Wednesday, September 19, 2007

Washington Consensus III/Financial Repression

I have not found a very good explanation of the Financial Repression Model so will type in a section of my class notes:
The simple model of a financial system in which the price of credit is administratively controlled and in which the quantity of credit is rationed as a result, was labelled the 'financial repression' model. Building upon the writings of Ronald McKinnon and E(dward) S. Shaw and others, many economists have expressed criticisms of financially 'repressed' financial systems since the early 1970s. In practice too, many governments, including those of many developing countries, have attempted to abandon such 'repression' and its component policies of controlled interest rate ceilings and government policy influence over the quantities allocation of credit to favoured sectors or firms.

During the 1980s, there have been many examples of governments setting interest rates free from controls and turning to more market-based systems in which credit allocation is done by price, within private financial institutions. In this process, known as 'financial liberalisation' or 'financial deregulation', many governments have attempted to refashion their financial systems into conformity with the second simple model. In the 'liberalised' or market-based model, credit allocation is pictured as working by means of effects of credit demand and supply on the price of credit - that is, the interest rate.

Well I finally did find a nice summation of the financial repression model from the IMF:
Box IV.1. Financial Repression and Economic Growth: Theoretical Background
The existence of interest rate ceilings is usually associated with financial repression, leading to financial underdevelopment and lower economic growth.33 In the McKinnon/Shaw framework, interest rate ceilings inhibit financial development mainly through keeping real interest rates below their market level. This, in turn, leads to the rationing of credit that affects negatively economic growth. Also, growth is hampered by the sub-optimal allocation of financial resources caused by the elimination of the price discrimination system that allows financial markets to allocate financial resources to those investment projects with the highest returns.

Financial repression, defined as the set of policies, laws, regulations, taxes, qualitative and quantitative restrictions and controls imposed by the government which directly interferes with the allocation of financial resources and the price discovery function of financial markets, was common prior to the 1970s. According to Roubini and Sala-i-Martin (1995, p. 276) financial repression was favored on the basis that (i) anti-usury laws were needed for social reasons; (ii) tight control and
regulation of the banking system was considered necessary to ensure banking soundness and proper monetary policy transmission mechanism; (iii) determining the allocation of financial resources to certain sectors or projects was a policy issue to be decided according to the government’s notion of socially “strategic” sectors or projects; and (iv) maintaining interest rates below market rates reduced the cost of servicing government debts.

Empirical research (Roubini and Sala-i-Martin, 1992 and 1995) suggests three main channels through which financial repression impacts negatively on economic growth: (i) productivity of investments is negatively affected; (ii) the overall level of investment and savings in the economy is reduced; and (iii) intermediation costs are increased. Recent research has found that the relationship between financial liberalization and economic growth is more relevant via the effect of liberalization on the efficiency of the financial system to allocate financial resources than via its effect on financial deepening. Increased financial system efficiency has been measured through higher access to external finance (Demigurc-Kunt and Maksimovic, 1996, and Rajan and Zingales, 1998), lower default rates (Jayaratne and Strahan, 1996), enhanced total factor productivity (Beck, Levine and Loayza, 2000), and lower variation in expected returns to investment (Abiad, Oomes and Ueda, 2004).

So I kind of went full circle with this journey and now back to the first post on this issue:
3.3.1 What are those different theories?
One example is the ‘financial liberalisation’ model developed by Ronald McKinnon, Edward Shaw and their followers. It provides a theoretical framework for policies of high interest rates and the abolition of credit controls, the policies that both the IMF and World Bank have promoted vigorously since the early 1980s. Washington Consensus???

Let me add a passage of Unit Two of DF201:
The 'financial liberalisation' school of thought therefore sees the aim of financial liberalisation as linked with controlling monetisation of government budget deficits and with controlling the money supply and inflation. They make a link between financial liberalisation and some aspects of stabalisation policy.

In conclusion, I thought I would link to Ronald McKinnon's academic web site where he teaches at Stanford still.

Key terms:
'Financial Repression' Model
Ronald McKinnon
Edward S.Shaw
'Financial Liberalization'='Financial Deregulation'

Three-Gap Model
Schumpeterian system of economic development

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