A critical examination of the mainstream approach of development finance
The adaptation of the Harrod-Domar growth models of the 1940s and 1950s has dominated in the traditional economics thinking regarding development finance. Development is constrained by the lack of resources due to the lack of the will or ability to increase domestic savings or to attract foreign capital (Kregel 2004a, 281).The need for financing/credit is often conflated with the need for savings. According to this view, developing nations must accumulate sufficient savings in order to finance their investment. This means that households must sacrifice current consumption. Governments also need to keep their financial house in order; they must run a positive budget balance, so as not to ‘squander’ resources from the private sector. Otherwise, deficit spending would take up investible resources and crowd out private spending, or jam up inflationary pressures. Financial intermediaries issue credit to generate ‘forced savings’; ultimately, financial intermediaries can only channel savings from surplus units to deficit units, rather than creating credit. As Gurley and Shaw (1955) put it, ‘the primary function of intermediaries is to issue debt of their own, indirect debt, in soliciting loanable funds from surplus spending unites, and to allocate these loanable fluids among deficit units whose direct debt they absorb.’
However, as Shaw-McKinnon thesis (Shaw 1973; McKinnon 1973) suggests, financial repression (the artificially lower than equilibrium interest rates), partially due to the government’s ill intention to lessen its debt burden, leads to low financial depth and slower growth. And the solution, is to liberalize domestic financial markets, which would raise the interest rates and in turn incentivize domestic savings. In addition, liberalizing the capital account would improve the access to foreign savings. Attracting foreign savings entails some additional benefits by filling the foreign exchange gap to allow developing nations to import necessary capital goods. As Kregel (2004a, 281) succinctly summarizes, ‘The sole aim of development policy can be reduced to the introduction and implementation of appropriate policies to improve the domestic mobilization of resources [savings] and to provide a hospitable domestic environment to attract the resources of foreign investors.’
Alas, the mainstream approach is founded on faulty theoretical grounds. As Keynes (1937) points out, the causality between savings and investment is the reverse of what the neoclassical believe. Given a monetary production economy, it is through investment and income growth that savings are made possible. Savings are a result, rather than a cause of income creation. Investment finance must be independent from previous savings (Studart 1995). As Liang (2012,18) notes,‘financing, or extending credit to entrepreneurs to deploy real resources for production and income generation, must take precedence over savings and cannot be constrained by the limited amount of existing savings.’ Moreover, savings are much more dependent on income level and growth than on those of interest rates. Furthermore,‘The role of banks in the process of growth is to supply finance, whereas savings and financial markets provide funding.’ (Studart 1995,63) Most developing countries have a bank-based financial structure, thus low and stable interest rates are an important requirement to avoid the inherent financial fragility that results from maturity mismatches. This is because in a high-interest rate regime, businesses are incentivized to borrow short to minimize interest costs while their investments may have much longer horizon, this could lead to serious maturity mismatches.Therefore, it is questionable that removing financial repression and raising interest rates would increase savings rather than worsening financial stability.
Proposition to attract foreign savings is equally dubious. First, attracting foreign capital may not be used to finance investment but promote consumption and imports. Second, even if foreign capital is invested, currency mismatch and maturity mismatch could heighten financial fragility and instability.This is because relying on foreign capital requires capital inflows to increase ‘at a rate equal to the rate of interest paid to the developed country lenders.’ (Kregel 2004b, 24) This amounts to attracting new flows to pay for interest accrued on old debt - essentially a ‘Ponzi’ scheme.
Last but not the least, net resources transfer to developing countries is simply a mirage. Instead of capital flowing from developed countries to developing countries as the neoclassical Marginalism theory predicts;2 capital in facts flows from developing to developed countries - a phenomenon dubbed as ‘paradox of capital’. (Lucas 1990; Prasad, Rajan and Subramanian 2007). Even though developing nations receive foreign investment and lending from advanced countries, the amount pales compared to debt servicing and principal repayments. As a result, net financial transfers to developing countries have been in the negative territory since 2005. In total, from 2005 to 2017, the net transfer of financial resources from developing and transition countries to developed economies was estimated at $405 billion, or 1.3 per cent of their aggregate GDP (see Figure 15.1). This included the total receipts of net capital inflows from abroad minus total income payments (or outflows), including increases in foreign reserves3 and foreign investment income payments (United Nations 2018,44).
It is thus evident, from the analysis above, that the mainstream theory has great difficulties in explaining development finance. It is not surprising, therefore, that empirical support to the two-gap (saving and foreign exchange gaps) modeling to explain less developed nations’ growth was utterly lacking (Kennedy 1971). Following the mainstream recommendations, developing countries in the past decades liberalized and opened their financial markets — which have not generated greater development financing but destabilized financial order
Figure 15.1 Net transfer of resources to developing economies and economies in transition.
Note: Data for 2017 early estimated.
Source: United Nations (2018).
and triggered financial crises.The theoretical and empirical failure of the mainstream approach to development finance paves the way for alternative paradigm, to which we now turn.
