Financial Depression&Liberalization; McKinnon-Shaw Hypothesis (EN)

In the first article we talked about how Bretton Woods system collapsed. And this time we are going to talk about what came after that.

In 1973, two people; McKinnon and Shaw, they came up with two books. Money and Capital in Economic Development by Mckinnon and Financial Deepening in Economic Development by Shaw. Actually, these people have different backgrounds. McKinnon used to work for USAID in South Korea. And he was able to convince Korean government for an experiment on liberalization during 1960’s. Whereas Shaw was an economist. They used two different method and they arrived to the same conclusion that’s why the method that they developed is known as McKinnon-Shaw hypothesis.

These people argued that what was wrong with the Bretton Woods system was something to do with the epistemological understanding of economics.

S = f(Y)

It was the Bretton Woods understanding and it was wrong. It was wrong because of the lack of price mechanism which means market were not given sufficiently enough importance. There’s too much government intervention. Instead, we have to see savings as function of interest rate not as function of disposable income.

S = f(r)

Based on this, they say developing countries face with two types of gaps; savings gap and foreign exchange gap.

Within the Bretton Woods system, these gaps could not be cured, could not be patched up because the Bretton Woods system said countries must grow their national income. As national income grows, that’ll lead to a growth in savings which will transfer itself into growth in investments. That kind of causality is wrong.

According to McKinnon, money is exogenous. It’s not generated within the system. The relationship between savings and investments to interest rate is like this:

If interest rate increases, it will lead to increase in savings. In this case all savings are in the form of bank deposit. But if interest rates are high, investments will be expensive. Interest rates will make investments more expensive. So lower the interest rate, higher the amount of investments. The relationship between investments to interest rate is just the opposite of savings.

In the Bretton Woods System, in order to achieve higher investments, interest rate artificially kept below their equilibrium level(r1) so that, countries can grow faster. At this level of interest rate, banks can only attract S1 level of savings. Government intervention will supplement savings gap.

In the model, investments are used as a planning device. A country can sit down and decide what kind of investments it’s going to have. For example, a country is going to build a factory in a city. But if savings are low in the country, then they will go and borrow from outside to produce that factory. And that is going to cause a savings gap.

So this price ceiling is the real cause of savings gap. That’s what McKinnon argued. So because savings are low, we need investments and these investments will require imports. For imports, you need to generate foreign exchange . Because country needs to grow, in order to import you need to export first. If imports are larger than exports, or export reserves are not corresponding to imports expenses, then there will be foreign exchange gap. In order to achieve these investments, you need to import equipment from abroad. And you need to pay money and if you don’t have enough reserve in the bank then you’re facing with a foreign exchange deficit. Therefore there are two types of gaps; savings gap and foreign exchange gap. They’re independent from each other but they feed each other. And that turns into a chronic gap.

McKinnon argues that developing countries are not obligated with these two gaps. They can actually deal with these gaps. They just have to give up on the system that brought about with the Bretton Woods which required import substituting industrialization which means heavy government intervention. Government will decide what to invest. 

If we take government out and liberalize the system, then there will be price competition. First, price will increase to a certain level and then it will bounce back. But at one point there will be an interest rate, this will be equilibrium rate of interest(re).

What’s happening with the Bretton Woods System is that countries in need of other nations' money coming primarily to the U.S. but the U.S. can’t provide these dollars because of Vietnam War and other problems. So, not being able to finance its investments, countries’ growth shrinks back to the level of their domestic sequence.

Countries are not developing as fast as they can/should because of lack of finances and international money market shranks. International debt crisis are causing such a contraction then the growth is also slowing down. So to deal with this, we need to change the system, we need to liberalize it according to McKinnon and the book came out in 1973 just when the Bretton Woods collapsed. It was the answer. IMF and World Bank immediately adapted this and around this, an understanding developed and that’s known as Washington Consensus. And countries are encouraged to adapt Washington Consensus.

What’s the Washington Consensus?

It’s a market based economic reform package. The main idea is that markets are more efficient tools in allocating resources. Markets must be given priority. There should be a policy in which the government withdraws from economics fear. If that is provided then economic growth will be achieved. The understanding that rules the Bretton Woods System actually prevents us from higher growth rates. If there is market based reform then what will happen is this:

The price ceiling will be withdrawn. Prices will shoot up because of increased competition. But then it will come down and then bounce back again and at one point, at the equilibrium level, savings gap will disappear. And this is going to increase level of savings from S1 to S2 and with increased savings, higher rates of investments can be financed. The economy is going to grow faster without the savings gap. And once you get rid of savings gap, you get rid of foreign exchange gap. Those chronical gaps will disappear as a result of interest rate liberalization.

McKinnon’s idea is based on the idea that how he sees money. Money is exogenous. But Shaw was an economist, coming from Marxist background. And he is critical thinker. He looks at money not as exogenous but endogenous Their view of money is different.

In McKinnon’s view there is no institutions. There is aggregate savings and there is aggregate investments as if banks don’t matter. But in fact, banks are in the business of intermediation meaning savers and investors. So if you look at money as endogenous then we have to bring that institutional structure in to the model. So he introduces this into the model. In a price ceiling setup where import substituting industrialization is the government’s policy for economic growth ie. The system under Bretton Woods that creates an environment for banks in which the difference between bank borrowing and bank lending is too much. 

Banks profits leak out of the system and after that the savings transformed into investments. Under Bretton Woods system bank profit is larger but if you liberalize, if you take the price ceiling out, banks will start competing. With market based reform, bank efficiency in intermediation will increase. With this understanding, he says liberalization increases efficiency and gets rid of savings gap and foreign exchange gap.