt can be considered affordable. In the case of fiscal policy in the form of social transfers, debt has to be managed by generating tax revenues. Government investment, on the other hand, implies that initial investment spending needs to be covered by the sale of produced public sector output. Both types of government revenues reduce effective demand if they are not spent again. However, this fact cannot justify the argument that economic policy shall be a zero-sum game just because repayment of debt compensates for the initial budget deficits. According to this view, what the demand stimulus contributed towards an increase in output and employment is exactly reduced once the government is forced to run budget surpluses. Yet, there is a dynamic potential of economic policy in the long term. To the extent that public intervention enables capital accumulation in the economy, it gives way to technological progress and productivity growth. As long as the public debt ratio is under control, debt can remain outstanding for quite a long time. For this reason, even if it has to be repaid by a certain point in time, it does so in an environment where the economy produces at a higher productivity level. Despite the demand-lowering impact of debt repayment, output and employment do not fall back to initial levels. There is an additional central aspect which relaxes the issue of debt further. Productive expenditures face another advantage over consumption expenditures. As explained, in the former case public debt is backed by a public capital stock, which could potentially be sold to repay debt in the case where it would otherwise reach uncontrollable amounts. In the presence of state-owned assets, there emerges a difference between gross and net debt ratios, where the latter is the appropriate way to represent the public sector’s financial health (Arestis & Sawyer, 2010b, pp. 337–339; Llorca, 2017, pp. 177–178). Turning the argument around, it is the normal case that a share of either private or public fixed capital is financed by debt. Hence, to the extent that debt is balanced by assets, there is no absolute requirement to repay all debt in the future. Likewise, there is no need for future surpluses (Arestis & Sawyer, 2010b, p. 338). This section relies on the sketch of the framework described above for economic policy to drive economic activity and reduce poverty in developing countries. The SFC model introduced in the previous chapter is extended in the following section to incorporate the effects of policy intervention. In particular, it analyzes the impacts of both government consumption spending and investment spending on output and employment. The respective mechanisms of economic policy effects are investigated. It will be shown that appropriate intervention leads to a crowding-in of the private sector, thus bringing about an increase in living standards.

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3.4 MODEL B): ECONOMIC POLICY FOR DEVELOPMENT The first submodel, model a), has shown the basic mechanisms of macroeconomics. The only policy tool available in that model is monetary policy. It is shown that expansive monetary policy can have a lasting impact on output. However, the effect is limited in size and time. There are no further means to trigger economic growth. Model b) now shows analytically what impacts fiscal policy and government intervention in a broader sense can have. The model dynamics are now briefly explained in advance. The model shows how government expenditures redistribute purchasing power to those who receive the transfers. While such action may be in line with ideals of social security, its main macroeconomic effect is an increase in effective demand. Firms enjoy an increase in sales and hence start increasing employment and enlarging production capacity. The government can ensure the reflux of its expenditures by taxes imposed on different agents in the economy. Depending on the level and structure of the tax system, the profit rate and effective demand can be influenced. The public sector can also afford deficits for a considerable time. To reduce it, tax rates have to be increased. Yet, the more capital accumulation has advanced and the higher the level of productivity achieved, the easier it becomes to reduce public debt. Besides exerting a macroeconomic influence through consumption expenditures, the public sector may even assume a more active role, as described in the previous section. It can start building its own production facilities. Investment induces demand from which the private sector benefits. But the accumulation of public capital does not only create effective demand, it also creates supply. Thus, the contribution to economic growth is twofold: it stimulates private sector activity, while the public sector itself produces another part of GDP. In cases where the public sector earns profits in the production process, they can be distributed and support social services. Both government expenditures and government production, as a kind of industrial policy, can contribute to economic growth, productivity and technology. Model b) contains 65 endogenous variables and the same number of equations. In addition to model a), the government is added as an agent in the economy. Since model b) is an extension of model a), some equations remain the same. This is why only the new equations and those which have to be modified are explained. Their numeration follows the order of model a).4

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Taxes and Social Transfers Let us first consider the government as an actor of redistribution of income. As a first adaptation of model a), firms’ profits are now reduced by corporate tax, TF, imposed by the government. Taxes may not be considered as production costs since they are only charged once production is completed. Yet, for the macroeconomy, profits after tax are the relevant variable: PF 5 YF 2 WF 2 rLN,21*LNF,21 2 TF (3’)



The income of workers changes in a similar way. It increases by government expenditures, G, which are fully distributed to workers as a social transfer. In this regard, the category of workers may also include unemployed people in the informal sector. They are not workers in the sense of being employed, but belong to the poorer fraction of the population and may benefit from social transfers. In this model, G means government spending for consumption goods such as public goods, social transfers or subsidies. Expenditures for investment are distinguished later on. Workers may be charged with taxes, TW, because the government may also recur to workers’ income and wealth in a situation where it wants to achieve a balanced budget. Transfer payments and taxes modify workers’ income out of which they decide to save a share. Even though we still assume workers’ saving rate to be zero, it is included for formal logic. Now, former equations (17) and (18) of workers’ consumption and savings, respectively, look as follows:

CW 5 (12sW) * (Wtot 1 rD,21*DW,21 1 G 2 TW) (17’)



ΔDW 5 sW* (Wtot 1 rD,21*DW,21 1 G 2TW) (18’)

Note that wage income WF has been modified to Wtot denoting the total sum of wages. The new notation is necessary because with an active government, workers no longer receive their salaries only from firms. The further components of wage income are introduced below. Now, in a simple analogy to wage income, capitalists’ income is reduced by the tax, TCap, and so are the respective shares of consumption and savings:

CCap 5 (1 2 sCap) * (PCap 1 rD,21*DCap,21 2 TCap) (20’)



ΔDCap 5 sCap* (PCap 1 rD,21*DCap,21 2 TCap) (21’)

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The tax imposed on firms is calculated by the tax rate multiplied by profits of the previous period. Likewise, taxes of workers and capitalists are calculated by the multiplication of the respective tax rates and incomes. Hence, taxes for firms, workers and capitalists are given by:

TF 5 tF*PF,21 (38)



TW 5 tW* (Wtot,21 1 rD,22*DW,22 1 G21) (39)



TCap 5 tCap* (PCap,21 1 rD,22*DCap,22) (40)

where tF, tW and tCap are the respective tax rates. If they were fixed, there would be no variation with falling or rising income. Moreover, they would not account for the government’s budget situation. The resulting tax income would usually be too low or too high compared to government spending. We make the tax rates endogenous by varying them with regard to wealth and the budget deficit. The first variable introduces a simple kind of progression in terms of wealth and therefore also past income. The second variable shows how the government changes the overall level of the tax rate depending on its need to fund expenditures or to repay debt resulting from past budget deficits: BD21 (41) Ytot,21



tF 5 2τF,1 *LNF,21 1 τF, 2 *



tW 5 τW,1 *DW,21 1 τW, 2 *



tCap 5 τCap,1 *DCap,21 1 τCap,2 *

BD21 (42) Ytot,21 BD21 (43) Ytot,21

where BD is the government’s budget deficit. Ytot means total output including production of the private sector and possibly also the government. The τ’s are parameters of the government’s tax policy. Since firms’ financial wealth is expressed by its level of debt, LNF, the definition of wealth is a negative one. Hence, the tax rate becomes ceteris paribus positive when LNF is negative, the latter being equal to a deposit. The budget deficit does not enter the equation as an absolute term but is related to total output. The acceptability of public debt depends on the expected ability of the government to pay it back in the future. Therefore, the higher output, the more easily debt can be managed and repaid. Government tax income, TG, is given by the sum of all tax payments:

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TG 5 TF 1 TW 1 TCap(44)

The public budget deficit is simply defined as government expenditures minus government income consisting of tax revenues and possible government profits of which undistributed profits have to be deducted: BD 5 G 2 TG 2 (PG 2 PUG) (45)



Government consumption expenditures can be considered as the central instrument of redistributive economic policy. They are set at an appropriate level to achieve a certain target. As a simple case, we say that the government defines a target rate of economic growth, gY, target. Whenever actual growth, gY, of the previous period was below the target rate, G is positive. If the difference diverges, G grows further. In the case that effective growth is higher than the target rate, G is zero. Moreover, government spending is influenced by a second term, consisting in the distribution of possible government profits arising from production. Hence, government expenditures are given by:

G 5 θ1* (gY, target 2 gY,21) 1 θ2* (PG 2 PUG) (46)

θ1 and θ2 are policy parameters reflecting the government’s decision on the tuning of expenditures. For now, government profits, PG, and government’s undistributed profits, PUG, are basically zero because there is no public sector production. However, as will be seen, PG also contains interest payments. Hence in the case of public debt due to budget deficits, PG is negative. The primary budget, which is the budget before interest payments, then has to be positive for the final budget to be balanced. Public Investment and Employment In the next step, we assign the government an even more active role and consider the possibility that it can also become an active producer and thereby contribute to total output. We assume that the state makes use of the average knowhow and technology available in the economy. This means that the measure of labor productivity, A, is the same for the private sector and the public sector. Public production, YG, is thus analogous to private production. The higher labor productivity, the more a given number of employed workers, LG, can produce:

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Total employment in the economy, Ltot, is the sum of workers employed in the private and public sectors. And total output, Ytot, is the sum of private sector and public sector production or the output arising from the employment of Ltot:

Ltot 5 LF 1 LG(48)



Ytot 5 YF 1 YG 5 A*Ltot(49)

Firms are now not the only economic group to supply consumption goods because a share of these goods is also produced by the public sector. So we get the modified version of the former equation (4):

CF 1 CG 5 CW 1 CCap

where CG is consumption goods produced by the state. The equation can be reformulated to:

CF 5 CW 1 CCap 2 CG(4’)

Just like private firms, the public sector may not be able to sell all goods in situations where effective demand is decreasing. Therefore, an indeterminacy from the model regarding the distribution of inventories arises. For example, when capitalists start saving, it is not clear whether the consumption goods of the private sector or those of the public sector remain unsold. Both sectors produce with the same labor productivity and pay workers the same wages (as is to be shown). For this reason, both the private sector and the public sector sell goods at the same price. If the government tried to cut prices by accepting a lower profit rate than private firms, all consumers would buy the goods of the former, while the latter would have to accumulate inventories. They would end up indebted and finally go bankrupt. To avoid such an unacceptable scenario, firms would cut their sales prices as well, to the level of the goods supplied by the public sector. This is again what Shaikh (2016, p. 259) calls real competition as the central regulating mechanism of capitalism. It is firms’ constant goal to cut production costs so that price cuts can follow. Yet, once production costs are given, price cuts by the public sector at the cost of its profit rate would also lower the private sector’s profit rate if it is to follow the price cuts. Finally, a lower general profit rate would imply higher real wages. But this would no longer be a profitable field of economic activity for private firms. Hence, price cuts by the government, if sufficiently large, would give rise to a crowding-out of the private sector. The state does not

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have any interest in triggering a decline in economic activity and therefore abstains from such price-cutting behavior. This does not mean, however, that public sector production always needs to match the private sector profit rate, as will be seen. The central feature of economic activity by the state, namely the ability to produce without profits, is not restricted. It is still a powerful tool to optimize overall economic outcomes. The problem of indeterminacy is the following: let us imagine that consumption goods of the private sector and the public sector are supplied at the same price and that not all goods are sold due to household saving. It may be that only private firms or only the public sector accumulates inventories. Or it may be that households distribute expenditures such that both firms and the government end up with a part of inventories. But it is undefined how the respective shares are distributed. We thus make a simple but reasonable assumption. If there is a change in inventories, it is shared between private sector and public sector according to relative outputs. The ratios of the change in stocks to output is the same for both sectors. Hence, the greater firms’ output, the larger the change in inventories they have to bear. The higher the production of a firm, the more it is present in the marketplace and the more it is concerned once households start saving. The equation: ΔING ΔINF 5 YF YG

can be reformulated to:

ΔING 5

ΔINF *YG(50) YF

INF is still defined as in equation (2) as firms’ output minus their investment and sales of consumption goods. The indeterminacy is dissolved.5 Now that the change in the government’s inventories is defined, sales of public sector consumption goods are given by a simple accounting equation as output reduced by stock accumulation and investment:

CG 5 YG 2 ΔING 2 IG(51)

Public profits, PG, are calculated in analogy to private profits as output minus wage and interest costs:

PG 5 YG 2 WG 2 rLN,21*LNG,21(52)

where WG and LNG are the state company’s wage bill and outstanding loans, respectively. Just as for the private firms, the public sector can measure its profit rate given by:

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pG 5

PG (53) KG 1 WG

where KG is the public capital stock. As mentioned, however, prG does not have to meet a minimum threshold. The public sector decides to produce in order to create employment or to guarantee social services (or both). Profits are a subordinated motive. The requirement that the profit rate is at least equal to the interest rate on deposits is only relevant for private firms. Capacity utilization in the public sector, CUG, is again the ratio of used capacity, KG, eff, to the total capital stock. In contrast to firms, where capacity utilization varies according to profit considerations, the government’s objectives such as employment and social services are best served if capacity is constantly fully utilized. We thus set CUG equal to 1. This is the socially optimal solution because it prevents waste in the form of idle production capacity:

CUG 5

KG, eff KG

5 1(54)

The government may also decide to keep spare capacity in order to react to unforeseen necessities. For the purpose at hand, it is sufficient to set CUG at a level that is considered as appropriate by the government and to point to the fact that the public sector is also able – if willing – to keep capacity utilization stable in situations where the economy needs support. Investment behavior of firms depends on the expected profit rate and current capacity utilization. With the public sector, the investment equation is different. Capacity utilization is stable and hence cannot be the subject of investment incentives. And profit is not the driving force of public production, as explained. Instead, investment is determined by the government’s growth target. Hence, if economic growth is below targeted growth, public sector investment expenditures are positive:

IG 5 θ3* ( gY, target 2 gY,21) (55)

θ3 is again a policy parameter measuring the public sector’s propensity to invest in expectation of economic growth. Capital accumulation of the public sector, KG, is determined by investment. The total capital stock, Ktot, is the sum of private sector and public sector capital stocks:

ΔKG 5 IG(56)



Ktot 5 KF 1 KG(57)

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Labor productivity is usually a composition of knowhow and technology available in the economy. Hence, both the private sector and the public sector contribute to the economy’s overall productivity when they accumulate capital. There are spillovers from one firm and sector to the others. The definition of productivity basically remains the same as in model a). We just have to modify equation (10) partially. So now, productivity is, first, determined by the total capital stock. A higher capital stock signifies better technology and economies of scale independently of whether production capacity is provided by firms or the government. However, marginal returns of capital decrease as accumulation advances. Second, any positive investment adds to productivity by improving the existing capital stock. After a possible recession where there is decumulation, new investment will not lead productivity back to the old level of a given capital stock. Productivity will be higher, because technology has improved in the meantime. Both private and public investment contribute to such improvements. Growth in overall labor productivity still tends to slow as the economy develops, but it does so in a partially irregular way due to the composition of the two impact factors:

A 5 δ1* (Ktot) 0.5 1 δ2*a a 0 IF 1 a 0 IG b  for all IF . 0, IG . 0 (10’) t21

t21

Since productivity is the same for all producers, the same is true for capital intensity because it is determined by the current level of technology. Just like productivity, it depends on the total capital stock. The rest remains the same as in model a):

ci 5 ε* (Ktot) 0.5(11’)

The next equation determines capacity utilization. Capital intensity defines how much capital is required per worker. Private firms make a decision on the level of employment. Once the latter is assessed, its multiplication with capital intensity yields the part of capital, which is effectively used. The corresponding accounting equation thus is the same for state production:

K G,eff 5 ci *LG(58)

However, as outlined above, the private sector and the public sector are different in one aspect giving rise to opposed causality. Private firms decide on employment based on effective demand. Capacity utilization is the resulting variable. With capital intensity given, capacity utilization is just

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as variable as effective demand and hence employment. As long as capacity utilization is below one, effective demand is the constraining variable for production. The government’s decision follows a different logic. It targets output and adjusts public investment correspondingly. The main goal is to increase output and reduce poverty by creating employment. As explained, production thus takes place under full utilization of production capacity. Since profit is not the main purpose, sluggish demand does not limit public sector output. Thus, for the public sector, production capacity rather than effective demand is the constraint impeding further increases in output. With capital intensity given, the capital stock of the government defines how many workers can be employed. Employment is the resulting variable. Equation (58) needs reformulation because causality has changed. Hence: KG, eff LG 5 ci Production at full capacity utilization implies CUG 5 1 as shown in equation (53). It is straightforward that KG, eff 5 KG so that we get the final equation:

LG 5

KG (59) ci

saying that the higher the capital stock and the lower capital intensity, the more workers the public sector can employ. The difference between the private sector and the public sector in this regard entails an important assessment. The private sector is driven by demand. Effective demand increases capacity utilization. Once full utilization is reached, effective demand still triggers further capacity-enlarging investment. The public sector is driven by political decisions on making investments and producing output accordingly. Hence, while the private sector is demandconstrained, the public sector is supply-constrained (see also Kalecki, 1958/1986, pp. 48–53; Kalecki, 1959/1986, pp. 72–73). The government offers jobs in the labor market just as firms do. The public sector’s wage bill, WG, is thus the number of workers multiplied by the wage rate. Total wage income, Wtot, in the economy is therefore the sum of the wage bills of firms and the government:

WG 5 w*LG(60)



Wtot 5 WF 1 WG 5 w*Ltot(61)

The state’s demand for labor has an impact on wages. If public sector production raises overall employment in the economy, the labor market is

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tighter. Hence, in equation (15) of model a) not only firms’ employment but total labor demand has a positive effect on wages:

w 5 γ0 1 γ1* a

Ltot L

x

b 1 γ2 * w0 *A^0(15’)

Minsky (1986/2008, p. 29) argues that since transfer payments are income without work, “each improvement in transfer-payment schemes has the effect of raising the price at which some people will enter the labor market.” In other words, such social transfers reduce labor force participation in the production of output (Vasconcelos, 2014, p. 29). However, we do not adjust equation (15’) in this regard. One reason is simplicity. The other reason is that the context of developing countries may allow for ignorance of this aspect. With large shares of the population being below the poverty line, social transfers are hardly sufficient to raise household incomes to a level where they can exert pressure in the labor market. In the same way as with private firms, investment by the state generates macroeconomic savings, SG, according to the investment‒savings identity:

SG 5 IG(62)

Again, investment, and hence savings, is part of profits. It is the part of profits that cannot be distributed because its real object is investment goods, which cannot be consumed via expenditure of profit income. This is perfectly in line with profit and savings characteristics of the private sector. Undistributed government profits, PUG, are defined by macroeconomic savings:

PUG 5 SG(63)

Besides macroeconomic savings, the public sector may decide to retain a fraction of the remaining profits. However, this is already defined in equation (45) where profits are distributed as part of general government expenditures, G. The policy parameter θ2 in that equation decides what part of the distributable profits is effectively distributed. Like a private firm, the public sector relies on credit to finance production. The credit circuit is analogous to private sector production. The government’s ability to repay a loan at the end of the circuit depends on the same factors, namely the saving rate of households and its decision on profit distribution. In addition, redistributive policy may give rise to a budget deficit when G exceeds tax income, TG. Hence, outstanding loans of the public sector at the end of the circuit are calculated as follows. First, they increase by investment. Investment expenditures, whether made

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by the public sector or the private sector, do not yield a reflux because they cannot be purchased by consumers. However, they are financed by retained profits. To the extent that the latter are equal to savings, investment is completely financed so that it does not give rise to remaining debt. Second, loans grow to the extent that the public sector has to accumulate stocks due to households’ savings. Third, a budget deficit also requires an increase in loans: ΔLNG 5 IG 2 PUG 1 ΔING 1 BD(64)



where LNG is loans of governments. The fact that the public sector can be a debtor (or a depositor) requires us to adjust the banking system equations from model a). Bank profits are now increased by interest payments if LNG is positive, or reduced accordingly when the government is a depositor with LNG being negative:

PB 5 rLN,21* (LNF,21 1 LNG,21) 2 rD,21* (DW,21 1 DCap,21) (28’)

The model is complete now. Only the wealth equations have to be modified and completed. First, banks’ wealth is complemented by outstanding loans to the public sector. Second, since the government has entered the model as an agent, we add another wealth equation, VG. Government’s wealth consists of the public stock of capital and inventories reduced by outstanding loans:

VB 5 LNF 1 LNG 2 DW 2 DCap(36’)



VG 5 KG 1 ING 2 LNG(65)

Total wealth of the economy is increased by the government’s wealth:

Vtot 5 VF 1 VW 1 VCap 1 VB 1 VG 5 KF 1 INF 1 KG 1 ING(37’)

3.5 THE EFFECTS OF REDISTRIBUTIVE ECONOMIC POLICY Let us now simulate the impacts that economic policy can have on macroeconomic variables. In this first step, we limit government interventions to income transfers via expenditures and taxation. The government sets a target of economic growth and makes public expenditures as long as the target rate is not met. Hence, it follows that in equation (46) θ1 and θ2 both

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0.20

0.20

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Panel a) government expenditures

20 01 20 04 20 07 20 10 20 13 20 16 20 19 20 22 20 25

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Panel b) tax revenues

Figure 3.1  Government expenditures and tax revenues are set to one (the latter taking into account possible interest payments contributing to a negative value of PG). In fact, it may be that the target is never actually achieved. But it provides a reference point for the government to decide on expenditures. At the beginning of 2004, the government starts the policy program by linearly increasing the target growth rate from zero to an ambitious 8 percent by end of 2005. The target could also be set higher, which would mean more intervention. In 2018, the target is degressively reduced again. This is a modeling assumption in order to identify the effects in the best way and not to produce too many ruptures in the graphs. Taxes are charged depending on agents’ wealth and the government’s budget deficit. The interest rate is kept stable now. Figure 3.1 shows government expenditures and total tax revenues. Once the policy starts being implemented, expenditures strongly increase because the growth target is itself rising. Once the target is fixed at 8 percent, expenditures slowly decrease, which is a sign that they are successful in moving the actual growth rate closer to its target rate. When the target is reduced again, expenditures fall back to zero. Tax revenues first grow more slowly because tax rates are set only with lagged values of private wealth and the budget deficit. However, tax income increases continuously and only starts slowing down when the economic policy program fades out. The pattern of the government budget is considered below, but it can already be seen from Figure 3.1 that the program starts with a budget deficit as expenditures exceed tax revenues. This implies that it provides a demand stimulus to the economy. Obviously, government expenditures as social transfers improve the financial situation of poor households. Taxes imposed on workers are only a very small fraction of their income while they receive all transfers, which they spend for consumption goods. However, redistribution is not

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0.40 0.35 0.30 0.25 0.20 0.15 0.10 0.05 0.00 –0.05

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Panel a) investment

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Panel c) productivity

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Panel d) output

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Panel e) private sector profit rate

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Panel b) employment

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Panel f) wage

Figure 3.2  E  ffect of redistributive economic policy on investment, employment, productivity, output, profit rate and wage only relevant regarding social considerations but also with respect to the macroeconomy. Figure 3.2 exhibits the main mechanisms. The demand stimulus implies higher capacity utilization (see Figure 3.3 below) and thereby triggers additional investment as can be seen in panel a). Stronger

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Panel a) capacity utilization

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effective demand gives rise to higher employment, plotted in panel b). Panel c) reveals the productivity-enhancing effect of investment and capital accumulation. Naturally, higher employment and higher labor productivity bring about an increase in production, which is shown in panel d). Productivity growth and higher capacity utilization, induced by government expenditures and private investment, raise firms’ profit rate, which itself contributes to further investment. Yet, panel e) shows that the private sector profit rate slowly falls back in the direction of its initial level. The first reason for this is decreasing marginal returns of capital, that is, the declining rate of productivity growth. The second reason can be found in panel f): higher employment implies rising wages which, at a certain level, grow stronger than productivity. A falling rate of profit entails a turnaround with investment decreasing again. Growth of employment, productivity and output is still positive but at falling rates. The role of the profit rate as a strong regulating mechanism is confirmed once again. Hence, the model shows that a redistributive program for economic policy has positive impacts on economic performance. Growing employment and wages show that particularly the poor are better off. Slowing productivity growth and rising wages set limits to redistributive policies. The result also shows that there may be a point where modern monetary theory would face its limits because demand as the only force of growth is insufficient. The changes in capacity utilization and inventories show in more detail how government expenditures impact on firms’ behavior. As mentioned, the rate of capacity utilization increases when demand grows, which is shown in panel a) of Figure 3.3. On the one hand, this is due to rising investment expenditures. On the other hand, growing capacity utiliza-

Panel b) inventories

Figure 3.3  E  ffect of redistributive economic policy on capacity utilization and inventories

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tion contributes to further investment. This is another example of the self-enforcing dynamics in capitalist macroeconomics. Once growth in effective demand slows again, capacity utilization starts falling. Panel b) shows the pattern of inventories. When additional demand from the government meets existing production capacity and employment, it needs to be accommodated by a release of stocked goods. Declining inventories are a signal for firms to increase production and employment. However, employment decisions are made with a lag. Hence, as long as effective demand is growing, inventories are used for sale. When output growth decelerates, firms are able to catch up and start bringing inventories back up. The restoration of stocks is supported by an effect that is opposed to effective demand. In the course of the policy program, the profit rate increases and is above its minimum threshold. This implies extraordinary income for capitalists, who start saving a part of it. A positive saving rate of any of the households entails unsold goods on the side of firms. The stock-lowering influence of effective demand dominates as long as the policy program extends demand. When the program fades out, the inventory-raising effect of capitalists’ savings becomes more important. Besides the falling profit rate, it is this constraint in effective demand that leads the economy to the new stationary state. The positive effects of a redistributive policy program can only be realized if the program is feasible. For this reason, if it involves the accumulation of debt on behalf of the government, that debt must be affordable and manageable in the long term. Too high a level of debt and constant deterioration of the government’s debt position would, first, make refinancing in credit and bond markets more difficult. Later on, with interest costs too high, the state would be threatened by bankruptcy. Figure 3.4 shows budget deficits and the total amount of the state’s outstanding

Panel b) public debt to output

Figure 3.4  E  ffect of redistributive economic policy on public deficit and debt ratios

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loans. However, as explained, it is not plotted in absolute terms but in relation to total output. The higher gross domestic product (GDP) is, the higher the chance to raise funds in the future to repay debt. Panel a) shows that the ratio of the budget deficit to output increases when the economic growth target of the government is successively raised. The ratio keeps rising, though at a lower rate, when the target is stable, and only converges back to zero when the policy program fades out. Whereas we have already realized that there is a budget deficit at the beginning of the program in order to stimulate demand, the same is not a priori visible later on. In Figure 3.1, it can be seen that tax revenues exceed government expenditures very soon after the launch of the program. Interest payments on outstanding loans are the reason for a persisting budget deficit. The primary budget thus would be in surplus. However, interest payments are responsible for continuous accumulation of debt and a rising public debt to output ratio, depicted in panel b) of Figure 3.4. Once the program is withdrawn step by step, the debt ratio stabilizes. And although not visible in the graph, it even starts decreasing slightly in mid-2023. This means that the government can afford the debt involved by a redistributive policy program. Public debt is mirrored by deposits held by firms and capitalists. Firms accumulate monetary savings because they sell previously existing inventories. Hence, they sell more than they produce in the periods under consideration. The capitalists save part of their income as deposits instead of spending it. Government expenditures end up as private wealth after having stimulated effective demand. This result raises the question of the role of budget deficits. If the policy program was designed for balanced budgets from the very beginning, it could not exert any additional demand. If there was a budget surplus, the government would build savings while withdrawing demand from the market. Speaking in terms of the credit circuit, firms could not sell all goods and hence would lower employment for the next period. The budget surplus would create inventories of the same amount. The effect would be a negative spiral and a decline in output. To measure the contribution to effective demand, the government’s budget after deduction of interest payments rather than the primary budget is the relevant magnitude. The primary budget may be in surplus, but if accounting for interest makes a deficit out of it, the government is still pushing demand. Interest is capitalists’ income and contributes to consumption expenditures. However, capitalists have a higher propensity to save out of income so that high debt involving high interest payments can give rise to a drag in effective demand. Is there a possibility of a later reduction in public debt? There is. But it requires budget surpluses and hence harms economic activity. However,

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in a situation where effective demand is high anyway and firms are willing to accumulate debt for investment, the government may repay debt while the economy’s growth performance is still considerable. In addition, it is not the case that the growth effect of the policy program is completely reverted once loans are paid back. Even though a policy program which is budget-neutral in the long term involves the injection of additional demand followed by the withdrawal of the same demand, it is not a zerosum game. It is crucial to understand that investment triggered by the program allows for technological progress and acquisition of knowhow. It contributes to productivity and can no longer be completely eradicated even if disinvestment should take place. The new units of the capital stock allow for a higher labor productivity than the initial ones. And a higher labor productivity implies a larger output even if employment should fall back to its initial level. Finally, interest rates are kept stable during the simulation of this policy program. But monetary policy may ease the debt burden by lowering the rate of interest. Figure 3.5 depicts the impact of the economic policy program on the general price level. The demand stimulus leads to slight inflation due to higher capacity utilization and reduction of inventories. Thereafter, price-lowering effects dominate. Productivity grows and firms become net depositors, hence earning part of their profits via interest. Speaking in technical terms, interest income is tantamount to production costs and reduces upward pressure on prices. When the program fades out, capacity utilization approaches its referential level again, while inventories slowly catch up to reach their initial level. Both patterns have a price-lowering effect. However, cost-pushing factors start to dominate. Productivity 0.85 0.83 0.81 0.79 0.77

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Figure 3.5  Effect of redistributive economic policy on the price level

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growth becomes slower while especially wages increase more strongly as a result of lower unemployment. Prices go up. Despite the result still being largely dependent on parameter calibration, we see that government expenditures do not unequivocally lead to systematic inflation. However, if we were to consider a policy program which steadily raises government expenditures, production capacity would constantly be at high levels and inflation may be persistent or even accelerating.

3.6  THE EFFECTS OF PUBLIC INVESTMENT Social redistribution of income through government expenditures and taxation faces several limits with regard to issues such as public debt and the unintended distributive impact of interest payments, as has been explained. For these reasons, developing countries may require more active policies than pure redistribution of incomes. Let us analyze the effects on the macroeconomy when the government starts investing in physical capital and becomes a producer and an employer. Like with redistributive economic policy in the previous section, the government sets the same target rate of economic growth, starting from zero and raising it in 2004 until 8 percent is reached in 2005. The target remains stable until 2018 when it is reduced again, step by step. The government decides on investment according to the policy equation (55) where the policy parameter θ3 is set to one. Hence, as long as actual economic growth is below the target, the state makes positive investment. Investment means accumulation of fixed capital such that the state can employ workers and produce output according to the logic described in model b). Since we want to investigate the impact of public sector production in isolation, the redistributive policy program of the previous section is deactivated. This means that θ1 in equation (46) is set to zero. θ2, however, is still equal to one, which tells us that all state profits arising from production, which go beyond retained savings to finance investment, are distributed as government expenditures. All tax rates are set to zero, too. Monetary policy does not intervene, so that the interest rate is kept constant. Figure 3.6 shows the effects that a public investment program exert on the macroeconomy. The government’s investment expenditures create demand, hence raising capacity utilization and lowering inventories of private firms. The latter’s perspective brightens and they start investing. Panel a) shows the patterns of public sector and private sector investment. Once the growth target is stable at 8 percent, the government does not have to raise periodical investment expenditures further. When the program fades out, investment goes back to zero. Private firms raise

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total (lhs)

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Figure 3.6  E  ffect of public investment on total investment, employment, productivity, output, profit rate and wage investment even further until they reach a peak from which they slowly fall back to zero. The impact on employment is significant, as can be seen from panel b). Both the government and firms are able to increase employment. Since the state starts from zero employment, its increase is measured by the right-hand side scale of the panel. Both left-hand side and right-hand

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side scales measure with the same units. Total employment grows to a new level, where it remains stable even after the policy program is closed. Needless to say, investment and capital accumulation support labor productivity growth of the economy, plotted in panel c). During the phase of high public and private investment, it increases strongly but still at a slightly decreasing rate. When the investment policy fades out, productivity converges to its new stable level. Panel d) exhibits the development of total output as well as the respective contributions of private firms and the public sector. Both sectors raise output over time due to higher employment and growing labor productivity. Even though public sector production makes up for a still limited share of total output in the end of the observed time period, it triggers considerable growth of total output. Notably, despite the increase in private sector employment being modest compared to employment by the state (see panel b), private firms’ contribution to output growth is more than proportional. The explanation for this observation is given by the fact that the whole contribution of the public sector is given by its new employment, which started from zero, multiplied with rising productivity. In contrast, in the private sector it is not only new employment that benefits from higher labor productivity. Instead, all hitherto employed workers now face higher productivity. Hence the relatively high increase in total output. As with redistributive economic policy, demand stimulus provided by public investment favors the private firms’ rate of profit, as revealed in panel e) of Figure 3.6. The higher profit rate triggers further investment until decreasing productivity growth and increased wages, shown in panel f), lead the profit rate back to its initial level. Higher wages are again induced by lower unemployment, to which the public sector also contributes now. The state’s profit rate reveals a distinct pattern. As it produces at the average level of labor productivity prevailing in the economy, its profit rate is always positive, just as the private sector’s rate is. However, even though it eventually catches up to the latter, it is significantly lower for most of the time. The reasons for this are given below. For now, the importance of the state’s critical characteristic is confirmed: it is also able to produce and contribute to economic development if its profit rate is below the level required by the private sector. Changes in firms’ capacity utilization and inventory accumulation are again helpful to explain the pattern of investment behavior. Panel a) of Figure 3.7 shows how the increase in the rate of capacity utilization is an important determinant of firms’ investment. After the start of the public investment program, capacity utilization falls again slightly because the public sector has started selling consumption goods of a sufficient amount, which affects the private sector. However, the still-growing profit

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Figure 3.7  E  ffect of public investment on capacity utilization and inventories rate stimulates investment expenditures further and hence keeps capacity utilization increasing. After the end of the investment program, capacity utilization falls back to its referential rate. As defined, public sector capacity is constantly and fully utilized. There is no need to plot the graph. Panel b) shows both private sector and public sector inventories. They basically follow the same pattern because we defined total inventories to be shared by private firms and the government according to their respective output. However, the share of public production is too low for the stock changes to be significant. Due to the state’s demand stimulus through investment expenditures, inventories fall first. However, the more the public sector contributes to the production of consumption goods, the less inventories have to be released so that they can increase again. The most important reason for the persistent increase is to be found in capitalists’ savings. The private sector profit rate is above its minimum level, so that capitalist households do not spend all their income and thereby cause inventory accumulation at the firms’ and the government’s stores. Once again, it is the fall in the profit rate but also the demand-side constraint that lead the economy to new stationary convergence. Figure 3.8 reveals what the public investment program means for government budget deficits and public debt. Panel a) shows that it involves budget deficits at the beginning. Thereafter, the budgets are balanced. For total debt, there is an accumulation of outstanding loans during the initial phase. For the rest of the period, the ratio of debt to output can be kept stable at a quite low level. One may ask why there is a budget deficit at the beginning of the program when both private and public inventories are decreasing at the same time. However, it is not possible that inventories decrease without anybody in the economy spending more than income

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Panel b) public debt to output

Figure 3.8  Effect of public investment on public deficit and debt ratios received. The decrease in inventories is thus a consequence of the government’s deficit. To explain why it is the government running the deficit while lowering stocks, we have to consider the composition of the public sector’s output. When the program starts, the government starts from zero production. Its first expenditure is completely dedicated to investment. Workers are paid their wages, but they cannot buy what they produced because it is 100 percent investment goods. This is why inventories have to be decreased in order to accommodate consumption needs of the workers newly employed by the government. The profit rate of government’s production in the first period is at the average level of the market. To cover the loan being issued at the beginning of the circuit, the government would have to sell its output to workers in order to generate sufficient revenues. But investment goods cannot be sold to workers. This is why the state ends up with a deficit and hence cannot repay the loan. In the following period, public investment is still positive. However, government’s capital stock ready for production grows and, therefore, the share of consumption goods in total state output grows as well. The government is able to sell consumption goods and use the proceeds to repay credit. Yet, as long as the share of investment goods in public sector production is sufficiently high, there remains a deficit at the end of the circuit, which increases in public investment but decreases as the share of consumption goods grows. Deficit entails interest payments in the following periods, thus ceteris paribus contributing to debt accumulation. Later in the public investment program, it is mainly the increase in inventories which raises public debt. But it happens at a rate which is, first, the same as that of the private sector and, second, sufficiently low to keep the debt ratio stable. Initial budget deficits and corresponding interest payments explain

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why the profit rate of the public sector is lower than that of private firms. They represent additional production costs. As the state’s output grows, the relative importance of interest decreases. The public sector profit rate converges to that of the private sector. Government expenditures as defined in equation (46) tell us that the government distributes all profits that exceed PUG, which is itself defined as public macroeconomic savings arising from investment. The government may reduce its debt to zero again by retaining part of profits to cover the missed sales due to inventory accumulation. However, as for any budget surplus, this would mean a drop in effective demand, since distributed profits are spent on consumption again. The government may think about reducing debt in a situation where private sector dynamics allow for a reduction in demand. But as an essential fact, after the phase of initial public capital accumulation is overcome, the state is able to produce and contribute to effective demand without running any further deficits. Even more than that, public production creates the means to fund social transfers. This can be seen from Figure 3.9, plotting the pattern of government expenditures. Increasing investment implies growing production and profits. They can be used for the provision of social services and transfers to poor households. Even after the public investment program is closed, production with a stable capital stock is a source of constant government revenues available for redistribution. While public sector production can itself be considered as an end in itself as it creates employment and thus income for workers, the additional generation of income for government expenditures represents a second beneficial effect. Yet, whereas public sector profits can be considered as a by-product, their distribution is also 0.6 0.5 0.4 0.3 0.2 0.1 0.0 2001 2004 2007 2010 2013 2016 2019 2022 2025

Figure 3.9  Effect of public investment on government expenditures

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Figure 3.10  Effect of public investment on the price level of fundamental importance to close the credit circuit and to keep demand at a high level. Finally, it should be noted that government expenditures funded by state profits are much higher than those of the income redistribution program in the previous section. For government spending to be depicted in Figure 3.9, its scale has to be stretched to a multiple of the scale in panel a) of Figure 3.1. Thus, the public investment program allows for more social transfers than the redistributive policy program itself. The impact of public investment on the general price level is shown in Figure 3.10. The effects are similar to the case of redistributive policy. Increasing capacity utilization and falling inventories caused by the initial demand stimulus give rise to a slight increase in the price level. The subsequent gains in productivity and the re-increase in stocks contribute to a falling price level. Note that the public sector does not contribute to the same price pressure when, for instance, its profitability falls because profitability is not its first objective. In the middle of the program, inflation becomes positive again. Even though inventories are rising and capacity utilization reverts back to its initial level, rising wages and slowing productivity growth are instrumental in raising the price level. The same conclusion from the other model simulations remains true: economic policy does not systematically lead to inflation. In this regard, we arrive at a result analogous to Minsky’s argument that the transition to full employment may trigger inflation, but that the maintenance of full employment is not inflationary (Wray, 2007, p. 15). The model results are a confirmation of heterodox economic theory, namely that government intervention can be quite effective in increasing employment and output as well as improving the social situation of the

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poor. It helps to make the economy more productive and allocate hitherto idle resources in the production process. As a particular example, full capacity utilization in the public sector allows for a more efficient use of resources compared to the private sector, where capacity utilization fluctuates around a certain normal rate, above which firms still have some spare capacity in order to react to market disturbances. Such efficiency also maximizes employment. Even though this result arises from partially stylized model assumptions, it is clear that public intervention can contribute to prosperity and macroeconomic stability. It provides effective demand from which the private sector benefits. Firms are provided with a reliable macroeconomic perspective, at least for the middle term. As a summary, appropriate economic policy through government expenditures and public investment leads to a crowding-in of the private sector rather than a crowding-out. Comparing the two policy programs of income redistribution and public investment, we find that both are useful. However, the model confirms that the latter has a couple of essential advantages. First, comparing the model outcomes, it is obvious that a program for public investment can achieve the same results regarding employment, output and wages as redistributive policy. But it ends up with only a fraction of public debt compared to the latter. To put it conversely, with the same amount of debt it can achieve a multiple impact. Second, lower debt also means that a lesser share of government expenditures is interest payment going to banks and finally to capitalists. Interest payments for public debt reverse the initial intention of social redistribution. Third, public sector production entails government profits, themselves providing a source for government expenditures. Such government spending is a multiple of what a redistributive program can afford with the same level of debt. And fourth, while redistributive policy accumulates pure debt that needs to be serviced and repaid via tax revenues, public debt arising from the public investment program is backed by real assets, that is, the capital stock (and possibly also inventories). In our example, public debt is only a small fraction of the capital stock of the state.6 Should there ever be difficulties for debt servicing, the government could still sell a part of its production plants. The public sector is able to raise output by means of appropriate economic policy. If the growth target was set higher in the model, government intervention would be stronger. Hence, the government can basically achieve even higher output levels and therefore it could effectively eliminate poverty.

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NOTES 1. According to this classification, a distinction is made between provision of public goods and public sector production based on a public capital stock. It is true that both activities yield an output that needs to be produced. Yet, we differentiate in the sense that public goods are defined as those goods and services that are non-excludable and nonrivalrous. Hence, their provision cannot be funded by sales returns, but requires taxes (or public deficits). Since they are measured by their costs, we assign them to government consumption expenditures. In contrast, we consider public sector production to involve a production process in the conventional sense, where production costs are covered by the returns from the sale of output. For a more detailed treatment of the categories of national income accounts, see Tsoulfidis & Tsaliki (2019, p. 390). 2. The alternative explanation for a crowding-out through rising interest rates relies on savings and investment in real terms being equilibrated by the natural interest rate in a Wicksellian sense (see for example Rochon, 2004, p. 3). This view is rooted in neoclassical economics in just the same way, and perceives money as exogenous commodity money. 3. Even if there was a partial crowding-out of the private sector, there would still be a net increase in total output. 4. For an overview of all model variables, values of exogenous variables and parameters, see Appendix I. For the full set of model b) equations and the stock and flow matrices, see Appendix III. 5. Model simulation with the equations as presented here would give rise to a circular argument because output, consumption and inventories are mutually dependent. This problem is resolved in a pragmatic way by lagging the variables on the right-hand side of equation (47) by one period, yielding INF, 1, YF, 1, YG, 1. Changes in results are infinitesimal. 6. This fact is not shown in a separate figure. But it can be seen from the area within the public investment curve and the virtual zero line in panel a) of Figure 3.6. Since the capital stock is the integrated function of investment (that is, the sum of all investments), the area signifies the total public capital stock. It is much larger than the area between the budget deficit curve and the zero line in panel a) of Figure 3.8, which is total public debt (the integrated function of the budget deficit or, respectively, the sum of all budget deficits).

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4. The domestic economy and the rest of the world Appropriate economic policy is quite effective at fostering economic growth and reducing poverty. This has been shown to be true at least as long as policy acts in a closed economic space. Does the conclusion still hold when a developing country faces international competition, trade and monetary flows to and from the rest of the world? This chapter analyzes constraints and new instabilities which may impede a country’s development strategy.

4.1 TRADE, CAPITAL FLOWS AND EXCHANGE RATES So far, the economy has been considered as an isolated space. Yet, countries are embedded in the global economy. For small economies, and hence for the average developing country, the relationship to the rest of the world is of particular importance. The economic setting changes in the sense that there are imports and exports of goods and services that can make domestic output differ from domestic consumption. Moreover, there is a current account and a capital account representing the two sides of the balance of payments, which states whether a country as a whole is indebted to the rest of the world or whether it is an international creditor.1 Cross-border trade and financial flows imply that the relative purchasing powers of currencies can change over time. The same applies to inflation rates. This involves variable nominal and real exchange rates whose fluctuations have to be explained by referring to monetary theory. First of all, there is no reason to assume that the macroeconomic principles introduced at the beginning change fundamentally when the economy is opened up to the rest of the world. Money is still endogenous. Effective demand remains a key principle deciding on whether growth of output and employment is realized. The state of effective demand still depends essentially on uncertainty. And the profit rate remains the target variable that private firms aim to realize. The logic of the monetary circuit (or credit circuit) does not alter. ­137

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At this point, however, it is necessary to widen the perspective. To summarize, the principle of the monetary economy of production applies to a closed economy where loans are issued to finance production. The exchange takes place when output is sold while workers spend their wages. The absolute character of the exchange is given by the fact that output in its real form exchanges against output in its monetary form. The circuit closes when firms repay loans by means of sales returns. It applies to any economic activity in capitalist economies and hence every economy can be analyzed according to the principles of the monetary economy of production. However, this does not allow for the conclusion that the whole world is a single monetary circuit. The world consists of different currency areas which mostly correspond to national borders but can also cover more than one country. Different currency areas imply different sources of credit. Every banking system issues loans denominated in the currency of the respective currency area. As a requirement of double-entry bookkeeping, the creation of a credit gives rise to simultaneous entries on both the asset side and the liability side of the banking system. When the loan is repaid, both the loan and the deposit are destroyed, and the balance sheet shrinks again. Therefore, loans can necessarily only be repaid to the same banking system they originate from. Another banking system in a different currency area could not absorb the repayment of a foreign loan because it misses the counterpart on the asset side of its balance sheet. In this sense, a currency area is a closed monetary structure, and as such it is a monetary space that defines income and a whole macroeconomic structure (see Piffaretti, 2017, p. 132). From this, it follows that no deposit can ever leave the monetary space where it originates (Rossi, 2007a, p. 312). Yet, this logic does not imply that monetary spaces are geographically bounded. Residents of an economy can be the owners of deposits denominated in foreign currency. This will be presented in more detail in the extension of the stock-flow consistent (SFC) model. Every monetary space creates a different credit circuit and therefore represents a monetary economy of production. All monetary economies of production are connected via international trade. Trade is, in the pure sense of the word, exchange. Hence, while monetary spaces exist as economies of production next to each other, their trade relationships represent an economy of exchange between them (Piffaretti, 2017, p. 132). Exchange is still an inclusive part of the economy of production and hence of the credit circuit. However, it now includes imports and exports and makes the analysis more complicated. Figure 4.1 reveals the coexistence of two economies of production,

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Domestic economy

Exchange: sale of output/ expenditure of income; including imports and exports

Rest of the world

Loan issuance

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Figure 4.1  T  he monetary economy of production as part of the global economy where one is a single (developing) country while the other one, for simplicity, summarizes the rest of the world. As long as households do not save in either one of the economies, all incomes are spent and hence all output can be sold. In this situation, it remains true that the credit circuit can be closed, and money disappears after the process is completed. Residents of the domestic economy spend a part of their income on imported goods, which causes a leakage of income. Domestic firms cannot sell all produced goods to the workers to whom they have paid wages. However, consumers in the rest of the world also spend all their income. And since a part of the output of the rest of the world is sold to the domestic economy as exports, they cannot spend income on their own output. Therefore, they have to spend it on imports from the domestic economy. Thanks to this, the latter is able to balance imports by exports. International trade and the current account are balanced. In both the domestic economy and the rest of the world, producers are able to repay loans through sale returns. In contrast to the circuit in the closed economy, returns consist of domestic sales and exports when the economy is open. Naturally, the basic logic of the investment‒savings identity does not change. However, when a country runs a current account deficit, it spends more than it produces. Its investment is higher than its savings. But this is the perspective of a single country. The current account deficit is mirrored by a current account surplus of the rest of the world. The latter earns more than it spends and hence accumulates savings. Investment cannot deviate from savings and, therefore, causality from the former to the latter is given in the open economy as well, owing to the unaltered logic of double-entry

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bookkeeping. The change, which actually takes place when the current account between two economies is in either surplus or deficit, is the altered distribution of aggregate savings between its domestic and foreign components (see Arestis & Cunha Resende, 2015, p. 444). Neoclassical Exchange Rate Models The explanation of current account surpluses and deficits, and hence disequilibria in the balance of payments, leads us to the issue of exchange rate theories. Neoclassical theory proposes two main models to explain exchange rate fluctuations, which are briefly presented here. The first one considers purchasing power parity (PPP) to be the crucial reference point. It assumes that the real exchange rate is always at parity. Hence, the domestic price level is equal to the foreign price level, the latter being corrected by the nominal exchange rate. Due to purchasing power parity, trade is balanced. Parity is realized via flexible adjustment of the nominal exchange rate when relative price levels diverge. If domestic inflation is higher than in the average of the rest of the world, the domestic currency has to depreciate to restore parity. The mechanism works as follows: a higher relative domestic price level implies a competitive disadvantage and hence a trade deficit and current account deficit. Relative demand for domestic goods declines, and so does demand for the domestic currency. The price of the domestic currency ‒ that is, the nominal exchange rate ‒ depreciates. Competitiveness and balanced trade are re-established and the purchasing power of each country is the same (Sarich, 2006, p. 473). The PPP model can be extended to the monetary model (see for example Harvey, 2005, p. 164). It makes use of the quantity theory of money, solves the quantity equation for the price level, and inserts it into the PPP equation. Hence, the relative price levels are now explained by relative values of output, the stock of money, and money velocity. Changes in the relative money supply are argued to affect relative prices and hence have analogous effects on the nominal exchange rate like the original model. Another extension is the Harrod‒Balassa‒Samuelson model, which distinguishes between traded and non-traded goods (Sarno & Taylor, 2002, pp. 89–92). Since only traded goods are relevant for exchange rate determination, different price development in the non-traded goods sector than in the traded-goods sector necessarily leads to the result that the overall relative price level does not correspond to PPP requirements. Overall, there is a broad consensus in literature that the PPP model is basically not supported by empirical analysis, and that for very long periods there are at best mixed results (see Harvey, 2005, pp. 168–171; Rogoff, 1996; Sarno & Taylor, 2002; Taylor, 2002).

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The second neoclassical model is the Dornbusch “overshooting” model, which combines the PPP with the interest rate parity (Dornbusch, 1976). The latter represents a no-arbitrage condition that links capital markets in different currency areas. Under a stable nominal exchange rate, the levels of real interest rates in two countries have to be equal. Otherwise, investors would enjoy systematic profits by changing their portfolio from one currency to the other. Arbitrage gives rise to equalization of interest rates because the more invested financial capital moves to the country with higher rates, the more those rates drop, while the previously lower rates increase. Interest rate differentials are justified if the nominal exchange rate is expected to change such that it compensates investors who hold a portfolio in the country with lower interest rates. Hence, investors are willing to invest in the lower-rate country if the currency of that country appreciates by an extent which is equal to the interest rate differential. Interest plus currency depreciation then yields the same return as in the higher-rate country. In the neoclassical approach, the combination of the purchasing power parity and the interest rate parity leads to a contradiction at first sight. Starting from the former, expansive monetary policy in the domestic economy takes place in the form of an increase in the money supply. The results are lower interest rates and higher inflation. The domestic price level increases relative to the foreign price level, thus giving rise to a depreciation of the nominal exchange rate in order to restore purchasing power parity. However, if interest rates are lower in the domestic economy than abroad, as caused by monetary policy, the interest rate parity requires an appreciation of the domestic currency. The Dornbusch (1976) model aims to overcome this seeming contradiction by the suggestion of exchange rate overshooting. When the money supply increases, agents in the market expect the currency to depreciate so that the purchasing power parity will be respected in the future. Therefore, the depreciation actually takes place. Yet, price adjustment is sluggish so that the reactions to monetary policy are not immediate. This means that the higher money supply has a temporary lowering impact on interest rates because money demand does not increase immediately. Financial markets react much faster. Agents now face an interest rate differential with domestic real rates being lower than foreign ones. Therefore, they expect the currency to appreciate. For this to happen, the currency has to depreciate by even more than purchasing power parity would suggest. This is the overshooting. From there, the currency can partially reappreciate to account for the interest rate parity. After a while, the domestic price level adjusts by increasing to a level where the real money supply is back to the initial level. For this reason,

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domestic interest rates are also back to the higher initial level, which is equal to the foreign rates. Interest rate parity is re-established so that the domestic currency does not have to appreciate further. However, the nominal exchange rate is now at a higher level (thus indicating a weaker domestic currency) than initially. It is the rate which corresponds to the new relative price level. As long as domestic prices have not completely caught up, the real exchange rate is favorable for the domestic economy. Lower domestic interest rates and the favorable exchange rate stimulate growth in output and exports. However, the potential temporary trade surplus disappears again after price adjustment. Likewise, output falls back to its initial equilibrium level once interest rates have increased again. Regarding empirical evidence, interest rate parity is largely rejected in a large number of studies (see for instance Chung & Crowder, 2004; Shrestha & Tan, 2005). While a relationship between exchange rate changes and interest rate differentials is observed, it clearly deviates from parity. Besides missing empirical support, neoclassical explanations of exchange rate fluctuations suffer serious theoretical weaknesses. First, they are based on the assumption that, in general, trade between countries is balanced. The assumption traces back to Ricardo’s principle of comparative costs (Shaikh, 2016, pp. 495–497, 502–503). Any trade imbalance gives way to an adjustment in the terms of trade such that imports and exports become balanced again. The nominal exchange rate adjusts to the extent required by purchasing power parity. In cases where the nominal rate is fixed, price adjustment achieves the same effect (see for instance Okawa, 2006). Prices in the deficit country have to fall in order for its goods to become competitive again. First of all, however, balanced trade contradicts real-world observations, which confirm large and even growing trade imbalances over decades. Second, the PPP model is based on exogenous money. It argues that a trade surplus of a country means higher demand for its currency and hence an appreciation. But demand for a currency can only raise its “price” ‒ that is, the exchange rate ‒ if the supply of that money is limited (Cencini, 2000, p. 2). This is obviously not true. Any demand for money can be accommodated by the issuance of a loan. In analogy, any trade deficit can be financed by granting a loan to the deficit country, which becomes an external debtor. Third, the PPP model takes trade flows as the only factor to influence demand for currency and hence the exchange rate. International financial flows do not play a role (Harvey, 2007, p. 151). Trade itself is driven only by relative prices, whereas income effects are excluded (ibid.). In contrast, reality would suggest that income growth in a country may

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cause a ­continuous trade deficit due to rising imports. Trade, the nominal exchange rate and relative prices are the only regulating forces in the PPP model. Including additional factors would likely disturb the equilibrium. The Dornbusch model does partially better in these regards. The relationship between interest rate differentials and exchange rates is plausible even though it is too indeterminate to be restricted to strict parity (Arestis & Sawyer, 2003a, pp. 7–8). However, its consideration of financial flows is limited to the arbitrage between interest rates. Larger capital flows such as, for instance, portfolio investment are excluded. They may exert an influence on the exchange rate by basing investment decisions not just on interest rate differentials but also on other variables such as expected profit rates and exchange rate fluctuations. Another shortcoming of the Dornbusch model is its reliance on rational expectations (Harvey, 2007, pp. 157–158): when monetary policy becomes expansionary, agents assume in advance that the currency has to depreciate to obey the condition of purchasing power parity in the middle term. By model construction, the depreciation takes place because agents expect it to do so. Without rational expectations, there would be no overshooting and hence the model would not find its final equilibrium. And finally, the neoclassical models rely on the assumption of full employment (ibid., pp. 160–161). Once unemployment is considered, the relationship between monetary policy and inflation changes. Moreover, monetary policy, and economic policy in general, can then achieve income effects. Therefore, abandoning the full employment assumption allows for many more nonlinear impacts on exchange rate determination. Explaining Nominal Exchange Rates To develop an alternative approach to exchange rates, we can proceed in two steps, where we first assess the determinants of the nominal exchange rate, and in a second step the additional factors defining the real exchange rate are analyzed. The alternative explanation can only be considered consistent if it respects the macroeconomic principles identified in Chapter 2. Those principles are the fundamental drivers of any macroeconomy and, naturally, their logic extends to exchange rate determination. Starting with the nominal exchange rate, let us see how it relates to the principle of endogenous money. If trade between two countries is balanced, no change in the exchange rate takes place, because demand for each currency to pay for imports is equal. So far, there is no difference to what neoclassical theory states. If there is trade disequilibrium, neoclassical economics becomes flawed when referring to the PPP model. According to purchasing power parity, the currency of the surplus country should ­appreciate

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because there is now higher demand for that currency than for that of the deficit country. However, as has already been criticized above, this can only be wrong in a world of money endogeneity. Money is not scarce. The deficit country has two possibilities. Either it makes use of its foreign reserves to pay for net imports, or it demands a loan denominated in the currency of the surplus country. Alternatively, it could issue bonds denominated in foreign currency. In either case, the required amount of money can be created out of nothing and any demand can be fully accommodated. There is no net demand left for either currency, and hence there is no reason for a currency to appreciate or depreciate (Cencini, 2000, pp. 2–4). Trade flows have an influence on the exchange rate, as is to be explained in a moment, but they do not immediately have to give way to exchange rate changes. The equilibrating mechanism of the PPP model does not work. Straightforwardly, the same is valid for capital inflows into a country and capital flowing out of it (Cencini, 2000, p. 5): cross-border loans can be granted and bonds can be issued even in the absence of trade flows without necessarily involving exchange rate changes. From this first analytical result based on endogenous money, it follows that an inflation differential between two countries does not give rise to a change in the nominal exchange rate via net demand for either currency (Cencini, 2005, p. 186). Trade deficits can be financed even if they become larger owing to different price developments. Still, to explain changes in nominal exchange rates, there must be differences in relative demand for currencies which lead to changes in their valuation. The explanation is provided by the analysis of the international monetary structure by quantum macroeconomics (Baranzini & Cencini, 2001, pp. xix–xxii). As Rueff (1963, p. 324) discovered, trade imbalances, international lending and money transfers give rise to a monetary duplication. When a country faces net exports to the rest of the world which are paid in foreign currency, it is able to accumulate foreign reserves. The following changes in the balance sheet of the country and the summarized balance sheet of the rest of the world take place: the domestic banking system records foreign reserves on its asset side, while the corresponding liabilities consist of deposits denominated in domestic currency (Baranzini & Cencini, 2001, p. xx; Cencini, 2000, p. 9; Rossi, 2007b, p. 100). The foreign reserves are deposits with the foreign banking system that are acquired by the banking system of the exporting country on behalf of the country’s exporters. Literally, the exporting firms are paid in foreign currency. But simultaneously with the payment on their account, the sum in foreign currency is exchanged into domestic currency, so that exporters find exports returns denominated in domestic currency in their account. This is how the domestic banking system monetizes the foreign reserves.

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The monetary units of these new deposits are issued by the domestic banking system. They can be created because they are backed by the export returns in foreign currency, which become the banks’ property. The balance sheet of the country’s banking system thus grows by the amount of net exports, while domestic output does not increase. This means that there are domestic deposits to which no real output corresponds. At the same time, the balance sheet of the rest of the world does not shrink by the same amount. Exports are paid in foreign currency. To be clear, they are paid by the importers of the rest of the world who use their deposits in global reserve currency units to pay with. Those deposits had originally come into existence via issuance of a loan by the foreign banking system. The net export means that the domestic banking system becomes the owner of those foreign deposits. It records this property as an asset on its balance sheet. At the same time, the deposits remain on the balance sheet of the rest of the world, with the single difference that a non-resident (the domestic banking system) has become their owner. Hence, the balance sheet of the domestic economy’s banking system grows, while the balance sheet of banks in the rest of the world remains constant. This is the mechanism of monetary duplication. Precisely the same thing happens when a resident of the rest of the world wants to transfer their wealth to a bank of the domestic economy, even when no trade takes place (see Rossi, 2007b, p. 100). The domestic banking system becomes the owner of the deposit denominated in foreign currency in the foreign banking system. At the same time, the resident is provided with a deposit in domestic currency, thereby inducing growth of the balance sheet. It is important to understand that if the country changed from a net exporter to a net importer, the money outflow for international payments would shorten the balance sheet of the domestic banking system again (see Rossi, 2007a, p. 316; Cencini & Schmitt, 1991, p. 71). The accumulated foreign reserves can be used for the payments, while the importers’ deposits decrease due to their payment for the imported goods. The decline in foreign reserves means that the deposits in the rest of the world’s banking system change ownership from a non-resident to a resident again. If there are no foreign reserves left, the importing country becomes indebted, while the balance sheet grows in the rest of the world. Observation reveals, however, that net imports are usually not paid for by the release of currency reserves, but rather by accessing new foreign currency via a loan (Baranzini & Cencini, 2001, p. xx). The case of the debtor country is to be considered in more detail in the next chapter. All in all, the mechanism of today’s international payments involving monetary duplication confirms the closed character of the monetary space. Even though ownership of

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a deposit may change from a resident to a non-resident, “no capital can indeed flee from a currency area . . . as capital exists in the form of bank deposits” (Rossi, 2007b, p. 99). Deposits have a real counterpart if its existence stems from loans which were issued to finance production. Given by logic of the credit circuit, the deposits used for the payment of imports have a real counterpart because they originate from the economy of production of the respective monetary space. However, the monetary duplicate ‒ that is, the newly created deposit in the surplus country ‒ misses any real content (Cencini, 2000, p. 9). The surplus country can make use of these deposits to make investments or to lend them. They are considered as assets whose price is determined by supply and demand in the foreign exchange market (ibid.). It is the transformation of currencies “from means into objects of exchange” (Cencini, 2000, p. 10) which gives them a price. The variation of these prices is tantamount to changes in exchange rates. In practice, however, there is no distinction between the original deposits and their duplicates, because both exert the same effects in the foreign exchange market (ibid.). From this derivation it follows that any factors which trigger a change in supply and demand in the foreign exchange market have an impact on the exchange rate. Let us start with external debt servicing as a first factor. An externally indebted country has to raise foreign funds every year to pay interest due. This means that the domestic debtor needs to offer a domestic deposit in the foreign exchange market to exchange it against foreign currency that can be used to serve debt (Cencini, 2000, p. 12). External interest payment thus exerts devaluation pressure on the domestic currency (Cencini & Schmitt, 1991, pp. 170–171). This is in contrast to a trade imbalance where no exchange in the foreign market takes place as long as payments for imports are made by referring to a foreign loan. As mentioned, payments for exports and imports are not the only international transactions. Capital flows in and out of the country also improve or, respectively, deteriorate the balance of payments. They can be foreign direct investment, portfolio flows or merely short-term speculative flows. While capital inflows can be accommodated by the creation of domestic deposits for the foreign investors, outflows are accommodated as well by accessing foreign currency via external loans. There is no need for exchange rate fluctuations. Capital inflows increase the accumulation of foreign reserves. In cases where the overall current account is negative, capital inflows reduce the need for foreign debt. This reduces external debt servicing. However, to the extent that the returns of foreign investment are transferred abroad, unilateral transfers analogous to interest on foreign debt take place.

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Moreover, financial transactions may not only take place in the way described here. Alternatively, banks and other financial institutions may exchange ownership of deposits in different currencies in the foreign exchange market such that neither monetary duplication nor an increase in external debt occurs. Thereby, the owner of the deposit has conversed the currency denomination of the deposit, that is, changed their wealth to a different banking system. The balance sheets of the banking systems do not alter. However, such transactions trigger a change in relative demand for currencies in the foreign exchange market and this implies exchange rate fluctuations. Both types of transactions are possible options for international payments. This is why, in addition to external debt servicing, the factors triggering capital flows and respective transactions in the foreign exchange market should also be taken into account in the determination of the exchange rate. The interest rate differential is thus a second factor. If domestic interest rates are higher than in the rest of the world, investors have an incentive to move their portfolio to the higher-interest currency area. Hence, the banking system offering currency deposits meets growing demand from depositors in a banking system with lower interest rates. For this reason, currencies in areas with relatively higher interest rates tend to appreciate. The argument is related to the interest rate parity in the sense that it also suggests a relationship between exchange rates and interest rates (Arestis & Sawyer, 2003a, pp. 7–8). However, it differs in important aspects. First, it does not make a statement on interest rate equilibrium. As related to the macroeconomic principle of endogenous money, short-run interest rates are exogenous, while long-term rates are in general tied to the former. The Dornbusch model ignores interest rate exogeneity and instead assumes that, due to rational expectations and the purchasing power parity, interest rates converge back to equilibrium after a shock. Yet, with interest rates being exogenous, interest rate differentials may basically persist for an indefinite time. Second, it is plausible that the currency with higher interest rates experiences an appreciation. This is in contrast to the expected devaluation inherent to the interest rate parity. The Dornbusch model overcomes this contradiction by modelling an exchange rate overshooting. However, that overshooting is itself conditional on the assumption of the purchasing power parity. For these two reasons, an interest rate differential is likely to lead to an exchange rate change. Thereby, appreciation or depreciation is not limited to a certain transition period restoring equilibrium. Instead, the differential and hence exchange rate changes may ceteris paribus last for an indeterminate time. It will be seen that continuous change in currency valuation is counteracted by other factors which make it unlikely to

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happen persistently. Nevertheless, there is no equilibrating tendency as an inherent part of the mechanism of relative interest rates. The third determinant factor of exchange rates is related to the second one. As argued, the interest rate parity has some analytical strength. However, it includes the implicit assumption that interest rates are the only type of returns investors account for. This restriction has no base because interest as fixed income is only one component of an average investment portfolio. Investors also aim to realize entrepreneurial profits by means of foreign direct investment or stock purchases. Moreover, they might likewise try to earn financial profits arising from changes in the prices of stocks and derivatives. Differences in profit rates between currency areas thus also give rise to capital flows and speculation in the foreign exchange market, thereby appreciating the currency of a high-profit-rate country. Such capital flows tend to equalize profit rates between countries since, in contrast to the general interest rate level, they are not exogenously determined but react to the abundance of capital and hence of output in different sectors in different countries. However, the speed of convergence may be highly indeterminate and be hampered by expected exchange rate fluctuations. This shows that economic fundamentals influence exchange rate determination to the extent that they have an influence on speculative activity on the foreign exchange market (Cencini, 2005, p. 192). This third factor reveals a further aspect of the complexity of exchange rate building. Both interest rate differentials and profit rate differentials influence the exchange rate in the same direction in the sense that higher differentials mean a stronger currency. However, the relationship between the two differentials tends to be negative. With regard to the real economy, as derived in the basic SFC model, firms’ investment is driven by the expected profit rate. To be precise, it is the net profit rate. Higher interest rates ceteris paribus imply a lower net profit rate. Concerning financial markets, the relationship between interest rates and profits of financial investment tends to be negative as well. Expansive monetary policy induces rising prices of financial assets via changes in liquidity preference and profit expectations (Oberholzer, 2017, pp. 47–54). Hence, while a positive interest rate differential has an appreciating direct effect on the exchange rate, it has a depreciating indirect impact through the lowering of the profit rate. The fourth factor is currency speculation in its proper sense. Investors may move wealth from one currency area to another one because they expect the destination currency to appreciate, which increases wealth in terms of the original currency. Likewise, asset and deposit holders may fear a devaluation of wealth due to expected depreciation. They change currency denomination by moving wealth to a currency area which is considered as safe. In both cases, speculation actually triggers the

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expected exchange rate change. A first depreciation can induce further speculative transactions and accelerate devaluation. Saving wealth by transmitting it to a currency area perceived as a “safe haven” describes the phenomenon which is in general denoted as “capital flight.” It may take place via conventional capital outflows or via transactions in the foreign exchange market. It deprives countries of financial and resources, as will be described in the next chapter in more detail. Capital flight is highly relevant in the context of developing countries. The first reason is the small size of their monetary space, which makes it vulnerable to volatility in the foreign exchange market. Second, capital flight may also take place when asset owners see their financial returns threatened. For instance, state-led development strategies may involve taxes, or competition between the private sector and the public sector. The profit rate could face a decrease. Even if it is only temporary, wealth might be transferred to another country in order to avoid shrinking profits. In Epstein’s (2005, p. 3) words, “capital flight is the transfer of assets abroad in order to reduce loss of principal, loss of return, or loss of control over one’s financial wealth due to government-sanctioned activities.” Capital flight may easily grow to uncontrollable amounts. The central bank may try to offset it by releasing currency reserves aiming at stabilizing the currency. However, capacity in developing countries to do so is usually limited. The resulting currency depreciation has serious consequences and might trigger currency and banking crises in the country. The opposite of capital flight is strong capital inflows. To the extent that they involve transactions in the foreign exchange market, they give rise to currency appreciation. Moreover, capital inflows as an international payment to a non-key currency country involve monetary duplication. The newly created deposits, if invested in the economy of the receiving country, may push up prices of financial and real assets, thus creating a financial bubble (see Schmitt, 2014, p. 56). While this basically accrues to any monetary duplication, the risk is particularly acute in times of strong waves of capital inflows. The sum of the factors which influence nominal exchange rates shows the complexity of their determination. There is no definite pattern of a currency’s value because the influence factors change weight and direction over time and are sometimes contradictory. This is why there is no reason to expect automatic convergence to an equilibrium exchange rate value. From Nominal to Real Exchange Rates Once nominal exchange rates are defined, the additional determinants of real exchange rates have to be explored. In the PPP model, changes in

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relative prices are explained by the single source of inflation in monetarist models: that is, by changes in the exogenous supply of money. Even though this is another mistaken conclusion of neoclassical analysis, it is not of great matter here because the PPP model implies a nominal depreciation to the extent that domestic prices increase relative to prices in the rest of the world. This actually amounts to no explanation of real exchange rates beyond the claim that they adjust in a way to restore trade balance. As Shaikh (2016, p. 508) argues, Ricardo’s trade theory based on comparative costs – criticized for its assumption of automatically balancing trade – should be replaced by absolute costs in order to provide a realistic explanation. In other words, real exchange rates are determined by relative price levels. Explaining exchange rate volatility requires the analysis of changes in price components. Any price of a good is the sum of production costs and profits. Production costs consist of wages, materials and depreciation. Decomposing material costs leads to the classical and Keynesian conclusion that labor is the only production factor; that is, the only component of production costs in the firms’ view. Profits represent the surplus over production costs and are determined by profit rate requirements. In a certain situation where the distribution between profits and wages is given and profit rates equalize across sectors and countries, it becomes obvious that prices and production costs are tied together (ibid., p. 509). A change in relative production costs causes a proportional change in relative prices. The real exchange rate thus represents the competitive advantage of the country with lower production costs. As a principle stemming from classical economics, real wages are socially determined in the labor market.2 Higher productivity growth allows for higher real wages while still remaining internationally competitive. Or, respectively, with real wages given, higher relative productivity growth entails a competitive advantage. Productivity development is an integrated part of wage bargaining. As a consequence, at first, real wages can be considered as given in international trade. Hence, they do not necessarily change when the nominal exchange rate changes or when trade imbalances increase. The cost advantage is absolute and therefore, unlike the claim of the theory of comparative costs, trade imbalances are not eliminated by inherent forces of price or exchange rate adjustment. The country with higher production costs tends to have a trade deficit (Sarich, 2006, p. 477). What are the channels through which nominal exchange rate fluctuations can affect the real exchange rate? A depreciation of a country’s currency makes imports more expensive. Since imported goods also enter production as material inputs, inflation raises the nominal price level in the country. Hence, international trade integrates production chains and spills over changes in real wages and productivity from one country to

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other countries. Inflation contributes to the restoration of initial relative prices. To the extent that domestic prices do not catch up to the initial level via inflation, there is indeed a change in the real exchange rate. Yet, this is tantamount to a change in real production costs. In this case, imported material inputs remain more expensive to domestic producers because domestic inflation compensates only partially. From their perspective, it is as if they have to pay higher real wages in the rest of the world, which raise prices of imported goods. At the same time, wages of domestic workers can no longer afford the same amount of imported consumption goods. Inflation is not sufficient to raise their wages to a level where real prices of imports are equal to the time before depreciation. Therefore, measuring real wages by means of a consumer goods basket, which also contains imported goods, it is evident that real wages of domestic workers have fallen. Foreign wages have increased relative to domestic wages. The nominal depreciation thus also entails a real depreciation. As part of wage bargaining, domestic workers aim to catch up in order to re-establish real wages. But apparently, in this example they fail to do so to the full extent. In addition to limited spillovers from nominal exchange rate changes to real exchange rates, effects on relative economic performance may also have an impact on relative production costs. If the competitive advantage gained raises domestic profitability, investment grows and may induce a positive dynamic in effective demand. As a consequence, domestic wages could increase due to tightness in the labor market. This effect also rebalances relative production costs. However, the alignment of comparative costs is never automatic but can only come about via changes in absolute costs. Hence, “so long as real wages are socially determined in each country, comparative cost advantages will change only if relative real wages or relative integrated productivities changes” (Shaikh, 2016, p. 514). The conventional theory of comparative costs and hence the neoclassical explanations of exchange rate determination can only maintain the claim of balanced trade by implicitly assuming that real wages are automatically adjusting to the requirements of international trade (ibid.). The social determination of wages via wage bargaining is eliminated by assuming it away. Yet, in contrast to the failure of delivering evidence for the PPP model, the classical approach to explaining real exchange rates and trade imbalances by relative production costs finds considerable empirical confirmation (Martínez-Hernández, 2017; Sarich, 2006; Shaikh, 2016, pp. 522–535). Even though trade imbalance does not have a direct effect on nominal and real exchange rates, the exchange rate obviously has an impact on trade. A weaker currency ceteris paribus entails growing export demand

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and shrinking import demand. This is in line with all exchange rate theories. However, it is not a priori clear whether the Marshall‒Lerner condition holds (see Blecker & Setterfield, 2019, pp. 468–470). The condition states that the quantity effect of growing exports and decreasing imports exceeds the price effect of imports becoming more expensive. The Marshall‒Lerner condition must be fulfilled for the trade balance to effectively improve after a currency devaluation. Whether or not it holds in reality is in fact hardly possible to assess, because the exchange rate is not the only factor which influences the trade balance. Income effects must also be taken into account (Harvey, 2007, p. 160). A country’s imports grow with domestic output, while exports increase with economic growth in the rest of the world. A currency devaluation has a direct influence on domestic economic performance, which itself has an impact on imports. This additional effect may strengthen the isolated reaction of the trade balance to the depreciation. But it may also go in the opposite direction, depending on whether the depreciation weakens or strengthens domestic investment and employment. The latter again have an impact on wages and productivity growth, themselves exerting an influence on relative prices. Changes in absolute cost advantages further influence exports and imports. On the other hand, domestic economic performance may not react significantly as long as exchange rate changes are not so large that imbalances in trade and balance of payments may last for a long time. In general, a trade surplus contributes to a positive current account. A favorable balance of payments helps to reduce external debt or accumulate foreign reserves. The capital account tells us to what extent a country is an international debitor or creditor and hence either owes or claims foreign interest payments. As derived above, international interest payments have an influence on the nominal exchange rate. It is via this channel that international trade still has an impact on a currency’s strength. Yet, this result is far from the statement of the PPP model saying that trade and exchange rate have a mutual equilibrating influence. Exchange rate fluctuations have numerous reasons and as such they can have various consequences. Domestic economic growth may react positively or negatively to a depreciation or appreciation. The resulting effects on income and production costs then may either increase current account imbalances or smooth them. Additionally, investors observe past and current economic outcomes and hence build expectations. According to those expectations, they make investment decisions in the foreign exchange market, which again gives way to a large set of effects on the exchange rate and macroeconomic variables. The relationships between nominal exchange rates, real exchange rates and international trade are indeterminate. They may trig-

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ger continuous fluctuations without there being any inherent equilibrium (see for instance Nicolini-Llosa, 2016). The connections identified in this analysis can be used to investigate a certain economic situation. Individual assessment of each case is necessary, because in the real world there is no general automatic force which restores equilibrium in foreign exchange markets, trade balances and current accounts. The neoliberal proposition of free trade, which refers to a self-equilibrating trade balance, stands on wrong assumptions. Free trade by no means eliminates absolute cost advantages (Shaikh, 2016, p. 513). This is particularly true because nominal exchange rates do not simply behave in a way to equilibrate relative prices. The notion of “terms of trade” expresses the same ratio as relative prices or, respectively, the real exchange rate. However, it is often used in a different context and valued differently. When a country experiences a real depreciation, it is caused by a change in relative prices inducing a gain in competitiveness (which may or may not also come together with a change in the nominal exchange rate). Improved competitiveness brings about a long-term advantage to the country. In contrast, the same real depreciation, when the notion of the terms of trade is used, is denoted as a “deterioration in the terms of trade” (see for instance Saadi, 2012, pp. 623–624). So, how can the same change in relative prices be considered as both positive and negative at the same time? Even though it is usually not emphasized with the clarity that would be required, the different conclusions rely on different assumptions. The real exchange rate as analyzed here is defined by real production costs and internationally equalized profit rates, thus generating the close link between relative production costs and relative prices. Yet, a price change may have a different origin than altered production costs (Sarich, 2006, p. 477). For the domestic economy, it is obvious that prices can be influenced by both demand and production costs (Kaldor, 1976, p. 705). The same is valid for relative prices in international economics. For example, it may be the case that demand for commodity exports of one country are very high, while demand for manufactured exports of another country stagnates. The opposite tends to turn out when the commodity boom is over and relative demand for exports alters. In the boom phase, the commodity-exporting country enjoys increased export returns because the price change is not a competitive one but caused by high demand. If the price increase was due to higher production costs and hence a loss in competitiveness, the country’s export revenues would fall, because the reaction would be a fall in demand for those commodities. Whenever a rise in a country’s price level relative to another country or relative to the rest of the world is denoted as an improvement in the

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terms of trade, the expression points to a shift in relative demand which is in favor of the country’s export returns. The base of such a phenomenon is a price structure which is different from the classical analysis of relative prices as determined by relative production costs. The key point is the following: a favorable shift in relative demand, while production costs remain unaltered, means that the exporting firms enjoy a higher profit rate. This means, however, that profit rates are not equalized internationally. This is why such an imbalance in relative demand basically cannot last forever. The high profit rate attracts new capital to the respective sectors. Production of those goods increases. The easing of supply constraints lowers the price and contributes to the tendency of profit rate equalization across countries. The tendency of profit rates to equalize drives relative prices to their long-term level, which is determined by relative production costs. Three qualifications should be made at this point. First, the time scale within which the process of profit equalization materializes is uncertain. This may particularly be true when the price of an export good is not brought to the original level just by growing supply. For example, commodity prices are also influenced by financial investment in the futures market. Speculative price movements in the futures market may raise a price for a considerable time despite relaxing supply constraints in the spot market (see for instance Oberholzer, 2017). This means that favorable terms of trade for a country may last for a long time. Second, to the extent that attraction of new investment in export sectors enjoying favorable terms of trade leads to the expansion of employment in the country, wages may increase. The long-run effect thus could be that the demand-induced price increase turns into a cost-triggered one. The same happens via the nominal exchange rate. The profit-rate differential triggers a nominal appreciation via the foreign exchange market. It raises relative prices of the country to the extent that it affects relative production costs. Third, the equalization of profit rates may be impeded in certain sectors. In particular, many commodities face supply constraints. Those constraints can be absolute, as is the case for some fossil energy sources or minerals (whether or not these constraints are close to current production levels is a different question). But they may also be relative, in the sense that demand can be accommodated by growing production, but only at higher production costs because the remaining production sites are less productive. In such a case where supply is restricted, profit rates may remain high. The reason for this is that profits do not just arise from production but also consist of rents. The market price in this case is determined by the production site with highest production costs. Rents, as defined in classical economics, cannot be equalized by competition

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between capitals (see for instance Marx, 1894/2004, pp. 602–788; Ricardo, 1821/2001, pp. 39–50; Smith, 1776/1976, pp. 160–275). Whenever the terms “real exchange rate” or “terms of trade” are used, the underlying forces driving their change should be considered carefully. A rise in a country’s terms of trade may be good for a certain time if driven by demand but might also be the expression of a competitive deterioration.

4.2 INSTRUMENTS TO CONTROL THE EXCHANGE RATE Currency areas, and hence countries in most cases, have an interest in a stable exchange rate. Uncontrolled exchange rate fluctuations have many implications which jeopardize macroeconomic stability. First, as described above, a change in the nominal exchange rate affects the price level through altered relative prices of imports. Moreover, workers bargain for higher wages in the case of a depreciation, while in the case of an appreciation firms want to lower wages in order to regain international competitiveness. Hence, a depreciation raises the inflation rate, bringing about potential instability and allocation problems. Exchange rate appreciation, on the other hand, tends to give way to deflation and economic contraction. Second, exchange rate volatility entails a revaluation of external debt. For an externally indebted country, a nominal depreciation (appreciation) implies an increase (decrease) of foreign debt in terms of the domestic currency. For countries which are foreign creditors, the opposite applies, so that they benefit from a depreciation while suffering a loss from an appreciation. Third, altered exchange rates affect the balance of trade and may give rise to growing imbalances. As far as the balance of payments is concerned, it may further raise the international debtor or creditor position of a country. Fourth, exchange rate changes affect income distribution in the domestic economy and thus may give rise to expanding or contracting dynamics depending on the wage-led or profit-led character of the growth regime (see for instance Ribeiro et al., 2017, 2020). At first sight, exchange rate instability seems to be ambiguous in its impacts. A depreciation may be bad for foreign debt, but strengthen net exports (see Rodrik, 2008). Yet, exchange rate fluctuations have further consequences for macroeconomic performance. For example, a growing export surplus may not even be sufficient to cover the increased weight of external debt. In order to service foreign liabilities, firms may constrain investment expenditures while banks might retain profits and contract lending activities in order to deleverage their balance sheets. The

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result is economic contraction (see also Blecker & Razmi, 2008). In the opposite case, where a depreciation pushes effective demand via improved export performance, the good economic outcome may be at the cost of a neighboring country. It might be that the country which experiences an appreciation is concerned by the opposite effects. Repercussions would reach back to the country through international links of trade and capital flows. A clearly unambiguous result of exchange rate fluctuations is their allowance for speculation in the foreign exchange market. Speculative transactions can give rise to fluctuations in the exchange rate which are completely unrelated to the trade patterns between economies. Moreover, a volatile exchange rate increases uncertainty in economies, which may constrain investment spending, the consequence of which is deteriorating economic performance. For developing countries, the impacts of exchange rate fluctuations are all the more important because they are specifically prone to capital flight, which is perhaps the most extreme case of exchange rate depreciation. Additionally, they are usually externally indebted (World Bank, 2018b). Resource-rich countries may be the exception as their current account tends to be positive in times of economic booms. But those countries are even more exposed to exchange rate volatility because the current account depends on the price pattern of a few or even a single commodity (see for instance Bruno et al., 2011; Pérez Caldentey & Vernengo, 2010). To the extent that, for example, a depreciation implies a competitive advantage, or an appreciation contributes to the fight against inflation, a country may also benefit from changes in the exchange rate. Hence, an exchange rate does not have to be fixed forever. Yet, to exploit any advantages of currency appreciations or depreciations, they have to take place in a controlled manner. If they are not controllable, they are likely to occur in the wrong moment. Moreover, they tend to be self-enforcing when they are accompanied by currency speculation. In the end, the bad effects dominate. This results in deflation in case of an appreciation, and a banking crisis in the course of continuous depreciation since the banking system of a country can no longer bear external debt service. This relates to the problem termed the “original sin” by Eichengreen et al. (2005), where countries, notably developing countries, which have to borrow in foreign currency, face the problem of exchange rate fluctuations. The latter give rise to output volatility, thus triggering further exchange rate changes. Higher currency instability, among other effects, raises risk perceptions of foreign creditors and thereby increases risk premia.

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Floating versus Pegged Exchange Rates In the economic mainstream, two main alternatives of exchange rate regimes are presented. Accordingly, exchange rates can either be floating or be pegged to a currency of a certain anchor country. In the free-floating regime, monetary policy does not intervene, such that the nominal exchange rate is exclusively determined by market forces. In the second regime, the central bank intervenes by purchasing or selling foreign currency reserves in the foreign exchange market. An extensive research literature investigates the advantages and disadvantages of each alternative. Exchange rate pegging can provide a country with important benefits (Mishkin, 1998, pp. 82–84): inflation can be controlled because the prices of imported goods do not fluctuate as a consequence of an altered currency valuation. By means of this “nominal anchor,” inflation expectations can also be smoothed in the rest of the domestic economy. Moreover, since monetary policy has to credibly follow the requirements of the exchange rate peg, it cannot be used for short-term growth objectives. According to the monetarist view, expansive policy would only result in higher inflation without raising output in the long term, because there is no trade-off between the two. It is also argued that a pegged exchange rate increases the volume of trade between two countries, thus allowing for output specialization (Lee & Shin, 2010). Yet, exchange rate pegging is not without problems. There are arguments in favor of free-floating (for a summary see Mishkin, 1998, pp. 84–87). First, a country whose currency is pegged to that of an anchor country loses its monetary policy independence, because policy tools cannot be employed towards the demands of the domestic economy but have to be devoted to maintaining exchange rate stability. Second, economic shocks in the anchor country are directly transmitted to the domestic economy because for the stable exchange rate to be guaranteed, domestic monetary policy has to follow the actions of the anchor country’s central bank on step. Third, the exchange rate peg can be subject to speculative attacks. For instance, traders may bet on a falling exchange rate and sell domestic currency. The central bank has to purchase it and thus is forced to release a growing amount of its foreign reserves. If the reserves are insufficient to sustain speculative pressure, the currency devaluates. Currency reserves are lost, while the weight of the country’s foreign debt increases. It may be that the mere anticipation of a future abandonment of the peg triggers capital flight and makes it even more difficult to defend the exchange rate target (see for example Sivramkrishna, 2016, p. 88). With regard to speculation, it is thus especially the introduction and the exit of a peg

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which may trigger additional capital movements and volatility. Fourth, market-driven currency depreciation may be an important warning signal of overly expansive monetary policy. Exchange rate pegging eliminates this indicator. Fifth, when exchange rate pegging is used to prevent a currency appreciation, the exchange rate does not react to capital inflows. In a floating regime the appreciation would slow down capital inflows because the chance of a subsequent depreciation increases. With a pegged exchange rate there is no inherent limiting force to capital inflows. The growing volume of capital may create booms and bubbles possibly ending in a financial crisis (Mishkin, 1998, p. 89). Finally, exchange rate pegging, especially in its strictest form as a currency board, limits the central bank’s role of the lender of last resort (ibid., pp. 93–94). Exchange rate stabilization may aim to prevent a banking crisis. By doing so, however, monetary policy cannot support banks whose lending is contracting due to external debt or due to withdrawal of deposits by customers. Short-term lending would jeopardize the maintenance of the exchange rate target. This argument is a specific form of the loss in monetary policy independence from external conditions. Developing and emerging countries are particularly exposed to foreign exchange risks and therefore also to exchange rate pegging. Compared to industrial economies, their shares of short-term debt and debt denominated in foreign currency are larger (Eichengreen et al., 2005; Mishkin, 1998, pp. 88–89). Moreover, they often have histories of high exchange rate volatility and inflation. At the same time, foreign currency reserves tend to be less, which makes developing countries vulnerable to speculative attacks. The discussion of the trade-offs between free-floating and pegging seems to reveal that there is no definite solution to the issue of exchange rate volatility. Pegging ensures stability with regard to external debt in terms of the domestic currency, inflation control and reduction of uncertainty. However, it bears new risks in the form of transmission of external shocks, speculative attacks, loss of independent monetary policy, bubbles due to unlimited capital inflows, and large shocks to the economy once the peg can no longer be maintained. While certain neoclassical claims on issues such as the basic role of monetary policy and its limits regarding price stability are to be questioned, it goes without saying that neither one of the proposed exchange rate regimes can guarantee an optimal outcome. The free-floating regime is generally considered to be the one where monetary policy autonomy can be maintained, in contrast to the pegging regime. Indeed, the central bank can use its central tool, the interest rate target, to employ it to the benefit of the economy. However, any monetary policy action is likely to have an impact on the nominal exchange rate, and

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thus on imported inflation, the current account and external debt. From this it follows that even in a free-floating regime the central bank cannot just target domestic economic performance in the way it would in a closed economy. Therefore, monetary policy is not completely independent. In other words, it is hardly possible for a country to let its exchange rate fluctuate by too large an amount as the macroeconomic costs of uncontrolled exchange rate volatility are likely to be high, as explained. If the central bank does not fix this by means of a pegging regime, it will at least exert a stabilizing influence by setting the interest rate target accordingly. In the middle to long term, a country cannot have an interest rate level diverging too far from those of other countries it is interlinked with. This is even more true for developing countries and their small economies, which are more vulnerable to exchange rate fluctuations than industrial countries. Data reveal a strong positive correlation of policy interest rates in different countries independently of whether they have floating or pegged exchange rates, thus confirming the emerging dominance of “intermediate regimes” or “managed floats” (Guzman et al., 2018, p. 58; Ilzetzki et al., 2017; Mohanty, 2014, pp. 4–5). Capital Controls As an additional tool to stabilize the exchange rate while avoiding some of the disadvantages of exchange rate pegs, capital controls can be applied. They aim to set certain obstacles to currency convertibility in order to prevent, or slow down, sudden capital inflows and outflows and avoid “sharp changes in the bull‒bear sentiment from overwhelming market makers (Davidson, 2006c, p. 183). As can be seen from the factors determining exchange rates, capital flows from one currency area to another one – be they triggered by interest rate differentials, profit rate differentials or speculative expectations – affect the relative strength of a currency. Moreover, as international payments, they give rise to the phenomenon of monetary duplication. Those duplicated deposits in the country receiving the capital flows are likely to create a lending boom and a financial bubble (see Schmitt, 2014, p. 56). The bubble may trigger a financial crisis once the boom is over. Likewise, the country may end up in a currency crisis once capital flows out of the country as fast as it had flowed in. Capital controls aim to limit exchange rate volatility. The less domestic currency can be purchased or sold in the foreign exchange market at a time, the less exchange rates vary. And accordingly, the less the central bank has to intervene by selling or purchasing foreign currency reserves. In the same vein, by preventing fast capital inflows and outflows, capital controls aim to reduce instability in a country’s financial market.

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The baseline of neoclassical economics is general equilibrium and efficient markets. Despite certain disagreements regarding the pace of financial liberalization, capital controls are generally considered as obstacles preventing market efficiency (see for instance Rogoff, 2002). Moreover, they are criticized for suffering from poor implementation and circumvention in many cases, as well as facilitating corruption (Mishkin, 1998, p. 91; Rogoff, 2002). Since the financial crisis, however, the stance towards capital controls has become more differentiated. In part of the recent literature using general equilibrium models, a case is made for capital controls under specific assumptions (see for example Benigno et al., 2016; Bianchi, 2011). Yet, a further fundamental criticism of capital controls regards the neoclassical view of the relationship between exchange rates and international trade. Trade imbalances eliminate themselves, because they trigger a change in relative demand for currencies which devaluates the currency of the deficit country, thus rebalancing trade. Capital controls may prevent the exchange rate from finding the equilibrium level required to achieve balanced trade. Such exchange rate manipulation violates trade rules and diminishes support for free trade (Jeanne, 2012, p. 205). Moreover, trade integration requires financial integration (Rogoff, 2002). Restriction in capital flows also constrains payments in inter­ national trade and thereby restricts free trade itself. In other words, if the current account is to be liberalized, the capital account should be so as well. Once markets are not considered as complying with general equilibrium and balanced trade, capital controls can be justified for their contribution to financial stability. The literature admits the at least partial ability of capital controls in directing capital flows (see for instance Binici et al., 2010; Jeanne, 2012, pp. 203–204; Klein & Shambaugh, 2015; Rodrigues van der Laan et al., 2017). Their effectiveness may be due to the different forms they can take (Bortz, 2016, p. 165): for instance, unremunerated reserve requirements where an investor who buys stocks or bonds is forced to hold a deposit in an unremunerated term account; minimum stay periods; or prohibition of certain types of investment. Taxing capital inflows, as applied by Brazil between 2008 and 2013, is another version of capital controls (Rodrigues van der Laan et al., 2017). Different measures may be appropriate in different circumstances. Besides reducing exchange rate volatility and financial fragility, capital controls still allow for independent monetary policy, so that the latter can be directed towards the needs of the domestic economy. Representing an additional tool, they provide economic and monetary policy with an additional degree of freedom (see Ghosh, 2005). In contrast, with a pegged exchange rate, monetary policy is engaged with maintaining an exchange

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rate target and cannot be used for different purposes. However, despite obvious advantages, capital controls leave several gaps open. First, they can reduce the challenges of exchange rate fluctuations resulting from sudden capital inflows and outflows, but they cannot eliminate them. Complete control would require complete blockage of those capital flows in excess of what international trade requires. In reality, it is hardly possible to distinguish these flows. On the one hand, there are the flows as part of the balance of trade. They are indispensable. On the other hand, there are external loans, bonds and foreign direct investment unrelated to trade. In addition, there are further capital flows such as speculation in the foreign exchange market. While some of these transactions do not have an impact on the exchange rate, as they are balanced by offsetting loans or bonds, others do affect the value of the currency. Capital regulation may differentiate by excluding, for instance, foreign direct investments because they are used for productive investment. This was the case in recent capital controls in Brazil (Rodrigues van der Laan et al., 2017, p. 210). But this may even be the case for short-term flows, too. Even though often being of a speculative nature, they might nevertheless be indispensable in a given situation as they provide the foreign currency to finance a negative current account. Since perfect fine-tuning to the requirements of exchange rates, trade and financial markets is not possible, the regulating authority needs to apply capital controls generous enough to prevent significant damages to economic activity. However, this allows the possibility of exchange rate fluctuations and financial bubbles, even if to a more limited extent. Second, in extreme situations, the introduction of capital controls can be a challenge. Any explicit or implicit information of its implementation would trigger capital flight as investors and depositors anticipate the coming restrictions. Capital controls would induce what they aim to prevent. The same objections apply to the exit from capital controls. If it comes too soon, it entails strong exchange rate fluctuations. If strict capital controls, which have been employed in an extraordinary situation, are removed too late, costs in terms of lost output are the consequence. The third concern is perhaps the most relevant one. International payments are the source of monetary duplication, whether the financial flows are speculative or required to settle trade. Capital controls should not prevent the latter. This implies, however, that they are powerless against bubbles building up from deposit duplicates. If trade imbalances last for a sufficiently long time, those duplicates build up and are likely to exert either upward or downward pressure on a country’s currency, even if capital controls reduce the number of transactions in the foreign exchange market.

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4.3 CONSTRAINTS IN FACE OF INTERNATIONAL COMPETITION The fact that an individual country is exposed to international competition sets boundaries to its development path. Fluctuations of the exchange rate, loss of foreign currency reserves, external debt and the balance of payments are essential macroeconomic issues that need to be taken into account by any development strategy. If they get out of control, macroeconomic costs in terms of inflation, recession, stagnation and poverty can grow high. This section considers the most important problems and challenges in economic literature that a developing country faces with regard to the rest of the world. Thereafter, the SFC model examines the limits of economic policy in more detail. The Balance-of-Payments Constraint In a world of endogenous money, there are no limits to debt. Yet, as is already clear from model a), leverage cannot grow to infinity without causing higher risk premia on interest rates and bankruptcy. There is no difference in this when a whole country is considered. If external debt grows too high, exchange rate depreciation, inflation and potentially a banking crisis are the consequences. Such is the threat of the “original sin” that externally indebted countries face. Therefore, the current account has to be balanced in the long term in order to maintain a stable exchange rate and to control external debt. Since domestic economic growth induces higher imports due to rising incomes, it deteriorates the trade balance and, ceteris paribus, the balance of payments. For this reason, the requirement of a balanced current account limits the affordable economic growth rate of a country. From this constraint, rules known under the notions of “balance-of-payments-constrained growth” and “Thirlwall’s Law” can be derived (Thirlwall, 1979, 2002, 2013). Thirlwall (1979; Thirlwall, 2013, pp. 88–94) starts from the long-run condition of an equilibrium in the balance of payments. Exports depend on growth in the rest of the world, while imports depend on domestic growth. Moreover, both exports and imports are influenced by the real exchange rate. The importance of each factor is empirically given by the respective price elasticity or income elasticity of export demand and import demand. These elasticities determine the extent to which changes in relative prices or in internal and external growth rates impact the balance of payments. An increase in the real exchange rate, which is tantamount to a loss in competitiveness, raises the growth in income that is still compatible with a

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balanced current account. This is due to imports being cheaper for domestic consumers. So with the income elasticity of import demand given, a higher growth rate is allowed before a current account deficit occurs. However, a real appreciation also lowers export demand. If exports fall and imports increase by a sufficient amount, they ceteris paribus entail a current account deficit. Under this condition, the balance-of-payments constrained growth rate falls with a real appreciation. In accordance with real exchange rates being determined by relative production costs, the latter would have to fall in the domestic economy so that the existing growth rate can be maintained while keeping the current account balanced. To the extent that production costs are reduced via wage cuts, domestic demand is reduced. Hence, while the balance-of-payments consistent growth rate increases, actual growth may decline.3 Most effective relaxation of the external constraint is to come about through falling production costs by productivity growth. With the real exchange rate given, the growth rate consistent with balance-of-payments equilibrium depends on the relation of the incomes elasticities of exports and imports (Thirlwall, 2013, pp. 92–94): the higher exports are, the higher the domestic growth rate can be for corresponding imports to still be consistent with a balanced current account. Hence, with economic growth in the rest of the world given, the domestic balanceof-payments constrained growth rate is the ratio of income elasticity of export demand to income elasticity of import demand. The growth rate increases in the former and falls in the latter. The basic version of Thirlwall’s law (see Thirlwall & Hussain, 1982) can be extended by allowing for capital flows. This means that the mere consideration of the trade balance is extended to the current account. Exports are not the only source of foreign currency inflows. Capital may flow into the country as foreign direct investment, portfolio investment or financial transfers (Thirlwall, 2002, pp. 74–76; Vera, 2006). Since they provide the economy with foreign currency reserves, the balance-of-payments constraint is relaxed. More imports are allowed with the current account still balanced. The growth rate consistent with balance-of-payments equilibrium is thus higher, too. However, short-term flows do not only relax the constraint but may radically restrict it suddenly once capital flight sets in. On the other hand, foreign currency may not just be spent on imports but also on interest payments. Any existing debt thus restricts the balanceof-payments consistent growth rate (Thirlwall, 2013, pp. 107–108). It can be shown theoretically and empirically that even if capital inflows are stable and sustainable regarding their affordability, their positive impact on growth is limited (McCombie & Thirlwall, 1997). In the long term, developing countries’ economic growth is constrained

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by external conditions. Foreign debt and the exchange rate have to be kept under control so that development can take place in the long term. On the other hand, those restrictions limit economic growth. Demand-led growth can be considered according to the demand components. In the closed economy, a distinction has already been made between wage-led and profit-led growth (see for instance Onaran & Galanis, 2012). Higher wages contribute to growth via higher consumption expenditures, while higher profits tend to promote investment expenditures.4 Despite their different characters, they share a common feature from an international point of view. They both raise demand for imports. Due to the balance-of-payments constraint, such a growth strategy may have tight limits. Relaxing factors such as capital inflows allow for a higher growth rate but at the same time are quite dangerous under such a kind of demand-led regime because they raise future external indebtedness. This is unequivocally the case for consumption while investment at least lays the base for potential future exports. This leads us to the third variant of demand-driven growth. Higher growth entails more imports. As follows from Thirlwall’s law, a high growth rate can only be guaranteed in the long run if exports increase sufficiently (Hussain, 2006, p. 27). Export growth is the means to relax the balance-of-payments constraint on domestic demand. Exports are the third source of demand for a country. In contrast to the other demand components, it does not deteriorate but rather improves the balance of payments and the external constraint (León-Ledesma, 2006, p. 84). Export-led growth is the key to promoting domestic growth and controlling external debt. It may also be achieved through import substitution, that is, by shifting resources to sectors with a high income elasticity of export demand and away from sectors with high income elasticity of import demand (Thirlwall, 2013, p. 98). To the extent that a country’s international competitiveness involves a nominal exchange rate appreciation, exchange rate stability can basically be ensured by intervening in the foreign exchange market (ignoring the undesired effects this can produce). The central bank would accumulate foreign reserves. From the perspective of a single country, export-led growth relieves the domestic economy from external restrictions. Export-led growth tends to be related to profit-led growth. For export goods to be internationally competitive, production costs must not be too high, which requires a certain restriction of wages. This result is derived from the classical analysis of real exchange rates (see section 4.2) and is also supported by new developmentalism (see Bresser-Pereira, 2016, p. 339). The latter’s strong emphasis on a competitive exchange rate points to the high relevance of the wage level for growth dynamics.

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Yet, export-led growth can neither resolve all challenges nor remove all constraints. Export-led growth may be driven by productivity growth entailing a competitive advantage. However, productivity progress requires investment. Most likely, those capital goods need to be imported. Therefore, poor countries are in need of imports for development (Cencini & Schmitt, 1991, p. 71). The purchase of capital goods may result in a trade deficit, thus involving a balance-of-payments disequilibrium. Productivity gains in the long term thus might be prevented by the external constraint in the short term. Alternatively, the competitive advantage might be realized by wage cuts; which, however, comes at the cost of contracting demand in the domestic economy. As any macroeconomic view easily shows, export surpluses of one or several countries mirror corresponding deficits of other countries. The relaxation of one country’s balance-of-payments constrained growth via export surpluses is the tightening of the same constraint for another economy. While employment grows in the surplus countries, it falls where deficits are incurred. The advantage of one country involves “equal disadvantage to some other country” (Keynes, 1936/1997, p. 338). As shown by the example of the euro crisis, macroeconomic stability is seriously jeopardized. For an individual developing country, global macroeconomic dynamics are necessarily exogenous factors and may not influence it in its policy strategy. Naturally, its own contribution is negligible at a global scale. However, there may also be direct consequences for a country or a whole region to exclusively rely on exports. In Thirlwall’s law, income elasticity of demand for exports is a given parameter. Exports of an individual country may be absorbed by the rest of the world even if exports grow over time. However, the export-led development strategy may meet its limits if a sufficient number of developing countries targets the same export sector and if the world economy’s income elasticity of demand for goods of that sector is low, resulting in a kind of “fallacy of composition” (Arestis & McCombie, 2006, p. 4; Blecker & Razmi, 2008, 2010). In this way, countries may end up with decreasing export returns and overcapacity in the export sector. Such dynamics were a contributing factor to the Asian crisis in 1997 (Erturk, 2001). Today, developing countries face new export constraints because global growth is low (McMillan et al., 2017, p. 35). Another challenge many export-oriented developing countries have to struggle with is the phenomenon generally known as the “Dutch disease.” Theoretically elaborated for the first time in Corden and Neary (1982), the problem focuses on the impact that a change in the terms of trade can have on parts of a country’s export sector. In an economic boom, a country may feature strong foreign demand for one of its export goods, mostly a commodity. The resulting price increase signifies an improvement in the

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economy’s terms of trade. What appears as a favorable situation, as it allows the country to run a current account surplus, entails major challenges for the rest of the export sector. The surplus gives rise to a nominal and therefore a real appreciation of the exchange rate. Moreover, the wellperforming sector attracts foreign capital. Both factors trigger demand for the domestic currency in the foreign exchange market. Additionally, current account surpluses raise domestic monetary income and thereby inflation, thus further inducing real appreciation. The appreciation harms all other export sectors that do not face increased demand. They suffer a competitive disadvantage and are no longer able to export their goods. Only deflation would bring relative prices of those sectors back to their original level. Exchange rate pegging may help, while involving the wellknown undesired consequences. The Dutch disease may particularly arise from export orientation where countries, and notably developing countries, focus on one sector. Export of commodities is the easiest way to earn foreign exchange. The strategy is in line with Ricardo’s theory of comparative advantage as, by exporting agricultural and mining produce, developing countries focus on the sector they are best at. While a commodity boom favors developing countries in many regards, gains may only be short-term. First, the countries are exposed to volatile commodity prices. Second, the real appreciation harms the performance of manufacturing industries, which can have lasting consequences because it impedes the long-term development of productivity in those industries (see for example Ocampo et al., 2017). A well-known example of a Dutch disease effect is China’s economic growth and corresponding demand for commodities, which improved the terms of trade of the commodity-exporting countries in Latin America while at the same time contributing to the deindustrialization of the continent (see for instance Bruno et al., 2011). The new developmentalism approach considers the Dutch disease as an essential, if not the most important, obstacle to growth for developing countries. Instead of tracing back the disease merely to currency appreciation during commodity booms, it argues that commodity orientation involves a permanent, although varying, overvaluation that is supported by high interest rates to attract foreign capital, turning a country into a rent-seeking economy (Bresser-Pereira, 2018). As another weakness of export-led strategies, economic growth is restricted by development in the rest of the world. If the world economy stagnates or international trade is concentrated on the trade of advanced economies among themselves, exports are unlikely to contribute to the development of a country (Bortz, 2016, p. 173). Hence, while persistent current account deficits sooner or later trigger a financial crisis, giving way

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to bankruptcies and currency devaluation, persistent surpluses may be a promising pattern for a single country under favorable circumstances. But export-led growth also involves instabilities and growth limits. A longterm development strategy thus should focus on both external and internal demand components (see Blecker & Razmi, 2010, p. 393). Additionally, and crucially, any effective growth regime also faces a policy constraint. Policies which want to promote development in growth either via a domestic demand or an export regime rely on appropriate strategies such as public investment, described in the previous chapter. They need to ensure that both growth engines ‒ that is, effective demand and profitability ‒ are in place. Since the market is not able to accomplish this task alone, political intervention is required. However, any policy measure that threatens profits of the private sector including rich individuals can easily give rise to capital flight. Whether the anticipation is right or not, the effects of capital flight restrict any scope of action for economic policy. Long-term growth and productivity progress would benefit from policy. But it is not only that economic development is restricted by the balanceof-payments constraint. Effective policies to push economic growth are punished by capital flight and set the external constraint even tighter. Assessing the Importance of International Trade Before closing this section, let us see whether international trade can contribute to solving the problem of the external constraint, and whether it plays such a catalyzing role as proponents of free trade claim. Questions about the political economy of the structure and design of trade arise. Even though it is an intensely discussed point on the international policy agenda, it is not so often embedded in the domestic and international financial structures that have been analyzed here. Mainstream economics usually stresses the welfare gains from trade liberalization to make everybody better off (see for instance Nash & Mitchell, 2005). Productivity increases because free trade allows efficient firms to expand, while less efficient companies disappear; higher productivity results in lower prices, thus benefiting particularly the poor (IMF et al., 2017, pp. 19–23). The main arguments have been presented in Chapter 1. Ricardo’s principle of comparative advantage provides the theoretical background. Free trade allows completely market-led resource allocation. International exchange of goods and services is considered as a general equilibrium situation where the trading partners are two endowment economies. Since both economies are supply-determined and thus operate at full employment and full capacity utilization, the exchanged goods are just assumed as given. The only impact on the supply constraint is

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exerted by productivity spillovers, as all goods of a certain sector now are produced according to the most advanced knowledge. Specialization and division of labor in a Smithian manner provide the rationale as, for instance, in Borland and Yang (1992). Any deviation from the general equilibrium solution represents a distortion. Liberalizing trade therefore guarantees that international trade is balanced as predicted by the PPP model (see for example Harvey, 2007, p. 150). Trade between monetary spaces can be considered an exchange economy even from a heterodox point of view. Therefore, the efficiency argument of free trade appears better grounded than within a monetary space where mainstream economics relies on the supply-determined equilibrium while ignoring the fundamental macroeconomic principles. However, exchange at an international level does not take place in an isolated space. It is influenced by the monetary economies of production in the national economies, and exerts influences back on them. The national economies determine what the export sectors’ endowments in international exchange actually are. Now that macroeconomic principles, the role of the public sector, the limits faced by open economies and the explanation of exchange rates have been introduced in this book, it becomes clear where the issue of international trade should be located: it is a very important element of economic activity. But still, it is one element among others of at least equal importance. Hence, there is no rule that trade should be liberalized in any case in the sense of a universal economic principle. Instead, it should be regulated in a way to serve countries’ needs; that is, to best meet external constraints as well as the internal state of development. Thirlwall (2013, pp. 118–119) points to the fact that policies should be implemented such that net trade performance relaxes the balance-of-payments constraint in order to maximize the sustainable growth rate. There is no guarantee that growth can be maximized by liberalizing trade, because liberalization may raise imports while only having a limited positive impact on exports. Indeed, empirical evidence of the success of free trade is mixed, as has been discussed in Chapter 1 (see for instance Dowrick & Golley, 2004). Neoclassical theory, by means of purchasing power parity, assumes that the domestic economy automatically adjusts to the requirements of international trade by making the price level, and therefore production costs and real wages, consistent with external balance (Shaikh, 2016, p. 514). In reality, however, there is no such equilibrating force because relative production costs may not converge for a long time. Therefore, as has been shown, real exchange rates may involve persistent trade imbalances. Free trade would generally be the best solution if national economies behaved the way they are supposed to by mainstream theory. Since this is not the case, free trade is merely one option among other, more regulated, trade regimes.

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The economies of production within the monetary spaces of currency areas are the eventual source of wealth creation. Hausmann et al. (2007) provide evidence that countries which export processed goods exhibit better economic performance than those exporting primary goods. The structure of international trade thus should be designed according to the needs of those production economies rather than the other way around. For example, tariffs on imports may be an appropriate instrument to raise the balance-of-payments constraint such that domestic growth can be maximized. Since developing countries usually face competitive disadvantages due to lower productivity, their real exchange rate tends to incur them trade deficits. While free trade proponents argue that openness maximizes welfare provided by existing supply of goods, there is no definite explanation as to how it can contribute to productivity development. It has been shown countless times that today’s industrial countries protected their infant industries from international competition as long as productivity, and thus production costs, was not ready for the global market (see for instance Chang & Grabel, 2004, pp. 10–12). Arguing that free trade improves productivity thus reveals that advanced economies may gain at the cost of developing countries due to initial differences in production costs. This may be an improvement in welfare in the short or middle term. In the long term, however, developing countries lose the opportunity to develop their own manufacturing industries. As Chang (2006, pp. 33–34) argues, the theory of comparative advantage tells us where the countries currently are; but it does not say anything about where these countries may potentially be in the future. Considering the economy as being supply-led obscures the view of its dynamically evolving character. According to free trade theory, optimality is achieved if developing countries export what they are best at, that is, primary goods. Yet, such optimality also implies that the potential is exhausted. With free trade, developing countries are likely bound to remain commodity producers for an indefinite time. A specific proposal to relax the external constraint and create an opportunity to compete internationally despite initial disadvantages is suggested by new developmentalism. It applies to situations of overvaluation caused by the Dutch disease. Neutralization can take place via different ways, of which the conventional one is lowering domestic interest rates (Bresser-Pereira, 2020, p. 639). Alternatively, tariffs may be set on imports of manufactured goods, while manufacturing exports are subsidized. This would restore their competitiveness. A possibly more efficient instrument is a tax imposed on the exports of the commodities that cause the currency overvaluation (Bresser-Pereira, 2018). Demand for the commodities

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would fall, but be re-established by the resulting exchange rate depreciation maintaining their price in foreign currency at the original level. Such measures would open the space for industrialization. In general, developing countries are in need of tariffs to develop productive industries whose manufactured goods can replace or complement commodity exports. An appropriate design of protection is key. On the one hand, it is obvious that poor countries require access to internationally traded (investment) goods in order to raise their level of technology. On the other hand, too much protection may hamper productivity development in infant industries and create new inefficiencies. In South Korea, for example, the focus on the world market was an explicit policy instrument to force sectors to improve on efficiency and technology implementation (Chang, 2006, pp. 37–40). Yet, tariffs meet their limits as a policy instrument at a level where a country starts being harmed by tariffs of other countries. Liberalized trade has the potential to improve welfare. With relationships between industrial and developing countries being unequal, however, it is not the engine of an effective growth strategy. Once a productivity level similar to that of trading partner is achieved, a country may envisage a reduction of tariffs. In such an environment, the benefits of exchange and specialization between countries can unfold better.5 No Space for Economic Policy To sum up: developing countries, in search of economic growth to reduce poverty, are bounded by the external sector. Growth must not be too fast, to prevent trade and current account deficits; the exchange rate should be held stable to keep inflation and external debt under control; at the same time, countries need to develop productivity to foster output growth and international competitiveness. But, first, a strong growth strategy is usually not compatible with an equilibrated balance of payments. Second, economic policy, be it redistribution or public sector investment, may trigger capital flight and give rise to a currency crisis, a banking crisis and a surge in inflation. The international economy also clearly reveals the limits of modern monetary theory, particularly for developing countries (see Bonizzi et al., 2019).6 Neither trade liberalization nor financial liberalization provide solutions to this problem. To the extent that liberalized trade incurs developing countries a trade deficit, the external constraint is even tightened (see for instance Pacheco-López and Thirlwall, 2007). The same applies to financial liberalization. While capital inflows relax the constraint, sudden outflows compress it, thereby increasing macroeconomic instability. Exchange rate pegging may give counterbalance in such a situation.

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But with limited foreign reserves, many developing countries are powerless against capital outflows. Moreover, even if successful, exchange rate targeting produces potential disturbances in the domestic economy, mainly due to uncontrolled capital flows and the (at least partial) loss of monetary policy autonomy. Capital controls reduce exchange rate volatility to some extent, but cannot make it completely unhappen. Yet, in the long run, neither exchange rate pegging nor capital controls can relax the balanceof-payments constraint. Likewise, neither one of those instruments can avoid monetary duplication as the origin of exchange rate fluctuations (see also Cencini & Schmitt, 1991, p. 86) Avoiding such prospects by forcing a country on an export-led growth path may be successful, but could entail imbalances at a higher level. Moreover, it constrains development to the dictate of demand from the world economy, which may grow but may just as well stagnate. Growth driven by domestic demand components is again subject to the balanceof-payments constraint. Export booms themselves may provide a country with foreign currency reserves for a while. But the surpluses may also be a sign of a long-term obstacle to the economy’s productivity in cases where exchange rate appreciations produce Dutch disease effects. Tariffs on traded goods may be a way to relax the balance-of-payments constraint, and necessary to develop domestic manufacturing. But while they may be part of the solution, they also bear potential risks. Additionally, they do not provide the government with a means to effectively control capital flows and exchange rate fluctuations. It seems that whatever strategy a developing country chooses, undesired consequences harm the result and prevent effective poverty reduction. The next two sections present the extended SFC model where the economy is opened up to the rest of the world. The effects of monetary policy and active economic policy on output will reveal the limits any country faces. The model does not account for exchange rate pegging, capital controls or tariffs. They could partially reduce the observed effects, but not eliminate them (while sometimes triggering new ones). For the sake of a simpler analysis, the focus is on the fundamental mechanisms that a country is confronted with on its development path.

4.4 MODEL C): LIMITS TO ECONOMIC POLICY IN THE OPEN ECONOMY Submodel b) of our SFC model reveals the effectiveness of active economic policy as public intervention. Yet, the effects are simulated with the assumption of the economy as a closed system. Once the model is opened

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up to the rest of the world, it has to be seen whether economic policy can still be effective. The changes implied by the opening of the economy are analyzed in submodel c). The economic structure of submodel b) is put into the context of a globalized world. In model terms, we have the domestic economy as opposed to the rest of the world. The latter is referred to as the external sector. It will be seen that an open economy implies numerous complications and limits the space of action for a government to implement active economic policy. This comes through changes in the flows of goods and finance. Economic policy can no longer be made in an isolated space. In particular, the model shows the channels through which the external sector has an impact on domestic policy. First, the central bank is no longer able to set the interest rate target completely independently from the interest rate level in the rest of the world. Second, government expenditures such as investment affect the trade balance and thereby also the balance of payments. External indebtedness can affect the banking system, the producing economy, the public sector and potentially even private households. However, since there are limits to the level of affordable debt especially for private sector agents, there is also a limit to domestic demand. Moreover, growing external debt leads to a depreciation of the domestic currency in the foreign exchange market. Currency depreciation makes existing interest payments in foreign currency more expensive and hence gives way to further external debt and continuous depreciation. On the other hand, a weaker currency again entails a certain improvement in the trade balance via increasing exports and declining imports. But since foreign debt weighs heavier when the domestic currency depreciates, a growing share of the revenues arising from a possible trade surplus is used for external interest payments. An indebted economy cannot enjoy a part of its output because it is needed to fund debt service. Model c) thus reveals the many complex aspects of the external constraint, which hamper economic growth and poverty reduction in developing countries. Two new simplifications, which were not relevant in the closed-economy cases, are introduced now. First, population growth is neglected. Total labor is assumed to remain constant. Population growth, such as caused by immigration, could potentially be added in a further extension of the model. Second, remittances are ignored, too. They are an important kind of social transfer in developing countries. Another extension of the model could reveal the impact of an economic shock in the country where the remittances originate in the balance of payments and domestic growth (see also Le Heron & Yol, 2019). Submodel c) is a further extension of the baseline model and consists of 84 endogenous variables explained by 84 equations. Speaking in model

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terms, the rest of the world is added in the form of an additional agent. Total output now consists not only of domestic consumption, investment and inventory changes, but also of exports. Likewise, imports add to the goods for which domestic income is spent. The numeration of the model equations follows the logic of submodels a) and b). Only equations which are either new or need to be modified from the preceding models are shown in this section.7 Imports and Exports Firms now not only sell produced output to domestic consumers but also export part of it. Inventories are still the residual being left after sales. But their calculation needs to be adjusted as follows: ΔINF 5 YF 2 CF 2 IF 2 EXF (2’)



with EXF being the amount of goods exported by private firms. Note that the assumption about the public sector’s inventories still holds. Hence, total stock changes divide into a private component and a public component according to their respective shares in total output. Once government inventories are thus determined, the sale of public consumption goods is still given by total public output minus investment and the change in inventories. However, to assess domestic consumption, public exports, EXG, have to be deducted as well: CG 5 YG 2 ΔING 2 IG 2 EXG(51’)



Similarly to inventories, firms’ profits are now formed under consideration of exports. They are still the difference between sale revenues and production costs and taxes. However, this can no longer be represented by simply setting total private output equal to returns. Output contains exports, which are paid and valued in foreign currency. Exports thus need to be adjusted by the exchange rate, ER, expressing the ratio of domestic to foreign currency, whereas the other components of output, that is, domestic consumption, investment and inventories, are measured in domestic currency. Profits from public sector production are defined in the same way except that there are no taxes. Therefore, hitherto equations (3’) and (52) become:   PF 5 CF 1 IF 1 ΔINF 1 EXF*ER 2 WF 2 rLN,21*LNF,21 2 TF (3’’)

PG 5 CG 1 IG 1 ΔING 1 EXG*ER 2 WG 2 rLN,21*LNG,21(52’)

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The multiplication of exports by the exchange rate shows the logic of proper accounting in the model. All model variables are expressed in terms of the domestic currency at the current price level. By correcting exports by the exchange rate, they are translated from foreign into domestic currency. Expressions in domestic currency are monetary but, nonetheless, the correct measure of real quantities by definition of the model. A change in the exchange rate ceteris paribus does not alter the amount of exported goods. However, due to the increased cash flow, profits increase. They are expressed in domestic currency and measure the claim on a certain amount of goods measured in domestic currency. This is why exports are not corrected by the exchange rate in equation (2’) where the change in inventories is assessed. There it is about goods in the physical sense (despite them being expressed in the monetary terms of the domestic currency). Since exports impact profits of domestic firms, which affects their investment decision, the model incorporates an aspect of the virtuous and vicious growth cycles, as in the Kaldorian export-led cumulative causation model where exports are the main driver of demand and growth (Blecker & Setterfield, 2019, Ch. 8; Kaldor, 1970a). Yet, such self-enforcing growth is restricted by the balance-of-payments constraint, as will be shown below. Exports of both the private sector and the public sector are influenced by economic performance in the rest of the world. The higher is economic growth in the external sector, the higher is demand for goods from the domestic economy. Second, a higher exchange rate, which signifies a weaker domestic currency, gives rise to an increase in exports. It should be noted that the real exchange rate instead of the nominal exchange rate is relevant here. The domestic currency may be weak in nominal terms, but if the domestic price level is high compared to the price level in the external sector, exports are still expensive for foreign purchasers. On the other hand, the exchange rate might appreciate, but as long as inflation is lower in the domestic economy than in the rest of the world, exports may still remain competitive. In this regard, the model thus broadly follows the tradition of Dixon and Thirlwall (1975) that admits significant relevance to the exchange rate for exports. Private and public exports are thus given by:

EXF 5 ηF, 1 *YR 1 ηF, 2 *RER(66)



EXG 5 ηG, 1 *YR 1 ηG, 2 *RER(67)

ηF, 1, ηF, 2, ηG, 1, and ηG, 2 are sensitiveness parameters signifying the degree to which exports react to changes in external output, YR, and the real exchange rate, RER. However, they are not fixed. For if they were, there

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would be no possibility for the respective shares of private and public exports in total exports to change. In reality, YR and RER determine the amount of total exports, but do not say anything about how those are divided into its private and public components. Just as in the case of inventory accumulation, we assume that export shares are determined by the respective shares in total output. Exports are influenced by productivity growth as a second component. Higher productivity relaxes the export constraint even when there is generally no growth in the rest of the world. A^0 denotes total growth in productivity since the starting point of the model. The more productivity increases, the more the country is able to export goods. This is supported by two main arguments. First, productivity development in a country usually goes along with an increase in the variety of its products. Thus, it can gain access to more and different markets and sectors in the rest of the world.8 The model thus allows for the impact of non-price competitiveness (see also McCombie, 1989, p. 611). Second, higher productivity means lower production costs. For the external sector, imported goods from that country serving as input material to production processes lowers their production costs to some extent, too. Lower real prices of imported goods and lower production costs imply an increase in the external sector’s productivity. The latter has a positive impact on growth. This impact may be invisible due to its infinitesimal size at the global level. However, it can be of considerable importance to the country whose export goods have become cheaper because additional global demand is directed to the domestic economy’s exports. In sum, the spillover of productivity growth strengthens exports:

η F,1 5

YF * (η11 1 η12*A^0) (68) Ytot

ηF,2 5 ηG,1 5

YF * η (69) Ytot 2

YG * (η11 1 η12*A^0) (70) Ytot

ηG, 2 5

YG * η2  Ytot

(71)

where η1, η2, η11 and η12 are fixed parameters. This means that government’s production has the same propensity to export out of its output as the private sector does. One may also imagine an export-led development strategy where the government specializes in the production of export goods, hence

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having higher parameters η1 and η2 implying a higher export propensity. For now, the assumption of equal export propensities is sufficient. The sum of CF and CG is still what is sold to workers and capitalists for consumption. There is no adaptation of the corresponding equation needed. However, their interpretation changes slightly in the sense that they no longer represent total consumption but only domestic consumption goods, which are sold to domestic consumers. The latter may spend part of their income for import goods. For this reason, workers’ and capitalists’ consumption expenditures have to be renamed as follows:

CW, tot 5 (1 2 sW) * (Wtot 1 rD,21*DW,21 1 G 2 TW) (17’’)



CCap, tot 5 (1 2 sCap) * (PCap 1 rD,21*DCap,21 2 TCap) (20’’)

where CW, tot and CCap, tot are the respective shares of incomes spend for consumption that were formerly called CW and CCap, respectively. Notably, they are consumption expenditures in the proper sense of the word. CW and CCap in model b) denoted monetary expenditures but they also expressed the physical quantity of purchased goods (expressed in domestic currency). In model c), CW, tot and CCap, tot also contain the purchase of import goods, which have to be paid in foreign currency. Exchange rate changes affect import prices in terms of the domestic currency. A weaker currency makes imports more expensive, such that given consumption expenditures buy less import goods. CW, tot and CCap, tot as defined in equations (17’’) and (20’’) thus mean consumption expenditures in monetary terms, but do not express how many physical goods can be purchased as this depends on imports and the exchange rate. The composition of total workers’ and capitalists’ consumption expenditures is then straightforward:

CW, tot 5 CW 1 IMW * RER



CCap, tot 5 CCap 1 IMCap *RER

with CW and CCap, as in model b), representing consumption of domestic goods. IMW and IMCap are workers’ and capitalists’ respective consumption of import goods. They denote import goods in their physical sense. But since they are traded in foreign currency, they have to be translated into domestic currency by multiplication with the real exchange rate. Again, the amount of import goods that consumption expenditures can buy depends not only on the nominal exchange rate but also on the foreign price level compared to the domestic price level. Since total consumption

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expenditures are already defined in equations (17’’) and (20’’), the above equations are reformulated such that they express consumption expenditures for domestic goods:

CW 5 CW, tot 2 IMW *RER(72)



CCap 5 CCap, tot 2 IMCap *RER(73)

Import goods purchases of workers and capitalists are influenced by two main factors. First, we assume that there is a certain propensity to import out of income. This is analogous to the assumption that exports depend on the output, and thus income, of the rest of the world. There are goods which are not produced in the domestic economy and hence need to be imported. Growing income allows for growing imports. As the above equations show, we say that when workers and capitalists receive their respective incomes, they first decide on the saving rate and then on the division between expenditures for domestic goods and for imports. The second influence factor is again the real exchange rate. The more expensive import goods are, the less consumers purchase them:

IMW 5 μ1 *CW, tot 2 μW, 2 *RER(74)



IMCap 5 μ1*CCap, tot 2 μCap, 2 *RER(75)

where µ1, µW, 2 and µCap, 2 reflect the sensitiveness of the respective influence factors. While µ1 is a fixed parameter that does not require further specification, µW, 2 and µCap, 2 are varying parameters. The reaction of total imports of workers and capitalists to a change in the real exchange rate again depends on the share of the respective total expenditures in total output. Hence:

μW, 2 5 μ2 *



μCap, 2 5 μ2 *

CW, tot Ytot

(76)

CCap, tot Ytot



(77)

where µ2 is a fixed parameter. Trade Balance, Balance of Payments and Exchange Rate Up to here, the model has defined the equations that describe international trade. It is difficult to assess whether an exchange rate depreciation

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improves the trade balance, that is, whether the Marshall‒Lerner condition is fulfilled. It is not only that imports and exports react to a change in the real exchange rate. They involve a change in effective demand, employment, wages, profits, price level, and eventually output and income. Income again impacts on expenditures and hence on exports and imports. Moreover, the condition may be fulfilled in the short term but not in the long term, or vice versa. And finally, an improving trade balance does not necessarily imply a better balance of payments, as will be shown. The trade balance is an accounting equation which does not follow any predetermined path. Variables such as the exchange rate impact the trade balance through various channels without there being a definite sign of the total effect. We define the trade balance variable as the difference between imports and exports, which is total net imports. From the perspective of the rest of the world, it is the net exports of the external sector, EXR. The amount of money to be paid for an imported good depends on the nominal exchange rate and on the foreign price level. Hence, imports have to be multiplied by the real exchange rate. In contrast, exports yield a return which depends on the nominal exchange rate but not on the foreign price level. Multiplication of exports with the nominal exchange rate is therefore correct. Net imports or, respectively, net exports of the external sector represent the net amount of domestic income going abroad for the purchase of goods. Since international trade is in foreign currency, EXR has to be multiplied by the nominal exchange rate. The trade balance thus is given by:

EXR *ER 5 IMW *RER 1 IMCap *RER 2 EXF *ER 2 EXG *ER

By dividing by ER in all terms, we can simplify the equation to:

EXR 5 IMW*PLrR 1 IMCap*PLrR 2 EXF 2 EXG(78)

with PLrR defining the ratio of foreign to domestic price levels. The result arises because the real exchange rate is the nominal exchange rate ­multiplied by the relative price level, PLrR:

RER 5 ER *PLrR(79)

The determinants of the nominal exchange rate are crucial factors influencing the trade balance. Different exchange rate theories have been introduced and criticized. An appropriate analysis of exchange rate determination requires taking account of the macroeconomic principles

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and particularly of the endogenous nature of money. We follow the argument of quantum macroeconomics (Cencini, 2005, pp. 181–184) arguing that external imbalances give rise to speculation in the foreign exchange market, where supply and demand for bank deposits determine the price of currencies. Foreign deposits are in fact what are commonly denoted as foreign reserves. Demand for foreign currency is driven by interest payments on external debt, LNR. The higher the interest due, the more foreign funds need to be raised in order to service debt. Furthermore, if expected returns on capital are higher (lower) in the rest of the world than in the domestic economy, capitalists are more (less) prone to make investment in the external sector. Demand for foreign currency deposits thus depends on the profit rate in the domestic private sector compared to the foreign general rate of profit, which is approximated by the interest rate level in the rest of the world, rR. When domestic expected profits are higher (lower) than external interest rates, demand for foreign reserves falls (rises). A similar consideration is made with regard to interest rates. When the level of domestic interest rates is higher (lower) than in the rest of the world, demand for foreign currency decreases (increases). Finally, there may also be speculative shocks and waves in the foreign exchange market. They may be due to random noise but also be caused by speculative bubbles in booming markets. Or they may be a reaction to economic policies. For instance, as introduced right at the beginning of this book, when a country announces new directions in economic policy, capital flight may set in. In particular, policies aiming to strengthen the public sector may induce private wealth to be transferred to other currency spaces. We thus model the speculative shock, Cspec, as an exogenous variable leading to an increase in demand for foreign currency. Summing up these influencing factors, demand for foreign reserves, DRes, is driven by five terms:

DRes 5 rR,21*LNR,21 2 σ1* ( prF,21 2 rR) 2 σ2* (rD 2 rR) 1 Cspec

where σ1 is a parameter measuring the share of debt, which needs to be renewed in each period; σ2 and σ3 denote the respective importance of relative profitability and relative interest rates. One may argue that the fourth and fifth term of the equation signify more or less the same thing. It is true that they are related. But, as has been seen, depending on monetary policy and economic policy programs, the profit rate may move in line with the risk-free interest rate but it may also go in the opposite direction. Moreover, it is reasonable to assume that the third and fourth term already contain speculative elements. But those possible speculative

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impacts are bound to pure profit considerations and do not account for risk considerations such as political changes. The latter can be replicated by the speculation term. Demand for foreign deposits is accommodated, conditional upon abundance of those deposits. However, since they are not unlimited in contrast to loans, suppliers require a higher price when demand increases. Hence, foreign deposit holders are willing to exchange those deposits against deposits in domestic currency, if they consider the exchange rate to be favorable. Supply of foreign reserves, SRes, is thus higher, the higher the exchange rate. A higher amount of SRes requires a depreciation of the domestic currency, the amount of which depends on the parameter σ’3:

SRes 5 σr3 *ΔER

By logic of exchange, supply and demand in the foreign exchange market are always equal. Solving for ∆ER yields:   ΔER 5 σ3* (rR,21*LNR,21 2 σ1* ( prF,21 2 rR) 2 σ2* (rD 2 rR) 1Cspec ) (80) where σ3 is defined as equal to 1/σ’3. The formula looks more complicated than it is. The five determining factors are still as explained above. To get from the nominal to the real exchange rate, the explaining factors of the relative price levels have to be analyzed. The domestic price level has already been derived in model a). Yet, in the face of the external sector, it has to be complemented by an additional component. Namely, the external price level, PLR, has an impact on the domestic price level to the extent that domestic production uses imported goods as inputs in the production process. Higher import prices imply higher production costs and thereby transmit to higher output prices. The most familiar example in this regard is an increase in oil prices. Imports as material inputs are ignored in this model. But they are covered implicitly as we consider exports of the private and public sectors as exports net of imports used in production. The impact of the foreign price level is measured by the pass-through parameter β5. Foreign prices are translated into domestic prices by multiplication with the nominal exchange rate. This means that a currency depreciation has the same impact on the domestic price level even when foreign prices remain stable. The domestic price level is thus assessed as follows:9 PL 5 β1* (CU21 2CUref ) 2β2*ΔIN21 1 β3*w21 1 β4*LNF,21*rLN 1 β5*PLR,21*ER 21



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(32’)

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The price level in the external sector is calculated in an analogous way. However, we take economic performance in the rest of the world as exogenous. PLR may still vary, but not due to variables defined in this model. The ratio of price levels thus is given by:

PLrR 5

PLR  PL

(81)

The real exchange rate is determined by relative price levels. Let us assume that capacity utilization fluctuates around its normal rate while the change in inventories is stationary in the middle to long term. Moreover, we assume that the interest rate is stable or, alternatively, that its difference to the external rate does not exceed a certain range. The impact of the external price level on the domestic price level does not fundamentally alter relative prices since it makes both price levels move in the same direction. These assumptions may be too strict in the short run but are reasonable over the longer term depending on the empirical values of the parameters. Once they are accepted, we see that the price levels in both the domestic economy and the rest of the world are given by real wages relative to productivity, which is tantamount to unit costs of production. Hence, relative prices are the result of relative real production costs. In this sense, real exchange rate determination in the model is in line with the classical analysis in Shaikh (2016, pp. 508–535). In an open economy, external debt becomes a potentially very important source of finance. Whenever there is a deficit in the current account, the domestic economy has to run into external debt in order to balance external payments. The analytical part of this chapter argues that foreign direct investment can potentially play a quite important role on the development path of an economy. For simplicity, however, this model is limited to external debt and hence excludes foreign direct investment (FDI). In each period, and under the assumption that the nominal exchange rate is stable, the change in total external debt is the sum of the trade balance of that period and the interest payments due on hitherto existing external debt. These two components describe the current account. If, however, the exchange rate fluctuates from one period to the next, previous external debt is revalued in terms of the domestic currency. This particular effect can potentially have a large impact on total external debt, which is measured in domestic currency. A currency depreciation raises the weight of external debt, implying that the country needs to export even more in the future to repay external debt. When the currency appreciates, the domestic economy has to export less in the future. Hence, currency appreciation in this case is a kind of export. The total change in external debt is given as follows. A trade deficit

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raises indebtedness to the rest of the world. Interest payments on external debt have to be funded out of returns from exports. If there is no export surplus, interest due inevitably adds to external debt. Interest in foreign currency thus ceteris paribus adds to foreign indebtedness. Notably, all terms containing the variable LNR have to be corrected by the nominal exchange rate to express them in domestic currency. This is necessary to bring it in line with the overall model in order to express the balance of payments correctly:

ΔLNR*ER 5 EXR*ER 1 rR,21*LNR,21*ER

The equation can be simplified by dividing each term by ER, thus yielding:

ΔLNR 5 EXR 1 rR,21*LNR,21(82)

This balance of payments is simplified but without any loss of generality. It assumes that all capital inflows and outflows assume the form of debt, which is either loans or bonds. However, capital may also flow in and out as foreign direct (dis-)investment as just mentioned. The higher the share of the capital account covered by FDI, the lower the share of external debt and interest payments. Yet, what the country thereby does not have to pay to foreign investors as interest still tends to flow out of the country. Foreign direct investment earns a profit from domestic production, which is thus not owned by domestic residents. External debt and FDI thus are similar in this regard. Moreover, short-term capital flows are also part of the balance of payments. However, they do not contribute to real investment but rather to financial bubbles. Since they flow in and out according to differentials in profit rates and interest rates as well as capital flight movements, they disappear as fast as they have flowed in as soon as differentials change their sign. Since financial markets are not modelled explicitly here, it is justified to keep them out of the balance of payments without sacrificing the essential economics. Long-term and short-term capital flows are a function of the terms in equation (80). This is how they affect the exchange rate. Thus, even though the balance of payments is itself kept simple, those effects on the exchange rate are properly taken into account. The Banking System in the Open Economy Obviously, external balance becomes part of the domestic banking system. An external debt is, ceteris paribus, created when the domestic economy imports more than it exports, or when interest payments due on external

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debt are not matched by at least net exports of the same amount. In both cases, there is insufficient reflux of income in foreign currency that could be used for the required payments to foreigners. When domestic firms are granted a loan to finance production, they have to sell output for loan repayment. If part of output is sold to the external sector, returns in foreign currency are exchanged against domestic currency via the banking system so that credit can eventually be paid back in just the same way. As a consequence, an external deficit means that sales at home are insufficient because consumers spend their income abroad so that the credit circuit cannot be closed. Alternatively, it might mean that consumers get consumer credit that they use for the purchase of import goods. The banking system, analytically speaking, is granted a loan in foreign currency by the external sector, but also has a claim in the form of non-repaid loans in domestic currency on its asset side. In any case, the accumulation of external debt is mirrored by the accumulation of debt of the same amount in the domestic economy. For this reason, the balance sheet of the banking system is still exactly balanced when external liabilities are taken into account. Banks’ profits thus basically are again the sum of interest revenues on loans granted minus the sum of interest due on liabilities. This consideration is complete as long as the exchange rate is stable. However, the ­possibility of exchange rate fluctuations has to be considered. If the domestic currency depreciates (appreciates), external debt accumulated in previous periods suddenly weighs heavier. Banks incur a loss or at least a reduction in profits. On the other hand, the same currency depreciation raises domestic wealth if the domestic banking system is a net creditor to the rest of the world. So banks’ profits from conventional lending business are modified to the following equation. Moreover, there is a source of extra profits (or extra losses), PB, extra, arising from exchange rate changes: PB 5 rLN,21* (LNP,21 1LNG,21) 2 rD,21* (DW,21 1DCap,21) 2rR,21*LNR,21*ER

(28’’)

PB, extra 5 2LNR,21 * ΔER(83)

It goes without saying that total bank profits are the sum of PB and PB, extra. There is an essential change in the banking system once the economy is opened towards the rest of the world. Banking still plays a rather passive role by granting loans to finance production and administering savers’ deposits. In models a) and b), at a given interest rate level, banks have a guaranteed profit rate provided by the differential between lending and

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deposit rates. This is no longer the case in model c). First, the interest rate level in the rest of the world, rR, is exogenous from the perspective of the domestic economy.10 The domestic interest rate differential may still allow for profit, but if the average domestic interest rate level is sufficiently below the external rate, interest on external debt ceteris paribus contributes to a loss. Second, exchange rate volatility may also contribute to lower bank profits or even net losses via revaluation of external debt. Banks may behave in an accommodative way with regard to credit demand, and they may also not be too engaged in investment banking in sophisticated financial markets. Such a structure of the banking system is simplistic, but it is actually true that most developing countries do not have highly developed financial markets. Yet, this does not at all imply that banks are also passive with respect to the profitability of their business. They rather aim to keep profitability of an average loan at a level corresponding to the interest rate differential d. This means that they have to adjust the way they set market rates of interest. This is why we adjust the interest rate system in the following way: the central bank is, in principle, still able to achieve a general interest rate level in line with the target rate. But whereas we set the central bank rate equal to the deposit rate in submodels a) and b), it is now equal only to the average rate of the banks’ liabilities. The difference is that previously there was merely one rate on the liability side, namely the deposit rate, rD. Now, there still are deposits but possibly also external debt on the banks’ liabilities side. In such a case, there are two rates, that is, rD and rR. The average rate of both rates is called ṝD, the expression signifying the modification from the previous model a). The average is calculated by taking the respective shares of domestic deposits and external debt in total liabilities as weighing factors:

rD 5 rCB(84)

In an open economy, banks’ assets are domestic loans but potentially also external loans in the case of a favorable balance of payments. The former yield the loan rate, rLN, the latter yield rR. These two rates are the components of the average loan rate, ṝLN . It is also weighted according to the respective shares of domestic and external loans. Banks aim to achieve an average loan rate which allows them to realize the interest rate differential that they were guaranteed in the closed economy. Therefore, the average loan rate is higher than the average liability rate by d:

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External debt and the external interest rate threaten banks’ profits. But since they are exogenous, banks can only re-establish profitability by altering interest rates that they require for domestic loans and those they pay for domestic deposits. To achieve the required profitability, they set rLN and rD according to the following formula:

,

LNR*ER BS , *rR b * rD 5 arD 2   with LNR 5 max (LNR,0) , BS BS2LNR*ER  (26’) rLN 5 arLN 2 

LNR*ER BS , *rR b *   with LNR 5max (2LNR,0) , BS BS2LNR*ER (27’)

where BS denotes the total balance sheet of the banking system. BS is a measure of the size of the balance sheet and can thus be assessed by summing up all assets or all liabilities. The derivation of the two formulae can be found in Appendix IV b). When LNR is smaller than zero, the economy is a creditor to the rest of the world, so that the banks’ liability side consists , only of domestic deposits. This means that LNR in equation (26’) is zero. As a result, rD 5 ṝD. If LNR is greater than zero, ṝD is a weighted average of rD and rR; rD can be calculated according to the formula. The same applies to the asset side of the banks’ balance sheet. If the domestic economy is a net debtor, thus LNR being larger than zero, banks only grant domestic , loans. Setting LNR equal to zero in equation (27’), we get rLN 5 ṝLN. Again, if LNR is below zero, denoting net credit to the rest of the world, the average loan rate ṝLN is different from rLN due to the influence of rR becoming part of asset returns. Obviously, when the country is a net debtor and the monetary policy target (set equal to ṝD) is below the external interest rate level, banks have to set the deposit rate, rD, even lower in order for the policy rate to match the average rate. Since banks have to pay higher interest to the external sector, they lower the rate for domestic deposits to sustain the profit rate on average. Otherwise, they would incur a loss (or a reduced profit). On the other hand, in case of the country being a net creditor and the external interest level being above the domestic level, the rate on domestic loans is lower than it would be without loans to the rest of the world. Higher returns on external credit levy profitability above the level implied by the interest rate differential d. Competition makes banks reduce the rate on domestic loans to a level where profitability of the average loan corresponds to d. It is important to understand that the notion of the economy “only

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providing domestic loans” or “only having domestic deposits” is not a contradiction to the assumption that the economy is open towards the rest of the world. In fact, the notion “domestic” signifies assets and liabilities denoted in domestic currency. However, this by no means implies that they concern only domestic residents. A deposit in domestic currency can be held by a foreign resident, while a domestic loan can be granted to a foreign resident as well. But this does not impair the fact that they belong to the domestic economy. They were created by the domestic banking system and hence are inevitably a part of domestic double-entry bookkeeping. We see that once the banking system opens up to the rest of the world, the central bank can still target the general interest rate level. However, since the external rate enters the average rates of the banking system, domestic rates alter. Banks adjust them in order to sustain profits. Hence, despite the impact on average rates, monetary policy has limited control over domestic rates. The exact modeling regarding the relationship between domestic rates, external rates and the central bank rate is not essential. The relevant issue is that the influence of the external rate influences banks’ rate setting for them to maintain profitability. It will be seen in the simulation of model c) that in a globalized world, monetary policy is even more limited owing to the exchange rate. In the closed economy case of models a) and b), banks enjoyed profits guaranteed by the interest differential. To the extent that they did not retain any profit, bank equity would be exactly zero. In model c), banks adjust domestic rates in order to achieve the same interest rate differential on average. However, banks’ profits still are not guaranteed. As shown by extra profits in equation (83) above, total bank profits are also influenced by exchange rate changes. This means, by definition, that the change in equity is influenced by the size of retained profits from conventional banking but also by the change in the exchange rate. Hence:

ΔEQB 5 PUB 1 PUB, extra(30’)

If we assume that banks distribute all profits arising from conventional banking, the first term in equation (30’) is zero. If, at the same time, the country is indebted to the external sector and the currency depreciates in the considered period, the second term is negative. Equity decreases in this period, and if total equity is negative, the banking system is bankrupt. To prevent this, banks retain a part of profits arising from the lending business, thus giving rise to a positive value of PUB. The same happens when the currency appreciates while the country is a net creditor to the rest of the world. In this case, extra profits are also negative. On the other hand, if the country is a net debtor (creditor) while the currency appreciates

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(depreciates), there are positive extra profits. Banks may even consider distributing more than the profits earned from conventional banking. Hence, PUB would be negative. Finally, only the wealth equations have to be modified. First, the banking system’s wealth is to be corrected by external debt. Second, the external sector’s wealth is given by its loans to the domestic economy measured in domestic currency:

VB 5 LNF 1 LNG 2 DW 2 DCap 2 LNR*ER(36’’)



VR 5 LNR*ER(86)

The total wealth equation does not change, because wealth of the external sector consists in only financial assets and liabilities instead of real assets.

4.5 THE EFFECTS OF MONETARY AND ECONOMIC POLICY IN THE OPEN ECONOMY To see how international trade and financial flows impact the effectiveness of development policies, we simulate the effects of policy instruments in submodel c). The parameters from previous models are unchanged at first, while the new parameters are again set according to economic theory. We assume that output of the rest of the world remains constant. This may be considered unrealistic, but nevertheless does not miss the point to be made here. Our interest is in the impacts of certain policy measures compared to the baseline rather than the baseline itself. Moreover, the external rate of interest is assumed to be constant, too. Initially, it is equal to the domestic deposit rate and hence also equal to the minimum profit rate. However, we say that foreign productivity does not stand still but grows linearly with a corresponding impact on the relative price level. Otherwise, any productivity-enhancing domestic investment would improve the competitive position compared to the external sector and thereby would logically depreciate the real exchange rate. A trade surplus would be the inevitable result. Yet, in reality, the rest of the world as a competitor works on improving its productivity as well. Additionally, the trade balance is zero before the policy shock occurs. The same is assumed to hold for external debt and foreign currency reserves in the banking system. Both nominal and real exchange rates are stable. Again, this initial equilibrium state is defined just to test the isolated impact of policies.

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Monetary Policy Effects We start with expansive monetary policy again, where there are neither government expenditures nor public sector production. It will be seen that with parameters unchanged, a decrease in the interest rate is quite effective. However, closer analysis will reveal that in order to match the reality of the open economy, certain parameters have to be adjusted. This will illustrate the limits of monetary and economic policy in a globalized world. Figure 4.2 shows the macroeconomic effects of the central bank interest rate being reduced by one percentage point in 2004. Obviously, the effects are less linear and more complex than in the closed economy. At the beginning, the lower interest rate means a profit rate above its referential minimum rate. Hence, firms start investing, as shown in panel a). Employment and output increase correspondingly (see panels b and c). The impact on productivity and wages is as before. However, income growth also means growing imports. Therefore, a trade deficit emerges as exhibited in panel d). A trade deficit necessarily implies that the economy is accumulating external debt, which is plotted in panel e). External debt results from the fact that domestic firms cannot sell all their output. A part of the income formed by the wages they pay to workers is spent abroad. As a consequence, effective demand is dragged down. As soon as this effect becomes strong enough, investment expenditures are cut back, as can be seen from panel a). Output starts stagnating while employment even falls a bit. However, there is an additional effect, which becomes ever stronger until it dominates other effects: as can be seen from panel f), the nominal exchange rate increases, thus signifying a depreciation of the domestic currency. This is caused by several factors arising from the exchange rate equation (80). First, the accumulation of external debt raises demand for foreign currency or, to be precise, for foreign deposits, due to interest payments. Second, the domestic interest rate level now is lower than the external level, which triggers capital outflows. For now, we assume any speculative attack to be absent in the foreign exchange market. Exchange rate depreciation improves the trade balance, which turns into a surplus (see panel d). Increased external net demand is tantamount to higher effective demand faced by domestic firms. Hence, once sufficient currency depreciation has turned the trade deficit into a surplus, investment rises again. The higher profit rate is also supported by the beneficial impact of the weaker domestic currency. Any exported good priced by the currency of the rest of the world means higher profits for domestic firms since profits are measured in domestic currency. Growing employment and income raises imports again but the effect is weakened by the ever-increasing exchange rate.

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Figure 4.2  E  ffect of a 1 percentage point decrease in the interest rate on investment, employment, output, trade balance, external debt and exchange rate (parameters not adjusted) One may ask why the currency keeps depreciating even though the trade balance turns into surplus. The reason can be found in panel e). External debt caused by the initial trade deficit involves interest payments. The repayment of any external debt has to be funded by a future export

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surplus. As long as there is no trade surplus, any interest payment on past debt adds to the stock of debt. Therefore, external debt accumulates sufficiently so that the following trade surpluses help to prevent a further increase, but are not enough to lower the external debt stock. Growing debt towards the rest of the world means growing relative demand for foreign currency and hence continued depreciation. This is crucially supported by the fact that external debt from past periods measured in domestic currency weighs ever more in the course of depreciation. The same is true for interest payments. In other words, even though depreciation yields higher profits for domestic firms, it is not enough to compensate for the revaluation of external debt. The effect of nominal exchange rate depreciation is partially offset by higher inflation in the domestic economy relative to the rest the world.11 It is mainly due to higher prices of imported production inputs. However, this does not change the intuition of the analysis. Moreover, note that investment is finally stagnating while output growth starts slowing down, even though it is not yet clearly visible graphically, in the time window considered. Higher employment means higher wages. Firms can sustain it as long as currency depreciation raises the profit rate up to some point where the latter starts curbing. In this simulation, the domestic economy grows but an increasing share of it is used to service external debt. The more the domestic currency depreciates, the more goods have to be exported to pay one monetary unit of interest on foreign debt. Currency devaluation and rising external indebtedness imply that living standards do not increase despite economic growth, thus representing a case of “immiserizing growth” (Bhagwati, 1958). Figure 4.2 reveals the result of the open economy if we leave all parameters unchanged. What we observe is growth in the trade surplus, external debt and the exchange rate. The result shows what happens when the external constraint is violated. However, for this outcome to materialize, agents in the economy would have to be willing to accumulate debt to infinity. Let us consider in some more detail how debt is formed. Whenever the domestic economy has a favorable balance of payments, its revenues from exports and foreign interest returns exceed its expenditures for imports and foreign interest payments. Since all deposits in a currency area can only be denominated in that respective currency, it follows straightforwardly that it is not the exporters or the domestic depositors who hold international currency. Instead, the deposits in foreign currency gained by the positive current account are exchanged against domestic deposits in the banking system. The banks’ asset side consists of foreign currency facing domestic deposits on the liability side.

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Table 4.1  E  ffect of a 1 percentage point interest rate decrease on the balance sheet of the banking system (parameters not adjusted) Assets Loans to firms Bank equity

   Liabilities 22.0 10.6

   Domestic deposits    External debt

 6.3 26.3

On the other hand, if there is a current account deficit, domestic agents exchange domestic deposits against foreign currency in order to pay for net imports and interest payments. For the banks to be able to provide foreign currency, they have to reduce their reserves or become indebted towards the external sector. In our case where initial foreign currency reserves are assumed to be zero, the second option applies. In this case, the asset side of the banking system balance sheet consists of domestic loans that are outstanding because a part of the income they created has been used to pay for imports and interest payments. Since a corresponding amount of domestic goods remains unsold, a part of loans cannot be repaid. On the other side of the balance sheet, liabilities consist of external debt owed by the banking system. From Figure 4.2 we know that external debt accumulates despite a growing trade surplus. Let us see what the balance sheet of the banking system looks like at the end of the considered period, that is, in 2025. Table 4.1 depicts the components of the asset side and the liability side. The values result from model calibration and are mainly important with regard to their sign and hence their nature as assets or liabilities. We observe, first, that domestic firms become highly indebted. Part of this can be explained by domestic deposits saved by capitalists. The other part is explained by a part of external debt mirroring the unfavorable balance of payments. The second observation is banks’ equity turning negative. In reality, this means nothing but bankruptcy. The cause of negative equity is to be found in the revaluation of external debt in the course of currency depreciation. It entails negative extra profits, which cannot be compensated by the positive profits from conventional lending business. It is justified to ask why the interest payments to the external sector impact domestic firms’ indebtedness. As explained, the banking system is the external debtor, while firms’ debt is denominated in domestic currency. From this perspective, growing external debt should not bother firms. Its full effect should be on banks’ equity. Yet, such a consideration ignores the profit-seeking behavior of banks. As defined in the model equations, banks set interest rates such that, on average, profitability of conventional lending business corresponds to

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the interest rate differential d. Since external debt keeps growing, namely in terms of the domestic currency, foreign interest payments do likewise. To maintain profits, banks have to charge domestic loans with a higher interest rate. This is how external debt and external interest payments translate to domestic firms’ interest payments and eventually their stock of debt. The higher the external indebtedness of the economy, the higher are domestic lending rates to compensate for currency devaluation. This is one argument showing how monetary policy can be limited in its ability to influence the economy. It aims at lowering the interest rate level but results in higher domestic loan rates. The effect would be strengthened further if foreign lenders raise risk premia on loan rates the more debt grows. This additional effect is not taken into account by the model, yet without loss of generality. Overall, currency depreciation entails a contraction of domestic lending via increased lending rates. Obviously, this first model simulation cannot be the appropriate one. First, banks cannot allow equity to become negative. Second, firms on their behalf could justify their rising amounts of debt if investment gives way to capital stock growth that at least matches the increase in debt. However, additional real capital is only about half of firms’ debt and hence is far from justifying the latter.12 One would expect firms to let output stagnate at a certain level because the growing saving rate of capitalists drags domestic demand. The reason why firms keep raising production for a long time is the high profit rate and rising exports due to currency depreciation. As long as this effect is stronger than the counteracting impact of sluggish domestic demand, output grows. At the same time, firms’ debt grows owing to the domestic realization problem. In reality, it is clear that neither banks nor firms would accumulate net debt to infinity. Hence, facing debt problems, they would rather decide to retain a share of past profits in order to repay debt. For the next simulation, we therefore adjust both firms’ and banks’ parameters defining undistributed profits, xP and xB, respectively. Hence, both sectors retain a positive share of profits in order to control debt. With firms and banks retaining part of profits, the impact of expansive monetary policy is altered. The balance sheet of the banking system in Table 4.2 has now reduced in size and the debt positions look more bearable. Banks’ equity has turned slightly positive, which means that they are viable instead of going bankrupt. Firms are still indebted, but by a much lower amount. Moreover, the balance of payments has even become slightly positive, stating that the country has become a net lender to the rest of the world. Thanks to this fact, banks no longer face exponentially increasing external debt. Banks’ interest payments on the liability side remain controllable. Therefore, lending rates no longer have to increase

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Table 4.2  E  ffect of a 1 percentage point interest rate decrease on the balance sheet of the banking system (firms and banks retaining part of profits) Assets Loans to firms Loans to external sector

Liabilities 3.7 1.0

Domestic deposits Bank equity

4.4 0.3

as before, since banks’ profitability can now be sustained at lower rates. Monetary policy is effective again in the sense that the lower central bank rate transmits to the general interest rate level in the domestic economy. The behavior of firms and banks now is more realistic, which can be seen from the more stable balance sheet of the banking system. However, adjusted behavior, which takes into account the requirements of the open economy, comes with real macroeconomic consequences. In Figure 4.3, the same variables are plotted once again. When the central bank interest rate is cut, the higher relative profit rate entails growing investment (panel a). Accordingly, employment and output grow at first, which increases imports, giving way to a trade deficit (panels b, c and d). Domestic effective demand is thereby reduced such that capacity utilization falls below its normal rate. Firms’ loans remain partially outstanding because not all goods can be sold, due to a share of consumers’ income being spent for imports. Firms aim to repay those loans by not distributing all profits, which further reduces consumer income (that is, capitalists’ profit income) and thereby drags down effective demand. The decline in investment, employment and output lasts until imports decrease sufficiently. After the trade balance has turned positive, domestic effective demand improves and firms’ profit prospects increase again. This cycle repeats several times, with a slightly positive trend for employment and output. This is possible because debt control keeps the trade balance and the current account (panel e) more or less in balance in the long term and allows for a quite stable nominal and real exchange rate (panel f). The cycles fade out because the profit rate converges, though slowly, to the level of the new lower minimum profit rate. At the same time, the trade balance and the balance of payments slowly go back to their initial balanced level. Firms and banks retain parts of profits, which is motivated by their microeconomic perspective allowing them to control debt exposure. This is necessary in the open economy. However, it is not a modeling requirement but arises from agents’ behavior. Such behavior also has important macroeconomic effects in that the exchange rate, trade balance and

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Figure 4.3  E  ffect of a 1 percentage point decrease in the interest rate on investment, employment, output, trade balance, external debt and exchange rate (firms and banks retaining part of profits) current account can be kept stable. However, stable conditions imply that any increase in domestic demand which gives way to a trade deficit has to be eliminated for those stable conditions to be maintained. Otherwise, the domestic currency would depreciate. This would contribute to rising

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export demand but would at the same time involve inflation and growing external debt. This second model simulation of expansive monetary policy is more realistic than the first one. Yet, the first simulation has not been conducted in vain. The transition from the first to the second simulation precisely shows the policy limits ‒ that is, the power of the external constraint ‒ arising when the economy opens up to the rest of the world. A cut in the interest rate level has only quite small impacts on employment and output. In a globalized world, its contribution to poverty reduction is rather restricted. The regime of a pegged exchange rate is not explicitly modeled here. However, we can see what it would involve. As argued, a pegged exchange rate regime requires sufficient currency reserves. In the case of economic growth being larger in the domestic economy than in the rest of the world, as modeled here, the corresponding trade deficit would require central bank intervention to prevent currency depreciation. It is questionable how long the monetary authority could sustain it. Moreover, even if the exchange rate could be kept stable, the trade deficit caused by rising imports (themselves caused by growing income) would reduce effective demand in the domestic economy and raise firms’ indebtedness. The trade deficit would possibly be even larger because there is no export-stimulating and import-reducing effect of a weakening currency. Firms would likely take measures for debt control by retaining a share of profits. Thus, monetary policy would still be limited in its effectiveness. In general, economic theory tends to expect that expansive monetary policy supports economic activity in an open economy because it leads to a devaluation of the domestic currency and hence strengthens the trade balance. As the model shows, this does not necessarily happen immediately, because an exchange rate cannot simply be depreciated by raising the supply of money, as mainstream models often suggest. There are different counteracting effects. While the interest rate differential favors devaluation, increased domestic economic activity and profitability drive the exchange rate in the opposite direction. However, we can see that in the middle and long term of the first simulation, a depreciation actually takes place while the trade balance improves. In this sense, the Marshall‒Lerner condition is fulfilled over this term. Yet, economic growth stimulated by exports does not necessarily imply a positive current account. Imports are more expensive, and debt from past periods weighs heavier. Hence, a large part of net exports does not increase domestic wealth and thus does not contribute to higher living standards. Export returns, rather, have to be used to service external debt. Competitive devaluations might be effective in specific contexts depending

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on the magnitude of the relevant parameters. But their impact is clearly limited. To put it differently, their impact is prevented because nobody in the economy is willing to let debt, and notably external debt, get out of control. Indeed, it is the second simulation which shows the limited effect of expansive monetary policy in the open economy. Effects of Public Investment Now, what happens to economic policy in the open economy when the government wants to make public investment expenditures? We start with the initial assumptions again, meaning that neither firms nor banks retain any profits. Public sector output is neutral to the total economic structure in the sense that we assume foreign demand for public sector goods to be analogous to that for private sector goods. As before, we also act on the assumption that government profits are spent as social transfers to worker households. In 2004, the government starts to increase its growth target continuously to 8 percent. It raises its investment expenditures according to the gap between the target rate and the actual rate. In 2018, the growth target starts declining back to zero. In Figure 4.4, we see what happens to economic activity, notably in the private sector. In panel a), public sector investment increases when the growth target is defined and then remains positive during that time, signifying that actual growth remains below the target so that investment continues to be required. After the target fades out, government investment does likewise. Panels b) and c) show that public sector employment and output patterns are similar to that of the closed economy case in submodel b). Yet, the private sector behaves entirely different. Private investment in panel a) first grows due to improved effective demand caused by government expenditures. However, public spending generates additional income and hence entails a trade deficit, as can be seen from panel d). The initial deficit in the trade balance causes external debt to increase. Moreover, it depresses domestic demand because a share of income is spent abroad. This regards the private sector and the public sector alike. Lower domestic demand and interest payments due to firms’ indebtedness imply lower capacity utilization and a lower profit rate. Investment thus falls strongly, and so do private employment and output. By contrast, the government does not adjust its investment pattern in response to the trade deficit, but only follows its growth target. The trade and current account deficit give way to a slowly accelerating nominal currency depreciation. Despite the decrease of private sector activity involving an improvement in the trade balance, the balance of

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Figure 4.4  E  ffect of public investment on private investment, employment, output, trade balance, external debt and exchange rate (no profits retained) payment keeps worsening due to interest payments, and increasingly also due to the depreciation. As before, a share of the growing trade surplus does not raise domestic wealth because it is used to pay for interest on external debt. However, both nominal and real depreciation (despite the

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latter being weaker than the former) lead to a growing trade surplus, which itself also raises domestic demand and hence, eventually, private investment, employment and output. Even though private economic activity reacts more sluggishly to public sector production, it seems that economic policy eventually is successful in achieving economic growth and crowding in the private sector. However, we observe patterns similar to the case of expansive monetary policy when neither firms nor banks retain any profits. We renounce plotting the balance sheet of the banking system again. However, we find that private firms accumulate debt which cannot be justified by growth in the real capital stock, as the increase of the real capital is only about 15 percent of the growth in debt by 2025. For the public sector, the situation is better. It also accumulates debt, but the accumulated capital stock exceeds outstanding loans. One reason for the better result of the government is that private firms’ debt keeps growing even when they disinvest, which worsens the capital stock to debt ratio. Second, the public sector produces by using full capacity, which allows it to produce more output and earn higher profits per unit of capital. Likewise, in the case of full profit distribution banks’ equity is negative again. The current account deficit involves the accumulation of external debt, which the banks find on the liability side of their balance sheets. Currency depreciation means a revaluation of external debt and hence extra losses for the banking system. Under the scenario in Figure 4.4, banks would go bankrupt again. It should be noted, however, that external debt does not grow as large as in the case of expansive monetary policy, in Figure 4.2. The difference is that while a cut in the interest ceteris paribus merely raises domestic demand and hence imports, public sector production also contributes to exports and at least helps to maintain a more equilibrated balance of payments. Again, let us consider the case where firms and banks retain a part of profits, for the former to reduce debt exposure and for the latter to have non-negative equity. The public-investment curve in panel a) of Figure 4.5 still looks almost equal. In contrast, private investment now falls back in an even more pronounced way (after a small initial increase owed to public-investment stimulus) and regains a positive level only towards the end of 2025. Overall, the net effect on private investment is negative. While state employment increases according to the growth target in panel b), private employment clearly falls and only augments slightly when the growth target is cut back step by step. A similar pattern is observed for output in panel c) despite the fall in private sector production being less pronounced than that in employment. This can be explained by the fact that due to public investment, productiv-

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Figure 4.5 Effect of public investment on private investment, employment, output, trade balance, external debt and exchange rate (firms and banks retaining parts of profits) ity grows, so that output declines by less when employment falls. Overall, employment and output grow, but at a lower rate than in the preceding simulation. Hence, the government is less successful in realizing its target. The reasons for these results are twofold. First, profit retainment of firms and banks reduces consumers’ income and thereby depresses effective

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demand in the domestic economy. As a consequence, firms cannot sell all produced goods, while capacity utilization falls.13 The paradox of thrift, caused by firms’ and banks’ undistributed profits, thus gives rise to lower private sector employment and falling investment. Second, the reduction of domestic consumer income is sufficient to keep the exports and imports broadly in balance. Thus, while domestic demand shrinks due to profit retainment, there is no trade surplus that could compensate by contributing to effective demand. The prevention of an initial trade deficit impedes the accumulation of high amounts of external debt and subsequent interest payments, as can be seen from panel e). The balance of payments becomes even more favorable towards the end of the considered period. A broadly balanced current account requires neither the release of foreign currency reserves nor the purchase of new reserves to refinance external debt and pay for interest rates. Therefore, the nominal exchange rate is largely stable compared to the first simulation (panel f). The absence of a nominal depreciation also avoids domestic inflation through imports, so that the real exchange rate hardly deviates from the nominal rate. On the one hand, these conditions keep the domestic economy in overall balance. On the other hand, the stable exchange rate does not allow the domestic economy to regain ­effective demand via a trade surplus. The simulations of public investment confirm that, in analogy to expansive monetary policy, economic policy is not very effective in the open economy. With public intervention there is one particular observation in the first simulation, and even more so in the second, more realistic, simulation: namely, private employment is negatively correlated with public employment. The same applies to output. The more employment in the government sector increases, the more it falls in the private sector. What the model reveals is, indeed, a crowding-out of the private sector by the public sector. Even though the model may suggest it by exhibiting the respective private and public employment curves, the labor market is not the channel through which crowding-out takes place. In both model simulations with public investment, disinvestment of the private sector is explained by a lack of domestic demand. In the first case, this is due to higher imports, such that a part of consumer income is not spent at home. In the second case, effective demand is depressed by profit retainment. Both explanations are in line with observed results. However, there is an additional effect. In both cases, exports are assumed to remain constant in the initial periods after the policy program has started. This is realistic because exports depend on external demand and hence on economic performance in the rest of the world. A developing country is not able to influence the global business cycle. Thus, as long as the exchange

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rate is stable, exports do not increase with domestic economic growth apart from the productivity effect defined in the model. In the first case, constant exports and increasing imports mean a trade deficit. In the second case, profit retainment avoids this trade deficit (entailing costs in terms of output growth, though). However, exports being constant does not necessarily imply that individual export components are constant as well. The government has the same export propensity of output as the private sector. Its share in exports depends on its share in total output. Once the state starts producing, its contribution inevitably rises from zero to a value greater than zero. With public sector exports growing while total exports are constant, private sector exports inevitably fall. A drop in private firms’ export sales further contributes to inventory accumulation and lower capacity utilization followed by disinvestment. In the first simulation, this constraint is eased by currency depreciation and hence export growth. In that situation, private exports increase despite state exports doing the same, because overall exports grow. In the second simulation with profit retainment, exports do not grow because there is hardly any counteracting effect of a devaluating currency. The net impact of public investment is still positive since total output grows slowly. However, it partially crowds out private sector activity. The economic intuition can be given in less technical terms than the model as follows: public intervention in a closed economy is able to produce a crowding-in rather than a crowding-out of the private sector because it gives rise to an expansion of total production and supports private firms via growing effective demand. There is scarcity neither with regard to money nor in the labor market as long as there is no full employment. In contrast, a certain type of “scarcity” exists in the open economy. In order to keep foreign debt under control, any imports need to be met by corresponding exports in the long term. However, exports are limited by the capacity of the external sector to absorb them. The more a policy program of public investment involves exports by the government, the more difficult it is for the private sector to sell its own export goods. Hence, the private sector and the public sector compete for the export market. In this sense, the latter is a scarce resource. The effect is mitigated to the extent that productivity growth in the domestic economy raises the variety of goods that can be exported (see equations 68 and 70). Yet, in many developing countries, it is the case that the economy depends on a single branch. But crowding-out via the export market can potentially be mitigated to the extent that the public sector is able to establish its production in new branches that do not compete with the private sector.14 The model results support the view that economic policy is strongly

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limited in the open economy. The detected effects of both monetary policy and public investment in the open economy confirm Thirlwall’s law: in the end, the economy is not able to substantially exceed the growth rate of the rest of the world. Since the latter is assumed to stagnate, the domestic economy is also broadly bound to that level. As long as the exchange rate does not depreciate, the country’s exports are restricted at least to some degree, and cannot contribute much to effective demand and growth. With exports constrained, domestic growth implies a current account deficit giving way to the respective undesired consequences. Policy strategies are largely ineffective. Capital controls and tariffs might relax the constraint and give more productive space to policy. However, they do not remove the fundamental dilemmas.

4.6  THE THREAT OF CAPITAL FLIGHT In the open economy, another crucial problem arises, which has already been addressed in the theoretical introduction of this chapter. It is particularly relevant for developing countries. The exchange rate is an inherently unstable variable. The central bank may intervene in the foreign exchange market, but its means are limited. Especially developing countries facing external debt miss sufficient foreign reserves to maintain a stable currency in a phase of depreciation. As derived for equation (80) of submodel c), the exchange rate depends on the dynamics of supply of and demand for foreign currency reserves. Speculation, to which the term Cspec belongs, can also be a potentially important demand force there. Besides this, the government may announce a policy program that entails, for instance, redistribution of wealth from the wealthy to the poor households. Capitalist households may be affected by higher taxes, while firms might face both higher taxes and wages, hence a lower profit rate. When such a program is implemented or even when it is just expected, capital flight is likely to take place. Technically speaking, it means that domestic depositors want to exchange their savings against foreign deposits. This involves a currency depreciation. Such a currency shock has numerous consequences, which have been described above. First, external debt immediately weighs heavier in terms of the domestic currency. As a result, interest payments are higher, too, despite the external interest rate being constant. It means, in fact, that the economy has to export a larger part of current or future output to earn the returns for debt service. In the opposite case of net foreign currency reserves, currency devaluation implies a profit to reserve holders. Second, an upward push to inflation occurs because imports are suddenly more

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expensive. Production costs and hence prices increase. Third, sudden currency depreciation may boost exports and give rise to a big trade surplus, thus partially compensating for the first and the second effect. Several qualifications need to be made at this point, because the model does not take account of all possible impacts of a speculative shock to the exchange rate. First, it starts at an equilibrium where external debt is assumed to be zero. Hence its higher valuation in domestic currency is not reflected. Yet, net external debt is the common case with developing countries, at least most of the time for non-resource-rich countries (World Bank, 2018b). This means that a devaluation has serious effects. Furthermore, a strong inflation shock may have an impact on the equations defining private investment and private employment. Under simplistic textbook circumstances, currency depreciation has a positive influence on the profit rate because exports yield a higher income in terms of domestic money. The export boom also raises capacity utilization. Subsequent investment as well as the dynamics of effective demand stemming from exports both give rise to output growth. However, inflation at high rates distorts resource allocation. Moreover, it raises the level of uncertainty since the future becomes even less predictable. High and sudden inflation thus damages economic activity. It is thus not guaranteed that private investment and employment increase. It might as well be that firms suspend investment expenditures and do not raise employment due to instability and uncertainty, which are caused by capital flight. Productive capacity thus may not take off while effective demand does not improve. The model does not account for such possible scenarios. Nonetheless, it is obvious that an uncontrolled currency devaluation in the face of external debt and inflationary consequences is harmful to any economy. Moreover, the dynamics of capital flight tend to be self-enforcing. A first depreciation means that the financial wealth of those who still hold their deposits in the domestic banking system is jeopardized by devaluation. To prevent further losses, they also exchange deposits against foreign currency, thus triggering continuous depreciation of the domestic currency. Such a situation represents a currency crisis, which may additionally give way to a banking crisis. Despite limitations, the model is able to show the effect of an individual shock of capital flight. In Figure 4.6, sudden capital flight reduces the value of the domestic currency by half compared to the rest of the world. What follows is a partial nominal reappreciation due to the subsequent export boom. High relative profitability as well as an improvement in the trade balance and the balance of payments are the reasons for the strengthening of the domestic currency. In the following, increased output

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4 3 2 1

nominal exchange rate real exchange rate

0 –1 2001 2004 2007 2010 2013 2016 2019 2022 2025

Figure 4.6  Effect of capital flight on the exchange rate and employment, caused by exports, give way to a stepwise deterioration to the trade balance and lead to another smaller depreciation. The real exchange rate exhibits a different pattern. Right after the shock, inflation shoots up such that the real exchange rate is instantly back to its initial level. From there, profitability triggers investment, which raises productivity. Higher productivity implies improved competitiveness and hence a “weaker” real exchange rate. The following nominal depreciation raises inflation again, so the real exchange rate remains broadly constant. Since the exact long-term consequences are subject to parameter definition of profit retainment,15 the interest in Figure 4.6 is on the short-run effect of capital flight. Even though capital flight is simulated as a one-time shock instead of a continuous and accelerating phenomenon, the consequences are visible. Inflation appears as a shock while foreign debt weighs heavier. If investment and employment do not react in conventional ways owing to distortion of price signals, there is less output stimulation than the result in Figure 4.6 suggests. And if capital flight continues, the currency keeps weakening, thus worsening the harmful consequences. As to how the credit market is defined in this model, it is mainly the banks being threatened by bankruptcy due to the grown size of foreign debt on their balance sheets. Clearly, the monetary authority has to intervene in order to re-establish the exchange rate and to maintain purchasing power of the domestic currency. The central bank could do this by means of intervention in the foreign exchange market. However, currency reserves are limited at best, while capital flight does not have any inherent restrictions. To counteract currency depreciation persistently, monetary policy is forced to increase the interest rate level. Model equation (80), which defines exchange rate

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behavior, explains how monetary policy is effective. While the speculative component, Cspec, weakens the currency, an increase in the domestic interest rate level raises the interest rate differential, rD – rR, and hence contributes to a stronger currency. The latter effect aims to compensate for the former. Let us consider the results of restrictive monetary policy, which aims at counteracting capital flight. The same speculative shock as before triggers a currency devaluation in 2004. The central bank immediately reacts by raising the central bank rate very strongly. This increase is temporary. After five quarters, when the monetary authority considers its policy to be effective, it successively cuts the target rate such that it is back to its initial level half a year later. For now, we assume that the state is not actively participating in economic activity through a redistributive policy program, nor via public investment. Panel a) in Figure 4.7 shows how investment reacts to the combination of these two events. Capital flight gives way to an inflationary shock. It destroys a large part of gained international competitiveness. Additionally, the upward shock to the interest rate level implies that production at current profitability is no longer interesting for capitalists. They rather would store wealth as deposits, where the return is much higher now. Investment thus drops very low.16 In the following periods, the restrictive policy exerts the expected impact on the key macroeconomic aggregates: employment and output (panels b and c) decline. Lower domestic income means lower imports and hence an improved trade balance and current account, as can be seen from panels d) and e). As panel f) reveals, the higher interest level also impacts the price level. This can be explained from a weakening real exchange rate which goes in the opposite direction to the nominal rate. In other words, a deflation sets in, implying in fact a real depreciation and thus making the domestic economy more competitive. This triggers some additional dynamics: exports grow and thereby contribute to the trade surplus and the international creditor position of the country. After this, investment becomes strongly positive, even though the net profit rate ‒ that is, the profit rate compared to its minimum reference level ‒ is negative. The reason is capacity utilization, the second determining factor of investment decisions. Due to the export boom, production capacity is fully utilized and hence demands enlargement. Investment and the favorable trade balance boost effective demand. The result is growth in output and employment. The effect of domestic growth, however, involves rising wages and higher imports. Higher production costs mean a partial real appreciation with corresponding negative effects on exports. The trade balance goes

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Figure 4.7  E  ffect of restrictive monetary policy in the face of capital flight (banks retaining parts of profits) back to zero where no long-term imbalance is implied. Employment and output fall back to levels lower than the initial one. The decline of the former is stronger than that of the latter because labor productivity has increased in the meantime. Investment, the current account and the

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exchange rate become broadly balanced as well. This means that the central bank is successful in bringing back the exchange rate to its initial level, and hence limiting structural inflation from imports and preventing external debt from being multiplied according to the stronger foreign currency. Bankruptcies thus can largely be avoided (or, at least, monetary policy limits the harmful consequences). Remember that the interest rate level is already back to its original level by the end of 2005. The difference to the initial state thus cannot be explained by a permanently more restrictive monetary policy. The reason for the new outcome to be below the initial level is due to banks’ deleveraging of debt. The speculative shock to the currency and the subsequent positive current account imply revaluation of the foreign currency position of the banks. This entails negative equity. Therefore, banks retain a part of profits to reduce the debt stock. This drags effective demand and keeps the economy restricted. If a higher speed of deleveraging was chosen, the economic outcome would be worse. The assumption that reserves are held by banks does not imply a loss of generality. If capitalists held those deposits or used them to buy bonds, the reappreciation of the domestic currency would make them suffer losses in just the same way, and induce them to deleverage by lowering consumption expenditures. The negative impact on effective demand would be the same. Obviously, and much like in the real world, the central bank is not able to fine-tune macroeconomic outcomes. This can notably be observed in the paths of the trade balance and the real exchange rate. Changes in the interest rate target have complex and sometimes non-linear effects on macroeconomic variables. The outcome could be smoothed by making the variables interdependent not only on single data points but on, say, yearly moving averages. But this would not alter the essence of the result. The main relevant effects of this simulation are the two counteracting effects: restrictive monetary policy gives way to economic contraction, while the currency depreciation expands the economy via exports. Moreover, the final result is lower economic activity. However, macroeconomic disturbances could be much worse. The model shows the still more advantageous situation of a one-time shock caused by capital flight. If capital flight, as any speculative activity tends to be, is self-enforcing, the currency depreciation would continue. The central bank would be forced to employ much stronger measures in order to maintain the international purchasing power of the domestic currency. The economic contraction as observed in 2004 would be stronger and longer. In fact, it would be a recession or even depression. The central bank would face the trade-off between depressing the economy or accepting currency devaluation, very high inflation rates and banking crisis.

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The issue of capital flight confirms the limited options of any policy in an open economy. First, monetary policy has limited means to control a fluctuating currency. Second, the economy is exposed to speculative waves. The threat of capital flight can force economic policy programs to be stopped before they have even started. Exchange rates of small economies are even more vulnerable, as relatively small changes in the foreign exchange market cause larger volatility. In particular, this applies to developing countries, which often lack sufficient amounts of foreign reserves to defend the exchange rate. Their perspectives to reduce poverty are not pleasant.

NOTES   1. Any current account surplus (deficit) implies a capital account deficit (surplus) because these two components of the balance of payments represent an identity. The balance of payments summing up to zero is thus a tautology which always holds. Even though, in general, this is not an equilibrium concept, we refer to an equilibrium in the balance of payments to express the situation when the current and capital accounts are balanced, hence inflows of goods and finance being equal to their outflows.   2. This is represented and explained in equation (15) in submodel a), where it is shown that wages are determined by three components: a subsistence wage level, labor market tightness and the ability of workers to obtain their share of productivity growth.   3. See also Blecker (1989) on this dilemma.   4. However, a part of profits (or all profits when investment is zero) is capitalists’ income as can be seen from model a). As such it is either spent for consumption or saved.   5. At this stage, however, the question of how trade agreements have to be defined in terms of social and environmental impacts is not yet discussed.  6. If unlimited deficit spending is possible in a globalized economy, its application is restricted to countries with a global reserve currency, that is, mainly the United States (see Epstein, 2019).   7. For an overview of all model variables, values of exogenous variables and parameters, see Appendix I. For the full set of model c) equations and the stock and flow matrices, see Appendix IV a).  8. For another model, which emphasizes the number of export goods a country can produce and its relation to competitiveness, see Cimoli and Porcile (2014).   9. The variables enter the equation with a lag due to reasons of technical modelling. This does not affect the model results. 10. The model makes a simplification, as rR is the same rate independent of LNR being ­positive or negative, thus dropping the interest rate differential, d. If it is positive, rR means return on foreign assets. If it is negative, it denotes interest payments on external debt. 11. If there is inflation, past domestic debt reduces in terms of the current price level. This effect is neglected in the model. While it is not a priori clear whether the pass-through from external prices to the domestic price level is small or large, it is certainly below one because only part of input material stems from imports. Debt deflation would dampen the impact of external indebtedness due to currency depreciation but would not fundamentally change the conclusion of the model. 12. The calculation is not presented separately but can be followed by considering the area between the investment curve and the zero line in panel a) of Figure 4.2 and relating it to firms’ debt in Table 4.1.

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13. There is an additional effect via exports contributing to the trend. It is explained below. 14. Interestingly, however, the variation of model parameter η12 accounting for product variety and growth spillovers through productivity growth does not alter the long-term model outcomes significantly. An export surplus is followed by a currency appreciation, tending to give way to a current account deficit. The corresponding drain in domestic demand prevents productivity development. This seems to be the dominating impact in the long run. 15. In Figure 4.6, profit retainment of both firms and banks is zero, which leads them to debt accumulation. With profit retainment, there would be less currency depreciation in the long term but also less output growth (for the explanation, see the previous model simulations). However, the immediate effect of capital flight is insensitive to parameter definition. In comparison to the following simulation, the long term will nonetheless matter in order to analyze the persistent consequences of capital flight. 16. Note that the scale of the axis had to be enlarged to show all values. The same applies to panel d).

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5. A reform to remove the external constraint The analysis so far has shown that monetary policy and the quite powerful economic policy instruments to foster economic growth and poverty reduction are made ineffective to a large degree once the economy is opened up towards the rest of the world. If developing countries are to reclaim the possibility of implementing autonomous development strategies, they have to find a way to stabilize their economies’ external conditions. Exchange rate pegs and capital controls feature several strengths but also important weaknesses that have been explained in the preceding chapter. A new solution is required which removes the trade-offs of the conventional policy measures. It is provided by a reform of international payments enabling developing countries to foster development and poverty reduction. Thanks to the establishment of monetary and economic stability, even small open economies can apply effective policy programs.

5.1 THE DOUBLE PAYMENT OF INTEREST ON EXTERNAL DEBT The reform of the system of international payments introduced in this chapter is a reform which can be implemented globally but also by an individual country. Based on the famous Keynes plan and Schumacher’s (1943a, 1943b) proposal, it was further developed by Bernard Schmitt (2014). Yet, before the reform itself can be presented, it is necessary to take one step back to the analysis of today’s functioning of international payments. Schmitt’s insight of double payment of interest on external debt lays the theoretical base to the elaboration of a stable international payment system to the benefit of developing countries. The essence of the external constraint consists in the need for foreign currency to make international payments. The only limit for a country to import goods and services is the availability of foreign currency. From this it follows that countries whose national currencies are used as global reserve currencies do not face this constraint. They have unlimited access to the source of the reserve currency, that is, the domestic banking system. ­210

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Endogenous money creation provides those countries not only with the credit to enable domestic production but also with the currency to pay for the imports. This fact endows the United States (US) with the “exorbitant privilege” (Eichengreen, 2011; Gourinchas & Rey, 2007) since the US dollar as the leading global reserve currency is issued in the monetary space representing the US. In contrast, non-reserve currency countries have to purchase foreign currency on the foreign exchange market or access it via loans, thus suffering from the “original sin” of exchange rate volatility (Eichengreen et al., 2005). Since currencies, mainly key currencies, are traded as if they were assets on this market, their price is determined by supply and demand (Cencini, 2000, pp. 9, 16). Countries have to purchase those currencies to pay for the imports. Hence, their access to imports is not for free. This asymmetry reveals the different conditions under which countries participate in international trade. The double payment of foreign interest stems from the fact that the debt of externally indebted countries is twice as high as it should be (Cencini, 2017a, p. 144). This bottom line can be traced further to the insight that countries are paying twice for their net imports. Sovereign debt represents the external debt of a country. It must not be considered as public debt, since the government is only one resident among the full set of residents of a country. The set of residents represents the country’s economy. Each resident who imports more than they export contributes to the formation of external debt. Besides the individual debtors among the domestic residents, the weight of external debt is carried by the whole economy, hence by the set of all residents independent of whether they import goods or not. External debt is thus a macroeconomic debt, giving rise to the conclusion that each international payment involves a macroeconomic payment (Beretta, 2017, p. 107). At the same time, any payment carried out by an individual resident obviously involves a microeconomic payment. Schmitt (2014) shows how these payments add up to one another, resulting in a double payment. Residents pay for net imports, whereby a second debt ‒ that is, sovereign debt ‒ accumulates. The illegitimacy of the second debt can be detected by analyzing the current structure of the system of international payments. This system is often referred to as an actual “nonsystem” consisting of ad hoc arrangements since the Bretton Woods order collapsed at the beginning of the 1970s (see for instance Ocampo, 2017, p. 3). International payments are carried out in a way which respects neither the endogenous nature of money nor its necessary direct association with economic output. Instead, currencies are traded as if they were assets in the foreign exchange market, as has been shown in the previous chapter. Schmitt (2014) provides a variety of proofs of the double payment

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Table 5.1  E  ffect of a payment for imports in today’s international payment system Country A (importer) Assets     (1)     (2)

Deposit at bank B Deposit at bank B

Liabilities 1y 2y

Loan from bank B Deposit of importer

0 Country B (exporter) Assets     (1)     (2)

1y 2x 1y2x

Liabilities

Loan to bank A

1y

Deposit of bank A Deposit of bank A Deposit of exporter

1y 2y 1y

Loan to bank A

1y

Deposit of exporter

1y

Source:  Based on Rossi (2007b, p. 100).

of interest as well as the duplication of debt. A pragmatic approach is pursued here to explain the fundamental mechanism of how international payments involve a loss of resources for indebted countries. First, let us look in more detail at what happens when an international payment takes place. We assume, first, that there are two countries A and B. Second, it is assumed that the banking systems in the respective countries each consist of one bank, called bank A and bank B. Third, country A is considered a developing country, while country B is the monetary space of a global reserve currency. These simplifications do not involve any loss of generality. Table 5.1 shows the payment of country A’s imports from country B and reveals what happens at the macroeconomic level when a country’s imports exceed its exports. The goods have to be paid in foreign currency, namely in country B’s currency. We assume that one monetary unit of country A (MA) exchanges against y/x monetary units of country B (MB) such that x MA 5 y MB. Given that country A does not have any foreign currency reserves, it has to access a loan in B’s currency. Hence, under (1) in Table 5.1, bank A becomes a debtor to bank B, which enters the monetary units of that loan in a deposit account owned by bank B. y is the price of imports in international currency. As is usual in international payments, the importer, an individual resident of country A, pays the imported goods by using money of their deposit. This amounts to saying that the importer pays in domestic currency MA. In the second step, (2), the deposit of the

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importer is therefore reduced by x, which is the price of imports expressed in domestic currency at the current exchange rate. The domestic bank has to make use of the foreign loan to pay in foreign currency as required by the exporter in country B. Bank A thus loses ownership over the deposit at bank B. Its assets thus shrink by y. In country B, the only thing that changes now is that ownership of the deposit changes from bank A to the exporter. Summing up (1) and (2) yields a balance sheet of bank A, which has not changed in size because y is equal to x at the current exchange rate. Meanwhile, bank B’s balance sheet has increased by the amount of the export return y. The balance sheet of the importing country shows the key reason for the twofold payment for imports. Both assets and liabilities shrink by the same amount in step (2). The importer pays by means of a deposit in domestic currency. At the same time, the banking system in country A transfers the amount due in foreign currency, which therefore disappears from its balance sheet because the corresponding deposit is now owned by the exporter of country B. Hence, the payment is made twice: once in domestic currency by the importer, and once in foreign currency by the banking system. The latter adds to the former and contributes to the accumulation of external debt. While the single resident making the payment meets their obligations in full, an additional payment has to be made by the whole country. A second very important feature needs to be mentioned. The importer in country A pays in domestic currency. However, the deposit of x units in domestic money is not transferred to the exporter in country B because the latter is to be paid in foreign currency. Neither exporters nor any other agent in either country A or B gains ownership of the deposit in domestic money spent by importers. As a matter of fact, the payment simultaneously cancels the importer’s deposit and the deposit in foreign currency acquired through a foreign loan from the banking system’s balance sheet. The foreign currency is gained by the exporters of country B. By contrast, the x units of domestic money are lost to the economy (Cencini, 2017a, p. 147). Based on the logic of endogenous money and quantum macroeconomics, we know that those lost monetary units came into existence via issuance of a loan used for production. They are output in its monetary form representing an “internal income” (Cencini & Schmitt, 1991, p. 183). Their destruction implies that a corresponding share of domestic output is going unconsumed. The result is a drop in effective demand and an increase in unemployment (Cencini, 2017a, p. 148). It shows the double payment from a different aspect: there is a monetary payment to which a real payment adds (ibid., p. 150). To compensate for declined income, the

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importing country has to be granted another loan from country B. This is necessary if country A wants to “maintain its standard of living through a supplementary import of commercial goods” (Cencini & Schmitt, 1991, p. 189). This second loan, used to make the monetary payment, adds to the first loan, thus showing that external debt is twice what it should be. Hence, Table 5.1 shows the essence of the duplication of external debt in today’s non-system of international payments. Needless to say, the effect of the double payment is set off to the extent that imports are met by simultaneous exports of an equal amount. Double payment takes place at the amount of net imports of a country. To be still more precise, inter­ national payments arising from financial income also need to be accounted for. Therefore, it is the state of the current account that decides whether external debt piles up. Of course, the presentation in Table 5.1 is stylized. It may also be that the importing country ran a current account surplus in preceding periods such that it can release currency reserves to pay for the imports. Those reserves led to monetary duplication. Current imports thus would reverse this effect by reducing the balance sheet again. It nonetheless remains true that any international payments take place twofold, as a reduction in foreign reserves is tantamount to an increase in external debt. By another extension, it could be shown that the mechanism does not change when country B is not a key currency country. In that case, both countries would still rely on an international reserve currency by accessing loans and holding deposits with the banking system of the respective key currency country. The duplication of external debt remains unaltered ­ however complex the international monetary structure is. This fact has been present all through our simulations with submodel c) without having explained it explicitly. But even though it usually goes unnoticed, it can be found in real data of countries’ external debt positions (Schmitt, 2014, pp. 47–51). A different and interesting way to show the duplication of external debt is by explicitly referring to the specific nature of payments of interest on foreign debt. Based on the analysis of nominal exchange rates in the preceding chapter, interest payments are different from payments arising from trade, in that they have an impact on the nominal exchange rate while trade, as long as it is matched by corresponding financial flows, does not (Cencini, 2000 p. 12). Now, let us imagine that the banking system of a country has accumulated external debt because of past current account deficits. In the period considered, interest is due. The corresponding bank has to purchase foreign currency by exchanging it against a deposit in domestic currency. This involves a depreciation, because demand for foreign currency increases relative to demand for domestic currency so

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that the latter’s price needs to fall for the supply-demand identity to be guaranteed (see Cencini & Schmitt, 1991, pp. 169–177). To ensure exchange rate stability, original demand and supply conditions in the foreign exchange market must be re-established. There is a possibility to achieve this. Increasing relative demand for foreign currency, caused by the interest payment, has to be met by an equally increasing supply of foreign currency. For this purpose, the central bank sells an amount of foreign exchange reserves equal to the interest payment in the foreign exchange market. This allows to maintain a stable exchange rate because the respective states of demand and supply finally remain unchanged. However, there are obviously two payments, which add to one another. Hence, the country loses an amount of foreign currency which is twice the amount of interest due: once as an increase in external debt, and once as a loss in official foreign reserves (Cencini, 2000, p. 12). This fact finds striking empirical confirmation. Indeed, case studies of individual countries show that interest payments on external debt largely go along with an increase in external debt and a decrease in official reserves of the same amount, each resulting in effective double payment (see for instance Beretta, 2017, p. 114). The fundamental flaws of the current non-system of international payments have serious consequences, notably for developing countries. Current account deficits imply a drag in effective demand and an increase in unemployment. They also lower investment expenditures and thereby prevent capital accumulation and productivity development. At the same time, monetary duplication gives rise to the building-up of a financial bubble in surplus countries. Finally, and this is one of the very central issues, the inadequate structure of the international payment system involves turbulent exchange rate fluctuations. It has been derived in the previous chapter that nominal exchange rates are influenced by a number of factors, namely external interest payments, interest rate differentials, profit differentials, and other financial movements being caused by capital flight or simply speculation in the foreign exchange market. Current account deficits lead to accumulation of external debt. Corresponding interest payments imply a currency devaluation if the central bank does not intervene by a further release of currency reserves. The problems of exchange rate depreciation have been emphasized above. They mean a heavier weight of external debt, higher inflation, and possibly an acceleration of the increase in external debt, the latter effect depending on the Marshall‒Lerner condition. There is a trade-off between the balance of payments and exchange rate stability. If countries want to ensure a stable currency, they are not allowed to run current account deficits. The trade-off can be partially mitigated by capital inflows such

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as foreign direct investment. However, the relaxing effect of capital flows is limited. If countries still plan to run deficits while maintaining a stable exchange rate, they run into an ever-increasing spiral of external debt, due to double payment of interest. At the beginning, the exchange rate may be kept stable by releasing currency reserves. Once they are gone, the debt spiral moves on. At a certain debt level, interest rates start increasing, as foreign lenders may no longer consider the country’s external debt affordable. In other words, it is Thirlwall’s law that seriously constrains country’s development prospects. It requires balance-of-payments a ­ equilibrium. The monetary analysis of international payments reveals why the balance-of-payments constraint is binding. It must be respected if a country wants to keep both external debt and the exchange rate stable. Yet, developing countries depend on imports either for basic goods or for capital goods. The latter are necessary to obtain access to technology, which is essential to steer development. To satisfy basic needs while at the same time accelerating industrial development via import of capital goods, however, countries inevitably run trade deficits. But today’s working of international financial and monetary flows does not allow deficits, because it leads to a drag in domestic demand, exchange rate depreciation and increasing external debt. The same restriction applies to any kind of monetary and economic policies. To the extent that they involve a demand stimulus, they give way to a current account deficit. The external constraint thus makes policy instruments powerless to a large degree, as has been analyzed in Chapter 4. If developing countries want to have a chance of poverty-reducing development, they need a solution which allows them to participate in trade and technology transfer even if they involve current account deficits. Moreover, governments of those countries should be able to reclaim the policy instruments. For those instruments to be effective, they must not be jeopardized by the instabilities implied by current account deficits. Therefore, a development strategy involving public investment ­ roduction should take place in an appropriate international payment and p system. This system should be such that current account imbalances do not trigger exchange rate disturbances. Current account deficits should not withdraw effective demand from the domestic economy, and nor should they entail the duplication of external debt. External stability is required so that developing countries can afford current account deficits for an initial development phase. This allows for capital accumulation and productivity growth which will provide the base for external surpluses in the future.

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5.2 THE GLOBAL REFORM OF THE INTERNATIONAL PAYMENT SYSTEM There is a response to address the external problem which goes beyond exchange rate pegging. Keynes (1942/1980) and Schumacher (1943a, 1943b) made a proposal for a global reform of the international payment system. They published it at about the same time in the early 1940s, but independently of each other. The global reform will be briefly introduced here in order to show the outline of its basic principles. Thereafter, since our interest is in the perspective of a single developing country, emphasis will be on the enhancement of the reform, showing how it can be applied by an individual country. In Chapter 2, it has been explained by means of the theory of money emissions what is required for a payment to be final: whenever a borrower pays another agent in the economy, the payee becomes the creditor of the payer, who becomes the debtor. Payment finality means the necessary equality of credits and debits, of assets and liabilities (Keynes, 1942/1980, p. 44). Monetary intermediation goes along with a financial intermediation (Rossi, 2009, p. 42). At the international level, however, payments are not final. An importing developing country is left with external debt to the monetary space of the key currency, while the resident’s payment in domestic currency is lost to the economy. As shown in Table 5.1, the remaining loan in domestic currency on the domestic banking system’s balance sheet is met by an external debt. The claims are not settled, thus making the payment unfinished. Payment finality can be traced back to what Keynes (1942/1980, p. 44) denotes the “essential principle of banking.” His proposal, which was presented at the Bretton Woods conference in 1944, consists of generalizing this “essential principle of banking, as it is exhibited within any closed system, through the establishment of an International Clearing Bank” (ibid.). This issues a supranational currency, called bancor, according to the needs of the national economies. Any international payment is settled in bancor units. Hence, deficit countries obtain the amount of bancor granted which is required to pay for imports and external interest payments. Surplus countries, on the other hand, obtain the respective amount of bancor deposits. Overdrafts for deficit countries are allowed up to a certain quota (Keynes, 1942/1980, p. 173). Deficit countries are provided with the currency to make international payments without putting pressure on the exchange rate. Moreover, no country has a claim left on the other country. Above the quota, surplus countries are obliged to pay fines. Hence the responsibility is put on the surplus country rather than the deficit country.

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This is supposed to prevent a deflationary vicious cycle, because the debtor country is not forced to cut down its expenses (Varoufakis et al., 2011, p. 305). Doing so would improve the balance of payments but at the same time depress domestic effective demand. However, as Schumacher (1943b, p. 15) criticizes, it is not clear whether those fines are effective enough to actually influence current account balances; moreover, it may not be the surplus country’s imports which are boosted, but its exports which are cut down. The corresponding economic contraction in the surplus country may also spill over to the deficit country. Yet, there is an even more fundamental weakness to the Keynes plan. Indeed, it does not modify international payments in such a way as to avoid duplication of international payments. The deficit country is provided with the amount of bancor required to cover the deficit. Just as with any external deficit, domestic residents pay for it in domestic currency while the banking system pays for it in international currency, which is now the bancor. The domestic deposit used for the payment is lost to the deficit country, while external debt in bancor grows by the same amount. At the same time, the balance sheet of the surplus country’s banking system grows to the extent of the surplus. The banking system is credited with bancor, while the domestic residents are endowed with domestic currency of the same amount. Monetary duplication thus makes the balance sheet grow and implies the creation of monetary units to which no real output corresponds. The principle of this case has been shown in Table 5.1. Hence, with this reform there may be no unsettled claims of one country towards the other. With regard to the international clearing bank, however, claims continue to exist unless the deficit country earns an external surplus whose returns in bancor can be used to repay the debt towards the international clearing bank. Likewise, the surplus country only settles its claim when it runs a deficit by spending its bancor deposit. Payments are not final, thus representing an “essential weakness of Keynes’s plan” (Cencini & Rossi, 2015, p. 253).1 For payments to be final, they have to be real. Therefore, the reform should be completed by a mechanism which ensures that a monetary payment also entails a real payment (see Cencini & Rossi, 2015, pp. 253–259). The balance-of-payments identity implies imports and exports to be equal. In today’s flawed system, however, this is done by balancing net imports by a foreign loan whose object are goods which the debtor country will export in the future (Schmitt, 2014, p. 67). It has been shown how this entails a double payment. Payment finality rests on the idea that net imports are matched by exports of an equal amount in the current period. This means that by making an international payment, deficit countries have to transfer real

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resources to the payee country. This can most easily be done by selling securities (see for example Rossi, 2015, pp. 221–222). That is, the Keynes plan is amended by a second payment of a different kind, tied to the first one. The deficit country receives the bancor units as a loan from the international clearing bank to pay for its net imports and net interest. At the same time, the country sells securities. The sales revenues are, logically, denominated in bancor. The country is thus able to finalize the payment, since the bancor receipts are used to settle the outstanding debt towards the international clearing bank. The surplus country receives bancor units as export returns, which it uses to purchase foreign securities. All bancor units disappear after they have been created, and all payments are final. As a consequence, the international currency is used as a means instead of an object of payments (Cencini & Rossi, 2015, p. 254), in clear contrast to today’s character of key currencies. The surplus country is finally paid in terms of real resources, because the securities represent purchasing power as they are a claim on the deficit country’s wealth.

5.3 THE ONE-COUNTRY REFORM OF THE INTERNATIONAL PAYMENT SYSTEM The global reform requires the agreement of all countries. Yet, for a policy measure to be viable, it must be designed in such a way that it can also be implemented unilaterally by an individual country. Therefore, after this sketch of the global reform, let us now explore in more detail how the reform can be implemented by a single country that may be a developing country in our case. The essential elements of the reform can be found in Schumacher (1943a, pp. 151–152). Based on this, it has been further developed by Schmitt (2014) as a solution to the double payment of interest on foreign debt.2 The Functioning of the Reform in the Case of a Current Account Deficit A country aiming to implement the reform cannot count on an international clearing bank being established. This is not necessary. But an institution which settles the country’s international payments is still required. This institution is called the “clearing fund” in Schumacher (1943a) and the “bureau” in Schmitt (2014). It is a public institution. To see its functioning, the more relevant case of a deficit country is considered first: the residents of the country have to pay for their net imports. For them,

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nothing changes, so that they would not realize the implementation of the reform if they did not know about it. This means that, just as before the reform, they pay in domestic currency by giving up ownership of deposits. The bureau receives the payment. At the same time, it pays the foreign exporters in the international reserve currency. To get hold of currency reserves for the payment, the bureau has to be granted a foreign loan. Thanks to this institutional change, the bureau becomes the owner of a deposit in domestic currency that it receives via the payment of the importers. It can make use of this deposit by spending it in the domestic economy. As a first important result, it follows that, thanks to the reform, the domestic deposit used to pay for imports is no longer lost. Instead, the bureau can and should make productive use of it by investing it in the domestic economy (Schmitt, 2014, p. 98). Thereby, not only is effective demand and employment maintained in the domestic economy, but the economy’s future productive potential is even increased. So far, the increase in external debt is a fact because the bureau has to access a loan to pay foreign exporters. To avoid this and to make the payment final, the bureau compensates the increase in foreign debt by another loan in the opposite direction: that is, it lends the same amount in foreign currency “on the financial market of the rest of the world” (Schmitt, 2014, p. 59). The bureau thus receives the foreign loan from a different resident than the one it lends it back to. The effect of this loan is, first, to ensure that net external debt is zero, because the two counteracting loans compensate for each other. Second, it means that the foreign borrower becomes the owner of a corresponding part of the domestic economy’s output (Cencini, 2017b, p. 8; Schmitt, 2014, p. 64). The best way to do this is by the provision of financial securities, which are part of real output. The final situation is thus as follows: while the debt incurred by the deficit country means the payment of its net imports by the rest of the world, the loan granted to the rest of the world implies, analogously, the payment of an equal amount of the rest of the world’s imports by the domestic economy (see Schmitt, 2014, p. 61). Financial inflows are thus equal to outflows, such that the balance-of-payments identity is respected without involving double payment (Cencini & Rossi, 2015, p. 256). The same applies to the flow of real goods. The payment is final. In fact, the importing country pays the exporting country by means of real assets. Let us look at the working of the one-country reform in detail by the respective double bookkeeping entries. Again, we have two countries with a banking system in each. Country A is assumed to import goods abroad, while country B exports that same good. Let us also assume that this import is of the size of country A’s net imports. Hence, for the period considered, country A is the deficit country and country B is the

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Table 5.2  Effect of a payment for net imports with the one-country reform Country A (importer) Assets

Liabilities

   (1)

Deposit of importer Deposit of bureau Deposit of bureau Deposit of firm F

  (3) 0 Bureau of country A Assets    (1)    (2)    (3)

Deposit at bank A Loan to B Deposit at bank A Capital stock

Capital stock Country B (exporter) Assets    (1)    (2)

–x 1x –x 1x 0

Liabilities 1x 1y –x 1x

Loan from bank B Financial securities

1y 1x

1x

Securities

1x

Liabilities

Loan to bureau Financial securities

1y 1x

Deposit of exporter Loan from bureau

1y 1y

Securities

1x

Deposit

1y

surplus ­country. For simplicity, both banking systems are assumed to consist of only one bank each. Country A may be a certain developing country, whereas country B is the originator of a global reserve currency. The exchange rate is such that x MA 5 y MB. Country A has reformed its  external payments unilaterally by implementing the one-country reform. Table 5.2 shows how the payment for country A’s imports takes place and how the bureau functions. The order of steps is chronological here even though they could also be expressed in a more reduced form. In step (1), the importer in country A pays the amount of x in domestic currency for imports. As said above, nothing changes for domestic residents. However, the deposit is not lost to the economy but is acquired by the bureau. The association of output with money thus remains stable in the domestic economy. The bureau earns a profit in domestic currency. Yet, it is also responsible to fulfill the obligations towards the exporting country B. To pay for the imports, which are due in foreign currency, the bureau has to access a foreign loan y. The bureau’s assets thus increase by x, while

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its liabilities grow by y. The exporting country B becomes the creditor of country A. At the same time, the exporter is endowed with sales revenues in the form of a deposit y.3 So far, the payment is not final because the bureau, by representing country A, has incurred a macroeconomic external debt. To make the payment final, the bureau lends back the foreign loan and, at the same time, disposes of an equal amount of the country’s real resources, that is, financial securities in domestic currency in step (2). Bank B obtains the securities the purchase of which is financed by the loan from the bureau in A. Now, it can already be said that the reform is fully effective. The payment is final because the trading countries exchange physical goods against securities, which both represent real output. By contrast to the current non-system, monetary stability is guaranteed. The two loans cancel each other out, thus ensuring that country A’s net external debt is zero (Brunette, 2015, pp. 133–134). To conclude, duplication of international payments by the deficit country and the formation of any external debt are ruled out. Country A is thus able to finance required imports without shrinking domestic demand by selling securities to the surplus country. Given that the bureau uses the gain in domestic income for productive investment, it spends the deposit to purchase investment goods in step (3). The deposit thus changes ownership from the bureau to a certain firm F, which sells those goods. While the bureau’s assets have been financial until this point, they now become real. The bureau ends up with production equipment ‒ that is, a capital stock ‒ which does not have to be financed by foreign debt. Hence, the capital stock is, in fact, owned by country A even though residents in country B own financial securities which are registered on the bureau’s balance sheet. It is important to note that the financial securities obtained by country B from the bureau do not necessarily imply a claim on the bureau’s assets. Schmitt (2014, p. 91) is even more explicit, saying that the rest of the world “becomes the owner not of the ‘personal’ product of A’s government [including the bureau], but of the equivalent of this product in any of the goods . . . produced by economy A.” For example, it may also be that the securities are provided by the central bank, which purchases them in the  domestic financial market. In this case, the bureau’s liability is not financial securities but a debt towards the central bank. The bureau can also access a formal loan from the domestic banking system to purchase the appropriate assets to give up in favor of country B. The macroeconomic outcome is not affected by different ways of accounting. The version presented here is chosen for its simplicity.

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The External Surplus Case What happens if country A changes from a deficit to a surplus economy? Since the bureau is responsible for all international payments, it now has to pay domestic exporters their revenues in domestic currency. For domestic residents, still nothing changes in the way they make or receive payments. At the same time, the bureau receives the export returns in foreign currency because they are paid in key currency by the importers in country B. However, it comes as no surprise that the payment is not yet final. The bureau now uses the newly gained foreign currency reserves to purchase securities from country B. Thereby, payment finality is achieved again: country A exports goods and imports securities, both representing real output. No claims are left between the countries. The provision of domestic monetary units for the exporters means that the bureau loses domestic income. As a consequence, it has to be granted a loan by the domestic banking system to finance the payment to exporters. This is a monetary duplication as it occurs in any surplus country in today’s non-system of international payments. The domestic economy receives additional monetary units without a corresponding increase in domestic output. To establish domestic monetary stability, the bureau issues additional securities denominated in domestic currency (see Schumacher, 1943a, p. 152). Thereby, it gains access to domestic income which it can use to pay the exporters. This balancing internal effect of the reform prevents the bureau from interfering with “internal monetary policy” (ibid.). Thanks to this sterilization mechanism, the payment is final again. Table 5.3 analyses the effects of a payment for exports, which we assume to be the country’s net exports, when a country has implemented the reform. The procedure is again presented in a stylized way to reveal the analytical details. In step (1), the bureau pays domestic exporters the export bill x in domestic currency. For this reason, the bureau has to be granted a loan from the domestic banking system. At the same time, the importers in country B pay in foreign currency an amount of y. The corresponding deposit thus changes ownership from the importer to the bureau of country A. To finalize the payment, the bureau purchases securities from country B in step (2). Thereby, exports and imports are equalized. In our simplest case, country A thus acquires back the financial securities it had given up when it was in deficit, but these can also be other assets. Consequently, the bureau spends the foreign income y gained from net exports and purchases securities of y (or x, if it is about the repurchase of domestic securities from the previous period). In step (3), the bureau issues securities x to the r­ esidents

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Table 5.3  Effect of a payment for net exports with the one-country reform Country A (exporter) Assets    (1)    (3)

Liabilities

Loan to bureau Financial securities Loan to bureau

1x 1x –x

Deposit of exporter

1x

Financial securities Bureau of country A Assets

1x

Deposit of exporter

1x

   (1)    (2)

Liabilities

Deposit at bank B Financial securities Deposit at bank B

1y 1y –y

Financial securities Country B (importer) Assets

1y

   (3)

   (1)

Loan from bank A

1x

Financial securities Loan from Bank A

1x –x

Financial securities

1x

Liabilities

–––––––––––––––––––

Deposit of bureau Deposit of importer Financial securities Deposit of bureau

   (2) 0

1y –y 1y –y 0

in the domestic economy such that it receives the funds to repay the loan it obtained from bank A. Those securities also represent real output. The bureau backs them by the securities it has purchased from country B. Since country A is no longer a deficit country, there is no net profit in domestic income accruing to the bureau. So there is no need to make expenditures on investment goods in order to support domestic employment and build production capacities. Therefore, nothing changes on the bureau’s asset side in this respect. Regarding its liabilities, there is no fundamental change either, the only difference being that financial securities had been owned by non-residents and are now owned by residents of country A. While the export of securities was necessary to equalize exports and imports in line with a sound payment system when the country was in deficit, the repurchase of securities now means the equalization of imports with otherwise surplus exports. Again, the presentation in Table 5.3 is quite stylized. Instead, it could

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leave the reform uncompleted by simply accumulating foreign currency reserves. From the perspective of a single country, the reform’s main merit is to remove the external constraint. As it is binding only when there is a current account deficit, the country may possibly also decide to only employ the reform in the deficit case. Let us summarize the core elements of the reform: on the one hand, the bureau pays country A’s exporters and is paid by domestic importers in domestic currency; on the other hand, it pays the external banking system for imports and is paid by it for exports in foreign currency (Cencini & Rossi, 2015, pp. 246–247). The bureau has the role of country A’s ­settlement institution for international payments. Hence, the domestic banking system no longer has assets or liabilities in foreign currency on its balance sheet. All international payments are channeled and made final by the bureau. In Schmitt’s (2017, p. 160) words, the bureau’s address to exporters is, “your only rights are defined in your national currency and the bureau is your only debtor”; while to importers it says, “your only debts are defined in your national currency and the bureau is your only creditor.” Importers pay the bureau in domestic currency, whereas the bureau pays for imports in foreign currency. Hence, all net imports are paid by an expenditure of a domestic income as well as an expenditure of a foreign income (Schmitt, 2014, p. 58). So far, the payment takes place twice. However, by giving up a part of the deficit country’s current output, the bureau makes the payment final. Thereby, “1. The deficit country remains the owner of the totality of its domestic income, as if its imports were not in surplus. 2. The government of country A obtains, as a final profit, the total value, in a domestic income, of the surplus imports” (ibid., p. 60). The bureau, as it represents the government in this context, reinvests that profit to maintain domestic employment and support capital accumulation. In general, the bureau and its relationship with the government can be considered in different ways. While it is clear that it is a public institution, it can be organized in close or loose connection to the government and the central bank. Hence, it may be the bureau itself spending domestic income for the purchase of investment goods. Alternatively, the bureau might also transfer the profit to the government, which makes investment decisions. Likewise, it may be the bureau which organizes the sale of financial securities to residents of the rest of the world, or it may be the central bank. In any case, the economics of the reform remain unaltered. In our analysis, we consider the bureau as part of the public sector but as a distinct tier. Thereby, investment expenditures by the bureau can be distinguished from government expenditures, the latter thus representing the “general” or “conventional” public sector.

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An aspect to note is that the bureau has a dual nature. In its function as a settlement institution, it is a truly macroeconomic agent, in the sense that it represents the whole economy to the rest of the world. The bureau is the common expression of the set of the country’s residents. By contrast, when it spends the profit as obtained from the country’s deficit, the bureau makes investment decisions like any other agent in the economy. When the accumulated capital stock is employed in production, it even becomes a producer. Therefore, in this second function, the bureau is itself one of the country’s residents. As such, the bureau can be called a “co-resident,” which enables country’s payment for net imports to take place as if the payment was made between residents of the same country (Schmitt, 2014, p. 45). The same consideration applies to the issue of debt. The country sells securities to compensate for all net imports of goods and services as well as interest on those securities. In total, sale of securities balances the current account. From a macroeconomic perspective, therefore, there is no foreign debt because net imports of real assets are compensated by net exports of financial assets (see Brunette, 2015, p. 143). Yet, the bureau in its microeconomic function as a domestic investor and producer faces debt of the amount of the securities it gives up to the rest of the world. But, it is not external debt because no foreign currency is required. With respect to the use of the bureau’s profit arising from current account deficits, the bookkeeping analysis reveals the advantage and importance of spending it for productive investment. Table 5.2 shows that, as a result of the international payment, the bureau ends up with a capital stock that is mirrored by liabilities that correspond, directly or indirectly, to the real resources the rest of the world obtains. The higher the deficit economy’s productive potential, the better it is able to provide valuable financial securities to the net exporters. If the bureau only purchases consumption goods, or if it just holds a domestic bank deposit as its assets, deterioration of the economic situation due to external deficits may make it difficult to maintain the reformed system. Foreign investors may not trust in those assets’ value, and demand higher risk premia. If, by contrast, the bureau strengthens the productive potential of the economy, financial securities can be transferred at a lower interest rate and, accordingly, at a better price.

5.4 THE EXCHANGE RATE AFTER THE ONECOUNTRY REFORM In the analysis of the one-country reform, it is assumed that the exchange rate between country A’s and country B’s currencies is stable. This

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assumption is sensitive because exchange rate volatility, specifically in the context of current account imbalances and capital flight, has been identified as a restriction that strongly limits the development potential of poor countries. However, there is no conclusion yet about what happens to the exchange rate once the reform is implemented. A look at the modification of the credit circuit is helpful. Without mentioning it above, it is implicitly clear that since the bureau takes responsibility of international payments, the banking systems of each monetary space no longer have to go to the foreign exchange market to purchase foreign currency. All residents in each monetary space are able to make all payments in their own currency. Before the reform, the circuit of the deficit country cannot be closed, because a part of domestic income is lost with the payment for imports. Thanks to the intervention of the bureau, domestic income is maintained, thus allowing for the closure of the credit circuit. At the same time, the bureau prevents its residents from running into external debt. This new state is depicted in Figure 5.1 which takes up Figure 4.1 of the previous chapter again by focusing on international payments. It reveals the functioning mechanism of the one-country reform from a different angle: the establishment of the bureau leads to the separation of the credit circuits in the domestic economy and in the rest of the world. Both circuits can be completed, because neither one of the monetary spaces loses any income nor does it experience any harmful consequences of monetary duplication caused by international payments. The bureau manages international payments by serving the domestic economy’s needs with domestic currency and the rest of the world’s requirements with foreign currency. Yet, payment traffics in different currencies are strictly

Domestic economy

International exchange: imports and exports

Rest of the world

Loan issuance

Loan issuance

Loan repayment

Loan repayment

Figure 5.1  T  he open monetary economy of production after the onecountry reform of international payments

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separated. Domestic currency is not exchanged against foreign currency at any moment. As a logical consequence, the foreign exchange market is abolished by the reform. In the figure, the square space, which represented the foreign exchange market, has a new meaning after the reform. It now signifies the bureau’s management of international payments. The closure of the credit circuits and the consequent disappearance of the foreign exchange market give way to the proper treatment of money. It is now in line with its suggested nature as a means of payments instead of an object of payments (see Cencini, 2000, p. 10; Cencini & Rossi, 2015, p. 254). The abolishment of the foreign exchange market means that the nominal exchange rate remains undetermined because there is no market where the price of the domestic currency can be discovered. Even though currencies do not exchange against each other, they still have to be valued relatively because goods still move from one monetary space to another. Hence, an exchange rate is needed in order to know how many goods at given prices in domestic currency exchange against other goods at given prices in foreign currency. The solution to the problem is simple: the bureau can determine the nominal exchange rate at a level it considers as appropriate. Since there is no longer a foreign exchange market, the relative prices of currencies cannot be influenced by relative supply of and demand for those currencies. For this reason, no pressure can be exerted to trigger either appreciation or depreciation. There is no longer any way for foreign interest payments, speculators and other investors to influence the relative price of a currency. After showing how the reform avoids double payment of interest on external debt, this is the second main result: the reform ensures exchange rate stability. The bureau – and hence the government – can define the nominal exchange rate. It is not necessary to defend the currency value against supply and demand pressures because pressure can no longer build up. In the words of the school of quantum macroeconomics, the reform entails a system change from relative to absolute exchange rates where “each currency is exchanged against itself” (see Cencini, 2000, p. 14). The reform of international payments solves a fundamental problem of development economics. As emphasized in abundance, Thirlwall’s law defines the balance-of-payments constraint of a country. If the economy grows at a rate beyond the constraint in today’s non-system of international payments, current account deficits give rise to currency depreciation, external indebtedness and a decline in domestic demand. With the reform, by stark contrast, the external constraint loses its significance. Countries are allowed to run trade and current account deficits by importing more goods than they export, because the bureau guarantees

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monetary and balance of payments equilibria by compensating for net imports through the transfer of real resources.4 Yet, while doing so, those countries do not put pressure on the exchange rate, nor is there any double payment of external interest rates. In other words, the one-country reform of international payments removes the balance-of-payments constraint. This makes developing countries’ development prospects much better. On the one hand, they can import the goods they need for the satisfaction of the most urgent needs of their poor populations (Cencini, 2000, pp. 14–15). Moreover, they can afford the import of capital goods to foster industrialization and productivity growth. Without triggering monetary instability, the poor countries can develop their capital stock. On the other hand, developing countries can target economic growth rates even if they involve temporary current account deficits. In this new system of international payments, a country can reclaim its instruments of monetary and economic policy to the favor of the poor population. Those instruments are effective again while monetary conditions and the exchange rate remain stable.

5.5  WHAT IS LEFT OF CAPITAL FLIGHT The one-country reform of international payments is able to keep an economy’s exchange rate stable despite current account imbalances. Yet, payments for good imports and exports are not the only payments taking place at an international level. We need to know how the reformed system deals with financial transactions. It is capital flight that today can jeopardize the economic stability of almost any country. Are developing countries which have implemented the reform able to absorb the harmful impacts of capital flight? Capital flight which triggers currency devaluation via net supply of deposits in domestic currency in the foreign exchange market is ruled out thanks to the abolishment of this speculative market. It remains to clarify what happens to capital outflows which take the form of payments from the domestic to a foreign banking system. Table 5.4 reveals the effects on the bureau’s balance sheet when a certain person P (in terms of the model, we would talk about a capitalist) transfers their savings to a foreign bank. The setting is analogous to the above tables. As with any international payment, the bureau is involved. Hence, in step (1), it receives the deposit in domestic currency that P wants to exchange against a deposit in the foreign banking system B. The bureau has to take a loan to make the payment of the same amount to bank B. The issuance of a counteracting foreign loan to eliminate the net macroeconomic external debt and the corresponding handover of financial securities, depicted in

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Table 5.4  Effect of a capital flight with the one-country reform Country A

Assets

Liabilities

  (1)

Deposit of P Deposit of bureau Deposit of bureau Deposit of firm F

  (3) 0 Bureau of country A Assets   (1)   (2)   (3)

–x 1x –x 1x 0

Liabilities

Deposit at bank A Loan to B Deposit at bank A Capital stock

1x 1y –x 1x

Loan from bank B Financial securities

1y 1x

Capital stock

1x

Securities

1x

Country B Assets   (1)   (2)

Liabilities

Loan to bureau Financial securities

1y 1x

Deposit of P Loan from bureau

1y 1y

Securities

1x

Deposit

1y

step (2), has already been emphasized in detail. The banking system in country B now owns securities the purchase of which is financed by a loan from the bureau. On the other hand, it has provided the bureau with a loan which was necessary to transfer P’s deposit from country A to country B. These two loans cancel each other out again. The third step again reflects the expenditure of the bureau’s deposit for capital goods. In this regard, capital outflows, which we define as a kind of capital flight, are partially different from conventional current account flows. They are not particularly linked to current account deficits, nor to surpluses. Hence, there is not necessarily a specific need to raise productive investment to reduce the external deficit in the long term. The bureau may therefore also think about purchasing other securities in the domestic economy instead of installing additional physical production plants. For instance, it may purchase shares of existing companies. This would mean that the bureau acquires the ownership of the economy’s existing capital stock. The analysis clearly shows that even in the presence of capital flight,

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country A’s reformed payment system is able to maintain exchange rate stability. Net external debt remains at zero. The volume of financial securities given up to country B increases, but the bureau makes use of it by accumulating a capital stock. One of the most important reasons causing capital flight is thus removed: currency depreciation caused by capital flight triggers even more capital flight. By ensuring stability of the currency’s value, the self-enforcing dynamics are ruled out. The main effect of the reform is that despite capital aiming to flow out of the country, it actually remains within it. Before the outflow, P holds a share of domestic output via its deposit. After the outflow, the same share is held by a nonresident through ownership of financial securities. In the same vein, as with any international payment, capital outflows cause the loss of domestic income in today’s non-system. The reform is also effective in maintaining domestic effective demand. Output and employment are thus supported. International payments no longer trigger economic instability, thereby removing a further incentive for wealth owners to move their money out of the monetary space. Finally, the central bank does not have to react to capital flight by raising interest rates, which would contribute to economic contraction. One may ask the question of whether capital controls are still necessary after the reform. Basically, the answer is no. However, one may imagine the hypothetical situation where capital outflow does not seem to stop soon. Any domestic money the bureau receives is fed back to the economy by the bureau’s spending. Assuming that the agents who get the returns from the sales of goods (or securities) to the bureau again move those returns out of the country, capital flight may continue forever, as it is fed by the bureau’s revolving expenditures. Yet, such a potential effect has inherent limits. First, an expected decrease in the profit rate, possibly caused by economic policy, is the main reason for capital to flee a country. A second reason is the self-enforcing effect of currency depreciation, because it threatens the value of capital measured in foreign currency even further. However, as explained, the second cause is ruled out with the onecountry reform. It is thus unlikely that the first reason, a drop in the profit rate, will apply for a longer time since it is the new system which supports economic performance. Another factor making continued capital flight unlikely is the bureau’s strategic influence. The bureau can make strategic choices with respect to its expenditures in the domestic economy. It may use the profit from capital flight for the creation of additional capital. Alternatively, it can purchase shares of existing companies. This second option would mean that it purchases from private capital owners. As a result, a growing share of output is produced by the public sector, as the bureau is a part

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of this. It is mostly the upper income class moving wealth out of the country. Those incomes stem from capital income to a large degree. To the extent that production plants are taken over by the public sector, capital incomes in the private sector erode and thereby so does the basis of capital flight. These factors make it unlikely that the bureau cannot prevent the harmful effects of capital flight. There is thus no need for capital controls, so that bureaucratic controls giving rise to circumvention endeavors are not necessary. In specific situations, the government may still think about applying them for particular purposes and types of capital flows. The reform and any additional measures are complementary. The only possible bottleneck is the provision of appropriate financial securities by the bureau to the rest of the world. In cases where they become scarce, capital controls may be useful to limit capital outflows at least partially. The reform is also able to deal with the opposite of capital flight; that is, capital inflows. Inflows of foreign currency can be used to buy back the securities that have been handed over to the rest of the world in former deficit periods. Alternatively, the bureau buys new securities abroad. Capital inflows are easier to deal with than capital flight. The bureau’s main role in this case is to prevent monetary duplication feeding a speculative bubble in the domestic economy. It successfully satisfies this requirement. So far, it has been shown how the reform solves many of the macroeconomic problems faced by developing countries. Their open economies are exposed to the duplication of external payments, exchange rate fluctuations and capital flight. The reform separates the domestic credit circuit from the external one. The proper treatment of money thus avoids the twofold payment of interest while providing deficit countries with a net gain to be used in the domestic economy. Exchange rate stability is ensured, while effective demand is maintained. These are the conditions for developing countries to regain their autonomy for economic policy.

5.6 MODEL D): THE RECLAIMING OF MONETARY AND ECONOMIC POLICY Submodel c) has revealed the limits of successful economic policy in a globalized world. In line with the preceding analysis, the model is extended one more time to integrate the reform of international payments by a single country. Now the country is able to retain a stable nominal exchange rate thanks to the bureau, which settles international payments of the domestic economy. Moreover, the strict separation of the domestic credit circuit from the foreign circuit prevents the loss of a part of domestic output

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arising from payments to the rest of the world. Both double payment and monetary duplication are ruled out. Effective demand can be maintained. It contributes to investment, capital accumulation and hence productivity development. Model d) also shows that monetary policy and public intervention such as investment programs reclaim their effectiveness in the open economy. A decrease in the interest rate triggers investment. Growing output and employment give rise to a trade and current account deficit. However, the bureau reinvests the net gain it earns from the external deficit. As a result, productivity grows, thanks to the bureau’s contribution to the economy’s capital stock. Higher productivity means a more competitive real exchange rate and also export growth. Likewise, economic policy in the form of public investment entails domestic output growth and a current account deficit. The bureau complements the proper government’s investment with its own productive expenditures. Overall, productivity growth strengthens exports. In the cases of both monetary policy and public investment, the stabilization of the exchange rate by the bureau prevents any depreciation, which would raise the weight of external debt and interest payments. Moreover, thanks to the finality of international payments, external indebtedness does not reduce living standards in the sense that a growing part of output has to be spent on interest payments, as will be shown. Finally, productivity growth enables the economy to move from the initial external deficit back to the balanceof-payments equilibrium or even a surplus position. The monetary reform thus provides an economy with an additional powerful instrument which can be embedded in a development strategy. Submodel d) is represented by 104 equations explaining 104 endogenous variables. Besides the firms, workers, capitalists, the government and the external sector, there is the bureau as another macroeconomic agent. It is created by the implementation of the one-country monetary reform and responsible for the maintenance of the new system for international payments. It is able to spend the extra gains from current account deficits on capital goods. By accumulating capital, it contributes to domestic output in a similar way as private firms or the proper public sector do. As in the previous chapters where the new models were introduced, the following explanations focus on the new and the modified equations.5 The Bureau’s Settlement of Payments Let us start with the core element of the reform. The domestic credit circuit no longer interferes with the external circuit. There is no foreign exchange market, such that the nominal exchange rate is not exposed to

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volatile supply and demand sources. Exchange rate stability is maintained by the bureau. In fact, therefore, the level of the exchange rate is subject to political decision-making and can be considered a “policy rate,” ERpolicy:

ΔER 5 ΔERpolicy(80’)

We take the exchange rate as held constant by policy. Assuming that the economy runs a current account deficit, a certain amount of domestic income has to be spent on net imports and external interest payments. It will be seen how the latter is built now that interest payments are no longer double. Essentially, the bureau receives the payments from domestic residents which are directed to foreign payees. However, since the latter have to be paid in foreign currency, the bureau has the payments in domestic currency at its disposal. The bureau makes use of this net gain by spending it on investment goods, IBU. The current account deficit in monetary units from the preceding period defines current investment of the bureau. The time lag is necessary to avoid a circular argument, because the current balance of payments is also determined by the bureau’s expenditures. This is precisely how the practical functioning of the bureau is suggested in Schmitt (2014):6

IBU 5 ΔLNR,21*ER21  for ∆LNR, 21 . 0



IBU 5 0  for ∆LNR, 21 # 0

(84d)

The bureau acquires investment goods, while the monetary units of domestic income have found their way back to the domestic circuit or, respectively, have never left it because the bureau is part of the domestic circuit. This increase on the asset side of the bureau is matched by the same amount, ∆LNR,  21*ER21, on its liability side where it is owed in foreign currency. So far, a partial success of the reform is achieved because the additional payment in domestic currency for net imports is eliminated due to its acquisition by the bureau. Yet, the bureau’s gain is not final because it still faces an external debt of the same amount. This is to be addressed in a second step. As explained in the previous section, the loan the domestic economy has to access is compensated by a loan back to the rest of the world. Hence, these loans, LN*R, are denominated in foreign currency and are equal to the new foreign debt incurred. As with the bureau’s expenditure of its profit in domestic currency in equation (84d), the compensating loan is granted one period later to avoid a circular argument. This step is made as long as there is positive external debt. If this is not the case ‒ that is, when

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the country is a net owner of foreign reserves ‒ such counteracting loans are no longer necessary:

ΔLN R* 5 ΔLNR,21 for LNR, 21 . 0



ΔLN R* 5 0 for LNR, 21 # 0

(85d)

The equation also implies that when the domestic economy runs a current account surplus that reduces its external debt, the compensating loans decrease again, too. It would not serve any macroeconomic necessity to maintain them. In total, the country is now relieved of external debt because it is all compensated by loans in the opposite direction. As they net out, external debt is zero.7 In cases where it is required to express external debt as it would be implied by the accumulated current account deficit, we refer to “gross external debt.” The bureau’s loan to the rest of the world means the domestic economy’s payment for the rest of the world’s imports of the respective amount. The loan thus implies that real resources are transferred to the foreign economy. In the simple construction of the model, this is done by bonds provided by the bureau in domestic currency. Hence, bonds owned by foreign residents, B*, increase to the extent that external debt and the compensating loans grow, corrected by the exchange rate. Since the loans cancel each other out, this means that bonds are sold abroad at an amount of the external deficit, LNR: ΔB* 5 ΔLN *R *ER(87)



There is no gain for the bureau when the country runs a current account surplus. In today’s international monetary order, a surplus gives rise to monetary duplication, thus increasing the amount of monetary units available in the domestic economy. To make the payment final, the bureau issues financial claims denominated in domestic currency. They are bonds, B, equal to B* with the mere difference that the former are owned by residents and the latter by non-residents. Since bond purchasers have to pay from income available in the economy, the issuance of bonds withdraws domestic deposits from circulation such that the latter’s amount remains stable. This is how the returns from the external surplus are sterilized. Again, the bureau refers to the preceding period and defines the amount of newly issued bonds by the size of the current account surplus:

ΔB 5 ΔLNR,21*ER21 for ∆LNR, 21 , 0



ΔB 5 0 for ∆LNR, 21 $ 0

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To make it easier once again to understand the accounting logic in line with the bookkeeping analysis above, let us imagine the case where the economy starts from zero liabilities in foreign currency. In the first period it runs a current account deficit, followed by a surplus of the same size in the second period. When the deficit occurs, first, the bureau makes investment expenditures. The acquired capital stock is matched by bonds held by foreign residents. Hence, the capital stock is actually owned by foreigners. In the next period, the current account surplus endows the bureau with foreign currency which can be used to buy back the bonds. At the same time, the exporters earn the corresponding revenues in domestic currency. These monetary units can be used to purchase the bonds. Hence, bonds held by non-residents (B*) decrease by the same amount of bonds held by residents (B) increase. In fact, financial securities just change ownership. Ownership of the bureau’s assets thus changes from the rest of the world to the domestic economy. Since there is no longer any net external debt, there is no more selfaccumulating effect due to interest payments on foreign loans. An additional aspect still has to be accounted for. Bonds yield interest in domestic currency. Yet, to the extent that they are owned by foreigners, it is very likely that they transfer this capital income to their own banking system. The current account thus deteriorates by the amount of interest on B* corrected by the exchange rate: r *B * * ) 1 D,21 21 (82’) ΔLNR 5 EXR 1 rR,21* (LNR,21 2 LN R,21 ER As explained, the bureau’s investment in case of an external deficit maintains employment in the domestic economy. Inventories of private firms increase by less (or decrease by more) than would be the case without the bureau’s investment expenditures. Likewise, sales of investment goods to the bureau raise private sector profits. IBU, F is the part of the bureau’s purchases of investment goods which is sold by the private sector. The following equations thus have to be adjusted by the term:

ΔINF 5 YF 2 CF 2 IF 2 IBU, F 2 EXF (2’’)

  PF 5CF 1IF 1IBU, F 1ΔINF 1EXF*ER2WF 2rLN,21*LNF,21 2TF (3’’’) The same holds for the public sector. Following the derivation of model b), the form of the equation is different as it is solved for consumption. But its meaning is analogous. The share of the bureau’s investment goods sold by the public sector, IBU, G, becomes part of its total output. Just in

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the same way as in the private sector, government profits increase because output sold grows:

CG 5 YG 2 ΔING 2 IG 2 IBU,G 2 EXG(51’’)

PG 5 CG 1 IG 1 IBU,G 1 ΔING 1 EXG *ER 2WG 2 rLN,21 *LNG,21 (52’’) It is not a priori clear how the demand from the bureau’s investment expenditures is divided between the private and the public sector. Since both sectors produce at the same level of labor productivity, and as long as the public sector sells at given market prices, there can basically be any distribution of the bureau’s investment. We simply assume that IBU, F and IBU, G are distributed according to their respective shares in the sum of private sector and government output:

IBU, F 5

YF *I (89) YF 1 YG BU



IBU,G 5

YG *I (90) YF 1YG BU

In the case of a current account surplus, the bonds sold by the bureau are purchased by capitalists; because, by definition, capitalists are the only agents in the economy to buy financial assets.8 This means that their income is complemented by interest revenues from bonds. We assume that the bond rate is equal to the rate on deposits as both are considered as riskless investments. Capitalists’ consumption expenditures and savings thus increase correspondingly. In addition, capitalist savings are reduced by the increase in the volume of bonds in the current period. They exchange deposits against bonds. Capitalist deposits can potentially even be negative, while the number of bonds increases. This means that capitalists become indebted to buy bonds, thus giving rise to leveraged investment:   CCap,tot 5 (1 2 sCap) * (PCap 1 rD,21*DCap,21 1 rD,21*B21 2 TCap) (20’’’)   ΔDCap 5 sCap* (PCap 1 rD,21*DCap,21 1 rD,21*B21 2 TCap) 2 ΔB(21’’) The bureau’s investment expenditures imply the accumulation of its own capital stock, KBU. With production equipment, the bureau becomes another macroeconomic agent contributing to total output. In reality, it

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is likely that production by the bureau is an integrated part of general production of the public sector. In this model, we keep distinct the general public sector as introduced in submodel b) and the bureau as a “second public sector”. This allows us to see the impacts of the bureau in isolation. Hence, the bureau has a dual nature. On the one hand, as explained, it is the domestic economy’s settlement agency for international payments. On the other hand, it is a domestic producer, like private firms or the government: ΔKBU 5 IBU (91)



Much like the public sector, the bureau can fully use production capacity because its primary objective is the country’s development rather than its own profitability. Yet, for reasons that will become clear, it may be better to vary capacity utilization. Therefore, we consider the bureau’s rate of capital utilization, CUBU, as a kind of policy variable. Since the bureau produces at the average level of the economy’s productivity by benefiting from existing knowhow and technology, the capital intensity of production is equal to that in the private and public sectors. The level of employment in bureau production is thus given as follows: LBU 5 CUBU *



KBU (92) ci

The formula is analogous to those of the other sectors. Utilization of the bureau’s capital stock gives rise to a certain level of employment, which falls when capital intensity grows. Once technology is given, employment varies with capacity utilization. The calculation of bureau wage sum, WBU, and bureau output, YBU, is straightforward:

WBU 5 w*LBU (93)



YBU 5 A*LBU (94)

Productivity, total employment, total output, total capital stock, and total wage income are thus each complemented by an additional variable:

A 5 δ1* (Ktot) 0.5 1 δ2*a a 0 IF 1 a 0 IG 1 a 0 IBU b



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t21

t21

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t21

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Ltot 5 LF 1 LG 1 LBU (48’)

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Ytot 5 YF 1 YG 1 YBU 5 A*Ltot(49’)



Ktot 5 KF 1 KG 1 KBU (57’)



Wtot 5 WF 1 WG 1 WBU 5 w*Ltot(61’)

Thus, as with the general public sector, the bureau contributes to productivity development in the economy by means of its investment that adds to the total capital stock. The bureau purchases capital goods, with which it produces other goods which are either sold to workers and capitalists at home or exported. When not all goods are sold, inventories are accumulated. Solving for the domestic sale of consumption goods, CBU, the equation yields:

CBU 5 YBU 2 ΔINBU 2 EXBU (95)

where INBU and EXBU are the bureau’s inventories and exports, respectively. The bureau’s inventories are equally defined as those of the private and the general public sector. When either domestic savings or a trade deficit entails the stocking of goods in the domestic economy, the inventories distribute between the sectors according to their share in total output. This has been derived in more detail in submodel b). Inventories change by the same amount as in the private sector, but corrected for the size of the bureau’s output. The change in INBU in every period thus is given by:

ΔINBU 5

ΔINF *YBU (96) YF

The bureau’s exports are also defined in analogy to the other sectors. They grow in income in the rest of the world and by a depreciation of the real exchange rate. Just as in the other sectors, we assume that an increase in productivity increases product variety and triggers a small growth stimulus in the external sector. As explained in model c), the rest of the world purchases more domestic goods when productivity grows. The factor which determines the influence of the external sector’s income is thus variable. Additionally, exports react to changes in external sector output and the real exchange rate according to their share in total domestic output. This guarantees that the overall parameters for total exports of the country remain stable and do not increase by adding a new sector in the domestic economy:

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EXBU 5 ηBU,1*YR 1 ηBU,2*RER(97)

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ηBU,1 5



YBU * (η11 1 η12*A^0 ) (98) Ytot

ηBU, 2 5



YBU *η2 Ytot

(99)

The bureau’s exports improve the economy’s trade balance by diminishing the external sector’s net exports, EXR:

EXR 5 IMW *PLrR 1 IMCap*PLrR 2 EXF 2 EXG 2 EXBU (78’)

A small adjustment has to be made in the market for consumption goods. Workers and capitalists now spend their income not only on private firms’ and government goods but also on consumption goods sold by the bureau. Solving for private sector consumption goods (in line with previous models), we get:

CF 5 CW 1 CCap 2 CG 2 CBU (4’’)

which means that private firms now have to share the market not only with the general public sector but also with the bureau. Yet, this is not an absolute loss, to the extent that the whole consumer goods market ‒ that is, CW 1 CCap ‒ grows. The Bureau as a Domestic Producer Just like the other sectors, the bureau is able to make profits, denoted as PBU. They arise from the fact that it produces at the same productivity as the rest of the economy and pays average market wages. As with the general public sector, the bureau could influence the labor market by setting higher wages than the private sector or by promoting wage moderation. We abstract from those extensions here. The second source of profits (or losses) arises from international monetary flows. The domestic and foreign credit circuits are separated now due to the bureau’s bookkeeping of imports and exports as well as international interest payments. For this reason, it is on the bureau’s balance sheet that domestic and international monetary flows meet. However, even if the economy is running a current account deficit or did so in the past such that there is gross external debt, there is no net interest due because foreign loans in opposite directions approximately “cross each other out” and can actually be cancelled. Remaining interest payments to the external sector (or possibly also earnings from it) have to be corrected by the exchange rate; which is, however,

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stable as long as there is no other policy decision. Interest payments on domestic-currency bonds reduce profits likewise. In the case where the bureau becomes a depositor, the reasons for which are explained in a moment, deposit returns are a source of profits. The whole formula thus can be presented as follows: * ) PBU 5 CBU 1 ΔINBU 1 EXBU*ER 2 WBU 2 rR,21* (LNR,21 2 LN R,21

*ER 2 rD,21* (B21 1 B *21) 1 rD,21*DBU,21(100)

where DBU are the bureau’s deposits. Before explaining this variable, another point needs to be emphasized. As noted, interest payments on foreign debt are due in foreign currency. By contrast, the bureau’s profits are measured in domestic monetary units. Profits arise from domestic economic activity. So how can interest in foreign currency influence those profits, given that the domestic and the foreign circuit are separated? On the other hand, it is obvious that the bureau has to take external interest payments into account on its balance sheet, which is the macroeconomic representation of the domestic economy in its relationship with the rest of the world. The problem can be solved by considering the term rR,      –1*(LNR ,   –1 – LN*R ,   –1)*ER more carefully. With net exports given, interest on external debt adds to the amount of that existing debt. This is shown in equation (82), which was already introduced in model c). With the reform, the bureau is the only external debtor of the country. This means that it has to carry the whole burden of foreign interest payments. If not taken into account properly, those interest payments just add to the bureau’s liabilities without being met by a corresponding increase in its assets. For this reason, external interest is accounted for in the bureau’s profit equation (100). The term rR,    –1*(LNR,    –1 – LN*R ,    –1)*ER does not just translate interest from foreign currency into domestic currency: rather, it signifies an amount of money (or deposits, to be precise) in domestic currency which is equal to foreign interest. In other words, the increase in the bureau’s liabilities in the form of external interest has to be met by an increase in its assets in order to prevent negative equity. This is why profits diminish by the amount of foreign interest. It is clear now that the whole equation is composed of terms that all denote domestic currency.9 This bookkeeping step is necessary. Otherwise, profits would be too high, and if they were distributed, the bureau would be left in net debt. Yet, since net external debt is asymptotically zero, this explanation is more of theoretical than practical relevance. The requirement of a sound balance sheet of the bureau is now fulfilled. However, as long as the bureau keeps the counterpart of external interest

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due in the form of liquid deposits on its asset side, it withdraws income from the domestic credit circuit. Growing foreign debt implying growing interest payments would thus entail an increasing drag in effective demand. The impact on the domestic economy would be the same as in today’s (non-)system of international payments. Even though the monetary units would basically still be available in the economy by considering the bureau a domestic agent, they are, in fact, lost for economic activity. Interest would still be paid twice: once in domestic currency and once in foreign currency or, respectively, once in real terms and once in monetary terms. For this reason, it is essential for the bureau to feed the “domestic part of the interest payment” back into the economy. This is taken into account in equation (84d) above. The formula guarantees that the bureau’s investment expenditures are of an amount which is not only equal to the country’s trade deficits, but to the whole current account, thus including foreign interest payments. Hence, the domestic income in the amount of foreign interest that is retained by the bureau in profit equation (100) is spent in the subsequent period on investment goods. The deposits on the bureau’s balance sheet are replaced by real assets. The balance sheet is equilibrated. At the same time, the spending of this amount of income in the domestic economy guarantees that interest on external debt is paid only once. While the bureau in its role as the macroeconomy’s external settlement agency should not withdraw income from the economy, it may indeed do so in its role as a conventional domestic producer. Just as with private firms or the general public sector, the bureau can also decide to retain a part of profits so that undistributed profits, PUBU, are given by:

PUBU 5 xBU *PBU (101)

The determinant factors of the bureau’s deposits mentioned in equation (100) are now given. First, the bureau accumulates savings if it does not distribute all its profits.10 Second, in the case of a current account deficit it receives the domestic monetary units, which are spent on net imports. In this second term, ΔLNR*ER, the money retained by the bureau to account for foreign interest payments is also contained. Yet, the bureau makes use of this income by spending it on investment goods, IBU . It should be noted that these two components do not offset each other, because it is the current account deficit of the current period which adds to the bureau’s deposits, while investment of the current period is equal to the current account deficit of the preceding period (see equation 84d). Hence, they are not equal. The fourth term, ΔB, adds to the bureau’s deposit as bonds are issued in domestic currency, the receipts of which are deposited. Recall that bonds

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are issued when there is a current account surplus. This implies a decrease in external debt (a negative second term) and zero investment expenditures (third term). For the final term, the bureau in its function as a producer may not be able to sell all goods, so that the corresponding missing sales diminish the bureau’s deposits. The bureau’s deposit thus has a the role of a residual, thanks to which the bureau is able to make its payments and to bridge time. The equation is given as follows:

ΔDBU 5 PUBU 1 ΔLNR*ER 2 IBU 1 ΔB 2 ΔINBU (102)

Even though this is not our focus here, we may consider what happens when the bureau – or the government in general – decides to depreciate the currency. Owing to the revaluation of foreign credits and debits, this would imply a change on the bureau’s balance sheet without any link to current economic activity. Besides retained profits, exchange rate changes are another factor leading to an adjustment of the bureau’s equity, EQBU:

* ) *ΔER(103) ΔEQBU 5 PUBU 2 (LNR,21 2 LN R,21

In the case of net external debt, a depreciation would give way to negative equity. The bureau could deal with such a situation by retaining a share of its profits to re-equilibrate its balance sheet. This, however, would depress domestic effective demand. On the other hand, the bureau could use undistributed profits to purchase investment goods. The overall impact on effective demand would thus eventually be neutral. To the extent that nominal depreciation also gives rise to a real devaluation, in the end the economy has to export more goods to repay external debt than it would have had before the depreciation. The bureau’s profits can be used in the same way as any other public sector profits. We assume that they enter government revenues. Therefore, the distributed part of profits contributes to a smaller budget deficit:

BD 5 G 2 TG 2 (PG 2 PUG) 2 (PBU 2PUBU) (45’)

If those government revenues are used for social services, they enter government expenditures that are simply used to support workers’ income in our model. In this case, the parameter θ4 takes the value one:   G 5 θ1* ( gY, target 2 gY,21) 1 θ2* (PG 2 PUG) 1 θ4* (PBU 2 PUBU) (46’) The separation of the domestic credit circuit from its external counterpart means that domestic banks only have assets and liabilities in domestic

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currency on their balance sheets. As a consequence, bank profits are neither fed nor diminished by foreign interest and therefore simplify to: PB 5 rLN,21* (LNP,21 1 LNG,21) 2 rD,21* (DW,21 1DCap,21 1DBU,21) (28’’’) This means that the structure of the bank balance sheet is the same again as in submodels a) and b) where the economy is closed. The only difference is given by the bureau’s interest-bearing deposits (or the bureau’s debt, should DBU be negative). With the separation of circuits, domestic banks only have to take into account domestic interest rates on the lending and borrowing sides. Thanks to the reform, a difference in the domestic and the foreign interest rate levels no longer distorts banks’ profitability. As a result, the interest rate target of the central bank directly transmits to market rates. Complicated interest rate calculation by using weighted averages of model c) shrinks back to the closed economy case of sub­ models a) and b):

rD 5 rCB(26)



rLN 5 rD 1 d(27)

The simplifying restructuring of the banking system gives a sketch of how domestic monetary policy becomes more autonomous again because now it is able to implement its interest rate target in the market more directly. Finally, the model is completed by adding the bureau’s wealth equation. Its wealth consists of its real assets, that is, the capital stock and unsold goods, as well as net financial wealth in the form of deposit minus external debt and bonds issued:   VBU 5 KBU 1 INBU 1 DBU 2 (LNR 2 LN *R,21) *ER 2 B 2 B*(104) The wealth equations of the other sectors and the equation of the whole domestic economy have to be adjusted accordingly. Bonds add to capitalists’ wealth, while banks’ wealth is reduced by the bureau’s deposits. On the other hand, foreign debt no longer influences banks, so it disappears from their wealth equation:

VCap 5 DCap 1 B(35’)



VB 5 LNF 1 LNG 2 DW 2 DCap 2 DBU (36’’’)

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A reform to remove the external constraint ­245



* ) *ER 1 B*(86’) VR 5 (LNR 2 ΔLN R

Vtot 5 VF 1 VW 1 VCap 1 VB 1 VG 1 VBU 1 VR 5 KF 1 INF 1 KG

1 ING 1 KBU 1 INBU (37’’)

5.7 MONETARY AND ECONOMIC POLICY AFTER THE REFORM We are now keen to know how the development of the economy changes with the reform in place. In particular, we test for the impacts of monetary and economic policy and want to see if policy regains the space it lost when we moved from the closed economy to the open one. Model d) continues from the previous version with the same values and sets the new parameter values according to reasonable economic theory.11 We assume that the bureau keeps the exchange rate stable throughout the period considered. Moreover, it distributes all profits from its own production, meaning that they are transferred to the public budget, where they are used for government spending. The bureau’s capacity utilization may vary in the different simulations. It will be seen that its value is important for the appropriate design of policy measures. Monetary Policy Effects Let us start again with expansive monetary policy. To the extent that the cut in the interest rate level impacts the balance of payments, the bureau becomes active by either investing in the domestic economy (current account deficit case) or issuing bonds in domestic currency (surplus case). Hence, in a country where the reform is implemented, any domestic policy measure is accompanied by a second one in order to settle international payments. However, even though the bureau has some space to define its concrete measures appropriately, it is not a completely independent force. Indeed, it is triggered by other events that have an impact on the relationship to the external sector. Figure 5.2 exhibits the effects of a 1 percentage point cut in the interest rate. We assume that the bureau in its function as a domestic producer keeps its capacity utilization at 75 percent. The explanation for this is given below. Panel a) shows how private investment reacts to improved credit conditions and profit expectations. Investment initiates growing private employment and output, as depicted in panels b) and c). The result of domestic economic growth is rising imports and hence a deficit in the

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bureau

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Figure 5.2  E  ffect of a 1 percentage point decrease in the interest rate on investment, employment, output, trade balance, external debt and exchange rate (CUBU 5 0.75) trade balance and the current account as can be found in panels d) and e). To prevent double payment of net imports and interest, the bureau starts transferring bonds abroad while investing the same amount of domestic monetary units at home (see panel a). Hence, even though a current

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account deficit occurs, net foreign debt remains at zero, such that there is no external constraint to put pressure on the domestic economy. The bureau’s additional source of productive investment strengthens economic growth further beyond the effect of expansive monetary policy. The bureau starts employing workers for its own production. Increasing total employment (panel b) gives way to higher wages.12 Higher wages diminish the profit rate in the private sector where investment falls even below zero while private employment declines. This process goes on for a certain time, while the positive impact of the bureau’s investment and employment dominates the negative impact of the private sector such that total employment keeps growing. Trade deficit and current account deficit increase further as well. However, bureau investment and employment not only raise imports: investment also supports productivity growth. The effect of higher productivity is twofold. First, as panel f) shows, it allows for a stable real exchange rate despite increasing wages. Second, once the bureau has accumulated a sufficient capital stock representing a certain level of technology, the economy’s exports grow sufficiently so as to turn the trade deficit into a surplus. Rising exports reduce the amount of bonds transferred abroad. Notably, it is not only the bureau that benefits from its own investment but also private firms. Productivity grows in all sectors. Thus private exports also accelerate. Towards the end of the period considered, private sector investment and employment rebound. One may argue that such an economic outcome should be rejected because it crowds out the private sector via the labor market, as panel b) clearly shows. Yet, for firms to stay in the market, employment is not the key indicator. Panel c) reveals that private output grows slightly over time (with growth even slowly accelerating towards the end of the time frame). They benefit from increased productivity, as enabled by the bureau’s investment. Figure 5.2 reveals the key role of the reform. It allows countries to run current account deficits for a longer time without triggering currency crises and subsequent economic disturbances. In other words, Thirlwall’s law is removed. This does not mean that external deficits can grow forever. But their limits are no longer of a macroeconomic nature. Instead, debt limits are merely subject to the creditworthiness of the domestic economy, hence eventually its ability to provide valuable real resources to the rest of the world. Economic development and the fostering of productivity and growth necessarily involve temporary deficits. With the reform, they are no longer a development obstacle. The growth of total output is due to the cut in the interest rate. This shows that monetary policy can be an effective tool to support

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­ evelopment and poverty reduction. This result contrasts with those of the d preceding chapter, where we concluded that monetary policy is a useless tool in the open economy. The fundamental importance of the reform of international payments is thus revealed. The economy remains open, but the reform allows the country to reclaim monetary policy as an instrument for development. Additionally, monetary policy is not only effective, but it is also more autonomous. Hence, it does not have to be dedicated to the stabilization of the exchange rate, but can be better devoted to the needs of the domestic economy. The Effects of Public Investment Let us investigate the second main policy instrument of our model: public intervention in the form of government investment. We assume again that the government’s target of economic growth is increased from zero to 8 percent starting in 2004, and goes back to zero step by step from 2018 onwards. In panel a) of Figure 5.3, the general public sector raises investment expenditures according to the gap between the growth target and actual growth. Government investment creates demand to which the private sector reacts by increasing investment at first. Total employment grows and so does output as shown in panels b) and c). Yet, economic growth involves another trade deficit entailing a corresponding increase in the amount of securities to be sold abroad, exhibited in panels d) and e). As a reaction to the deficit, the bureau is activated by spending the monetary units of the current account deficit to purchase investment goods from domestic producers, while transferring bonds to the external sector. Domestic effective demand is strengthened further. Since a current account deficit triggers additional investment by the bureau and hence additional output growth, the increase in the external deficit is selfenforcing for a while. Bureau investment even exceeds investment of the proper economic policy target. While employment by the bureau and in the general public sector grows, private sector employment declines. The same applies to respective outputs produced. Overall, accelerated investment fostered by the general public sector and the bureau implies productivity growth. Again, higher productivity prevents the real exchange rate from appreciating (see panel f). Moreover, it relaxes the external constraint. The economy becomes more competitive in the rest of the world, and can export more as well as more varied goods. As a result, the trade deficit turns into a trade surplus. Net exports provide the country with currency reserves with which the country’s financial securities can be regained. In this simulation, the economic policy program actually leads to a

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Figure 5.3  E  ffect of public investment on private investment, employment, output, trade balance, external debt and exchange rate (CUBU 5 0.75)

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crowding-out of the private sector. This is shown not only by falling private employment, but this time also by a drop in private sector output. This effect is to be discussed further. However, the setting-in of current account surpluses in 2017 means the end of the bureau’s investment spending. Tightness in the labor market is eased. Moreover, higher productivity and external demand are also to the favor of private firms. Their profitability improves such that they increase investment again. Towards the very end of 2025, a slight new growth in private sector output is visible. Much as in the case of monetary policy, the reform of international payments enables public investment to be another effective tool for a country’s development strategy. Domestic growth entails temporary external imbalance, which can be dealt with by the country thanks to the stabilization of the exchange rate and the separation of the domestic credit circuit from the international circuit. Depending on the growth target of the policy program, public investment can be pushed to the level desired to reduce poverty sufficiently. The reform allows the country to employ its policy instruments autonomously while maintaining the openness of the economy and a stable relationship to the rest of the world. Figure 5.4 shows that public investment is not only effective in influencing the macroeconomy. As in the closed economy case, it is also feasible with respect to the level of public debt. At the beginning, panel a) shows a budget deficit in a few subsequent periods. As in model b), this is due to the fact that the government starts investing from zero. Investment goods, which cannot be sold to workers, make up the largest part of public sector output. When the new capital stock is employed in production of consumption goods, sales allow the government to run a balanced budget. Initial budget deficits raise the ratio of public debt to output. With growth in output, the ratio falls again. The release of inventories in the course of export growth presses public debt even below zero. Besides

Panel b) public debt to output

Figure 5.4  Effect of public investment on public deficit and debt ratios

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this special effect, it can be said that the public investment program can be implemented with public debt remaining stable. At the same time, investment has allowed the government to build up a capital stock that more than outweighs public debt, even if there has not been any change in inventories. The economic result of active monetary and economic policy is promising. In particular, the latter can be implemented under control of public debt. But what do those development paths imply for the bureau, both in its role as the country’s responsible institution for international payments on the one hand, and as a domestic producer on the other hand? We defined that the bureau is a sector separate from the general public sector. In reality, however, it is quite obvious that it is necessarily an additional component of the public sector, despite its particular characteristics. Let us see what the bureau’s balance sheet looks like at the end of the period considered after the implementation of a public investment program like the one in Figure 5.3. The balance sheet in Table 5.5 decomposes the bureau’s liabilities. A large share of it consists of bonds owned by foreign residents (the country’s real resources). They result from the periods where a current account deficit took place. Yet, at the end of 2025, the accumulated amount of bonds transferred abroad has already been decreasing. This can be seen from a further component of liabilities, that is, bonds B owned by domestic residents. As explained, they are issued in periods of a current account surplus. In such periods, receipts of foreign currency reserves from the surplus are used to buy back bonds from foreign residents. In fact, therefore, ownership of those bonds changes from foreign to domestic. A final component of liabilities is made up of the decrease in inventories compared to the initial level. This means that goods were sold that were not produced in the same period, so that sales returns have to be corrected by the reduction in the stock of produced goods. However, this third component is specific to the simulation at hand but not essential to understand the key role of the bureau. The reason why the bureau could sustain growing external deficits until their final reduction is to be found on the asset side of the balance sheet. Table 5.5  Effect of public investment on the bureau’s balance sheet Assets Bank deposit Capital stock Foreign loans

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The net gain from net imports was used to purchase production equipment backing the liabilities. Moreover, the bureau owns a bank deposit containing receipts that are only spent in a later period due to time lags in the model. Thanks to the reform, the bureau, and hence the country, does not face any net external debt. The small amount of foreign loans results from the time lag that does not net out foreign loans and debt exactly, but only approximately. Despite the obvious advantages of the reform, there is a channel through which developments in the balance of payments potentially distort the domestic economy. Any change in the state of monetary or economic policy also tends to influence the current account. Bureau investment driven by current account deficits pushes effective demand in the domestic economy. Hence, the economic impacts exerted by the bureau are driven by forces which are at least partially exogenous and independent of the needs of the domestic economy. A possible result of this may be overheating of the labor market, thus crowding out private competitors. How can the external and the internal requirements in an open economy be reconciled? The crowding-out argument of private sector proponents may be considered a weak aspect of the reform. In the following, we investigate this issue by looking at the impact of a varying capacity utilization at the bureau’s production plant and its connection with the performance of the private sector. Therefore, the different macroeconomic impacts of the bureau have to be distinguished. Bureau investment in the course of a current account deficit exerts demand in the domestic economy. Once a capital stock is created, the bureau employs workers. Additional consumption expenditures improve the state of demand further. However, employment in the “bureau sector” also implies rising wages, which eventually gives way to the crowding-out of the private sector. If we assume that, for instance, the bureau’s capacity utilization is only 50 percent instead of 100 percent, we are in a situation where the bureau’s investment spending triggers effective demand, while the second effect, upward pressure on wages, is strongly reduced. For the private sector, this situation is preferred, since private firms benefit from the bureau’s purchase of investment goods, while there is only reduced competition in the labor and goods markets. In practice, reduced capacity utilization by the bureau can be interpreted as a distinction of different components of its capital stock. For example, if the model assumes a rate of capacity utilization of 75 percent, this may mean that 75 percent consist of industrial production plants while 25 percent contain public infrastructure projects such as railways or energy provision, which raise productivity of the economy but do not produce

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goods themselves. Such investments improve effective demand but do not directly involve employment (or only to a much smaller degree). In order to broadly regulate the impact of the bureau’s investment expenditures on the domestic economy, and notably on the private sector, the bureau may vary the respective shares of investment going to industrial production capacity or improvement in the country’s infrastructure. In model terms, this means that the bureau regulates capacity utilization, CUBU. In a situation of a high current account deficit where bureau investment runs the risk of crowding out the private sector, capacity utilization may be lowered. In a situation where unemployment is very high, the opposite would be appropriate. This is how the impact of the balance of payments can be brought roughly into line with the requirements of the domestic economy. Fine-tuning is hardly possible, but the variation in capacity utilization can be considered as an additional instrument of economic policy. Its level also depends on the policy strategy and the importance generally attributed to private sector development. Figure 5.5 shows how a change in the bureau’s capacity utilization influences economic activity of private firms and what consequences it entails for the macroeconomy. In panels a) and c), the above case of expansive monetary policy is depicted; while panels b) and d) exhibit the scenario of a public investment program. In panel a), the reduction of CUBU from 0.75 to 0.5 yields the expected result for private sector production. Due to less tightness in the labor market, the profit rate is higher, so that private investment and private employment are higher too, giving rise to higher output growth. Panel b) shows the same for public investment. Whereas there is a crowding-out effect stemming from bureau production with higher capacity utilization, private sector output remains stable when capacity utilization is 50 percent. As panels c) and d) show, a change in capacity utilization has consequences for the amount of securities to be transferred abroad. Infrastructure investment, which is not directly productive, does not contribute to the country’s exports. Lower capacity utilization implies that a larger share of the bureau’s investment consists in mere expenditure (purchase of the investment goods), without subsequent productive activity. As a consequence, lower capacity utilization deteriorates the balance of payments. Paradoxically, this strengthens domestic economic growth even more, and triggers further crowding-in of the private sector: a current account deficit means continuous investment of the bureau and hence continuous demand in the domestic economy. To sum up, lower capacity utilization in the bureau’s capital stock favors the private sector. On the other hand, it deteriorates the balance of payments and lengthens the period of current account deficits. Hence,

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Panel a) effect of monetary policy on private output

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Figure 5.5  E  ffect of a change in the bureau’s capacity utilization (CU) on private sector activity and external debt it might be more difficult for the country to provide appropriate financial securities to balance the deficit. Variation in capacity utilization ‒ that is, in directing investment expenditures ‒ optimizes this trade-off and allows the bureau to support domestic needs in the best way.

NOTES   1. It is precisely this critical point which is also raised against the monetary architecture of the European monetary union and its TARGET2 system that works in an analogous way (Rossi, 2017, p. 135).   2. The derivation and explanation of the reform is provided in a summarized form. For a more extensive analysis and additional sources, in addition to Schmitt (2014) and Schumacher (1943a, 1943b), see for example Brunette (2015), Cencini (2017b) and Schmitt (2017).

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  3. Many elements of step (1) in Table 5.2 are similar to the payment in Table 5.1 where they are emphasized in more detail.   4. Securities define real output just as much as conventional goods do. However, when referring to the current account, we mean the deficit or surplus which exists “before” the bureau equilibrates it by issuing securities. This clarification simplifies the further analysis because such a definition of the current account covers the same goods, services and interest as the current account does in today’s meaning, that is, in the absence of a reform.   5. For an overview of all model variables, values of exogenous variables and parameters, see Appendix I. For the full set of model d) equations and the stock and flow matrices, see Appendix V.   6. The “d” in the numeration of this equation and the following one is due to the fact that submodel d) introduces additional formula compared to submodel c). However, there are two equations of model c) (84 and 85) dropping out here. To ensure chronological and logical order of the equations, they are replaced by the new equations, the lettering of which differs by adding “d.”   7. This is “asymptotically” (Brunette, 2015, p. 128) the case, as the time lag in the granting of the compensating loan usually leaves a very small difference between external debit and credit.   8. Firms could also purchase them, but the distinction between firms and capitalists is mainly made for model purposes because, in fact, the latter own the former.  9. The same applies to the bureau’s exports. Even though exports are remunerated in foreign currency, foreign reserves are deposited with the bureau in its function as the macroeconomic actor to settle the country’s international payments. The bureau receives its export returns in domestic currency because as a producer it is a conventional economic agent like private firms or the government. 10. The bureau’s savings in this context mean microeconomic rather than macroeconomic savings, because it is not about savings generated by investment but merely the distribution of existing savings according to the sectors’ propensity to spend income or to distribute profits. For the derivation of the difference between macroeconomic and microeconomic savings, see Chapter 1. 11. The only parameter from model c) which is changed in model d) is η12. The value is increased, implying that the imports increase more strongly with productivity growth. In model c), it has been remarked that model results are not significantly responsive to changes in the value of this parameter. In model d), sensitivity is stronger. In particular, as will be shown here, the relaxation of the balance-of-payments constraint in the course of economic development is an important feature and influences the required design of policy to achieve targeted results. It will later be seen that comparability with the previous model is still given despite parameter variation. 12. As the panel legend explains, private employment does not fall below bureau employment, because the former is measured by the left-hand scale and the latter by the right-hand scale.

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6. Macroeconomic strategies to guide the economy With the results of the previous four chapters, we have the elements to formulate a macroeconomic strategy for developing countries; a strategy that may multiply into different strategies depending on specific circumstances. Such macroeconomic governance must be able to ensure stability, lay the foundations for long-term productivity development and economic growth, and allow for a fair income distribution. At the same time, often weak institutions in developing countries have to be taken into account. Macroeconomic strategy and economic policy arising from it need to be feasible even when institutional capacity is limited. In the long run, the instruments at hand may also go beyond pure development issues. They allow for an outline of economic transformation.

6.1 A MACROECONOMIC STRATEGY FOR DEVELOPMENT Let us start with the aspects concerning the domestic economy. Our analysis, based on the essential macroeconomic principles, reveals that there is no self-sustaining economic development if market forces are left to themselves. Sufficient profit rate and effective demand are the conditions for economic activity to take off. But there is no reason why these conditions should automatically be fulfilled. The government is needed to intervene by creating demand. Via social redistribution, it can create demand and a corresponding supply by spurring investment and productivity. By making investment expenditures, the public sector can even directly contribute to capital accumulation, growing output and technological progress. Public sector production tends to have an impact on the labor market by increasing wages. However, as long as full employment is not approached, there is no risk of crowding out the private sector. As long as this does not happen, government intervention actually crowds in the private sector, via additional effective demand and increasing productivity from which all agents in the market benefit. This is how economic policy can lift what we may call the “internal constraint.” ­256

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By driving public investment and production, the government also disposes of an instrument to influence the labor market. The public sector can impact the general wage level via its employment policy, for instance through the definition of minimum wages in public production or in general. Given the limited institutional capacity, developing countries do not have to guarantee full employment. But they can raise employment continuously, and by influencing the wage level they affect the degree of the crowding-in of the private sector. Moreover, a varying wage level impacts effective demand and profitability. The government can thus use this instrument to influence the process of investment, growth and development. Economic policy can also help to direct resources to the sectors where they are needed most. While money can be provided through credit without preliminary restrictions, resources such as specialization in skills are limited, notably in developing countries and at least at a given moment. It may be useful and necessary to focus on specific sectors where a country, given its resources and institutional capacity, has the potential to establish a supply chain (see also Perry, 2020, pp. 406–407; Rodrik, 2018). This might involve discrimination of other sectors by not providing them with credit or granting loans at favorable conditions to the priority sectors. This has been common practice in the development history of East Asian countries (see for instance Chang, 2003, p. 262; Zhu, 2007, p. 267). Developing countries usually do not have a far-developed finance sector. This allows the government to better direct credit flows. National development banks can be the institutions to finance policy strategies. These institutions already exist in many countries but often are rather weak. However, their importance can easily change depending on political priorities, as the case of Brazil shows (Palludeto & Borghi, 2020). They could be strengthened and prepared for national conditions. In contrast to multilateral development banks and international financial institutions which provide credit in United States dollars (and only under specific conditions), national development banks do not face any finance constraints since they lend in domestic currency. Moreover, they endow countries with more sovereignty regarding the decision on which sectors should be promoted. Public banks have the possibility to provide loans at lower interest rates in order to support strategic long-term investment. Such policy could be supported by the central bank of the country by providing central bank reserves at favorable conditions to the respective banks. This financial architecture may also be created at a regional level, as blueprints of the Banco del Sur in Latin America show (see for instance Marshall & Rochon, 2009). As analyzed in detail in Chapter 4, development strategies focusing on

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the domestic economy reach their limits once the global economy is considered. Growth-enhancing economic policy interventions are ineffective because they involve current account deficits, exchange rate depreciation, inflation and growing foreign debt. The balance-of-payments constraint tells us that in order to keep the current account balanced and the exchange rate stable, economic growth must be restricted. Currently, international trade relations and global financial flows make economic policy powerless. In particular, policy intervention tends to be punished by capital flight. In this situation, a developing country is forced to pursue an export-led growth model, thus entailing the respective shortcomings discussed in Chapter 4. As argued by new developmentalism and others, the feasibility of a successful export-led regime depends on a competitive exchange rate (see for instance Libman et al., 2019; Rodrik, 2008). Currency devaluations for this purpose are only successful if they are able to minimize the following increase in inflation, which may require wage repression. The latter can be useful but requires strong institutional settings of wage bargaining. Additionally, wage repression can be difficult to implement in poor countries where wages are already at a minimum level, while competitiveness is still not given due to low productivity. The government may not be able to impose a real devaluation involving social hardship, leading to what new developmentalism calls “exchange rate populism” (Bresser-Pereira, 2018, p. 11). And finally, the impact of exchange rate devaluation may be ambiguous due to undesired effects such as inflation, debt revaluation and possible negative dynamics in the domestic economy (see Ribeiro et al., 2020). Therefore, the internal constraint cannot be removed without relaxing the external constraint. The problem of the external constraint is not current account deficits as such. These must be allowed so that developing countries can import investment goods required for the industrialization of targeted sectors. The difficulty is that, today, external deficits tend to go along with currency depreciation, thus involving macroeconomic instability, inflation and a growing burden of foreign debt. This can even happen to export-led growth regimes in initial phases. Hence, current account deficits should be possible while keeping macroeconomic conditions stable. Exchange rate pegging may be a partial solution to the problem. However, it entails unintended consequences such as the increased risk of a financial bubble. Additionally, mainly heterodox economists propose tariffs to protect domestic infant industries but also to positively influence the trade balance. With respect to financial flows, capital controls are suggested. This is not to deny that both instruments can be useful. Yet, they are insufficient to provide a comprehensive solution to the external constraint problem. Tariffs are helpful to pursue specific targets in specific

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industries. But they are hardly able to guarantee an equilibrated balance of payments. Capital controls can contribute to the limitation of speculative international financial flows. However, they can also be circumvented. Furthermore, circumvention may create a shadow foreign exchange market with a deviating exchange rate. The conventional solutions proposed to the external constraint problem have a common feature. They do not account for the fundamental flaw of the current non-system of international payments. It consists of the monetary duplication of international payments, which feeds into a financial bubble in surplus countries and involves a loss of domestic income in deficit countries. This inconsistent monetary structure gives way to shrinking demand in the deficit countries, that is, in developing economies. Monetary duplication also explains exchange rate fluctuations in the foreign exchange market. The reform of international payments establishes a better system, which can be implemented by a single country. It allows an economy to run current account imbalances while keeping macroeconomic conditions stable. Since there is no longer a foreign exchange market, the exchange rate can be set by the country. External deficits provide the government with an extra gain of income, which can be used to invest in the domestic economy. The reform removes the balance-of-payments constraint and thus enables countries to exploit its policy instruments to relax the internal constraint. Productivity growth can be enhanced so that current external deficits are followed by future surpluses. With this new perspective, not only exportled but also wage-led and domestically profit-led growth regimes become feasible. The reform thus responds to the observed need that “sustainable long-run development must emphasize internal markets and domestic demand much more” (Blecker & Razmi, 2010, p. 393), as export-led strategies are facing more limits in an environment of slow global growth. With regard to the implementation of the reform, several aspects have to be taken into account. First, despite the ability of the reformed system to sustain current account deficits, growth entails higher imports. Hence, on the one hand, the reform strengthens domestic growth and development; while on the other hand, it ceteris paribus worsens the trade balance. This may be a temporary phenomenon because domestic capital accumulation gives way to productivity growth, as just mentioned, and hence lower production costs. The real exchange rate improves, which allows to increase net exports again. Yet, this development may last for a longer time and thus imply a considerable amount of securities to be transferred abroad before it can be reduced again. Now, since the reformed system for international payments compensates any external debt by a transfer of securities, no net external debt builds up.

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The only possible limit may arise when a deficit country runs short of appropriate assets, mostly financial securities, to supply to the surplus country. Economic policy can improve this pattern by directing public investment to either import-substituting or export sectors. The more productivity gains can be realized in those sectors, the less domestic growth implies a current account deficit. Substituting imports or promoting exports are development strategies which cannot be delegated to the private sector, because it does not share a macroeconomic view of the country. Firms do not include balance-of-payments considerations in their decisions. However, as explained below, the reform includes a mechanism which supports a country’s capacity to provide the securities. As a second aspect, the reform needs to be applicable by existing political and economic institutions in developing countries. The original proposal of the reform defines a bureau (or a clearing fund, respectively) as the responsible institution for the implementation, and so does our analysis here by integrating the bureau into the model. Clearly, the bureau is a public institution. Regarding the degree of independence from the rest of the public sector including the central bank, different propositions are possible. What is more important is the requirement of the bureau as the only external debtor of the economy. This implies that both private and public banks are not allowed to keep deposits, nor to access loans in foreign currency. Whereas this condition can easily be fulfilled with public banks, it has to be legally imposed and controlled in the case of private banks. This may be challenging for developing countries to implement and guarantee. However, it is probably easier to accomplish than capital controls, which require the consideration of numerous details and thus create gaps for circumvention. Moreover, since developing countries usually do not have well-developed financial markets, less financial institutions and less balance sheets need to be supervised. As explained in the previous chapter, all international transactions have to be settled via the bureau. Once banks obey this obligation of the bureau’s exclusivity, the only way one may imagine circumvention is through the use of cash. Depositors can withdraw their wealth by being paid in cash and exchange it at an unofficial exchange rate. However, closer examination reveals that the seeming problem does not exist. If the domestic currency in cash is exchanged at a weaker rate than provided by the bureau, the domestic agent is disadvantaged and would better exchange their deposit in domestic currency against one in foreign currency via the bureau. The same applies to the foreign agent willing to exchange in the case that the rate of the domestic currency is higher than that of the bureau. Circumventing the bureau does not yield any benefit, so there is no problem for the bureau to defend its exchange rate.

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In today’s system, growing external debt bears the danger of increasing interest rates because foreign lenders consider the loans as more and more risky. This is problem is solved by the reform, thanks to which net external debt no longer forms. The double institutional character of the bureau brings about several important advantages. In its macroeconomic role, the bureau is the only debtor and creditor of the monetary space it represents. It, alone or jointly with the government and the central bank, is also responsible for providing the rest of the world with financial securities of an amount corresponding to the external deficit. Beyond this, the bureau also assumes the role of an investor in the domestic economy (or in the rest of the world in the case of sustained surpluses). As such, its role is a microeconomic one. Thanks to the proper treatment of money, the bureau receives the monetary units of a current account deficit. They can be used to invest, and hence to create or acquire assets, which enter the bureau’s balance sheet. Either they are real assets such as production plants and infrastructure, or they are financial assets representing a claim on real assets. The more the bureau contributes to the creation of new production capacity, the larger the country’s reserve of real resources to give up to the rest of the world becomes. As mentioned, this logic can also cope with capital flight. Any capital leaving the economy endows the bureau with a profit that can be reinvested to back the transfer of financial securities. Since stability of the domestic currency’s value in terms of foreign currencies is given, the main cause of self-enforcing capital flight is eliminated because there is no more fear of (uncontrolled) depreciation. It is important to understand that there is a connection between the internal constraint and the external constraint. It is true that the removal of the external constraint allows to shift the boundaries of the internal constraint. However, this does not mean that the domestic economy is detached from the rest of the world. Relations via trade and financial flows remain close, despite payments being administered differently. Pushing the external constraint by allowing for current account deficits under stable conditions implies that the domestic economy can shift its internal constraint by growing at a higher rate, which entails higher imports. Reinvestment of deficits by the bureau brings about new dynamics. Investment by the public sector, to which the bureau belongs, raises growth. Given that economic conditions in the rest of the world remain equal, growth leads to higher net imports. Higher net imports provide the bureau with a higher extra profit that is used for reinvestment. This can be considered as a positive self-enforcing process. However, such dynamics show the full success of the reform. Due to economic growth, the deficit country’s real resources increase, such that the restrictions to the real

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payment of external deficits via the transfer of securities are continuously relaxed. Such dynamics show that what happens at the country’s economic border crucially impacts the domestic economy. Under the assumption that the bureau reinvests all the extra profit it has received, domestic growth is to a large extent not determined by a particular policy program. Rather, it is at least partially driven by the economy’s propensity to import out of income. Hence, the factors defining the external constraint in today’s non-system of international payments are still at work, even though in different ways. This mechanism can have several consequences. First, the profits accruing to the bureau may be of an amount that cannot be reinvested in an appropriate way in a short period of time. Second, and more importantly, reinvestment of the bureau affects the domestic labor market. When investment accelerates, the labor market moves in the direction of full employment. In developing countries, this point is usually far from being reached, so that this is not an immediate problem. But potentially, domestic investment of which a part is caused by external conditions may give rise to increasing wages and thereby entail a crowding-out of the domestic private sector. There are different ways to react to such an effect. The government may potentially adjust wages in the public sector to influence the overall wage level. But there are also short-term solutions. As simulated in the model, the bureau may change the investment to sectors with lower employment intensity. Instead of establishing supply chains, investment can also go to infrastructure projects. Infrastructure requires a lot of labor in the construction phase, but considerably less when it is in operation. Still, infrastructure is necessary to make the overall economy more productive. The bureau may thus strengthen productivity while having less impact on the labor market. Alternatively, instead of spending the extra profits arising from current account deficits for new productive investment, the bureau can purchase existing assets, thus having no direct impact on the labor market. However, this might have the side effect of pushing up the prices of securities, meaning that public resources are transferred to capitalists. The bureau may also keep the domestic currency in its account without spending it. This, however, would entail the same shortcoming in the way payments for net imports are made today. Finally, the government may also neutralize the bureau’s potential impact on the labor market by increasing taxes or lowering expenditures so that a part of wage-driving demand is withdrawn. Besides these instruments to regulate growth in employment and wages, a macroeconomic strategy may also refer to the conventional tools. Growing trade deficits may be reduced with specific tariffs or value-added

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taxes. Such measures were taken in East Asia, not only to protect certain industries but mainly to pursue macroeconomic purposes: in South Korea, tariffs were imposed on luxury imports so that less income was spent abroad, and the rich also contributed to financing the much-needed domestic investment (Chang, 2006, pp. 24–28). In a similar vein, capital controls can be applied if deemed necessary. While the one-country reform guarantees the stability of the exchange rate and the adequate treatment of money as a means of payment, capital controls can prevent certain payments from taking place and hence limit the required transfer of assets. In particular, it may be a political priority of a country not to give up too much in terms of internal real resources, as this would possibly mean the ownership of key assets by non-residents. By contrast to the current situation, tariffs and capital controls are not the only instruments in a country where the reform of international payments is implemented. But they can be added for specific purposes such as preventing external imbalances from growing too large, in analogy to the quotas and fines intended by Keynes (1942/1980, p. 173) in the global reform. To sum up again: the framework represents a complement to the classical developmental state (see for instance Chibber, 2014; Williams, 2014). Using public investment, income redistribution and taxation, developing countries possess the means to generate economic growth and fight poverty; that is, to remove the internal constraint. These instruments allow poor countries to achieve what the private sector in unregulated markets cannot deliver. Yet, capital mobility in today’s globalized markets punishes active economic policies that may diminish the profitability of that capital. Capital flight depreciates the economy’s currency and makes economic policy powerless. Therefore, in addition to domestic policy instruments, the one-country reform of international payments must be implemented. Its benefits are numerous: it avoids double payment of interest on foreign debt, keeps the exchange rate stable, and endows the government with the capacity to implement development strategies despite globalized markets and capital flight.

6.2  THE END OF GROWTH? So far, this book has provided the analysis and tools for developing countries to start a development process by making use of their limited resources, multiply them thanks to productivity growth, and create the wealth necessary to reduce poverty. Appropriate macroeconomic governance points the way out of the miserable living conditions people around the world suffer from. Yet, it has only analyzed development as a

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process, without saying where this pattern eventually leads to. The very central question suggesting itself is the question of the limits of growth. Approaching the end of this book, let us outline a sketch of this. Is there a point in the development process where no further increase in people’s wealth is needed, such that a stationary economy is sufficient? This would be the solution of “the economic problem of mankind,” as Keynes’s (1930/1963) argued in his long-term vision of economic growth. There are reasons both supportive of and against this hypothesis, from either a positive or a normative point of view. We have seen in the structure of the model that there are arguments for an inherent tendency of the macroeconomy to converge to a certain state where it stagnates. This is due to the fact that capital accumulation tends to lower the profit rate because the denominator of the ratio grows. A falling profit rate means that one of the essential conditions for capitalism to prosper is no longer fulfilled. As discussed, there are counteracting effects allowing growth to be sustained. Most importantly, productivity growth allows for higher output with an equal amount of capital invested. The faster productivity progresses, the higher ceteris paribus the profit rate. However, productivity rarely grows to infinity. At a lower level of development, technological progress can be steered better, since there are more areas of human life which have the potential to be rationalized. For developing countries in particular, catching up to technologies of advanced economies provides a source of extra productivity growth. Moreover, once basic needs are met, as in advanced economies, demand does not necessarily increase strongly when productivity in a specific sector increases. Overall productivity growth then is limited because technological progress does not take place in a sector where demand is sufficient (see Husson, 2009, p. 186). When productivity growth flattens, growth necessarily does likewise, because firms invest less. Empirical evidence of declining economic growth in advanced countries is quite strong and has been observed for at least 60 years (Freeman, 2019). Monetary policy can be a second means to counter declining growth rates. For firms, the differential between the profit rate and the interest rate level ‒ that is, in fact, the net profit rate ‒ is eventually the relevant variable. A falling profit rate may thus be compensated by equally falling interest rates. Indeed, such an interest rate decline has been observed almost all over the world since the beginning of the 1990s (see for instance Caballero et al., 2008, p. 359). But once interest rates approach zero, further cuts become more difficult and less likely. The potential of monetary policy to stimulate the economy diminishes.1 The conclusion is similar to the secular stagnation hypothesis (see Summers, 2015, 2016). Yet, this mainstream interpretation, by arguing in a Wicksellian manner that high

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savings and low investment drag the natural interest rate below zero, is quite different from our analysis. In addition, fiscal policy may push the boundaries of growth convergence, too. Deficit spending by the government to create demand may indeed stimulate economic activity and increase employment, as argued by modern monetary theory (see for example Tymoigne & Wray, 2013). Yet, it can only do so as long as the profitability condition is satisfied at the same time. Otherwise, production capacity cannot react to growing nominal demand. With output not growing, government spending translates into inflation (Palley, 2015, p. 6). In the end, it is therefore equally dependent on the factors determining the profit rate, such as productivity growth. The use of the public sector as a macroeconomic agent requires qualifications, as will be argued. The second major argument supporting the end of economic growth is based on ecological sustainability and the planetary boundaries. While the first argument is founded on the positive analysis of actual growth data, the demand to end environmental destruction is normative. The Club of Rome (Meadows et al., 1972) argued some decades ago that economic growth cannot last forever, due to limited natural resources. Or, to reverse it, economic growth will lead to the breakdown of the natural foundations upon which humanity depends. Where the question is probably less about a growth rate of exactly zero, it is justified to ask whether efficiency gains are large enough to reduce resource consumption while the economy keeps growing. As a matter of fact, energy consumption is still dominated by fossil fuels and is growing continuously (see for example Chester, 2017, pp. 338–340). Despite decreasing energy intensity of output, economic growth has gone along with increasing consumption of natural resources throughout history. It is quite clear that economic expansion cannot continue in the way it did in the past. This view also argues that poverty should not be reduced by lifting poor people’s living standards via growth. As Woodward (2015, p. 50) calculates, between 1999 and 2008, the poorest 30 percent of world population received only 1.2 percent of the material benefits of global growth, and their share of income has even been falling since the 1980s. If this pattern is assumed to hold for the future, and if the much faster development in China is excluded, poverty as defined by a daily per capita income of $5 would be eradicated by the year 2224; for this, global output would have to multiply by 173 (ibid., p. 58). It is hard to imagine that this can happen within planetary boundaries. These data point to the fact that what is needed is not mainly more growth, but the reduction of inequality through the redistribution of existing wealth. By contrast, another equally normative view demands continuous

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growth. With rising productivity, the same level of output requires less labor. A stagnating economy thus increases unemployment. Growth is needed to keep workers employed. However, a proper analysis reveals the need for productivity growth, since it is slowing of the productivity advance that makes unemployment rise. Given that productivity growth is low for the reasons suggested above, the bargaining struggle intensifies. The profit rate being in decline, firms seek to re-establish it by increasing wage pressure. Lower wages imply higher profits feeding into an improved profit rate. This comes at social cost, as declining wages are tantamount to deteriorating living conditions for the largest fraction of the population. Additionally, it drags on effective demand. This view thus expresses the necessity for the economy to grow in order to fulfill the needs of the population, that is, to provide everyone with income. Its main problem is that sufficient productivity growth is a precondition to satisfy the two requirements of the growth engine: effective demand and profit rate. However, productivity growth depends on objective factors rather than wished-for requirements from a social point of view. Limiting economic growth would support sustainable development respecting the ecological boundaries of the planet. On the other hand, no growth entails downwards pressure on wages. While maintaining the profit rate, it depresses demand. The fundamental contradiction of capitalism is revealed again. There is no tendency of today’s economy to converge to a stable steady state which would serve all human needs while respecting ecological constraints. Instead, the choice is between economic growth with a strong tendency to overconsume natural resources, and economic stagnation implying unemployment and more poverty (see Smith, 2010, pp. 31, 34). At the same time, there is analytical and empirical support that economic growth effectively declines along the development pattern of a country. The analytical insights of the stock-flow consistent (SFC) model in this book help us to get straight to the core of the issue. The contradiction between effective demand and the profit rate is not compatible with a stable non-growing economy that is beneficial to everyone. In Chapter 3, it has been shown how economic development may be spurred when the market left to itself stagnates. The public sector is able to act even if the profitability of investment is not guaranteed. At a high level of economic development as described here, where the fundamental contradiction becomes stronger, the government can support economic activity because it can exclusively focus on effective demand as the second condition. Since it does not depend on a sufficient profit rate, it can maintain high wages even when profitability is weak. The government can thus continue production in sectors where the private sector is in downturn due to a

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deteriorating rate of profit. With a sufficient share of the output produced by the public sector, the government can determine the level of economic activity and therefore also stabilize it. Socialists make the strongest claim by labelling this the public ownership of the means of production (Marx & Engels, 1848), while Keynes’s (1936/1997, p. 378) terminology of the socialization of investment is more general. The essential question for the present is less about how far to go, but more about how to realize the transition process. However, such an economic transformation is uncertain in various regards. It is not clear when and at what speed it should take place, as well as what unintended consequences it entails. It may involve uncontrollable instability. Yet, the most harmful effects, such as capital flight and currency crises, are ruled out thanks to the reform of international payments based on Keynes, Schumacher and Schmitt. The government is thus enabled to use the policy instruments described and developed here not only for the fight against poverty but also to eventually prepare a transformative pattern to a stable sustainable economy that is beneficial to everyone. Whereas in poor countries public sector investment expenditures are made to steer growth, they can be used later to establish the government in important sectors that are not served by the private sector, in order to ensure stability and employment. Moreover, while economic policy should be careful not to crowd out the private sector at the initial stages of development, crowding-out may precisely be a means to realize a stable transformation path. By driving employment and influencing the wage level, the public sector has a strong impact on the private sector. To the extent that the public sector is able to unfold production in new sectors, the threat of an increasing wage level gradually crowds out profit-seeking private firms. This opens the possibility to transform the production sphere and the labor market into institutions that are not for profit and growth but instead are oriented towards the needs of humans and planetary boundaries.

NOTE 1. The United States Federal Reserve started using quantitative easing once the federal funds rate had reached the zero lower bound by end of 2008. This, however, was not done to depress interest rates below zero, but to reconnect market rates to the target rate of the central bank, since the transmission mechanism was broken (see Pollin, 2012, pp. 67–68). Other central banks set target rates slightly below zero but hesitate to go down further.

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Conclusion Global capitalism as we face it today has deprived countries of their autonomy in making economic policy decisions. This is even more true for small economies such as developing countries. If they want a chance to provide their populations with acceptable living conditions, they need to regain their scope of action. In particular, countries must be able to defend themselves against devastating macroeconomic events such as capital flight and currency crises. This book has delivered arguments for how poor countries may design macroeconomic strategies to foster economic development. After removing the external constraint and getting the system for their international payments right, developing countries are able to direct the domestic economy. Taxation and social expenditures on the one hand, but mainly public investment on the other hand, are important instruments to bring about economic prosperity and poverty reduction. With the reform of international payments, they can unfold their full potential because they no longer trigger exchange rate volatility, nor do they involve a drag on domestic demand caused by the twofold payment of imports and interest on foreign debt. No doubt, there are gaps in the analysis. It was argued at the beginning that inequality is an important factor determining both objective and subjective poverty. Yet, it has not been systematically integrated into the theoretical analysis. At least, however, the potential of economic policy to influence income distribution, be it by taxation and social transfers or by the public sector’s (intentional) impact on the labor market, has been highlighted. There is a sketch of how a development strategy can also direct the share of total income going to labor. This can be emphasized further, particularly regarding the harmful impact of inequality on a society’s health and violence. Poverty is a multidimensional issue to which this book cannot do justice. But a macroeconomically sound system is necessary to even think about how to reduce it. There are obvious parallels between the conclusions of this book with regard to the role of the state and economic policy on the one hand, and the successful development experience of East Asia on the other hand. Indeed, many of those countries followed or are still following several of this book’s recommendations in some way or another. Nonetheless, ­268

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even though the East Asian experience can be an example for developing countries, they have to find their own path. In the course of trade and financial liberalization, we have come to a different situation compared to the decades after World War II until the 1970s when East Asia started its growth pattern. Moreover, we are facing a moment of low global economic growth. And it may not just be a moment, but rather another station in the long-run growth slowdown in the advanced economies. More than ever before, it is time for poor countries to adopt their own development strategies. To be successful, they must be based on a consistent view of macroeconomics. One may argue that too much corruption in developing countries makes successful policies impossible. Institutions are weak not only due to limited resources, but also because the existing resources are taken away by the political and economic elites. Clearly, corruption is a very high barrier to development. However, we are in the even worse situation that poor countries, with governments which are effectively willing to change the miserable conditions for the better, lack any scope of action to establish sovereign policies. Even if there was no corruption, developing countries would be caught in the constraints of the global economy. There is a long list of country governments that tried to improve the poor’s conditions, but failed to provide an example to other countries. This is where this book aims to make a contribution. With the right macroeconomic strategy at hand, a better perspective can be given to the poor.

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FE.ZS?view=chart and https://data.worldbank.org/indicator/SL.EMP. VULN.MA.ZS?view=chart. World Bank (2019f). World Development Indicators. Available at https:// databank.worldbank.org/data/source/world-development-indicators. World Economic Forum (2014). Strategic Infrastructure: Steps to Operate and Maintain Infrastructure Efficiently and Effectively. Industry Agenda. Available at http://reports.weforum.org/strategic-infrastructure-2014/. World Health Organization (WHO) (2018). WHO HIV Update, July 2018. Available at https://www.who.int/hiv/data/en/. Wray, L.R. (2007). Minsky’s Approach to Employment Policy and Poverty: Employer of Last Resort and the War on Poverty. Levy Economics Institute of Bard College, Working Paper No. 515. Wray, L.R. (2015). Modern Money Theory: A Primer on Macroeconomics for Sovereign Monetary Systems (2nd edn), New York: Palgrave Macmillan. Yang, H., Shi, F., Wang, J. & Jing, Z. (2019). Investigating the Relationship between Financial Liberalization and Capital Flow Waves: A Panel Data Analysis. International Review of Economics and Finance, 59, 120–136. Young, A. (1928). Increasing Returns and Economic Progress. Economic Journal, 38(152), 527–542. Zezza, G. (2004). Some Simple, Consistent Models of the Monetary Circuit. The Levy Economics Institute of Bard College, Working Paper No. 405. Zhu, T. (2007). Rethinking Import-Substituting Industrialization: Development Strategies and Institutions in Taiwan and China. In H.-J. Zhang (ed.), Institutional Change and Economic Development, New York: United Nations University Press and Anthem Press (pp. 261–279).

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Appendices APPENDIX I: VARIABLES AND PARAMETERS A B B* BD CBU CCap CCap, tot CF CG Cspec CW CW, tot ci CUF CUG CUn d DBU DCap DW EQB EQBU ER ERpolicy EXBU EXF EXG EXR G gY, target IMCap IMW

Labor productivity Bonds owned by domestic residents Bonds owned by foreign residents Budget deficit Supply of consumption goods by the bureau Demand for domestic consumption goods by capitalists Total demand for consumption goods by capitalists Consumption goods supply by firms Supply of consumption goods by the government Speculative component of exchange rate (exogenous) Demand for domestic consumption goods by workers Total demand for consumption goods by workers Capital intensity Capacity utilization rate of firms Capacity utilization rate of government Normal rate of capacity utilization (exogenous) Interest rate differential (exogenous) Deposit of the bureau Deposit of capitalists Deposit of workers Bank equity Bureau equity Nominal exchange rate Exchange rate set by policy (exogenous) Exports by the bureau Exports by firms Exports by the government Rest of the world exports Government consumption expenditures Target rate of economic growth (exogenous) Imports by capitalists Imports by workers ­298

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IBU IBU, F IBU, G IF IG INBU INF ING KBU KF KF, eff KG KG, eff Ktot LBU LF LG LNR LN* R Ltot L

LNF LNG PB PBU PCap PB, extra PF PG PL PLR PLrR prF prG prmin PUB PUBU PUF PUG rCB rD

Appendices ­299

Bureau investment Supply of investment goods to bureau by firms Supply of investment goods to bureau by the government Firm investment Government investment Bureau inventories Firm inventories Government inventories Capital stock of the bureau Capital stock of firms Effective capital stock utilization of firms Capital stock of the government Effective capital stock utilization of government Total capital stock Employment by bureau Employment by firms Employment by government Loans provided by the rest of the world Loans provided to the rest of the world Total employment Total labor force (exogenous) Loans to firms Loans to government Bank profits Bureau profits Capitalist profit income Bank extra profits Firm profits Government profits Domestic price level Price level in the rest of the world (exogenous) Terms of trade Profit rate of firms Profit rate of government Minimum profit rate Undistributed bank profits Undistributed bureau profits Undistributed firm profits Undistributed government profits Central bank interest rate target (exogenous) Deposit rate

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300 rD

rLN

rLN

rR RER sCap SF SG sw TCap tCap TF tF TG TW tW VB VBU VCap VF VG VR Vtot VW w wref WBU WF WG Wtot xB xBU xF YBU YF YG YR Ytot z ηBU, 1

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Averag deposit rate in model c) Lending rate Average lending rate in model c) Rest of the world interest rate (exogenous) Real exchange rate Capitalist saving rate Firm savings Government savings Worker saving rate Capitalist tax Capitalist tax rate Firm tax Firm tax rate Government tax revenue Worker tax Worker tax rate Bank wealth Bureau wealth Capitalist wealth Firm wealth Government wealth Rest of the world wealth Total (domestic) wealth Worker wealth Wage rate Reference wage rate Wages to bureau workers Wages to firm workers Wages to government workers Total wage sum Propensity to retain bank profit (exogenous) Propensity to retain bureau profits (exogenous) Propensity to retain firm profits (exogenous) Bureau output Firm output Government output Rest of the world output (exogenous) Total (domestic) output Propensity of worker saving rate to increase in wage (exogenous) Propensity of bureau exports to increase in foreign output

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ηBU, 2 ηF, 1 ηF, 2 ηG, 1 ηxG,  2 μCap,  2 μW,  2 θ1 θ2 θ3 θ4

Appendices ­301

Propensity of bureau exports to increase in the real exchange rate Propensity of firm exports to increase in foreign output Propensity of firm exports to increase in the real exchange rate Propensity of government exports to increase in foreign output Propensity of government exports to increase in the real exchange rate Propensity of capitalist imports to decrease in the real exchange rate Propensity of worker imports to decrease in the real exchange rate Policy variable: government spending according to growth target (exogenous) Policy variable: government profit spending (exogenous) Policy variable: public investment according to growth target (exogenous) Policy variable: bureau profit spending (exogenous)

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Table A.1  Calibrated parameter values and baseline exogenous variable values α1 α2 β1 β2 β3 β4

10 5 1 0.5 0.88 1

τF, 1 τF, 2 τW, 1 τW, 2 x Cspec

β5 γ0 γ1 γ2 δ1 δ2

1 4.5 6.26 1 1 0.05

CUref d ERpolicy gY,  target L PLR

ε η2 η11 η12

0.82 1 0.001 0.001 (exception: 0.02 for bureau in model d)) 1 0.11 1 1 1 0.05 0.02 2

rCB rR xB xBU

0.01 0 0.1 0.5 10 0 (one-time shock of 20 in model c)) 0.9 0.02 1 0.08 9 1 (starting value, decreasing by 0.1 percent in every period) 0.05 0.05 0 0

xF YR z θ1 θ2 θ3 θ4

0 1000 0 1 1 1 1

κ μ1 μ2 σ1 σ2 σ3 τCap, 1 τCap, 2

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Appendices ­303

APPENDIX II: MODEL A) YF 5 A*LF  (1) ΔINF 5 YF 2 CF 2 IF (2) PF 5 YF 2 WF 2 rLN,21*LNF,21(3) CF 5 CW 1 CCap(4) PF prF 5 (5) KF 1 WF prmin 5 rD (6) Keff CUF 5 (7) KF IF 5 α1* ( prF,21 2 prmin ) 1 α2* (CUF,21 2 CUn )  (8) ΔKF 5 IF (9)

A 5 δ1 * (KF) 0.5 1 δ2 * a 0 IF   for all IF . 0 (10) ci 5 ε * (KF) 0.5 (11) KF, eff 5 ci *LF  (12) (YF,21 2 ΔINF,21 1 ΔIF) LF 5 * (1 1 prF,21 2 prmin ) (13) A WF 5 w *LF  (14) x LF w 5 γ0 1 γ1 * a 2 b 1 γ2 * w0 * A^ 0(15) L t21

wref 5 w0* (1 1A^0)  (16) CW 5 (1 2 sW) * (WF 1 rD,21 *DW,21)  (17) ΔDW 5 sW * (WF 1 rD,21 *DW,21) (18) sW 5 z * (w 2 wref )  (19) CCap 5 (1 2 sCap) * (PCap 1 rD,21*DCap,21)  (20) ΔDCap 5 sCap * (PCap 1 rD,21 *DCap,21) (21) sCap 5 κpr21 2prmin 2 1 (22) SF 5 IF (23) PUF 5 SF 1 xF *LNF,21 (24) ΔLNF 5 IF 2 PUF 1 ΔINF  (25) rD 5 rCB (26) rLN 5 rD 1 d (27) PB 5 rLN,21 *LNF,21 2 rD,21 * (DW,21 1 DCap,21)  (28) PUB 5 xB *PB (29) ΔEQB 5 PUB (30) PCap 5 PF 2 PUF 1 PB 2 PUB (31)

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Development macroeconomics

β1* (CU21 2 CUn) 2 β2*ΔIN21 1 β3*w21 1 β4*LNF,21*rLN PL 5 (32) A VF 5 KF 1 INF 2 LNF (33) VW 5 DW  (34) VCap 5 DCap (35) VB 5 LNF 2 DW 2 DCap (36) Vtot 5 VF 1 VW 1 VCap 1 VB 5 KF 1 INF (37) Table A.2  Stock matrix model a)

Capital Loans / deposits Inventories Net wealth ∑

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Firms

Workers

Capitalists

Banks

∑

1KF 2LNF 1INF

1DW

1DCap

1LNF 2 DW 2DCap

1KF 0 1INF

2VP

2VW

2VCap

2VB

2Ktot 2 INF

0

0

0

0

0

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­305

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Stock  accumulation Capital  accumulation

∑

Change in loans /  deposits

Stock  accumulation Wages Profit Interest

Production /  consumption Investment

0

0

0

0

2ΔEQB

1PUB

0

0

0 0 0

0

0

0

1IF 5 ΔKtot

0

2ΔDCap

2PB 1rLN,21*LNP, 21 2rD, 21 *(DW, 211 DCap, 21)

Cap

1IF 5 ΔKtot

0

2ΔDW

1PCap 1rD, 21*DCap, 21

Cu

∑

1ΔINF

0

1rD, 21*DW, 21

1WF

1sCap* (PCap1 rD, 21*DCap, 21)

Cap

Banks

1ΔINF

0

1PUF

2WF 2PF 2rLN, 21*LNF, 21

1ΔLNF

2ΔINF

1ΔINF

2sCap*(PCap1 rD, 21*DCap, 21)

2sW*(WF1 rD, 21 *DW, 21)

Cu

1IF

1sW*(WF1 rD, 21 *DW, 21)

Cap 2CCap

Cu

Capitalists

2CW 2SF

Cap

Workers

1CF

Cu

Firms

Table A.3  Transactions matrix model a)

306

Development macroeconomics

APPENDIX III: MODEL B) YF 5 A*LF  (1) ΔINF 5 YF 2 CF 2 IF (2) PF 5 YF 2 WF 2 rLN,21*LNF,21 2 TF (3’) CF 5 CW 1 CCap 2 CG(4’) PF (5) prF 5 KF 1 WF prmin 5 rD (6) Keff CUF 5 (7) KF IF 5 α1* ( prF,21 2 prmin) 1 α2* (CUF,21 2 CUn) (8) ΔKF 5 IF (9) A 5 δ1* (Ktot) 0.5 1 δ2* aa 0

t21

ε * (Ktot) 0.5

IF 1 a 0

t21

IG b   for all IF . 0, IG . 0 (10’)

ci 5 (11’) KF, eff 5 ci *LF  (12) (YF,21 2 ΔINF,21 1 ΔIF) LF 5 * (1 1 prF,21 2 prmin) (13) A WF 5 w*LF  (14) Ltot x w 5 γ0 1 γ1* a 2 b 1 γ2 *w0 *A^ 0(15’) L

wref 5 w0 * (1 1 A^0)  (16) CW 5 (1 2 sW) * (Wtot 1 rD,21 *DW,21 1 G 2 TW)  (17’) ΔDW 5 sW * (Wtot 1 rD,21*DW,21 1 G 2 TW) (18’) sW 5 z* (w 2 wref)  (19) CCap 5 (1 2 sCap) * (PCap 1 rD,21*DCap,21 2 TCap)  (20’) ΔDCap 5 sCap * (PCap 1 rD,21 *DCap,21 2 TCap) (21’) sCap 5 κ pr21 2prmin 2 1 (22) SF 5 IF (23) PUF 5 SF 1 xF *LNF,21 (24) ΔLNF 5 IF 2 PUF 1 ΔINF  (25) rD 5 rCB (26) rLN 5 rD 1 d (27) PB 5 rLN,21 * (LNF,21 1 LNG,21) 2 rD,21 * (DW,21 1 DCap,21)  (28’) PUB 5 xB *PB (29) ΔEQB 5 PUB (30)

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Appendices ­307

PCap 5 PF 2 PUF 1 PB 2 PUB (31) β1* (CU21 2 CUn) 2 β2*ΔIN21 1 β3*w21 1 β4*LNF,21*rLN PL 5 (32) A VF 5 KF 1 INF 2 LNF (33) VW 5 DW  (34) VCap 5 DCap (35) VB 5 LNF 1 LNG 2 DW 2 DCap (36’) Vtot 5 VF 1 VW 1 VCap 1 VB 1 VG 5 KF 1 INF 1 KG 1 ING(37’) TF 5 tF *PF,21 (38) TW 5 tW * (Wtot,21 1 rD,22 *DW,22 1 G21) (39) TCap 5 tCap* (PCap,21 1 rD,22 *DCap,22) (40) BD21 tF 5 2τF,1 *LNF,21 1 τF, 2 * (41) Ytot,21 BD21 tW 5 τW, 1 *DW,21 1 τW, 2 * (42) Ytot,21 BD21 tCap 5 τCap,1 *DCap,21 1 τCap, 2 * (43) Ytot,21 TG 5 TF 1 TW 1 TCap (44) BD 5 G 2 TG 2 (PG 2 PUG)  (45) G 5 θ1* ( gY, target 2 gY,21) 1 θ2* (PG 2 PUG)  (46) YG 5 A*LG (47) Ltot 5 LF 1 LG (48) Ytot 5 YF 1 YG 5 A*Ltot(49) ΔINF ΔING 5 *YG(50) YF CG 5 YG 2 ΔING 2 IG(51) PG 5 YG 2 WG 2 rLN,21 *LNG,21(52) PG prG 5 (53) KG 1 WG KG, eff CUG 5 5 1(54) KG IG 5 θ3* ( gY, target 2 gY,21)  (55) ΔKG 5 IG(56) Ktot 5 KF 1 KG (57) KG, eff 5 ci *LG(58) KG LG 5 (59) ci

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Development macroeconomics

WG 5 w*LG (60) Wtot 5 WF 1 WG 5 w*Ltot (61) SG 5 IG(62) PUG 5 SG(63) ΔLNG 5 IG 2 PUG 1 ΔING 1 BD (64) VG 5 KG 1 ING 2 LNG(65) Table A.4  Stock matrix model b) Firms

Workers

Capitalists

Banks

Capital Loans /  deposits Inventories

1KF 2LNF

1DW

1DCap

1LNF 1 LNG 2 DW 2 DCap

Net wealth

2VP

2VW

2VCap

2VB

0

0

0

0

1INF

∑

OBERHOLZER_9781800371118_t.indd 308

Government

∑

1KG 2LNG

1Ktot 0

1ING

1INtot

2VG

2Ktot 2INtot

0

0

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­309

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Stock  accumulation Capital  accumulation

∑

Change in  loans / deposits

Taxes Government  expenditures

Interest

Stock  accumulation Wages Profit

Production /  consumption Investment

0

0

1ΔLNG

1PG 2 BDG

2ΔING

2SG

0

0

0 0

0

0 0

0

0

0

1Itot 5 ΔKtot

0

1TG 2G

2rLN, 21 *LNG, 21

2WG 2PG1BDG

1ΔING

1IG

Cap

1IG 5 ΔKG

0

2ΔEQB

1PUB

Cu 1CG

1IF 5 ΔKF

0

2ΔDCap

1rLN, 21* (LNF, 21 1 LNG, 21) 2 rD, 21 * (DW, 211 DCap, 21)

2PB

Cap

∑

1ΔINtot

0

2ΔDW

2TCap

1rD, 21* DCap, 21

1PCap

Cu

Government

1ΔING

0

2TW 1G

1rD, 21* DW, 21

1Wtot

1sCap*(PCap1 rD, 21*DCap, 21 2TCap)

Cap

Banks

1ΔINF

0

2TF

1ΔLNF

1PUF

2WF 2PF

2rLN, 21 *LNF, 21

2ΔINF

1ΔINF

2sCap*(PCap 1rD, 21* DCap, 21 2 TCap)

Cu

2sW*(Wtot1 rD, 21 *DW, 21 2TW1G)

1sW*(Wtot1 rD, 21*DW, 21 2TW1G)

Cap

1IF

Cu 2CCap

2SF

Cap

Capitalists

2CW

Cu

Workers

1CF

Firms

Table A.5  Transactions matrix model b)

310

Development macroeconomics

APPENDIX IV: MODEL C) IV a) YF 5 A*LF  (1) ΔINF 5 YF 2 CF 2 IF 2 EXF (2’) PF 5 CF 1 IF 1 ΔINF 1 EXF*ER 2 WF 2 rLN,21*LNF,21 2 TF (3’’) CF 5 CW 1 CCap 2 CG(4’) PF prF 5 (5) KF 1 WF prmin 5 rD (6) Keff CUF 5 (7) KF IF 5 α1* ( prF,21 2 prmin) 1 α2* (CUF,21 2 CUn) (8) ΔKF 5 IF (9) A 5 δ1* (Ktot) 0.5 1 δ2* aa 0

t21

IF 1 a 0

t21

IG b for all IF . 0, IG . 0

(10’)

ci 5 ε * (K tot ) 0.5 (11’) KF, eff 5 ci *LF  (12) (YF,21 2 ΔINF,21 1 ΔIF) LF 5 * (1 1 prF,21 2 prmin ) (13) A WF 5 w *LF  (14) Ltot x w 5 γ0 1 γ1 * a 2 b 1 γ2 * w0 * A^ 0(15’) L

wref 5 w0 * (1 1 A^0)  (16) CW, tot 5 (1 2 sW) * (Wtot 1 rD,21*DW,21 1 G 2 TW)  (17’’) ΔDW 5 sW * (Wtot 1 rD,21 *DW,21 1 G 2 TW) (18’) sW 5 z * (w 2wref )  (19) CCap, tot 5 (1 2sCap) * (PCap 1 rD,21*DCap,21 2 TCap)  (20’’) ΔDCap 5 sCap* (PCap 1 rD,21*DCap,21 2 TCap) (21’) sCap 5 κpr21 2prmin 21 (22) SF 5 IF (23) PUF 5 SF 1 xF *LNF,21 (24) ΔLNF 5 IF 2 PUF 1 ΔINF  (25)

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Appendices ­311

,

LNR *ER BS ,   with LNR 5 max (LNR,0) rD 5 arD 2 * rRb * , BS BS2LNR *ER  (26’) , LNR *ER BS ,   with LNR 5 max (2LNR,0) rLN 5 arLN 2 * rRb * , BS BS2LNR*ER  (27’) PB 5 rLN,21* (LNP,21 1 LNG,21) 2 rD,21* (DW,21 1 DCap,21) 2 rR,21*LNR,21*ER(28’’) PUB 5 xB*PB (29) ΔEQB 5 PUB 1 PUB, extra (30’) PCap 5 PF 2 PUF 1 PB 2 PUB (31) PL 5 β1* (CU21 2 CUn ) 2β2*ΔIN21 1 β3*w21 1 β4*LNF,21*rLN 1 β5*PLR,21*ER21 A (32’) VF 5 KF 1 INF 2 LNF (33) VW 5 DW  (34) VCap 5 DCap (35) VB 5 LNF 1 LNG 2 DW 2 DCap 2 LNR*ER (36’’) Vtot 5VF 1VW 1VCap 1VB 1VG 1VR 5KF 1INF 1KG 1ING(37’) TF 5 tF *PF,21 (38) TW 5 tW * (Wtot,21 1 rD,22 *DW,22 1 G21) (39) TCap 5 tCap* (PCap,21 1 rD,22*DCap,22) (40)

BD21 (41) Ytot,21 BD21 tW 5 τW,1 *DW,21 1 τW, 2 * (42) Ytot,21 BD21 tCap 5 τCap,1*DCap,21 1 τCap, 2 * (43) Ytot,21 TG 5 TF 1 TW 1 TCap (44) BD 5 G 2 TG 2 (PG 2 PUG)  (45) ( ( ) ) G 5 θ1* gY, target 2 gY,21 1 θ2* PG 2 PUG  (46) YG 5 A*LG (47) Ltot 5 LF 1 LG (48) Ytot 5 YF 1 YG 5 A*Ltot(49) tF 5 2τF, 1 *LNF,21 1 τF, 2 *

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Development macroeconomics

ΔINF *YG(50) YF CG 5 YG 2 ΔING 2 IG 2 EXG(51’) PG 5 CG 1 IG 1 ΔING 1 EXG *ER 2 WG 2 rLN,21 *LNG,21(52’) PG prG 5 (53) KG 1 WG K G, eff CUG 5 5 1(54) KG IG 5 θ3* ( gY, target 2 gY,21)  (55) ΔKG 5 IG(56) Ktot 5 KF 1 KG (57) KG, eff 5 ci *LG(58) KG LG 5 (59) ci WG 5 w *LG (60) Wtot 5 WF 1 WG 5 w *Ltot (61) SG 5 IG(62) PUG 5 SG(63) ΔLNG 5 IG 2 PUG 1 ΔING 1 BD (64) VG 5 KG 1 ING 2 LNG(65) EXF 5 ηF,1 *YR 1 ηF, 2 *RER(66) EXG 5 ηG,1 *YR 1 ηG, 2 *RER(67) YF ηF,1 5 * (η11 1 η12 *A^0) (68) Ytot YF ηF, 2 5 *η (69) Ytot 2 YG ηG,1 5 * (η11 1 η12*A^0) (70) Ytot YG ηG, 2 5 * η2(71) Ytot CW 5 CW, tot 2 IMW *RER(72) CCap 5 CCap, tot 2 IMCap*RER(73) IMW 5 μ1*CW, tot 2 μW, 2 *RER(74) IMCap 5 μ1*CCap,tot 2 μCap, 2*RER(75) CW, tot μW, 2 5 μ2* (76) Ytot ΔING 5

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Appendices ­313

μCap, 2 5 μ2*

CCap, tot

(77) Ytot EXR 5 IMW*PLrR 1 IMCap*PLrR 2 EXF 2 EXG(78) RER 5 ER*PLrR (79) ΔER 5 σ3* (rR,21*LNR,21 2 σ1* ( prF,21 2 rR) 2 σ2* (rD 2 rR) 1 Cspec )  (80) PLR PLrR 5 (81) PL ΔLNR 5 EXR 1 rR,21*LNR,21(82) PB, extra 5 2LNR,21*ΔER(83) rD 5 rCB (84) rLN 5 rD 1 d (85) VR 5 LNR *ER (86) Table A.6  Stock matrix model c) Workers

Capitalists

Banks

Capital Loans /  deposits

1KF 2LNF

1DW

1DCap

Inventories

1INF

1LNF 1 LNG 2 DW 2DCap 2LNR*ER

Net wealth

2VP

2VW

2VCap

2VB

2VG

2VR

2Ktot 2INtot

0

0

0

0

0

0

0

∑

OBERHOLZER_9781800371118_t.indd 313

Government 1KG 2LNG

RoW

∑

Firms

1LNR *ER

1ING

1Ktot 0

1INtot

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Development macroeconomics

Table A.7  Transactions matrix model c) Firms Cu Production /  consumption Investment

Stock accumulation Wages Profit Interest

Taxes Government  expenditures Export / import

Cu

Capitalists Cap

2CW

1CF 1IF

2SF

1ΔINF 2WF 2PF 2rLN, 21* LNF, 21

2ΔINF 1 PUF

2sW* (Wtot 1 rD, 21 * DW, 21 2TW 1 G)

Cu

1sW* (Wtot1rD, 21 *DW, 21 2TW1G)

1Wtot

2sCap* (PCap 1 rD, 21* DCap, 21 2 TCap)

2TW 1G

2TCap

1EXF* ER

2IMW * RER

2IMCap * RER

0

0

2ΔDW

0

1 sCap* (PCap 1 rD, 21* DCap, 21 2 TCap)

1PCap 1 rD, 21* DCap, 21

1rD, 21* DW, 21

1ΔLNF

Cap

2CCap

2TF

Change in loans /  deposits Debt revaluation ∑

Workers Cap

0

2ΔDCap

0

0

Stock accumulation 1ΔINF Capital 1IF 5 ΔKF  accumulation

IV b) The banks set the interest rates for domestic lending and deposits such that the averages of domestic and external rates meet required ­profitability. On both the asset and liability sides of the banking system, we weigh domestic and external rates by the respective shares in total length of the balance sheet. Therefore, we need to calculate the balance sheet length, BS. Since its components can all either be positive or negative and change their sign from one period to the next, they cannot just simply be summed up. However, it can be calculated by taking the absolute values of all balance sheet components and summing them up. This yields total assets plus total liabilities as a sum and thereby measures the balance sheet length twice. Dividing the sum by two thus yields the correct result:

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Appendices ­315

Banks

Government

Cu

Cap

Cu

∑

RoW

Cap

Cu

Cap 0

1CG

1PUB

2PB 1rLN, 21*(LNF, 211 LNG, 21) 2 rD, 21* (DW, 211DCap, 21) 2 rR, 21*LNR, 21*ER

1IG

2SG

0

1ΔING 2WG 2PG1BDG 2rLN, 21* LNG, 21

2ΔING

0 0 0 0

1PG 2 BDG

2PR 1rR, 21*LNR, 21 *ER

1ResR

0 0

1TG 2G 1EXG * ER

2PB, extra

2ΔEQB

1LNR, 21 * ΔER

2LNR, 21 *ΔER

0

0

1EXR * ER 1ΔLNG

0

0

1ΔING 1IG 5 ΔKG

0 0

2ΔLNR * ER

0

0

0

0 1ΔINtot 1Itot 5 ΔKtot

BS 5 ( /LNF / 1 /LNG / 1 /DW / 1 /DCap / 1 /EQB / 1 /LNR*ER / ) *

1 2

The average interest rates on both the asset and liability sides of the banking system’s balance sheet are calculated as the averages of the ­ internal and the external rates, each weighted by their share in the balance sheet. We know that if LNR is negative, the country is an external creditor. In this case, rR is not relevant for the liability side of the balance sheet, hence rD 5 ṝD. This means that the external rate is only relevant for the average loan rate if the country is a net debtor with LNR being positive. For this case, we redefine external debt to limit it to strictly positive values:

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,

LNR 5 max (LNR,0)

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The average deposit rate then is given by:

,

,

LNR*ER BS 2LNR *ER rD 5 *rR 1 *rD BS BS



Hence, as long as LNR is positive, it influences the average deposit rate to the extent that rR deviates from rD. If LNR is negative, it disappears , from the formula because in that case, LNR is set to zero. Consequently, ṝ D 5 r D. The same procedure applies to the asset side of the balance sheet and thus to the average loan rate. The external rate is relevant here as long as the economy is a net creditor, thus LNR being greater than zero. For this case, we redefine LNR correspondingly, now expressing:

,

LNR 5 max ( 2LNR, 0)



which leads us to the average loan rate:

,

,

LNR *ER BS 2LNR *ER rLN 5 *rR 1 * rLN BS BS



In analogy to the banks’ liability side, the loan rate on the asset side is impacted by the external rate to the extent that LNR is below zero. , , LNR then takes a positive value. If LNR is negative, LNR becomes zero and hence ṝLN 5 rLN. Reformulating both formulas yields the model equations:

,

LNR *ER BS ,  with LNR 5 max (LNR,0) rD 5 arD 2 * rR b * , BS BS 2LN *ER (26’) R

,

LNR *ER BS ,   with LNR 5 max (2LNR, 0) rLN 5 arLN 2 *rRb * , BS BS2LN *ER (27’) R

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Appendices ­317

APPENDIX V: MODEL D) YF 5 A*LF  (1) ΔINF 5 YF 2 CF 2 IF 2 IBU,F 2 EXF (2’’) PF 5 CF 1IF 1IBU, F 1ΔINF 1EXF *ER 2WF 2rLN,21*LNF,21 2TF (3’’’) CF 5 CW 1 CCap 2 CG 2 CBU (4’’) PF prF 5 (5) KF 1 WF prmin 5 rD (6) Keff CUF 5 (7) KF IF 5 α1* ( prF,21 2 prmin ) 1 α2* (CUF,21 2 CUn) (8) ΔKF 5 IF (9) A 5 δ1* (Ktot) 0.5 1 δ2* aa 0 IF 1 a 0 IG 1 a 0 IBU b for all IF . 0, IG . 0, IBU . 0(10’’) t21

t21

t21

ci 5 ε* (Ktot) 0.5 (11’) KF, eff 5 ci *LF  (12) (YF,21 2 ΔINF,21 1 ΔIF) LF 5 * (1 1 prF,21 2 prmin) (13) A WF 5 w*LF  (14) x Ltot w 5 γ0 1 γ1* a 2 b 1 γ2 *w0 *A^ 0(15’) L wref 5 w0* (1 1A^0)  (16) CW, tot 5 (1 2 sW) * (Wtot 1 rD,21 *DW,21 1 G 2TW)  (17’’) ΔDW 5 sW * (Wtot 1 rD,21*DW,21 1 G 2 TW) (18’) sW 5 z * (w2wref )  (19) CCap, tot 5 (1 2sCap) * (PCap 1 rD,21 *DCap,21 1 rD,21 *B21 2 TCap)  (20’’’) ΔDCap 5 sCap* (PCap 1 rD,21*DCap,21 1 rD,21*B21 2 TCap) 2 ΔB(21’’) sCap 5 κpr21 2prmin 2 1 (22) SF 5 IF (23) PUF 5 SF 1 xF *LNF,21 (24) ΔLNF 5 IF 2 PUF 1 ΔINF  (25) rD 5 rCB (26) rLN 5 rD 1 d (27) PB 5 rLN,21* (LNP,21 1LNG,21) 2rD,21* (DW,21 1DCap,21 1DBU,21)  (28’’’)

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PUB 5 xB*PB ΔEQB 5 PUB 1 PUB, extra PCap 5 PF 2 PUF 1 PB 2 PUB PL 5 β * (CU 2 CU ) 2β *ΔIN 1 β *w 1

21

n

2

21

3

(29) (30’) (31)

21 1 β4*LNF,21*rLN

1 β5*PLR,21*ER21

A

(32’) VF 5 KF 1 INF 2 LNF (33) VW 5 DW  (34) VCap 5 DCap 1 B(35’) VB 5 LNF 1 LNG 2 DW 2 DCap 2 DBU  (36’’’) Vtot 5 VF 1 VW 1 VCap 1 VB 1 VG 1 VBU 1 VR 5 KF 1 INF 1 KG 1 ING 1 KBU 1 INBU (37’’) TF 5 tF *PF,21 (38) TW 5 tW * (Wtot,21 1 rD,22 *DW,22 1 G21) (39) TCap 5 tCap* (PCap,21 1 rD,22 *DCap,22) (40) BD21 tF 5 2τF, 1 * LNF,21 1 τF, 2 * (41) Ytot,21 BD21 tW 5 τW, 1 *DW,21 1 τW, 2 * (42) Ytot,21 BD21 tCap 5 τCap,1 *DCap,21 1 τCap, 2 * (43) Ytot,21 TG 5 TF 1 TW 1 TCap (44) BD 5 G 2 TG 2 (PG 2 PUG) 2 (PBU 2 PUBU) 

(45’)

G 5 θ1* ( gY, target 2 gY,21) 1 θ2* (PG 2 PUG) 1 θ4* (PBU 2 PUBU)  (46’) YG 5 A*LG (47) Ltot 5 LF 1 LG 1 LBU  (48’) Ytot 5 YF 1 YG 1 YBU 5 A*Ltot(49’) ΔINF ΔING 5 *YG(50) YF CG 5 YG 2 ΔING 2 IG 2 IBU,G 2 EXG(51’’) PG 5CG 1 IG 1 IBU,G 1 ΔING 1EXG *ER 2WG 2 rLN,21 *LNG,21(52’’) prG 5

PG (53) KG 1 WG

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Appendices ­319

KG, eff

5 1(54) KG IG 5 θ3* ( gY, target 2 gY,21)  (55) ΔKG 5 IG(56) Ktot 5 KF 1 KG 1 KBU  (57’) KG, eff 5 ci *LG(58) KG LG 5 (59) ci WG 5 w *LG (60) Wtot 5 WF 1 WG 1 WBU 5 w*Ltot (61’) SG 5 IG(62) PUG 5 SG(63) ΔLNG 5 IG 2 PUG 1 ΔING 1 BD (64) VG 5 KG 1 ING 2 LNG(65) EXF 5 ηF,1 *YR 1 ηF, 2 *RER(66) EXG 5 ηG,1 *YR 1 ηG, 2 *RER(67) CUG 5

YF * (η11 1 η12 *A^0) (68) Ytot YF 5 *η (69) Ytot 2

ηF,1 5 ηF, 2

YG * (η11 1 η12 *A^0) (70) Ytot YG ηG, 2 5 * η2(71) Ytot CW 5 CW, tot 2 IMW *RER(72) CCap 5 CCap, tot 2 IMCap *RER(73) IMW 5 μ1*CW, tot 2 μW, 2 *RER(74) IMCap 5 μ1*CCap, tot 2 μCap, 2 *RER(75) ηG,1 5

μW, 2 5 μ2 *

CW, tot

(76) Ytot CCap, tot μCap, 2 5 μ2 * (77) Ytot EXR 5 IMW*PLrR 1 IMCap*PLrR 2 EXF 2 EXG 2 EXBU (78’) (79) RER 5 ER*PLrR

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ΔER 5 ΔERpolicy (80’) PLR PLrR 5 (81) PL r *B * * ) 1 D,21 21 (82’) ΔLNR 5 EXR 1 rR,21* (LNR,21 2 LN R,21 ER PB, extra 5 2LNR,21 *ΔER(83) IBU 5 ΔLNR,21 *ER21 for ∆LNR, 21 . 0 (84d) IBU 5 0 for ∆LNR, 21 # 0 ΔLN R* 5 ΔLNR,21 for LNR, 21 . 0 (85d) ΔLN R* 5 0 for LNR, 21 # 0 * *ER21(87) ΔB* 5 ΔLN R,21 ΔB 5 ΔLNR,21*ER21 for ∆LNR, 21 , 0 (88) ΔB 5 0 for ∆LNR, 21 $ 0 * ) *ER 1B* VR 5 (LNR 2 ΔLN R (86’) YF IBU, F 5 *I (89) YF 1YG BU YG IBU,G 5 *I (90) YF 1YG BU ΔKBU 5 IBU (91) KBU LBU 5 CUBU * (92) ci WBU 5 w *LBU  (93) YBU 5 A*LBU  (94) CBU 5 YBU 2 ΔINBU 2 EXBU (95) ΔINF ΔINBU 5 *YBU (96) YF EXBU 5 ηBU, 1 *YR 1 ηBU, 2 *RER(97) YBU ηBU,1 5 * (η11 1 η12*A^0) (98) Ytot YBU ηBU,2 5 *η (99) Ytot 2 * )* PBU 5 CBU 1 ΔINBU 1 EXBU*ER 2WBU 2 rR,21* (LNR,21 2 LN R,21 ER 2 rD,21* (B21 1 B *21) 1 rD,21*DBU,21(100) PUBU 5 xBU *PBU  (101) ΔDBU 5 PUBU 1 ΔLNR *ER 2 IBU 1 ΔB 2 ΔINBU  (102) * ΔEQBU 5 PUBU 2 (LNR,21 2 LN R,21) *ΔER(103) * ) *ER 2 B 2 B*(104) VBU 5 KBU 1 INBU 1 DBU 2 (LNR 2 LN R,21

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Appendices ­321

Table A.8  Stock matrix model d) Firms

Workers Capitalists

Banks

Government

Bureau

1KG 2LNG

1KBU 1 DBU 2 (LNR 2 LN*R) *ER 1INBU 2B 2 B*

RoW

∑

Capital Loans /  deposits

1KF 2LNF

Inventories Bonds

1INF

Net wealth

2VP

2VW

2VCap

2VB

2VG

2VBU

2VR

2Ktot 2INtot

0

0

0

0

0

0

0

0

∑

1DW

1DCap

LNF 1 LNG 2 DW 2 DCap 2 LNR*ER

1ING

1B

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1 (LNR 2 LN*R)) *ER

1 B*

1Ktot 0

1INtot 0

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Table A.9  Transactions matrix model d) Firms Cu Production /  consumption Investment

Workers Cap

Cu

Capitalists Cap

2CW

1CF

2sW*(Wtot 1rD, 21* DW, 21 2TW 1 G)

Cu 2CCap

1 sW*(Wtot 1 rD, 21* DW, 21 2 TW  1 G)

2sCap* (PCap 1 rD, 21* DCap, 21 1 rD, 21* B21 2 TCap)

1 IF 1 IBU, F

2SF

Stock accumulation Wages Profit

1ΔINF 2WF 2PF

2ΔINF

Interest

2rLN, 21 *LNF, 21

1rD, 21* DW, 21

1rD, 21* DCap, 21 1rD, 21 * B 21

2TF

2TW 1G

2TCap

1EXF  * ER

2IMW* RER

2IMCap* RER

Taxes Government  expenditures Export / import Change in loans /  deposits

1PUF

1Wtot

1sCap* (PCap1 rD, 21 *DCap, 21 1rD, 21* B21 2 TCap)

1PCap

2ΔDW

1ΔLNF

Cap

2ΔDCap

Change in bonds

2ΔB

Debt revaluation

∑ Stock accumulation Capital accumulation

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0 1ΔINF 1IF 5 ΔKF

0

0

0

0

0

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Appendices ­323

Banks Cu

Government Cap

Cu

Cap

1CG

2PB

1PUB

1rLN, 21* (LNP, 211 LNG, 21) 2rD, 21* (DW, 211 DCap, 21 1 DBU, 21)

Cu

∑

RoW Cap

Cu

Cap 0

1CBU

1IG1 IBU,G

2SG

1ΔING 2WG 2PG1 BDG 2rLN,21 *LNG,21

2ΔING 1PG 2BDG

1ΔINBU 2WBU 2PBU

2IBU

0

2ΔINBU

0 0 0

1PUBU

2PR

1rD, 21* DBU, 21 2 rR, 21 * (LNR,21 2LN* R, 21) *ER2rD, 21 *(B*211B21)

1rR, 21* (LNR, 21 2LN*R, 21) *ER 1 rD,21*B* 21

1EXBU*ER

1EXR* ER

1ResR

0

0 0

1TG 2G 1EXG* ER 1ΔLNG

2ΔEQB

0

Bureau

0

0 1ΔING 1IG 5 ΔKG

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0

1(LNR, 21 2LN* R, 21)* ΔER2 ΔEQBU 0 1ΔINBU 1IBU 5 ΔKBU

1(ΔLNR2 ΔLN* R)* ER 2ΔDBU 1 ΔB 1 ΔB* 2(LNR, 21 2LN* R, 21) *ΔER 1 ΔEQBU 0

0 2(ΔLNR 2ΔLN* R) *ER 2ΔB*

0

0 0

0

0

0 1ΔINtot 1Itot 5 ΔKtot

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Index advanced economies 2, 6, 10, 15, 21, 24–25, 28, 30, 37, 109, 166, 169, 264, 269 Africa 1–2, 7–11, 13, 24–25, 29, 35, 37–39 agricultural goods 28, 39, 166 AIDS 10 allocation, resource 20, 25–26, 29, 32, 34–35, 90, 93, 98, 155, 167, 203 Argentina 1 Asia 1–2, 7–12, 34, 37–38, 165, 257, 263, 268–269 Asian crisis 1, 33, 165 balance-of-payments constraint 5–6, 19, 37, 162–165, 167–172, 174, 190, 195, 210, 216, 225, 228–229, 247–248, 255, 258–259, 261–262, 268 crisis see currency crisis equilibrium and disequilibrium 140, 152, 163, 165, 170, 198, 216, 229, 259 balance of payments, definition of 137, 177–178, 182, 208, 218 balance of trade see trade balance Banco del Sur 257 bancor 217–219 bank, development 257 bank equity 79–80, 186, 191–193, 198, 207, 241 banking system 31–33, 42, 45–46, 50, 67, 78–79, 90, 95, 121, 138, 144–145, 147, 156, 172, 182–187, 190–193, 198, 203, 210, 212–214, 217–218, 220–223, 225, 227, 229–230, 236, 244 bookkeeping, double-entry 46, 54, 64, 77, 84, 99, 138, 140, 186, 220

Botswana 39 Bretton Woods 211, 217 budget deficit 1, 20–23, 97–98, 107, 110, 113–114, 120–122, 125–126, 131–132, 136, 243, 250 surplus 23, 93, 98, 100, 107, 110, 126, 133 see also primary surplus bureaucracy 39 capacity utilization 18, 58, 66, 68–69, 84–87, 93–94, 99, 103, 106–107, 117–119, 124–125, 127–128, 130–131, 134, 196, 200–201, 203, 205, 238, 245, 252–254 capacity utilization full 17, 56–58, 92, 99, 119, 135, 167 normal rate of 17, 58, 69, 80, 82, 135, 181, 193 capital account 137, 152, 160, 182, 208 accumulation 14–16, 21, 26, 48, 61–64, 70, 81, 84, 94, 99, 105, 109–111, 117–118, 124, 128, 130, 133, 198, 215–216, 225–226, 231, 233, 237, 247, 256, 259, 264 controls 31–32, 159–161, 171, 202, 210, 231–232, 258–260, 263 fixed see capital stock flight 1–2, 6, 33, 149, 156–157, 161, 163, 167, 170, 179, 182, 202–209, 215, 217, 229–232, 258, 261, 263, 267–268 flows 1–2, 22, 32–33, 137, 143, 146–148, 156, 159–161, 163, 171, 182, 216, 232 see also financial flows, portfolio flows ­325

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marginal efficiency of 61–62, 64, 68, 70 stock 14, 16–17, 52, 60, 66–71, 84–85, 87, 90, 103, 110, 117–118, 127–128, 132–133, 135–136, 192, 198, 221–222, 226, 229–231, 233, 236–239, 244, 247, 250–253 capitalist economy 4, 15, 22, 36, 39–41, 47, 52, 60–61, 63, 68, 86, 94, 115, 138, 264, 266, 268 Caribbean 8–12, 26, 38 central bank 1, 4, 34, 39, 41–46, 78, 86, 92, 99, 109, 149, 157–159, 164, 172, 184, 186, 188, 193, 195, 202, 204–205, 207, 215, 222, 225, 231, 244, 257, 260–261, 267 central bank reserves 45, 99 China 2, 8, 12, 24–25, 29–30, 39, 166, 265 circuit domestic and foreign 227, 232–234, 240–244, 250 and interest 52, 54 monetary 3, 49–59, 64–65, 76, 94, 97, 105, 120, 126, 132, 134, 137–139, 146, 183, 227–228, 232–234, 240 and profit 51–54 classical theory 4, 17–18, 43, 55, 61, 67, 69, 150–151, 154, 164, 181 Club of Rome 265 commodities and primary goods 16, 28, 37, 56, 153–154, 156, 165–166, 169–170 commodity prices 1, 154, 166 comparative advantage 27–28, 30, 36, 166–167, 169 costs 142, 150–151 see also Ricardo, D. competition, real 63, 115 competitive advantage 150–151, 156, 165 disadvantage 166, 169 exchange rate 19, 195, 233, 258 competitiveness 140, 142, 153, 155, 162, 164, 169–170, 175, 204–205, 208

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contraction 1, 104, 155–156, 192, 207, 218, 231 convergence of income levels and living standards 8–9, 15–16, 30 corruption 160, 269 credit circuit see circuit and debt 50–54, 57, 97, 152, 155, 217–218, 222, 225, 243, 255 discrimination 257 creditworthiness 44–45, 54, 78, 109, 247 crisis Asian see Asian crisis banking 149, 156, 158, 162, 170, 203, 207 currency 1, 5, 21, 33, 35, 159, 170, 203, 247, 267–268 debt 1–2, 24 financial 3, 33, 35, 77, 93, 158–160, 166 crowding-in 104–105, 107, 110, 135, 198, 201, 253, 256–257 crowding-out 4, 26, 91, 98–104, 107–108, 115, 136, 200–201, 247, 250, 252–253, 256, 262, 267 culture 13 currency appreciation see exchange rate appreciation crisis see crisis, currency depreciation see exchange rate depreciation devaluation see exchange rate devaluation instability see exchange rate instability reserves see foreign reserves current account deficit 5, 21, 139–140, 146, 161–163, 166, 170, 181, 191, 196, 198, 202, 208–209, 214–216, 225–230, 233–236, 240, 242, 245, 247–248, 251–253, 258–262 surplus 139–140, 152, 156, 166, 190, 195, 207–208, 214, 235–237, 243, 250–251 see also trade balance

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Index ­327

debt external 1–2, 5, 23, 142, 146–147, 152, 155–159, 162, 164, 170, 172, 179, 181–185, 187–192, 194–204, 206–208, 210–211, 213–220, 222, 226–229, 231, 233–236, 240–244, 246–247, 249, 252, 254, 258–261, 263, 268, 315 foreign see debt, external see also crisis, credit and debt, public debt debt deflation 208 debtor see credit and debt deflation 43, 47, 155–156, 166, 205, 218 see also stability, price deindustrialization 37, 166 demand, effective 4–5, 26, 58, 60–62, 64–66, 70–72, 77– 78, 83, 85–86, 88–90, 93–95, 100, 103, 105, 107–111, 115, 118–119, 124–127, 133, 135, 137, 151, 156, 167, 178, 188, 193, 195–196, 200–203, 205, 207, 213, 215–216, 218, 220, 231–233, 242–243, 248, 252, 253, 256–257, 266 see also demand-led growth democracy 39–40 deregulation see regulation and deregulation development bank see bank, development economic 4, 6–7, 13, 16, 23, 28, 30, 39–40, 89–91, 97, 101, 130, 167, 247, 255–256, 266, 268 finance 96 human 13 social 1 strategy 7, 13, 31, 34–35, 37, 90, 137, 149, 162, 165, 167, 175, 210, 216, 233, 250, 257, 260, 263, 268–269 sustainable 266 technological see technological progress see also Human Development Index developmentalism classical 16, 19, 39 new 19, 164, 166, 169, 258

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developmental state 22–23, 263 distortion, market and price 4, 20–21, 23, 26–27, 32, 44, 91–93, 168, 203–204, 252 distribution income 18, 21, 89–90, 106–108, 155, 256, 268 profit 114, 120, 130, 198 wealth 2, 12 division of labor 14, 168 Dornbusch model 141, 143, 147 Dutch disease 165–166, 169, 171 economic development see development, economic economic planning 12, 23 stagnation see stagnation, secular stagnation economy of exchange 49, 55–57, 138 see also monetary economy of production education 1, 9, 13, 19, 21, 40, 91 emerging countries and economies 8, 10, 24–25, 34–36, 28, 39, 158 employment formal 13, 103 full 14, 23, 25–26, 47, 57–58, 71–73, 82, 92, 101–103, 106, 108–109, 134, 143, 167, 201, 256–257, 262 vulnerable 10–12 see also informal sector endogenous and exogenous money see money environment 6, 13, 96, 208, 265 equilibrium general 30, 42–43, 48, 82, 91–94, 99, 160, 167–168 supply-side 18, 42–43, 56, 94, 100, 103 see also growth, supply-led Europe 8–11, 29, 38 European monetary union 254 exchange rate appreciation 141–144, 147–149, 152, 154–156, 158, 163–164, 166, 171, 174, 181, 183, 203, 205, 207, 209, 228, 248 depreciation 21, 141, 143–144, 147–153, 155–156, 158, 162,

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Development macroeconomics

170, 172, 177, 180–183, 186–192, 194–198, 200–205, 207–209, 214–216, 228, 231, 233, 239, 243, 258, 261, 263 devaluation 1, 146–149, 152, 157, 160, 167, 190, 192, 195, 202–203, 205, 207, 215, 229, 243, 258 floating and pegging 5, 157–160, 166, 170–171, 195, 210, 217, 258 and inflation 150–151 models, neoclassical 140–143 nominal 143–149 overvaluation see Dutch disease populism 258 real 149–155 stability and instability 155, 157, 162, 164, 200, 215–216, 228, 231–232, 234 stabilization 158–159, 233, 248, 250 exchange rate, absolute 228 exchange, unequal 16 exorbitant privilege 211 expectations, rational 59, 93–94, 143, 147 expenditure, public see public expenditure export promotion 37, 260 external constraint see balance-ofpayments constraint fallacy of composition 59, 88, 94, 165 finance constraint, government 26, 91, 95–97, 257 financial bubble 33, 149, 158–159, 161, 179, 182, 215, 232, 258–259 flows 35, 37, 137, 142–143, 161, 187, 214, 258–259, 261 see also capital flows, portfolio flows institutions 32, 147 see also financial institutions, institutions repression 34 fiscal deficits see budget deficits discipline 2, 19, 21–23, 25 policy 3–4, 7, 21–23, 86, 89–95, 97–102, 104–106, 109–111, 265

OBERHOLZER_9781800371118_t.indd 328

policy, discretionary 93 surplus see budget surplus see also redistribution, stabilization foreign exchange market 146–149, 152–154, 156–157, 159, 161, 164, 166, 172, 179–180, 188, 202, 204, 208, 211, 215, 227–229, 233, 259 reserves 144–146, 149, 152, 157–159, 162–164, 171, 179–180, 187, 191, 195, 200, 202, 204, 207–208, 212, 214–216, 220, 223, 225, 235, 248, 251, 255 functional finance 106 GDP per capita see income per capita governance, macroeconomic 6, 13, 256, 263 government intervention 35, 37, 39, 60, 82, 88–89, 91–92, 94–95, 97, 100, 103, 106, 108, 110–111, 121, 134–135, 167, 171, 200–201, 233, 248, 256, 258 growth convergence 265–266 demand-led 58, 62, 99, 164 export-led 164–167, 171, 174–175, 258–259 immiserizing 190 laws, Kaldor’s 28, 36 limits of 264 model, Kaleckian 17–18, 58, 69 natural rate of 18 profit-led and wage-led 62, 155, 164, 259 supply-led 62 target 117, 119, 121–122, 126, 128, 135, 196, 198–199, 205, 229, 243, 248, 250 theory 7, 13–19 theory, endogenous 16 theory, heterodox 17–19 Harrod–Balassa–Samuelson model 140 heterodox economics 3, 22, 32–33, 39, 48, 55, 57–58, 61, 95, 134, 258 growth theory 17–19 horizontalism 45–46, 65, 78

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Index ­329

human capital 16 see also education Human Development Index 9 hyperinflation 1, 21 identity of loans and deposits 46, 51, 77, 79 of demand and supply 57, 60, 64, 67, 215 of savings and investment 46, 52, 57, 64, 75, 99, 120, 139 import substitution 37, 164, 260 income effects 142–143, 152 per capita 7–9, 12 India 8, 11, 24–25, 29–30 industrial countries 8, 24–25, 28, 63, 159, 169 industrialization 16, 28, 34, 36–37, 166, 177, 229, 258 industrial policy 3, 7, 35–37, 91, 103, 111 see also deindustrialization, infant industries inequality of income and wealth 9, 12, 35, 107, 109, 265, 268 infant industries 36–37, 169–170, 258 inflation 1, 19–23, 42–43, 47–48, 73, 80–81, 85–86, 109, 127–128, 134, 137, 140–141, 143–144, 150–151, 155–159, 162, 166, 170, 174, 190, 195, 200, 202–205, 207–208, 215, 258, 265 inflation, cost-push and demand-pull 48, 80–81, 87, 127 see also deflation, Phillips curve, price stability informal sector 10, 12–13, 20, 72, 103, 112 settlement 12 see also employment, vulnerable infrastructure 19, 21, 95–96, 252–253, 261–262 instability and exchange rate see exchange rate stability financial 35 Harrodian 72 macroeconomic 1, 23, 32–33, 35, 170, 258 monetary 229

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institutional economics 38 institutions 3, 7, 20–21, 38–40, 91, 95–97, 109, 256–257, 260, 267, 269 institutions, inclusive 39 see also financial institutions, international financial institutions international clearing bank 217–219 international financial institutions 19–20, 35, 39, 257, 260 see also institutions interest rate controls 32 see also financial repression equilibrium 31, 34, 43, 46, 147 exogeneity 45, 78, 99, 147 liberalization see financial liberalization parity 141–143, 147–148 risk premium 32, 156, 162, 192, 226 target 45, 83, 158–159 term structure 78 interest rate natural rate of 43–44, 47–48, 265 risk-free 68, 179 short-run 43, 78 internal constraint 6, 256, 258–259, 261, 263 International Monetary Fund 1 investment bureau 225, 233, 247–248, 252–253, 261–262 fixed 66, 79, 182 foreign direct 20, 33, 35, 146, 148, 161, 163, 181–182, 216 private 95–96, 98, 103, 108, 124, 128, 130, 196–199, 203, 245, 247, 249, 253 public 22–24, 34, 90–91, 95, 97–98, 100, 108–109, 114, 118–119, 128–136, 167, 196–202, 205, 216, 233, 248–251, 253–254, 257, 260, 263, 268 investment gap 95–96 investment, socialization of 23, 267 see also identity of savings and investment IS-LM model 99

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330

Development macroeconomics

Jamaica 1 Japan 8, 29 Kaldor, N. 17, 19, 28, 36, 44, 70, 174 see also growth laws, Kaldor’s Kalecki, M. 52, 58, 76 see also growth model, Kaleckian Keynesian multiplier 103–106, 108–109 Keynes, J.M. 4–5, 23, 33, 46, 55–59, 60–64, 68, 70, 86, 89, 103, 165, 217, 263–265, 267 Keynes plan 210, 218–219 labor market 17, 30, 57, 72, 81, 87, 98, 101–102, 104, 108–109, 119–120, 151, 200–201, 247, 252, 256–257, 262, 267–268 market participation 101, 109, 120 market tightness 150, 208, 250, 253 as a production factor 49, 67, 150 productivity see productivity of labor supply 14 Latin America 1–2, 8–12, 19, 21, 26, 30, 32, 34, 37–38, 166, 257 liberalization financial 3, 19–20, 31–35, 37, 160, 170, 269 market 2 trade 3, 19, 26–31, 35, 37, 167–168, 170 life expectancy 9, 10, 12–13 Manley, Michael 1 manufacturing 28–29, 36–38, 40, 153, 166, 169–171 marginal returns see returns, marginal Marshall–Lerner condition 152, 178, 195, 215 Marxian theory 16, 52, 61–62, 64, 68, 71 Marx, K. 52, 58, 61–62, 64, 155, 267 see also classical economics, profit rate Mauritius 39 Mexico 25, 29–30, 35 microeconomics 13, 59, 193 micro-foundations 65 Millennium Development Goals 7

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modern monetary theory 106, 109, 124, 170, 265 see also monetary sovereignty monetarism 42–44, 47, 80, 150, 157 see also money, quantity theory of monetary circuit see circuit, monetary duplication 144–145, 147, 149, 159, 161, 171, 214–215, 218, 222–223, 227, 232–233, 235, 259 economy of production 4, 49, 55–57, 65, 94, 97, 101, 138–139, 227 policy 4, 34, 42–46, 48, 78, 82, 84–87, 92–93, 95, 111, 127–128, 141, 143, 148, 157–160, 171, 179, 185–186, 188, 192–193, 195–196, 198, 200, 202, 208, 210, 223, 233, 244–245, 247–248, 250, 253–254, 264 sovereignty 106, 109 space 5, 138, 145–146, 149, 168–169, 211–212, 217, 227–228, 231, 261 monetary policy, new consensus in 43, 48 money commodity 41–42, 56, 136 endogenous 3, 41, 44–49, 55, 64–65, 78, 80, 97, 99, 105, 107, 137, 143–144, 147, 162, 179, 211, 213 see also horizontalism, structuralism exogenous 41–44, 46, 48, 50, 56, 95, 97, 99, 103, 136, 142, 150 fiat 41 neutrality of 48, 55–57 quantity theory of 42, 140 velocity of 42, 140 see also modern monetary theory money as a flow 50, 53 money multiplier 42, 44 national innovation system 20 natural resources 13, 265–266 neoclassical economics see neoclassical theory equilibrium see general equilibrium exchange rate model 140–143, 151 growth model 14–15, 20 model and theory 3–4, 15–18, 20, 26–27, 33, 38, 41–43, 46–48,

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55–60, 62, 69, 71, 82, 91–94, 99, 101, 103, 136, 140, 143, 160, 168 see also equilibrium, marginal returns, microeconomics, microfoundations monetarism, production function, utility maximization new classical economics see real business cycle theory new Keynesianism 43, 93 new neoclassical synthesis 43 Nigeria 1, 25, 29–30, 34 non-system of international payments 5, 211, 214–215, 223, 228, 242, 259, 262 non-tariff barriers 26, 40 North America 8–11, 30, 38 original sin 156, 162, 211 paradox of thrift 59, 77, 200 see also fallacy of composition payment double or twofold (of interest) 5, 210–216, 218–220, 228–229, 232–234, 246, 263, 268 finality 51, 217–218, 223 international 5–6, 145, 147, 159, 161, 210–212, 214, 216–219, 222–223, 225, 227, 231, 245, 255 microeconomic and macroeconomic 211 see also (non-)system of international payments see also reform of international payments Phillips curve 81 planetary boundaries 6, 265, 267 planning state see economic planning policy autonomy 158, 171, 232, 244, 248, 250, 268 economic 2–3, 5–6, 13, 22, 33, 37, 40–41, 48, 51, 60, 65, 82, 86, 90–91, 94, 101–104, 106, 108, 110, 114, 121–125, 127–128, 130, 134–135, 137, 143, 162, 167, 170–172, 179, 187–188, 196, 198, 200–201, 208, 210, 216, 229, 231–233, 245, 248,

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251–253, 256–258, 260, 263, 267–268 industrial see industrial policy see also government intervention population growth 14–15, 82, 101, 172 poor 11–12, 26, 74, 229 urban 12 portfolio flows 33, 35, 146 post-Keynesian theory 4, 17–19, 34, 44, 46, 48–49, 52, 55, 58, 60–61, 63, 69 see also capacity utilization, effective demand, endogenous money, uncertainty poverty global 11–12 poverty line ethical 12 international or general 11, 120 poverty reduction 12–13, 26, 30, 88–90, 103, 106, 108, 110, 119, 137, 170–172, 195, 208, 210, 216, 248, 250, 263, 268 Prebisch, R. 16, 28 primary surplus 22 privatization 20, 25–26, 95 production costs 51–52, 63, 67–68, 70, 80–81, 87, 112, 115, 127, 133, 136, 150–154, 163–164, 168–169, 173, 175, 180–181, 203, 205, 259 see also comparative costs function 14–15, 17, 56, 67, 99 productivity of capital 15–16 growth 16, 18, 26–28, 36–37, 63, 70–71, 73, 81, 84–85, 99, 102–103, 105–106, 110, 124, 130, 134, 150, 152, 163, 165, 175, 201, 208–209, 216, 229, 233, 247–248, 255, 259, 263–266 of labor 28, 67, 72, 114–115, 118, 124, 127, 130, 206, 237 spillover 36, 168 profitability see profit rate profit maximization 56, 60, 62, 65 profit rate 4, 18, 26, 29, 31, 34, 60–64, 66, 68–69, 72, 74–75, 80–86, 88–89, 95–97, 100, 102, 107, 109, 111, 115–117, 123–125, 129–134,

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332

Development macroeconomics

137, 143, 148–151, 153–154, 159, 167, 179, 182–188, 190, 191–193, 195–196, 202–205, 231, 238, 244, 247, 250, 253, 256–257, 263–266 profit rate, tendency of a falling 62–63, 124–125, 264 propensity to consume 62, 86 to export 30, 175–176, 201 to import 30, 177, 262 to invest 107, 117 to save 107, 126 property rights 20, 39–40 protection and protectionism 27–28, 37, 170 public debt 22, 24–25, 109–111, 113–114, 125–126, 128, 131–132, 135–136, 211, 250–251 expenditure 19, 93, 95, 98–101, 103, 107–109, 121, 196 goods 21, 89–93, 97–98, 102, 112, 136 gross and net debt 22, 24–25, 110 see also investment, public public sector enterprises 23, 25 purchasing power parity 140–144, 149–152, 168 quantum macroeconomics 51, 57, 62, 144, 179, 213, 228 real business cycle theory 43, 58 redistribution income 4–5, 9, 21, 39, 86, 102, 106, 109, 112, 128, 134–135, 263 profit 80 social 2, 128, 135, 256 wealth 202, 265 reform of international payments 210, 227–229, 232–233, 248, 250, 259, 263, 267–268 by one-country 6, 219–224, 226–227, 229–230, 232–233, 259, 263 regulation, capital 161 regulation and deregulation 20, 31, 34, 39 rent 154–155, 166 research and development 36–37

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returns decreasing 14, 62, 70, 80 increasing 14, 16 marginal 14, 118, 124 Ricardian equivalence 93–94, 98–101, 104 Ricardo, D. 14, 27, 62–63, 142, 150, 155, 166–167 see also comparative advantage rigidities, nominal and wage 33, 43, 56, 92 see also new Keynesianism saving, macroeconomic and microeconomic 54, 59, 75, 78, 120, 133, 255 saving rate 14–15, 54, 59, 62, 74–75, 78, 82, 86–87, 103, 105, 107, 112, 120, 125, 177, 192 savings deposits 68, 74–75, 78 see also identity of savings and investment Say’s law 56–57 see also identity of demand and supply Schmitt, B. 5, 50–51, 105, 210–211, 219–220, 222, 225, 267 see also quantum macroeconomics Schumacher, E.F. 5, 210, 217–219, 267 secular stagnation see stagnation SFC model see stock-flow consistent model Singapore 8 slum see informal settlement Smith, A. 14, 155, 168 social expenditures and transfers 90–91, 93, 101, 107, 109–110, 112, 120, 122, 133–134, 196, 268 services 4, 89, 91, 107, 111, 117, 133, 243 socialists 267 Solow model 14–15 South Korea 2, 8, 35, 170, 263 speculation 33, 67, 148–149, 154, 156–157, 161, 215 speculative attacks, flows or shocks 146, 157–158, 161, 179–180, 188, 203, 205, 207–208, 259

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bubble see financial bubble stability macroeconomic 33, 135, 155, 165, 210 price 21, 42, 44, 108, 158 stabilization economic 20, 22–23, 89–93, 211, 267 exchange rate see exchange rate stabilization stagnation economic 14, 18, 70, 82, 162, 166, 171, 188, 192, 202, 264, 266 secular 264 state as a macroeconomic agent 4, 88, 94, 226, 233, 237, 265 sterilization 223, 235 stock-flow consistent model 4–6, 41, 64–65, 88, 106, 110, 138, 148, 162, 171, 266 structuralism in development economics 16 in monetary theory 45–46 supply constraint 48, 100–101, 103, 154, 167

technological progress 14–18, 27, 34, 36, 70, 110, 127, 256, 264 technology transfer 27, 36, 216 terms of trade 16, 142, 153–155, 165–166 Thirlwall’s law 162–165, 202, 216, 228, 247 see also balance-of-payments constraint trade balance 150, 152–153, 155, 161–163, 172, 177–178, 181, 187–189, 193–197, 199, 203–205, 207, 240, 246, 249, 258–259 deficit 1, 140, 142–144, 150, 165, 169–170, 181, 188–189, 193–196, 199, 200–201, 206, 216, 239, 242, 246–249, 262 surplus 142, 152, 172, 187, 190–191, 197–198, 200, 203, 205, 248 trade, free 27–28, 30, 153, 160, 167–169 see also liberalization, trade transformation, economic 256, 267

Taiwan 2, 8 tariffs 19, 26, 28–29, 36, 96, 169–171, 202, 258, 262–263 see also liberalization of trade, nontariff barriers tax base 19, 23 on capital flows 160 on exports 169 incentives 25, 32 on income 93, 107, 112 increase 93, 98, 100, 106, 111, 202, 262 on profits 113 reform 19 revenues 21–23, 26, 90, 107, 110, 113–114, 120, 122, 126, 135 Taylor rule 44 technical progress, Harrod-neutral, Hicks-neutral, Marx-biased, Solow-neutral 71

uncertainty 4, 17, 21, 33, 45, 53–55, 59–60, 64–65, 88–89, 94, 100, 137, 156, 158, 203 unemployment 1, 17, 23, 47–48, 56, 66, 84, 89–90, 101, 103, 106, 108, 128, 130, 143, 213, 215, 253, 266 utility maximization 56, 59, 65, 92, 100

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Venezuela 1 Verdoorn’s law 28 violence 7, 9, 268 wage bargaining 47, 73, 84, 150–151, 258, 266 rate 80, 87, 98, 108, 119 share 18, 62, 102 wage, minimum 1, 72, 108, 257 Washington Consensus 3, 7, 19–22, 25–26, 31, 35, 91

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