Emerging Economies and the

Global Financial System

This book provides a comprehensive overview of the financial integration of

emerging economies through an in-​depth analysis of the international mon-
etary system, how it impacts capital flows and exchange rates, and its implications
for policy making.
The financial integration of emerging economies has been a remarkable
development of the past two decades. The growth of cross-​border transactions
and asset ownership, not least through the accumulation of foreign exchange
reserves, has put many of these countries in a more prominent, if still peripheral,
position within the global financial system. This has not been a smooth process,
as integration has been marked by cyclical waves of capital flows, with financial
and currency instability often accompanying the acute phases of these cycles.
While conventional economic theory traditionally sees financial integration as
a positive development, Post-Keynesian economists, working in the tradition of
Keynes, Minsky and Kalecki, have long taken a more sceptical viewpoint. By
centring the analysis of financial dynamics on concepts as liquidity, uncertainty,
balance-​sheet structures and institutions, Post-Keynesian theory highlights the
intrinsic character of shocks imposed by financial integration upon emerging
economies, and their implications for economic growth and distribution. This
book demonstrates that these analyses can be fruitfully used to gain a better
understanding of financial (in)stability and economic development in emerging
economies as they integrate into the global financial system.
This work provides key reading for students and scholars of economics, pol-
itical economy and finance that are interested in the financial integration of
emerging economies, and how the heterodox tradition of Post-Keynesian eco-
nomics contributes to its analysis.

Bruno Bonizzi is a Senior Lecturer in Finance at the University of

Hertfordshire, Business School, UK.

Annina Kaltenbrunner is Associate Professor in the Economics of

Globalisation and the International Economy at Leeds University Business
School, UK.

Raquel A. Ramos is a Research Associate at the Centre d’Économie de

l’Université Paris Nord, France.
Routledge Critical Studies in Finance and Stability
Edited by Jan Toporowski, School of Oriental and African Studies,
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Unconventional Monetary Policy and Financial Stability

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Emerging Economies and
the Global Financial System
Post-Keynesian Analysis

Edited by Bruno Bonizzi,

Annina Kaltenbrunner
and Raquel A. Ramos
First published 2021
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Names: Bonizzi, Bruno, editor.
Title: Emerging economies and the global financial system : post-Keynesian
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Description: Abingdon, Oxon ; New York, NY : Routledge, 2021. |
Series: Routledge critical studies in finance and stability |
Includes bibliographical references and index. |
Identifiers: LCCN 2020049126 (print) | LCCN 2020049127 (ebook) |
ISBN 9780367111427 (hbk) | ISBN 9780429025037 (ebk)
Subjects: LCSH: International finance. | Developing countries–Foreign
economic relations. | Keynesian economics.
Classification: LCC HG3881 .E447 2021 (print) |
LCC HG3881 (ebook) | DDC 332/.042091724–dc23
LC record available at https://lccn.loc.gov/2020049126
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ISBN: 978-​0-​367-​11142-​7 (hbk)
ISBN: 978-0-367-70059-1 (pbk)
ISBN: 978-​0-​429-​02503-​7 (ebk)
Typeset in Bembo
by Newgen Publishing UK
Contents

List of figures  viii

List of contributors  ix

PART I
Introduction and background  1
1 Introduction  3
B RU N O B O N I ZZI , ANNI NA K ALTE NB RUNNE R AN D
R AQU E L A . RAMO S

2 Two post-​Keynesian approaches to international

finance: The compensation thesis and the cambist view  14
M A RC L AVO I E

3 Trade versus capital flows: The key implicit and

methodological differences between the Neoclassical
and the Post Keynesian approaches to exchange rate
determination  28
J O H N T. H ARV E Y

PART II
Minsky, balance sheets and cycles  41
4 A Minskyan framework for the analysis of financial
flows to emerging economies  43
B RU N O B O N I ZZI AND ANNI NA K ALTE NB RUNN ER

5 Post Keynesian and structuralist approaches to boom-​bust

cycles in emerging economies  56
K ARSTE N KO HLE R
vi Contents
6 Cost competitiveness and asset prices as determinants
of the current account in emerging economies  70
ALE X A N D E R GUSCHANSK I AND E NGE LB E RT STOCKH A M M ER

7 Space in Post Keynesian monetary economics: An

exploration of the literature  84
GARY DY M SK I AND ANNI NA K ALTE NB RUNN ER

PART III
Currency hierarchy  99
8 Evolving international monetary and financial architecture
and the development challenge: A liquidity preference
theoretical perspective  101
JÖRG B I B OW

9 International money, privileges and underdevelopment  116

H AN S JÖRG HE RR AND ZE Y NE P NE TTE KOVEN

10 The Post Keynesian view on exchange rates: Towards

the consolidation of the different contributions in
the ABM and SFC frameworks  137
RAQU E L A . RAMO S AND DANI E LA MAGALHÃES P R AT ES

11 A Post Keynesian framework for real exchange rate

determination: An overview  149
LÚ C I O BARB O SA, FRE D E RI CO G. JAY ME JR. A N D FA BRÍCIO J. M ISSIO

PART IV
Current account and growth  165
12 The Kaleckian theory of exchange rates  167
JA N TO P O ROWSK I

13 Financial liberalisation, exchange rate dynamics and the

financial Dutch disease in developing and emerging
economies  181
ALB E RTO B OTTA

14 Global financial flows in Kaleckian models of growth

and distribution: A survey  197
PA B L O G. B ORTZ
 Contents vii
PART V
Policy implications  215
15 Implications of modern money theory on development
finance  217
YAN LI AN G

16 Monetary sovereignty in the Post Keynesian perspective:

In the search of a concept  230
DAN I E L A M AGALHÃE S PRATE S

17 Dealing with global financial asymmetry: Contributions

of regional monetary cooperation between emerging
markets and developing countries  245
L AU R I SSA MÜH LI CH AND BARBARA FRI TZ

18 De-​regulation of finance in China and India:

A Post-Keynesian analysis  258
S U N AN DA S E N

Index  275
newgenprepdf

Figures

1.1 Emerging and developing economies, cross-​border assets

and liabilities %GDP.  4
1.2 Publications and citations per year.  6
9.1 Interest bearing monetary wealth held by a representative
wealth owner in US dollar and Ugandan shilling assuming
a stable exchange rate and the same interest rates in both
countries.  122
13.1 Determination of foreign portfolio flows and interest rate on
international financial markets.  183
13.2 Temporary credit euphoria in the early stages of a financial
boom.  186
13.3 Multiple equilibria and financial instability in the (e-​ρe) space.  188
13.4 (Relative) manufacturing development, labour productivity
growth and finance-​led development traps.  190
13.5 Long-​run perverse development effects of temporary portfolio
inflows and financial booms.  191
15.1 Net transfer of resources to developing economies and
economies in transition.  220
15.2 Unemployment rates (%) by country income groups.  224
15.3 Employment status (percentage of employees, employers,
own-​account workers and contributing family workers)
by country income groups, 2018.  224
16.1 Pyramid of liabilities.  235
Contributors

Lúcio Barbosa is a researcher in applied economics at Fundação João Pinheiro

research institute of Minas Gerais, Brazil. His research focuses on exchange
rate determination, exchange rate policies and Minas Gerais economy.
Jörg Bibow is Professor of Economics at Skidmore College. His main research
areas are international finance and European integration as well as inter-
national trade and development and the history of economic thought.
Bruno Bonizzi is Senior Lecturer in Finance at the University of Hertfordshire.
He researches and has published on financial integration, financialisation
and pension funds, with particular reference to the context of emerging
economies.
Pablo G. Bortz is Assistant Professor at the National University of San Martín
and tenured researcher at the National Council of Sciences and Technology,
Argentina. His research interests are international macroeconomics, eco-
nomic growth and climate finance in developing countries.
Alberto Botta is Senior Lecturer in Economics at the University of Greenwich.
His research activity focuses on topics such as financial liberalisation, struc-
tural change and macroeconomic stability in developing countries, and
financialisation and inequality in advanced economies.
Gary Dymski is Professor of Applied Economics at the Leeds University
Business School. His research focuses on credit-market discrimination and
redlining, economic development, financial crisis, and banking and financial
regulation. Most recently he has been involved in UK projects on the prod-
uctivity puzzle, on ‘rebuilding’ macroeconomics and on creating a gender-
equal economy.
Barbara Fritz is Professor of Economics at the Institute for Latin American
Studies, and the School of Business and Economics of the Freie Universität
Berlin. Her area of expertise lays at the encounter of international
macroeconomics and finance, and development economics for emerging
market countries. She has special focus on inequalities at the global, regional
and national levels.
x Contributors
Alexander Guschanski is a lecturer in economics at the University of
Greenwich and a member of the Institute of Political Economy, Governance,
Finance and Accountability. He has published on the determinants of current
account imbalances, income distribution and unemployment.
John T. Harvey is Professor of Economics at Texas Christian University in
Fort Worth, Texas, where he has been on the faculty for thirty-four years.
His main areas of research interest are exchange rates and business cycles. He
has published over forty refereed articles, two edited volumes and two books.
Hansjörg Herr is Professor Emeritus at the Berlin School of Economics and
Law, Germany, for “Supranational Integration”. He is an expert in develop-
ment economics including trade, global value chains and financial systems.
He also works in the field of labour markets, minimum wages and wage
bargaining systems as well as the development of the international mon-
etary system and the European integration. He is one of the founders of the
Global Labour University which carries out activities under a trade union
perspective together with the International Labour Organisation. Hansjörg
Herr has been teaching in many universities around the world.
Frederico G. Jayme Jr. is Professor of Economics in the Department of
Economics and Director of Cedeplar, Federal University of Minas Gerais,
Brazil. His research areas include macroeconomics, growth and distribution,
and economic policy, especially emerging economies.
Annina Kaltenbrunner is Associate Professor in the Economics of Globalisation
and the International Economy at Leeds University Business School.
She has published on financial integration, currency internationalisation,
financialisation and macroeconomic policy in emerging capitalist economies.
Karsten Kohler is a lecturer at King’s College London. His research interests
are business and financial cycles, exchange rates and macroeconomic vola-
tility in emerging markets, as well as financialisation, income distribution
and growth models in advanced countries. Most of his work can be found
at karstenkohler.com.
Marc Lavoie is Professor Emeritus at the University of Ottawa and at the
University Sorbonne Paris Nord. He is also a Research Fellow at the
Macroeconomic Research Institute of the Hans Böckler Foundation. His
latest work is Post-Keynesian Economics: New Foundations – an exhaustive
account of post-Keynesian economic theory.
Yan Liang is Professor of Economics at Willamette University and a research
scholar at the Global Institute for Sustainable Prosperity. Her research
focuses on international trade and finance, Modern Money Theory, eco-
nomic development and the political economy of China.
Daniela Magalhães Prates is Senior Economic Affairs Officer at the Debt and
Development Finance Branch of the United Nation Conference for Trade
and Development (UNCTAD). Her main areas of research are International
 Contributors xi
Economics and Open Macroeconomics with focus on monetary and finan-
cial issues and developing countries. She has published many papers in aca-
demic journals (such as the Journal of Post Keynesian Economics, Review of
Keynesian Economics, International Review of Applied Economics and ECLAC
Review) and book chapters.
Fabrício J. Missio is Professor of Economics at Cedeplar and Department of
Economics, Federal University of Minas Gerais, Brazil. His research areas
include macroeconomics, growth and distribution, and economic policy,
especially emerging economies.
Laurissa Mühlich is Research Associate and Lecturer at the Chair of
Economics, Institute for Latin American Studies and the School of Business
& Economics of the Freie Universität Berlin. Her research interests are
international macroeconomics, monetary policy and financial system devel-
opment in developing and emerging economies, development economics
and development policy.
Zeynep Nettekoven is a lecturer of Economics and coordinator of the
German-Israeli International Certificate Program at Europäische Akademie
der Arbeit in der Universität Frankfurt am Main. Her research areas are
monetary policy, financial system regulations, and labour market institutions
and policies.
Raquel A. Ramos is Associate Researcher at the Centre de Recherche en
Économie et Gestion de Paris Nord, Sorbonne Paris Nord. Her PhD thesis
on the determination of exchange rates of emerging market economies
received the BRICS thesis award in 2017. Her research interests include
exchange rates, international economics and monetary policies.
Sunanda Sen has been a professor at the Centre for Economic Studies and
Planning of Jawaharlal Nehru University. She has contributed in areas of
development economics, financialisation and colonialism.
Engelbert Stockhammer is Professor of International Political Economy
at King’s College London. His research areas include macroeconomics,
financialisation, growth and distribution, and economic policy in Europe. He
has published more than 70 articles in peer-refereed journals and co-edited
“https://www.palgrave.com/page/detail/wage-led-growth-marc-lavoie/?s
f1=barcode&st1=9781137357922” Wage-Led Growth: An Equitable Strategy
for Economic Recovery.
Jan Toporowski is Professor of Economics and Finance at the School of
Oriental and African Studies, University of London; Visiting Professor of
Economics at the University of Bergamo; Visiting Professor of Economics
at Meiji University, Tokyo; and Professor of Economics and Finance,
International University College, Turin, Italy. He has published widely on
macroeconomics , monetary policy and finance, and is the author of two
volumes of biography on Michal Kalecki.
Part I

Introduction and background

1 
Introduction
Bruno Bonizzi, Annina Kaltenbrunner
and Raquel A. Ramos

In March 2020, as the COVID-​19 crisis started to ravage Europe, global finan-
cial markets went into turmoil. In emerging economies1 (EEs), unprecedent
amounts of portfolio investments (García-​Herrero and Ribakova, 2020) were
pulled out from capital markets and international access to credit was strained.
The result were huge adjustments in domestic exchange rates and asset prices.
These adjustments came after a decade of EEs, which started to include a
growing number of hitherto excluded countries, having reached unprece-
dented access to global financial markets. As of yet, the full consequences of this
sudden stop are not clear but are likely to be severe.
These boom-​bust dynamics of foreign financial2 inflows, asset prices and
exchange rates, have been a recurring theme for EEs over the past forty
years –​even if each time the transmission mechanisms and markets affected
were different. Latin American and African countries suffered external debt
crises in the 1980s as a hike in US interest rates made debts, mainly in the
form of syndicated loans from commercial banks and accumulated on the back
of recycled petrodollars (United Nations, 2017), unsustainable. A new wave
of financial inflows, increasingly dominated by short-​term private operators,
ended abruptly and resulted in a series of devastating balance of payments crises
in Latin America, East Asia, Russia and Turkey in the late 1990s and early 2000s.
Many EEs opted for sharp increases in interest rates and abandoned their pegged
exchange rate regimes.The 2000s boom in financial flows, again larger and more
diversified –​thanks to the rise of portfolio and derivative transactions –​than
anything seen before, ended with a great reversal in 2008–​2009 in the context
of the Global Financial Crisis (GFC). This time newly financially integrated
economies from Eastern Europe were particularly hardly hit.
The experience of EEs with foreign financial flows shows therefore a
growing and troubled integration. The current financial shock is only the most
recent in a long series of ever-​increasing cycles of foreign financial flows; each
larger and more complex in its vulnerabilities than the previous. This is shown
in Figure 1.1 which evidences the secular, but volatile growth in cross-​border
assets and liabilities, interrupted periodically by financial adjustments and crises.
These adjustments have been extremely costly for emerging markets. The
debt crises of the early 1980s are widely regarded as the start of a ‘lost decade’
4 Bruno Bonizzi et al.

90%
80% 90%
80%
70%
70%
60%
60%
50%
50%
40%
40%
30% 30%
20% 20%
10% 10%
0% 0%

1970
1974
1978
1982
1986
1990
1994
1998
2002
2006
2010
2014
1970 1975 1980 1985 1990 1995 2000 2005 2010 2015

FX Reserves Debt assets Debt liabilies FDI liabilies

FDI assets Porolio equity assets Porolio equity liabilies

Figure 1.1 Emerging and developing economies, cross-​ border assets and liabilities
%GDP.
Source: Dataset by Lane and Milesi-​Ferretti (2018). Emerging and developing econ-
omies are all countries except for the Eurozone, European Free Trade Association
countries, the United Kingdom, the United States, Canada, Japan, Australia and New
Zealand. The graph on the left shows cross-​border assets, the graph on the right shows
cross-​border liabilities.

for economic development in Latin America and Africa, as policy responses

focussed on fiscal adjustment to face restructured debt commitments. Similarly,
the EE crises of the late 1990s have been estimated to cost about 8% of GDP
on average (World Bank, 2005). The current COVID-​related unprecedented
retrenchment of financial flows significantly increases the policy challenges
of EEs having to consider their international financial relations and access to
global liquidity, in addition to the massive task of addressing a pandemic and a
global recession (García-​Herrero and Ribakova, 2020). Given the prominence
of this process and its potentially detrimental implications, a critical analysis of
the causes and effects of financial integrations for exchange rates, asset markets,
monetary policies and the domestic economy in general is fundamental to fully
understand the current situation and prospects of EEs.
Standard neoclassical models offer unqualified support to free capital
movement, which would allow capital to flow to where it is scarcer and there-
fore higher yielding, i.e. developing countries (Obstfeld, 1998). Over the last
decades, most economists have become more careful about their support for
financial globalisation, both on the back of the damage originated by financial
crises and the elusiveness of its benefits: integration is no longer seen as a boon
for growth directly, but rather affects a number of ‘collateral benefits’ (Kose
et al., 2006) and requires a number of good policies as preconditions to be ‘done
right’ (Mishkin, 2007). Most recent contributions have clearly highlighted
the potential negative consequences of liberalisation. Nevertheless, they still
 Introduction 5
effectively keep liberalisation as a policy objective, though qualified in terms of
timing and scope and complemented with additional policy measures to miti-
gate its harmful consequences (Furceri et al., 2019; Broner and Ventura, 2016).
Outside the mainstream of the profession, other economists and political
economists have historically been more critical about financial globalisation. In
particular, basing their analyses on John Maynard Keynes and Hyman Minsky,
among others, Post Keynesian economists have long provided alternative ana-
lyses and perspectives, which do not start from the premise that financial inte-
gration is fundamentally positive for economic growth and stability. Instead,
these authors have highlighted the endogenous and inherent instability created
by short-​term financial markets, studied their implications and offered policy
alternatives. The purpose of this book is to collect contributions on this topic
of scholars working broadly within the school of thought of Post Keynesian
economics, which have not yet been grouped together, as we review in the
next section.

The Post Keynesian contribution: A historical overview

Post Keynesian economics is an approach to economic analysis with some
distinctive characters, such as the focus on monetary theory, the principle of
effective demand, and income distribution. As the authoritative book by Lavoie
(2014) shows, open economy issues are however not as well established as other
core Post Keynesian themes. Historic exceptions to this observation are works
based on Keynes’ plan for reforming the international monetary system, and
the so-​called balance of payments constrained growth theory. The former are
policy-​oriented contributions, discussing Keynes’ idea of a system based inter-
national clearing agency to account for imbalances between debtor and creditor
countries. This literature however mostly ignores the experience of EEs. The
latter, originated by Thirlwall (1979), is based on a version of the Harrordian
growth model, where export demand drives long-​term growth, constrained by
the growth of imports to achieve external current account stability. This theory
was frequently applied to the analysis of EEs, especially by authors influenced
by Latin American Structuralism, which has a long tradition in analysing long-​
term growth on the basis of export composition (Missio et al., 2015). By and
large, however, these contributions focussed on trade, mostly ignoring the role
of finance and financial integration.
Since the 1990s, and especially since the currency and financial crises at the
end of that decade, new studies emerged that sought to extend and apply some
of the theoretical apparatus of Post Keynesian economics to the case of foreign
financial flows, exchange rates and EEs. A bibliometric research shows how this
literature emerged in 1991 with a seminal article by John T. Harvey, (1991),
which puts forward the foundations for a Post Keynesian theory of exchange
determination based on the concept of fundamental uncertainty. A search for
the main keywords of the area through Scopus shows how this literature has
progressively grown over time, with over 200 articles included in our sample
6 Bruno Bonizzi et al.

300

250

200

150

100

50

Figure 1.2 Publications and citations per year.

Source: Scopus. We searched for ‘exchange rate’, ‘capital flows’, ‘financial integration’,
‘financial globalisation’ and ‘open economy’ in the Abstract, Title or Keywords, in the
Journal of Post Keynesian Economics, the Journal of Economic Issues and the Review of Political
Economy, as well as in all journals when combined with the words ‘Minsky’ and ‘Post
Keynesian’. The graph on the left shows total publications in the given period. The
graph on the right shows the number of citations per year of all papers included in our
sample.

search (Figure 1.2 left graph). This does not capture the full extent of the lit-
erature, as books and reports for example are excluded and publications in
languages other than English only appear if they have keywords or abstracts in
English, but serves as an indication of an expanding branch of scholarship.
The increased interest in the subject is also reflected in rising numbers of
citations, which, as proxied citations to the articles captured by the search
presented in Figure 1.1 shows, have increased significantly in recent years.
Indeed, in the last four years the number of citations to Post Keynesian articles
on capital flows and exchange rates in EEs has more than tripled (Figure 1.2
right graph). Of these publications about 45% are published in the Journal of
Post Keynesian Economics, 20% in the Journal of Economic Issues, the Review of
Political Economy and the Cambridge Journal of Economics, and the remaining
35% in other journals and reviews. The literature seems to be geographically
concentrated among authors from three countries: 29% of the papers have
an author affiliated to a US institution, 19% to a Brazilian one and 13% to
a UK institution. Articles included are mainly in English, but a significant
minority were in Portuguese or Spanish. While these figures do not capture
the entirety of the literature and focus only on peer-​reviewed articles, they
nonetheless show its clear expansion over the past two decades and a sharp
increase in interest more recently.
 Introduction 7
Table 1.1 Post Keynesian literature on foreign financial flows, exchange rates and EEs

Area, topics Theoretical background Seminal references

Exchange rate Fundamental uncertainty, (Alves et al., 1999; Harvey,

determination animal spirits (Keynes,
Davidson)
Interest rate parity and Endogenous money (Le
the Forward Rate Bourva, Lavoie)
Financial instability and Financial instability
crisis hypothesis (Minsky)
Currency hierarchy Liquidity preference
German Monetary
Keynesianism (Keynes,
Minsky)
Current account and Balance-​of-​payment
growth constrained growth
Structuralism (Kaldor,
Thirlwall, Kalecki)
Capital controls
and international
monetary system
1991; Davidson, 2002a)
(Kregel 1982, Lavoie,
2000; Smithin, 2002)
(Arestis and Glickman,
2002; Dymski, 2000;
Kregel, 1998)
(Andrade and Prates,
2013; Dow, 1999; Herr
and Hübner, 2005;
Kaltenbrunner, 2015;
Terzi, 2005)
(Blecker, 1989; Thirlwall,
1979; Thirlwall and
Hussain, 1982)
(Keynes, 1942; Davidson,
2002b; Grabel, 2003)

The PK literature on open economies builds on a variety of well-​established

concepts of the wider PK tradition. Table 1.1 seeks to summarise these various
strands. The list is likely not exhaustive and might not do full justice to the
complex and variegated existing research but aims to give a broad overview of
the main topics pursued in Post Keynesian open economics.
The first seminal area was the application of Post Keynesian monetary
theory to exchange rate determination itself. A large part of this literature owes
a lot to the work of John T. Harvey and Paul Davidson as key references. These
authors sought to challenge conventional exchange rate theory by applying
the Post Keynesian concepts of fundamental uncertainty and inter-​subjective
expectations formation, such as conventions and Keynes’ famous beauty con-
test, to the foreign exchange market.
A second key strand of Post Keynesian monetary analysis which has been
applied to the open economy is the theory of endogenous money. Here the
debate centred on the nature of the forward exchange rate and interest rate parity,
i.e. the extent to which the forward exchange rate represents market expectations
or results from a simple mark-​up over the spot rate given the current interest rate
differential at which banks have to borrow to provide the (future) foreign currency.
This mattered because, just as in the closed economy, these different interpret-
ations of covered interest parity and the forward rate had different implications for
the monetary authority to set interest rates exogenously to market expectations.
8 Bruno Bonizzi et al.
A third topic of analysis has been the application of Minsky’s financial
instability hypothesis to the open economy. Here the focus has been mainly on
EEs exchange rate and balance of payments crises and the endogenous cycles in
EEs caused by large and often exogenously determined capital flows. It is also
concerned with the repayment capacity of EEs debt.
In parallel to these debates, a fourth area of the literature has been the estab-
lishment of the concept of currency hierarchy, based on the theory of liquidity
preference and Keynes’ theory of the own rate of interest through the work
of German monetary Keynesians and emerging market scholars, in particular
located in Brazil. These authors theorise the negative implications of financial
integration due to EEs’ lower liquidity premium, i.e. their inability to work as
money in the international context, which leads to excessive volatility, external
vulnerability, and structurally higher interest rates in these countries. Put differ-
ently, this literature associates the vulnerability of EEs’ to international financial
conditions, as often manifested in low monetary policy autonomy, to the non-​
central place occupied by their currencies in the international monetary system,
what makes them closely related to the third and sixth strands here presented.
A fifth strand has been the extension of Kaleckian, Kaldorian and Harrodian
balance-​of-​payment constrained growth models to include more explicit finan-
cial dynamics. As mentioned, this line of work is also closely related to Latin
American Structuralism, which highlights how business cycles in peripheral
economies are heavily dependent on the interaction between external trade
and financial cycles Finally, and closely related to the previous strands, a Post
Keynesian literature has developed addressing specific policy issues, in particular
the question of monetary reforms and capital controls. This literature has often
been inspired by Keynes’ plans for monetary reform and the acknowledgement
of the problems caused by financial integration in EEs.
As this summary conveys, despite its Post Keynesian character, this rapidly
growing literature has not clearly been part of a unified research programme.
While the diversity of approaches testifies the richness of Post Keynesian eco-
nomics, this has meant that the contributions have remained scattered across
time and space. Furthermore, in addition to the areas identified above, which
represent established literature, more recent contributions have attempted to
seek connections across the various strands or bring in new perspectives, such
as the neo-​chartalist views of Modern Monetary Theory (MMT). This volume
attempts to fill this gap by being the first systematic comprehensive collection
of the Post Keynesian literature on financial integration and exchange rates
applied to the context of EEs. The next section provides details about how this
is done by outlining the chapters.

Author contributions and plan of the book

The structure of this book mirrors loosely the literature classification proposed in
Table 1. In the first section, beside this introduction, the chapters discuss key tenets
of Post Keynesian theory as applied to the open economy in the context of EEs.
 Introduction 9
Chapter 2, by Marc Lavoie, focuses on two key concepts: the cambist view of interest
rate parity, and the compensation thesis. Both concepts arise from the extension of
endogenous money theory to the open economy. The chapter explores the concepts
and discusses the empirical evidence in their support, especially in light with recent
evidence about covered interest parity and EEs. Overall, the chapter concludes that
these concepts remain valid and ought to be included in Post Keyenesian open
economy analysis of EEs. Chapter 3 by John T. Harvey reviews the main propos-
itions of neoclassical and Post Keynesian theories of exchange rate determination.
The chapter highlights that the difference between these two approaches is due to
the different epistemological standpoint and fundamental underlying assumptions,
rather than details about specific exchange rate determinants.
The following section is dedicated to interpretations that are based on
Minsky’s theory. In Chapter 4, Annina Kaltenbrunner and Bruno Bonizzi out-
line the key elements of a Minskyan analysis of financial flows to EEs. These
include: highlighting that these are financial transactions rather transfers of real
resources; the importance of agents’ liability structures in determining their
asset purchases and their liquidity preference; the need to ground financial flows
into their structural and historically-​specific context, particularly the evolution
of the key actors and their motives in the global financial systems. The chapter
discusses two applications of such a framework, EEs new forms of external
vulnerability and the implications rising pension fund investment will have for
the former. Chapter 5, by Karsten Kohler, focuses on the dynamics of boom-​
bust cycles in EEs, where structural factors such as openness, external financial
vulnerability, currency mismatches, and high exchange rate pass-​through, are
associated with volatile cycles, reinforced by capital inflows and exchange rates.
The chapter reviews how, over time, the literature has managed to capture these
regularities by including Minskyan financial dynamics as well as exchange rate
flexibility into Post Keynesian models of cycles. By adding Minskyan dynamics
to the Structuralist and Kaleckian open economy models in the context of EEs,
Kohler’s chapter shows the possible integration of two of the seminal strands of
literature discussed above.
Chapter 6, by Alexander Guschanski and Engelbert Stockhammer, focuses
on the determinants of the current account in EEs. Similarly to Kohler, they
highlight how Minskyan insights, such as financial inflows and asset prices, can
enrich the traditional Post Keynesian explanations of balance of payments dis-
equilibria which largely focus on trade-​related factors, such as wages and aggre-
gate demand. Based on the empirical evidence on current accounts, the chapter
concludes that both factors matter and highlights the importance of taking into
account both trade and finance-​related factors when analysing current account
dynamics. Chapter 7, by Gary Dymski and Annina Kaltenbrunner, also seeks to
build bridges, by exploring the potential synergies between Minskyan analyses
and financial geography. In particular, it highlights how adding proper consider-
ations to space could enhance Minskyan and Post Keynesian analyses of finan-
cial integration, as agents and their balance sheets are embedded into specific
geographical locations and consequently power relations.
10 Bruno Bonizzi et al.
The next section of the book focuses on chapters that make explicit the-
oretical reference to Keynes’ liquidity preference theory and the concept
of currency hierarchy. In Chapter 8, Joerg Bibow reviews the evolution of
the international monetary system through the lenses of liquidity preference
theory. He argues that financial integration means liquidity preference now
acts at the global level, with assets from different countries being assessed
against dollar-​denominated liquid assets. In this way, it will reduce EEs’ policy
space, while also exposing them to the vagaries of international markets. In
Chapter 9, Hansjoerg Herr and Zeynep Nettekoven, explore the monetary
Keynesian roots of the existing hierarchies between currencies, emphasising the
role of the ‘liquidity premium’ of different currencies as the key determinant
of their position in this hierarchy. The authors also classify currencies empir-
ically, highlighting the pyramidal structure of the global currency hierarchy,
with the US dollar on top, with the highest international liquidity premium,
and the vast majority of currencies sometimes not even able to function as
domestic currencies. Chapter 10, by Daniela M. Prates and Raquel Ramos
focuses specifically on the implications of the currency hierarchy for exchange
rate dynamics, discussing its relation to other Post Keynesian approaches based
on uncertainty and conventions. It proposes the use of Stock-​Flow-​Consistent
or Agent-​Based modelling approaches as a framework that presents different
Post Keynesian insights, bridging contributions with an intention of facilitating
discussion. Chapter 11, by Lúcio Barbosa, Frederico G. Jayme Jr. and Fabrício
J. Missio, also focuses on exchange rate determination, but specifically focuses
on how the currency hierarchy framework can be extended to the analysis of
real exchange rate determination. By so doing their chapter builds another
bridge, this time between the currency hierarchy literature, which focuses
mainly on the financial factors determining nominal exchange rates, with the
Post Keynesian concerns about growth and income distribution.
The next section focuses on those contributions which specifically attempt
to integrate financial dynamics with the concerns of Post Keynesian and
Structuralist authors about growth, business cycles and income distribution.
Chapter 12, by Jan Toporowski, presents Kalecki’s theory of exchange rates. It
highlights how Kalecki’s view of the business cycles and investment suggests
that exchange rate movements have income effects but limited substitution
effects. Therefore, depreciations are not a suitable instrument for growth in
EEs but have important implications for the distribution of profits between
firms at the global level. Market-​determined exchange rates and free movement
of capital flows only serve to exacerbate this situation. In Chapter 13, Pablo
Bortz also focuses on Kalecki, and how financial flows can be integrated into
traditional Kaleckian models of growth and distribution. Over time, models
have introduced net and, recently, gross financial flows, which have substan-
tial implications for growth regimes of EEs. Chapter 14, by Alberto Botta, also
discusses the impact of financial flows on the development prospects of EEs.
Financial inflows may bring about a boom in a domestic speculative sector and
 Introduction 11
appreciate the exchange rates. In this way the economy experiences a ‘financial
Dutch disease’, whereby financial integration actually has negative long-​term
structural consequences for the development prospects of EEs.
The final section is dedicated to the policy implications and discussions of
Post Keynesian analysis. In Chapter 15, Yan Liang discusses the MMT per-
spective on development finance. The chapter presents the mainstream view
that saving is a precondition for financing investment and that financial lib-
eralisation, including the capital account, is necessary for development. This
understanding is faulty however, as money is an IOU monopolised by the
State, and therefore, provided capital and trade controls are in place, EEs are
able to finance development locally, through development banks. In conver-
sation with this perspective, Chapter 16 by Daniela Prates, focuses on the
conceptualisation of monetary sovereignty that has commonalities with the
MMT position, but also differences, particularly with respect to money and
the Treasury-​central bank nexus underlying the concept of monetary sov-
ereignty. Moreover, the chapter argues that the relationship between mon-
etary sovereignty and policy space does not depend only on the exchange
rate regime, as the MMT proposes, being also shaped by the position of the
country’s currency in the currency hierarchy of the international monetary
system. Chapter 17, by Barbara Fritz and Laurissa Mühlich, focuses on the pos-
sibility of regional monetary cooperation between EEs. The authors contrast
the traditional understanding of monetary cooperation based on the theory
of Optimum Currency Areas with a Post Keynesian/​Structuralist perspective,
which recognises the asymmetries of the global monetary system. This per-
spective allows for a dynamic approach to regional monetary cooperation,
which emphasises the liquidity provision and shock-​absorbing capacity of such
arrangements. Finally, in Chapter 18, Sunanda Sen focuses on the experience
of China and India with financial de-​regulation. She argues that financial de-​
regulation policies are unlikely to succeed because they are based on an incor-
rect understanding of ergodic markets. Conversely, Post Keynesian approaches
focus on uncertainty and animal spirits, which would see deregulated financial
markets as unstable and not suited to the long-​term growth needs of EEs.
Such an approach is better suited to understand the limited success with de-​
regulation, as shown by the experience of China and India.

Notes
1 This book primarily focuses on ‘emerging economies’ as those economies which
are outside the ‘core’ advanced economies of (Western) Europe, North America and
Japan but have a degree of international financial connection to these economies.
However, different chapters might choose a different terminology and/​or change the
scope of countries included.
2 We use here the term ‘financial flows’ as it is consistent with the Balance of Payment
Statistics guidelines (IMF, 2009). It is also more appropriate to define what are essen-
tially financial transactions as opposed to the older, but still common, ‘capital’ flows.
12 Bruno Bonizzi et al.
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2 
Two post-​Keynesian approaches
to international finance
The compensation thesis and the
cambist view
Marc Lavoie

Introduction
A major claim of post-​Keynesian economics, and of heterodox economics in
general, is that it is more realistic than mainstream economics. Typical examples
of the realisticness of post-​Keynesian economics is its long-​time adherence to
cost-​plus pricing and the adoption of a view of the monetary system based on
endogenous money and the peculiar role played by banks in credit creation.The
French economist Jacques Le Bourva (1962) has been particularly important in
arguing the case for a demand-​led endogenous money supply, going beyond the
vertical or exogenous money supply found in American textbooks and models.
French economists are also at the origin of two theories that extend the con-
cept of endogenous money and the ability of the central bank to set interest
rates in open economies, and hence ought to be part of the post-​Keynesian
approach to international finance (Lavoie 2001; 2014, ch. 7).These two theories
are the compensation thesis and the cambist view.
The claim of the compensation thesis is that purchases of foreign currency
by the central bank, so as to avoid the appreciation of the domestic currency,
do not lead to an increase in the monetary base despite the increase in for-
eign exchange reserves on the asset side of the central bank balance sheet,
and vice versa when the central bank sells foreign currency (Lavoie 1992,
pp. 189–​192; 2001). The claim of the so-​called cambist view is that the forward
exchange rate is the result of a simple arithmetic calculation, and hence that the
covered interest parity condition properly defined always holds (Lavoie 2000;
2002–​2003).
While a few post-​Keynesian authors have recently endorsed one or the
other theory, there has been a concern, both among orthodox and heterodox
authors that, since the global financial crisis, substantial deviations from the
covered interest parity condition have been observed, and also that the com-
pensation thesis does not apply to emerging economies. This chapter offers a
reconsideration of the compensation thesis and of the cambist view.The outline
of the chapter is thus the following. In the next section I recall the origins and
the mechanisms of the compensation thesis, while the third section discusses
 Two approaches to international finance 15
the concerns that have been raised about the compensation thesis. The fourth
section presents the cambist view, while the fifth section tries to make sense of
the apparent deviations from the covered interest parity condition. The main
conclusion of the chapter can be provided here: post-​Keynesians ought to inte-
grate the compensation thesis and the cambist view in their work on inter-
national finance.

The compensation thesis

Pierre Berger (1972a; 1972b), a former general director of the Banque de
France, was probably the first to provide a detailed analysis of the compensation
thesis. It was also endorsed by Le Bourva (1962, pp. 48–​49; 1992, pp. 462–​463),
who saw it as an extension of the endogenous theory of money. In a comment
to Berger (1972a), Le Bourva recalled that the compensation phenomenon was
already observed at the Bank of England in the first half of the 19th century.
Furthermore, statistical evidence supporting the compensation phenomenon
was provided by Nurkse (1944) and Bloomfield (1959), concerning both the
heyday of the gold standard and the inter-​war period of the 1920s and 1930s.
Thus, the compensation thesis, or the belief that foreign reserves can be sys-
tematically sterilised, goes beyond the current policies of interest rate targeting,
which have induced some central bankers to explicitly support the compensa-
tion thesis (Angrick 2017, p. 120).
Those who support the compensation thesis argue that an increase in for-
eign exchange reserves, following interventions by a central bank in the case
of a balance-​of-​payment surplus, will not lead to an increase in the reserves of
commercial banks. The increase in the foreign assets of the central bank will be
compensated by a decrease in the domestic assets of the central bank –​namely
a fall in the government securities held by the central bank or in the advances
made to the domestic banking sector. More recently, the increase in foreign
exchange reserves has also been compensated by an increase in government
deposits on the liability side of the central bank. In some countries, central
banks have also sold central bank bills to the banking sector. Thus, whether
there is or not an increase in the balance sheet of the central bank does not
matter: what happens is that an increase in foreign exchange reserves does not
lead to an increase in the reserves held by banks at the central bank, and thus
to no increase in high-​powered money. When commercial banks are indebted
towards the central bank, compensation will be automatic, since they will wish
to reduce their debt. Otherwise, one will tend to speak of sterilisation, as the
central bank will either sell its government securities or issue central bank bills
which banks will gladly acquire, since these are likely to carry a higher yield
than that of reserves. Thus, even sterilisation as defined here can be said to be
automatic. All of this is based on the standard post-​Keynesian assumption that
the supply of credit is demand-​led, meaning that banks will provide all the
loans that they deem to be creditworthy. This is also coherent with the pos-
ition advocated by modern monetary theory (MMT), according to which the
16 Marc Lavoie
expenditures of central government financed out of its account at the central
bank must be ‘neutralised’, as they increase the reserves of banks.
Full support of the compensation thesis can be found in a number of post-​
Keynesian works, most explicitly in the detailed articles of Serrano and Summa
(2015) and of Angrick (2017). In addition, Arestis and Eichner (1988), Orlick
(2008–​2009), De Lucchi (2013) and Michell (2012, ch. 7) approved of the thesis,
with Harvey (2014, p. 34) taking note of a negative correlation between foreign
reserves and the domestic assets of the central bank. All these works deal with
emerging economies: Asian countries including China, Brazil and Argentina.
Indeed, the compensation thesis is also invoked to understand the Argentinian
convertibility experience, showing that even with a currency board, there has
to be some compensation whenever foreign reserves rise or fall. This was also
the case of the Bulgarian currency board (Lavoie 2006).
What are some of the consequences of the compensation thesis? Besides
the effects already mentioned, the presumption is that in a fixed-​exchange rate
regime or in a managed floating regime, a balance-​of-​payment surplus will lead
neither to a fall in interest rates nor to an acceleration of price inflation, while
a deficit will not lead to an increase in interest rates or to deflation. Thus, mon-
etary authorities benefit from some liberty in these regimes, in contrast to the
claim of Mundell-​Fleming advocates. In other words, even in fixed-​exchange
rate regimes, the interest rate is under the control of the central bank. Thus,
the exchange rate regime is not the key aspect; what matters is whether there
is a surplus or a deficit in the balance of payments as the latter case will lead
to a reduction in reserves and hence eventually generate an unsustainable pos-
ition, with the central bank or the government being forced to put in place
restrictive policies to reduce imports or capital outflows. By contrast, in the
former case there exists no pressure whatsoever for the central bank to change
its target interest rate. A related consequence, as emphasised by Angrick (2017)
and noted by Serrano and Summa (2015, p. 262), is that the Trilemma trade-​off
is invalidated.

The compensation thesis revisited

The compensation thesis is at the heart of the open-​economy stock-​flow con-
sistent models of Godley and Lavoie (2007). In his review of the book, Lance
Taylor (2008, 660) expressed scepticism with regards to the possibility of full
sterilisation in the case of financial inflows, based on his knowledge of and past
experience with developing countries.The Argentinian economist Frenkel also
initially expressed scepticism, arguing –​as have others –​that the cost of steril-
isation in emerging countries accumulating foreign reserves, due to the interest
differential on foreign reserves and domestic liabilities of the central bank, was
likely to be overly high. But Frenkel (2007) eventually reduced the relevance of
this objection to the compensation thesis.
A number of economists have tested the idea that these flows could be
sterilised to a large extent in the case of emerging or developing countries.
 Two approaches to international finance 17
Aizenman and Glick (2009), looking at six Asian economies and three Latin
American countries, concluded that sterilisation occurred at 100 per cent.
Others, for instance Cardarelli et al. (2010), found high, but by no means
complete sterilisation. Angrick (2017, p. 129) also performed an econometric
analysis for Asian countries –​Korea, Taiwan and Malaysia –​and came to the
conclusion that ‘sterilisation offsets foreign exchange inflows systematically and
endogenously’, thus reinforcing the empirical results found earlier for China
by Lavoie and Wang (2012). While the compensation thesis had been initially
put forward to explain the evolution of the balance sheet of central banks in
developed countries –​mainly France and Germany –​it would seem that this
concept applies as well to emerging economies.
Two objections to the validity of the compensation thesis can or have been
raised. As recalled earlier, one implication of the compensation view is that cen-
tral banks are able to control the overnight interest rate and hence other short-​
term rates. Indeed, the justification for compensation when it is not automatic
(when the central bank takes sterilisation actions) is that the central bank has a
target overnight rate and hence needs to proceed to sterilisation or compensa-
tion if it wishes to keep the actual overnight rate on target. But then a question
arises: whereas it seems clear that central banks can control the short-​term
rate of interest as well as the size and composition of their balance sheets, what
about long-​term rates?
Nearly all stock-​ flow consistent models assessing the interdependence
between two countries in a fixed-​exchange rate regime do so by dealing only
with one type of security per country –​a short-​term government security.What
if there are two sorts of securities? While it may be possible to design a model
where central banks can manage both the short-​term rate and the low-​risk
long-​term interest rate, as was done in a number of countries before 1951 and
as Japan has done since 2015 through its policy of yield curve control, in general
one would expect that the long-​term rate would respond to the liquidity pref-
erence of agents and hence to the laws of supply and demand. Indeed, such a
two-​country stock-​flow consistent model yielding precisely these implications
already exists. It can be found in the working paper of Wynne Godley (1999),
which presented three versions of a stock-​flow consistent model of a two-​
country economy. In the second version, each government issues two securities,
bills and bonds, and one of the central banks intervenes in the foreign exchange
market so as to keep fixed its exchange rate. In this case, unless asset holders react
strongly to interest rate differentials, while the short rate (the bill rate) can be
kept at a constant level, the long-​term rate (the bond rate) will rise progressively
in the country where there occurs a balance-​of-​payment deficit. Symmetrically,
in the country running a balance-​of-​payment surplus, the bond rate would
progressively fall, unless fiscal policy adjusts and becomes more expansionary.
Thus, if we are to believe this version of Godley’s model, there is room for scep-
ticism about the neutralising impact of sterilisation or compensation on interest
rates, as Taylor (2008) contended. Short-​term interest rates will remain under
the control of the central bank but this, in general, will not be the case of long
18 Marc Lavoie
rates. Note that this has nothing to do with an excess amount of money, as all
these stock-​flow consistent models are built on the assumption that the supply
of money is endogenous and responds to the demand for money.
A possible response to this analysis would be that today, with the corridor
system, that is, with a target overnight interest rate being at the mid-​point of a
range of interest rates delimited by the rate of interest on the deposits of com-
mercial banks (their reserves) at the central bank and by the rate of interest
on credit facilities (formally the discount window at the central bank), there
is a partial disconnect between the overnight interest rate and the amount of
reserves in the banking system. Furthermore, there is a total disconnect, when
interest rates reach the two extremities of the corridor, that is, either when the
actual overnight interest rate reaches the rate of interest on credit facilities or
when it attains the rate of interest on reserves. Indeed, with quantitative easing
the target interest rate is the rate of interest on reserves –​the so-​called floor
system. In this case, the central bank has full control over short-​term interest
rates, while the monetary authorities and the central government would be able
to contain long-​term rates of interest by modifying the quantities of long-​term
securities available to the general public. For instance, in the case of large cap-
ital inflows which, if unrestricted, would be likely to lower long-​term interest
rates, the government could issue more long-​term bonds and less short-​term
securities, while the central bank could sell the long-​term bonds that it holds,
so as to increase the supply of long-​term securities in line with the increase in
demand arising from foreign capital inflows.
Another argument against the standard understanding of compensation or
sterilisation has been put forth by Bleaney and Devadas (2017).While they rec-
ognise that the stock of high-​powered money will remain under the control of
central banks despite the existence of a fixed-​exchange rate regime, they argue
that all the previous empirical studies of the effects of sterilisation ignore the
relationship between balance-​of-​payment surpluses and the evolution of the
broad money supply (M2 or M3, rather than M0). As they believe that there is
a causal and strong relationship between broad money and prices, they argue
that what ought to be tested is whether there also occurs an implicit sterilisa-
tion of broad money. Despite taking into account changes in real economic
activity, they find that ‘unlike reserve money, broad money is to a significant
degree not sterilised against foreign exchange intervention’ and conclude that
‘the accumulation of foreign exchange reserves feeds through significantly to
broad money in the long run, which raises concerns about inflationary pressures
and asset price bubbles’ (Bleaney and Devadas 2017, p. 262). What we have
here is another version of the ‘imported inflation’ thesis, popular in the 1960s,
which was said to mar countries in a fixed-​exchange rate regime running trade
balance surpluses.
This objection to the compensation thesis based on the effects over broad
money is not new and was dealt with from the very beginning by a number of
French economists in the 1970s. Looking at the case of a surplus trade balance,
Berger (1972b, p. 175) argued that exporters would first use the proceeds
 Two approaches to international finance 19
of their sales and thus their newly-​acquired money balances to reduce their
debt towards the banking system –​a case of deleveraging and a version of the
reflux principle advocated by the Banking School, Nicholas Kaldor and Joan
Robinson. Thus, both the banks and the exporter would reduce the advances
previously taken. Berger further noted that, historically, he had indeed observed
an increase in the stock of broad money in periods of balance-​of-​payment
surpluses, but this did not necessarily imply a causal effect on economic activity
or price inflation. In the case of a capital account surplus due to short-​term
capital flows, Berger claimed that they would allow the government or private
firms to diminish their debt towards the domestic banking system. Coulbois
(1979, pp. 282–​284) provides similar counter-​arguments to this imported infla-
tion thesis. By contrast, Prissert (1972b, p. 302) pointed out that the inflows of
funds associated with a balance-​of-​payment surplus could lead to an increase in
economic activity if agents had been previously credit-​constrained, by domestic
banks or the regulations of the monetary authorities. Thus, in the case of pre-
vious credit restrictions, the compensation thesis may not fully apply to broad
money.This possibility is likely to apply most particularly to emerging countries.

The cambist view and covered interest parity

There are tight links between the compensation thesis and the cambist view
of the forward exchange rate as both taken together show that central banks,
even in fixed-​exchange rate regimes, dispose of more autonomy than is usually
thought. There are three views of the determination of the forward rate in for-
eign exchange markets. The first view holds that the forward exchange rate is
an appropriate estimator of the future spot rate. The forward rate is determined
by the unbiased expectations of speculators. This is also called forward market
unbiasedness or the unbiased efficiency hypothesis. Along with the uncovered
interest parity condition, the unbiased efficiency hypothesis has been entirely
discredited: the forward rate is tied to the contemporaneous spot rate and not
to the future spot rate (Moosa 2004; 2015).
The second view can be attributed to Keynes (1923, pp. 115–​139), and has
been called the academic theory. According to this view, the forward exchange
rate is the result of a confrontation between speculators, who take open positions,
and Keynes’s arbitrageurs, who do not. Speculators compare the forward rate (f  )
with their expectations of the future spot rate (se). Arbitrageurs verify whether
covered interest parity holds, that is, whether we do have, in logarithmic values:

f –​ s = id − if (1)

where s is the current spot exchange rate, id and if are the nominal domestic
and foreign interest rates, with the exchange rates expressing the domestic cur-
rency price of one unit of the foreign currency (thus when s goes up the local
currency is depreciating). If the domestic interest rate is higher than the foreign
one, the forward rate ought to be larger than the spot rate for the arbitrageurs to
20 Marc Lavoie
be indifferent between holding either currency. Covered interest parity is thus
a tendency and is only realised when markets are efficient.
Starting from a situation where equation (1) holds, assume that speculators
now expect the future spot rate (se) to be higher than the present forward rate
f: they believe that in the near future the dollar will depreciate relative to the
sterling pound more than is indicated by the forward rate. Speculators will sell
dollars and buy sterling on the forward exchange market (for instance, they
promise to pay $1.30 for each pound they buy in three-​month time, but hope
that once they get the pounds they will get back $1.40 on the spot market at
that time). As speculators sell dollars forward, the forward rate of the dollar
moves up, opening up an intrinsic premium (or a cross-​currency basis), as the
covered interest parity condition given by equation (1) will not hold anymore.
This produces a profit opportunity for arbitrageurs, who can gain the intrinsic
premium without taking any risk, by acting as a counterparty to the speculators,
purchasing dollars forward and selling them on the spot market, thus resorting
to covered interest arbitrage. Thus, for those economists holding the academic
view, arbitrageurs bring about a rise in the spot rate of the dollar (the dollar
depreciates spot and the pound appreciates), causing the Bank of England to
gain reserves if it were to keep the dollar/​sterling exchange rate fixed. The
interest rate differential will thus converge towards the forward-​spot exchange
rate differential, as arbitrageurs reduce the pressures on the forward rate and
as domestic interest rates rise, either because the Fed feels the need to raise
the target interest rate or because the arbitrageurs are keen to borrow dollars
on money markets at any cost in order to benefit from this risk-​free profit
opportunity.
By contrast, the cambist view, also sometimes called the bankers’ view or the
dealing-​room view, is that the forward exchange rate is the result of a simple arith-
metic calculation made by the banks dealing in the forward foreign exchange
markets, and that covered interest parity always holds by definition. Intrinsic
premia or discounts only happen temporarily, as a result of mis-​measurements.
As Moosa (2017, p. 474) puts it, ‘commercial banks simply quote a forward rate
on the basis of the known interest differentials and spot exchange rate to ensure
that covered interest parity (CIP) holds.This means that CIP is an identity’.The
forward rate is set so that bank dealers cover their costs, given by the interest
rate differential. The main difference with the academic theory is that, in the
cambist view, the covered interest parity condition is achieved through the
hedging behaviour of banks and not through the arbitrage behaviour of some
financial investors. It follows that the verification of the covered interest parity
condition has no relationship with whether financial markets are efficient or
not. Another difference is that, in the cambist view, sales of the dollar on forward
exchange markets have an immediate effect on the spot market, as banks will
cover themselves by selling dollars spot. A third difference is that the cambist
view implies that covered financial flows have no effect whatsoever on the spot
exchange rate or on foreign exchange reserves, in contrast to what is asserted by
the academic view, because the bank involved will not take any further action
 Two approaches to international finance 21
since from its perspective the effect of the forward order cancels that of the spot
order. Another implication is that central banks that have the nerves to counter
speculation by purchasing their own currency on the forward market will not
lose any reserves, provided they renew their position when contracts come due
and hence hold on to their position until speculators give up theirs.
The name cambist view arose from the fact that the main features of this variant
of Keynes’s proposition was first made by a French cambist –​Pierre Prissert
(1972a; 1972b). It gave rise to a workshop in 1972 (Coulbois 1972), then later
to a book (Coulbois 1979), and to two papers published in English by Coulbois
and Prissert (1974; 1976). I have tried to persuade my fellow post-​Keynesians
of the worth of the cambist approach on a number of occasions (Lavoie 2000;
2002–​2003; 2014, ch. 7), but few seem to have adhere to it or even mention it,
with the exception of Smithin (2002–​2003), Kaltenbrunner (2012), Cieplinski
and Summa (2015), and Macalós (2020).The most enthusiastic supporter of the
cambist view has been an Australian econometrician –​Imad Moosa. Indeed, for
Moosa (2017, p. 473), the cambist view is the post-​Keynesian view.
At this stage it is important to explain why the covered interest parity condi-
tion is achieved through hedging and not through arbitrage. The cambist story
goes as follows. Whenever an agent wishes to purchase a currency forward –​
this can be merchants trading abroad who wish to cover the foreign exchange
risk, speculators, covered non-​bank arbitrageurs, smaller banks that do not have
access to international markets –​the foreign exchange dealer (usually a large
systemic bank) will be the counterparty to the purchase. However, unless the
bank itself wishes to take a long or short position on a currency (but then it
does not need to wait for a customer to show up, it can do it of its own initia-
tive), it will take cover by buying the currency on the spot market, so as to have
it ready when the forward contract must be delivered.What will be the forward
rate quoted to the customer? That rate as argued earlier will be determined by
an elementary arithmetic operation. The forward rate will simply be equal to
the spot rate plus the interest rate differential, as shown in equation (1), plus
some small service fee that will be charged to the customer. The forward rate
is thus determined by a near identity –​the covered interest parity condition.
There is no need for any arbitrage by any financial agent to achieve the con-
dition. In the case of a client who acts as a covered arbitrageur, wishing to take
advantage of an interest differential that seems to give rise to an intrinsic pre-
mium, the bank need not do anything because the forward order is annulled by
the spot order. This means, as noted above, that a covered interest arbitrage has
no effect on both the spot and the forward rates.
Why is it that the forward exchange customer is being charged the spot
rate plus the interest rate differential? Let us take again our example of the
speculator who believes that the dollar future spot rate will be higher than the
current forward rate.The bank who acts as the counterparty, buying dollars for-
ward, has now bought dollars spot and has forsaken pounds to do so. The bank
thus gets the money market interest rate on dollars and has to take into account
the opportunity cost of its forsaken pounds, or else it must pay interest on the
22 Marc Lavoie
pounds that it had to borrow. This bank now holds more dollar assets and less
pound assets, or, more likely, it has more pound liabilities.The bank has covered
itself, but its cash position has changed. It had to borrow pounds and it has to
lend dollars. This will be done on domestic money markets and on eurocur-
rency markets.
An easy way to handle the new cash position is to do it through swap
operations, that is, through the forward exchange interbank market. Here the
bank will borrow pounds, promising to give them back, say in one month, and
in exchange will lend dollars, promising to take them back in one month. This
forward exchange interbank market is not really a foreign exchange market. As
Coulbois and Prissert (1976, p. 297) point out, ‘in spite of the fact that a swap is
ordinarily defined as a spot purchase (sale) of one currency coupled with a sim-
ultaneous sale (purchase) of this same currency forward, it is practically treated
as a lending-​borrowing operation, and the only reference to the spot market is
that dealers, for their calculations, use the prevailing spot rate at the moment
the operation is completed’. The forward exchange interbank market is there
essentially to handle the cash position of banks active in international markets
(Prissert in Coulbois 1972, p. 116). Its role is similar to the domestic interbank
market (Prissert 1972a, p. 93). Thus, these autonomous hedging operations
performed by banks represent most of the action in exchange markets. For
one operation due to a customer, there may be 20 operations involving only
banks (Coulbois 1972, p. 38). It is these operations between banks that deter-
mine, through their effects on the various money market rates, the forward rate
that will be charged to clients that do not have access to this interbank forward
market. The proof of the pudding, according to Moosa (2004; 2017) is that,
when one takes into account bid/​offer spreads, there is no way that arbitrageurs
can make a profit next to the covered interest parity condition, whereas hedging
banks will. ‘Cambists’ profits stem from the bid-​ask spread’ (Coulbois 1982,
p. 199). Thus, the condition arises from hedging, as the cambists say, and not
from arbitrage.

The cambist view revisited

Since the global financial crisis, there has been some concern that apparent sub-
stantial and frequent deviations from the covered interest parity condition have
been observed, and not only at the height of the global financial crisis, but also
during less turbulent times. Among heterodox authors this has been noted by
Cieplinski et al. (2017) in the case of the Brazilian real/​dollar rate, and several
other papers have claimed that covered interest parity has been clearly violated
for several key currencies (Borio et al. 2016).Thus, this would put into question
the cambist interpretation, while holders of the academic view would wonder
about the efficiency of international money markets.
This claim is not new. In the past, the response of the cambists has been that
studies testing covered interest parity were not using proper data. For instance,
in the 1970s, nearly all studies were looking at Treasury bill rates whereas foreign
 Two approaches to international finance 23
exchange dealers were making use of domestic money market rates and euro-​
market rates (Coulbois and Prissert 1974, p. 291). However, this is not the case
of modern empirical studies, which use the published data involving these rates.
Those who find persistent deviations usually argue that they arise because of
some transaction costs, often related to liquidity and counterparty credit risks,
or to bank balance-​sheet constraints. The response of advocates of the cambist
view is that the presumed deviations from covered interest parity arise because
published data rather than the actual transaction data is being used in these
studies (Moosa 2017). A crucial explanation of divergences is that ‘exchange
and interest rates used in calculations are middle rates, whereas dealers take into
account the rates that are effectively paid or received at one particular moment’
(Coulbois and Prissert 1974, p. 291).
In particular, as noted by Prissert (in Coulbois 1972, p. 29) and as pointed
out earlier, because of this bid/​offer spread, international banks will make more
profits if they get asked to make a deal than when they ask another bank for its
rates in an attempt to strike a deal. Now in times of turbulence or of one-​way
markets, it is very likely that this bid/​offer spread will become much larger than
usual, so this is likely to create an apparent intrinsic premium when looking
at published data, whereas in reality banks just applied the covered interest
parity formula, taking these spreads into account. Another tentative answer is
that the LIBOR, as once thought, is not the appropriate measure of interest
costs, since most transactions now occur through collaterised loans instead of
uncollaterised ones.
A final tentative answer is that the apparent deviations occur because of bank
balance-​sheet constraints that affect mainly American banks. In other words,
there are now tight regulatory constraints on the cash positions of banks. Their
relevance for the apparent deviations can be understood from the observa-
tion of Borio et al. (2016, p. 45) that there has been persistent evidence of a
cross-​currency basis (an intrinsic premium), that is, ‘the interest paid to borrow
one currency by swapping it against another differs from the cost of directly
borrowing this currency in the cash market’. More precisely, ‘since 2007, the
basis for lending US dollars through the FX [foreign exchange] swap market
became more expensive than direct funding in the dollar cash market’. The
cause of this is that the balance sheet space of banks is rented, it is not free,
especially so in the United States. American banks are submitted to the daily
average (instead of an end-​of-​quarter) requirement of a high-​quality liquidity
ratio (HQLR). As a consequence, swaps with foreign banks in a foreign cur-
rency, taking or lending dollars, carry a regulatory cost which induces a break-
down of the parity between offshore and onshore dollars (Pozsar 2016). Thus,
we have gone back full circle: once again, the apparent deviation from the
covered interest parity is due to the fact that the wrong interest rates are being
taken into account. The situation is similar to what existed when there were
capital controls in Europe (Coulbois 1979, p. 264): when doing their currency
swaps, banks charge the interest rate differential in relation to the cost that they
encounter, but in the monetary markets which they can access.
24 Marc Lavoie

Conclusion
I have argued in this chapter that both the compensation thesis and the cambist
view ought to be adopted by post-​Keynesian economists concerned with
open-economy macroeconomics, just like the hierarchy of currencies is part
of the toolbox of economists dealing with emerging economies. Although the
compensation thesis and the cambist theory are independent of each other,
those authors who have advocated one of these have often also endorsed the
other, as is the case of Coulbois and Prissert for instance.The reason is that both
theories are consistent with the post-Keynesian theory of endogenous money.
The compensation thesis asserts that within a fixed-​exchange rate regime, a
balance-​of-​payment surplus (or deficit) has no impact on the amount of bank
reserves held by banks, and hence no impact on domestic short-​term interest
rates, as the increase (decrease) in foreign exchange reserves will be compensated
by changes in other entries of the balance sheet of the central bank, either
through an automatic adjustment initiated by banks or through interventions
of the monetary authorities so as to achieve their target interest rate. The com-
pensation thesis thus makes an important point: fixed-​exchange rate regimes
don’t necessarily imply a loss of monetary sovereignty, so that the impossible
trinity does not hold. Of course, in the medium run, this point applies mostly
to a situation where a country –​emerging or not –​runs a current account sur-
plus, since deficit countries will be gradually losing their foreign reserves. Thus,
short of imposing capital or trade controls, such deficit countries will eventually
see their central bank raise interest rates or their central government pursue
fiscal austerity. In other words, one can argue that over the medium run the
compensation thesis only operates asymmetrically.The strength of the compen-
sation thesis may be also be restrained by the recognition that the beneficiaries
of capital inflows or trade surpluses may decide to increase their expenditures
and hence economic activity, especially if they were credit-​constrained. Thus,
although these inflows have no impact on the amount of base money, they may
still have an impact on the economy.
The cambist view also implies that monetary authorities have more room
than is usually thought. According to the cambists, covered interest parity
always holds because the determination of the forward rate is the result of
a simple arithmetic operation conducted by dealer banks, where the interest
rate differential determines the differential between the forward and the spot
exchange rates. Thus, the central bank, in setting the domestic interest rate,
is not constrained by the market or speculative forces acting in the forward
exchange market since causality runs the other way around. For this reason,
the cambists also insist that the forward exchange rate in no way can be a pre-
dictor of the future spot rate. The cambist view also implies that central banks
can counteract adverse speculation by intervening on the forward exchange
market without fear that their action will be endangered by covered arbitrage
since such arbitrage has no impact on both spot and forward exchange rates or
on the amount of central bank reserves. Interventions on the forward exchange
 Two approaches to international finance 25
market allow central banks to avoid losing foreign reserves (as long as they
roll over their position until speculators end up giving up theirs). Some cen-
tral banks, such as the central bank of Brazil, have found other means to avoid
losing foreign reserves, by offering foreign exchange swaps that are settled in the
domestic currency (Macalós 2020).
The lesson to be drawn here is that post-​Keynesians should surrender the
Mundell-​Fleming framework as well the use of uncovered interest parity to
close their models.

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3 
Trade versus capital flows
The key implicit and methodological
differences between the Neoclassical
and the Post Keynesian approaches to
exchange rate determination
John T. Harvey

The market for foreign currency is the largest on the planet, boasting a volume
of over $5 trillion per day (Bank for International Settlements 2016: 3). Indeed,
the exchange rate has been called ‘the single most important variable in an open
economy’ (Moosa and Bhatti 2010: 3). Given Neoclassicism’s preoccupation
with market systems as the only legitimate, natural, or pure economic institution,
one would assume that they would possess widely accepted and sophisticated
explanations of this magnificent example of the capitalist system in action. In
point of fact, however, not only have they been unable to settle on a standard
approach, but at least one of their number has suggested that short-​run currency
markets might not be a proper subject for economic analysis at all (Pentecost
1993: 179)! This is, of course, absurd and a function of Neoclassicists’ tendency
to define the borders of their discipline on the basis of what appears to fit their
preconceptions. If markets are not efficient and expectations rational, then it is
not economics. Capitalism, with few exceptions and outliers, is a happy place.
By contrast, Post Keynesians have developed a set of mutually inclusive and
complementary approaches to exchange rate determination and have not been
afraid to reach into other disciplines and fields when extant tools were insuffi-
cient. Within this tradition, markets are viewed as tools with no more inherent
suitability to solving the problems of human provisioning than hammers to
addressing the challenges carpentry. Without the straitjacket of a pre-​ordained
set of policy conclusions, Post Keynesians have been free to focus instead on
the salient empirical features of the currency market: extreme volatility, chronic
misalignment, and hot capital flows. What they have produced is a far cry from
the core Neoclassical contribution that exchange rates come to rest at levels
that equate national price levels.
This chapter will argue that the true sources of the contrast between the
Neoclassical and Post Keynesian approaches to exchange rate determin-
ation are deep-​seated and unrelated to superficial considerations like which
variables should be included as key determinants or how they should be
measured. Instead, they begin with epistemology and differing base level (and
often implicit) assumptions regarding macroeconomic behaviour. It will be
 Trade versus capital flows 29
concluded that our deepest disagreements about currency price determination
are really a function of contrasting visions of agent decision making, disagree-
ment over the propriety of induction versus deduction, and Neoclassicism’s a
priori bias toward market solutions versus Post Keynesianism’s policy-​neutrality.
Analyses are path-​dependent and once we accept a given premise we have
thereby eliminated one range of possible conclusions and permitted another.
The chapter will proceed as follows. The next section will review selected
Neoclassical exchange rate models, distilling from them the main assumptions
and themes of their research. Following that, their contrast with the Post
Keynesian approach is discussed, after which concluding comments are offered.
Because the challenge here is teasing out of the mainstream models their
unstated foundational elements, relatively more time will be spent on that task
than the others.

Neoclassical exchange rate theory(ies)

As suggested above, perhaps the most notable fact regarding Neoclassical
exchange rate theory is that there is not just one. Rather and in stark contrast
to the situation in Neoclassical trade theory, there are many. This is not, how-
ever, a function of each taking a different methodological approach or adopting
a unique set of premises. Indeed, it is specifically because they share a common
method and assumptions that has forced multiple starts and restarts. In order to
illustrate this, a representative selection of Neoclassical exchange rate theories
will be introduced and analysed below.
The workhorse of Neoclassical theory is Purchasing Power Parity (see for
example Balassa 1964 or Jolliffe and Prydz 2015). It essentially argues that exchange
rates come to rest at levels that equate same-​currency prices across countries. If
US goods and services are, for example, more expensive than Japanese when both
are translated into yen (or dollars), then US goods and services will be unpopular
and, by extension, so will dollars. The dollar will depreciate relative to the yen
until US goods and services are no more or less expensive than Japanese.
To this basic concept are then added various caveats and provisos like the
effect of transactions or transportation costs, traded versus untraded/​untradeable
goods and services, and the possibility that this process manifests itself in rates of
change rather than levels (which is quite common). Because the relevant data
are easy to find, this theory has been tested many, many times, undoubtedly
more so than any other Neoclassical currency price determination model. The
methods range from ordinary least squares to cointegration and data sets have
included countries all around the world over very long and varied time periods.
Through all that, the best that Neoclassicals can say is that there is some evidence
that Purchasing Power Parity may have validity for the major exchange rates
over the long run (Sarno and Taylor 2002: 96). In the short run (where ‘short’
equals three to five years –​‘long’ can mean up to a century), even the research of
erstwhile supporters offers very little support. Currency dealers themselves have
characterised the theory as ‘only academic jargon’ (Cheung and Chinn 2000).
30 John T. Harvey
What can we discern from this in terms of underlying premises and method?
Perhaps the most striking revelation is the implicit assumption that financial
capital flows have no impact whatsoever on currency prices.Trade flows are the
one and only relevant force. Furthermore, and despite a great many Neoclassical
empirical studies supporting the idea that imports and exports are much more
income than price elastic, there is no role here for changes in the overall level
of economic activity. What if prices in both countries remain constant but the
US experiences an economic expansion? Will this not increase US imports
and necessitate a dollar depreciation even at current domestic Japanese and US price
levels? This is impossible in Purchasing Power Parity.
Both the passivity of financial capital and the omission of changes in income
make perfect sense, however, if we are operating under the assumption that the
economy tends toward full employment. This results when agents are modelled
as operating in an environment of certainty or risk, wherein there is no reason
to hold cash other than for convenience and supply thus creates its own demand.
Households might still save, but only in response to the offer of interest from finan-
cial institutions. In that event, all such idle funds are immediately channelled to
firms for investment spending. Every penny of income is ultimately spent either as
consumption or investment with interest rate adjustments ensuring this outcome.1
The manner in which this justifies the omission of portfolio capital flows
is as follows. In their world, the financial sector is entirely accommodative.
It passively supplies funding for real economic activity while the latter is the
real driver, determining all the important (i.e., non-​monetary) variables. Seen
in that light, the fact that Purchasing Power Parity considers only trade flows
is not an oversight, but a recognition of the fact that capital flows are an epi-
phenomenon. Purchasing Power Parity proponents’ answer to the fact that the
volume of financial capital far exceeds that of international trade is that mul-
tiple covering operations must occur throughout the system for every position
necessitated by imports and exports.
The fact that changes in the level of economic activity are overlooked also
results from the implicit assumption of decision making under certainty or
risk and the consequent systemic tendency to full employment. Significant
fluctuations in income do not occur in such a world and thus little remains but
price changes to alter the trade flows that affect currency prices –​precisely the
story told by Purchasing Power Parity. And while it is clear to everyone that
wide swings in national levels of GDP can and do occur in the real world, these
are viewed as temporary deviations.The truly significant economic relationships
are revealed over the long run.
The Monetary Approach (Johnson 1977 and Elhaddadi and Karim 2017) is
essentially Purchasing Power Parity with a specific theory of price determin-
ation tacked on. This means that it shares all the basic premises outlined above.
What it adds can be seen more clearly mathematically. Consider first this simple
version of Purchasing Power Parity:

$/£ = P$/​P£ (1)

 Trade versus capital flows 31
where $/​£ is the price of sterling in dollars, P$ is the price level in the United
States, and P£ is the price level in the United Kingdom. As the Monetary
Approach is based on Monetarism, it has as a core relationship the quantity
theory of money:

MV = Py (2)

where M is the money supply,V the velocity of money, y real output, and P the
price level. Solving (2) for P yields:

P = MV/​y (2’)

Substituting this into (1) gives the Monetary Approach to exchange rate
determination:

$/​£ = (M$V$/​y$)/​(M£V£/​y£).2 (3)

As is typical in Monetarism, it is assumed that V is constant, M is exogenous

and under the control of the central bank, and y tends towards full employment.
One of the implications of this is that since $/​£ is a function of P$ and P£ and
because the latter are determined by their respective money supplies, exchange
rate movements result from exogenous monetary policy choices. It is further
argued that any attempt to make your country more competitive via price
deflation will be frustrated by the consequent and inevitable domestic currency
appreciation that results from any trade surplus. For example, a decrease in M$
would initially drive down prices in the US, making it more competitive at the
current $/​£ and P£. However, the increase in the demand for the dollar that
would follow would eventually lower $/​£ to the point that restores balanced
trade. Hence, in the long run money is neutral and economic outcomes are
actually determined by the ‘natural’ forces akin to those driving unemployment.
The latter were explained by Milton Friedman as follows:

The ‘natural rate of unemployment’, in other words, is the level that would
be ground out by the Walrasian system of general equilibrium equations,
provided there is embedded in them the actual structural characteristics of
the labor and commodity markets, including market imperfections, sto-
chastic variability in demands and supplies, the cost of gathering infor-
mation about job vacancies and labor availabilities, the costs of mobility
and so on.
(Friedman, 1968: 8)

As suggested above, this approach shares all of the basic premises of Purchasing
Power Parity. It is therefore implicitly assumed that agents make decisions in an
environment of certainty or risk, which in turns creates a systemic tendency
toward full employment (which for Friedman would be the natural rate of
32 John T. Harvey
unemployment).This means that the financial sector continues to be accommo-
dative and neutral. More than this, however, the Monetary Approach takes for
granted a commodity-​money economy in which the central bank has complete
and total control over its supply. M changes if and only if policy makers decide
that it should and banks and other financial institutions are strictly limited in
the liquidity they can provide customers. The long-​run constancy of V is also
related to this financial market characterisation.3
Uncovered Interest Rate Parity (Lothian and Wu 2011), too, shares a great
deal in common with Purchasing Power Parity, though initially it does not
appear to do so. It focuses on interest rates and, therefore, the capital market.
The basic argument is that in equilibrium, national interest rates can only
differ by the amount that the high-​interest rate country’s currency is expected
to depreciate. Were that not true, capital would flow to the country promising
the higher return until their interest rates fell and their currency appreciated
(meanwhile, countries experiencing net outflows would see their interest
rates rise).
But this is really Purchasing Power Parity in disguise.When measured in rates
in change (as is typical), Purchasing Power Parity predicts that high-​inflation
economies will experience currency depreciation. Meanwhile, because the
Neoclassical approach assumes that real interest rates will equate across coun-
tries (the Fisher effect), the nominal ones will only differ by expected inflation
rates. Therefore, Uncovered Interest Rate Parity’s contention that high-​interest
rate currencies are expected to depreciate can be restated as high-​inflation
currencies are expected to depreciate. This is, once again, Purchasing Power
Parity.
To stop for a moment and take stock, this examination of Purchasing Power
Parity, the Monetary Approach, and Uncovered Interest Rate Parity reveals that
the Neoclassical approach implicitly assumes the following:

1. agents make decisions in an environment of certainty or risk;

2. there is an automatic tendency toward full employment;
3. the financial sector is accommodative and epiphenomenal;
4. money is exogenous.4

The stark contrast with the Post Keynesian approach is obvious, suggesting,
as was argued at the outset, that the divergent paths of each set of analyses are
determined well before specific currency market determinants are specified or
modelling techniques are considered.
To their credit, Neoclassicals themselves would admit many problems with
these models. The Dornbusch Approach (Dornbusch 1976 and Rogoff 2002),
for example, arose as a means of reconciling the currency market stability
implied by Purchasing Power Parity, the Monetary Approach, and Uncovered
Interest Rate Parity with the extreme volatility witnessed in the real world.
While it accepts and formally adopts all three, its unique feature is allowing
for domestic price rigidity and temporary deviations from Purchasing Power
 Trade versus capital flows 33
Parity. This creates the exchange rate ‘overshooting’ that they believe mimics
the real-​world volatility.
It would be easiest to explain this model via an example. Say we start in a
situation where trade flows are balanced and Uncovered Interest Rate Parity
and Purchasing Power Parity both hold. Now imagine a domestic macroeco-
nomic expansion caused by a monetary stimulus. Returning to the Monetary
Model’s equation (2) above and given the assumption that both V and y remain
constant, this should yield a rise in P. However, Dornbusch invokes sticky prices
so that, with P unable to adjust, y rises above the level associated with the nat-
ural rate. The argument is that this is possible because, given the temporarily
fixed prices, the monetary expansion is real and not nominal and thus actually
increases demand. A fall in the domestic interest rate also occurs in response to
the real monetary stimulus.
While product markets lag, financial markets adjust immediately. Uncovered
Interest Rate Parity must therefore react to both the fall in domestic interest
rates and the fact that agents’ expectation of the future exchange rate will have
changed. Herein lies the key to the overshooting, for only one of these two is permanent
while the other will eventually return to its long-​run equilibrium value. With respect
to the expectations, the model assumes that currency dealers’ use Purchasing
Power Parity as the basis for their forecast, meaning that agents now expect a
weaker domestic currency once prices have time to adjust. They take positions
based on this so that today’s spot rate is immediately driven to the expected
future value. The additional assumption of rational expectations ensures that,
on average, agents’ forecast of the final equilibrium position is dead on. This
saves the model from having to deal with the problem that would be created by
dealers’ expectations being inconsistent with the actual long-​run position. This
will never happen.
But not only must Uncovered Interest Rate Parity account for the change
in expectations, it must also reflect the fall in the interest rate. This creates add-
itional, but temporary, selling pressure on the domestic currency’s spot value –​
overshooting. Eventually, interest rates will return to their original level because
those sticky domestic prices will adjust.When this occurs we will be back at the
natural rate of output and unemployment, at which point the entire burden of
the increase in M in equation (2) is borne by P. The size of the money supply
in real terms (M/​P) is therefore unchanged and interest rates go back up to
where they started. According to Uncovered Interest Rate Parity, this will result
in financial capital inflows and a domestic currency price increase. In summary,
there is still a net depreciation, but we overshoot it because:
1. through the change in agents’ expectations (as guided by Purchasing Power
Parity), Uncovered Interest Rate Parity immediately takes us to the long-​run
equilibrium exchange rate; however,
2. the temporary fall in interest rates caused by the price rigidity (and conse-
quent real, not nominal, monetary policy stimulus) leads to an additional degree
of depreciation that will eventually disappear.
In the end it looks a lot like Purchasing Power Parity again.
34 John T. Harvey
It is difficult not to admire this attempt to make what readers of this volume
would agree is a fatally flawed approach into something that reflects real-​world
events. The idea that financial markets react more quickly than product ones
certainly rings true and allowing for the possibility that currency prices can
react solely to changes in agents’ expectations is a welcome addition. However,
not only is it business as usual in the long run, but some of the mechanisms used
to create the short-​term outcomes are questionable. First and foremost is the
requirement that currency dealers use Purchasing Power Parity for their long-​
run exchange rate forecasts. It is an absolutely key element in the overshooting
phenomenon; indeed, the model falls apart without it. If one posits a different
forecasting mechanism, then there is no longer any guarantee that the exchange
rate consistent with equilibrium in the product market (as determined by
Purchasing Power Parity) is consistent with that in the financial capital market
(as determined by Uncovered Interest Rate Parity). What would happen, for
example, if equation (1) were satisfied:

$/£ = P$/​P£ (1)

but inputting that exchange rate into the Uncovered Interest Rate Parity rela-
tionship yielded an expectation of excess return on dollar interest-​bearing
assets? Capital would flow into the United States, driving $/​£ lower and
causing $/​£ < P$/​P£. If and only if market participants agree that Purchasing Power
Parity represents the true long-​run equilibrium position of the currency can the system of
equations that comprise the Dornbusch Approach yield an internally consistent solution.
Currency dealers must agree with Neoclassical economists that the financial
market is long-​run irrelevant and that trade flows drive exchange rates. It is
noteworthy to recall what was mentioned above regarding dealers’ characterisa-
tion of Purchasing Power Parity as ‘academic jargon’.The fact that Neoclassicals
count ‘long run’ as calendar periods as long as a century makes it even less likely
that this plays any role whatsoever in agents’ forecasts.
On top of this we have the assumption of rational expectations. This is, in a
sense, overkill since in many respects it is sufficient to say that currency dealers
use Purchasing Power Parity as their forecasting guideline. One thing it does
accomplish is to simplify the modelling process since it allows proponents to
assume that agents’ expectations are always correct. That is, not only do they
use Purchasing Power Parity, but they always get it right. Were that not the
case, then the model would be forced to deal with the possibility of the scen-
ario described above wherein both conditions cannot be satisfied simultan-
eously. A more subtle implication of the rational expectations assumption is the
indirect support it offers to Purchasing Power Parity. If it is the case that rational
agents would conclude that Purchasing Power Parity is the best forecasting
method, then equation (1) must truly hold in the real world. If it did not, then
those rational currency dealers would not believe it! Absolutely nothing in the
above list of four implicit premises is rejected and to them are added the explicit
assumptions of rational expectations and Purchasing Power Parity as agents’
forecasting anchor.
 Trade versus capital flows 35
This and other attempts to modify Neoclassical models sufficiently to
explain real-​world currency price fluctuations failed even in their own esti-
mation. These frustrations came to a head in Richard Meese and Kenneth
Rogoff ’s 1983 article, ‘Empirical Exchange Rate Models of the 1970s: Do
They Fit Out of Sample?’. Their answer was a resounding ‘no’. Not surpris-
ingly and despite their impressive Neoclassical pedigrees, they had a diffi-
cult time getting the paper published. Once they did, however, it opened the
floodgates to similar studies yielding like results. In response to this, mainstream
scholars shifted increasingly to small-​scale models aimed at examining what
they characterised as micro aspects of currency markets. One example of a
superficially promising attempt accepted the fact that currency dealers regularly
employ technical analysis –​despite the questions this raises for market effi-
ciency –​and posited a world populated by Chartists (market participants who
follow technical analysis) and Fundamentalists (those who rely on fundamental
factors). A third group is represented by fund managers who sell assets to the
other two. Interesting questions are then posed regarding how exchange rates
may fluctuate given different percentages of Chartists versus Fundamentalists.
Within this context, agents must learn within an evolving market. So far so
good. Unfortunately, in the end the actual determinant of the exchange rate is
assumed to be a combination of agents’ forecasts, plus ‘other contemporaneous
determinants’ (Frankel and Froot 1986: 29). The latter are, with no stated justi-
fication whatsoever, proxied by the current account! Perhaps it is uncharitable
to say that this is simply a watered-​down version of Purchasing Power Parity,
but it is awfully close. Other approaches were similar and despite empirical
work that raised doubts regarding market efficiency and rational expectations,
what had been a promising change of direction ended with a shift back towards
focusing on the long run as being the only time horizon over which ‘economic’
behaviour made itself felt. As suggested in the introduction, when models fail
the tendency is to blame the data rather than the tools.
Another promising Neoclassical contribution has been the behavioural
finance approach of De Grauwe and Grimaldi (2018). However, even though
Post Keynesians may rightly applaud their enthusiastic inclusion of psycho-
logical factors, their approach remains wedded to the idea of ‘fundamental’
factors that are ‘related to the current account’ DeGrauwe and Grimaldi 2018;
51).5 It seems impossible for Neoclassicals to escape the intellectual straitjacket
of Purchasing Power Parity.
While omitting models like the Portfolio Balance Approach, Order Flow,
Mundell-​Fleming, and others, this is nevertheless sufficient to give insight into
the underpinnings of the mainstream approach to exchange rate determination.
Note how little is really added after Purchasing Power Parity. It is the assumed
tendency towards full employment –​something that most Neoclassicals would
deny has anything to do with their exchange rate modelling –​that actually
becomes the central issue. It condemns financial capital flows to irrelevance,
which is why their approach fails.
Before discussing the Post Keynesian alternative, consider some broader
tendencies within the mainstream. Chief among these is a priorism. One
36 John T. Harvey
can argue that nothing on the above list results from a inductive analysis of
the conditions in today’s currency market. Indeed, even their own empirical
research offers very little support for rational expectations, for example. But it
is axiomatic, a premise whose basic truth seems so obviously true to supporters
that anomalous observations are dismissed as errors or outliers. This has its
roots in Scottish Common Sense philosophy, an approach similar to Cartesian
Deductivism and something that was very influential in the early development
of Classical/​Neoclassical economics (see chapter 2 of Harvey 2015). On top of
this is the paradigmatic bias towards believing that markets are natural and ben-
evolent, which is also rooted in the early days of our discipline. Markets are the
default solution because, everything else being equal, they generate equilibria
that are Pareto optimal and efficient.This is why, for example, Purchasing Power
Parity has been such an important anchor. It not only results from deductive
reasoning based on a priori, axiomatic premises, but those premises lead us to
a happy place: exchange rate movements make all nations equally competi-
tive. Developing nations need not worry about technology gaps, nor should
developed states be concerned about the loss of jobs to cheap labour. Currency
price movements will make the necessary adjustments. One cannot attribute
this simply to a priorism as the latter could just as easily lead to the develop-
ment of a set of models that predict volatility and misalignment. It must be the
result of an inherent bias towards thinking that markets are good.

Post Keynesian exchange rate theory

What if we start instead with the methodological belief that induction is
superior to deduction and add to it the implicit premise that the market is not
a benevolent external force, but rather just people in a particular social setting
(reflecting, rewarding, and encouraging whatever is reflected, rewarded, and
encouraged in that society)? This is how Post Keynesian scholars approach their
work and it is why their exchange rate theory is distinct, rooted in the financial
capital market, and successful. It starts with the following question: why do we
witness extreme volatility, chronic misalignment, and hot capital flows in the
real world? Success is then measured by how well models recreate this observed
behaviour, including over the short run.6
Beginning with Post Keynesianism’s a prioris (beyond the methodological
ones mentioned in the previous paragraph), central is the belief that agents
make decisions in an environment of uncertainty. This not only opens the door
for less-​than-​full employment equilibrium, but it means that agent ration-
ality (under any guise) is not a core assumption. The problem is not so much
that people act irrationally (though they may) but that sufficient data simply
do not exist in the real world for them to generate the conclusive arguments
that expected value calculations allow. This leaves agent forecasting under-​
determined and it opens the door to the incorporation of not only Keynes’
­chapter 12 observations regarding long-​term expectations, but the wider psy-
chological literature. For Post Keynesians, including the latter does not require
 Trade versus capital flows 37
a sub-​discipline that grants special dispensations as in ‘behavioural’ economics;
it is just economics. One witnesses this, for example, in Harvey’s volume on
exchange rates (2009):

Because Post Keynesian economists see agents’ expectations as key

determinants of foreign currency prices, explaining the latter is an essential
step in building a theory of exchange rate determination. Doing so will
require reference to the work not only of economists (primarily Keynes),
but of psychologists as well.
(Harvey 2009: 45)

He goes on to build a Mental Model that reflects both the above considerations
and the social nature of currency market participant’s view of what determines
exchange rates. Kaltenbrunner (2015), too, makes these factors central, as does
Davidson (1998).
A second important a priori is the assumption that production takes time.
This, along with the lack of a full employment assumption, lays the ground-
work for the key role played by the financial sector. Economic activity would
grind to a halt without the extension of credit and Post Keynesians there-
fore believe that it is imperative to explain this phenomenon. Related financial
market assumptions, this time drawn from observation, include the endogeneity
of money and the tendency of agents to take increasingly precarious positions
during economically stable times. While these issues would simply not be
worth studying from the Neoclassical perspective, it is impossible to find a Post
Keynesian exchange rate piece that does not place these front and centre.
Because of these pre-​analytical differences and the consequent freedom to
pursue an unfettered explanation of the observed characteristics and regularities
of currency markets, the Post Keynesian literature is not marked by waves of
empirical failures and frustrated critical self reflection. Instead, there has been an
incremental addition to our base of knowledge and an iterative and productive
relationship between empirical and theoretical work. Even seemingly disparate
approaches like Harvey’s open-​economy Z-​D diagram (Harvey 2009) and
Andrades and Prates (2013) and Kaltenbrunner’s (2015) adaptation of Keynes’
­chapter 17 asset equation are entirely complementary and merely focus on
different parts of the process. And why? It is not so much our understanding of
currency markets per se that is superior, but our approach to economic science
in general.

Conclusions
The goal of this chapter was to show that the key differences between the
Neoclassical and Post Keynesian approaches to exchange rate determination
are a function of what scholars from each tradition assume before they give first
thought to currency prices. This is important for two reasons. First, it is what
makes conversation so difficult. Exchanges with mainstream economists, as few
38 John T. Harvey
and informal as they may be, tend to focus on what each of us judges to be the
salient issues in currency markets. For us, this would centre around explaining
empirical observations of volatility and misalignment; for them, it would focus
on justifying their perception that trade flows play the dominant role. But all that
is a waste of time and destined to fail because what we each respect as evidence
is different. Second, laying bare the foundation of the Neoclassical approach
makes it clear why even when they make erstwhile reasonable assertions, it is
for naught. I do not think any Post Keynesian would raise serious objection to
the Dornbusch Model’s assumption that financial markets react more quickly
than product ones or that agent expectations can, by themselves, drive spot
currency prices. Quite right on both counts. Nor is the basic idea (if not the
implementation) of the Chartists-​Fundamentalists approach a bad one. But they
are straitjacketed by the factors that Neoclassicals do not even think to question.
Like economies, research is path-​dependent. If you start with a wrong step, you
are unlikely to get where you need to go.

Notes
1 This view of the relationship between savings and investment also implies money
exogeneity; however, as this enters more explicitly below it will not be pursued
quite yet.
2 Like Purchasing Power Parity, this is often modeled in rates of change rather than
levels. For simplicity I use the latter here.
3 As the inverse of the velocity of money is the percentage of income agents keep
as cash, its constancy can also be explained in those terms. The assumption is that
this fraction is a function of slow-​to-​change habits, based solely on a transactions
demand for money. It therefore discounts the possibility of a speculative or precau-
tionary demand, both of which might be expected to change much more quickly
and substantially.
4 While to a large extent #3 results from #2 and #2 from #1, it is nevertheless helpful
to make these derivative assumptions explicit.
5 Nor is any of our work cited, incidentally. Indeed, Keynes is nowhere to be found,
although Hayek gets a mention!
6 This section will proceed in the opposite direct of the previous one, first identifying
underlying premises and then offering examples. As the reader will be much more
familiar with these topics, less effort will be expended in developing them.

References
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Balassa, B., 1964.‘The purchasing-​power parity doctrine: A reappraisal,’ Journal of political
Economy, 72(6), pp.584–​596.
Bank for International Settlements, 2016. Triennial Central Bank Survey: Foreign exchange
turnover in April 2016, BIS Monetary and Economic Department.
Cheung,Y. and Chinn, M.D., 2000. ‘Currency Traders and Exchange Rate Dynamics: A
Survey of the U.S. Market,’ University of California Santa Cruz Department of
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Economics Working Paper. Online. Available http://​econ.ucsc.edu/​faculty/​cheung/​
nysurvey.pdf (accessed February 28, 2004).
Davidson, P., 1998. ‘Volatile financial markets and the speculator,’ Economic Issues, 3(2),
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De Grauwe, Paul, and Marianna Grimaldi. 2018. The exchange rate in a behavioral finance
framework. Princeton, NJ: Princeton University Press.
Dornbusch, R., 1976. ‘Expectations and exchange rate dynamics,’ Journal of Political
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Elhaddadi, M. and Karim, M., 2017. ‘Monetary approach to the balance of payments:
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rate determination. London: Routledge.
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thought. Cheltenham: Edward Elgar Publishing.
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technical guide,’ Journal of International Economics, 7(3): 251–​268.
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turies,’ Journal of International Money and Finance, 30(3): 448–​473.
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Pentecost, E.J., 1993. Exchange rate dynamics: A modern analysis of exchange rate theory and
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Part II

Minsky, balance sheets

and cycles
4 
A Minskyan framework for
the analysis of financial flows
to emerging economies
Bruno Bonizzi and Annina Kaltenbrunner

1 Introduction
This chapter contributes to our understanding of financial flows to emerging
economies (EEs), and the motives behind it. It relates conceptually to existing
Post Keynesian literature on financial flows and exchange rates (Harvey this
volume, 2010, Andrade and Prates 2013, Kaltenbrunner 2015, Bonizzi 2017). It
more widely contributes to the debates about the nature of global financial flows,
imbalances and the structure of the international monetary system (Bernanke
2005, Bibow 2009, Borio and Disyatat 2011, Stockhammer 2012, Tokunaga
and Epstein 2014). Based on the authors’ previous work it proposes a Minskyan
framework both to understand currencies’ position in the international monetary
system and the interrelated nature and behaviour of financial flows to EEs.
Existing Post Keynesian literature on exchange rate and financial flows can
be broadly divided into two main strands.The first strand, embedded in Keynes’
assertion of fundamental uncertainty in (global) money and financial markets,
largely bases itself on Keynes’ liquidity preference theory and ‘own rate of
return equation’ in ­chapter 17 of the General Theory (Dow 1999, Riese et al.
2001, Davidson 2002, Herr and Hübner 2005, Terzi 2005, Harvey this volume,
2010, Andrade and Prates 2013, de Paula et al. 2017, see part III of this volume).
Based on the fundamental assumption that international currencies can be
treated as international monies, which –​in the open economy –​become asset
classes assessed against the money of the system, this literature theorises some
of the key features of international financial flows, exchange rate dynamics,
and the international monetary system. These include the hierarchic struc-
ture of the international monetary system, the dependence of international
financial flows and consequently exchange rates on conditions in the mon-
etary space of the top currency, and several key macroeconomic features of
subordinate currencies such as their heightened external vulnerability, volatile
domestic asset prices, and constraints on domestic policymaking.
However, this literature faces some shortcomings. Firstly, theoretically, it
focuses largely on international monies’ differential ability to store value and
international agents’ decision to invest in them accordingly. This emphasis on
the asset side of international portfolio decisions fails to explain why some
44 Bruno Bonizzi and Annina Kaltenbrunner
currencies sit at the top of the currency hierarchy, and others fail to climb
it, despite similar value stability and/​or sound economic fundamentals which
should allow them to do so. More fundamentally, the emphasis on the investment
decisions of international agents overemphasises domestic economic conditions
at the expense of putting analytical focus on the structure of the international
financial system. Finally, the view remains very often generic about the specific
nature of financial actors, and their motives behind. While liquidity preference
is a general theoretical proposition, financial decisions need to be rooted in
actual institutional and historical dynamics.
The second strand focuses on financial cycles and crisis, and interprets the
boom-​bust cycle in financial flows in line with Minsky’s Financial Instability
Hypothesis (Kregel 1998, Arestis and Glickman 2002, Schroeder 2002, Onaran
2007, Frenkel and Rapetti 2009, cf Guschanski and Stockhammer this volume).
In this line of inquiry, financial flows add to the domestic build-​up of financial
fragility in EEs: financial liberalisation –​both domestic and external –​kicks
off the boom phase of the cycle. Financial flows will be attracted and generate
a boom in asset prices and easy credit conditions. This will build up financial
fragility and eventually, a particular event, such as the failure of a major bank
or a policy decision, triggers the ‘Minsky moment’, after which financial flows
reverse, wreaking havoc to financial and foreign exchange markets.
The main weakness of this literature, which originated as a result of EEs’
crises of the late 1990s, is the insufficient care in recognising the monetary
nature of financial flows, evident empirically in the failure to distinguish expli-
citly between gross and net flows. Current account imbalances are generally
taken as a measure of the ‘direction’ of financial flows, a view that has theoretical
shortcomings, insofar as it treats financial flows as flows of real resources, and
therefore simply the mirror image of trade dynamics. Moreover, this literature
cannot explain empirically the more recent boom-​bust cycles of EEs. Its focus
remains the endogenously created fragilities of EM actors’ balance sheets, rather
than the cyclical nature of international financial flows whose dynamics are
largely determined in the world’s global financial centres. In this vein, it also
fails to analyse properly the historical and institutional nature of investors and
their decisions.
This chapter sets out a Minskyan framework to the analysis of international
financial flows and exchange rate dynamics in EEs. Such a framework, rooted in
Minsky’s financial view of the economy, extended suitably to the open economy,
recognises that financial flows are nothing but financial transactions between
economic units (characterised by a balance sheet and cash flows). Rather than
on domestic economic conditions, this balance sheet view puts the emphasis on
the spatial and temporal distribution of debtor-​creditor relations and financial
structure to explain some of the key features of exchange rates and financial
flow dynamics in these countries, such as currencies’ differential position in the
international currency hierarchy, their external vulnerability, and need to offer
higher returns. Moreover, it shows that once the focus is on debtor-​creditor
relations, this also requires specific analysis of the actual actors and institutions.
 A Minskyan framework 45
After this introduction, Section 2 will review existing literature on financial
flows and exchange rates. Section 3 outlines the essential conceptual elements
of an alternative Minskyan approach. Section 4 discusses two applications of
such approach.

2 Literature review
Large parts of Post Keynesian writings on exchange rate dynamics and financial
flows, both in developed and developing countries, have their root in Keynes’
assertion that markets –​and in particular financial markets –​are characterised by
fundamental uncertainty and non-​ergodicity. This means that financial market
actors do not and cannot know the underlying probability distribution of the
variables they base their decisions on. In the spirit of Keynes’ c­ hapter 12 of the
General Theory, what drives expectations and economic decision making in an
environment of such fundamental uncertainty are conventions (the assumption
‘that the existing state of affairs will continue indefinitely, except in so far as we
have specific reasons to expect a change’ (Keynes 1936), animal spirits, and the
famous beauty contest (Keynes 1936, Davidson 1978, 2003).
This view has been applied to the foreign exchange market most prom-
inently by the work of Paul Davidson (2003) and, based on that, J.T. Harvey
(1991, 1998, 2010, 2019, this volume). In Harvey’s model, (short-​term) finan-
cial flows and the expectations in these markets drive exchange rates; there
are no underlying objective economic relations that determine exchange rates
at all times, but ‘fundamentals’ are whatever market participants expect the
drivers of the exchange rate to be in the future. These expectations, in turn,
are primarily anchored by social conventions and the confidence with which
financial market participants hold these conventions. Thus, in Harvey’s model,
the domestic currency (and consequently the exchange rate as the expression
of the relative price of one currency relative to another) is an international
asset class whose price is determined by expectations formed in the context
of fundamental uncertainty. To characterise this expectations formation ana-
lytically he refers to some of the key subjective and inter-​subjective processes
set out by Keynes, mainly in c­ hapter 12 of the General theory. The result of
these subjective and inter-​subjective process of expectations formation are large
destabilising bubbles, volatility, and financial crisis.1
A second strand of Post Keynesian literature on exchange rates and finan-
cial flows based itself on another one of Keynes’ key insights: the emergence
of money as an institution to protect against uncertainty. Applying Keynes’
liquidity preference theory (Herr 1992, Dow 1999, Riese et al. 2001, Herr and
Hübner 2005, Terzi 2005, Part III of this volume) or his more extended own
rate of return equation (r = l + q –​c) (Andrade and Prates 2013, de Conti et al.
2014, de Paula et al. 2017) to the international economy, these authors theorise
some fundamental features of the international monetary and financial system,
such as the dependence of international financial flows, and hence exchange
rates, on international liquidity preference (Dow 1999).
46 Bruno Bonizzi and Annina Kaltenbrunner
Authors concerned with the peculiar position of EEs in the international
monetary system have used Keynes’ writings on money to theorise the hierarchic
structure of the international monetary system. In these approaches, currencies’
differential liquidity premia, that is their varying ability to perform international
money functions, creates a currency hierarchy. On the top of the pyramid sits
the currency with the highest liquidity premium, that is the money of system (in
Keynes’ time the Pound sterling, nowadays the US dollar). It performs all inter-
national money functions and just as money ‘rules the roost’ in the domestic
economy, financial conditions in the country with the top currency spill over to
the rest of the global economy (in particular through capital and exchange rate
movements). It has the ‘exorbitant privilege’ of full policy freedom, borrowing in
its own currency. Underneath the top currency are intermediate currencies (e.g.
the Euro and the UK Pound) which fulfil most international money functions
and have a considerable degree of policy freedom.
At lower ranks of the hierarchy are developing countries, which hardly fulfil
international money functions and frequently even have to cede domestic mon-
etary functions to an international currency (e.g. the funding function). This
monetary subordination, in turn, makes these currencies much more sensitive
to changes in international liquidity preference (reflected in large and sudden
exchange rate changes largely independent of domestic economic conditions),
requires them to offer higher returns (to compensate for their lower liquidity
premium), and restricts monetary policy autonomy (because they are deemed
less able to secure domestic currencies’ ability to perform domestic and inter-
national money functions). Importantly, even within the three categories, there
is considerable nuance and differentiation as currencies are situated on a wide
spectrum of different degrees of liquidity.
Whereas this literature makes a crucial contribution to the analysis and the-
orisation of the peculiar monetary and financial dynamics in EEs it faces, in
our view, one substantial shortcoming. In order to theorise currencies’ different
international liquidity primacy it focuses largely on currencies’ differential
ability to store value and investors’ investment decisions and asset sides of their
balance sheets. This analytical primary of currencies’ store of value function,
however, creates two empirical problems. First, it does not really explain why
one currency sits at the top of the currency hierarchy.There are many, relatively
liquid currencies, which are characterised by value stability (or even appreci-
ation tendencies like the Japanese Yen), but only one currency dominates the
international financial system and is also likely to continue doing so in the
next future. Second, as a corollary, it also does not explain why even those EE
currencies whose governments maintain sound ‘fundamentals’ (e.g. a current
account surplus, solid fiscal situation, and a war-​chest of foreign exchange
reserves) find it difficult to climb the international monetary ladder. Put dif-
ferently, by focusing on currencies’ differential ability to store value, this litera-
ture continues to focus analytically on domestic economic conditions, rather
than the spatially distributed ownership structure of the international financial
system, to theorise a currencies’ position in the international monetary system.
 A Minskyan framework 47
A second strand of PK literature on international financial flows, and the
instability these financial flows create, has focused on understanding the EEs’
crises of the late 1990s (Kregel 1998, Arestis and Glickman 2002, Schroeder
2002, Onaran 2007, Frenkel and Rapetti 2009). The boom-​and-​bust cycle of
capital inflows, which started in the 1990s, ended in a sequence of damaging
‘sudden stops’, severely damaging financial and non-​financial corporations and
crushing currencies in several countries, including Mexico (1995), East Asia
(1996), Russia (1998), Brazil (1999), Argentina (2001) and Turkey (2002). Given
the cyclical nature of these financial processes, authors have sought to apply
the fundamental concepts of Minsky’s Financial Instability Hypothesis (Minsky
1975, 1982).
In line with Minsky’s view, a period of stability and optimistic prospects for
EEs (for example prompted by financial liberalisation or a change in policy)
attracts foreign investors and lenders. Real exchange appreciation induces
borrowers and lenders to take increasingly risky positions, so that foreign finan-
cing compounds growing indebtedness and balance sheet fragility in domestic
economies. Eventually, Ponzi structures emerge, so that a shift in liquidity pref-
erence by foreign investors and/​or a domestic problem, quickly precipitates a
fully-​fledged financial and currency crisis. Crucial to the destructiveness of the
process is the foreign currency indebtedness of domestic institutions, which
becomes unsustainable as foreign financing dries up.
These Post Keynesian contributions put liquidity and attitudes of finan-
cial actors towards it as primary determinants of financial flows and exchange
rates. In addition, the Minskyan literature on financial instability and crisis also
considers actors’ liability structures. However, the literature’s focus is on the
endogenously created fragilities in EEs actors’ balance sheets rather than the
cyclical nature of financial flows whose dynamics are largely determined in
the world’s global financial centres and often independent of domestic eco-
nomic conditions. As such it cannot explain the continuous gyrations in these
financial flows and EEs’ continued external vulnerability and volatile exchange
rate, despite relatively sound domestic economic conditions and solid balance
sheet structures.
This shortcoming is reflective of a more fundamental issue about the nature
of financial flows. Post Keynesian economists have long emphasised the monetary
nature of capitalism, but have so far not fully extended this issue to the analysis
financial flows at the macroeconomic level: indeed, very often Minskyan ana-
lyses of EM crises focus on the current account as a measure of ‘net’ financial
flows. This, as we discuss below, is a limitation that needs to be overcome.

3 A Minskyan framework of international financial flows

and exchange rate dynamics in EM
A Minskyan approach to international financial flows and exchange rates
should start from Minsky’s vision about a modern capitalist economy, as a
Keynesian ‘monetary economy of production’. Minsky characterises the
48 Bruno Bonizzi and Annina Kaltenbrunner
economy as a set of interacting balance sheets, whose assets/​liabilities generate
cash inflows/​outflows for economic units. The interaction between balance
sheets generates the financial transactions that characterise economic activity.
Such decisions remain intertwined with both sides of actors’ balance sheets,
so that every asset acquisition decision is always taken in conjunction with a
particular liability structure.
The deployment of Minsky’s vision in the cross-​border context indicates
four key points. Firstly, financial flows are nothing but financial transactions
between economic actors in two different jurisdictions. This means that finan-
cial flows do not represent a movement of real resources, but rather a transfer
in the ownership of existing or the creation of new financial assets across
borders, generating new cross-​border balance sheet positions in the process.2
Importantly, these need not be related to current accounts: the mirror image
of current accounts (the so-​called ‘net financial flows’) are nothing but the
transfer of ownership of financial assets (commonly bank deposits) to settle
trade or income obligations. But financial assets are also transferred for one-​
another, with zero ‘net’ effect on the current account. In a world that is increas-
ingly financially interconnected, such ‘gross’ financial flows are likely to become
increasingly important.
Secondly, in deciding to acquire or dispose of foreign assets, economic actors
are mindful of the two-​sided nature of their balance sheets. In other words,
liabilities are crucial to determine the demand for financial assets, including for-
eign ones, and therefore to determine the patterns of financial flows. Different
foreign assets, and for that matter different funding structures, generate different
balance sheet exposures. The currency dimension is particularly crucial, as for-
eign assets, funded with domestic liabilities, will generate currency mismatches,
exposing actors to exchange rate risks.
Thirdly, following from the previous point, rather than by their ability to
store value alone, in this Minskyan view the liquidity of international financial
assets is fundamentally shaped by their ability to be used to meet the finan-
cial obligations of those who purchase these assets. For example, to a domestic
financial actor the liquidity of a bank deposit deposits issued by a foreign insti-
tution, depends on the ease of use of that deposit to service upcoming debt.
This ability, in turn, depends on (a) the patterns and predictability of cash flows
generated by different financial assets in relation to the total stock of out-
standing obligations (e.g. fixed income securities whose cash flows match the
cash obligations on existing liabilities) and (b) the ability to convert these cash
flows (or indeed outstanding principals) quickly and with little loss of value
into the mean which can settle these obligations, that is traditional notions of
market liquidity (e.g. ease of disposal). In the case of foreign assets these factors
depend crucially on the ability of the country to generate the necessary for-
eign exchange and the ‘institutional’ liquidity of the foreign exchange markets,
including the amount of foreign exchange reserves, any regulations on financial
flows, the exchange rate regime, and the central banks’ ability and willingness
to provide foreign exchange to the market.3
 A Minskyan framework 49
Fourthly, it is fundamental to locate these concepts in the specific historical
nature, behaviour and role of contemporary economic actors.4 Different types
of actors will have different views of the liquidity and purpose of different finan-
cial assets, depending on their liability structure and institutional constraints.
The growing literature on financialisation helps us understanding these histor-
ical changes, as new types of actors, with different liability structures, emerge
and grow, shaping the asset demand and therefore financial flows and exchange
rates in EEs.
These four points have a number of important analytical implications for
the analysis of financial flows and exchange rates in EEs, which allows us to
overcome some of the limitations described in the previous section. First, a
focus on debtor-​creditor relations (i.e. interacting balance sheets) reinforces
and improves our understanding of the global currency hierarchy. It is not
only different currencies’ abilities to serve as store of value that determines
their liquidity premium, but crucially, their varying degree to serve as a means
of international liability settlement. Clearly then, the prevalent currency of
denomination of international liabilities becomes the top currency, i.e. the
means of settlement of international liabilities largely overlaps with the inter-
national ‘unit of account’. It is not their superior value stability which puts this
currency at the top of the currency hierarchy, but the fact that it denominates
the majority of international debt contracts, which means foreign agents have
to acquire this currency to meet their outstanding external obligations. As the
vast majority of international debt is denominated in US dollars, a pattern that
the global financial crisis has paradoxically reinforced, it is not surprising that
it remains the currency at the top of the hierarchy and other currencies subor-
dinate to it. This is particularly the case for emerging markets which see both
a higher share of their debt denominated in foreign currencies (in particular
the US dollar), and/​or a higher proportion of foreign investors funded in those
core currencies.
A focus on liabilities also helps shifting the attention from local to global
factors as the ultimate drivers of financial flows and exchange rates in EEs. The
ultimate originators of financial flows are institutions whose liability structures
are embedded into international financial markets and core currencies, which
makes their considerations often independent of local macroeconomic
‘fundamentals’. Indeed, as has also been highlighted in a recent mainstream
literature on the Global Financial Cycle (Rey 2013), investment decisions of
these global investors are driven strongly by international liquidity and funding
conditions rather than by domestic economic conditions in the recipient econ-
omies. Any change in these funding conditions can lead to large and sudden
capital and exchange rate movements independent of domestic economic
conditions. This also means that in order to assess a country’s risk to sudden
financial and exchange rate movements, we need to look at the structure and
nature of its financial integration (e.g. its net foreign assets or amount of foreign
capital funded on international financial market), rather than domestic eco-
nomic conditions.
50 Bruno Bonizzi and Annina Kaltenbrunner
Equally when it comes to local factors, the focus is shifted towards those
factors that enhance the ability of actors to use local-​currency assets to face their
financial obligations. This goes a long way to explain why, for example, foreign
exchange reserves accumulation has become so important to many EEs: it is
a buffer that stabilises the value of the currency, which foreign investors can
indirectly ‘access’ if they need to repatriate their investments and cannot do so
using private intermediaries.
More than that, this focus on the liability side of international investors’
balance sheets, also shows why certain locations/​currencies continue to dom-
inate the international economy as the loci of the spatial concentration of
these liabilities, such as the main global financial centres. Given the spatial
concentration of international liabilities in these centres, financial conditions
in these centres will not only determine the cyclical movements of financial
flows, but also ‘impose’ the macroeconomic, institutional, regulatory, and legal
conditions upon the rest of the global capitalist system. In order to minimise
the risk for international investors, that is a mismatch between their inter-
national investments and domestic liability structures, such deviations should be
reduced by global harmonisation of international governance. Any deviations of
these global rules of governance will have to be compensated by higher returns
to compensate international investors for the ‘risk’ they are assuming on their
international investments. Thus, in this view, rather than outcome of domestic
vulnerabilities, the higher returns encountered in many EEs are the results of
historical and structural deviations in their local regulator, macroeconomic and
legal frameworks.

4 Applications of a Minskyan view of international

financial flows and exchange rates: New forms of external
vulnerability and the implications of pension funds
investments in EEs
Above sections have set out the unique contributions a Minskyan framework
can make to the analysis of international financial flows and exchange rates
in EEs. It has highlighted the importance of international liability structures
and the historical and institutional evolution of economic and factor actors
to understand capital flow dynamics, currencies’ position in the international
monetary system, EEs’ continued external vulnerability and financial sub-
ordination. This section sets out briefly two concrete applications of this
Minsky view.
First, Kaltenbrunner and Painceira (2015) discuss EEs continued external
vulnerability despite an improvement in domestic economic fundamentals
(e.g. the current account and the fiscal situation) and reduction in traditional
forms of external vulnerabilities, that is their inability to borrow in domestic
currencies (original sin) and the consequent large share of foreign currency
liabilities of these countries. The authors show using the example of Brazil that
despite a comfortable current account surplus, low inflation, a record stock of
 A Minskyan framework 51
foreign exchange reserves, and a substantial reduction in foreign currency debt,
the Brazilian Real remained one of the world’s most volatile currencies and
exposed to large financial flows movements.
This continued external vulnerability, the authors argue is the result of
increased foreign investment in Brazilian domestic currency assets, including in
the public debt market, equity market, and the currencies itself as the most liquid
asset per se. Although these new forms of foreign investment in domestic cur-
rency assets have reduced the external debt and currency mismatch of domestic
agents, that is their original sin, they have shifted the same currency mismatch
to the international investor. This is so because foreign investors remain funded
largely on international financial markets and in core currencies, which creates
a mismatch between their EE currency assets and their foreign currency liabil-
ities. This mismatch, however, has several implications. First, the fact that inter-
national investors remain funded in core currencies and financial centres keeps
them, and, as a consequence, financial developments in EEs, extremely sensi-
tive to international market conditions as any change in international funding
conditions can alter their portfolio allocation. Second, the currency mismatch
in international investors balance sheets means that these investors become very
sensitive to (expected) changes in domestic currencies. This, in turn, makes
them more likely to pull out suddenly if any factors that are likely to affect
the value of EE currencies are expected to change. Finally, foreign investments
in domestic currency assets, makes exchange rate changes a crucial element
of the total return for international investors. This, in turn, creates the risk
of destabilising feedback dynamics (in both ways) as foreign investors hold
EE assets to take advantage of favourable exchange rate movements. Given
thin financial markets, these investments in turn contribute to the (expected)
exchange rate movements, contributing and exacerbating large swings in finan-
cial flows and exchange rates.
The second application is an article by Bonizzi and Kaltenbrunner (2019)
and discusses the potential financial stability implications of the recent increase
in Insurance Companies and Pension Fund (ICPF) investments in EEs. In con-
trast to existing views which see these investors as stabilising for EEs’ financial
markets and currencies, given their longer horizon and more ‘fundamentalist’
trading strategies, this paper argues that ICPF investments in EEs might fur-
ther destabilise these economies. This, the paper argues, is due to the recent
change in ICPF investment strategy which puts the matching of their liabilities
at the core of their portfolio strategy. Given their losses in the equity bubbles
of the early 2000s and low interest rates (the ‘perfect storm’), ICPF have seen
the emergence of substantial funding gaps, that is they cannot meet their cur-
rency (and future) liabilities in the form of pension and insurance payments,
with their current asset allocations.5 These funding gaps have spurred ICPF
to divide their portfolio allocation in two distinct tranches. First, the liability
matching portfolio which contains highly liquid and safe assets, such as govern-
ment bonds, which match ICPFs liability structure very closely and thus seeks
to protect the balance sheets from further shifts in interest rates. The second
52 Bruno Bonizzi and Annina Kaltenbrunner
tranche is the so-​called growth portfolio, which contains assets which do not
match ICPF’s liabilities but generate higher returns. It is in this growth port-
folio were EE assets can be found. This is so for several reasons, but primarily
related to their different macroeconomic, institutional, and regulatory environ-
ment which creates distinct governance risks for these institutions, and their
subordinate position in the international monetary and financial system which
keeps them vulnerable to sudden and large financial flows and exchange rate
movements.This allocation of EE assets to the growth portfolio, in turn, has two
major implications for ICPF investments into EE.
First, being in the growth portfolio means EE assets are in competition with
a whole range of other asset classes (e.g. high-​yield bonds, private equity, infra-
structure, commodities, hedge funds, etc.). As such the ‘loyalty’ of global ICPF
to EE is contingent on the conditions of several other asset classes. The second
and more crucial implication is that, the demand for EE assets by global ICPF
is contingent on the dynamics of the their liabilities. As funding gaps have
increased in the post-​crisis era, ICPF have been forced to tilt their growth
portfolio to riskier assets to generate the necessary return to fill this gap. EE
assets have been very attractive in this regard, given their diversification benefit
and relatively high returns. The fact that EE assets are allocated to the growth
portfolio, though means that they remain very vulnerable to any changes in
the funding conditions of ICPF and hence large and sudden financial outflows
largely independent of domestic conditions.
In this way, a Minskyan approach contributes to an understanding of the
unevenness of the global financial system –​and thus add to the study of the
geography of global finance. The uneven distribution of actors’ liabilities, pri-
marily concentrated across a few advanced economies, reproduces the subor-
dination of EE assets within investors’ portfolio, which can lead to self-​feeding
and cumulative tendencies: it is the monetary and financial subordination of EE
which relegates EE assets to the growth portfolio of ICPF investments; on the
other hand, it this same relegation which cements and perpetuates EE mon-
etary and financial subordination.

5 Conclusions
This chapter has outlined the key elements of a Minskyan approach to the
study of financial flows and exchange rates, with particular attention to EEs.
The focus on actors’ liabilities, and their implication for cross-​border financial
flows, is probably the most distinctive aspect of this approach. This can have
fruitful applications to study the evolution of financial integration before and
since the global financial crisis, as highlighted in the two case studies discussed.
Overall, the conclusion for EEs is that financial integration has changed some
of its characters, but remains ongoing, and, crucially, maintains its hierarchical
structures, in which EEs are subordinate. Based on the core elements of this
approach, future research on these themes needs to pay closer attention to the
 A Minskyan framework 53
interconnections between balance sheet of different actors in the global finan-
cial systems, and the way these propagate ebbs and flows of global liquidity.

Notes
1 For an application of this view to the analysis of financial crisis in EEs see, for example
(Alves et al. 1999).
2 This is why we chose to use financial flows instead of capital flows. The latter is
potentially a misleading term, insofar as it evocates the idea of physical movement
of fixed capital. Indeed, financial flows is the terminology followed by the current
balance of payment convention (IMF 2009)
3 In contrast to the domestic economy, the central bank cannot act as lender/​dealer of
last resort given that it cannot print foreign currency.
4 This point also follows from Minsky’s own view of capitalism as an evolutionary
system, where financial innovation is key driver of economic dynamics (Minsky and
Whalen 1996).
5 Low interest rates have squeezed the balance sheets of ICPF for two reasons. First,
they have increased their liabilities which are discounted by interest rates in highly
rated assets and they have lowered their returns on traditional save investment assets
such as government bonds.

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Independence. Jackson Hole, WY: Federal Reserve Bank of Kansas City, Presented at
2013 Economic Policy Symposium.
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 A Minskyan framework 55
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5 
Post Keynesian and structuralist
approaches to boom-​bust cycles
in emerging economies
Karsten Kohler

Introduction
Business cycles in emerging market economies (EMEs)1 are considerably more
volatile compared to industrial economies and are often referred to as boom-​
bust cycles.They exhibit specific characteristics such as strongly countercyclical
trade balances, and procyclical capital flows and exchange rates (Kaminsky
et al. 2005, Reinhart and Reinhart 2009, Cordella and Gupta 2015, Uribe and
Schmitt-​Grohé 2017, ­chapter 1).2 Recessions are typically deeper and costlier
compared to rich economies, and tend to be more severe when they coincide
with banking and currency crises (Calderón and Fuentes 2014).3 Economic
theory faces the challenge to explain why business cycles in EMEs are more
extreme and exhibit different patterns from cycles in rich economies.
Mainstream approaches build on real business cycle (RBC) models to
explain some of the specificities of EME cycles (Neumeyer and Perri 2005,
Aguiar and Gopinath 2007, Chang and Fernández 2013; see the textbook by
Uribe and Schmitt-​Grohé 2017). RBC models assume intertemporal optimisa-
tion of representative agents and full utilisation of resources. Cycles in EMEs
either stem from shocks to productivity growth that are non-​stationary (Aguiar
and Gopinath 2007) or, in New Keynesian versions, from interest rate shocks
that are amplified by domestic financial frictions (Neumeyer and Perri 2005).
In contrast, Post Keynesian and structuralist (PK-​S) approaches focus on the
demand side and on distributional struggles. Agents are assumed to follow
simple behavioural rules rather than intertemporal optimisation. While PK-​
S have traditionally placed a somewhat stronger focus on long-​run growth,
they have also contributed to a better understanding of short-​to medium-​run
macroeconomic fluctuations in EMEs. Unlike mainstream approaches, where
fluctuations are caused by exogenous shocks, PK-​S highlight the endogenous
nature of EME cycles (Palma 1998), which are driven by mechanisms internal
to capitalist economies.
The aim of this chapter is twofold. First, it provides a survey of some
important PK-​S contributions to explaining boom-​bust cycles in EMEs. PK-​S
approaches comprise rich narrative accounts and case studies that dissect the
complex mechanisms behind boom-​bust episodes, as well as their institutional
 Post Keynesian and structuralist approaches 57
and historical context (Palma 1998, Taylor 1998, Frenkel 2008, Frenkel and
Rapetti 2009, Harvey 2010, Herr 2013, Ocampo 2016). On the other hand, there
are formal models that examine a more limited set of theoretical mechanisms
and their logical implications (Sethi 1992, Foley 2003, Taylor 2004, ­chapter 10,
La Marca 2010, Lima and Porcile 2013, Sasaki et al. 2013, Botta 2017, Kohler
2019). In this chapter, we focus on the formal literature but with an eye on the
empirical facts highlighted in the non-​formal literature. The second aim of the
chapter is to evaluate the capacity of PK-​S models to account for key structural
features of EMEs and stylised facts. Based on this evaluation, the chapter iden-
tifies gaps in the existing PK-​S literature and suggests areas for future research.
The chapter concludes that, over time, PK-​S models have devoted more
attention to exchange rate flexibility and that Minskyan models of finance-​
driven business cycles are better equipped to capture the experience of EMEs.
Future areas for research are empirical model calibration and the explicit mod-
elling of government policies.
The remainder of the chapter is organised as follows: The second section
introduces some key structural features of EMEs and stylised facts of boom-​bust
cycles.The third section summarises key formal PK-​S contributions and assesses
them based on the empirical evidence discussed in the second section. The last
section summarises and concludes by identifying areas for future research.

Business cycles in EMEs: Structural features and

stylised facts
EMEs exhibit certain structural characteristics that make their macroeconomies
behave differently from industrial economies. Weak domestic institutions, poor
policies, and political instability feature prominently in the mainstream (e.g.
Aguiar and Gopinath 2007, Calderón and Fuentes 2014), while Keynesian
theory places a stronger focus on external and financial macroeconomic factors
(e.g. Stiglitz et al. 2006, ­chapter 4). From this perspective, there are at least six
important structural features:

(1) Openness. Trade-​to-​output ratios are comparatively high in most EMEs

and macroeconomic activity is strongly dependent on export performance.
Exports also constitute an important source of foreign currency. At the
same time, production often relies on imported intermediate inputs which
are typically invoiced in foreign currency.
(2) Balance-​of-​payments constraints. While almost all economies face some
balance-​of-​payments constraint on growth in the sense that they cannot
run ever growing external debt ratios, in EMEs this constraint typic-
ally bites earlier. In the balance-​of-​payments constrained growth litera-
ture, this has motivated the strong assumption of balanced trade in the
long run (Thirlwall 2011). We will call this the strong the balance-​of-​
payments constraint. In the short to medium run, EMEs may be able to
finance trade deficits via net capital inflows, but may eventually run into
58 Karsten Kohler
balance-​of-​payments problems which can curb economic expansion. We
will call this the weak balance-​of-​payments constraint.
(3) External financial vulnerability. EMEs have relatively open financial accounts
and are exposed to large and often erratic portfolio capital flows (Ocampo
2016, Kaltenbrunner and Painceira 2015). As the domestic financial system
is often less developed, private agents and governments rely on foreign
borrowing. At the same time, the supply of external credit tends to be
unstable and highly dependent on liquidity and risk appetite in global
financial centres (Rey 2015).This makes EMEs more vulnerable to external
financial shocks –​for instance, in the form of rising country risk premia on
interest rates due to lower risk appetite of foreign investors (Frenkel 2008,
Frenkel and Rapetti 2009).
(4) Procyclical currency mismatches. Due to their subordinate position in the inter-
national currency hierarchy (Andrade and Prates 2013), private sectors in
EMEs can usually only borrow from abroad in foreign currency, which
creates currency mismatches on balance sheets (Eichengreen et al. 2007).
When the private sector is a net debtor, a currency mismatch works in a
procyclical fashion: a depreciation of the domestic currency raises the value
of foreign debt, reducing net worth and discouraging spending. Conversely,
expansionary balance sheet effects may take place when the currency
appreciates.
(5) (Semi-​)Flexible exchange rate regimes. Within the last two decades, many
medium and large EMEs adopted semi-​flexible exchange rate regimes,
especially managed floats (Ghosh et al. 2015). In a managed float, the cen-
tral bank smoothens fluctuations through foreign exchange interventions,
but exchange rate dynamics are ultimately market driven.
(6) Nominal exchange rate as a key distributional variable. As a result of their
dependence on imported intermediate goods, the nominal exchange rate
is a major determinant of the price level in EMEs, which is reflected in
higher exchange-​rate pass-​through compared to rich economies (Calvo
and Reinhart 2000).This turns the nominal exchange rate into a key distri-
butional variable, with depreciations often feeding into distributional con-
flict between workers and firms.

While certainly not exhaustive, these structural features are likely to be among
the factors that render EM business cycles different compared to rich econ-
omies. The foremost fact that makes them stand out is their severity: aggregate
output in EMEs is more than twice as volatile as in rich countries (Uribe and
Schmitt-​Grohé 2017, ­chapter 1). Besides such excess volatility, at least three fur-
ther stylised facts of business cycles can be identified:

(1) Procyclical capital inflows, countercyclical trade balances. While gross capital in-​
and outflows are generally procyclical (Broner et al. 2013), net capital
inflows to EMEs tend to be more strongly procyclical and exhibit larger
amplitudes than in advanced economies (Kaminsky et al. 2005). Trade
 Post Keynesian and structuralist approaches 59
balances, in contrast, are strongly countercyclical (Uribe and Schmitt-​
Grohé 2017, ­chapter 1). Boom periods in EMEs are thus characterised by
gross and net capital inflows and a worsening trade balance, while busts
come with contractions in capital flows and current account reversals.
(2) Procyclicality of exchange rates. Nominal and real exchange rates in EMEs are
procyclical, i.e. they appreciate during the boom and depreciate during
the bust (Cordella and Gupta 2015). In contrast, exchange rates of most
rich countries are counter-​or acyclical. Moreover, there is evidence that
the procyclicality of the real exchange rate largely stems from the nominal
exchange rate rather than the domestic price level. The former is highly
correlated with the real exchange rate (Cordella and Gupta 2015), while
inflation has not been found to exhibit a clear pattern during capital flow
cycles (Reinhart and Reinhart 2009).
(3) External and financial crises during the trough.The trough of boom-​bust cycles
in EMEs is often associated with external and financial crises, which tend
to deepen recessions (Calderón and Fuentes 2014). This phenomenon is
connected to the structural feature of a tight balance-​of-​payments con-
straint: when a country cannot finance its current account deficit any
longer, the current account deficit must be reduced abruptly, which is
often achieved by a sharp depreciation of the currency. Due to currency
mismatches in the private sector, currency depreciation then often worsens
the recession and may come with a financial crisis.

Post Keynesian and structuralist approaches to business

cycles in EMEs
The special structural features and stylised facts of business cycles in EMEs call
for theoretical approaches that take these characteristics into account.The most
obvious implication is that business cycle theories for EMEs need to integrate
the external sector. Models of EME cycles must be open economy models and
they need to address the question of exchange rate determination. Conventional
heterodox business cycle models in the tradition of Kalecki, Kaldor, Goodwin,
and Minsky are predominantly closed economy models, and are as such not
directly applicable to EMEs.4 PK-​S approaches to business cycles in EMEs
appreciate this fact and pay strong attention to the open economy dimension.
Differences among PK-​S approaches arise with respect to two factors. The
first concerns the assumed exchange rate regime and is largely due to historical
reasons. Descriptive accounts that were written under the impression of the
Latin American crises in the 1990s and early 2000s, as well as the East Asian crisis
in 1997–​1998, highlighted the role of fixed exchange rates, reflecting the dom-
inant exchange rate regime at the time (e.g. Taylor 1998, Frenkel and Rapetti
2009). This is embodied in the assumption of a fixed nominal exchange rate in
several formal models (Sethi 1992, Foley 2003, Taylor 2004, ­chapter 10). More
recent approaches discuss exchange rate volatility (Herr 2013, Kaltenbrunner
and Painceira 2015, Ocampo 2016), which came with the adoption of (semi-​)
60 Karsten Kohler
Table 5.1 Classification of heterodox boom-​bust cycle models

Fixed exchange rate Flexible exchange rate

Real-​side focus Sethi 1992; La Marca 2010 Sasaki et al. 2013;

Lima and Porcile 2013
Financial-​side focus Foley 2003, Taylor 2004 Botta 2017; Kohler 2019

flexible exchange rate regimes in the last two decades. The switch to flexible
or semi-​flexible exchange rates has also been captured in more recent cycle
models (Lima and Porcile 2013, Sasaki et al. 2013, Botta 2017, Kohler 2019).
The second dimension along which PK-​S approaches to EME cycles differ
concerns the role of (external) financial factors. PK-​S open economy business
cycle models in the Kaldorian, Goodwinian, and Kaleckian traditions are more
tilted to the real side and focus, e.g., on capital accumulation and income distri-
bution (Sethi 1992, La Marca 2010, Lima and Porcile 2013, Sasaki et al. 2013),
while Minskyan theories of finance-​driven business cycles assign a greater
role to financial factors such as interest rates and external debt (Foley 2003,
Taylor 2004, ­chapter 10, Botta 2017, Kohler 2019). In the non-​formal literature,
where unstable capital flows feature prominently, the Minskyan view has been
dominant (Palma 1998, Taylor 1998, Frenkel and Rapetti 2009, Harvey 2010,
Kaltenbrunner and Painceira 2015).
We will use these two dimensions, exchange rate flexibility and real-​versus
financial-​side focus, to structure our review of heterodox boom-​bust cycle
models (see Table 5.1).

Models with fixed exchange rates

Real-​side focus
Sethi (1992) presents a Kaldorian model with an unstable goods market due
to a strong accelerator effect of demand on investment. Different from closed
economy models in this tradition, instability is contained by a balance-​of-​
payments constraint rather than supply-​constraints such as full employment.
A shock to investment will bring investment expenditures on an explosive path
due to the accelerator. During the resulting boom phase, the economy incurs a
trade deficit which leads to a reduction in the stock of foreign reserves, as there
is no capital mobility. As in the classic Mundell-​Fleming approach, reductions in
reserves directly translate into a drop in the money supply pushing up interest
rates.This mechanism brings the investment boom to an end. On the downward
trajectory, the accelerator effect leads to an overshooting of the equilibrium.
Sethi’s (1992) contribution captures a strong balance-​of-​payments constraint
(structural feature 2) through the assumption that trade must be balanced, as
well as countercyclicality of trade flows (stylised fact 2). Apart from that, the
model does not capture other stylised facts. Especially the strong assumption of
 Post Keynesian and structuralist approaches 61
capital immobility contradicts the experience of financially open EMEs which
are subject to strong capital flows over the cycle.
La Marca’s (2010) ‘Structuralist-​Goodwin’ model also exhibits a strong focus
on the real economy but with a significantly richer structure compared to
Sethi (1992). Due to its openness, aggregate demand is assumed to be profit-​
led: nominal wage increases are contractionary as they reduce long-​run export
competitiveness and decrease the domestic value of interest earnings on for-
eign currency-​denominated assets. During boom periods, the bargaining power
of workers improves, and the wage share increases, which depresses aggregate
demand. This configuration leads to Goodwin-​type counter-​clockwise cycles
in the output-​wage share space. Notably, throughout the boom, the current
account, whose dynamics is determined by the savings-​investment gap, improves
because savings increase more strongly than investment.
The model developed by La Marca (2010) pursues the explicit aim of cap-
turing key characteristics of EMEs. The economy is strongly open (structural
feature 1), which is captured by the assumption that aggregate demand is profit-​
led. The model also addresses the link between distributional conflict and the
exchange rate (structural feature 6); however, the distributional role of the
nominal exchange rate is not captured as the latter is fixed. The stylised fact
(3) of a procyclical real exchange rate is reproduced by the model, although
only partially, as the effect exclusively runs via domestic inflation. The empir-
ical evidence discussed above, by contrast, suggests that the nominal exchange
rate is the key driver. The model further aims to capture the foreign-​currency
denomination of external assets and liabilities (structural feature 5). However,
due to the assumption of a positive net foreign asset position in the private
sector, balance sheet effects work countercyclical in the model, which does
not accord well with the experience of most EMEs. A further weakness of the
model is the assumption of a procyclical trade balance, which does not corres-
pond to stylised fact (2).

Financial-​side focus
Foley (2003) develops a Minskyan model of endogenously generated financial
fragility in open economies, in which interest rate dynamics are at the centre.
Economic busts may end in financial crises, placing a stronger emphasis on
the financial side compared to the previously discussed models. Foley (2003)
derives different configurations of the investment, profit, and interest rate for
which firms that borrow from international capital markets find themselves in a
hedge, speculative, or Ponzi financial regime.The dynamics are generated by the
interplay of a confidence factor that drives investment expenditures and a cen-
tral bank that raises the interest rate whenever the growth rate of the economy
is above its target level.The confidence factor introduces Minskyan momentum
effects: when the growth rate exceeds its equilibrium level, confidence increases
and reinforces the boom. Confidence is tamed by a countercyclical policy
interest rate which dampens the boom. The increase in interest rates at the
62 Karsten Kohler
end of the boom will push some firms into Ponzi territory, thereby generating
financial fragility. Recessions are thus associated with external debt crises.
Foley’s (2003) model addresses stylised fact (4) of external financial crises
during busts. His neat formalisation of the Minskyan terminology of hedge,
speculative, and Ponzi finance makes a step towards an extension of Minskyan
models to the open economy. However, apart from the fact that business debt is
financed through capital inflows, the model does not capture any features that
are specific to EMEs. As a result, the model’s capacity to capture ‘financial fra-
gility in developing economies’, as the title claims, is limited.
Taylor (2004, ­chapter 10) presents a stripped-​down cycle model in which
interest rates play the main role, but unlike in Foley (2003), these are determined
in financial markets through endogenous risk premia. Uncovered interest rate
parity sets a floor on the interest rate at which domestic agents borrow from
abroad. Capturing the Minskyan idea of herd behaviour in financial markets,
country risk premia are on the one hand driven by self-​destabilising momentum
dynamics, and on the other hand by a fundamental value that is related to
the stock of foreign reserves. As the exchange rate is fixed, exogenous capital
inflows will initially lead to an increase in foreign reserves, which reduces the
risk premium as it improves investor confidence. However, the capital inflow
shock is likely to induce a (debt-​financed) domestic boom during which the
current account deficit widens. As a result, foreign reserves begin to shrink and
the risk premium increases. The resulting rise in interest payments on external
debt accelerates the fall in reserves and a currency crisis may ensue.
Despite its simplicity,Taylor’s (2004) model captures several structural features
and stylised facts. It features a weak balance-​of-​payments constraint (structural
feature 2) in the sense that a loss in foreign reserves as a result of trade deficits
eventually depresses the economy through rising interest rates. The model also
incorporates external financial vulnerability: capital inflows are driven by the
preferences of foreign investors, and domestic financing conditions hinge on a
country risk premium.Taylor also discusses the possibility of a currency crash at
the end of the cycle, which is a form that external crises may take (stylised fact
3). Capital inflows are associated with boom periods, during which the current
account worsens (stylised fact 1); however, the goods market is not explicitly
modelled, which means that some of these aspects are only captured indirectly.

Models with flexible exchange rates

Real-​side focus
Sasaki et al. (2013) present a Kaleckian open economy model with distributional
conflict and semi-​flexible exchange rates. They key idea is that price-​setting
firms and nominal wage-​setting workers take international competitiveness
into account when forming their factor share targets. Both firms and workers
reduce their profit share targets when the economy loses international com-
petitiveness through a real appreciation. The exchange rate regime is a crawling
 Post Keynesian and structuralist approaches 63
peg, where the nominal exchange rate adjusts sluggishly to deviations from
an exogenously determined real exchange rate target. Together with delayed
output adjustment to excess demand, the model constitutes a dynamic system
in the wage share, the real exchange rate, and the rate of capacity utilisation.
The authors evaluate the conditions under which sustained cycles can emerge
without, however, providing much economic intuition for the occurrence of
those cycles.
Sasaki et al. (2013) make a step towards introducing a (semi-​ )flexible
exchange rate (structural feature 4) into a PK-​S business cycle model. They
also address the link between the exchange rate and distributional outcomes
(structural feature 6), but in a peculiar way: both workers and firms seek to pre-
serve international price competitiveness. Whether an appreciation ultimately
decreases the wage or profit share depends on who cuts back more vigorously
on their income claims, workers or firms. Moreover, the nominal exchange
rate does not have direct distributional implications as the model abstracts from
imported intermediate goods. This fails to capture conflict inflation triggered
by nominal depreciations (structural feature 6). Overall, the model has limited
relevance for EMEs.
Lima and Porcile (2013) also emphasise class conflict and consider struggles
over the preferred real exchange rate as a potential cycle mechanism. Different
agents control different variables: as in Sasaki et al. (2013), workers set the nom-
inal wage and the government determines the nominal exchange rate path.
Unlike in Sasaki et al. (2013), however, the nominal exchange rate directly
feeds into domestic prices; firms set a mark-​up on unit costs rather than the
price level, and agents have conflicting interests when it comes to the preferred
exchange rate. The government lets the nominal exchange rate vary when-
ever the price mark-​up is inconsistent with the government’s real exchange
rate target. Firms change the mark-​up whenever the nominal exchange rate is
inconsistent with their real exchange rate target. The idea behind this config-
uration is that the government is more concerned about income distribution
than international price competitiveness. A rise in the mark-​up will induce
the government to appreciate the nominal exchange rate in order to avoid
a reduction in the wage share. Firms, in turn, react by lowering mark-​ups to
restore international price competitiveness. This mechanism can give rise to
fluctuations in mark-​ups and the nominal exchange rate, which feed into the
real economy through investment and net exports, producing cycles in the real
exchange rate and output.
Arguably, Lima and Porcile (2013) are more successful than Sasaki et al.
(2013) in capturing distributional struggle linked to the nominal exchange
rate (structural feature 6): nominal exchange rates matter for distributional
outcomes as they determine import costs, and there is genuine social conflict
between agents.The authors also highlight the possibility of joint fluctuations in
output and the real exchange rate, but it is difficult to assess whether the model
generates procyclical exchange rates (stylised fact 2), as they do not examine the
nature of these cycles in detail.
64 Karsten Kohler

Financial-​side focus
Botta (2017) presents a model of Dutch disease caused by a boom in inward
foreign-​direct investment (FDI). While the main focus is on long-​run dein-
dustrialisation, the medium-​run dynamics of the model describe a boom-​bust
cycle. As in Taylor (2004, ­chapter 10), there is an endogenous risk premium on
the rate of interest. In Botta (2017), however, the risk premium is increasing
in the stock of foreign currency-​denominated external debt and its valuation
through the nominal exchange rate, rather than determined by the stock of
foreign reserves. A shock to FDI inflows leads to a nominal exchange rate
appreciation, which reduces the risk premium and thereby attracts portfolio
inflows. However, as the stock of external debt successively increases during the
boom, foreign investors get anxious and demand a higher risk premium, which
discourages further capital flows. At the same time, the resulting real appre-
ciation worsens the current account position, which puts further downward
pressure on the nominal exchange rate. This mechanism brings the boom to an
end and a period of depreciation and external deleveraging sets in.
Building on Taylor (2004, ­chapter 10), the parsimonious model in Botta
(2017) captures a number of structural features of EMEs. Importantly, it extends
Taylor’s treatment of external financial vulnerability due to endogenous risk
premia to flexible exchange rate regimes (structural features 3 and 4), and fur-
ther considers currency mismatches (5). The model also describes the stylised
facts of procyclical behaviour of capital flows (1) and exchange rates (2), as well
as external debt crises (3); but the real side of the economy is not modelled
explicitly. Notably, unlike in La Marca (2010), procyclical real exchange rate
dynamics in this model are governed by the nominal exchange rate rather than
inflation, which corresponds better with the empirical evidence
Lastly, Kohler (2019) develops a model in which procyclical exchange rates
along with currency mismatches drive EME business cycles.The key idea is that
firms are indebted in foreign currency so that exchange rate dynamics affect
investment expenditures through balance sheet effects. Nominal exchange rate
dynamics, in turn, are driven by disequilibria between trade flows and capital
flows. Capital flow dynamics are governed by an external debt target ratio,
which is exogenous and reflects risk appetite and liquidity in international
financial centres. This set-​up can give rise to endogenous cycles if the adjust-
ment speed of the exchange rate, which is interpreted as the degree of financial
openness, is sufficiently high. Exchange rate appreciation triggers a boom in
investment as it improves the net worth of firms.The exchange rate overshoots,
and further capital flows are attracted as external debt ratios initially decline.
Throughout the boom, the current account deficit worsens and is not fully
accommodated by exogenously determined capital flows, which eventually
puts downward pressure on the exchange rate. The resulting depreciation then
induces contractionary balance sheet effects and a recession. It is shown that an
exogenous increase in the target debt ratio, e.g. due to an increase in risk appe-
tite, increases the amplitude of the endogenous fluctuations.
 newgenrtpdf
Table 5.2 Incorporation of EMEs’ structural features and stylised facts by PK-​S models

Structural feature Stylised fact

(1) (2) (3) (4) (5) (6) (1) (2) (3)

Openness Balance-o​ f-​ External Flexible Procyclical Distributional Procyclical Procyclical External
payments vulnerability exchange currency conflict capital flows, exchange and
constraint rate mismatches countercyclical rate financial
trade flows crises

Post Keynesian and structuralist approaches 65

Sethi 1992 ✓ strong × (✓)
La Marca 2010 ✓ × (✓) × (✓)
Foley 2003 ✓ ✓
Taylor 2004 ✓ (weak) ✓ (✓) ✓
Sasaki et al. 2013 ✓ ✓ (✓)
Lima and Porcile ✓ ✓ ✓
2013
Botta 2017 ✓ (weak) ✓ ✓ ✓ (✓) (✓) ✓
Kohler 2019 ✓ weak ✓ ✓ ✓ ✓ ✓ ✓

Notes: ✓: Successfully captured. (✓): Partially captured. ×: Contradiction. A strong balance-​of-​payments constraint precludes trade deficits, whereas a weak con-
straint only involves a mechanism through which trade deficits ultimately reduce economic activity.
66 Karsten Kohler
The model in Kohler (2019) captures a weak balance-​of-​payments con-
straint (structural feature 2), since rising trade deficits drag down growth
through downward pressure on the exchange rate. External financial vulner-
ability (structural feature 3) is modelled by an exogenous external debt target
ratio that drives capital flows. Currency mismatch (structural feature 5) plays a
major role for business cycle dynamics as balance sheet effects in the firm sector
behave procyclically. The goods market and its interaction with the balance-​
of-​payments is explicitly modelled, reproducing the procyclicality of capital
flows and nominal exchange rates, as well as the countercyclicality of the trade
balance (stylised facts 1 and 2). The bust is characterised by financial difficulties
as foreign debt ratios surge and depress investment spending (stylised fact 3).

Discussion and conclusion

Post Keynesians and structuralists have produced a number of innovative models
to explain boom-​bust cycles in emerging market economies over the past three
decades. In contrast to shock-​driven business cycle models with optimising
agents (Neumeyer and Perri 2005, Aguiar and Gopinath 2007, Chang and
Fernández 2013), they discuss endogenous cycle mechanisms and highlight the
importance of unstable investment decisions, distributional conflict, and erratic
behaviour in financial markets. Reflecting historical developments in major
emerging markets, there has been a shift from models with fixed exchange rates
towards a greater consideration of exchange rate flexibility.5 Another difference
within PK-​S concerns the emphasis on financial factors. Here, no historical
tendency emerges –​real-​side models inspired by Kalecki, Kaldor and Goodwin
have remained popular (Sethi 1992, La Marca 2010, Lima and Porcile 2013,
Sasaki et al. 2013). However, in the non-​formal literature, the Minskyan view
stressing financial factors such as capital flows, external debt, and interest rates,
is more prominent (Palma 1998,Taylor 1998, Frenkel and Rapetti 2009, Harvey
2010, Kaltenbrunner and Painceira 2015). Given the firm integration of EMEs
into international financial markets and the important role of portfolio capital
flows mentioned in the second section, it seems warranted to conclude that
adequate business cycles models for EMEs can no longer disregard the cru-
cial role of foreign finance. While PK-​S real-​side models highlight important
features such as the distributional role of exchange rates, they overall fall short
of providing a satisfactory explanation for some of the most salient features of
boom-​bust cycles. Minskyan models of finance-​driven cycles have come closer
in capturing the role of capital flows and, more recently, exchange rate dynamics
(Foley 2003, Taylor 2004, Botta 2017, Kohler 2019). This is a line of research
that should be pursued further and can be extended in at least two ways:
First, compared to mainstream models that are usually calibrated to match
stylised facts, Post Keynesian and structuralist models are more loosely connected
to empirical evidence. This runs the risk of misjudging the quantitative rele-
vance of different channels. It would be desirable to build more complete
and yet simple models that replicate stylised facts through calibration. Second,
 Post Keynesian and structuralist approaches 67
macroeconomic policy is presently modelled only in a rudimentary form. This
is unsatisfactory, given that fiscal policy is often procyclical in emerging markets
(Kaminsky et al. 2005, Ocampo 2016), and that inflation targeting can have
adverse effects on capital flow dynamics (Ocampo 2016). It is thus important
to explicitly model policy interventions to better understand their deficiencies
and to come up with policies that curb the boom-​bust cycle.

Acknowledgements: I am grateful to the editors, Alberto Botta, Alexander

Guschanski, and Thereza Balliester Reis for helpful comments. All remaining
errors are mine.

Notes
1 The classification of an emerging market economy can be conceived of as a per-
formative act by international financial institutions, rating agencies, and investment
research firms. For example, to be included in the MSCI Emerging Markets Index a
country must exhibit a sufficient degree of financial openness and be home to listed
companies with a certain minimum size and liquidity. Most countries that fall into
this category are middle-​income countries.
2 ‘Procyclical’ means positively correlated with aggregate output.
3 There is a sizeable literature on discrete crisis events such as banking and currency
crises or sudden stops. The focus of this chapter is on events with a certain period-
icity, i.e. cycles.
4 For a review of canonical Kaleckian, Kaldorian, and Goodwinian cycle models, see
Semmler (1986). For a recent survey of Minskyan approaches, see Nikolaidi and
Stockhammer (2017). Notably, none of the reviewed business cycles models therein
is an open economy model.
5 That does not mean that models with fixed exchange rates have become irrelevant.
There is still a large number of developing countries with fixed exchange rates, espe-
cially small ones. Moreover, fixed exchange rate models are important to understand
cycles in historical periods during which fixed exchange rate regimes were in place.

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6 
Cost competitiveness and asset
prices as determinants of the
current account in emerging
economies
Alexander Guschanski and Engelbert Stockhammer1

Introduction
The closer integration of low-​and middle-​income countries into the inter-
national financial system coincided with the divergence of current account
balances, in particular since the mid-​1990s. This period is also associated with
a change in the nature of international transactions: by 2014 only a third of
(gross) financial flows in emerging market economies (EMEs) are related to
trade flows while the majority is based on investment in assets such as currency,
bonds or equities (Borio and Disyatat 2015). Although the Great Recession
contributed to a narrowing of global imbalances, there is no evidence of general
convergence.2 Particularly in EMEs and developing countries, current account
deficits are found to precede financial crises and sudden capital flow reversals
(Reinhart and Reinhart 2009).This makes an understanding of current account
determinants a high policy priority and suggests an increasing relevance of
financial factors.
However, the determinants of current account imbalances are still open to
debate. The contribution of this chapter is two-​fold. First, we offer a systematic
review of the post-​Keynesian literature on the determinants of current accounts.
Second, we provide a survey of the empirical literature on current account
determinants in EMEs, thereby assessing which of the channels highlighted
in the theoretical literature is supported by empirical evidence. We review
contributions with a wide range of research questions that include the current
account as part of an open-​economy framework. We are solely concerned with
the trade balance, thereby ignoring other parts of the current account such as
income receipts/​payments and official reserves.
We find that the existing theoretical post-​ Keynesian literature can be
classified into two main currents: The trade-​centred approach highlights the
role of wages in determining the trade balance. Wage increases lead to a real
exchange rate appreciation which reduces net exports. Furthermore, wage
increases lead to a more egalitarian income distribution which has repercussion
on domestic demand with ensuing changes in the trade balance. In contrast,
finance-​centred approaches focus on financial flows, driven by the return to
 Cost competitiveness and asset prices 71
assets and financial conditions abroad. A surge in financial inflows can lead to a
nominal exchange rate appreciation which is translated into a real appreciation.
Furthermore, financial inflows contribute to an increase in domestic demand.
Both factors will reduce net exports.
We find that the majority of the post-​Keynesian literature adopts the trade-​
centred approach.This applies to neo-​Kaleckian distribution and growth models
(Blecker 1989, 1999; Onaran et al. 2011; Stockhammer and Wildauer 2015),
balance-​of-​payment constrained growth models (Thirlwall 1979; Thirlwall and
Hussain 1982), as well as a large share of the Structuralist literature (La Marca
2010; Lima and Porcile 2013).The effect of financial flows features prominently
in models that apply Minsky’s (1978) Financial Instability Hypothesis to the
open economy context and particularly EMEs (Arestis and Glickman, 2002;
Gallardo et al., 2006; Botta, 2017; Kohler, 2019). However, these models place
no emphasis on the trade-​centred channels. Guschanski and Stockhammer
(2020) provide a synthetic treatment of current account determinants that
considers both the trade-​centred and finance-​centred channels. The empirical
literature supports both the trade-​and the finance-​centred approach. All eight
econometric analyses with a focus on EMEs reviewed in this chapter find an
effect of either wages or asset prices on the current account. Strikingly, none
of the articles control for both factors simultaneously. We therefore note that
future research needs to integrate both trade-​and financed-​centred channels in
theoretical and empirical models of the current account.
In contrast to post-​Keynesian approaches, the mainstream literature views
the current account as determined by imbalances between saving and invest-
ment which are the outcome of inter-​temporal maximisation decisions of
rational agents. These studies do not usually consider the impact of income
distribution or financial flows.3
The next section provides a review of the theoretical literature while
the third section surveys the empirical literature. The last section concludes,
revisiting our suggestions for future research.

The determinants of the current account in different

theoretical frameworks
In this section we first establish a general framework common to all post-​
Keynesian models of the trade balance. Thereafter, we discuss a wide range of
post-​Keynesian literature streams and assess whether they pertain to the trade-​
centred or finance-​centred approach.
All post-​Keynesian approaches to the trade balance build on a generic frame-
work that considers the real exchange rate, domestic income and the income of
trade partners as the key determinants of net exports. A common assumption
with respect to the real exchange rate is that a depreciation increases net exports,
i.e. the Marshall-​Lerner condition holds.4 A real depreciation can be brought
about either by a decrease in the domestic price level relative to the prices of
trade partners, or by a depreciation of the nominal exchange rate. An increase
72 Alexander Guschanski et al.
in domestic income, in turn, reduces net exports through an increase in the
demand for imports. An increase in the income of trade partners increases net
exports.
The trade-​centred approach focuses on the effects of wages and income
distribution on net exports. Financial flows do not play an independent role in
this literature –​they are solely the reflection of trade flows. Two main channels
are highlighted:

(1) wage-​real appreciation channel: Post-​Keynesian approaches emphasise the role

of wages in determining the domestic price level. An increase in nominal
wages will partly be passed through to the real exchange rate, the main
measure of international competitiveness. The ensuing appreciation of the
real exchange rate will decrease net exports.
(2) distribution-​demand channel: Post-​Keynesian models have highlighted the
impact of income distribution on aggregate demand. Hence, wages play
a dual role in this literature. Besides the first channel discussed above, an
increase in nominal wages can also impact functional income distribution
(the wage share) and subsequently domestic demand. If the impact of the
wage share on demand is positive (i.e. domestic demand is wage-​led), net
exports will decline.

The finance-​centred approach emphasises the role of financial flows. Again,

two major channels via which financial flows impact the current account are
discussed in the literature:

(3) inflow-​nominal appreciation channel: An increase in financial inflows, e.g. due

to increased demand for domestic assets, appreciates the nominal exchange
rate and subsequently the real exchange rate. This leads to losses in com-
petitiveness and a reduction in the trade balance. In contrast to the first
trade-​centred channel the reduction in competitiveness is initiated via a
nominal appreciation rather than inflation.
(4) inflow-​asset price channel: Financial inflows can increase domestic demand,
thereby increasing imports and contributing to a trade deficit. Three main
sub-​ channels are emphasised. First, financial inflows increase investment
through access to credit –​often denominated in foreign currency.This is par-
ticularly relevant for EMEs which are often credit constrained. Second, finan-
cial inflows tend to appreciate the nominal exchange rate. As firms in EMEs
often issue foreign currency denominated debt, an appreciation decreases the
debt burden and can stimulate investment (balance sheet effects). Third, an
increase in asset prices can increase consumption if people consume out of
their wealth (wealth effect). This channel is probably less relevant for EMEs
due to lower wealth to GDP ratios than in advanced economies.

Consequently, two different sets of variables emerge as potential determinants of

the trade balance: trade-​centred approaches emphasise wages as the determinant
 Cost competitiveness and asset prices 73
of competitiveness and aggregate demand, although other non-​ financial
determinants of aggregate demand (e.g. animal spirits) are also included in the
models. Finance-​centred approaches focus on the determinants of financial
flows such as the (expected) return on financial assets. In what follows we assess
how these features are integrated into the post-​Keynesian literature.

Trade-​centred approaches
Neo-​Kaleckian distribution and growth models
The neo-​Kaleckian literature focuses on the relation between economic growth
and functional income distribution, assessing the effect of a change in income
distribution on consumption, investment and net exports (Blecker 1989, 1999).
The impact of an increase in the wage share, or equivalently real unit labour
costs, if induced by an increase in nominal wages, has an unambiguous negative
effect on exports through loss of competitiveness. Additionally, if the economy
is wage-​led, an increase in the wage share increases aggregate demand, conse-
quently further reducing net exports. Some newer studies explicitly include the
effect of asset prices on consumption (and thereby imports) through a wealth
effect (Onaran et al. 2011). Stockhammer and Wildauer (2015) additionally
consider a negative effect of real estate prices on competitiveness. However,
asset price booms are not explicitly linked to financial inflows, and there is no
other effect of financial inflows on either aggregate demand or competitive-
ness. Hence, the trade balance is driven by wages and demand in this literature
according to the wage-​real appreciation channel and the distribution-​demand channel.

Balance-​of-​payments constrained growth models

Another strand of literature based on Thirlwall (1979) focuses on the balance-​
of-​payments constrained growth rate, i.e. the growth rate that is consistent with
a balanced trade position. This literature is particularly relevant from the per-
spective of emerging and developing economies, as these countries are often
credit constrained on international markets and thus face pressure to maintain
a balanced trade position. In the balance-​of-​payments constrained growth lit-
erature, exports and imports are functions of domestic and foreign income and
the real exchange rate. Yet, in the long-​run the real exchange rate is assumed
to be constant and hence does not impact the balanced growth rate –​the so-​
called strong version of Thirlwall’s law.While in the original model by Thirlwall
(1979) balanced growth is solely determined by the growth rate of exports and
the income elasticity of imports, the extension of the model (Thirlwall and
Hussain 1982) allows for financial flows. If net financial inflows are positive, the
country can sustain negative net exports without being bound by the balanced
growth rate. However, financial flows are captured by an exogenous parameter,
and no further effect of financial flows on domestic demand or the exchange
rate is considered. Thus, while this literature integrates the wage-​real appreciation
channel, it does not consider any of the other channels discussed above.
74 Alexander Guschanski et al.
Structuralist models
The interaction between income distribution and demand that features in the
neo-​Kaleckian literature has been integrated into Structuralist models of EMEs,
which however have a stronger focus on open economy issues. La Marca (2010)
analyses business cycles in small open economies. Households hold equities and
consume out of their wealth. However, equity prices and dividend payments
are determined by firms’ net profits and not impacted by financial inflows,
while nominal wages and the nominal exchange rate are exogenous. The real
exchange rate is impacted by changes in the domestic price level, which is
determined through mark-​up pricing on wages and imported intermediate
products. Lima and Porcile (2013) develop a model where the government,
capitalists and workers hold conflicting targets for the real exchange rate. The
government controls the nominal exchange rate, while firms set their mark-​
up given nominal wages set by workers. The model gives rise to cycles in the
real exchange rate and growth, with consequent cycles in the trade balance.
Though, financial flows do not play a role as the nominal exchange rate is set by
the monetary authority and there are no assets other than money in the model.
Summing up, the focus of the Structuralist literature lies on the interaction
between the real exchange rate, income distribution and economic growth
while effects of financial inflows are not taken into account.

Finance-​centred approaches
Minskyan literature
Literature which has prominently focused on financial flows describes the
causes and consequences of financial crises. Several contributions attempt to
explain the Latin American debt crisis of the 1980s as well as the Asian Crisis of
the 1990s. In contrast to mainstream approaches that often rely on exogenous
factors such as excessive fiscal expansion or foreign interest rate hikes, post-​
Keynesian scholars tend to model crises as the endogenous result from the
normal functioning of capitalism, in line with Minsky’s (1978) Financial
Instability Hypothesis.
Several contributions incorporate the effect of financial flows on aggregate
demand (inflow-​asset price channel). Taylor (1998) discusses how financial inflows
can trigger an expansion of credit denominated in foreign currency, thereby
exposing firms to exchange rate risk. This leads to an investment boom and a
current account deficit. The deterioration of the current account can induce a
capital flow reversal and subsequent financial crisis. Arestis and Glickman (2002)
argue that the credit boom leading up to the Asian Crisis was fuelled by specu-
lative financial inflows following capital account liberalisation. The loans were
largely taken up by real estate companies which entered a risky financial position
where their refinancing was dependent on asset price increases and continuous
credit expansion, often denominated in foreign currency. The succeeding
surge in investment and growth led to a current account deterioration. As
 Cost competitiveness and asset prices 75
international lenders’ perceived risk increased due to mounting foreign debt
and exchange rate exposure of firms, capital inflow stopped and firms that were
not able to refinance themselves went bankrupt. Recent literature (Bonizzi
and Kaltenbrunner, 2019; Kaltenbrunner and Painceira, 2015, also Chapter 1
in this volume) discusses how tighter integration of EMEs into global financial
markets increases the exposure to, and adverse effects of, financial inflows.
Structuralist models that have a Minskyan approach formalised many of
the channels discussed in Arestis and Glickman. Oreiro (2005) builds a post-​
Keynesian model inspired by the portfolio balance literature.5 Net exports are
modelled as a function of the real exchange rate and aggregate demand, while
capital flows are a function of the interest rate differential and exchange rate
expectations. An exchange rate shock, e.g. due to liberalisation of the capital
account, can induce a bubble in equity prices, based on portfolio reallocation
of traders from foreign to domestic assets. The increase in asset prices induces
a decline in the interest rate which stimulates aggregate demand. Increased
aggregate demand and an appreciated exchange rate reduce the current
account and deplete the country of foreign reserves until it is faced with a
currency crisis.
Gallardo et al. (2006), Botta (2017; also Chapter 12 in this volume) and
Kohler (2019; also Chapter 14 in this volume) additionally incorporate the
inflow-​nominal appreciation channel. Gallardo et al. (2006) present a Structuralist
model to analyse the Mexican peso crisis of 1994. Net exports are driven by
income and the real exchange rate, while financial flows are driven by asset
prices and the interest rate. An exchange rate appreciation and an increase
in asset prices triggers financial inflows, while net financial inflows can also
increase the real exchange rate and asset prices. Thereby the authors allow for a
feedback loop between asset prices and financial inflows on the one hand and
the exchange rate and financial inflows on the other hand. Besides a real appre-
ciation, financial inflows also lead to domestic credit expansion, thereby con-
tributing to output growth and a further decline in net exports. Botta (2017)
presents a model where a surge in foreign direct investment (FDI) into the
natural resource industry leads to an appreciation of the exchange rate which
induces further financial inflows in the form of short/​medium-​term bonds.
This increases aggregate demand due to the expansion of the natural resource
sector. The loss in competitiveness leads to a contraction of the manufacturing
sector and the country finds itself in an FDI-​induced Dutch Disease. Kohler
(2019) presents a Minskyan open-​economy model where firms borrow in for-
eign currency. An exchange rate appreciation stimulates investment through
balance sheet effects, which attracts pro-​cyclical capital flows leading to a fur-
ther appreciation.This is accompanied by a current account deficit which exerts
downward pressure on the exchange rate, leading to contractionary balance
sheet effects and a recession. The model can give rise to endogenous cycles. To
summarise, the focus of the Minskyan literature lies on the inflow-​nominal appre-
ciation channel and the inflow-​asset price channel. Even though the inclusion of the
real exchange rate implicitly allows for an impact of wages on competitiveness
76 Alexander Guschanski et al.
(wage-​real appreciation channel), with the exception of Oreiro (2005) wage effects
are not explicitly modelled in most papers.

A synthesis of trade-​and finance-​centred approaches

Guschanski and Stockhammer (2020) provide a model of the trade balance that
integrates trade-​centred and finance-​centred channels. Net exports respond to
changes in unit labour costs (wage-​real appreciation channel), the nominal exchange
rate and aggregate demand. Demand is impacted by unit labour costs via
income distribution (distribution-​demand channel) and by asset prices via wealth
and collateral effects. Asset prices respond to financial inflows which transmit
global financial cycles to national economies and the current account. A finan-
cial inflow shock drives up asset prices, increases aggregate demand (inflow-​asset
price channel), and appreciates the nominal exchange rate (inflow-​nominal appre-
ciation channel), which passes through to the real exchange rate. Both processes
reduce the trade balance.Thus, the model takes all four finance-​as well as trade-​
centred channels into account. However, it is geared towards advanced econ-
omies and thus omits aspects that may be more relevant for EMEs, like balance
sheet effects of an exchange rate adjustment (e.g. Kohler, 2019).

Empirical evidence
This section discusses empirical evidence for the four channels identified in
the previous section. Most studies focus on the determinants of the current
account rather than the trade balance. However, all regression analyses include
net foreign assets as an explanatory variable, which should account for a large
share of the current account that is not related to the trade balance. Additionally,
a set of variables derived from the mainstream saving-​investment imbalances
approach are included in most studies but are not discussed in detail below.This
comprises the government budget, the old-​age dependency ratio, GDP relative
to the United States and the quality of (financial) institutions.

Empirical evidence for trade-​centred channels

There is robust evidence for an effect of competitiveness on the current account
(wage-​real appreciation channel). Tsangarides et al. (2008) assess the effect of an
exchange rate depreciation on the trade balance using a sample of 46 EMEs
for the 1980–​2005 period. They find that exports increase following a decline
in export prices relative to unit labour costs of trading partners. However,
the effect is statistically significant only for countries whose main exports are
manufacturing goods. Additionally, export prices also increase following an
increase in inflation. Leigh et al. (2015) conduct country-​level estimations for
60 countries, of which 37 are EMEs, for the 1980–​2014 period. They find that
a 10 per cent depreciation in the real exchange rate will, on average, induce
an increase of net exports by 1.5 per cent of GDP. The International Institute
 Cost competitiveness and asset prices 77
for Labour Studies (IILS, 2011) use a sample of 59 advanced and emerging
economies for the 1980–​2008 period and obtain a negative impact of the wage
share on the current account. As GDP per capita is controlled for in their ana-
lysis, the effect is likely due to a reduction in competitiveness.There is a sizeable
literature on the effect of structural policies on the current account and a small
set of these studies include measures linked to competitiveness. Jaumotte and
Sodsriwiboon (2010) analyse the determinants of current account imbalances
using a sample of 49 advanced and emerging economies for the period 1973–​
2008. The authors control for the minimum wage to mean wage ratio and
find a negative effect on the current account. The negative effect of minimum
wages on the current account is also confirmed by Ivanova (2012) who uses
a larger sample of 106 advanced and emerging economies for the 1975–​2009
period.
While the previous articles provided evidence for the wage-​real appreciation
channel, additional support for the distribution-​demand channel is presented by
Onaran and Galanis (2014) who estimate demand regimes in line with neo-​
Kaleckian models for the G20 (including seven emerging economies) between
1970 and 2007. Accounting for an effect of unit labour costs on export prices
and of the wage share on demand they find that an increase in the wage
share reduces the trade balance in all countries. Alarco (2016) provides fur-
ther evidence for the effect of functional income distribution on demand and
net exports. Similar to Onaran and Galanis he estimates demand regimes in
16 Latin American countries for the 1950–​2012 period. However, he does
not report separate results for the trade balance. Variables that control for the
finance-​centred channels are not included in any of the articles discussed so far.

Empirical evidence for finance-​centred channels

Literature focusing on the impact of financial flows on current accounts in
EMEs is scarce.6 Bems et al. (2016) find that the exchange rate in EMEs is
determined by financial flows, while Tsangarides et al. (2008) provide evidence
for an improvement of the trade balance following a nominal exchange rate
depreciation (although the result is stronger for countries whose main export
products are oil or non-​oil commodities rather than manufacturing products).
Tsangarides et al. further find that the improvement of the trade balance after
a nominal depreciation is mainly the result of a decline in imports, partly due
to negative effects of depreciation on domestic absorption, which they link
to balance sheet effects. Ghosh and Qureshi (2016) analyse the effects of cap-
ital inflow surges using a sample of 53 EMEs over the 1980–​2013 period.
They find that net portfolio investment (rather than FDI) is associated with
a surge in aggregate demand, an exchange rate appreciation, credit expansion
(denominated in domestic as well as foreign currency) and increasing bank
leverage. While the trade balance is not the focus of their analysis, external
deficits are discussed as a likely consequence of the increase in aggregate
demand due to financial inflows.7
78 Alexander Guschanski et al.
There are three studies that include asset prices in regressions on the current
account. Interestingly, these variables are usually interpreted as a measure of
financial development in line with the saving-​glut hypothesis which is inspired
by the saving-​investment imbalances approach, rather than a control variable
for the finance-​centred channels. Gruber and Kamin (2009) conduct a panel
analysis using data for 84 advanced and emerging economies between 1982 and
2006. They find a statistically significant negative effect of the growth in stock
market capitalisation on the current account while bond market capitalisation
has a positive impact in line with the financial channels, as higher bond prices
are associated with lower returns. However, these variables do not perform
well in explaining the current account surpluses of emerging Asia which are
absorbed by dummy variables. Additionally, the descriptive statistics show that
surplus countries, on average, experienced higher stock market and lower bond
market capitalisation than deficit countries in the 2002–​2006 period. Cheung
et al. (2013) use a panel of 30 OECD and 64 emerging and developing coun-
tries for the 1994–​2008 period. In their analysis stock market capitalisation is
reported to exercise a negative effect but results are not shown.Without further
investigation they suggest that this is likely due to a wealth effect and therefore
most relevant for advanced economies. Chinn et al. (2014) use a large sample of
23 advanced and 86 emerging and developing economies covering the 1970–​
2008 period. They find that current account imbalances prior to the Great
Recession cannot be explained by variables derived from the saving-​investment
imbalances approach. Rather they are driven by returns on financial investment
measured by property price and stock price indices.The authors deem a wealth
effect to be the most likely mechanism.
Guschanski and Stockhammer (2020) use a reduced form of their model
to estimate current account imbalances in 28 OECD countries, including
several European EMEs, from 1971 to 2014. They find that once financial
variables are controlled for, (nominal) unit labour costs do not impact the
current account. These results suggest that finance-​ centred channels are
more relevant than trade-​centred channels in determining current account
positions in the OECD. According to their estimations, if property prices in a
country grew by 10 per cent between two periods, while the average growth
rate in the OECD was 0 per cent, the current account to GDP ratio in that
country would have declined by 1 percentage point.Table 6.1 summarises the
empirical literature.

Conclusion
This chapter reviewed a rich post-​Keynesian literature addressing EMEs, from
which we have extracted four main channels that are relevant for the determin-
ation of trade balances: (1) the wage-​real appreciation channel; (2) the distribution-​
demand channel; (3) the inflow-​nominal appreciation channel; (4) the inflow-​asset price
channel. We classify contributions that focus on channels (1) and (2) as trade-​
centred and those focusing on channels (3) and (4) as finance-​centred.
 Cost competitiveness and asset prices 79
Table 6.1 Empirical literature on the current account

Author Sample Dependent Covariates

variable

Tsangarides et al. 1980–​2005 NX ULCrel (+), CPI(-​),

2008 46 EMEs e_​nom(-​), growth(-​),
FGDP(+)
Jaumotte and 1973–​2008 CA min_​wage(-​), growth(0),
Sodsriwiboon 49 AE & EMEs OIL(+), FINS, LMI, SI
2010
IILS 2011 1980–​2008 CA WS(-​), GDP p.c.(0),
59 AE & EMEs CBRES(+), INEQ(-​),
FINS, SI
Ivanova 2012 1975–​2009 CA min_​wage(-​), growth(0),
106 AE & EMEs OPEN(0), OIL(+), tax(+),
FINS, LMI, SI
Leigh et al. 2015 1980–​2014 NX e_​real(-​), ULC, FGDP, GDP
37 EMEs
Gruber and Kamin 1982–​2006 CA ∆SP(-​), BP(+), GDP p.c.(+),
2009 84 AE & EMEs growth(0), OIL(+),
OPEN(0), FINS, SI
Cheung et al. 2013 1994–​2008 CA SP(-​), LEGAL(-​),
30 AE, 64 EMEs CREDIT(-​), OIL(+),
growth(0), SI
Chinn et al. 2014 1970–​2008 CA PP(-​), SP(-​), BP(-​),
23 AE, 86 EMEs CREDIT(-​), LEGAL(0),
growth(0), OPEN(0),
OIL(+), ir(-​), FINS, SI
Guschanski and 1971–​2014 CA PP(-​), SP(-​), ULC(0), i(+),
Stockhammer 28 OECD FGDP(+), CREDIT(-​), SI
(2020)

Notes: AE = advanced economies; BP = bond market capitalisation; CA = current account;

CBRES = central bank reserves; CPI = consumer price index; e_​nom/​real = nominal/​real exchange
rate, (-​) means that appreciation reduces NX; FGDP = GDP of trade partners; FINS = financial
institutions (e.g. financial openness index, etc.); growth = GDP growth; INEQ = personal income
distribution; ir = real interest rate; LEGAL = institutional quality; LMI = labour market indicators;
min_​wage = minimum wage; NX = trade balance; OIL = oil price, oil trade balance or dummy
for oil-​producing countries; OPEN = exports plus imports/​GDP; PP = property price index;
SI = variables emphasised by the saving-​investment imbalances approach as described in the text;
(Δ)SP = (change in) stock market capitalisation; tax = corporate income tax rate; ULC = unit
labour costs; ULCrel = export prices relative to unit labour costs of competitors.
(-​), (+), (0) stands for statistically significant and negative, statistically significant and positive, and
statistically insignificant, respectively.

Our analysis shows that the trade-​centred channels are thoroughly captured
in the neo-​Kaleckian literature, Structuralist models and partly in balance-​of-​
payments constrained growth models. Nonetheless, the majority of the litera-
ture in this tradition does not consider finance-​centred channels. Asset prices are
usually not modelled, and if they are, they are determined exogenously without
taking the impact of financial flows into account. Minsky-​inspired models
80 Alexander Guschanski et al.
Table 6.2 Determinants of the current account in the post-​Keynesian literature

Trade-​centred Finance-​centred

(1) wage-​real (2) distribution-​ (3) inflow-​nominal (4) inflow-​asset

appreciation demand channel appreciation channel price channel
channel

Neo-​Kaleckian ✓ ✓
Balance-o​ f-p​ ayment ✓a
constrained
growth
Structuralist ✓ ✓
Minskyan ✓ ✓

a The strict version of Thirlwall’s Law does not consider an effect of the exchange rate on the
trade balance in the long run.

provide the most comprehensive treatment of the effect of financial flows on

the current account, integrating one or both of the finance-​centred channels.
The majority of the Minskyan literature also includes the real exchange rate,
thereby allowing for an effect of wages on the current account. Albeit, with the
exception of Oreiro (2005), wages are not modelled explicitly so that trade-​
centred channels are not emphasised. Table 6.2 indicates which channels are
covered by different literature streams.
The dichotomy of a trade-​and finance-​centred focus which characterises
theoretical contributions is also reflected in empirical analyses: none of the
eight econometric studies that use a sample including many EMEs to ana-
lyse current account determinants controls for both trade-​as well as finance-​
centred channels simultaneously. This is in stark contrast to the reported
findings as all studies obtain an effect of either wages or asset prices on the
current account. Unless GDP and the real exchange rate are controlled for
in the analysis, omitting wages or asset prices excludes potentially important
determinants. Of the reviewed studies all include GDP (growth), thereby indir-
ectly capturing potential expansionary effects of asset price bubbles or distribu-
tional effects of wage increases (channels 2 and 4). But, only Leigh et al. (2015)
and Tsangarides et al. (2008) additionally control for the exchange rate thereby
covering channels (1) and (3). Thus, other studies potentially suffer from an
omitted variable bias. Furthermore, assessment of the relative size effect of both
sets of variables would require including wages and asset prices simultaneously.
Given the empirical evidence for all four channels future theoretical and
empirical work on the current account should consider both trade-​and
financed-​centred channels.This is especially relevant in the case of EMEs whose
export performance depends on price competitiveness while these countries
are also subject to sudden and drastic changes in the direction of capital flows.
Guschanski and Stockhammer (2020) provide a theoretical and empirical ana-
lysis for advanced economies that integrates all four channels and find that
 Cost competitiveness and asset prices 81
financial variables are the main determinants of current account imbalances
for a sample of 28 OECD countries. Thus, an extension of their theoretical
and empirical framework, controlling for specific characteristics of emerging
economies, such as balance sheet effects due to exchange rate changes, seems
desirable.

Notes
1 The second and third sections of this chapter build on Guschanski and Stockhammer
(2020) which, however, has a focus on advanced economies.
2 The absolute sum of surpluses and deficits in EMEs was less than 0.5 per cent of
world GDP in 1995, around 1.5 per cent at their peak in 2008, and around 1.2 per
cent in 2014 (Borio and Disyatat, 2015).
3 An exception is Kumhof et al. (2012) whose DSGE model includes a negative effect
of income inequality on the trade balance. In the two-​country DSGE model by
Fratzscher and Straub (2010) news shocks can impact equity prices with subsequent
changes in the trade balance. However, news shocks are anticipated technology
shocks and not liked to financial flows.
4 However, the Marshall-​Lerner condition has often been rejected in empirical studies
and shown to hold only under restrictive assumptions in theoretical analyses (Godley
and Lavoie, 2007, ­chapter 12; Kohler, 2019).
5 This approach considers different asset types whose demand depends on the respective
rate of return, while also allowing for shocks to the demand for a specific asset.There
are also several Stock-​Flow Consistent (SFC) models in this tradition. However, asset
prices and returns are exogenous in the majority of the SFC literature (Belabed et al.,
2018; Duwicquet and Mazier, 2010). An exception is Lavoie and Daigle (2011), who
model speculative behaviour on foreign exchange markets.
6 There is more evidence for the effect of asset prices on the current account in advanced
economies (Guschanski and Stockhammer, 2020; Fratzscher and Straub, 2010).
7 Additionally, they find that exchange rate overvaluation and credit expansion
increases the probability of financial crises in EMEs.

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7 
Space in Post Keynesian monetary
economics
An exploration of the literature
Gary Dymski and Annina Kaltenbrunner

1 Introduction
This book’s focus on what the Post Keynesian tradition in economics has to
say about emerging economies’ financial integration throws a basic theoret-
ical question into sharp relief. Post Keynesians have generated innumerable
models of monetary processes and financial crises, primarily in closed-​economy
settings. These frameworks almost invariably describe single representative
economies, even in the few analyses that describe core-​periphery areas inside
nation-​states. But analyses of emerging economies’ financial integration require
a conceptual framework encompassing distinct geographic entities, with one or
more of these entities hosting the firms or markets into which the other entities
are being integrated. That is, the two sides of this process of integration possess
different levers of market power and occupy different spaces; and the flows of
capital embodying this integration cross the borders between these spaces. To
analyse financial integration on more than a conjunctural basis, then, requires
a theoretical framework encompassing space, power, and borders. These are
underdeveloped categories in the Post Keynesian monetary framework. How
then can both the emerging economies and the global areas with which
they are integrating financially be represented analytically in Post Keynesian
Economics?
This chapter explores the possibility that taking space and the related spa-
tial borders more seriously can fundamentally enrich Post Keynesian analyses
of emerging markets’ financial integration, and international monetary and
financial dynamics more generally. It is hypothesized that for analyses in which
heterogeneous agents engage in financial relations across geographic borders,
space may be as important as uncertainty for Post Keynesian theory. If it is,
then uneven development across space, at regional, national, and global scales,
will be a foundational insight of the Post Keynesian approach. We suggest
some criteria for what might comprise a definition of spatial –​as opposed to
aspatial –​analysis, and then explore relevant work to see whether these criteria
are relevant and whether they are met. The intention is not to add to wide-
spread confusion about the nature of Post Keynesian economics, but to explore
the possible importance of space and spatiality in one of the strands of Post
 Space in Post Keynesian monetary economics 85
Keynesianism identified by Hamouda and Harcourt (1988) –​the monetary
approach, which emphasizes the consequences of real time and uncertainty
for economic decision-​making and outcomes. To do so, this chapter reviews
the treatment of space in some of the leading contributions to Post Keynesian
monetary economics.1
What difference does space make in understanding monetary and financial
dynamics? Clearly, financial processes and crises unfold in space –​either within
or across the spatial boundaries of cities, regions, and nations –​as much as they
unfold in real time. Post Keynesians have generated important insights about
the non-​neutrality of money by using the lens of temporal uncertainty. Their
explorations of the role of space –​both in the ‘open​’ and ‘closed’ e​ conomy,
suggest that the spatial dimension may rival that of time in financial outcomes
and economic dynamics more generally. Our objective is to use this tour
through the literature to assemble the analytical building blocks needed for a
spatially sensitive approach to Post Keynesian monetary and financial theory.
We argue that taking space more seriously in the analysis of financial integra-
tion can analytically delineate more clearly both the additional dimensions of
the inherent instabilities financial integration nurtures, and the specific power
relations underpinning it.
The next section begins with a brief review of the importance of real time
and uncertainty in Post Keynesian approaches to money and finance, presenting
some key insights from the work of Sheila Dow and from Paul Davidson, both
in the closed and the open economy. Section 3 then argues that just as the
real time/​uncertainty distinction provides a foundation for a distinctly Post
Keynesian monetary approach, a parallel distinction can be used to anchor a
distinctly Post Keynesian analysis of the role of place in economic dynamics.
Specifically, we define two independent dimensions of place –​whether they
pertain to ‘open’ or ‘closed’ economies, and whether they are ‘spatial’ or ‘aspatial’.
Using this 2 × 2 framework makes it possible to see the key resemblances
between Post Keynesian analyses that take place seriously, whether they discuss
national, regional, or even intra-​urban economic dynamics. The idea of a ‘spa-
tial’ analysis vis-​à-​vis the place of any analysis is analogous to that of uncertainty
vis-​à-​vis time. It is one thing to recognize that place exists –​as, say, in Davidson’s
writing on the open economy -​but another to acknowledge that differences
of agents’ location in space are of fundamental analytical importance, and their
implications should be as fully explored as those of real time, unequal agent
wealth endowments, and so on.
While the spatial/​aspatial distinction is novel to this chapter, the importance
of space (as characterized here) for economic units’ decision-​making and for
economic dynamics is clear (if implicit) in many Keynesian analyses of both
‘closed’ and ‘open’ economies. Section 4 reviews three spatial Keynesian closed-​
economy analyses; these pay special attention to centre-​periphery dynamics
related to regional location and/​or to social factors, especially stratification.
Section 5 then focuses on Keynesian open-​economy frameworks in which the
impact of national borders does not reduce to differences in transaction cost
86 Gary Dymski and Annina Kaltenbrunner
or in the number of contracts needed to sterilize exchange-​rate risk. Section
6 briefly summarizes and draws out some implications of our analysis for the
treatment of place in financial geography.
Note that this chapter, and especially Sections 4 and 5, is selective in its
coverage of the relevant literature. There are many more Post Keynesian ana-
lyses in which space matters. In virtually all of these, the analytical importance
of place is not typically fully recognised because of the lack of analytical cat-
egories for place. It is hoped that the terminology introduced here may lead to
a more profound understanding of how place –​and especially space –​matter in
socio-​economic dynamics.

2 Open-​economy, aspatial Keynesian approaches

Two analytical features that define Keynes’ own approach to macroeconomics
are his rejection (Keynes 1936, chs 2–​3) of Say’s law –​that is, his insistence
that aggregate demand is independent of aggregate supply –​and the impact of
fundamental uncertainty on decisions about investment and liquidity (Keynes
1936, Chapter 12; Keynes 1937).2
What does this mean for a Keynesian approach to money and finance?
Sheila Dow (2012) argues that the methodology of finance depends on ‘the
way in which the real process of finance is understood’ (p. 218). In the case
of Post Keynesian economics, Dow argues that financial institutions and
practices are understood as having evolved to deal with an uncertain future
that ‘cannot be captured in probabilistic measures. There is therefore no true
price based on a true measure of risk … [and] markets are understood to be
unstable’ (p. 221).
Paul Davidson’s Money and the Real World ‘[s]‌tart[s] from Keynes’s funda-
mental axioms that in the real world (1) the future is uncertain (in the sense
that Knight and Keynes used the term), (2) production takes time and hence if
production is to occur in a specialisation, monetary economy, someone must
undertake contractual commitments involving performance and payment in
the future, and (3) economic decisions are made in the light of an unalterable
past while moving towards a perfidious future’ (1978, page xii).
In his International Money and the Real World (1982), Davidson extends this
analysis to the case of monetary transactions (for goods and services or for
financial assets) that cross national borders. A nation has a unionized monetary
system (UMS) when all of its transactions are in the same currency; it is a non-​
monetary union system (NUMS) when its contracts involve currencies whose
value relative to the home currency can vary over time. This introduces, of
course, another source of uncertainty. Which money is in use where depends
on ‘law and custom’ (Davidson 1982, p. 104). Because imbalances in trade
or financial flows can arise, the need for reserves arises: maintaining suffi-
cient liquidity –​for precautionary purposes, per Keynes –​now means holding
both domestic and foreign currency. Davidson presents this largely as a control
problem:
 Space in Post Keynesian monetary economics 87
Consequently, just as expansion of the money supply is a necessary pre-
requisite for expanding economic activity in a closed UMS, so the expan-
sion of international running and reserve asset supplies is a necessary
precondition for the orderly continuous growth of international eco-
nomic activity. In the days of the automatic gold standard, … there was
a tendency towards ‘congestion’ in international financial markets which
constrained the growth of trade; and this limitation was in addition to the
separate question of how individual nations could finance their ensuing
trade deficits when international activity did not expand at an equal pace
in each nation.
(Davidson 1982, p. 108)

In his chapter on Euromoney, Davidson highlights another implication of the

open economy. He argues that financial assets such as equities and bonds are
valued as ‘liquidity time machines’ in part because of the availability of active,
deep resale markets. He writes (ibid., p. 217):

As long as there is no international money generally available to all domestic

and foreign residents, and generally accepted by all for the legal discharge
of contractual obligations, then, if there is to be organized trade between
residents of different nations in a NUMS, there must be an organized,
orderly spot market for foreign exchange.

The key is to have liquid resale markets, ‘which are well organized with institu-
tional market ‘makers’ operating under explicit rules for trading.’ (ibid., p. 218, italics
in the original). Davidson argued against the Tobin tax (Davidson 1997) on
the basis that it would make markets less liquid and would reduce the volume
of global trade. Davidson warns against fully flexible exchange rates on the
basis that they heighten uncertainty (ibid., p. 261); given the infeasibility of a
unionized monetary system, he argues instead for an International Monetary
Clearing Unit, held only by central banks and fixed in value against every cur-
rency (Davidson, 1992–​93).
In Davidson’s view, then, the open economy setting amplifies the importance
of ‘uncertainty: the fact that finance crosses borders only adds another possible
layer of real time’ to the analytical problem; the fact that these operations also
take place in different places is not explicitly unacknowledged. This approach,
following Davidson’s seminal contributions, is replicated in other Post Keynesian
work on the open economy. For example, John Harvey’s pioneering Keynesian
models of exchange rate dynamics (1991, 2013), which focus on the nuances
of time and uncertainty in the process of exchange rate determination, remain
silent on the importance of space and place in shaping these dynamics.
Minsky’s original work on financial instability (for example, Minsky 1986)
invariably maintains an analytical focus on ‘the capitalist economy’ or ‘the
financial system’ as a unified analytical subject, and thus ignores place; even
his exploratory paper on ‘money-​market capitalism’ (Minsky 1996) does not
88 Gary Dymski and Annina Kaltenbrunner
delve into how the spread of this system across much of the globe –​that is, its
incorporation into different places –​might matter. The one exception to this
approach came in Minsky’s co-​authored proposal for ‘the creation of banks in
communities lacking such institutions’ (Minsky et al., 1993), which does con-
sider specific differences (in the scale and bankability of businesses, for example)
between underserved and other communities. It should be noted, however, that
the implications of having two kinds of communities within the economy is
not carried over into any of his writings on financial instability or on the finan-
cial system per se.
In sum, these authors’ work shows that real time and uncertainty are sufficient
to ground a distinctive Post Keynesian approach to money and finance: space is
only implicit and plays no important analytical role. The next section discusses
how such an approach could be extended to incorporate an explicit spatial
angle, and considers the contributions this would make to Post Keynesian ana-
lyses of money and finance –​in both the closed and the open economy.

3 The building blocks of a ‘real space’ approach to Post

Keynesian theory
The Keynesian approach to time contrasts with the efficient-​market notion
that processes with stochastic outcomes are repetitive. This enables the use of
probability theory to generate risk-​return parameters, thus reducing decisions
about such processes to certainty-​equivalence. So whereas time is ‘real’ in Post
Keynesian theory, and a source of disruption, time in efficient-​market worlds
reduces the impact of short-​term volatility.
The contrast between efficient-​market, and Post Keynesian understandings
of how the passage of time affects economic processes, provides a guide to
thinking about space. Just as the passage of time associated with economic
events or processes sometimes matters so profoundly as to affect how decisions
are made, the fact that economic events or processes take place in different
places can present special challenges that market prices cannot fully discount.
The analysis of events that unfold in two or more places can be ‘spatial’ (‘ter-
ritorial’) or ‘aspatial.’ It is not just a question of noticing where events occur
(as in the aspatial Post Keynesian approaches discussed above), but of analysing
explicitly whether and how the separation between two points in space has
consequences that matter in agents’ trajectories –​or in their calculations. If so,
can analyses of spatially separated events and processes consider this place-​based
impact? Note that the distinction being drawn here is independent of whether
an ‘open’ or ‘closed’ economy framework is used. Indeed, spatial differentiation
can be as far removed as Brazil and the United States and as close together as
house numbers on a road, just as real-​time considerations can play out in a few
seconds or in the consideration of a long-​term, high-​r isk capital investment pro-
ject. And just as the length of time to maturity matters for investment project
risk, separation in space between the investor mobilizing finance and the invest-
ment project itself matters too, especially in the case of cross-​border capital flows.
 Space in Post Keynesian monetary economics 89
We set out three ways in which we think spatiality can be consequential in
economic outcomes so as to clarify our argument.
First, at any point in time, location in space affects market possibilities (e.g.
liquidity, access to finance, access to information etc.) and hence relations of
power between spaces.This applies as much to the different opportunities avail-
able to inner-​city dwellers and suburban residents of a US city, as it does to
centre-​periphery divergences within a country or across a global system. Space
is not just physical, but relational, social, networked, and structured (Barnes
and Christophers, 2018). The idea of structure differs from that of culture or
of norm. Structure refers to the social forces that operate on an agent or set of
agents and that are outside their control. It is not a matter of will, and cannot
be negated through behavioural adaptations by individual agents or localized
groups of agents. That is, bringing in spatially defined structures of control and
submission necessarily introduces power into the analytical framework. This
power refers to both: (a) the ability of one space to exercise influence and/​or
control (either directly or indirectly) over another space; and (b), as a conse-
quence, one space profiting disproportionately from processes of monetary and
financial integration. The latter highlights how core-​periphery relations and
processes of uneven development both shape and are shaped by monetary
and financial processes.
Second, the processes to which one is exposed also are locationally dependent.
This is a through-​time aspect of spatiality. These processes unfold in real time,
but are not reducible to time –​they can neither be ascribed to probabilistic risk
nor can they be adequately described as the effects of uncertainty per se. In par-
ticular, decisions about asset location can be irreversible –​and thus the future
return of such an asset is likely to depend on spillover effects from elsewhere
in that decided-​upon space. Uncertainty contains the terrors of the future in
part because it forces us to confront the spatiality of structure. Whereas the
flows between different spaces become increasingly fluid, the assets and liabil-
ities involved in these flows remain firmly embedded in specific locations and
spaces with defined institutional, regulatory, and social conditions. This points
immediately to another source of risk in monetary and financial relations once
we take space seriously. Whereas the uncertainty approach emphasizes the risks
emanating from the passage of time and the dynamic mismatch of assets and
liabilities across time, the same risks emerge from assets and liabilities embedded
into different spaces. From this perspective, an asset’s liquidity –​whether it can
be converted into money quickly and at no loss, in the medium of contractual
settlement, but also whether the cash flow generated by an asset embedded in a
specific space – can meet contractual obligations set out by financiers who are
able to shift their commitments from one space to another.
Finally, there is the question of distance mentioned above: the farther apart are
two economic agents, the less able they are to negotiate private arrangements –​
the more that power relations (differential access to resources, or to technolo-
gies, or information) will interfere in the transmission, pre-​determining its
outcomes. Structure matters –​the depth, technology, and speed of markets;
90 Gary Dymski and Annina Kaltenbrunner
the instruments that are available; the degree of competition. These are meso
factors –​they stand between the individual transaction (micro) and the aggre-
gate level (macro). They are as fundamental to a comprehensive picture of eco-
nomic dynamics as is real time.
These ideas about spatiality and its possible impacts have only appeared impli-
citly, as noted, in the work of most Post Keynesian economists. Incorporating
space more explicitly in Post Keynesian analyses of money and finance would
give more prominence to the relations of power underlying them and allow a
more precise spatial delineation of the risks and instabilities inherent in monetary
and financial relations. The next section discusses some of the contributions in
Post Keynesian Economics which have already made first steps in developing
such ‘spatial’ Keynesian approaches to money and finance.

4 Closed-​economy spatial Keynesian approaches

The spatial application of Keynes’s work to regional differences within a national
area has been pioneered by Sheila Dow and Victoria Chick, and continued
in joint work with Carlos Rodriguez-​Fuentes. Based on the Post Keynesian
notion of a monetary production economy, the authors argue that money and
finance have a fundamental impact on core-​periphery relations and uneven
regional development through the structure and behaviour (liquidity prefer-
ence) of the national banking system.
In her early work Dow (1987) discusses explicitly the ways the domestic
banking system can exacerbate regional ​core – periphery structures in the con-
text of the regional independence of the demand and supply for money. The
underlying mechanism is a change in liquidity preference on the part of both
those supplying credit and those demanding it. Liquidity preference, in turn,
derives primarily from the speculative demand for money, and in particular
from expectations of asset price changes. An increase in liquidity preference
due to an expectation of falling asset prices has a dual impact. It reduces banks’
willingness to lend, and thus available credit for highly geared asset purchases
and working capital. At the same time, credit demand for investment also falls.
Both shifts further exacerbate the downturn.
Whether changes in liquidity preference are transmitted along core-​
periphery lines, in turn, depends on the structure of the domestic banking
system. In a segmented banking system, where regional financial institutions
serve the local economy, higher liquidity preference leads to higher demand for
national –​rather than regional –​assets, which reduces the lending capacity of
regional banks. Regional banks’ ability to borrow from the national market is
limited by their capitalization, which aligns their lending capacity more closely
with regional savings. In a nationally integrated, branch-​based system, on the
other hand, with few actual barriers to inter-​bank lending, it is predomin-
antly the behaviour/​liquidity preference of core banks –​vis-​à-​vis the proper-
ties of regional assets –​which interacts with core-​periphery structures. In this
case, national banks’ assessments of lenders’ creditworthiness become the main
 Space in Post Keynesian monetary economics 91
determinant of credit. Information asymmetries, which rise with the distance
from the lender to the borrower, affect this assessment and lower credit avail-
ability for the periphery.3
Thus, Dow pays explicit attention to the differences in market possibilities
their differentiated spatial situation attributes to regions, both through access
to funding (in more segmented banking system) and latterly access to infor-
mation (in more integrated ones). These different possibilities are both shaped
by core-​periphery structures and exacerbate them. Moreover, actual spatial
distance matters for these market possibilities. The immediate power relations
spatially differentiated financial structures create, however, are less explicit in
her work.
Building on Victoria Chick’s work on the stages of banking (Chick 1986),
Chick and Dow use an explicitly temporal and evolutionary approach to
explore the impact of domestic banking structure on uneven regional devel-
opment. Their 1988 paper (Chick and Dow 1988) argues that the transmission
mechanisms connecting monetary and financial factors with regional devel-
opment change as the domestic banking system develops. In the first stages of
banking development, with complete separation between regional banks –​as
in Dow’s segmented banking system, discussed above –​the reserve constraint
is relatively binding for regional banks. With the development of interbank
markets, branch-​banking, and ultimately of the central bank as lender of last
resort, this constraint almost disappears; the central bank accommodates the
reserve needs of peripheral banks (Chick and Dow 1988).4
The authors observe that this further development of the banking system will
lead to a centralization of financial operations in the centre, where old wealth
resides, and to more marked swings in liquidity preference on the periphery: an
increased demand for central financial assets in times of rising liquidity pref-
erence and, in turn, to more marked demand for more ‘high-​r isk’ assets in the
periphery when liquidity preference falls:

The importance of the speculative-​demand mechanism does not vary with

the stages of banking development; it is the relative power of borrowers
and lenders in the Centre and Periphery and the structure of real and
financial assets which vary with the stage of banking. But it is easier for
shared expectations to have their full effect in a higher Stage of banking
development, and the expectational factors are also working with an ever
increasing capacity of the banking system to affect the aggregate amount of
credit available. The more powerful credit multiplier in turn supports and
intensifies the Keynesian income multiplier. Thus disparities in regional
investment, income and employment are likely to be more marked over
booms and slumps in the later stages of banking development.
(ibid., pp. 17–​18)

These tendencies are exacerbated by a tendentially higher liquidity preference

in the periphery, due to a lower level and high fluctuation in income and wealth
92 Gary Dymski and Annina Kaltenbrunner
and less assured access to credit. This means any instability can cause cash flow
problems and difficulties in servicing debt, resulting in reluctance to take on
debt and commit to capital investments, and to a tendency to allocate wealth to
assets issued in the financial centre as the most liquid available.
Dow’s and Chick’s narrative about the historical trajectory of banking devel-
opment has affinities with cumulative causation and dependency theory: existing
financial constraints exacerbate income fluctuations, which themselves cement
existing financial constraints and sensitivity to changes in liquidity preference,
both in centre and periphery. This in turn leads to strong policy conclusions
at odds with the efficiency-​based spatial financial centralization advocated by
neoclassical economists: the authors argue for a segmented banking system
which can allow regional banks to exploit their knowledge advantage with
regional customers and which will sever regional linkages to cycles of national/​
international liquidity preference.
The need for regional segmentation in banking structures, so that local
banks can better meet local needs, has remained the focus of more recent
Post Keynesian research on the interaction between money and finance
and (uneven) regional development (Rodriguez-​ Fuentes, 1996; Dow and
Rodriguez-​Fuentes, 1999; Chick, Dow, and Rodriguez-​Fuentes, 2013; Dow,
2016). Supposed efficiency gains from spatial concentration and economies of
scale are juxtaposed with local banks’ spatial proximity to their local customers.
Under the right circumstances, this proximity translates into superior know-
ledge, permitting local banks to mitigate negative effects of fundamental uncer-
tainty in financial markets. Moreover, local banks are less susceptible to swings
in international liquidity preference in providing credit for embedded and pos-
sibly vulnerable households and small/​medium enterprises (SMEs). Whereas
large multinational enterprises have ready access to global financial markets,
smaller companies –​themselves crucial for local development and employ-
ment –​are more dependent on local financial agents.
This research suggests that continued support for local/​regional financial
institutions and credit provision has become increasingly important in recent
years, due to the globalization-​fuelled centralization of financial activities, to
changes in bank practices such as credit scoring, and to the rise of shadow
banking. The alternative providers of finance, including the megabanks, whose
activities have been facilitated by these shifts, represent dangerous competition
for regional banks, in part because their deposit base is more sensitive –​espe-
cially in the post-​financial crisis period –​to domestic economic conditions,
such as interest-​rate and regulatory policy shifts (Dow 2016).
Some of the core ideas advanced in this literature have received support
in applied studies. Several studies of Los Angeles’ vast banking and finan-
cial system from the 1980s to the present (Dymski and Veitch 1996; Dymski
and Li 2003; Chiong, Dymski, and Hernandez 2018) have shown how US
megabanks and local banks –​including minority-​owned banks –​provide very
different levels of credit and banking services in core and peripheral areas
of Southern California. Crocco, Cavalcante, and Barra (2005–​06) –​building
 Space in Post Keynesian monetary economics 93
on the Chick-​Dow framework –​provide a rigorous empirical test of two
aspects of the centre-​periphery hypothesis for the case of Brazil. They dem-
onstrate that Brazil’s 11 largest metropolitan areas have a hierarchical rela-
tionship in terms of the size of banks located and making loans there, and
also that there is a relationship of mutual causality between metropole and
financial-​sector size.

5 Open-economy spatial Keynesian approaches

As noted above, while significant work has been done in Post Keynesian mon-
etary economics on open-​economy problems, very little work in this field has
pursued an explicitly ‘spatial’ approach (in the sense defined here) to cross-​
border monetary flows and financial dynamics.
Dow and Rodriguez-​ Fuentes have, in several studies, applied the Post
Keynesian analysis of regional banking dynamics describe in the previous
section to the case of the European monetary union. These studies represent
hybrid open-​economy analyses, since Eurozone member nations have distinct
national banking systems, but use the same currency and monetary policy.
As in the closed-​economy regional studies of banking structure, these studies
focus on the potential impact of increased financial integration and compe-
tition, together with unified regulation, on the structure and functioning of
European banking. Of particular concern is the capacity of national/​regional
banks to service local customers in the face of tendencies toward centralization
and concentration. For example, Dow and Rodriguez-​Fuentes (1999) argue
that increased concentration and growing segmentation in the Spanish banking
system are likely to increase non-​productive lending, especially to households,
and to reduce the availability of credit to SMEs.
Having examined regional trade imbalances (Dow 1986), Dow (1986–​87)
turns to the problem of international monetary relations. She observes that
unlike the case of regional trade imbalances, international trade imbalances
can lead directly to exchange-​rate shifts. These shifts, in turn, can heighten
market participants’ uncertainty –​the point that Davidson also emphasizes
(see above) –​and rapidly increase the speculative demand for money, feeding
back on both investment decisions and banks’ willingness to lend. Because
banks’ move away from peripheral regions now takes the form of capital flight,
worsening exchange-​ rate movements and widening imbalances, the open-​
economy centre-​periphery dynamic can lead to even more polarized outcomes
than in the (intra-​national) regional case.
As with Dow’s analysis of regional disparities in the closed economy, these
explorations of financial aspects of open-​economy scenarios meet two of the
three criteria set out in Section 3 for ‘real space’ analysis: market possibilities
differ significantly across space (liquidity and access to finance, in particular),
and distance matters (trust and proximity). The irreversibility of through-​time
commitments does not arise, however, nor does power, which represents the
obverse of trust –​it grows in significance the greater the gaps in market capacity
94 Gary Dymski and Annina Kaltenbrunner
and social connectedness between participants in different spatial partitions of
real-​world financial systems.
One reason for these lacunae is that the Chick-​Dow approach, following
Davidson, is built on the foundation of fundamental uncertainty and liquidity
preference which emphasizes the asset side of spatially differentiated balance
sheets, that is the speculative demand for money and assets ability to store
wealth. Without denying the importance of uncertainty, shifting the analytical
emphasis to other dimensions of the Post Keynesian monetary matrix, in par-
ticular Minsky’s attention to both sides of the balance sheet, opens up other
ways in which space can matter. Here we briefly explore two additions to the
bedrock uncertainty assumption in the context of open economy spatial theor-
izing that lead to fuller ‘real space’ frameworks.
The first of these is Dymski’s (1999) exploratory ‘spatialization’ of Minsky’s
financial instability framework. Minsky, as noted in Section 2, did not have a
spatial analysis; he didn’t need one, because his financial instability hypothesis
played out in real time. Dymski (1999) makes an initial stab at exploring how
Minskyian dynamics might emerge in the context of cross-​border flows of
credit and capital. In other words, what if the increasingly agitated asset-​price
dynamics and debt build up that Minsky pegs to the business cycle instead
played out across space? Dymski applies Minsky’s ideas to the Asian financial
crisis, modifying them to incorporate cross-​border financial flows. He shows
that in a multi-​region economy, the relative rates of inter-​regional economic
growth and of intra-​and international capital flows determine whether capital
flows will generate asset-​price growth (a bubble); once an asset bubble exists,
any reversal of the pace of capital inflow may bring about a bust. The fact that
cross-​border balances occur frequently suggests that asset bubbles and/​or asset-​
price deflations are ever-​present tendencies in bordered spaces; indeed, shifting
cross-​border flows can bring about Minsky crises even without Minsky cycles.
Dymski’s results, while suggestive, are only schematic.To take one example: des-
pite the importance of banking in his overall research profile (see above), this
paper ignores banks’ role in such crises.
A slightly different approach to ‘spatializing Minsky’ is taken by Bonizzi and
Kaltenbrunner (2019). The authors show how an explicit Minskyan angle to
the analysis of cross-​border capital flows helps to theorize the financial fragility
which emerges not only from agents’ balance sheet mismatches across time, but
also across space. Moreover, they theorize explicitly the power dynamics that
emerge from uneven geographically distributed financial relations. Focusing on
investment flows by pension funds and insurance companies (ICPF) to emer-
ging markets, they argue that the spatial concentration of international liabil-
ities in core financial centres not only makes EM very dependent on funding
conditions in these centres, but also subjects them to homogenizing pressures
to model their assets according to these centres’ institutional, regulatory, and
macroeconomic conditions. Any deviations from these conditions will be
priced in as ‘risk’, as core ICPF cannot match their liabilities with these assets.
This explicitly spatial analysis using Minsky’s theoretical apparatus shows the
 Space in Post Keynesian monetary economics 95
inherent and structural fragilities of cross-​border capital flows, which –​rather
than due to domestic economic conditions in EM –​are caused by the uneven
geographical distribution of global financial activities. Moreover, it highlights
the power that one place –​specifically one where financing occurs and hence
liabilities are concentrated –​can have over another.

6 Conclusion
Every economic transaction and process has a timestamp and a geocode: just as
everything doesn’t happen at once, everything doesn’t happen at the same place.
Economic models based on any given entry point make choices about whether
to render time and place visible analytically –​whether they do, and how they do,
depends on three factors. One of these is the topic of the analysis. The second
two are rooted in what Schumpeter (1954, pp. 40–​41) termed theorists’ pre-​
theoretic vision. First, what is the ideal against which reality is to be measured –​
what Hyman Minsky used to call, in conversation, ‘the model of the model’?
And second, is the theorist a hedgehog or a fox?5 The model of the model
for neoclassical theorists, of course, is the Pareto-​efficient equilibrium, whether
static or dynamic. Hamouda and Harcourt (1988), cited above, have observed
that Post Keynesian economics has distinct entry points; the vision underlying
its monetary economics is that of ‘fundamental uncertainty’ and its implications
for economic decision-​making and outcomes.The question then is whether this
guiding insight –​this ‘one big thing’ (see footnote 3) is not only necessary but
sufficient to explain any real-​world situation to which it might be applied.
We have argued here that the ‘one big thing’ of real-​time and uncertainty is
not likely to be sufficient to account for all situations involving heterogeneous
agents possessing differential economic or social power in different places.
These situations call for ‘real space’ analyses, which we have suggested here may
involve three elements. First, situations in which agents in different locations
boast different degrees of market access, network connectivity, and resources
endow them with differential capacities to profit from monetary and finan-
cial integration. Second, when investments are irreversible, the market and use
value of those investments depends on external factors which investing agents
are not able to control. One such external factor, particularly important in a
Minskyan interpretation of spatial relations, is the liability structure set up by
the agents controlling the sources of finance. And third, social and economic dis-
tance, combined with differential resources, increases the power of some agents
to dictate terms and conditions for others, without any recourse. If any of these
circumstances are present, space matters as more than an extra transaction cost;
what makes it ‘real’ is that it brings power into the equation –​power rooted not
just in the degree of market monopoly (though this is part of that equation),
but in the social and historical embedding of these market interactions. Borders
between different ‘real spaces’ then mark out two key boundaries –​one between
the current-​ account and capital-​ account flows between areas, and another
demarcating the lines of historical and social difference.
96 Gary Dymski and Annina Kaltenbrunner
The financial integration of emerging economies is clearly one theoretical
subject for which real space is as important as real time. Indeed, our review of Post
Keynesian explorations of both regional and open economy scenarios suggests
that many authors have already captured the idea of real space in their analyses.
Our purpose here is to make this implicit acknowledgement of the key role of
geographical and historical difference into an explicit analytical category –​a way
to bring space and a richer concept of power into Keynesian economics.
Vis-​à-​
vis financial integration, we might note that theories focusing
on liquidity preference theory have tended to focus primarily on domestic
conditions, or to treat international scenarios as analogous to domestic ones,
rather than appreciating the challenges posed by structures of integration into
the global financial system in which differently empowered cross-​border agents
operate. The fact that assets and liabilities not only have different spatial points
of origin but are also linked to spatially-​distinct development processes is fun-
damental to the topics explored in this volume. We tried to show that it is
possible to more deeply link Keynesian ideas to the problematics of historically
embedded uneven development and inequality that dependency and stratifica-
tion theorists have highlighted. It is hoped that the links suggested here will lead
to more and richer cross-​fertilizations between Keynesians and investigators
beginning from other geographic, social, and historical reference points.

Notes
1 The problem of multiple entry points in Post Keynesian economics, which Hamouda
and Harcourt (1988) point out is linked to the numerous reference points for its
progenitors –​from Keynes to Marx to Sraffa to Kalecki and beyond –​remains, iron-
ically, one of its defining features. In an overview of the topic written a quarter of a
century later, Harcourt and Kriesler (2013) document this continuing unity in diver-
sity. It is for this reason that we use the modifier ‘monetary’ to denote our theoretical
reflections herein.
2 Cardim Carvalho shows in a series of papers (summarized in Dymski and Guizzo
2020) that analytical acknowledgement of the impact of uncertainty on firm and
household decisions is itself sufficient to support the independence of aggregate
demand and supply in macroeconomic dynamics.
3 In addition, even in a national branch-​based system individual branches cannot lose
reserves indefinitely while not reducing credit growth. At some point, head offices
might impose a credit constraint to avoid further leakage of reserves.
4 ‘Almost’ because, as in Dow’s earlier paper, a constant reserve drain of specific central
banks might lead to a reduction in inter-​bank lending at some point.
5 The phrase was immortalized by Isaiah Berlin, who wrote: ‘There is a line among the
fragments of the Greek poet Archilochus which says: ‘The fox knows many things,
but the hedgehog knows one big thing.’ (Berlin 2013, p. 1).

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Part III

Currency hierarchy
8 
Evolving international monetary
and financial architecture and
the development challenge
A liquidity preference theoretical
perspective
Jörg Bibow1

Introduction and overview

This chapter investigates the peculiar macroeconomic policy challenges faced
by middle-​income countries opening up their financial system to the vagaries
of today’s monetary (non)order and globalised finance (conventionally referred
to as ‘emerging economies’). It reviews the evolution of the international mon-
etary and financial architecture against the background of Keynes’ original
Bretton Woods vision highlighting the U.S. dollar’s hegemonic status. Keynes’
liquidity preference theory informs the analysis of the loss of policy space and
widespread instabilities in emerging economies that are the consequence of
financial globalisation. While any benefits promised by mainstream promoters
remain elusive, heightened vulnerabilities have emerged in the aftermath of the
global crisis.

Keynes’ liquidity preference theory in a global setting

Keynes’ (1936) ‘The General Theory of Employment, Interest and Money’
delivered two pivotal blows to the mainstream (neo)classical thought of his
time, one concerning labour markets, the other concerning financial markets.
On the mainstream view, employment is determined in labour markets and
unemployment arises because workers are asking for too much. Work would
be readily available to anyone willing to work at a lower (market-​clearing)
wage, unemployment is therefore always voluntary. Exemplifying a more gen-
eral warning to economists to not blindly apply microeconomic thinking
to macroeconomic issues, Keynes identified a fallacy of composition in this
argument: whereas individual workers might be able to price themselves into
employment, wage cuts across the economy are prone to yield deflation and
instability instead. Any macroeconomic employment gains are unlikely to arise
other than through raising a country’s external competitiveness (a ‘beggar-​thy-​
neighbour’ zero-​sum game) which, at the global (supra-​macro) economy level,
102 Jörg Bibow
still constitutes said fallacy of composition.The global economic calamity of the
Great Depression playing out at the time illustrated Keynes’ point rather well.
At the macro level, the crucial employment constraint overlooked by the
mainstream theory of employment is the level of ‘effective demand’, which
depends on entrepreneurs’ sales expectations in general and perceptions of profit
opportunities on real investment projects in particular. Moreover, in ‘monetary
production economies’, money cannot be ‘abstracted from’ and only added on
later as an after-​thought to the ‘real analysis’. Instead, being far from ‘neutral’,
money must be part of the analysis from the start, affecting motives, decisions,
and employment outcomes.
The financial system comes to the fore here as either facilitating or poten-
tially constraining economic activity and employment, capital accumulation and
development. In this spirit, Keynes’ second important theoretical advancement,
was to take issue with mainstream thinking on money and interest prevailing
at the time. He rejected both the ‘quantity theory of money’ and the ‘loanable
funds theory of interest’.
The former is preoccupied with the medium-​of-​exchange role of money
and naïvely posits a proportionality between the monetary facilitator of market
exchanges and the price level; with causality supposedly running from money
to prices. Already in his ‘Tract on Monetary Reform’, Keynes (1923) found that
the quantity theory of money was useless for policy purposes. In the General
Theory, he highlighted that the quantity theory of money was not only out
of touch with the realities of bank money and organised securities markets,
but also rendered useless as a theory by ruling out effective demand as the key
determinant of employment by assumption.
Hopelessly trapped in an agricultural (‘corn economy’) worldview that
has the ‘not consumed’ (i.e. saved) corn becoming the investment of the next
period, loanable funds theory was no better, Keynes found. For in monetary
production economies real capital gets produced and therefore requires, like
any other economic activity, advance finance rather than prior saving. Hence
those engaged in economic activity need to first find the money –​to then
spend, produce, or acquire assets. They need to either convince those who have
money to hand it over, or those who can produce money to do so –​at a price of
course: ‘the’ rate of interest.
This key insight underlies Keynes’ ‘liquidity [preference] theory of the rate
of interest’: interest rates are determined by the financial system as the price
that, at the margin, balances desires of those who want to become more liquid
and of those willing to become less so, including the producers of liquidity, the
banking system. Not saving decisions are at issue here, but portfolio decisions
concerning the form in which wealth is held and finance raised, with the
banking system providing ‘liquidity par excellence’: money. In other words,
economic activity and employment, capital accumulation and development
are conditioned by the liquidity provided by the financial system but do not
depend on –​or are somehow ‘financed by’ –​saving; as loanable funds theory
would have it (Chick 1983, Bibow 2009a).
 Evolving international architecture 103
Modern mainstream macroeconomics may have written money and the
quantity theory of money out of the play –​replaced by an independent cen-
tral bank setting a policy interest rate with a view of hitting its inflation target
(by following some ‘Taylor rule’ while chasing Wicksell’s ‘natural rate’). Yet,
upholding loanable funds theory, the mainstream still has the financial system
channelling saving flows into investment, with banks churning deposits into
loans.Applied globally, financial globalisation was promised to enable poor coun-
tries to invest more and catch up faster –​by borrowing richer countries’ ample
saving resources. The ‘Washington Consensus’ advice for developing countries
aspiring to catch up to advanced ones then seems straight forward: to liberalise,
privatise, and open up their economies to the market forces of wisdom ruling in
today’s (hyper-​)globalised world (Fischer 1997, Summers 2000, Rodrik 2012).
Liquidity preference theory, applied in a global setting, offers a rather different
perspective on the supposed virtues of financial globalisation. The point about
money is, as Keynes emphasised, that money (the ‘money rate of money
interest’) sets the floor below which other rates of return on assets in general
will not fall. In other words, the terms of liquidity provision as determined by
the financial system condition the production of new capital assets and hence
employment and development. The question is whether liquidity production
should better be organised locally or globally.
For countries lacking capabilities to produce real capital assets, access to
global finance appears to offer an alternative to the payment for imports
solely by means of exports. But under globalised finance returns on assets,
denominated in different national currencies or not, will also compete glo-
bally and be subjected to the whims of arbitrage, hedging, and speculation. In
fact, national currencies themselves, as financial assets constantly assessed by
global financial market players, will be subject to the same forces too. And some
currencies may be considered safer and more liquid than others.
‘Disciplined by’ financial market players, representing the international
powers of wealth (mainly located in rich countries) acting freely across borders,
national authorities will see their options and ‘policy space’ shrink accordingly.
For those with sufficient faith in the invisible hand (or vested interest in the
global rule by the powers of wealth) this outcome may seem attractive (Hayek
1977). Bolstered by his own immense practical experience, in addition to
superior theoretical insight, Keynes was sceptical that globalised finance would
necessarily foster development and the general good (Bibow 2009a, 2017).
Keynes illustrated the importance of money and finance in monetary pro-
duction economies in terms of his ‘own rates’ analysis, featuring the concept of
the ‘liquidity premium’ and yielding a structure of asset prices (Bibow 2009a,
Kaltenbrunner 2015, De Paula et al. 2017).
Keynes distinguishes different types of assets as possessing the following
attributes in different degrees: yield q, carrying cost c, and a liquidity premium
l. To determine the expected returns on different types of assets over a period
of time, in addition, the expected percentage appreciation or depreciation rela-
tive to some standard of value –​normally the national money –​is required.
104 Jörg Bibow
The total expected return on an asset, or its ‘own rate of (money) interest’, is
the sum of these four elements (1): Ri = qi –​ ci + li + ai; where the resulting
(net) yields are default-​r isk adjusted and incorporate the cost of financial inter-
mediation. An equilibrium requires the demand prices of all different types of
assets to be such that their total expected returns are all equal. In such a general
portfolio equilibrium, all assets are held and wealth holders have no incentive
to reshuffle their portfolios at the current structure of asset prices –​at least for
a nanosecond.
Money appears in a pivotal position in this general portfolio allocation
approach. First, money is the standard of value or unit of account. Second,
Keynes identifies money as the asset with the highest liquidity premium. Having
a certain (money) value under (almost) any circumstances makes money an
attractive store of value in a world of fundamental uncertainty. The strength of
the desire to hold money is not constant irrespective of circumstances though.
Rather, as an indicator of our trust in the future, it is subject to abrupt change.
In this regard, bank money is par excellence ‘liquid’ in the eye of the
(nonbank) public, while central bank money provides the ultimate settlement
asset and liquidity par excellence from the banks’ perspective. Treasury bills and
other money market instruments may be more or less close substitutes. The
liquidity premium is not an actual yield but a notional reward, an amount of
actual yield wealth holders are willing to forego for having money instead of
less liquid assets at their disposal –​‘for the potential convenience or security
given by this power of disposal’ (Keynes 1936, JMK 7: 226).
Money may also provide an actual yield on top of its liquidity premium: the
short-​term interest rate traditionally set by the central bank as the expression
of its monetary policy stance. Competition will align the yield on bank money
(and close substitutes) with the set policy rate. (The yield on central bank
money –​if nonzero –​will depend on the central bank’s particular operating
procedures.)
Keynes’ own-​rates analysis highlights that monetary policy stands at the very
centre of the structure of asset prices. Its influence on economic activity, as seen
from this perspective, arises because money’s own rate of interest, its liquidity
premium plus any cash yield (together with typically negligible carrying
cost) sets the floor below which the own rates of interest on other financial
instruments and assets in general cannot decline.
Financial instruments traded in financial markets provide alternative ‘liquid’
stores of value that typically promise higher yields. Investments that are final and
permanent commitments by society are thereby made fluid for the individual
fleeting ‘investor’.The liquidity of markets can be compatible with stable prices
of debts and assets at times. But market conventions rooted in imagination can
dissolve rapidly, prices become unhooked and volatile, and market liquidity
totally evaporate at times of stress. At no time is there any guarantee that prices
will reflect some true and unique underlying real reality –​as the mainstream
view with its ‘efficient market theory’ of finance suggests. Asset market play is
self-​referential; asset prices restless and prone to excess volatility, bubbles and
 Evolving international architecture 105
crashes; liquidity and leverage disposed to sponsor mania and fragility –​as the
experienced global financial market player John Maynard Keynes understood
all too well (Minsky 2008, Carvalho 2016).
Financial conditions as determined by the financial system together with
entrepreneurs’ expected rates of return on potential projects (‘marginal effi-
ciencies of capital’) determine the demand prices for capital goods, while the
economy’s cost structure (wages etc.) determine their respective supply prices.
The production of capital goods ceases at the point at which their demand
prices drop below their supply prices.There is no guarantee that by some law of
nature this point will be at full employment. The financial system, determining
the terms on which money is made available to the economy, can err in its
allocative role, sponsoring wasteful activities. Under monetary policy guidance
and regulated to some degree, it can also go astray regarding macro stability, and
usher deep economic crises.
Under globalised finance the portfolio equilibrium condition depicted
above will be a worldwide structure of asset prices expressed in some common
standard of value. For reasons that will be elaborated upon below, the U.S. dollar
has served in that role since World War II, with the U.S. Federal Reserve (Fed)
setting the anchor rate for global finance and the floor below which the
own rates of interest on other assets cannot decline, globally (Ocampo 2001,
Terzi 2006).
In principle, national central banks may set their policy rates at different
levels. But they will now all be seen by the markets with reference to the
U.S. dollar anchor. Unless exchange rates are stabilised by the authorities, their
expected rates of appreciation or depreciation will be part of the a-​terms of
assets denominated in some national currency. Different national monies may
carry different and time-​varying liquidity premiums in the judgement of global
market players, depending on the perceived relative potential convenience or
security based on their respective power of disposal.
The current regime of globalised finance and U.S. dollar hegemony contrasts
starkly with Keynes’ envisioned ideal post-​war global monetary order –​which
we will briefly revisit in the next section.

The global monetary order envisioned by Keynes

Keynes’ draft proposals for the post-​war global monetary order were based
on decades of research and informed by the theoretical breakthroughs of his
General Theory (see Bibow 2009a and references provided there). Keynes’ two
foremost objectives were, first, to put the gold standard to rest and replace it by a
new –​more flexible –​order that featured no hegemonic national currency and,
second, to tame global finance so that national macroeconomic policies could
be applied to maintain full employment in line with his General Theory. The
key principles of his scheme may be briefly rationalised here.
In the Keynes plan, national currencies would be pegged to a new inter-
national unit of account: bancor. Exchange rates were meant to be stable but
106 Jörg Bibow
not rigid. Parity changes would arise as semi-​automatic adjustments designed
to maintain internationally balanced trade and payments positions. Keynes held
that wage and price inflation differentials would be the key driver of exchange
rate adjustments.
Up to certain generous limits, international liquidity would arise in line
with international payments imbalances as countries can freely draw on their
unconditional bancor overdraft lines provided by an international central bank
established to fulfil this bridging function. Rules would apply to surplus and
deficit countries symmetrically to contain and reverse imbalances. For instance,
surplus countries would face pressures to expand domestic demand while their
currencies appreciate.
Keynes foresaw that international (net) payments would be channelled
through national central banks rather than liberalised currency markets. Short-​
term (‘hot money’) capital flows had to be strictly contained. Keynes saw some
room for managed long-​term private capital flows supporting development and
complementing official development aid. Keynes also considered other poten-
tial supplementary global institutions designed, for instance, to stabilise com-
modity prices.
Overall, the envisioned international monetary order was devised to facilitate
global trade but tame global finance. Global liquidity to facilitate trade arises
endogenously –​curtailing any precautionary demand for national reserves.
Official Development Assistance (ODA) and managed long-​term capital flows
would only enable real capital and technology imports above and beyond what
is paid by current exports. By establishing an international order based on sym-
metry and designed to maintain international balance, countries would be
both prevented from pursuing ‘beggar-​thy-​neighbour’ strategies and enabled
to focus their national macro policies on maintaining internal balance. Finance
was meant to be not the master, but the servant of commerce and development.
Finance was to be primarily national (Keynes 1933, 1942, Bibow 2009a).
In the course of the bilateral negotiations culminating in the Bretton Woods
conference it became ever clearer to Keynes that his own scheme stood no
chance with the American side. His best hope was that America would really
sign up to their own plan in the end, masterminded by Harry Dexter White.
He defended the Bretton Woods agreement in the British Parliament as a clear
improvement over the gold standard –​that ‘barbarous relic’ (Keynes 1923) –​
and as a workable regime that would support post-​war prosperity. Overall,
the Bretton Woods regime fulfilled his hopes –​until its breakdown in the
early 1970s.

Evolution of the global U.S. dollar order: Finance tamed at

first, then (hyper-​)globalised
By design, the post-​war Bretton Woods international monetary order was based
on the U.S. dollar. While officially convertible into gold among central banks
until August 15, 1971, a supposed safeguard that got dropped when it became
 Evolving international architecture 107
too inconvenient to the United States, the U.S. dollar has claimed the top spot
in the global pecking order of currencies ever since. In fact, following the 1970s
global macroeconomic turmoil that featured U.S. weakness and lack of global
leadership, U.S. dollar supremacy was restored on the back of a mixture of tight
money (‘Volcker shock’) and fiscal expansion (Reagan’s ‘supply-​side’ mantra),
and supercharged under increasingly globalising finance starting in the 1980s
(Isard 2005, Bibow 2009a, Eichengreen 2011).
The inbuilt asymmetry in international financial affairs bestows the hegemon
with privileges and responsibilities.
International U.S. dollar liquidity is anchored by Fed policy and dependent
on the U.S. balance of payments position, granting the hegemon a unique
measure of policy space and capacity for global spillovers.The rest of the world’s
demand for U.S. dollar liquidity, official and private, is an indicator of perceived
vulnerability on their part, no longer primarily driven by needs to facilitate
commerce, the dollar ‘premium’ and exchange rate are measures of global
financial players’ degree of disquietude. Foreign official authorities (especially
of emerging economies) hold U.S. dollar liquidity as a precaution. For private
financial market players, too, access to U.S. dollar liquidity, in good times and
in bad, is a vital source of power they can wield, globally. The Fed stands as
their ultimate caretaker, with nationality of player and capacity for spillbacks on
U.S. interests as key determinants of the measure of care provided.
It was more of a symbiosis of interests at the post–​World War II outset. The
European periphery was lacking both dollar liquidity and real resources for
reconstruction. The U.S. had amassed the world’s gold and needed an outlet
for its exports to sustain full employment. ‘Marshall Plan’ aid bridged affairs
mutually and facilitated joint revival. Then U.S. foreign direct investments
became the main source of dollar liquidity, with the U.S. acting as ‘banker
to the world’ meeting the periphery’s trade-​driven and hence limited dollar
liquidity demand; supplemented to countries under duress by IMF resources
that were still adequate under the circumstances of the time.
Exchange rates proved far too rigid though. At first this was foremost an issue
within the (European) periphery. Associating devaluation with national defeat,
deficit countries delayed the inevitable. Worse, surplus countries stemmed
revaluation with utmost determination for mercantilist ambitions. For instance,
(West) Germany applied both capital controls and amassed gold and U.S. dollar
reserve holdings greatly in excess of precautionary needs –​to fire up its export
engine instead of managing domestic demand. Overall, however, the system
could withstand tensions within the periphery while the World Bank and ODA
lent some support to the developing world.
The Bretton Woods system only faltered and eventually collapsed when
the hegemon saw its trade surplus turn negative while offshore (‘euro’) dollar
markets –​emerging as capital controls and tight post-​war banking regulations
were gradually rolled back –​provided an avenue for reviving global finan-
cial players to also bet against the supreme but overstretched global reserve
currency.
108 Jörg Bibow
U.S. weakness created a global policy vacuum that was part of the pronounced
macro instabilities of the 1970s. Hit by a large negative terms-​of-​trade shock
advanced economies’ growth stalled while unemployment and inflation soared.
It was convenient that large developed country banks applied their newfound
global liberties to extend loans to willing borrowers in the developing world,
helping to sustain global growth at first, but laying the groundwork for the
1980s developing country debt crises.
The surge back of the U.S. dollar and stock markets in the 1980s also marked
the proper start of neoliberalism as both the U.S. and Western Europe raced to
liberalise their financial systems and claw back on external controls (Abdelal
2007). An ever-​expanding global financial system based on U.S. dollar liquidity
came to replace the demolished Bretton Woods monetary system. Mounting
‘financialisation’ featuring not only the expansion of power and influence of the
financial industry (with ‘Wall Street’ as global leader), but also rising inequalities
and a negative resource transfer from the developing world have been the rule
ever since (Kregel 2004, Bibow 2009b, 2012, Akyüz 2018).
The U.S. dollar experienced a rollercoaster ride over the course of the 1980s,
a decade that saw Japan at first emerge as a potential challenger to U.S. dollar
and Wall Street supremacy, but then end the decade in the doldrums. For many
developing countries, especially in Latin America, it was a ‘lost decade’. Very
high interest rates and the strong dollar, together with plunging commodity
prices, left numerous developing (debtor) countries insolvent. Developed (cred-
itor) countries focused on containing the impairment of their own ‘too large
to fail’ banks.
1991, at a time of recession and flattered by official transfers from allies
for U.S.-​led military action in the Middle East, was the last time that the
U.S. current account deficit briefly disappeared. Otherwise, under globalised
finance, huge U.S. current account deficits have become the norm –​providing
corresponding scope for the rest of the world to earn U.S. dollar liquidity in a
precarious world economy.
More generally, the 1990s were the heydays of neoliberalism as financial
liberalisation accelerated all round –​ushering in the era of ‘hyperglobalisation’.
Western Europe completed its ‘common market’, agreed to launch a common
currency, and embraced vast enlargement of its union towards the east (where
the Soviet Union had collapsed). Meanwhile, the IMF and World Bank
embarked on spreading the ‘Washington Consensus’ (Williamson 1989) in the
developing world. As an irony of history, financial crises in newly liberalised
emerging economies were piling up just at the time when the IMF tried to also
officially enlarge its mandate to include financial account liberalisation; when
its original remit in the Bretton Woods spirit had solely focused on current
account liberalisation to facilitate managed multilateral trade (Fischer 1997).
The so-​called ‘emerging markets’ crises around the turn of the millen-
nium –​crises instigated by the forces of global finance –​marked an important
watershed. Crisis countries suffered very deep recessions.They found their own
national defences inadequate to buffer financial stress while the conditional
 Evolving international architecture 109
collective insurance ‘help’ provided by the IMF often inflicted more pain than
any relief.
Responses featured ‘defensive’ macroeconomic policies. Emerging econ-
omies started amassing U.S. dollar reserves as they had learned that under
globalised finance precaution had to be sized by the vagaries of finance rather
than trade. To contain vulnerabilities arising from current account deficits and
external indebtedness competitiveness became a policy priority, foremost in
Asia.These efforts proved successful as the external and fiscal positions of emer-
ging economies generally improved markedly. So much so that the IMF was
running out of business in the 2000s and had to downsize as their customers
turned away from its collective insurance products and ‘self-​insured’ instead
(Bibow 2009b).
How could the global economy still experience an impressive boom in the
2000s despite the widespread recourse to defensive macro policies? The global
spreading of the neoliberal focussation was creating the deflationary forces and
rising inequalities that Keynes’ fallacy-​of-​composition argument had warned
against, but a global boom played out.The answer is that the U.S. hegemon met
its responsibilities and obediently played its role as global growth engine and
borrower and spender of last resort.2
For one thing, in response to the ‘dot.com’ bust, the G.W. Bush administra-
tion administered a huge fiscal easing. For another, the Fed responded to the
threat of deflation by cutting its policy interest rate to a record low 1 percent
rate. This duly translated into globally easy monetary conditions. Global finan-
cial players, fired up by the U.S. Fed, showed great keenness in acquiring assets
in emerging economies. These responded by amassing ever more U.S. dollar
liquidity, as a precaution and to protect and maintain their competitiveness and
export growth.
Prior to the global crisis, the relationship between the hegemon and the
developing world was symbiotic in the sense that the latter experienced growth
while containing their external vulnerability through defensive macro policies.
Meanwhile, the hegemon magnified its ‘exorbitant privilege’ through ‘dollar
levering’: private acquisitions of higher-​yielding external assets would push
dollar liquidity into the system only to get mopped up by cautious author-
ities as bulging FX reserves (Bibow 2011b). One party’s insurance premium
paid is the other party’s supercharged privilege. Compared to the restrained
trade-​related liquidity needs under Bretton Woods, globalised finance provided
a sheer feast to the hegemon.

Global financial crisis and its aftermath: The end of an era?

It appears the era of dollar supremacy under globalised finance reached a new
watershed with the global crisis and the policy choices made in response. The
crisis originated at the core of the global financial system, a trans-​Atlantic crisis of
the world’s most ‘sophisticated’ finance; made in the United States and Western
Europe. In the United States, Wall Street had levered up the U.S. household
110 Jörg Bibow
sector by innovative credit products sponsoring a housing bubble. European
banks had not only provided a helping hand in the U.S. bubble, but simultan-
eously also sponsored homegrown bubbles in Europe, especially inside Europe’s
peculiarly ill-​designed currency union.When the bubbles burst, the developing
world was affected as innocent bystander.Through the trade collapse the impact
was felt worldwide. Developing countries not yet integrated financially were at
an advantage compared to emerging economies suffering ‘sudden reversals’ in
capital flows and plunging currencies and asset prices on top –​as global finan-
cial players fled home and sought safety primarily in the U.S. dollar (Bibow
2011b).
Emerging economies hit by crises generally go through IMF ‘adjustment
programmes’ that require sharply contractionary macro policies.As an important
part of its privilege, the hegemon was free to implement sharply expansionary
macro policies instead. Initially the United States (and crisis-​stricken Europe
to some extent) implemented both monetary easing and lending of last resort
programmes as well as fiscal stimulus packages. In this way, the steep plunge in
global trade and production was halted by mid-​2009 and the initial bounce-​
back in 2010 was quite vivid.
For emerging economies, the policy responses organised at the centre were
a mixed blessing. The revival of export markets in developed economies was
surely welcome. But the macro policy mix adopted in the United States and
Europe created fresh challenges to the developing world, especially when fiscal
policy began to shift back into austerity mode in 2010. This premature and ill-​
guided fiscal policy U-​turn forced the U.S. Fed to engage in extreme monetary
easing policies with even greater force and for far longer.
In the early 1980s, super-​tight money administered by the U.S. Fed was the
unsolicited challenge, bankruptcies in the developing world the consequence.
Post-​2008, when finance had become far more globalised, ultra-​easy money set
off by the U.S. Fed leader (should have) set off bubble alarm bells among emer-
ging economy followers. Keynes’ foremost concern had been that tight money
would constrain economic activity. In the aftermath of the global crisis ‘ZIRP,
‘QE’, and finally even ‘NIRP’ pursued at the centre presented the periphery
with the opposite risk of instability by financial rentier mania.
The tide in global capital flows already began to turn in mid-​2009 when
the Federal Reserve was merely at the stage of ‘QE1’, pushing the dollar lower
and keeping it low for the next five years. Facing a fresh avalanche of cap-
ital flows, asset prices in recipient countries surged, financial conditions eased,
and credit booms got unleashed as emerging economies’ currencies generally
appreciated strongly. Emerging economies had not lost their appetite for defen-
sive macro policies. But the extreme easing at the centre left them little choice
in containing upward pressures on their currencies without obediently easy
money. Fresh vulnerabilities built up as a result. Household sector debts were
but one issue. Especially the nonfinancial corporate sector in emerging econ-
omies engaged in large-​scale U.S. dollar borrowing as part of the ‘carry trade’
game (McCauley et al. 2015a, 2015b, Cavallo et al. 2016, Ghosh et al. 2017).
 Evolving international architecture 111
Importantly, not real investment but corporate financialisation experienced a
boom. The relentless ‘searching-​for-​yield’ keenness of global financial players
also opened up new ‘frontiers’ in developing countries along the way, enticing
poor countries to load up on foreign debts; whenever this is convenient from a
rich-​country perspective.
China emerged as global growth engine number one in the aftermath of the
global crisis.To a significant extent sheltered from global finance through finan-
cial account management prior to the crisis (Ma and McCauley 2007), China
implemented huge fiscal stimulus measures in response and saw sharp rises
in corporate sector indebtedness, rebalancing its economy towards domestic
demand while undergoing controlled currency appreciation. With China as
chief global growth engine and Wall Street and the U.S. dollar continuing to set
the tune of global finance, the developing world must now somehow straddle
these two dominant poles in the world economy.
Turning points in Fed policy are always a special challenge in the per-
iphery. So fresh instabilities arose in 2013 with the approaching tapering of
‘QE3’, and matters worsened as the Fed’s interest rate ‘lift off ’ neared and the
dollar appreciated sharply in 2015 (Rajan 2014, Ghosh et al. 2017). Many
emerging economies’ fiscal and external positions had deteriorated markedly
under the regime of extreme monetary ease of previous years. Fragilities only
got worse when China experienced a marked growth slowdown and the ren-
minbi depreciated ominously in 2015–​2016. The cycle of global instability
that had last visited emerging economies around the turn of the millen-
nium, then paying its homage at the centre, was now making a return in the
developing world.
Only that this time round –​in contrast to the 2000s –​the United States
seems neither able nor willing to play the role of global growth engine while
practicing benign neglect regarding its external position. The Trump adminis-
tration has not only made it its goal to shrink America’s trade deficit through
bilateral strongarm dealings but also pursues a course of conflict with China.
Torn between the two power poles in the global economy, risks for emerging
economies are mounting.

(Hyper-​)globalised finance and the developing world:

Challenges and options
Today’s position of emerging economies under globalised finance starkly
contrasts Keynes’ bancor vision. Their lack of policy space and overall precar-
iousness are two sides of the same dollar coin.
Dollar hegemony and globalised finance preclude emerging economies
from establishing a structure of asset prices and financial conditions that might
suit their own domestic conditions. As fair game of global financial players, their
economies are integrated in the global structure of asset prices and financial
conditions, as determined for them by the U.S. Fed and Wall Street –​based on
U.S. domestic conditions.
112 Jörg Bibow
Mainstream monetary theory includes a branch called ‘optimum currency
area theory’, which investigates the conditions that either help or hinder coun-
tries in sharing a common currency. Unfortunately, this theory is little else but
a cousin of the mainstream ‘trilemma view’, promising that floating exchange
rates would secure countries’ policy autonomy even under globalised finance.
While this notorious view has recently been challenged even within the
mainstream (Rey 2014, 2016), liquidity preference theory suggests that floating
exchange rates can only grant emerging economies limited policy space anyway,
at best.The issue is not only a matter of monetary policy dependency per se, but
also one of exposure to the whim and fickleness of global financial conditions
and global financial players’ sentiment (Harvey 2009).
In addition, emerging economies are paying dearly for ‘self-​insurance’, with
foreign reserves sized to the vagaries of globalised finance –​when no such
burden would arise at all under Keynes’ scheme other than paying interest on
any bancor overdraft credit line actually used.
It would appear, then, that globalised finance is charging emerging econ-
omies a rather steep price, and for what exactly? Even mainstream studies have
trouble providing any compelling evidence of the promised benefits (Kose et al.
2006, Prasad et al. 2007).
The neoclassical loanable funds view that global finance would enable poor
countries to draw on rich country saving confuses finance and real capital. To
actually boost capital formation and technology in poor countries involves a
policy mix geared towards mobilising local resources paired with sustainable,
i.e. long-​term nonexploitative, external finances that can augment the acqui-
sition of foreign capital goods and technology beyond what exports currently
pay for. Acquiring foreign expert services in designing policies and institutions,
including financial system policies, can make a valuable contribution towards
this end. But importing ‘foreign expertise’ on the back of fickle capital flows is
unlikely to play a constructive part in development apart from remunerating
foreigners for unwarranted liquidity ‘services’: liquidity can be best produced
locally under the control of the national monetary authorities. Mainstream
theory remains trapped in prehistorical loanable funds confusions until this day.
Ultimately the argument for financial account liberalisation has to draw on
political economy concerns: the notion that free markets serve to discipline
politicians –​allegedly forever tempted to pursue their own rather than the
public good. Admittedly, this concern is a real one. Liquidity preference theory
reveals the role government can and should play in development, specifically
in managing national monetary and financial affairs, but it does not guarantee
that governments will comply. No doubt governments can be corrupt and/​or
incompetent; as in developed economies too.
By the same stroke one should then also admit to the fact that globalised
finance is hardly a reliable source of wisdom either. The global crisis has shown
that the most sophisticated finance can be little else but an organised scam. The
trade-​off in hiring global finance to contain the damage potentially done by
bad government seems to be that of undermining the scope for constructive
 Evolving international architecture 113
government toward development. For all but the worst governments, wisdom
will likely rest in keeping global finance at bay and organising liquidity pro-
duction locally instead (Bibow 2012). That Donald Trump’s America is today
aiming to sustain the benefits while trying to shield the United States from
the downsides of U.S. hegemony in global currency and finance is presenting
emerging economies with fresh challenges that only underline this conclusion.

Notes
1 I am grateful for comments on an earlier draft by Daniela Prates,Annina Kaltenbrunner,
and Raquel Almeida Ramos.
2 While the United States as a nation enjoys important benefits as global (currency
and finance) hegemon, benign neglect of its external position comes along with
marked internal distributional side-​effects. Essentially Wall Street gains at the expense
of accelerated de-​industrialization in the United States. The latter issue came to the
fore with the presidential election of 2016 and subsequent ‘trade wars’.

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9 
International money, privileges
and underdevelopment
Hansjörg Herr and Zeynep Nettekoven

1 Introduction1
In the world there are about 180 currencies.These currencies take over different
functions, compete with each other and create a currency hierarchy. This con-
tribution analyses currency hierarchies from a monetary Keynesian perspective.
The second section clarifies what is meant by a monetary Keynesian perspec-
tive. In the third section a simple Keynesian portfolio model is presented which
links the low quality of a currency to the reproduction of underdevelopment.
Section 4 discusses preconditions and advantages of currencies with inter-
national functions. Section 5 analyses different types of currency hierarchies.
The last section concentrates on the future of the currency system.

2 Basics of the monetary Keynesian approach

The Keynesian monetary approach goes back, as the name tells, to John
Maynard Keynes who, however, experienced very different interpretations.
Keynes developed a very unique understanding of money which is only partly
stressed by the mainstream interpretations or completely forgotten.2 Keynes’
monetary approach was made popular in Germany especially by Hajo Riese
(see Betz et al. 2001) who is internationally not very well known.
To explain the monetary approach, it is useful to use Keynes’ (1973 [1933])
metaphor of a capitalist economy. He spoke about a monetary production
economy which does not allow the separation of a real from a monetary sphere.
Unfortunately, most models in economics use the dichotomy between a real and
a monetary sphere and judge the real sphere as the important one. As a result most
economic models do not include money in an adequate way or do not acknow-
ledge money at all.3 Keynes (1979) in his draft for the General Theory supported
Marx’ idea that the nucleus of a monetary production economy can be shown by
the formula M –​C –​M’ with an entrepreneur parting with money (M) for com-
modities (C) in order to get more money (M’). In the stage of ‘C’ the entrepre-
neur buys capital goods, rents labour and organises the income creation process.

The employment of factors of production to increase output involves

the entrepreneur in the disbursement, not of product, but of money. The
 International money and underdevelopment 117
choice before him in deciding whether or not to offer employment is a
choice between using money in this way or in some other way or not using
it at all.
(Keynes 1979, p. 82)

The formula easily can be made more complicated by adding banks and wealth
owners financing the entrepreneur. Thus, in the centre of capitalist dynamic is
a credit-​income-​creation process in which credit is given to the entrepreneur
which invests the money in production processes. A very radical version of this
idea is presented by Joseph Schumpeter (1911) who argues that the banking
system is creating money out of nothing and, if the money is given and invested
by the entrepreneur, employment, income and savings are created.
The consequence of this approach is that capitalist economies are
characterised by a monetary macroeconomic budget constraint and not by a constraint
given by physical resources (Riese 1986; Kornai 1979).4 The Neoclassical para-
digm assumes exogenously given physical resources –​like manna from heaven –​
given to households which then start a (inter-​)temporal exchange process of
goods and labour services to increase their and societies’ welfare (see Walras
1874).There is no guarantee that a monetary production economy tends to full
employment. The opposite is the case: It must be expected that unemployment
is the normal state of affairs in capitalist economies (Keynes 1936, see also Herr
2014, Heine and Herr 2013).
The monetary Keynesian approach leads to several consequences which
are relevant for our later analysis. First, the monetary macroeconomic budget
constraint may erode if disbursement of entrepreneurs is very high and the
economy hits the physical macroeconomic budget constraint. Such a situation
typically leads to inflation driven by high demand confronted with full capacity
utilisation and high employment which tends to lead to increasing nominal
wages and cost driven inflation (Keynes 1930; Herr 2009). In such a constel-
lation the operating conditions of a monetary production economy force the
central bank to fight against inflationary processes and establish the monetary
macroeconomic budget constraint again. It should be mentioned here that
some countries have good institutions which allow high employment with low
inflation, other countries not. The worst case is a flexible nominal wage level
which responds quickly to changes of employment.
This leads us to the second and related point. The thing which functions as
money must have a low elasticity of production and the private sector should
not be allowed to produce it (Keynes 1936, ­chapter 17). Small iron rings which
are allowed to be produced by private firms cannot become money. In this
sense money must be made artificially scarce. In modern economies central
banks must have the monopoly to supply central bank money and the power to
guarantee the monetary macroeconomic budget constraint.
Third, money has three basic functions, the function as a unit of account, a
means of payment and a store of wealth. It fulfils these functions on a national
and international level.
118 Hansjörg Herr and Zeynep Nettekoven
Money as a unit of account is the most basic function. A particular unit
of account cannot be substituted without changing the monetary system. An
example for a change of the unit of account is the change from the D-​Mark
to the euro in 1999. Money as a unit of account is needed to express the value
of goods or the value of assets.Very important is money as a unit of account in
credit contracts.
Money as means of payment is transferred from one economic agent
to another to buy goods, to pay out or pay back credits, and to fulfil other
obligations like taxes. Money as means of payment implies that money has to
be kept as a store of wealth.
This brings us to the function of money as a store of wealth or to the
question how much money is demanded by economic units. In the typ-
ical Keynesian analysis three motivations are mentioned why money is held
(Davidson 2011): (a) money is kept to carry out daily transactions; (b) if cash-​
flows of private households or firms are irregular, money is kept for precau-
tionary purposes, (c) for speculators it can be advantageous to keep money.
However, there is one more motivation to keep money, (d) money can be kept
for hoarding purposes. It satisfies the desire to keep social wealth as such and
it helps to protect its owner from the imponderables of life in general and in
a capitalist system especially. ‘Gold is a wonderful thing! Whoever possesses it
is lord of all he wants. By means of gold one can even get souls into Paradise.’
(Columbus in his letter from Jamaica, 1503, quoted in Marx 1867, p. 85)
‘Because, partly on reasonable and partly on instinctive grounds, our desire to
hold Money as a store of wealth is a barometer of the degree of our distrust of
our own calculations and conventions concerning the future. … The possession
of actual money lulls our disquietude.’ (Keynes 1937, p. 316; see also Marx 1867,
p. 84f.). Fluctuations in the degree of confidence among economic agents cause
changes in the ‘propensity to hoard’ (Keynes, 1937, p. 216). Higher uncertainty
then leads to more hoarding. More concrete: Economic agents have a higher
preference to keep liquidity; entrepreneurs are reluctant to invest; banks are
afraid to give long-​term credits or credits at all; and private wealth owners stop
to buy long-​term bonds or shares.5
The fourth point is: ‘Inflation as well as deflation constitutes flights out of
the economy.’ (Riese 1986, p. 156, own translation). Both processes easily can
lead to cumulative processes and destroy the coherence of a monetary produc-
tion economy. High inflation fundamentally distorts the function of money as
unit of account for credit contracts and destroys the function of money as store
of value.

For it is unlikely that an asset, of which the supply can be easily increased
… will possess the attribute of ‘liquidity’ in the minds of owners of wealth.
Money itself rapidly loses the attribute of ‘liquidity’ if its future supply is
expected to undergo sharp changes.
(Keynes 1936, 241)
 International money and underdevelopment 119
Deflationary processes destroy the coherence of a monetary production
economy mainly because they lead to an increase of the real debt burden and
financial crises (Fisher 1933).
Based on these fundamentals a very simple portfolio model will be presented
in the next section which allows also the analysis of different currencies.

3 A simple monetary Keynesian portfolio model

Keynes (1936, ­chapter 17) argues that every asset, such as wheat, copper, real estate
as well as money has a rate of return which depends potentially on three elem-
ents: (a) the asset’s pecuniary rate of return, (b) carrying costs expressed in a rate,
and (c) a non-​pecuniary liquidity premium. The pecuniary rate is an interest rate
or a profit rate. Carrying costs are for example costs to store an asset. We will
assume carrying costs to be zero.The liquidity premium covers several dimensions.
First, it expresses the subjective judgement how quickly an asset can be used for
any purpose its owner wants to use it. It is also convenient and saves transaction
costs to hold a liquid asset. Second, it expresses the subjective expectation how the
value of the asset develops. If the asset is a credit claim it also can include the risk of
default.Third, it includes the general trust in an asset including all subjective factors
which makes it attractive to keep an asset or not. For example, wealth owners may
have a preference to hold real estate as they believe this is an especially safe asset.
The liquidity premium for money is of special importance. ‘The amount
(measured in terms of itself) which they are willing to pay for the potential con-
venience or security given by this power of disposal … we shall call its liquidity
premium.’ (Keynes 1936, p. 226, see also Keynes 1937, p. 316) Riese (1986)
speaks in this context from the asset safeguarding quality6 which can be expressed
in the liquidity premium of money. We can assume that money has usually
the highest liquidity premium. However, in certain historical constellations ‘the
possession of land has been characterised by a high liquidity-​premium in the
minds of owners of wealth’ (Keynes 1936, p. 241). This shows that the liquidity
premium covers much more than liquidity in the narrow sense. In our simple
portfolio model, we assume two types of monetary wealth –​liquidity or short-​
term monetary wealth and long-​term financial wealth. Money is here under-
stood as liquidity including demand deposits, short-​term time deposits and
other liquid assets.The definition of liquidity depends on the concrete situation
of a financial system. However, it should be clear that the character of assets as
liquid can quickly change. Short-​term liquidity earns a liquidity premium and
a short-​term interest rate. The latter is completely determined by the central
bank via its refinancing rate. Long-​term financial wealth earns a long-​term
interest rate plus also a liquidity premium. For simplification we also assume
that firms for investment purposes can only take long-​term credits.
The portfolio equilibrium for monetary wealth is then

il + lB = lM + is Eq. 1
120 Hansjörg Herr and Zeynep Nettekoven
or in gross returns

1 + il + lB = 1+ lM + is Eq. 2

with il as long-​term interest rate, lB as marginal liquidity premium of long-​term

interest-​bearing wealth, lM marginal liquidity premium of money, respectively
short-​term liquidity, and is short-​term interest rate determined by the central
bank. We assume falling marginal liquidity premiums with increasing stocks of
wealth held in an asset. For short-​term liquidity the fall of the liquidity pre-
mium with increasing liquidity holding may be small. In an extreme case of a
so-​called liquidity trap, the marginal liquidity premium may not fall at all with
an increasing stock of liquidity.
The long-​term interest rate increases when the central bank increases its refi-
nancing rate, when the level of the marginal liquidity premium of short-​term
liquidity increases or the level of the marginal liquidity premium of long-​term
wealth decreases, for example because of the expectation of higher default rates.
The portfolio model also allows us to explain functional distribution of
income in the monetary Keynesian approach. According to Keynes (1936,
­chapter 17) money earns a marginal liquidity premium which in an uncertain
world does not go down to zero. Interest rates cannot fall, so Keynes, below the
marginal liquidity premium. ‘If, however, the interest rate exceeds zero, a new
element of cost is introduced which increases with the length of the process.’
This leads to a situation that ‘the prospective price has increased sufficiently to
cover the increasing costs’ (Keynes 1936, p. 216). In an economy of pure com-
petition only the existence of a positive interest rate allows profits; otherwise,
competition would bring prices down to levels without profit. Of course, this
model can be made much more complicated with the central bank fixing a
minimum interest rate or with a certain spread between the interest rate and
the rate of return of productive capital. A second explanation of profit is the
existence of monopolistic, oligopolistic or monopsonistic markets, but this goes
beyond this analysis (Herr 2019).
We transfer now this approach to the international level to analyse the hier-
archy of currencies (see also Fritz et al. 2018; Kaltenbrunner 2015 as well as
Bonizzi/​Kaltenbrunner and Ramo/​Prates in this book).The currency in which
monetary wealth is denominated becomes an important and in many cases
a dominant element to determine the level of the liquidity premium or the
respective monetary wealth. Different currencies deliver for holder different
convenience and a different asset safeguarding quality. It makes for an economic
agent a difference, for example, to keep monetary wealth in United States (US)
dollar or in Ugandan shilling. A representative Ugandan wealth owner may
have a desire to hold US dollars whereas this desire is not very much distinct
of US wealth owners.
To keep the analysis simple, we assume one domestic and one foreign
country and look only at interest bearing long-​term monetary wealth. The
well-​known interest rate parity formula 1 + i = (1+ i*)(ef/​e) with i* as foreign
 International money and underdevelopment 121
interest rate, e as spot exchange rate (number of domestic currencies for one
unit of foreign currency) and ef as exchange rate in the future exchange market
or the expected exchange rate, gives the condition for the same rate of return
in both countries. Adding non-​pecuniary rates with lB as the marginal liquidity
premium for long-​term monetary wealth in domestic currency and lB* as mar-
ginal liquidity premium for long-​term monetary wealth in foreign currency,
the condition becomes:

1 + il + lB = (1+ il* + lB*)(ef/​e) Eq. 3

For example, if the United States is the domestic country and Uganda is the
foreign country and Uganda wants to keep the exchange rate stable, an increase
of US long-​term interest rates or a higher marginal liquidity premium for long-​
term US monetary wealth would lead to an increasing interest rate in Uganda –​
enforced by a higher refinancing rate of the central bank in Uganda. A fall in
ef/​e (expected appreciation of the US dollar) leads to an increase of the interest
rate in Uganda, otherwise the Ugandan shilling immediately depreciates.
Permanent and/​or strong depreciations are hardly possible for developing
countries. Depreciations may trigger expectation of further depreciation.
Also depreciations most likely reduce the level of the domestic liquidity pre-
mium further. In addition, depreciations trigger inflationary pressures and a
depreciation-​inflation spiral may develop. A real depreciation reduces the living
standard in a country which can be problematic in a developing country. Last
but not least, in case of debt denominated in foreign currency, real depreciations
increase the real debt burden with the effect of financial crisis.
If we assume that developing countries must keep the exchange rate
stable (or have to avoid strong depreciations) this allows us to set the value of
ef/​e as one. As the liquidity premiums in each country decrease with the stock
of monetary wealth denominated in the country-​specific currency, it follows
lB = lB(MW) and lB* = lB*(MW*) with MW domestic and MW* foreign long-​
term monetary wealth in country-​specific currencies. When we insert the two
functions in equation 3 and set ef/​e = 1 we derive:

[1 + il + lB (MW)] /​[1 + il* + lB*(MW*)] = 1 Eq. 4

The level of the marginal liquidity premium functions lB = lB(MW) and

lB* = lB*(MW*) depend to a large extent on the currency in which the mon-
etary wealth is denominated.The marginal liquidity premium function of mon-
etary wealth in US dollar has a much higher level than the marginal liquidity
premium function of the Ugandan shilling. The convenience and security
delivered for an economic agent keeping monetary wealth in US dollar must
be judged much higher than for keeping monetary wealth in Ugandan shilling.
Even if the interest rates in both countries are the same and the exchange
rate stable, in a world of uncertainty a wealth owner would have a preference
to keep US dollars. The different levels of the marginal liquidity premiums
122 Hansjörg Herr and Zeynep Nettekoven

z + lB(MW), z + lB*(MW*)

z + lB(MW) = z + lB*(MW*)

US dollar

Ugandan shilling · eUSD/shilling

MW* MW Monetary wealth measured in US
dollar
MW: Monetary wealth in US dollar, MW*: Monetary wealth in Ugandan shilling measured in US dollar
(Ugandan shilling · eUSD/shilling), z: Constant, lB: Marginal liquidity premium of interest bearing wealth in
US dollar, lB*: Marginal liquidity premium of interest bearing monetary wealth in the Ugandan shilling

Figure 9.1 Interest bearing monetary wealth held by a representative wealth owner in

US dollar and Ugandan shilling assuming a stable exchange rate and the
same interest rates in both countries.

of currencies signal the hierarchy of currencies. The different levels signal the
different qualities of currencies. A currency with a relatively low level of the
marginal liquidity premium is of relatively low quality.
To make the argument clear and its consequences, we assume that the mar-
ginal liquidity premium function of the Ugandan shilling is positioned below
the marginal liquidity premium function of the US dollar. Let us in addition not
only assume a stable exchange rate, but also the same interest rates in Uganda
and the United States. Then it follows: (1 + il) = (1 + il*) = z with z being
the value of this equation. From equation 4, it follows that in equilibrium: z
+ lB (MW) = z + lB*(MW*). In Figure 9.1, the marginal liquidity premium
functions for Ugandan shilling and US dollar of a representative wealth owner
are shown. Monetary wealth held in both countries is measured in US dollar. As
the level of the marginal liquidity premium function of the US dollar is on the
top, in equilibrium monetary wealth held in Ugandan shilling (MW*) is much
smaller than in the US dollar (MW).
What we see here is of fundamental importance to understand the rela-
tionship between the quality of a currency and underdevelopment. As behind
the creation of monetary wealth stands the creation of credit, it shows that
Uganda is seriously constrained to expand credits in domestic currency. The
Schumpeterian-​Keynesian credit-​income-creation process mentioned above,
which is the backbone of any prosperous development, is fundamentally
constrained in countries with low quality currencies.
 International money and underdevelopment 123
If we relax the assumption of the same interest rate a country like Uganda can
increase the interest rate above the level of the United States. In this case, wealth
owners keep more Ugandan shilling and Uganda can expand its domestic credit
expansion without triggering depreciation. However, higher interest rates have
negative effects for investment. In addition, higher interest rates change income
distribution towards the rich and reduce in this way the growth chances of
developing countries (Ostry 2015; Herr 2018).
The typical developing country will end up with a combination of higher
interest rates than the United States and at the same time a lower stock of mon-
etary wealth or credits in percent of gross domestic product (GDP).This constel-
lation very much fits to the empirical reality. In Table 9.1 it can be shown that
private credit to GDP in 2018 was highest in high-​income countries and lowest
in low-​income countries. If we take the United States as a comparison the table
clearly shows that in a typical developing country domestic credit to the private
sector as share of GDP is relatively low and/​or the real interest rate is relatively
high. Because of the highly regulated financial system, China is an exception.
A country with a low-​ quality currency can increase credit via credit
denominated in foreign currency. In this case credit expansion can continue
without increasing wealth in domestic currency. This sounds tempting. But the
sweet poison of foreign debt is extremely dangerous. It creates currency mis-
match and fragility of the financial system. As soon as credits are not rolled over

Table 9.1 Domestic credit to private sector in percent of GDP and real interest rates,
selected countries, 2018

Country Domestic credit to the private Real interest rates

sector in percent of GDP in 2018 in 2018

High-​income countries 144.5 -​

Middle-​income countries 105.2 -​
Low-​income countries 41.2 (2017) -​
United States 187.2 2.4
China 161.1 1.4
Brazil 61.8 35.0
Bolivia 65.9 4.8
Burundi 18.0 18.2
Guatemala 32.8 9.7
Honduras 63.0 15.7
India 50.0 5.1
Jamaica 32.0 (2016) 6.5
Kyrgyz Republic 23.9 17.8
Mali 34.6 3.0
Mexico 23.7 3.0
Nigeria 10.0 6.0
Pakistan 18.8 5.9
Uganda 16.4 16.1

Source: WDI (2019)

124 Hansjörg Herr and Zeynep Nettekoven
and credit expansion in foreign currency stops, a strong depreciation cannot be
avoided, which triggers a foreign exchange and domestic financial system crisis
without possibilities of the domestic central bank to stabilise the situation.

4 Factors which make a national currency an

international one
In a global economy, international currencies are needed. Internationally
important goods have to be priced in a common currency. More important,
cross boarder credits must be denominated in the currency of the creditor or
debtor or a third currency. As soon as an international currency exists there is
the need and motivation to use this currency as a store of international mon-
etary wealth. There is no world currency in the sense that this currency only
takes over international functions. Keynes’ (1969) proposed Bancor and later the
Special Drawing Rights (SDRs) created by the IMF have elements of an inter-
national currency but can only be used by central banks. International functions
are taken over by national currencies. Which currencies take over international
functions is selected by private wealth owners and other economic agents. The
selected currencies own a relatively high level of liquidity premium; they offer
for their users a lot of convenience and asset safeguarding quality.
We group the factors which make a national currency an international one
in macroeconomic, institutional and geopolitical factors.7 Until now monetary
Keynesians have not contributed much to this debate. But this debate is very
fruitful for monetary Keynesians.
The macroeconomic preconditions include factors of size. Important are the
relative GDP size, relative trade shares, diversification of trade structure, role
in global supply chains, and centrality in global trade networks. Essential is
also the domestic financial market development, meaning a deep, broad, liquid,
resilient financial system. Size factors lead, comparable with the use of a lan-
guage, to economies of scale and scope in terms of decreasing transaction costs
or increasing liquidity of keeping monetary wealth in a currency, the more
economic agents use it. Size factors support inertia, meaning the tendency of
using a currency which everyone else is using in spite of the erosion of factors
which make a currency an international currency. The erosion and rise of an
international currency are most likely cumulative and disruptive.
Importance for the asset safeguarding quality of a currency is a low level of
inflation and low variability of the inflation as well as the exchange rate. Overall
macroeconomic stability in the currency-issuing country is a precondition for
an international role of a currency.
Looking at institutional preconditions a liberalized domestic financial system
and free cross-​border capital flows are quintessential for currency international-
ization. Other relevant institutional factors are the existence of the rule of law
and its enforcement. About all these factors there is a broad consensus in the
literature.
 International money and underdevelopment 125
Geopolitical factors are of key importance as well. To play a leading inter-
national role the currency issuing country must provide a safe haven which
implies economic, political and military power. US military power and wide-
spread military bases across the world are considered to be a significant factor
sustaining the US dollar’s international status.
The mirror image of the disadvantages of countries with low levels of their
marginal liquidity premium functions of monetary wealth denominated in
their domestic currencies is the privilege of the countries issuing high-quality
currencies (Cohen 2012). Countries with international currencies, first of all,
can afford a much higher credit expansion in domestic currency and lower
interest rates and in this way increase their development chances.They can earn
high seigniorage because banknotes and coins held outside the country allow
the import of goods and services without exporting something or take a credit.
Internationally important goods are traded in the international currency. More
important is that domestic units from firms to public household can accumulate
foreign debt denominated in domestic currency and avoid currency mismatch.
Last but not least, countries issuing an international currency have high room
of manoeuvre to afford capital export for all kind of economic, political and
military purposes. In fact, a bidirectional relation exists, such that military and
political power supports a currency’s international role and an international
currency allows a large monetary policy space, which facilitates military and
political power.

5 Types of currency hierarchies

In the above sections we argued that different levels of marginal liquidity pre-
mium functions of currencies create a currency hierarchy. In such a hierarchy
three groups can be distinguished.
From the existing around 180 currencies a very small number takes
over international functions and can enjoy the privileges linked to it. These
currencies have the highest levels of liquidity premiums. What is specific for
these currencies is that they do not only take over national functions but in add-
ition international ones. Demand for these currencies is high as also foreigners
desire to keep them. In the present historical situation international functions
are mainly taken over by the US dollar which is dominating. On second place
is the euro and all other currencies play small or no international role (see
Table 9.2).
A second group of currencies take over all national functions. Obviously, the
liquidity functions of these currencies are high enough that economic agents
living in the currency areas keep the national currency as a store of wealth and
massive capital flight is prevented. Generously counted, around 25 currencies
may take over all national functions of money. These are the currencies mainly
issued by the advanced industrialized countries, for example by Canada,
Australia, Sweden, Denmark, Singapore, etc.
126 Hansjörg Herr and Zeynep Nettekoven
The remaining currencies have –​to different degrees –​low levels of marginal
liquidity premium functions. To keep them does not deliver a lot of conveni-
ence for their holders and especially as asset safeguarding quality of the cur-
rency must be considered to be low. These countries are confronted with the
problem that economic agents prefer to keep a large proportion of their mon-
etary wealth in foreign currencies which are on top of the currency hierarchy.
Even worse, many of these countries suffer from dollarisation (or euroisation).
This means that these currencies only partly take over national functions and
foreign currencies take over the most important money functions (De Paula
et al. 2017; De Conti and Prates 2018).
Historically currency hierarchies can have different characteristics. Two
especially important ones should be mentioned here. First, the integration of
global financial markets can have different degrees. As long as there are high
capital controls, a suppression of dollarisation in most countries in the world
and it is difficult for economic agents to hold foreign currencies, the competi-
tion between currencies is reduced.
Strict capital controls and government-​ supported or even government-​
driven domestic credit expansion is an option for developing countries and can
protect and trigger a sustainable domestic credit expansion. China (mainland)
is the latest successful example of such a policy (Herr 2010). Countries such as
early Japan, South Korea or Taiwan followed similar policies before (Stiglitz and
Uy 1996). Today for many developing countries this is difficult because of the
integration in global markets.
There is a second specific characteristic of currency hierarchies. The com-
petition on top of the currency hierarchy can be very intensive or not. In the
latter case we can speak about a hegemonic currency hierarchy. In a hege-
monic currency system one currency is uncontested with clearly the highest
asset safeguarding quality and fulfils all functions of money internationally. It
is also likely, not guaranteed, that the country issuing the hegemonic currency
takes the responsibility to keep the currency’s value stable, being an inter-
national lender of last resort, and also keeps its markets open in world crisis
constellations. It then provides the international economic public good of systemic
stability of the global financial system. However, a hegemon can exploit its pos-
ition at the cost of other countries, and therefore, may destabilize the system
(Kindleberger 1967, 1986; Herr 1992).
On top of the currency hierarchy also a small number of countries can
compete and create a multi-​currency system (Herr 1992). The whole logic of
money is that one thing takes over money functions. This already shows that
many currencies with international functions can become very problematic.
It leads to higher transaction costs due to limited economies of scale of each
of the currencies. But what is much more important. Economic and political
developments can lead to quick and substantial shifts in the evaluation of a cur-
rency in the eyes of economic agents and can potentially lead to violent shifts
of monetary wealth from one international currency to another. Exchange
rates between key currencies will be unstable and create shocks for the world
 International money and underdevelopment 127
economy. The level of uncertainty becomes high. Friedrich von Hayek (1976)
stressing the advantages of currency competition would be happy about sev-
eral international currencies. His main argument that the competition between
currencies would lead to disciplined macroeconomic policy making. Also the
advantage for wealth owners to diversify wealth holding and risk is mentioned
(see also Frankel 2009; Eichengreen 2009). These arguments are certainly valid.
But from a monetary Keynesian perspective the disadvantages of a multi-​
currency system are even bigger. The possibility of frequent shifts of monetary
wealth from one internationally important currency to another destabilises the
world economy. Governments and central banks are stimulated to follow too
restrictive policies to fight for a dominant position for their national currency.
This can push the world economy into an overall very restrictive macroeco-
nomic constellation with low growth. In addition, no country may be able and
willing to provide the public good of systemic international stability (Herr
2011; Kindleberger 1986). Under such a system, the development chances of
countries with low-quality currencies may be further reduced.
In what follows, we analyse the top of the present currency hierarchy in some
detail especially looking at the US dollar, the euro and the renminbi as poten-
tial new international currency. After its introduction in 1999 the euro became
the closest rival to the US dollar (ECB 2018).Yet, Table 9.2 shows that the US
dollar sustains its dominant role in official international reserves, as a unit of
account for internationally important products, in transaction volumes of for-
eign exchange markets, and for denominating international credit contracts.
The international role of the US dollar was most dominant in the 1970s and
then slightly decreased. An indicator is the development of official international
reserves. In the early 1950s, around 30% of international reserves were held in
US dollar and over 50% in pound sterling. Then the role of the pound sterling
eroded quickly and the US dollar gained in the 1970s a share of 80% (Schenk
2009). Overall, the euro has not been able to increase its importance after its
introduction. Until today the role of the renminbi as international currency is
unimportant in spite of some increases from a low level.
Looking at the preconditions for the international role of currencies the dom-
inance of the US dollar, the stagnating role of the euro and the continued
small role of the renminbi are not surprising (see Table 9.3). China became
an important power and ready for an international role of the renminbi when
the macroeconomic indicators like relative size of the Chinese GDP or trade
indicators are taken. Following the Global Firepower (2019) Index, also the mili-
tary power of China is high, and it ranks in the field of conventional weapons
closely behind the US and above Europe. But the strict capital controls, restric-
tion in the capital account, the highly regulated domestic financial system and
the low indicators of the rule of law prevent a market-​based substantial inter-
national role of the renminbi.
Macroeconomic indicators in the euro area and also openness to cross-​border
finance are comparable with the United States. But political and military power
of the euro area is not united. It lacks the character of a state, managed the crisis
 newgenrtpdf
128 Hansjörg Herr and Zeynep Nettekoven
Table 9.2 International role of currencies, US dollar, euro and renminbi

Year Year Year

US Dollar Euro Renminbi US Dollar Euro Renminbi US Dollar Euro Renminbi

Currency in which official foreign 71.0 17.9 -​ 62.1 27.7 -​ 60.72 20.58 1.94
exchange reserves are held, % of
total foreign exchange reserves
(1999, 2009, 2019)a
Foreign exchange transactions, 87.0 -​ 0.0 85.0 39.0 1.0 88.0 32.0 5.0
% of total foreign exchange
transactions (total: 200%) (1998,
2010, 2019)b
International debt securities, 44.9 12.0 0.003 29.8 49.4 0.055 46.3 38.8 0.432
% of total international debt
securities (Q4 of 1999 and
2009, Q3 of 2018)c
International loans and deposits, % 48.5 24.0 -​ 47.7 34.3 -​ 51.5 28.5 -​
of total international loans and
deposits (Q4 of 1999 and 2009,
Q3 of 2018)d
Cross-​border monetary -​ -​ -​ 33.3 39.8 0.57 45.5 34.0 1.14
transactions by banks, % of
total cross-​border monetary
transactions by banks (2012 and
2018)e

Source: a)International Monetary Fund (IMF) (2019a); b)Bank for International Settlements (BIS) (2019a); c) BIS (2018); d)BIS (2019b); e)SWIFT (2019)
 International money and underdevelopment 129
Table 9.3 Major preconditions for currency internationalisation

US or US Euro area1 China or

Dollar or euro Renminbi

GDP size2, % of world (2017)a 15.1 11.3 18.6

Share of export of goods and services, % of 10.1 25.8 10.1
world (2019)b
Share of imports of goods and services, % of 12.8 24.5 10.2
world (2019)c
Export diversification index3 (2014)d 1.7 2.2 2.0
Capital controls4 (2016)e 3.9 5.0 0.8
Chinn-​Ito index of freedom to cross border 2.33 2.33 -​1.22
capital flows5 (2018)f
Inflation differential from the average of 0.6 -​0.1 0.2
developed economics (G7) (2018)g
General government debt to GDP, % (2019)h 134.6 84.0 52.6
Rule of law (2017)i 1.6 1.2 -​0.3
Military power6 (2019)j 0.06 0.97 0.07

Notes: 1For the euro area the simple average is calculated except for GDP, exports and imports and
government debt; 2PPP GDP, constant 2011 international dollars; 3higher values indicate lower
export diversification; 41 indicates fully liberalized capital account; 4a high number indicates more
freedom to cross-​border capital flows, potential values go from 0 to 10; 5a higher index indicates
more freedom for cross-​border financial flows, in 2018 the values ranged from 2.33 to −1.92;
6
military power index for conventional weapons, including factors such as quantity and diversity
of weapons, geography, natural resources, industries development, available manpower, alliance,
financial stability, political and military leadership, the United States, Russia and China are the top
three in military power ranking as of 2019; 0 means highest military power.
Sources: a)WDI (2019); b), c)IMF (2019b), d), h)IMF (2018); e)Fraser Institute (2019); f)Chinn and Ito
(2018); g)IMF (2019c); i)Worldwide Governance Indicators (2019); j)Global Firepower (2019); own
calculations

after 2008 because of a lack of a fiscal centre and until 2012 very limited role
of the European Central Bank as lender of last resort for public households and
the asymmetric policy of the Troika to stabilise the euro area in an extremely
poor way, and has many unsolved problems of further integration (Herr et al.,
2019; Heine and Herr 2021). This prevents the euro to take over the same
international functions as the US dollar (for the debate see Eichengreen 2019;
Maggiori et al. 2018; Efstathiou and Papadia 2018).
The international monetary system in the post-​Bretton Woods era moved in
the direction of an inherently unstable system, meaning that it is uncoordinated
and characterised by unstable capital flows and has high exchange rate vola-
tility between leading currencies (Corden 1983). To speak about a substantial
erosion of the international role the US dollar would be wrong. However, the
euro is at least until today strong enough to create some currency competi-
tion. The very unstable US exchange rate after the end of the Bretton Woods
System in 1973 was caused by rather volatile capital in-​and outflows to the
United States.These destabilising capital flows were mainly caused by changing
evaluations of the liquidity premiums of the world key currencies, especially of
130 Hansjörg Herr and Zeynep Nettekoven
the US dollar. This instability at the top of the currency hierarchy contradicts
with a globalised financial system with large international credit relationships.
Depreciations and appreciations have the same destructive effects for inter-
national credit contracts as inflations and deflations for national credit contracts.
And a dominating international reserve currency with an unstable exchange
rate does not deliver a satisfactory asset safeguarding quality for wealth owners.
From this point of view, the Gold Standard before 1914 with free capital flows
and fixed exchange rates was a more functional world currency system than the
existing one. The Bretton Woods System and even more Keynes’ (1969) idea of
an international currency union with fixed but adjustable exchange rates and
some capital controls was a compromise between a functional international
monetary system and economic autonomy of nation states and delivered the
framework for the prosperous development after World War II.

6 The future of the world currency system

In the present situation and during the next decade there is no real rival for the
US dollar which could substantially reduce its dominance. It is not likely that
the euro increases its international role.The integration process of the euro area
towards a kind of state which would be needed to strengthen the international
role of the euro is slow and controversial. The renminbi might in the long-​run
become a competitor for the US dollar but not during the next foreseeable
future (Posen 2008; Prasad 2014).The institutional conditions and the develop-
ment stage of the domestic financial system alone prevent a substantial market-​
based international role of the renminbi. China will most likely politically push
for a bigger international role of its currency. A symbolic step was when in
2016 the renminbi became part of the SDR basket. China will support the use
of the renminbi in Chinese foreign trade by extending swap agreements with
trading partners. This avoids indirect payments via the US dollar for imports
and exports from China. China also can and will give foreign credits in ren-
minbi for development aid and support for countries involved in the Belt and
Road Initiative. These steps will further increase the international role of the
renminbi, but this are all small steps.
The dominant role of the US dollar in the foreseeable future does not imply
that the relative power of the United States has not been eroding. Cohen (2011)
stressed two dimensions of monetary power: Influence and autonomy. The
United States certainly has been confronted with eroding monetary power to influ-
ence countries, whereas China and the euro area have gained some of this power
and also more autonomy. One can think of the Chinese Belt and Road Initiative.
It cannot be excluded that the United States in future will to a lesser extent
provide the public good of global financial stability or even exploit the position
of the US dollar regardless of the consequences for global stability. There is a
very high likelihood that the world currency system will move slowly further
in a constellation of more intensive currency competition. Such a development
will take place against the background of shifts in the global power balance
 International money and underdevelopment 131
with a bigger role for China. This will lead to more instability and involves
potentially very negative effects for global stability. It will increase the need for
cooperation especially if a hegemon which could stabilise the world economy
becomes weaker.
For developing countries with currencies with low levels of their liquidity
premiums the globalisation model which developed after the 1980s creates fun-
damental problems.The tendency to reduce capital controls and the permanent
pressure from developed countries to agree to free trade and international
investment agreements to further open the capital account and economy in
general exposes them to intensive currency competition with all the problems
discussed above. In many cases, high foreign debt in foreign currency is the
short-​term strategy to overcome the restrictions in domestic credit expansion
which a low level of the marginal liquidity premium function of the national
currency poses. Foreign credit can create some relief but creates the risk of deep
and long financial crises and long-​term dependencies.
For the countries in the Global South a key strategy to develop is to increase
the level of the marginal liquidity premium function of their currencies,
respectively increase the asset safeguarding quality of their currencies. This can
be done by keeping inflation rates low and defend macroeconomic stability. Of
special importance is to avoid current account deficits and foreign debt. Capital
controls should become a normal economic policy instrument again to give
more room for domestic policy. The excessive reserve accumulation by some
developing countries over the last decades can be considered as self-​protection
(Ocampo 2010) or self-​insurance (Obstfeld 2011) against the unpleasantness of
the existing globalisation model. This instrument also can be used to prevent
temporary appreciation pressures and current account deficits.
Many economists have been demanding reform options for the inter-
national monetary system. All radical versions go back to Keynes’ idea of an
International Clearing Union and the creation of the Bancor as a supranational
currency for central banks (Keynes, 1969). A supranational currency as a reserve
currency could eliminate the Triffin Dilemma (1961) and provide liquidity for
central banks beyond a national currency which might not be able to fulfil this
function in an appropriate way (Zhou, 2009). A strong International Clearing
Union could help to stabilise exchange rates. But it should not be forgotten
that an International Clearing Union also includes certain capital controls
between developed countries and mechanisms to avoid high current account
imbalances. Such a reform would involve a completely new direction of the
globalisation project (Stiglitz 2000; Herr 2011; Ostry et al., 2011; Mundell
2000; Eichengreen 2016, among others). Less demanding reforms would be the
establishment of institutions and mechanisms which provide the international
public good of systemic stability (Helleiner 2010; Ocampo 2010). Examples
would be to strengthen the role of IMF’s SDR, to give developing countries
more room for domestic policy, to help them to avoid high foreign debt, to give
up aggressive mercantilist policies by some countries and give development aid
which is in the interest of developing countries.
132 Hansjörg Herr and Zeynep Nettekoven
Notes
1 For helpful comments we thank Annina Kaltenbrunner, Bruno Bonizzi and Thomas
Wolke.
2 In addition to the monetary Keynesian approach, the Neoclassical Synthesis with the
so called IS-​LM Model became a very influential Keynes interpretation. Money is
included in the model, but the model failed to develop a new paradigm and remained
in the framework of Neoclassical thinking. New Keynesian models have almost
nothing to do with the original Keynes.
3 This is for example the case for the very popular Dynamic Stochastic General
Equilibrium Models, but also for a number of Kaleckian and Marxian models.
4 ‘The volume of investment and not an endowment of physical resources is the
“first” budget constraint of the goods market system’ (Riese 1986, p. 273, own
translation).
5 It should be obvious that the demand for money as a store of value in the approach
presented here has not much in common with the demand for money in the
Neoclassical Synthesis.
6 Vermögenssicherungsqualität.
7 For the first two areas, see Aliber (1964); Ballantyne et al. (2013); Bergsten (2009);
Broz (1999); Chinn and Frankel (2005); Chen and Peng (2010); Eichengreen (2011);
Flandreau and Jobst (2009); Genberg (2010); Kindleberger (1967); Krugman (1984);
Prasad and Ye (2012); Lo (2010); McKinnon and Schnabl (2014); Tavlas (1991), for
the third area Helleiner (2008); Posen (2008); Cohen (2012).

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10 
The Post Keynesian view
on exchange rates
Towards the consolidation of the different
contributions in the ABM and SFC
frameworks
Raquel A. Ramos and Daniela Magalhães Prates

Introduction
The behaviour of nominal exchange rates has long been a puzzle in mainstream
economics. Unsurprisingly, the interest on this key issue has flourished in two
periods featured by the predominance of floating exchange rates –​the first
years of the interwar period and after the collapse of the post-​Bretton Woods
regime –​when the research on its determinants has become theoretically rele-
vant (Macdonald 2007). In the case of the Post Keynesian (PK) approach, focus
of this paper, exchange rates started to draw attention of some scholars in the
early 1980’s following the high instability of the new International Monetary
and Financial System (IMFS).
As it will be shown in this chapter, the different PK contributions share a
view of exchange rates in this historical setting as a result from bank dealers’
and, mainly, money managers’ portfolio decisions, predominantly, institutional
investors, whose increasing importance is a major feature of the current phase
of capitalism (Minsky 1986, Bonizzi 2017a). These decisions, in turn, are based
on social conventions due to fundamental uncertainty. Some authors also call
attention to the differences in exchange rate dynamics according to the level of
sophistication of foreign exchange (FX) markets and/​or to the position of the
currency in the IMFS. While central countries’ exchange rates would present
a zigzag pattern, the ones of Emerging-​Market Economies (EME) would face
cycles of continuous appreciation trends interrupted by sudden depreciations.
These cycles would be associated with different balance-​sheet constraints of
these investors that derive from specificities of EME currencies. Finally, the PK
approach to exchange rates share the school’s presuppositions (Lavoie 2014) of
realism, historical and irreversible time, and the importance of institutions.
However,the PK contributions on such crucial topic on open macroeconomics
has been rather disperse and, maybe because of that, has received relatively small
attention of PK scholars. A consolidation of these contributions in what we
could call the PK view on the nominal exchange rate has not been drawn
138 Raquel A. Ramos et al.
up yet and could contribute for the dissemination and improvements of the
school’s contributions.
This chapter contributes to fill this gap in the PK literature in two
interconnected steps. One step is the presentation of a critical assessment of the
different PK works on this issue, which highlight the role of technical analyses,
financial convention and behavioural insights in the decision-​making process
in advanced countries FX markets (first section), and the dynamics of EME
currencies linked to their position in the current IMFS that influences money
managers’ decisions (second section). The second step is the complementation
of this debate, as they are presented, with the suggestion of how to model the
different PK insights in equations as the ones used in agent-​based (AB) and
stock-​flow consistent (SFC) models. This exercise is expected to help consoli-
dating the main PK arguments in a common framework useful for both the-
oretical and empirical analyses of exchange rates. Differently from mainstream
works where equations pretend to present how an economy works (or how
the exchange rate is determined), the behavioural equations presented in this
chapter aim at fostering the debate by calling attention to the importance of
some (very) explicitly presented mechanisms that are supposed to specific to a
given set of institutions and flexible enough to be modified when used to dis-
cuss different cases.
Agent-​based models (ABM) as well as stock-​flow consistent (SFC) models
have recently gained considerable space among economists, especially driven by
the failure of existing models in face of the global financial crisis of 2008. SFC
models are increasingly esteemed among PK macroeconomists for allowing a
rigorous description of economic relations through different sectors’ balance-​
sheet relations without ‘black holes’ (Godley and Lavoie 2005, p. 3), while the
ABM framework allows the inclusion of heterogeneous agents and detailed
microeconomic interaction. By combining these two features, the incipient
AB-​SFC models (Caverzasi and Godin 2015) are thus agent-​led models where
the stock-​flow constraints hold.
Several characteristics of the ABM and the SFC frameworks make them per-
fectly suitable for Post Keynesian and for exchange rate analysis. Time is treated
as historical or in a period-​by-​period basis, allowing analysis of volatility, vola-
tility clustering and feedback effects. Another aspect is the possibility of mod-
elling the productive and monetary sides, and of having the exchange rate as
a result of the interaction of both. The flexibility offered by these frameworks
is also remarkable and specially fit for PK analyses and its institutional-​rich
details. Moreover, an AB-​SFC model with all economic sectors tied together
also allows analyses of contagion among markets that are part of an investor’s
network. Finally, the SFC constraint demands the consideration of both flows
and stocks, allowing for an analysis that considers the amount of capital avail-
able at a given moment for leaving a country (what is crucial for the analysis of
exchange rate crises, for instance).
The next section presents suggestions on how to incorporate Post Keynesian
insights in the AB-​ SFC framework. These aim at facilitating theoretical
 Post Keynesian view on exchange rates 139
Table 10.1 Differentiation of behavioural rules and assets

According to exchange rate Chartist Trader might be fast or slow

expectation formation
According to the currency
in which the asset is
denominated
According to the currency in
which an agent’s liabilities
are denominated
According to the impact of
current and past turbulence
on liquidity preference
(Equations (1)–​(2))
Trader might be trend follower or
contrarian (Equation (3))
Fundamentalist Traders differ according to the
weight given to different
fundamentals (Equation (4))
Portfolio allocation also depends on the liquidity
premium offered by different currencies
(Equations (9)–​(12))
In periods of crisis, agents convert their assets into the
currency of their liabilities (Kaltenbrunner 2015)
How much agents value liquidity changes with
turbulence in international markets (Equation (13))
and as the memory of turbulent events fade out
(Equation (14))

discussions and could enrich AB or SFC models, not constituting a model itself
(the inclusion of all these elements in one model only would probably make it
difficult to analyse the impact of each of them). The different insights provide
a differentiation of behavioural rules according to theoretical and empirical
works (and some differentiation of assets).The innovation in models that would
apply these rules would therefore be mostly on the ABM part of it, the SFC
structure being much like the one of other models (as Lavoie and Daigle 2011).
Table 10.1 presents some of the differentiation of agents discussed in the next
section.

The PK exchange rate view

Some exchange rate analyses are focused on peripheral or emerging countries’
currencies what reflects a structuralist centre-​periphery vision. Before discussing
them, we present analyses that, for being focused on the impact of the use of
currencies’ as assets by private agents, have interesting insights for analyses of
EMEs’ currencies. We label these as central economies’ exchange rates analyses
as the institutional background of their analyses match those of these countries
and no consideration of peripheral currencies’ features are included.

Central economies’ exchange rates

Important contributions for the understanding of exchange rates by PK scholars
come from the works of Schulmeister (1987, 1988, 2008, 2009, 2009b) and
Harvey (1991, 1998, 1999, 2009).These authors put forward the decision-​making
140 Raquel A. Ramos et al.
process in FX markets, underlining the volatility of exchange rates, and have in
common a search for realisticness in their assessments (Schulmeister’s work is
often based on survey studies), what is keen for Post Keynesian analyses. Their
analyses can be seen as highly complementary, as Schulmeister provides greater
details of the workings of technical trading systems (what is most of the time
chartist behaviour) and Harvey details the behaviour of agents that expect the
exchange rate to move according to changes in macroeconomic variables (simi-
larly to a fundamentalist behaviour). Their analyses are however not limited
to that.
Schulmeister (2008) argues that exchange rates present a systematic zigzag
pattern as a result of the interaction of a series of dynamics. One point are the
different strategies followed by traders. Trend followers buy (sell) when prices
are rising (falling), and according to the length of time considered in their
analysis their models can be fast or slow (the first ones considering a short
time-​span). According to this chartist behaviour, the exchange rate expectation
( E ce ) would be given as in Equations (1) and (2), respectively, for fast and slow
models, where m > n :

E t −1 − E t − m
E cSlow
e
= E t −1 + (1)
Et − m

E t −1 − E t − n
E cFast
e
= E t −1 + (2)
Et − n

Schulmeister (2008) also describes the existence of contrarian models, that sell
(buy) assets when their prices are rising, but at a slower pace (and buy when
prices are declining at a falling pace). In other words: if the exchange-​rate
change of period t(et) is greater than the average observed since period t – n,
the contrarian agent expects the future exchange rate change to be in the
opposite direction of the current trend (Equation (3) for an expectation of
trend reversal after three periods of falling pace).

ete+1 = −et if et < et −1 < et − 2 and e is positive, or

if et > et −1 > et − 2 and e is negative (3)

News and medium-​term expectations have important roles. News set off
trends as traders expect others to open new positions, but their impact is
influenced by the (medium-​term) ‘market mood’ prevailing: if in line with
it, a trend will get a higher recognition and reaction. The end of a trend, on
the other hand, could be due to a smaller number of traders getting into the
bandwagon, due to the speculation of some traders of its end, or because
traders decide cashing in their profits. Cash-​in can be included through the
 Post Keynesian view on exchange rates 141
inclusion of a selling sign when a certain threshold in the profits accumulated
is achieved. In an ABM framework, its modelling asks for a rule where an
agent sell an asset when the cumulated profits achieve a given percentage of
its wealth.
Harvey (2009) consolidates a series of his previous works on the subject.
Due to the considerable weight of portfolio flows among developed economies,
his work is focused on how portfolio investors build their expectations and
decisions. The analyses of expectation formation include Keynesian insights of
fundamental uncertainty, confidence, and animal spirits, and concepts of behav-
ioural economics that are used to explain forecast-​construction biases in FX
markets. To explain how forecasts are drawn, Harvey presents a ‘mental model’
describing the variables that affect the exchange rate. This model is based in
three layers. First, foreign currency demand depends on net exports, net for-
eign direct investments, and net portfolio foreign investment. Secondly, to build
their expectations about the final flow of capital, investors would analyse their
determinants: the expected inflation differential between the domestic and the
foreign country, the expected relative macroeconomic growth, the expected
relative interest rates, and the expected liquidity (the ‘base factors’). Finally,
variables that are published more often can be used as proxies for these ones –​
e.g., unemployment rates as proxy for GDP.
Given that ABM and SFC models can also simulate the dynamics of an
economy’s productive side, these models could include exchange rate
expectations that respond to change in those variables according to Harvey’s
description of what could be seen as a fundamental behaviour, resulting in an
endogenous fundamentalist behaviour and the study of interactions between
the productive and the financial sides. In this sense, a fundamentalist trader
could be given by Equation (4) (where $ and # represent the two countries).
If an ABM framework of heterogeneous agents is used, the macroeconomic
variables can also have different weights for different individuals by adjusting
the parameters γ, Ω, and θ.

E#e fHarvey = E# t −1 − E# t −1[ γ ( X # − IM # ) + Ω( y# − y$ ) + θ(r# − r$ )] (4)

While the ‘Mental Model’ discusses how investors could determine exchange
rate expectation, the ‘Augmented Mental Model’ includes other dynamics in
FX markets, as how exchange rate determination is impacted by the workings
of volatility, bandwagons, technical analysis, trading limits and cash-​in.
It should be noted that although some of these macroeconomic variables
might be seen as the exchange rate fundamentals in mainstream models, for
Harvey (2009) they determine the exchange rate dynamic through its influence
on agents’ expectations –​what is different from the idea that fundamentals dir-
ectly drive exchange rates to an equilibrium value (Harvey 2001). In this sense,
Harvey’s model can be seen as an example of the current financial convention
in the sense of Orléan (1999) –​the socially accepted, prevailing quantitative
142 Raquel A. Ramos et al.
model used to estimate the expected value. Indeed, Harvey (2009) argues that
this model evolves ‘as a function of the social context in which the agents
interpret their experiences and scholars and professionals engage in research’
(Harvey 2009, p. 54).

Peripheral economies’ exchange rates

The second group of contributions discussed in this chapter try answering why
the dynamics of exchange rates of peripheral economies would differ from the
central ones. If the latter are marked by zigzag patterns (Schulmeister 2009), the
first are subordinated to the international financial context, being marked by a
high frequency of extreme exchange rate depreciations in moments of turbu-
lence internationally (Kaltenbrunner and Painceira 2014, Ramos 2016). This
specific exchange rate dynamic would be related to different decisions taken by
investors in different moments, most of them being related to these currencies’
structural characteristics, as the place they occupy in the hierarchical inter-
national monetary system.
In the post-​Bretton Woods system, the U.S. dollar is placed at the top of the
currency hierarchy, due to its ability to perform the three functions of money
internationally (medium of payment, unit of account and denomination of
contracts, and store of value). In an intermediate position are the currencies
issued by other central economies used as means of payment and store of value
(with the Euro occupying a most prominent place than the others; De Conti
et al. 2014). At the bottom of the hierarchy are the currencies issued by EMEs
that are incapable of performing those functions, even marginally (Andrade
and Prates 2013). From the Post Keynesian perspective shared by these works,
the different layers in the IMS would be related to different levels of liquidity
premium paid by currencies –​the U.S. dollar paying the highest value. This
structural attribute was later analysed through an adaptation of the Keynesian
equation on an asset’s total return (Keynes 1936; Andrade and Prates 2013;
Kaltenbrunner 2015). With this equation, the liquidity premium (l) is a deter-
minant of a currency’s ‘total expected return’ (or ‘own interest rate’, r) together
with its expected appreciation (a), quasi-​rent (q, or yield), and carrying costs or
degree of financial openness (c) –​as in Equation (5); (Andrade and Prates 2013).

r = a + q−c + l (5)

Andrade and Prates (2013) argue that given the structurally low l of emerging
economies’ currencies, its desirability would only increase when compensated
by changes in the other variables (a, q, or c). Kaltenbrunner (2015) and De Paula
et al. (2017) consider a currency’s returns in relation to the attributes of a ‘com-
peting’ currency (*).
In De Paula et al. (2017), the consideration of relative terms emphasizes the
alternatives that emerging countries have to compensate for the low liquidity of
their currencies (l < l*): to offer a higher q, or to reduce c –​as in Equation (6).
 Post Keynesian view on exchange rates 143
l−l∗ = (a+q–​c) − (a*+q*−c∗) (6)

Considering transactions costs to be irrelevant, Kaltenbrunner (2015) uses the

framework to argue why emerging countries would have structurally higher
interest rates –​as in Equation (7).

(q−q∗) + a = (l−l∗) (7)

These studies shed light on aspects that have an influence on the demand of
emerging economies’ currencies and on the policy restrictions faced by per-
ipheral economies, but when considerations on the state of liquidity preference
are included in the analyses, these become closer to exchange rate analysis for
adding a temporal aspect –​as the impact of a sudden change, in this case of
uncertainty in international financial markets. The central element of diffe-
rence among central economies’ currencies and the ones of emerging econ-
omies being liquidity premium, the state of liquidity preference stands up as
a major aspect to be considered, as it affects the way investors value holding
liquid assets –​in other words, it impacts the l variable through β in Equation
(8). Given that emerging economies’ currencies offer a lower liquidity premium
than that of central economies’ currencies (l < l*), a hike in liquidity preference
(as due to a hike in uncertainty following a crisis) decreases the relative return
paid by the emerging currency.

r−r∗ = (a+q–​c) –​(a∗+q∗−c∗) + β(l−l∗) (8)

While these equations have non-​pecuniary (l) and monetary variables (a, q, c)
side-​by-​side directly determining returns, a more precise form for exchange
rate analyses might be to consider their impact on demand for a currency, and
the impact of the demand on exchange rates. This could be done by including
these considerations in portfolio allocation equations à la Tobin of SFC models
(see Godley and Lavoie 2007). In Equations (9) to (12), the total wealth (Vi ) of
investors based in an advanced country ($) is split among domestic ( B$$ ) and
EMEs’ financial assets (B$# ) according to the assets’ respective returns (ri) and the
expected exchange rate change ( eie ; a positive value denoting an expectation of
appreciation of the currency i):

(
B$$d = V$ λ10 + λ11 (r$ ) − λ12 (r# + e #e ) ) (9)

B$#d = V$ ( λ 20 − λ 21 (r$ ) + λ 22 (r# + e#e )) (10)

(
B##d = V# λ 30 + λ 31 (r# ) − λ 32 (r$ + e #e ) ) (11)

(
B#$ d = V# λ 40 − λ 41 (r# ) + λ 42 (r$ + e #e ) ) (12)
144 Raquel A. Ramos et al.
The consideration of the different liquidity premiums offered by currencies
and the cyclical liquidity preference of investors could be done when
defining the values of the equations’ parameters, as the consideration that
λ10 > λ 20 and λ 40 > λ 30 (standard restrictions related to Tobin’s portfolio allo-
cation parameters still hold, see Godley and Lavoie 2007; Kemp-​Benedict and
Godin 2017).These parameters could also be split into liquidity premium ( λ lpm i0 )
and liquidity preference ( λ lpf i0 ; as in Equation (13)). The parameter λ lpf
i0 should
increase in times of turbulence, leading to a shift of demand from EME to
central economy’s assets from both types of investors. Such change in liquidity
preference can be analysed with a SFC model through as a shock on λ lpf i 0 , or,
in an AB model through the use of an exogenous series. In the latter case, the
series could be modelled to resemble the VIX index (the most used proxy for
uncertainty and liquidity preference in the PK literature and for risk-​aversion
among the mainstream): mostly stable with eventual but marked peaks.

λ lpi 0 = λ lpm
i 0 .λ i 0
lpf
(13)

The literature devoted to emerging economies’ currencies also highlights the

fact that EMEs have very small markets when compared to the portfolio of
international investors. Haldane (2011, p. 2) uses the ‘Big Fish Small Pond’ meta-
phor to illustrate this issue: ‘The Big Fish here are the large capital exporting,
advanced countries.The Small Ponds are the relatively modest financial markets
of capital-​importing emerging countries.’ This configurates another structural
difference, between emerging and central currencies –​a ‘financial asymmetry’,
related to the current international financial system (Andrade and Prates 2013).
This asymmetry can be accounted for in exchange rate models through the
consideration of portfolios of different magnitudes among investors of different
countries (V$ > V#) together with home bias. The consideration of the later
demands considering that λ 60 < λ 50 and λ 20 /λ 30 > λ 60 /λ 50 (in order to simul-
taneously account for home bias and liquidity premium asymmetry).
The dynamics that result from these two asymmetries is one where emer-
ging economies’ currencies are highly subordinated to international financial
conditions: the capital inflows to these economies depend not only on its assets’
returns, but also on the investors’ liquidity preference; and these flows have an
important impact on their assets’ prices and exchange rates due to the relatively
small magnitude of their markets.
Most PK contributions can be seen through the lenses of investors’ decisions.
EMEs are increasingly integrated to markets across the globe through money
manager’s balance-​sheet networks –​their liabilities are funded in central econ-
omies and their assets are increasingly invested in EMEs (Haldane 2012, Ramos
2017). As it will be argued in what follows, in an international context featured
by monetary and financial asymmetries, the exchange rate dynamics put for-
ward by Post Keynesian analyses call attention to the fact that portfolio allo-
cation choices do not solely depend on expected returns but are sometimes
 Post Keynesian view on exchange rates 145
also a consequence of money managers’ decisions based on the balance-​sheet
constraints caused by those asymmetries.
The above discussion on liquidity preference cycles is for instance a con-
straint related to money managers’ assets –​in moments of uncertainty and high
liquidity preference, they prefer holding their assets in the most liquid format,
which is currently the US Treasury bonds.
Another relevant aspect derives from the fact that money managers’ liabil-
ities are essentially denominated in central currencies. In times of crisis, these
institutions have financial commitments to meet and must convert their assets
into those currencies, resulting in sudden depreciation of emerging economies’
currencies (Kaltenbrunner 2015).
A third balance-​sheet constraint is directly related to the abovementioned
fact that EMEs generally offer higher returns than central economies (Equation
(7)). Insurance companies and pension funds have target rates of returns, which
determine the growth of their liabilities. In case of very low interest rates in
central countries, EME assets are an alternative for ensuring a growth rate of
assets in line with the amount needed relative to the liabilities’ growth (Bonizzi
2017a, 2017b, Bonizzi and Kaltenbrunner 2018). In the short term, this con-
straint leads to the appreciation of the EME currencies, followed by depreci-
ation when monetary policies become more restrictive in central economies.
A fourth dynamic is related to the way emerging economies’ currencies
are seen by money managers and to these currencies more frequent major
depreciations than central currencies (Ramos 2016). After a major depreci-
ation and the sell-​out of emerging economies’ currencies, money managers
are reluctant about reinvesting in these countries. In Minskyan terms, such
an investment is seen as a Ponzi situation given the lower margins of safety
involved: investing in EMEs means incurring in a balance-​sheet currency mis-
match and with a higher risk than when the asset is labelled in another central
currency. As the memory of crisis fades, investors will however slowly consider
the decision of not investing in EME as excessively conservative and change
opinions, gradually increasing the amount of investment in this market. Given
the impact of their decisions in the currency itself, a self-​reinforcing mechanism
is created where the number of investors constantly increases and the currency
slowly appreciates (Ramos 2019).
This mechanism can be modelled in an AB framework through the consid-
eration of individual and subjective preference for liquid assets ( λtlpf ) that floats
according to changes in a general level of uncertainty ( σt ). Liquidity prefer-
ence of investor i at period t ( λ lpf i ,t ), would be a positive function of uncer-
tainty in period t ( σt ) and, in case of low uncertainty ( σt < x ), would decrease
with time –​Equation (14), where a higher n is given to the investor that takes
longer to react to a fall of uncertainty. This inclusion significantly improve
Tobin-​inspired portfolio allocation equations used in SFC models for adding
the risk feature and for treating it as a personal perception, not as a measurable
and single value (in line with the PK concept of fundamental uncertainty and
the behaviour economics’ concept of framing):
146 Raquel A. Ramos et al.

  1 −n 
λ lpf
f
=  n ∑, σ if σt < x
i ,t t −1
f ( σt ) otherwise
 (14)

These different analyses suggest that instead of a random walk (as suggested by
Meese and Rogoff 1983) and a zigzag pattern (Schulmeister 2009), emerging
economies’ currencies would have cycles that are subordinated to international
financial conditions (which can present ‘zigzag sub-​cycles’ in the case of deep FX
markets and can also be interrupted by internal conditions). These cycles would
be characterized by a major depreciation in case of crisis or a hike of uncertainty
internationally, and that would be followed by a slow and constant appreciation
the currency in a self-​feeding cycle in periods of tranquillity (Ramos 2019).
These different analyses call attention to the diversity of aspects affecting
the demand for a currency and exchange rates. Given the structural differences
between currencies and the size of markets, portfolio allocation decisions
go beyond expected gains with a currency and money managers’ balance-​
sheet constraints –​related to either their assets and/​or liabilities sides –​help
understanding some exchange rate dynamics.

Conclusions
Exchange rates have long been a puzzle in economic literature. Post Keynesian
analyses in this field have arisen after the breakdown of the Bretton Woods system,
yet they are rather disconnected with each other, and not broadly disseminated
even in the PK field. This chapter has contributed to strengthening the PK view
on nominal exchange rates through a critical analysis of the main PK works in the
field, highlighting their common views and limitations, and through the presen-
tation of forms of modelling the discussion in the SFC or the ABM frameworks.
The PK exchange rate view calls attention to the role of money managers
whose decisions are guided by expectations and social conventions, given fun-
damental uncertainty and the characteristics of Money Manager capitalism
(Minsky 1986) –​including the workings of FX markets. PK works also highlight
the consequences of structural characteristics of the current IMFS on emer-
ging economies’ currencies: they offer lower liquidity premiums and their small
markets are easily impacted by investors’ decisions. Due to such specificities,
investment decisions are not only guided by expected returns. Instead, as argued
in this chapter, these decisions respond to balance-​sheet constraints given their
association to aspects of these institutions’ assets and/​or liabilities.

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11 
A Post Keynesian framework
for real exchange rate determination
An overview
Lúcio Barbosa, Frederico G. Jayme Jr.
and Fabrício J. Missio

1 Introduction
This chapter presents an overview of the Post Keynesian (PK) analysis of the
determinants of exchange rate movements. Even though it focuses on nominal
exchange rates, we show that it can encompass a real exchange rate (RER)
framework. This is important because the RER is an important variable in
some PK growth and income distribution models.
We start by presenting Keynes’ view on the currency forward market. In
his Tract on Monetary Reform (1923), he set the basis for the PK discussion
on exchange rate determination. Since then, capital flows have emerged as the
main force behind exchange rate movements.
Harvey (1991, 1996, 2001, 2006, 2007, 2009, 2012) explores this view,
claiming that currency market participants’ decisions, induced by specula-
tive opportunities, drive exchange rate. Based on Keynes’ theory of the own
rate of interest of an asset (­chapter 17 of General Theory), one can state that
the demand for any currency is determined by its net return relative to other
currencies (Kaltenbrunner, 2011, 2015; Andrade and Prates, 2013).
This takes into account the liquidity premium paid by each currency.
Considering that currencies from Emerging Market Economies (EME)
have a lower liquidity premium, they are regarded as a risky asset. Following
a conventional behavior, money managers buy EME’s assets, engendering a
self-​feeding cycle of exchange rate appreciation, on one hand, and building
fragility, on the other. When international market conditions change, emer-
ging currencies are subject to sharp depreciations (Kaltenbrunner, 2011, 2015;
Ramos, 2016, 2019).
Up to this point, the PK theory has focused on nominal exchange rate
movements. Barbosa et al. (2018a) extended this framework to the analysis of
the RER, suggesting that capital flows and external fragility, consisting of the
stock of short-​run liabilities, are driving forces of its dynamics in the long-​run
as well. In this scenario, as the RER plays an important role in PK models, it is
important to design exchange rate policies properly. After discussing exchange
rate determination, we briefly present this issue.
150 Lúcio Barbosa et al.
The chapter will proceed as follows. The next section reviews the conven-
tional theory, identifying its main differences from the PK approach. Then, we
present in more detail the Post Keynesian framework and its empirical support.
In Section 4, we underline why this issue matters and what to do. After that, we
point out some concluding remarks.

2 Conventional theories
The most quoted theory regarding exchange rates is the Purchase Power Parity
(PPP), particularly in the conventional literature.1 It can be regarded as the
workhorse for the debate on the long run RER’s determinants, even if its
flaws have been long been recognized (Balassa, 1964a, 1964b; Samuelson, 1964;
Dornbusch, 1985). In an attempt to amend it, mainstream scholars shifted the
focus to the effect of transport costs and non-​tradable services, and some argue
that PPP applies in rates of change rather than levels, known as the weak or
relative version (Dornbusch, 1985).
The PPP theory advocates that the exchange rate is a relative price, which
fluctuates to reestablish the underlying market equilibrium. If the exchange
rate is fixed, the adjustment mechanism occurs via price level: if the price of a
good is higher in the domestic economy, it will be imported, forcing its price to
decrease until it equals the foreign one.When the exchange rate floats freely, the
adjustment mechanism occurs via the nominal exchange rate: higher domestic
prices would lower net exports, causing an exchange rate depreciation until
domestic and external prices are equal.
Since the empirical tests presented mixed results to validate the PPP theory
(Breuer, 1994; MacDonald, 1995), the conventional literature developed other
approaches to set the determinants of the RER (MacDonald, 2000; Isard, 2007).
Some of them are variants of the PPP theory itself, including the Balassa-​
Samuelson (BS) effect. This model distinguishes between tradable and non-​
tradable goods. If all goods were tradable, the PPP would hold. Nevertheless,
since services are generally not tradable, the RER will appreciate or depreciate
due to price level differences among countries. According to the BS model,
wages in the non-​tradable sector are higher in the more productive countries,
resulting in a higher price level and a more appreciated RER. Yet, this model
fails to explain RER differences across countries, and empirically the effect of
the productivity on RER is at best weak (Chinn, 1997; Kohler, 2000).
The monetary and the portfolio balance approach combined PPP theory
with monetary policy and the demand for financial assets (capital flows). In
general, they assume perfect capital mobility and the idea that uncovered
interest parity holds.2 Nonetheless, their emphasis is on how to explain short-​
term movements in nominal exchange rates rather than RER (Driver and
Westaway, 2004).
In addition to models deriving from PPP theory, the conventional theory
developed other concepts to define the equilibrium RER. Broadly speaking,
they can be distinguished between structural models and reduced-​form ones.
 Real exchange rate determination 151
The formers are based on the concept of macroeconomic (internal and external)
balance; the latter define directly RER as a function of economic fundamentals.
In the first group, the most popular approach is the Fundamental Equilibrium
Exchange Rate (FEER) developed by Williamson (1983). In this framework,
the current account (when economy operates at its potential) is equalized with
a sustainable capital account position, that is, the one which excludes specu-
lative capital flows. Another structural approach is the Natural Real Exchange
Rate (NATREX), which is mainly associated with studies by Stein (1994). It
states that the equilibrium RER equates the current account balance to the
difference between desired savings and investment. Again, it disregards specula-
tive capital flows.
In the second group, there is the Behavioral Equilibrium Exchange Rate
(BEER) approach suggested by Clark and MacDonald (1999). The authors
used the following variables to represent long-​run fundamentals: terms of
trade, the relative price of traded to non-​traded goods, and the net foreign
assets as a ratio of GDP. Moreover, their model specification accounts for short-​
term components, which are classified as transitory. In this approach, the links
between the economic theory and the RER equilibrium are essentially data-​
determined (Driver and Westaway, 2004).
In general, the conventional literature assumes that the RER is an equilib-
rium price, which fluctuates to adjust internal or external imbalances. In the
short run, price rigidity or sharp fluctuations might deviate the RER from
its fundamentals, but in the long run international trade and adjustmentss in
current account push it back to its equilibrium level. This approach is in line
with the efficient market hypotheses, according to which changes in relative
prices restore the required and efficient equilibrium in production and exchange
relations. In addition, it is based on the classical dichotomy, in which prices
flexibility detach real variables from nominal ones. Thus, short-​run deviations
do not have long-​lasting effects on real variables, assuming money neutrality3
in the long term. Moreover, fundamentals underlying the RER do not modify
over time, echoing agents’ perfect forecasts (or with measurable risks) of future.
Therefore, the conventional approach overlooks the financial side of the
economy. Short-​run portfolio flows only have a transitory effect on RER.
Carvalho (2018, p.118) briefly explains it as follows:

A traditional view of foreign currency markets, which assumes that

trade always prevails over finance, at least in the longer term. Finance is
considered, but less as an autonomous activity than as an auxiliary to trade,
the shadow of current account disequilibria. It is assumed that, ultimately,
capital flows result from current account imbalances.

The focus on trade flows seems incompatible with the relative size of finan-
cial markets. The currency market is probably the largest on the planet (much
larger than the trade market), averaging $5.1 trillion per day in April 2016 (BIS,
2016), while word merchandise exports were valued at $15.46 trillion in 2016
152 Lúcio Barbosa et al.
(WTO, 2016). The PK approach provides a different perspective, as it considers
that money managers and short-​run capital flows play a major role on exchange
rate dynamics.

3 The Post Keynesian framework for exchange rate

determination

3.1 Keynes’ and Harvey’s theory and the currency hierarchy model
Keynes criticized the emphasis on trade as the determinant of exchange rates.
The author formulated an alternative approach in 1923, which is known as the
interest rate parity theory. It can be explained by the following example: the
interest rate in England (GB) is lower than in the United States (US), but in
the forward market the pound tends to appreciate in relation to the dollar.
Therefore, if the appreciation of the pound more than compensates the interest
rate differential, investors from the US will buy debt instruments from GB. In
other words, they will exchange dollars for pounds. As a consequence, the value
of the pound will increase, so that the spot exchange rate will get closer to the
forward exchange rate. In the end, the yields between assets from GB and US
will be equivalent.
In this framework, capital flows have a major effect on the exchange rate.
Moreover, they are not random or erratic either and they are induced by arbi-
trage opportunities. However, in equilibrium they would be irrelevant, since
the yields would be the same across bonds denominated in different currencies.
There are at least two interrelated drawbacks in this reasoning. Bonds of
different countries do not share the same risks –​therefore, they are not per-
fect substitutes. In addition, there may be other kinds of arbitrage opportun-
ities rather than the one Keynes assumed. If the interest rate of a country is
high and there is an expectation of exchange rate appreciation, there will be
a capital inflow. Investors will profit from the interest rate differentials and
from the exchange rate appreciation. This strategy is known as carry trade.
In this case, a vicious circle is created, in which high relative interest rates
attract financial inflows that increase the value of the local currency and
make it doubly attractive. Instead of the equilibrating mechanism one would
expect, capital flows can create and recreate a continuously disequilibrium
process. Hence, they may generate persistent pressures on exchange rates in
one direction or another by themselves. This could also explain why some
forms of disequilibrium in the capital account could persist for long periods,
irrespective of current account movements (Ramos, 2016; Carvalho, 2018;
Resende, 2019).
Furthermore, the imbalances in the current account are not self-​correcting
by exchange rate dynamics. Speculative financial flows undermine the inter-
national trade adjustment mechanism, so that overvalued currencies may appre-
ciate and undervalued currencies may depreciate (Flassbeck, 2018). In this
scenario, an exchange rate overvaluation can persist for a long time. This will
 Real exchange rate determination 153
have negative effects on the real side of the economy, including competitiveness
downgrading and lower growth (Missio et al., 2015, Bresser-​Pereira et al., 2015).
Nevertheless, countries cannot accumulate deficits in the balance of
payments indefinitely. Eventually the RER will depreciate. Usually this happens
suddenly and engenders an exchange rate crisis. In a world where financial
flows are mostly disconnected from trade activities and are much larger than
trade payments, the Post Keynesian framework helps to shed some light on the
exchange rate pattern.
Harvey (1991, 1996, 2001, 2006, 2007, 2009, 2012) is probably the main
Post Keynesian author that embraces this task, focusing mainly on the nominal
exchange rate. He states that capital flows play the most important role in the
exchange rate changes since it seeks short-​run profit opportunities.
His theory stresses the importance of currency market participants (dealers
and fund managers), who are responsible for trading in the foreign exchange
market. He developed a mental model, identifying those factors that affect
agents’ decisions to buy or sell an asset.
The market is regarded as a social phenomenon, in which dealers interact
socially and professionally. In order to profit, the best strategy is to anticipate the
expectations of other economic agents. However, under an uncertain environ-
ment, it may be better to copy decisions (conventional behavior4), which can
even lead to herd behavior.
This decision is not arbitrary. The mental model guides it, taking into
account mainly the expectations on foreign portfolio flows, which allow dealers
to speculate (Harvey, 2009). If agents assume that the nominal exchange rate
will appreciate, there will be a contemporaneous rise in capital flows.
Harvey’s mental model is more complex than this. In a nutshell, expectations
on the real side of the economy (inflation, interest rate, growth, etc.) feed
expectations on financial flows. As a consequence, currency market participants
adjust their exchange rate forecast and speculate through portfolio flows. The
main contribution of Harvey’s theory is to emphasize the importance of expect-
ation and portfolio flows, and to consider the currency as a financial asset.

3.2 Asset choice under uncertainty and the exchange rate

Kaltenbrunner (2011, 2015) and Andrade and Prates (2013) went a step further
from Harvey’s work. They applied Keynes’ theory of the own rate of interest
of an asset (­chapter 17 of General Theory) to a global context. Following this
theory, the demand for a currency is determined by its net return relative to
other currencies. More specifically, any asset (including currencies) has a rate of
return (r) that is given by: its yield (q), which derives from profits in the pro-
duction process or from interest and dividends based on ownership, minus its
carrying costs (c); its expected appreciation (or depreciation), a; and its liquidity
premium, l:5

r = (q − c ) + a + l
(1)
154 Lúcio Barbosa et al.

The equivalent of these for the world reserve currency are (q * − c * ) + l * . In

equilibrium, these not need to be equal. In this case, agents must expect com-
pensating currency price movements.

r = ( q − c ) + a + l = (q * − c * ) + l *
(2)

Taking into account features of the foreign exchange market, we need to

reformulate the Equation (2). Firstly, this requires considering that speculative
financial flows, particularly portfolio ones, are largely determined by carry trade
positions in the global market (financial operations where investors are funded
in low-​interest rate countries and invest in countries paying high interest rates).
Then, it is usual to assume that a currency yield is primarily constituted by
short-​term interest in international money markets. Moreover, we assume that
the interest rate on the money of the system is not zero. Therefore, the diffe-
rence between them corresponds to the interest rate differential: (i − i * ) .6,7 The
expected appreciation of the exchange rate corresponds to: a = e e − e , where e e
is the expected exchange rate and e is the current exchange rate.8 Expectations
are formed in line with Harvey’s theory and are subject to social conventions
and herd behavior. Carrying costs of currencies or financial instruments are sig-
nificantly low. For simplicity, they can be disregarded (c = 0; c * = 0 ) . Therefore,
in equilibrium we have:9

(i − i * ) − (e e − e ) = (l − l * ) (3)

This equation shows that interest rate differential (i − i * ) needs to compen-

sate the difference between liquidity premiums, in order to keep the demand
for the currency. Following Kaltenbrunner (2015, 433), ‘if interest rates remain
unchanged, agents have to expect an appreciation of the currency’.
We can also rewrite this equation as:

(e e − e ) = β (l − l * ) + (i − i * ) (4)

The parameter β represents the liquidity preference. In Equation (4), it is

possible to handle the empirical causality between short-​run interest rate and
exchange rate fluctuation. When the international liquidity preference is con-
stant, or changes slowly, expectations on interest rates determine the currency
demand. Nevertheless, substantial changes may require interest rate adjustments
to keep currency demand. From another point of view, when liquidity prefer-
ence (β) decreases, investors will look for assets with higher yields (Ramos, 2016).

3.3 EME currencies and the hierarchical monetary system

Kaltenbrunner (2011, 2015) and Andrade and Prates (2013) have made another
important contribution.They have connected the Equation (4) to the currency
 Real exchange rate determination 155
hierarchy perspective. This allowed accounting for differences between EMEs
and advanced economies.
In the international monetary system, not all currencies can perform the
three functions of money: acting as a medium of exchange, as a unit of account
(and of denomination of contracts) and as a store value. The currency of EMEs,
which do not fulfill these three functions internationally, are placed at the
bottom of the international monetary system hierarchy, paying a low liquidity
premium. To compensate for that, these countries need to set a high interest
rate level, weakening their monetary policy autonomy. Besides, the exchange
rate becomes more volatile, since it is a risky asset. The dollar is in the opposite
situation: for performing all the money functions and offering a high liquidity
premium, it is placed at the highest level of the hierarchy and enjoys great mon-
etary policy autonomy.
Based on this framework, Kaltenbrunner (2011, 2015) and Ramos (2016,
2019) adopt a Minskyan approach to clarify the pattern displayed by currencies
from EMEs. They put emphasis on the currency’s ability to act as an inter-
national medium of contractual settlement (denomination of contracts) and
focus on the liability side of international balance sheets. As EMEs are usually
unable to borrow in their domestic currency, they assume debts in foreign
currency. Therefore, once they need to purchase foreign currency –​and sell
the domestic one –​to meet their external obligations, their currency faces a
depreciation pressure. In fact, this applies to any external liability funded on
international financial markets, so that even when it is denominated in local
currency, money managers’ decisions put pressure on it.
In times of increasing uncertainty, assets from EMEs are the first victims
of the ‘flight to quality’ (i.e. to assets denominated in the key currency) by
global investors. Notwithstanding, in situations marked by an excess of inter-
national liquidity and higher appetite for risk, ‘emerging assets’ incorporate a
high-​expected appreciation, which compensates for their lower liquidity pre-
mium (i.e. the attribute a exceeds the ‘yield’ or return implicit in the liquidity
premium l ). Thus, money dealers invest in them.
In this scenario, better fundamentals may only drag short-​run more financial
flows, which look for profit opportunities. Consequently, foreign liabilities rise.
Hence, they do not help to improve EMEs’ vulnerability; instead, they increase
their fragility.This cycle corroborates Minsky theory, since the same factors that
increase a country’s liquidity premium in the eye of the foreign investor also
slowly undermine this premium (Kaltenbrunner, 2015).
The analysis of Ramos (2016, 2019) validated this finding, stressing the role
played by money managers. Considering that there are a limited number of
agents who hold a significant amount of assets and liabilities across the globe
and whose balance sheets are interconnected, their portfolio allocation decisions
have a major impact on exchange rates. Following a conventional behavior, they
buy EME’s assets, engendering a self-​feeding cycle of appreciating assets and
currency and increasing demand.Thus, fragility is built and emerging currencies
are subject to sharp depreciations according to money managers’ decision. Also,
importantly, such decisions of selling EMEs assets and currencies can be related
156 Lúcio Barbosa et al.
to the EME conditions but can also be a simple increase in investors margins of
safety –​as it would reduce their balance-​sheets currency mismatch and elim-
inate the EME exchange rate risk.
Barbosa et al. (2018a) connected this framework with productivity’s dif-
ferential effect to set a model for the RER in EME. In order to do so, they
rearranged the Equation (4) and used the standard definition of RER, that
p*
is RER = e , where p * corresponds to the foreign price level and p to
p
the domestic price level, adding the BS effect, where the subscript N cor-
responds to non-​tradable and the subscript T to tradable. They associated the
productivity’s differential effect with the uneven terms of trade between emer-
ging countries and developed ones, which in turn undermine their ability to
force cash flows to meet the outstanding stock of external liabilities:

R = S e − (l − l * ) − (r − r * ) + ( pT* − pT ) + β ( pN* − pT* ) − α ( pN − pT )

(5)

In sum, in the present state-​ of-​

art of Post Keynesian economics, the
exchange rate determination can be explained by Equation (4). In this model,
on one hand, structural variables that indicate the position in international
debtor-​creditor relations affect the liquidity premium (stock of short-​term
external obligations). In addition, the context and time specific expectations
are responsible for currencies’ appreciation/​depreciation and portfolio flows are
the main channel through which money managers speculate. Moreover, interest
rate differentials contribute to draw foreign capital. Thus, this model is a good
starting point for modelling not only nominal exchange rate movements, but
RER dynamics as well.

3.4 Empirical findings

The Post Keynesian approach has presented some empirical evidence to
support it. Harvey (2006) tested if financial variables, particularly short-​term
interest rates, were the most significant in determining foreign exchange rates.
He selected data for the dollar-​Deutschemark and the dollar-​yen from 1975 to
1998 on an annual basis.These two currency pairs represented the overwhelming
majority of the currencies’ market. The results showed that financial variables
had the major impact on exchange rates.
Also, Harvey (2012) investigated the movements of the dollar-​euro exchange
rate around and during the Great Recession (2007 to 2009). According to his
analysis, before the subprime crisis, the dollar was already depreciating in rela-
tion to the euro due to closing interest rate differential. In 2007, when the
crisis hit, the dollar fell over 12% against the euro. However, in the following
year, despite a larger and growing trade deficit, the dollar made significant gains
over the euro. This happened due to the shortage of dollar credit as financial
institutions became extremely risk averse; US businesses brought cash back
 Real exchange rate determination 157
home to cover potential losses; and market participants moved toward liquidity
and quality. In 2009, as investor become increasingly convinced that the inter-
national financial market was stabilizing, the dollar depreciated.Therefore, these
movements suggest that capital flows drove foreign exchange rates, and the real
economy was forced to adjust to the condition they created. In other words, the
financial sector played a dominant role.
Kaltenbrunner and Painceira (2015), using the Brazilian example, argued
that despite sound macroeconomic fundamentals, Brazilian real has been subject
to very large exchange rate movements during the first decade of the 2000’s.
That is, the exchange rate becomes increasingly determined by international
portfolio considerations, whereas periods of capital inflows coincided with
exchange rate appreciation, and capital outflows with exchange rate depreci-
ation.This was the result of new forms of external vulnerabilities, once the sur-
ging share of foreign investors in Brazilian assets denominated in local currency
had increasingly tied exchange rate movements to international market and
funding conditions.
Ramos (2016) stressed that extreme depreciations and association with the
condition of international financial markets is not a feature of every emerging
currencies. Rather, the South African rand, the Turkish lira, the Brazilian real,
the Hungarian forint and the Polish zoloty are the currencies whose volatility
and frequency of extreme exchange rate depreciation are more linked to the
uncertainty level of international financial markets. These countries have in
common a type of financial integration that is of higher magnitude relatively
to GDP and trade, revealing a higher use of these countries’ assets by money
managers.10
Barbosa et al. (2018a) tested their model concerning the RER determin-
ation in EMEs. The empirical results suggested that even in the long run the
RER is driven by financial factors. Among them, the authors emphasized the
stock of short-​run foreign liabilities (as a percentage of international reserves)
and portfolio flows. The former portrays the country external vulnerability,
especially when investors change their positions according to international
market conditions.
In the face of these results, one can assume that financial variables have at
least an important impact on the RER. Therefore, two important questions
come up: i) why does it matter? and ii) what to do?

4 Real exchange rate, economic growth and exchange

rate policy
The relationship between RER and economic growth has been the subject of
great controversy in the economic literature. Nonetheless, in the last decades,
a series of works has presented theoretical frameworks suggesting a close
connection between a competitive (undervalued) exchange rate and economic
performance.
158 Lúcio Barbosa et al.
We can identify at least three Post Keynesian approaches in which an
undervalued RER may spur economic growth (Gabriel and Missio, 2018;
Missio et al., 2017; Oreiro et al., 2015):

a) Balance of Payments Constrained Growth Models (BPCG): in this

approach, economic growth can be constrained by the external sector if
the income elasticity of imports is higher than the income elasticity of
exports. In the canonical BPCG model, the level of the RER is neutral on
growth dynamics and only continuous nominal exchange rate depreciation
could foster it. However, there is robust evidence that undervalued RER
is an important determinant of tradable profitability and capital accumula-
tion (Frenkel and Rapetti, 2014; Dao et al., 2017). One can argue that trade
elasticities are endogenous to the RER, so that a competitive level of the
RER may stimulate new investments in the modern tradable sector (Palley,
1996, McCombie and Roberts, 2002, Ferrari et al., 2013 and Missio and
Jayme Jr., 2012).Therefore, exchange rate policy can affect growth not only
by improving short-​run competitiveness, but also by increasing incentives
to invest and to foster technological development.
b) Neokaleckian models of growth and income distribution: in these models,
the level of RER has a direct impact over income distribution. If a profit-​
led regime of accumulation prevails, then a RER devaluation will result
in an increase of capacity utilization and investment rate. This happens
because the devaluation of the RER reduces real wages and increases profit
margin of firms, inducing a rise in their planned investment (Bhaduri and
Marglin, 1990; Blecker, 2002). Although lower wages reduce consumption
demand, since workers propensity to consume is assumed to be higher
than capitalists’ propensity to consume, if the difference between both pro-
pensities is small and investment is highly sensible to changes in the profit
margin, then the fall in consumption demand due to lower wages will be
more than offset by increased investment demand. Hence, this leads to an
increase of capacity utilization.
c) Structural change: in this approach, the dynamics of the production
structures matter to growth. The modern tradable sector is an important
locus of learning-​ by-​
doing externalities and technological spillovers
(Eichengreen, 2008; Rodrik, 2008; Razmi et al., 2012). When labor and
other resources are transferred from less productive to more productive
activities, the economy grows at higher rates. Therefore, high-​ growth
countries are typically those that have been able to experience growth-​
enhancing structural change (McMillan et al., 2014). Again, an undervalued
RER promotes resource reallocation from the non-​tradable to the tradable
sector.

On the empirical findings, a series of works motivated by the contrast between

growth trajectories of Southeast Asian, African and Latin American coun-
tries have been published. They often supported the positive link between an
 Real exchange rate determination 159
undervalued RER and economic growth (Dollar, 1992; Eichengreen, 2008;
Rodrik, 2008; Missio et al., 2015, among others).
In order to sustain an undervalued RER, the monetary authority needs to
manage the exchange rate. According to the policy Trilemma framework, the
monetary authority can achieve only two out of three policies goals, which are
(1) financial integration, (2) exchange rate stability and (3) monetary autonomy.
However, the great majority of countries are not in fact restrained by binary
choices. They are able to choose the level of financial integration by standing
capital controls, and to manage their exchange rate under a managed float regime,
while keeping a monetary policy relatively independent (Bresser-​Pereira, 2012).
In this vein, adopting capital account regulations can be a useful tool to
keep RER undervalued. It is important mainly to curb short-​run international
capital flows. Nevertheless, due to the changing and increasing complex nature
of EME’s financial integration, there is not a set of policy measures that fits all
cases. On the contrary, there is a need for (i) a wide range of different measures,
so as to avoid regulatory loopholes, and of (ii) a significant degree of market
monitoring, adjusting the measures very precisely. By doing this, it may be pos-
sible to achieve and maintain a competitive RER (Kaltenbrunner and Paincera,
2015; Ramos, 2016; Barbosa et al., 2018b).

5 Concluding remarks
The RER is one of the most important macroeconomic variables, since if
affects the trade pattern of a country and its production structure. Economists
have tried to model its behavior unsuccessfully. Mainly, because they neglect that
the financial side of the economy is the most important determinant of RER.
The Post Keynesian framework puts it at the center of the debate. Speculative
financial flows have a significant impact on the nominal exchange rate and
on the RER. Considering that a country competitiveness is linked to RER,
policymakers should design policies to prevent its overvaluation. Therefore, it is
important to take on policies discouraging speculative flows. This is not an easy
task. Nowadays, there are different financial assets, such as derivatives, which
allow economic agents to circumvent national rules. Nonetheless, the Brazilian
experience from 2009 to 2013 shows that it is possible to refrain from overvalu-
ation pressures (Prates and Paula, 2017).

Notes
1 Conventional theories are those aligned with mainstream literature.
2 It assumes that the nominal interest rate differential between two countries should
be equal to the expected depreciation of the exchange rate.
3 Money does not affect real production, engendering inflation only.
4 ‘(1) The present is a much more serviceable guide to the future than a candid exam-
ination of past experience would show it to have been hitherto. (2) The existing
state of opinion as expressed in prices and the character of existing output is based
160 Lúcio Barbosa et al.
on a correct summing up of future prospects, so that we can accept it as such unless
and until something new and relevant comes into the picture. (3) Knowing that our
own individual judgment is worthless, we endeavor to fall back on the judgment of
the rest of the world which is perhaps better informed. The psychology of a society
of individuals each of whom is endeavoring to copy the others leads to what we
may strictly term a conventional judgment’ (Keynes 1973: 114).
5 ‘These attributes define a spectrum of assets among which wealth holders can
choose, ranging from capital assets, which offer a high yield but little liquidity and
high carrying costs, to money for which the yield and carrying cost are nil, but that
offers the highest liquidity premium’ (Kaltenbrunner, 2015, 430–​431).
6 The dollar interest rate, which is the basic rate of the system, is the smallest since
it pays for the currency of the system, regarded as the safest and the most liquidity
asset. The interest rate outside the core countries corresponds to the dollar interest
rate plus the country risk.
7 According to Ramos (2016), the weight of equities as a form of foreign liability
increased from 2000 on in several emerging market economies. Thus, considering
only the returns of debt instruments returns may be misleading.
8 Note that when ee<e, the currency appreciates and therefore investors increase
their earnings. In Equation (3) the signal before (ee-​e) is negative because a depre-
ciation entails an exchange rate rise.
9 This model looks like a slight modification of the Uncovered Interest Parity (UIP)
model where the l’s are some kind of risk premium. However, it is not an ad-​hoc risk
premium that invalidate this theory, but the liquidity premium itself.
10 In addition, they have a larger and more sophisticated foreign exchange market.

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Part IV

Current account and growth

12 
The Kaleckian theory
of exchange rates
Jan Toporowski

Introduction
When the Bretton Woods system of fixed exchange broke down in the early
1970s, free market economists rejoiced at a prospect that the removal of
‘market distortions’ would bring about an automatic equilibrium in trade
balances and, with the removal of a balanced trade constraint on foreign
exchange reserves, the expansion of economic activity (Friedman 1953). The
view that devaluation may have a stimulating effect on economic activity
continued to echo through the debates on economic policy in the rest of the
last century and has coloured criticism of the inadequacies of the European
Monetary Union.
However, from early on, Kalecki was sceptical about the benefits of devalu-
ation. In his earliest writings, he expressed the view that changes in exchange
rates merely affected the terms of trade in markets, transferring profits between
producers for markets abroad, to firms producing for the home market (Kalecki
1935). As his Oxford colleague, ‘Fritz’ Schumacher, observed ‘The effect of
devaluation on the trade balance is frequently unpredictable. Only one thing is
generally predictable: namely that devaluation is likely to result in a deterior-
ation of the country’s terms of trade.’ (Schumacher 1943).
Kalecki maintained this view through his critique of the Keynes and White
Plans for the Bretton Woods conference, and his subsequent criticism of the
settlement agreed at that conference.1 This chapter expands on this analysis by
showing the effects of changes in the exchange rate on corporate finance as the
key intermediary in international trade transactions.
Since at least 1949, more critical economists have noted that devaluation may
have deflationary effects on an economy (Hirschman 1949, Diaz-​Alejandro
1963, Cooper 1971, Krugman and Taylor 1978). In general, this literature
is based on ‘elasticity pessimism’, i.e., the absence of the Marshall-​ Lerner
conditions under which a currency depreciation is supposed to improve the
trade balance.These critics of devaluation argue that, in the absence of adequate
expenditure-​switching in response to exchange rate-​related changes in prices,
currency devaluation results in a fall in real incomes, due to the rise in import
costs, much as Kalecki had earlier argued.
168 Jan Toporowski
The elasticities approach may be disposed of by pointing out that in the real
world, with all variables changing through time, in accordance, say, with some
generalised business cycle, any elasticities depend on the lag that is assumed to
occur between the ‘exogenous’ change in the exchange rate and the change
in demand supposedly ‘caused’ thereby. Crucially, the elasticities approach, and
the criticisms of the ‘elasticity pessimists’, depend on the presumed effects of
the exchange rate changes on prices in domestic and export markets (the ‘pass-​
through effect’) and the expenditure switching between those markets that
the price changes are supposed to induce. The main alternatives to the elas-
ticities approach are the absorption approach, based on the national income
taxonomy, which identifies the difference between domestic income and
expenditure with the balance of trade (Alexander 1959, Ball et al. 1977), and
the monetary approach to the balance of payments, which identifies a deficit
in that balance with an inflationary gap caused by excess monetary expan-
sion (Johnson 1976). Neither of these two alternatives identify separately the
consequences of the trade balance and exchange rate for profits. This is per-
haps because of the long-​standing tradition of discussing international trade as
occurring between abstracted ‘agents’ buying and selling in different countries,
rather than between the trading companies that conduct actual trade between
national economies. The profits of those trading companies are the channel
through which one would expect changes in exchange rates and trade balances
to transmit the effects of those changes to the corporate sector and through that
to the economy as a whole.
This chapter argues that nominal exchange rate changes have, in the first
instance, price effects that are largely off-​set by changes in wages (Kalecki 1938)
but they do affect the distribution of profits. Kalecki argued that the influence
of exchange rates on aggregate wage income was limited, and hence consump-
tion was not much affected by exchange rates. It is therefore to their effects on
profits, and hence on investment, that we should look as the main channel of
influence of exchange rates on economic activity. This may seem implausible
to a generation of economists brought up to believe that prices respond to cost
changes, either as factors influencing supply, or as factors entering into some
cost-​plus price calculations. As Cooper pointed out, it is often convenient for
suppliers to blame price increases that would have occurred anyway on the
external force majeure of an exchange rate devaluation, or to time them so
that a devaluation may exonerate them in the eyes of their customers (Cooper
1971, p. 27). In practice, prices are determined by the level of demand relative
to productive capacity, according to the degree of competition in a market (cf.
Kalecki 1954, ­chapter 1). In some respects, this treats the exchange rate as a
‘transfer price’ between net importers and exporters in the corporate sectors
of particular countries, with the important difference that the price is not
administered by traders but is determined in international money markets.
The first section of this chapter lays out the essentially accounting relation-
ship between profits and the exchange rate in a trading economy without capital
flows. A second section examines the influence of trade-​determined exchange
 The Kaleckian theory of exchange rates 169
rates on economic development and corporate structure. The third section
discusses money capital flows and Fisher effects. The fourth section concludes
by arguing that free market determination of exchange rates destabilizes the
world economy because their price effects have income effects without the
substitution effects that would bring the world into general equilibrium.

Profits and the exchange rate

To determine the relationship between profits and the exchange rate, it is first
necessary to show how profits are determined, and the role in them of foreign
trade. Equation (1) is the familiar Keynesian saving identity, according to which,
in any given period, saving in an economy, S, is by definition equal to gross
domestic fixed capital formation, A, plus the fiscal deficit (government expend-
iture, G, minus government revenue, T) plus the foreign trade surplus (exports,
X, minus imports, M):

S ≡ A + (G –​ T) + (X –​  M) (1)

Dividing all incomes into wages and profits, P, the above identity shows the
total of saving out of both profits and wages. Deducting saving out of wages, Sw,
from the right-​hand side of the above identity gives an equation for capitalists’
saving. Adding consumption out of profits, Cc, gives an equation for total profits,
showing profits as equal to capitalists’ consumption plus their saving:

P ≡ A + (G –​ T) + (X –​ M) + Cc –​  Sw (2)

This is Kalecki’s profits equation showing the net financial inflow into
the private business sector (Kalecki 1971, ­ chapter 7; Toporowski 1993).
Although it is an identity, Kalecki argues that in fact the right-​hand side of
the equation determines profits because in practice economic units cannot
decide their income. They can only decide on their expenditure (Kalecki
1971, pp. 78–​79).
The balance of foreign trade is equal to the business sector’s net acquisition of
foreign assets or that sector’s total profits from foreign trade. It may be formally
divided up into the profits derived from exports, plus the profits derived from
imports. To simplify the analysis, we may assume that the only effective costs of
exports are domestic production costs, and the only effective costs of imports
are foreign production costs. This simplification may be rooted in the structure
of foreign trade. Because of the geographical scope of its transactions, foreign
trade is dominated by large companies to a far greater extent than domestic
trade. For large international trading companies, such as multinational firms, the
import content of their exports, and the export content of their imports will
tend to cancel each other out. Smaller companies using imported materials in
exports, will tend to buy them at domestic prices from the larger ones. Abroad,
smaller companies using exported materials in their imports, will tend to buy
170 Jan Toporowski
them at foreign prices from larger companies in foreign markets. The profits
from foreign trade may therefore be written as the difference between the for-
eign currency proceeds of exports converted into domestic currency, minus
the domestic cost of producing the exports, plus the domestic proceeds from
the sale of imports, less the foreign cost of the imports converted into domestic
currency:

(X − M) = (x.Pf/​ER − x.Cd) + (m.Pd − m.Cf/​ER) (3)

or

(X − M) = x(Pf/​ER − Cd) + m(Pd − Cf/​ER)

where x and m are the volume of exports and imports, respectively; Pf is the
unit price of exports abroad in foreign currency; ER is the exchange rate
shown as the foreign currency cost of the domestic currency unit; Cd is the unit
cost of exports in domestic currency; Pd is the unit price of imported goods in
domestic currency; and Cf is the unit cost of imports in foreign currency.
Substituting Equation (3) into the Equation (2) gives a profits equation
which shows how profits are affected by changes in the exchange rate:

P = A + (G − T) + (Cc –​ Sw) + x(Pf/​ER − Cd) + m(Pd − Cf/​ER)(2’)

A devaluation of the domestic currency reduces the amount of foreign currency

that may be purchased with a given unit of domestic currency, ER. The imme-
diate translation effect is therefore to increase the domestic currency equivalent
of exports, x.Pf/​ER, and to increase the amount of domestic currency needed
to buy the same volume of imports, m.Cf/​ER. The domestic cost of producing
exports, Cd, and the foreign currency cost of imports, Cf, are not affected by the
depreciation. These costs are determined by demand and supply in the home
and foreign markets which would not be directly affected by the exchange rate.
When prices do not change, but costs do, the effect is a change in the profit
margin. The devaluation therefore increases the profit margin on exports, and
reduces the profit margin on imports. If the economy has a trade deficit, so
that imports exceed exports, then the reduction in profits in the import trade
is greater than the increase in profits in the export trade. The devaluation thus
reduces profits overall. If, at the time of the devaluation, the economy has a
trade surplus, then the increase in export profits is greater than the fall in import
profits, and profits overall rise. Only if foreign trade is in equilibrium is the
export profits rise balanced by the import profits fall, and there is be no change
in total profits (cf. Hirschman 1949). But if foreign trade is not balanced, then
only if the Marshall-​Lerner conditions (if the elasticities of imports and exports
with respect to the exchange rate sum up to greater than unity) are fulfilled can
foreign trade eventually balance due to a change in the exchange rate.
 The Kaleckian theory of exchange rates 171
Similarly, an exchange rate appreciation increases the profit margin on
imports, and reduces the profit margin on exports. The profits of importers
rise, and the profits of exporters fall. If the country has a trade surplus, then the
appreciation reduces profits overall. If the country has a trade deficit, then the
appreciation of the currency increases total profits.

Trade-​determined exchange rates, economic development

and corporate structure
This analysis has a number of policy implications. First of all, left to the for-
eign exchange markets, or to the multilateral agency responsible for exchange
rate stability, the International Monetary Fund, exchange rates tend to move
perversely from the point of view of profits. Countries with trade deficits are
typically obliged to devalue their currencies, under pressure from the foreign
exchange markets and the International Monetary Fund. Yet, as was shown in
the previous section, this has the effect of squeezing profits overall. As a result of
such devaluations, the exchange rates for the currencies of countries with trade
surpluses, such as Japan and pre-​unification Germany, has tended to appreciate.
This appreciation then squeezes profits in those surplus countries. Exchange
rate realignments in which deficit countries’ currencies devalue, and surplus
countries’ currencies are revalued, reduces profits in both countries. By contrast,
a ‘contrary’ policy of raising the foreign exchange value of deficit countries’
currencies, and devaluing surplus countries’ currencies would increase profits
in both sets of countries.
This tendency can be incorporated into Equation (2’) by showing the
average exchange rate (the foreign currency cost of the domestic currency
unit) in period t as determined by the previous period’s exchange rate, ERt-​1,
plus some positive function, e1, of the trade balance (X –​M):

ERt = ERt-​1 + e1.(X-​

M)  e1 > 0 (4)

Equation (2’) can also be simplified by replacing the balance of autonomous

domestic income and expenditure, A + (G − T) + (Cc –​ Sw) by the term D.
Substituting equation (4) into this reduced Equation (2’) gives:

x.Pf − m.Cf
P = D + _​_​_​_​_​_​___​_​_​_​_​_​_​ + m.Pd − x.Cd (2’’)
ERt-​1 + e1.(X-​M)

Trade balances, and hence trade-​ determined exchange rate fluctuations

also have to be seen in the context of the trade cycle. Unless the cycles of
trading partners are synchronized, so that trading economies approach peaks
and troughs in economic activity at the same time, a country’s trade balance
fluctuates with domestic demand. For a small number of countries, such as
172 Jan Toporowski
France in recent years for example, the trade account is balanced over the
cycle. Exchange rate depreciation in a boom, with a trade deficit, would tend
to decrease profits which would then be decreased further when the trade
surplus in the recession causes the foreign exchange market to induce an
exchange rate appreciation.
However, most countries, and the largest trading countries such as Japan,
the United States, and Great Britain in particular, have either chronic trade
deficits which get smaller in a recession, or chronic trade surpluses which get
smaller in a boom. Successive trade deficits tend to increase as an economic
boom approaches its peak. At this stage the pressure to devalue the currency
of a deficit country generally increases. The squeeze on profits resulting from
a devaluation would then coincide with the fall in investment that occurs at
the peak of the boom and transforms it into a recession. For surplus countries,
exchange rate movements at the peak of the boom are relatively more neutral
in that the surplus is usually reduced in the boom, bringing more balanced
trade.This would tend to balance the decline in the profitability of imports that
comes with a devaluation, with a more equal improvement in the profitability
of exports. However, a recession would tend to increase the trade surplus in a
country, bringing with it pressure for exchange rate appreciation.The greater is
the trade surplus the more are profits squeezed by a given exchange rate appre-
ciation. By contrast, a deficit country has its smallest trade deficit as a recession
approaches its trough, so that any currency appreciation at this stage has a more
neutral effect on the profitability of foreign trade.
In sum then, ‘normal’ currency fluctuations squeeze foreign trade profits
most in deficit countries as their economic booms approach their peak. In
chronically surplus countries,‘normal’ (trade-​related) exchange rate movements
squeeze profits most as their currencies appreciate when their economic reces-
sion approaches its trough.The effects of trade-​determined currency movements
on countries with different trade imbalances are shown in Table 12.1.
The most neutral business cycle effects of trade-​ determined currency
changes therefore obtain in chronic surplus countries in the course of a boom,

Table 12.1 Trade-​determined currency movements and profits over the trade cycle

Trade disequilibrium Boom Recession

Chronic surplus Trade surplus alleviates any Trade surplus enhances

depreciation squeeze on currency appreciation
profits squeeze on profits
Cyclically-​balanced trade Trade deficit enhances Trade surplus enhances
currency depreciation currency appreciation
squeeze on profits squeeze on profits
Chronic deficit Trade deficit enhances Trade deficit alleviates any
currency depreciation currency appreciation
squeeze on profits squeeze on profits
 The Kaleckian theory of exchange rates 173
or in chronic deficit countries in the course of a recession. But elsewhere, and
in other phases of the business cycle (recessions in surplus economies; booms in
deficit economies) the changes in the exchange rate associated with imbalanced
foreign trade would tend to make the business cycle more extreme.
To be realistic, it has to be admitted that the trade balances of the largest
trading countries, Japan, the United States, Germany, the United Kingdom,
France and Italy, are relatively small, amounting to less than three per cent of
Gross Domestic Product before the 2008 financial crisis, but expanding since
then.This means that the net effect of exchange rate fluctuations on total profits
in those economies is small, even if they may be larger for businesses specialising
either in import or export trades. However, smaller open economies, such as
most of those in Europe and many of the developing countries, are much more
dependent on foreign trade. Their trade imbalances easily go beyond 5 per cent
and more of GDP. These smaller economies are therefore much more affected
by changes in profits due to exchange rate fluctuations. The adverse effects on
profits of changes in the exchange rate are also unequally distributed among
companies. Larger trading companies and multinational firms may more easily
evade the effects of exchange rate movements by spreading their purchasing
and production activities across a number of countries. This enables them to
off-​set adverse exchange rate movements in some countries with favourable
exchange rate movements in other countries. Such big businesses also hold
liquid financial assets in a number of countries, using leads and lags to avoid
converting payments at unfavourable exchange rates. They can also match cash
inflows with payments in particular currencies, avoiding the foreign exchange
market altogether. Smaller companies and indigenous companies in developing
countries, tend either to be solely importers or exporters. They do not have
their own international networks of trading and production activities, insulated
from exchange rate fluctuations by transfer pricing. Exchange rate movements
are much more like a lottery for such companies: If they are exporting when
their country devalues its currency, they benefit. But if they are importing they
lose. Their inability to off-​set such gains and losses makes the existence of such
companies much more hazardous than that of big business and multinational
companies.
In developing countries, exchange rate instability places particularly at
risk commodity producers exporting agricultural raw materials and minerals.
Typically, these are priced in US dollars (the currency of the main commodity
markets) and have only a limited (if any) home market. To the instability of
commodity prices are therefore added the vagaries of the US dollar exchange
rate. Profits from producing these products have benefited most from the
International Monetary Fund’s insistence on depreciation of the exchange
rate as a means of eliminating trade imbalances: With a low import content,
costs are not raised by such devaluation. But demand for such exports is nor-
mally price-​inelastic. For a number of lightly populated commodity-​exporting
countries, such a devaluation can bring a one-​off increase in profits. However,
most developing countries suffer from chronic trade deficits, so that the boost
174 Jan Toporowski
that devaluation gives to export profits is exceeded by the reduction in profits
in the import trade. Taking their corporate sector as a whole, the devaluation
squeezes profits.
This squeeze is exacerbated by the tendency in developing countries for
the money economy to be concentrated around the government and foreign
trade sectors. Such concentration is most marked in the least-​developed econ-
omies, and tends to decrease as industrialisation expands the domestic market.
Industrial backwardness therefore makes developing economies much more
‘open’ than more industrialised economies, and hence makes the profits of their
corporate sectors more vulnerable to exchange rate fluctuation.

Money capital flows and Fisher effects

Since the 1970s, international money capital flows have, because of their
size (amounting to twenty times the value of commodity trade), determined
exchange rates. While this has been the subject of much criticism, mainly due
to the loss of control by central banks over exchange rates, it has also disturbed
the system of perverse exchange rate effects on profits. Because of the effects
on exchange rates of capital flows going through the foreign exchange markets
some currencies have at times appreciated in the face of trade deficits, for
example, the rise of sterling between 1992 and 1997 or, even more contrary to
conventional wisdom, the appreciation of the US dollar after the 2008 crisis.
Other currencies have depreciated in the face of surpluses e.g., the depreci-
ation of the Japanese yen after 1994. Such changes in the exchange rate have
the paradoxical effect of increasing profits. However, this is by no means a sys-
tematic effect in the way in which, when exchange rates were determined by
trade flows, the currencies of countries with deficits tended to depreciate, and
those of surplus countries tended to appreciate. The exchange rate movements
that accompanied the financial crises in Mexico, in 1994, and East Asia, in 1997,
indicate that exchange rate determination by money capital flows can be even
more catastrophic than when exchange rates are affected only by trade flows.
International money capital flows are equal to total international cap-
ital flows minus the foreign direct investment that is in the form of tangible
plant and equipment, and such know-​how, property rights and licences whose
cross-​border transfer is not mediated through the foreign exchange markets.
International money capital flows therefore consist of that part of foreign direct
investment that is mediated through the foreign exchange market, namely the
purchase of company share capital or equity using foreign currency transferred
from abroad, plus international portfolio investment, plus cross-​border flows of
short-​term bank deposits.
The first two elements, financial foreign direct investment and portfolio
investment, are broadly pro-​cyclical in that they vary with and stimulate the
capital market (in the sense of the market for long-​term securities), which in
turn fluctuates with the general business cycle and the inflow of funds into that
market (Toporowski 2000b, Part I).These two kinds of money capital flow may
 The Kaleckian theory of exchange rates 175
therefore be regarded as tending to move the exchange rate of a country along
with the business cycle: appreciating a currency in the boom, and depreciating
it in the recession.
The third kind of money capital movements are short-​term flows of bank
deposits. A portion of such flows are the result of speculative arbitrage between
expected changes in exchange rates. But they are easily dominated by a more
certain form of arbitrage, between differences in interest rates in the money
markets of particular currencies. This is known as the ‘carry’ trade. Where
exchange rates are stable, an assured profit may be obtained by borrowing in
the money market of a low interest currency, to place on deposit in the money
market of a higher-​interest currency. As more of the low-​interest currency is
sold to buy the higher-​interest currency, the latter tends to appreciate against
the former, adding gains on the exchange rate (when the deposit in the higher
interest currency is withdrawn and converted back into the lower interest cur-
rency that was originally borrowed) to the profit margin of the higher interest
rate. The profit is obviously reduced, or even eliminated, if a higher interest-​
rate currency depreciates, or if a lower interest rate currency appreciates. The
‘interest rate parity’ implied by this would tend to discourage the carry trade
in such currencies. In such a situation, the exchange rate will tend to fluc-
tuate with longer-​term capital flows and the trade cycle. However, such a situ-
ation is not an equilibrium, or even a ‘central tendency’, as is implied by the
exchange rate parity theories (Interest Rate Parity, the International Fisher
Effect, and Purchasing Power Parity), if only because they assume that arbitrage
will take place until an equilibrium in the particular parity is achieved. Such an
assumption requires that all markets be characterised by perfect and continuous
liquidity. The foreign exchange markets can hardly be said to be in a state of
perfect and continuous liquidity where the carry trade is eliminated because
the exchange rate is off-​setting interest rate differentials. (See also Toporowski
2000b, pp. 40 and 135.)
In order to understand the flow of money capital through the foreign
exchange markets, it is necessary to combine the business cycle with a theory
of interest rate determination. Broadly, nominal interest rates rise and fall with
the rate of inflation (Fisher 1896 and 1931). While Fisher originally supposed
that bargaining between borrowers and lenders would result in parallel shifts in
the rate of product price inflation and the rate of interest, such bargaining has
now been replaced by the fixing of short-​term money market interest rates by
central banks. The prevailing central bank orthodoxy since the Second World
War has been for central banks to raise interest rates as inflation rises, usually
in a boom, and lower them as inflation falls in a recession. The pro-​cyclical
movement of interest rates makes them an adequate proxy for longer-​term
money capital flows. In a world of free international capital flows, international
capital flows from low inflation economies, with low nominal rates of interest,
to high inflation economies with high nominal rates of interest. Such flows
tend to raise the exchange rates of countries in a boom, increasing profits if,
as is likely, they have a trade deficit. Similarly, money capital outflows from
176 Jan Toporowski
countries in recession with low interest rates would tend to depreciate the for-
eign exchange value of those countries’ currencies. If they have trade surpluses,
as is more likely in a recession, the effect would be to increase profits from
foreign trade.
It may be argued, along the lines of this so-​called International Fisher Effect,
that if higher interest rates reflect higher rates of price inflation, then real interest
rates are more or less equal, and there is therefore no advantage to be gained
from moving money capital from countries with low nominal interest rates to
countries with high nominal interest rates. However, the real value of a stream
of interest payments from abroad depends on the exchange rate at which the
stream is converted into home currency, and the rate of price inflation in the
country to which that stream flows. The rate of price inflation in the country
of origin of that stream, as opposed to its rate of interest, may fire the febrile
imagination of would-​be speculators. But it does not affect the value of that
currency when it has been converted into another currency and taken abroad.
Given different rates of price inflation in any two countries, the flow of money
capital into the one with higher nominal rates of interest (and inflation) would
tend to cause that country’s currency to appreciate, relative to the currency of
the country with the lower rate of inflation. The benefits of higher nominal
rates of interest in the first country, together with the appreciation of its cur-
rency, is sufficient cause to attract further money capital into that country (see
also Dow 1986/​1987).
The tendency that international capital mobility imparts for exchange rates
to move with differences in nominal interest rates, which fluctuate in line with
the business cycle can be incorporated into the profit Equation (2’).The average
exchange rate in a period, ERt, may be approximated by the previous period’s
exchange rate, ERt-​1, plus some positive function, e2, of the difference between
the domestic nominal rate of interest, It, and the capital-​transactions-​weighted
average nominal rate of interest abroad, τt:

ERt = ERt–​1 + et(it –​ τt)   ;   e2 > 0 (4’)

Substituting this into Equation (2’) with, as before, D representing autonomous

domestic income and expenditure items, gives:

x.Pf –​  m.Cf

P=D+ _​ _ _
​ _
​ ​_​_​_​_​_​_​_​_​_​_​_​_​+ m .Pd –​ x.Cd (2”’)
ERt–​1 + e2(It –​  τt)

This equation shows the impact of monetary policy on profits in an economy,

through the effect of relative interest rates on the exchange rate, and through
that in turn on the value in domestic currency of profit from exports and
imports. An assumption implicit in this formulation is that the relative attraction
of different destinations for international money capital flows is determined by
relative nominal interest rates.The opportunity cost of a commitment of money
 The Kaleckian theory of exchange rates 177
capital to an economy is the nominal rate of interest which would be obtained
on that capital in a different financial centre.This may, or may not, be enhanced
by currency appreciation. The theory that the exchange rate will move to off-​
set differences in interest rates is known as uncovered interest parity. There is
little empirical evidence to support this theory (see, for example, Isard 2006),
in large part because of interest rate activism by central banks in recent years,
differences in monetary conditions in different countries, and especially the
impact of disturbances in the international financial system affecting coun-
tries in different ways. The possibility of international financial crisis affecting
the absolute attraction of all destinations of international money capital is not
precluded by the formulation in 2’’’. ‘Absolute’ here means, of course, relative
to domestic uses for money capital deployed abroad by its owners (corporations
and investment funds). What appears as a process of ‘contagion’, following an
outflow of money capital from a particular financial centre, is in fact the effect
of international capital seeking domestic shelter from the foreign investment
risks exposed in the course of a crisis.

Destabilising the world economy

Notwithstanding their effects on profits, international capital flows would tend
to exacerbate the trade cycle: A capital inflow in a boom would tend to prolong
the boom and have a positive effect on profits and hence business sentiment
and investment, while a capital outflow in a recession would tend to prolong
it, since it would then be viewed as reflecting badly on the prospects facing
the economy. The boom that coincides with success in attracting international
money capital to a particular financial centre may lead to lower interest rates
and exchange rate appreciation, providing incidental support for the uncovered
interest parity theory. Capital gains in one financial centre cause inflows into
other economies where similar potential is perceived. But crises of international
money capital outflows from particular centres, are easily also translated into
widespread withdrawal of money capital from those economies most dependent
on inflows of such capital.
Moreover, money capital inflows are usually associated with inflows of for-
eign direct investment. As was mentioned in the previous section, not all such
inflows are mediated through the foreign exchange market: The purchase of
equity in domestic companies in exchange for the equity of foreign companies is
commonly included in foreign direct investment, but it does not occur through
the foreign exchange market. Similarly, the most common form of foreign direct
investment, the transfer of excess capacity in the form of plant and equipment
from less buoyant markets to booming ones also does not commonly occur with
immediate payment through the foreign exchange market: Such transfers are
usually made between subsidiaries of multinational companies, or financed by
credits in domestic bond or stock markets (cf. Toporowski 1999). Such foreign
direct investment, and the portfolio capital inflows that move with them, are not
direct expenditures in the economy: While they may give rise to speculative
178 Jan Toporowski
profits in the financial or property markets, these profits cannot be realized (in the
sense of conversion into money) without a disintermediation from the market
in which a speculative profits is created. Only a rise in investment expenditure
in the economy, higher capitalists’ consumption, lower workers’ saving, a greater
fiscal deficit or an increased trade surplus, can raise the flow of profits into the
business sector of the economy (Kalecki 1971, ­chapter 7, Toporowski 1993).
The combined effect of foreign direct investment and higher business con-
fidence is usually sufficient to stimulate greater investment, just as the boom
encourages higher capitalists’ consumption and lower workers’ saving, even as the
boom reduces any trade surplus, or increases the trade deficit.The resulting rush to
install new or imported plant and equipment would exaggerate turning points in
the trade cycle with even greater over-​investment or under-​investment than may
otherwise have occurred. Since most private sector investment is undertaken by
large or multinational companies, it is unlikely that they would be able to insulate
themselves from the crisis of excess capacity that would follow a period of over-​
investment, even if their stronger credit positions makes it more likely that they,
rather than their smaller competitors, would survive that crisis (cf. Steindl 1945).
In large measure such catastrophic effects arise because international money
capital flows create foreign liabilities and assets. Again, in the case of multi-
national corporations and large companies in the industrialised countries,
such assets and liabilities are likely to be more or less balanced. Medium and
smaller businesses in the industrialised countries tend not to use foreign cap-
ital. However, during the 1990s, the larger indigenous companies in developing
and semi-​ industrialised countries were encouraged by prodigious capital
inflows and high domestic interest rates to enter into foreign liabilities, prin-
cipally denominated in US dollars, that were not balanced by dollar assets or
income flows. When substantial devaluations were forced on defaulting coun-
tries during the 1982 international debt crisis, and during the Mexican and
East Asian crises, in 1995 and in 1997, respectively, the value of the foreign
liabilities increased in proportion to the devaluation. This points to another
complication that arises through the use of the exchange rate as an instrument
of policy, namely that an exchange rate that makes exports more competitive
also increases the domestic resource cost of servicing foreign debt. In retro-
spect, the devaluations forced onto developing countries in the 1980s and 1990s
exacerbated their debt problems, rather than alleviating them.

Conclusion
The Kaleckian theory of exchange rates may be summarised as follows. Exchange
rates have an important influence on economic dynamics through their impact
on profits because, while consumption is an exchange between households
and firms in given countries, cross-​border trade is typically conducted between
companies. Exchange rates therefore affect the global distribution of profits.
Exchange rates responding to trade imbalances, by devaluation in countries
with trade deficits, and appreciation in countries with trade surpluses, cause
 The Kaleckian theory of exchange rates 179
shifts in that global distribution of profits. Such exchange rate movements tend
to affect most adversely profits in smaller and developing countries, and among
smaller businesses. This discrimination discourages international trade which
does not benefit directly big countries and big business. With the domination
of the foreign exchange markets by capital flows, a new form of instability arises
that boosts profits and investment in countries experiencing booms, and subse-
quently exacerbates recessions with capital outflows.
In influencing the global distribution of profits, the theory of the exchange
rate is a specific case of the general approach of Kalecki to the price system.
In Kalecki’s analysis, the neo-​classical function of prices, bringing supply and
demand into equilibrium, is relatively trivial. Their deeper, more important
function, according to Kalecki (also Marx) is in determining the distribution
among firms of the profits generated by firms’ investments, and governments’
fiscal balances so that changes in the exchange rate have important income effects,
but substitution effects are limited by the international ‘division of labour’, that
follows from the classical theory of comparative advantage in international
trade, and the dominance of the advanced capitalist countries. In this system,
the exchange rate determines the distribution of those profits among firms
in different countries. This is perhaps the least acknowledged contribution of
Kalecki to the theory of exchange rates.

Acknowledgements
This paper is a revised versión of ‘Una teoría kaleckiana sobre la dinámica
perverse de los tipos de cambio’ (A Kaleckian theory of perverse exchange
rate dynamics) in Guadalupe Mántey de Anguiano and Noemí Levy Orlik
(compiladores) Globalización financiera e integración monetaria Una perspectiva desde
los países en desarrollo Mexico City: UNAM 2002. I am grateful to Ilene Grabel
for helpful advice at an early stage in this research and to her, Noemi Levy,
Victoria Chick, Geoff Harcourt, Hansjőrg Herr, Nina Kaltenbrunner, John
King, Alfredo Saad-​Filho and Ron Smith for comments on earlier drafts. The
responsibility for any errors is mine.

Note
1 This aspect of Kalecki’s work is detailed in Toporowski (2018), pp. 127–​136, 155–​157,
172–​173.

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13 
Financial liberalisation, exchange
rate dynamics and the financial
Dutch disease in developing and
emerging economies
Alberto Botta

1 Introduction
Since the beginning of 1970s, neoliberal economists have emphasised financial
and capital account liberalisation as necessary reforms to promote fast and sus-
tainable growth in developing and emerging economies (DEEs henceforth). In
their view, financial liberalisation would enforce market-​driven discipline, end
fiscal dominance, increase savings and, eventually, raise capital accumulation and
economic growth. The remarkable increase in the number of financial crises
hitting DEEs since then (Kaminsky and Reinhart, 1999), together with the
evidence of the enduring economic stagnation these crises may bring about
(Cerra and Saxena, 2008), has considerably shaken that belief.
The abundant literature on the relation between portfolio capital flows and
development in developing and emerging countries almost exclusively focuses
on the heightened macroeconomic instability that may ensue in the aftermath
of financial liberalisation. Only a small group of contributions has considered,
implicitly or explicitly, how portfolio capital flows may foster or hinder eco-
nomic development by affecting the productive structure of DEEs.Taylor (1991,
­chapter 6), presents a theoretical model in which speculation waves unfold in
DEEs with poor connection, if any, with the manufacturing tradable sector,
but strong linkages with the (over-​) expansion of the financial industry and/​or
the real estate sector. This was the case of Kuwait in the 1980s or Chile in the
1970s.1 Taylor (1998) reaffirms the significant connection between episodes of
financial euphoria and hypertrophic real estate sectors in a subsequent study
about the financial boom-​and-​bust cycles of the 1990s in DEEs such as Mexico
and Thailand. More recently, Gallagher and Prates (2014) analyse the case of
Brazil in the first decade of the 2000s. They describe how the ‘resource curse’
in Brazil manifests itself together with the financialisation of the economy, i.e.,
the growing importance of financial investors in the determination of com-
modities’ prices and exchange rate dynamics. Botta et al. (2016) describe the
macroeconomic dynamics of Colombia since the beginning of the 2000s, when
the Colombian development pattern increasingly relied upon the exploitation
of domestic natural resources (the so-​called ‘locomotora minera’). The authors
182 Alberto Botta
describe how booming portfolio inflows following an initial surge in natural
resource-​oriented FDI caused a considerable appreciation of the Colombian
peso and a significant squeeze in the contribution of manufacturing to GDP.
Botta (2017) provides a formal model of that experience.
The present chapter aims at shedding some more light on what has been
previously labelled as the ‘financial Dutch disease’ (Botta et al., 2016). In par-
ticular, we describe through a formal model how, in the aftermath of financial
liberalisation, a temporary surge in (speculative) capital inflows may contribute
to generating a boom in a domestic ‘speculative’ sector, call it real estate or
finance, causing the appreciation of the nominal (and real) exchange rate and an
increase in the price of a domestic speculative asset. This temporary phenom-
enon may in turn bear long-​lasting perverse consequences on the productive
structure of DEEs, possibly causing a premature de-​industrialisation and a per-
manent reduction in the dynamics of labour productivity.
The chapter is organised as follows. Sections 2 and 3 describe the building
blocks of the model and the portfolio capital-​led speculative dynamics that may
characterise DEEs in the medium term. Section 4 extends the analysis to the
long run by showing how temporary financial booms may perversely reduce
the long-​run growth potential of the economy by affecting its productive struc-
ture, the relative importance of manufacturing in particular. Section 5 concludes
by drawing some policy implications of our analysis.

2 Portfolio inflows in a two-​sector economy with a

‘speculative’ sector
Let assume a small open developing economy, in which the domestic central
bank adopts a ‘pure’ inflation targeting monetary policy. Accordingly, it sets the
domestic (benchmark) interest rate with the sole purpose of controlling infla-
tion.The exchange rate in turn is left free to float. As for capital flows, portfolio
investment in particular, we assume them to be endogenously determined on
international financial markets through the interaction between the supply of
funds from the rest of the world (say the ‘centre’ of the international financial
system) and the demand of funds from the domestic economy (say the finan-
cial periphery). For the sake of simplicity, we assume portfolio flows to mainly
consist of short-​term lending that must be rolled over and renegotiated each
period. Accordingly, we can safely neglect the distinction between stocks and
flows.2 Equations (1) and (2) define the supply (LSf) and the demand (LDf) of
foreign currency-​denominated capital, respectively:

∂δ ∂δ
( )
LSf = δ i f , iint with
∂i f
< 0;
∂iint
>0 (1)

( )
LDf = λ iCB , iint , e, Pze , id with
∂λ
∂icb
> 0;
∂λ
∂iint
< 0;
∂λ
∂e
< 0;
∂λ

∂Pze
> 0;
∂λ
∂id
>0
(2)
 Financial liberalization and exchange rate 183

We assume ‘LSf’ to be a negative function δ(.) of the ‘centre’ interest rate if,
as exogenously controlled by the foreign central bank. The supply of foreign
resources responds positively to the endogenously determined international interest
rate iint.
According to Gallagher and Prates (2014) central banks in DEEs tend to set
high interest rates in order to keep the exchange rate appreciated and inflation
under control.3 In this context, domestic financial operators are often involved
in carry trade (Gagnon and Chabound, 2007), i.e., they borrow at lower interest
rates on international financial markets in order to lend at higher rates domes-
tically. Consistently with this story, in Equation (2) the demand for foreign cap-
ital ‘LDf’ is a positive function λ(.) of the benchmark domestic interest rate ‘iCB’,
set exogenously by the domestic central bank. In a similar vein,‘LDf’ is a negative
function of the agreed international interest rate iint.
In Equation (2), ‘LDf’ is also negatively related to the nominal exchange rate
‘e’ (here defined as the quantity of domestic currency one can buy with a unit
of foreign currency), given that a higher value of ‘e’ will increase the mismatch
between foreign currency-​ denominated liabilities and domestic currency-​
denominated assets. By the same token, ‘LDf’ will be higher the higher is the
expected capital gain Pze from investments in the domestic speculative asset ‘Z’,
or the higher is the domestic interest rate ‘id’ domestic financial institutions
charge on loans to domestic non-​financial productive (manufacturing) firms
(see more on this below).
Figure 13.1 shows how portfolio inflows Lf and the related interest rate iint are
endogenously determined on international financial markets. The endogenous

iint
LSf
iCB

i*int
if σ

LDf

Lf LfS, LDf

Figure 13.1 Determination of foreign portfolio flows and interest rate on international

financial markets.
184 Alberto Botta
spread σ between iint and if measures the ‘country-​factor risk’ international
financial markets usually attach to economies at the periphery of the inter-
national financial system.
Figure 13.1 also shows how international factors related to, say, ‘global finan-
cial cycles’ (Rey, 2015) may influence the determination of such variables. We
portray the supply of foreign funds ‘LSf’ as an inverted L-​shaped curve. On the
one hand, ‘LSf’ is initially very flat and flatter than the demand curve. In times of
bonanza, in particular in the aftermath of financial liberalisation, international
financial markets can mobilise huge amount of resources, at least with respect
to the size of DEEs, hence providing them with relatively cheap credit. On the
other hand, international financial markets may abruptly change their minds
if they believe that, for one reason or the other, DEEs have gone too far and
their international indebtedness is excessive. In this context, the ‘LSf’ may sud-
denly become very rigid (or even become backward bending). ‘Sudden stops’
take place and DEEs become unable to get access to additional external finance
whatever the ‘country-​r isk premium’ they pay. Changes in international finan-
cial markets exacerbate these dynamics. An exogenous increase in the inter-
national interest rate ‘if’, for instance, perhaps due to the end of a cycle of
abundant international liquidity, moves the ‘LSf’ curve up and can make its ‘rigid’
arm to emerge much earlier. The cost of external finance for DEEs suddenly
increases, possibly bringing to an end domestic financial euphoria as well (see
more on this below).
For the sake of simplicity, we assume that the domestic provision of funds
to the domestic financial system acts as a buffer. When (cheaper) resources
collected on international financial markets are not enough to finance
the desired uses, domestic financial operators can raise additional funds in
the domestic economy, say through the domestic inter-​banking market, at the
higher (with respect to the international one) domestic interest rate ‘iCB’ set by
the domestic central bank.
Domestic financial institutions are engaged in two different types of lending
activities/​financial investment. First, they provide loans ‘LM’ to firms in the
manufacturing sector in order to finance productive capital accumulation.
Second, domestic financial institutions also invest in the purchasing of a specu-
lative asset ‘Z’. ‘Z’ may represent the housing sector, which has been very often
tightly associated with episodes of financial euphoria in DEEs. Alternatively,
it may stand for some innovative financial assets, which may have recently
contributed to expand market-​based financial activities even in DEE countries
(see Karwowski and Stockhammer, 2017).
We assume that domestic financial institutions fully accommodate the
demand for loans coming from non-​financial manufacturing firms, so that
no credit rationing is considered. The expansion of ‘LM’ is demand-​driven and
depends on desired investment by non-​financial manufacturing firms. Financial
institutions charge an interest rate ‘id’ on loans to domestic firms. Such an
interest rate is set according to a mark-​up (μ) on the target rate ‘iCB’ of the cen-
tral bank (see Equation (3)):
 Financial liberalization and exchange rate 185

id = (1 + µ ) iCB
(3)

For the sake of simplicity, let’s assume investments by manufacturing

firms to be fully autonomous and based on expectations about future sale
opportunities. On the one hand, these are (positively) influenced by the
expected expansion of the domestic market, which in turn hinges upon the
increase in domestic wages. As usual in Post Keynesian models, wages stand
out as a productive cost for the individual entrepreneur, but they are also a
relevant source of demand (and profits) for the system as a whole. On the
other hand, a loss of competitiveness with respect to foreign competitors
may hinder domestic firms from undertaking further productive investments.
The international competitiveness of domestic manufacturing is captured
by the real exchange rate q (= ePf/​PM). The higher is q, the more competi-
tive are domestic goods with respect to foreign ones, and the more likely
domestic firms could gain market shares and decide to scale investments up
(see Equation (4)):

IM ∂g ∂g
= g ( wˆ , q (e )) with > 0; >0 (4)
KM ∂wˆ ∂q

As for the speculative asset, given ‘LZ’ as the outstanding stock of resources
domestic financial institutions pledged to the purchases of ‘Z’, it will increase
or decrease (in percentage terms) depending on the net expected capital gain
{ }
ρe (= Pze − Φ = Pze − iCB − φ (iCB − iint ) ) –​see Equation (5) and Figure 13.2.

Such a net return is defined as the expected percentage variation (P )

z
e

in the price of the speculative asset ‘Z’ minus the average cost of financing
{
Φ = iCB − φ (iCB − iint ) } domestic financial institutions jointly deal with on
domestic and international capital markets.
We also assume that the expansion of ‘speculative’ investments is negatively
influenced by ‘e’, given that higher values of ‘e’ will make the balance sheet of
domestic financial institutions more fragile. Accordingly, they might become
more reluctant to undertaking new finance-​led investments in the domestic
speculative asset, as well as advancing new requests for external funds, which
might impair their financial soundness even further.

 = ψ (ρe , e ) with ∂ψ > 0 and ∂( ∂ψ / ∂ρ ) < 0; ∂ψ < 0

e
L z
(5)
∂ρe ∂ρe ∂e

In Equation (5) and Figure 13.2, an increase in the net expected capital gain ρe,
as due to a rise in Pze , initially induces domestic financial institutions to expand
186 Alberto Botta

"LZ hat"

"Pze hat"

Figure 13.2 Temporary credit euphoria in the early stages of a financial boom.

the stock ‘LZ’ at increasing rates (i.e., LZ rises). This assumption captures the
financial euphoria and credit over-​activity that typically characterises the early
stages of a financial (speculative) boom. Such a rise, however, is not boundless.
The increasing indebtedness of domestic financial institutions on international
financial markets and the ensuing rise in the average costs of borrowing Φ (as
due to the rise in the endogenous interest rate ‘iint’) will lead financial exuber-
ance to slow down, sooner or later. Accordingly, the positive effect of PZe (and
∂( ∂ψ / ∂ρe )
therefore ρe) on LZ will vanish (i.e., < 0 ).4
∂ρe
The two sectors in which we decompose the economy work in different
ways. Manufacturing behaves in an oligopolistic fashion. The price of the
manufactured good ‘PM’ is determined by applying a fixed mark-​up rate ‘m’ over
unit labour costs (see Equation (6)). In Equation (6), w stands for the monetary
wage whilst ‘a’ represents labour productivity. The market for the manufactured
good clears through quantity adjustments.

w
PM = (1 + m ) (6)
a

The speculative sector, instead, reaches equilibrium via price adjustments. Given
the quantity of ‘Z’ in the short run and of the outstanding financial resources
LZ devoted to its purchases, the short-​run equilibrium on the market for ‘Z’
implies PZ Z = LZ , so that:

LZ
PZ =
Z (7)
 Financial liberalization and exchange rate 187

3 Portfolio booms, exchange rate appreciation and

medium-​term financial cycles in developing and
emerging countries
Let us now analyse how surges in portfolio capital inflows, exchange rate
appreciations and episodes of financial euphoria in DEEs may give rise to
financial boom-​and-​bust cycles. We focus on the joint time evolution of ‘e’
and ‘ρe’ ( e and ρ e being their time derivatives). Following Bhaduri (2003) and
Gandolfo (2016), we assume that the nominal exchange rate varies according
to appreciation or depreciation tendencies emerging from notional surplus or
deficit positions in the BoP (see Equation (8)):

−    −    + 

e = θ (TB(e ); L f (e, ρe , i f , iCB ) ; γ ( R , FDI , iint (ρe , e )L f (ρe , e )) (8)

In Equation (8), the time variation of the exchange rate ( e ) is a negative

function θ(.) of the trade balance ‘TB’, which in turn depends positively on
the nominal exchange rate (assuming the standard Marshall-​Lerner condition
fulfils). The exchange rate also appreciates in presence of large inflows of for-
eign portfolio investment (Lf).5 The dynamics of the exchange rate may also
be influenced by other factors entering the BoP such as policy-​determined
variations in ‘foreign reserve’ ( R ), the service of foreign debt (iintLf), and
Foreign Direct Investment (FDI).
Equation (9) describes how expectations about net capital gains evolve
through time.We assume a simple adaptive rule, according to which the upward
or downward revision of ρe hinges upon the comparison between its observed
and expected value. After reminding that ρ = ( PZ − Φ ) and ρe = ( PZe − Φ ), and
after taking the percentage variation of PZ from Equation (7), we get:

((
ρ e = η (ρ − ρe ) = η ρ LZ (ρe , e ) , Z
 (ρe − Ω ) − ρe
) ) (9)

Equations (8) and (9) form a system of two differential equations gener-
ating complex medium-​term dynamics. In this chapter, . we restrict our analysis
to the case in which the two loci for ( e = 0 ) and (ρe = 0 ) behave as inverted
U-​shaped curves and intersect twice, giving rise to two different equilibria with
different stability properties. In Figure 13.3, equilibrium A features saddle-​path
instability whilst point B is characterised by cyclical volatility in its neighbour-
hood. More importantly, Figure 13.3 shows that even small changes in the
feelings of domestic and/​or international financial actors may trigger financial
booms, in which the exchange rate initially appreciates and expectations about
capital gains get more optimistic, but eventually collapse in a final phase of
heightened volatility.
188 Alberto Botta

"e dot" = 0

A
C
ρe0
B

"ρe dot"=0

ρe

Figure 13.3 Multiple equilibria and financial instability in the (e-​ρe) space.

Let’s assume that a climate of generalised (financial) optimism, perhaps

due to financial liberalisation, causes the locus for (e = 0 ) to move upward in
Figure 13.3. If we assume the economy to be initially located in the saddle-​
path equilibrium, the exchange rate will now start to appreciate. Easy access
to foreign finance and a more appreciated exchange rate will in turn raise
Lz, PZ , and ρe. A more or less protracted financial boom may unfold. This is
represented in Figure 13.3 by the downward-​sloping section of dashed black
line from point C to point B. However, such a state of euphoria may not
last forever (see Frenkel and Rapetti (2009)). Indeed, the initial dynamics of
‘e’ and ‘ρe ‘ also give rise to considerable imbalances in the fundamentals of
DEEs. First, an appreciated exchange rate likely causes a sizable trade deficit to
emerge, which may in turn set the stage for a reversal in the dynamics of the
exchange rate. Second, depreciation pressures further reinforce due to rising
interest payments domestic financial institutions have to deal with as a conse-
quence of their speculation-​led (high) foreign indebtedness. The reversal in the
exchange rate dynamics eventually brings the financial boom to an end. Indeed,
the balance sheet of domestic financial operators becomes more fragile, so that
they start to withdraw from further investments in the domestic speculative
sector. As a consequence, PZ declines and the rise of ρe ends.6 Sudden stops in
portfolio inflows follow soon. All these stages of heightened financial volatility
in DEEs are described by the cyclical dynamics characterising the evolution of
the economy in the neighbourhood of point B.
 Financial liberalization and exchange rate 189

3 Long-​run damages of temporary financial booms

in developing countries
Boom-​and-​bust financial cycles may certainly entail harsh consequences for
the real economy by increasing macroeconomic volatility. More than this,
short-​lived episodes of financial euphoria may permanently affect the long-​run
development trajectory of developing countries by modifying their productive
structure.
The idea that the process of economic development is tightly connected
to the evolution of the productive structure of an economy has been exten-
sively investigated in the economic literature (McCombie and Thirlwall, 1994;
Imbs and Warzciag, 2003; Cimoli et al., 2010). More specifically, manufacturing
development has been traditionally considered as a fundamental ‘positive’ struc-
tural change that feeds growth and economic take off (Rodrik, 2009), due to
better opportunities for specialisation and a deeper division of labour, as well as
wider scopes for innovation, the enlargement of the product space, and export
diversification.
In this chapter, we maintain the centrality of manufacturing in the overall
development process. More specifically, let us assume that in our admittedly
oversimplified economy manufacturing development is captured by the ratio
(k) of the manufacturing sector capital stock ‘KM’ over the value of the specula-
tive sector (see Equation (10)):

PM K M
k= (10)
PZ Z

The evolution of (k) depends on the dynamics of several components. The

dynamics of the price PM of the home-​made manufactured good is given by
the joint percentage change of manufacturing labour productivity ( â ) and of
the nominal wage rate ( ŵ ) –​see Equation (11):

P
M = w
ˆ − aˆ (11)

Also assume that the growth rate of monetary wages is determined by the
growth rate of labour productivity (i.e. wˆ = aˆ ), so that the price PM stays con-
stant. This is certainly a simplifying assumption. However, it does not alter the
logic of the model but makes easier to get its implication.7
The growth rate of labour productivity is in turn a function α(.) of ‘k’ and
behaves as an inverted U-​shaped curve –​see Equation (12) and Figure 13.4.
At the beginning of the development process (i.e. when k is relatively small),
a rather low growth rate of labour productivity accelerates alongside with the
progressive industrialisation of the economy (i.e. a rising value of k). This is
precisely due to the growth-​enhancing properties historically associated to
190 Alberto Botta

α(k)

B ("k hat" = 0)
α*(k)
C

k0
kB kC k

Figure 13.4 (Relative) manufacturing development, labour productivity growth and

finance-​led development traps.

manufacturing (Naraguchi et al., 2017). At more advanced stages of this process,

the positive link between manufacturing development and productivity growth
weakens. This may be the result of the exhaustion of static economies of scale
characterising medium-​tech large scale manufacturing industries at the centre
of the development process in the golden age of capitalism, but increasingly less
important thereafter:8

a = α (k ) (12)

Given Equations (4), (10), (11) and (12), Equation (13) describes the rela-
tive dynamics of manufacturing (with respect to the speculative sector) in the
economy. Such dynamics is portrayed in Figure 13.4, where we plot together
Equations (12) and (13):

+ +
(
k = g(a , e ) − PZ + Z

) (13)

In Figure 13.4, we portray the evolution of the growth rate of (manufac-

turing) labour productivity as a function of ‘k’. On top of this, we report the
geometric locus that ensures ‘k’ to remain constant. It is reported as a straight
horizontal line in correspondence of the specific growth rate of labour prod-
uctivity (α*), which, ceteris paribus, would ensure the existence of a stable pro-
ductive structure in the periphery. In Figure 13.4 we show the case for three
long-​run equilibria: one corner solution (A) and two internal steady states
 Financial liberalization and exchange rate 191
(B and C). In interpreting the economic implications of Figure 13.4, note that
points B and C imply equal rates of growth of labour productivity, but different
levels of it.The traverse from point B to point C thus implies an acceleration of
the growth rate of labour productivity, so that the level of labour productivity
(as well as nominal and real wages) will be certainly higher in point C than in
point B.
More importantly, the instability characterising equilibrium B gives rise to
an underdevelopment trap. Hence, a relatively poor economy on the left-​hand
side of point B will hardly develop autonomously (i.e., to build up a large
enough manufacturing sector) unless she manages to overcome the threshold
level ‘kB’.
Now assume a developing country or emerging economy on its own way
for industrialisation (i.e., on the right-​hand side of but still close to point B).
Also imagine that a temporary boom in portfolio inflows starts, together with
domestic financial speculation, the appreciation of the nominal exchange rate
and the rise in the price of the speculative asset ‘Z’. Such a climate of financial
euphoria implies, at least for a while, an upward shift of the locus for ( k = 0 ), see
the dashed grey line in Figure 13.5. The appreciation of the nominal exchange
rate ‘e’, by causing an appreciation of the real exchange rate, first curtails the
international competitiveness of the domestic manufacturing industry, thus dis-
couraging manufacturing investment. Secondly, Pz and Z  increase. A rise in
the growth rate of labour productive α* is required in order to keep k = 0 .
From Figure 13.5, it is easy to see that, as a consequence such temporary finan-
cial euphoria, the process of manufacturing development can likely be reverted.
Without the necessary increase in α, the manufacturing sector shrinks, at least
in relative terms with respect to the domestic speculative sector. This in turn
brings down the growth rate of labour productivity, as well as the dynamics
of monetary (and real) wages, hence causing a second-​round contraction in

α(k)

B ("k hat" = 0)
α*(k) C
A
kB kC
k0 k

Figure 13.5 Long-​run perverse development effects of temporary portfolio inflows and

financial booms.
192 Alberto Botta
manufacturing investments due to a lower expected expansion of domestic
demand. Although a virtuous process of manufacturing development was
taking place before the beginning of the financial ‘party’, the economy even-
tually undergoes a process of premature (finance-​led) de-​industrialisation, and
ends up stuck in the underdevelopment trap on the left-​hand side of point B.9
It is also true, one might argue, that financial euphoria and booming portfolio
capital inflows may be temporary phenomena eventually causing the collapse of
the exchange rate and of the price of the domestic speculative asset. If so, sooner
( )
or later, the locus for k̂ = 0 might move back towards its original position
(or move even below it), and the process of manufacturing development restart.
This observation notwithstanding, the concerns about the long-​lasting per-
verse effects of temporary phases of financial exuberance are still there. Indeed,
the burst of financial booms usually comes together with significant degrees
of financial dislocations and economic contractions. In such a shaky economic
and financial environment, it might be hard to see any resurgence in productive
manufacturing investments. Stable and optimistic economic forecasts are basic
conditions for a sustained development process to unfold. The more or less
protracted period of ‘structural adjustments’ often following the end of financial
‘parties’ in DEEs certainly does not feed optimistic expectations. Unfortunately,
the idea that ‘financial parties’ may induce a permanent state of ‘development
hangover’ is more than a theoretical speculation.

5 Some concluding policy implications

Economic processes are often characterised by significant degrees of
cumulativeness and path-​dependence. This is particularly true when it comes
to structural change and productive development, which are shaped by know-
ledge, competencies and capabilities accumulated in the past. Accordingly, the
macroeconomic management of temporary medium-​term trends should not
be considered as an independent matter with respect to long-​run development
policies.
In this chapter, we put emphasis on the possible long-​ run perverse
consequences that financial booms and temporary over-​appreciation of their
exchange rate may have on the long-​run trajectory of DEEs by affecting their
productive structure. In a way, our analysis represents an additional contribution
to the expanding literature about the so-​called ‘too much finance’ argument
(Arcand et al., 2015). Our analysis can inform a number of policy choices.
The first consideration is related to the need of introducing tight controls
on capital movements, short-​run portfolio capitals in particular. There is a
widening consensus among economists about the destabilising effects that
complete financial account liberalisation may have on developing countries’
economies. Accordingly, restrictions on short-​term capital flows increasingly
appear as welcome policy measures taming foreign capital-​ led instability.
Given this widespread agreement, here we emphasise the more specific need
 Financial liberalization and exchange rate 193
for the introduction of quantitative and regulatory restrictions impeding short-​
term capitals to enter the economy. Indeed, monetary policy has very often
to deal with unresolvable dilemmas when it tries to counteract the undesired
effects of massive capital inflows (Akyüz, 2014). Fiscal policy, in turn, often
acts pro-​cyclically in DEEs. Ultimately, the rush adoption of restrictions to
capital outflows may come too late or untimely, or it risks making specula-
tive attacks deeper. Given these intrinsic contradictions (or weaknesses) in the
policy responses to massive portfolio capital flows, the best policy option is to
act ahead of time and quantitatively reduce, from the very beginning, the size of
short-​term portfolio capitals that may possibly enter the economy.
A second policy implication is about domestic monetary policy. Indeed,
quantitative restrictions on portfolio capital inflows should come together with
a developmentalist monetary policy, which does not take inflation control as
its sole goal. A developmentalist monetary policy implies the adoption of a
rather stable and low benchmark interest rate iCB. This strategy would bear posi-
tive consequences on both short-​term macroeconomic stability and long-​run
development. First, a low domestic interest rate reduces the incentives for carry
trade, hence weakening a source of speculative trading connecting domestic
to international financial markets. Squeezing carry trade is quintessential to
avoiding unstable financial dynamics. Second, low and stable interest rates may
encourage long-​term productive investment, including manufacturing invest-
ment, this way contributing to the process of industrialisation.
A final consideration refers to the importance of productivity dynamics
and of ‘a fair’ distribution of its fruits to domestic workers for the long-​run
development of the economy. Figures 13.4 and 13.5 show that long-​ run
underdevelopment traps may exist if productivity dynamics in underdevel-
oped countries is very low (i.e., if α(0) < α*).10 More than this, underdevel-
opment traps materialise, and manufacturing development can hardly take
place, if increases in labour productivity are not transferred into increases in
domestic nominal and real wages, which may stimulate manufacturing devel-
opment by creating enough effective demand for domestic goods. Indeed, the
‘transfer’ of all the benefits of domestic productivity dynamics to the joy of
foreign consumers (through reductions in the price of homemade goods), i.e.
a well-​known problem to early structuralist economists, or the ‘fallacy of com-
position’ among low-​priced manufacturing exports of DEEs, can constitute
serious constraints to the development process of DEEs themselves.11 In such
a context, industrial and technological policies may play a fundamental role
in exogenously boosting the dynamics of labour productivity (i.e. to increase
α(0)), and creating the necessary conditions for manufacturing development
to start. Moreover, fair increases in domestic wages, which are in line with the
dynamics of labour productivity but do not jeopardise international competi-
tiveness, may contribute to give rise to an equitable social environment, which
can certainly foster entrepreneurs’ animal spirits and their willingness to invest
in the real sector of the economy. Actually, the intertwined evolution of labour
productivity and wages was one of the distinguishing features of the golden age
194 Alberto Botta
of capitalism in the developed economies until the beginning of the 1970s. It
might be still useful to revive that socio-​political-​economic environment for
the developing countries of today.

Notes
1 Taylor (1991) does not formally consider foreign capital in his model. Nevertheless,
he recognises how it may have played a relevant role in several episodes of financial
instability in DEEs.
2 The relevance we attribute to short-​term international borrowing is consistent with
the vital role it played in the generation of some of the most relevant financial
crises happened since late 1970s, the 1997–​1998 East Asian crisis among others (see
Neftci, 1998). At the same time, the inclusion of other types of portfolio flows such
as purchases of domestic equity by international investment funds would have made
the model more complicated without adding much to the medium-​term dynamics
we describe. For this reason, here we neglect equity-​related portfolio inflows or
purchases of long-​term bonds.
3 In DEEs, the dynamics of the exchange rate and of inflation are tightly connected
due to the relatively high share of imported goods in the basket of goods consumed
domestically. This is why central banks in DEEs show a certain bias in favour of
appreciated exchange rates that contribute to reduce domestic inflation.
4 In Figure 13.2, we assume that, in an expanding economy, the stock of funds ‘LZ’
invested in the speculative asset ‘Z’ (say real estate) will normally increase (hence
Lz>0), albeit at different rates, according to the expected capital gains. Of course, a
very low value of PZe may even cause a temporary decrease of ‘speculative’ invest-
ment ‘LZ’ (i.e., Lz<0) by giving rise to negative net expected capital gains ρe.
5 In Equation (8), we use the implicit inverse function connecting PZe to ρe in order to
express (e) as a function of ρe.
6 In Equation (9), the decline in PZ and ρe may also be prompted by the increase in the
supply of the speculative asset ‘Z’ (i.e., Z>0) that may take place in the economy as a
lagged response (see parameter Ω) of the initial increase in the expected capital gains.
7 Equations (6) and (11) refer to the levels and growth rates of nominal wages and
labour productivity in manufacturing only. However, given the leading role manufac-
turing historically carried out as major driver of overall economic development, we
may assume that the dynamics of nominal wages and labour productivity in manu-
facturing are somehow transferred to the whole economy. In a way, this assumption
is consistent with the well-​known Balassa-​Samuelson effect.
8 The inverted U-​shaped behaviour of the growth rate of labour productivity is con-
sistent with historical data about the development experience of developed econ-
omies and of East Asian newly industrialised countries (see OECD, 2015).
9 The upward move in the locus for (k=0) also causes the stable ‘virtuous’ equilib-
rium ‘C’ to shift upwards. The new equilibrium will feature a relatively ‘smaller’
manufacturing sector but a higher level of labour productivity growth. In a way, this
change might stand for the de-​industrialisation process experienced by developed
financialized economies, in which only the more advanced highly productive manu-
facturing sectors can face the challenges coming from increasing international com-
petition in a globalised world. The crucial point of our analysis, however, is not
related to equilibrium ‘C’ per se. Indeed, what we what to analyse here is whether
 Financial liberalization and exchange rate 195
DEEs will ever reach that equilibrium if exposed to even temporary financial
booms.Through this model, we emphasise how financial booms may likely increase
the probability DEEs will eventually end up stuck in the underdevelopment trap on
the left-​hand side of point ‘B’, and experience worrisome phenomena of premature
de-​industrialisation (Rodrik, 2016).
10 α(0) stands for an exogenous (low) rate of labour productivity growth characterising
an economy with a largely underdeveloped manufacturing sector.
11 In our model, such constraint materialises unless the responsiveness of manufac-
turing investment to a higher international competitiveness more than compensates
for the detrimental effects of a lower domestic demand.

References
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CEPA Working Paper Series no. 6.
14 
Global financial flows in Kaleckian
models of growth and distribution
A survey
Pablo G. Bortz

1 Introduction
Kaleckian models of growth and distribution were developed in the early
1980s to account for an alternative view regarding the relation between (func-
tional) income distribution and economic growth. Contrary to the arguments
prevalent in the mainstream, and even within Post Keynesian authors such as
Joan Robinson and Nicholas Kaldor (in their works in the 1950s and early
1960s), early Kaleckian authors argued that higher real wages were associated
with higher, not lower, rates of economic activity and capital accumulation
(Rowthorn 1981, Dutt 1984, Amadeo 1986). Later work tended to nuance this
corollary, by emphasizing the double role of wages, both as a source of (con-
sumption) demand and as a cost to producers, affecting in contradictory ways
their profitability. This argument was reinforced by the impact of rising wages
on international competitiveness (Bhaduri and Marglin 1990).1
Together with Bhaduri and Marglin’s work, Blecker (1989) ignited a rich
literature that included and discussed the impact of distributive changes (in
mark-​ups, wages, and income policies) on the balance of trade performance and
its implications for the possibility of coexistence of rising real wages and higher
economic growth.2 In order to understand this impact, it is very important to
know the source of rising real wages: if it is due to increasing nominal wages,
then it is likely to have a detrimental impact on external competitiveness and
economic activity, while if the reason behind is a fall on mark-​ups, then it is
likely that the balance of trade improves along aggregate demand. This insight
was taken over by Von Arnim (2011) and Cassetti (2012) to explore alternative
income policies while maintaining the main corollary of Kaleckian models,
that rising real wages need not be detrimental to capital accumulation and eco-
nomic activity.
Notwithstanding the extensive literature on open-​ economy Kaleckian
models, up until recently all the analyses concerned solely the balance of trade
and tended to ignore international financial flows. Even otherwise detailed
analyses of the impact of devaluations on income distribution and economic
growth, such as Blecker (2011) and Ribeiro et al. (2017), consider only transmis-
sion channels through the balance of trade. In recent decades, however, global
198 Pablo G. Bortz
financial flows have increased more than global GDP (Akyüz 2014, Bortz and
Kaltenbrunner 2018). Developing countries, in particular, have experienced a
surge in corporate external indebtedness (Chui et al. 2016, Bruno and Shin
2017), most of it denominated in a foreign currency.
The gap in the literature has narrowed in recent years, however, and this
chapter surveys the different lines adopted to try to include capital account
factors into Kaleckian models. Most of these new works deal with net capital
flows, i.e. with the capital account balance considered as a whole. There are
some recent articles, however, that explore the effects of gross financial flows on
their own, i.e. rising corporate/​public indebtedness without paying too much
attention to the external assets of said economy.
The chapter is structured as follows. The next section will describe the first
model, to our knowledge, that combined the impact on economic growth of
changes to income distribution and the current account balance, developed
by La Marca (2005, 2010). Section 3 will review Köhler (2017), who ana-
lyses external debt sustainability in a fixed-​exchange rate regime along different
demand regimes. Section 4 describes Guimaraes Coelho and Pérez Caldentey
(2018)’s model, which mixes Minskyan insights regarding the dynamics of the
(external) leverage ratio of an economy with a Kaleckian model of growth
and distribution. Finally, Section 5 presents the work of Bortz, Michelena and
Toledo (2018, 2019) that looks at the impact of exogenously driven external
inflows on economic activity and income distribution, mediated by their impact
on the exchange rate and balance sheets.

2 The (net) capital account makes its entry

Up to La Marca (2005, 2010), open-​economy Kaleckian models dealt only with
the balance of trade, without including in their analyses the necessary coun-
terpart to imbalances in foreign trade: the accumulation of external assets or
liabilities, and the flow of corresponding interest or dividend payments.The art-
icles by La Marca are, to the best of my knowledge, the first attempts to include
net foreign assets/​liabilities as a dependent variable with feedback effects with
income distribution and capacity utilisation, the traditional proxy for aggregate
demand in Kaleckian models. Both models are very similar, and we will focus
on the 2010 paper.
Before describing the model in full and its corollaries, there are two
characteristics that put the model in context. First, like traditional Kaleckian
models, there is no convergence in the long run to any measure of a ‘normal’
rate of capacity utilisation. Second, and very important to keep in mind for the
rest of this chapter, the net accumulation of foreign/​assets and liabilities depends
on the performance of the current account, and notably on the trade balance.
There is no ‘capital flows driving the current account’ story in this model.
The model is composed of households, firms, government and the rest of
the world. The only financial assets/​liabilities are equities (assets of households,
liabilities of firms) and net foreign assets/​liabilities (held by firms and the rest
 Kaleckian models of growth and distribution 199
of the world). Government budget is balanced at all times. As per almost all
Kaleckian models, La Marca’s has a distribution block and an aggregate demand
(capacity utilisation) block, to which he adds a block describing the dynamics
of net foreign asset/​liabilities. Let’s go block by block.
Kaleckian models typically assume an imperfect-​ competition, mark-​ up-​
over-​costs setting.3 Costs in La Marca’s model comprise wage-​ labour and
imported inputs.The profit rate is a residual of sales over costs, and it is equal to
the profit share times capacity utilisation.The profit share and the real exchange
rate are negative related to the wage share. In truth, rising wage costs are passed
partially to prices (exchange rate) and partially into lower profits (via mark-​up
reduction), according to the price-​elasticity of exports. To sum up the distribu-
tion block, we must show how the wage share itself moves.
La Marca adopts a Phillips curve-​type of approach. Workers target a wage
share that moves with changes in capacity utilisation, with a certain adjust-
ment speed. Equations (1) and (2) reproduce Equations (8) and (9) of La Marca
(2010):

ψ = τ (ψ * − ψ ) (1)

ψ = τ (le (1+ ulk ) − ψ ) (2)

ψ represents the wage share, and ψ * the target wage share, which varies with
changes in capacity utilisation u, fixed labour productivity l and the capital to
labour supply ratio k, also constant in the model.
Capacity utilisation adjusts to discrepancies between planned investment,
savings and the current account. In a traditional Kaleckian fashion (after
Bhaduri & Marglin 1990), planned investment depends on the profit share and
capacity utilisation. Equation (3) reproduces Equation (11) of La Marca (2010):

g = απu + γ (3)

Where g is the investment rate, ∝ is the sensitivity of investment to changes

in the profit share π and capacity utilisation, and γ is an exogenous invest-
ment component. Savings are composed of different items, in turn. Households
save out of wage income, out of dividend payments, and out of capital gains
(their equity holdings). Firms have retained earnings, a proportion of their
profitability and interest revenues/​
payments. If we lump together retained
earnings plus the saved portion of dividends plus the saved portion of capital
gains, we obtain the following Equation (4), which replicates Equation (13) of
La Marca (2010):

σ = s p ( πu + j ξb ) + sh ψu
(4)
200 Pablo G. Bortz
Where σ is the savings rate normalized by the capital stock, s p is the combined
(households and firms) propensity to save out of firms profits and sh is the pro-
pensity to save out of wage income. Firms profits include production related
profitability and interest revenues (payments) on external assets (liabilities),
measured by the rate of return j , accumulated net assets/​liabilities b and the
real exchange rate ξ .
Capacity utilisation then adapts to close the gap between planned invest-
ment, savings and the current account, that is excess demand. The latter
includes exchange-​rate-​sensitive and insensitive components within the net
exports. Grouping the exchange-​rate sensitive components under z (notably,
price-​sensitive imports and exports, and the domestic value of interest returns/​
payments), capacity utilization changes at the following rate (which replicates
Equations (15) and (16) of La Marca (2010)):

u = λ ( g + z − σ )

or

{( ) ( )
u = λ  α − s p π − sh ψ − ξa  u + γ + ξ ηx + 1 − s p j ξb } (5)

The parameters that make their first appearance are ξa (the exchange-​rate
sensitive component of imports, used as intermediate inputs) and ξ ηx (the
exchange-​rate sensitive component of exports, with a price-​elasticity η ). It is
assumed that s p is sufficiently larger that α , assuring the stability of the dynamic
∂u
equation. It is easy to see that, if s p is smaller than one, then is positive. That
∂b
means that if the economy is a net creditor (b >0), capacity utilization will increase, and
vice versa if the country is a net debtor, i.e. in this open-​economy setting the model only
allows for a debt-​burdened regime, unlike Hein (2014), for instance. Later we will
review variants that allow for the existence of both debt-​led and debt-​burdened
regimes
The profit-​led or wage-​led character of the system depends on the reac-
tion of investment, savings and the trade balance to changes in the wage-​share.
A high price-​elasticity of exports η makes the system more profit-​led. But
there is an additional impact, coming from the net creditor-​debtor position of
the economy. If the economy is a net-​creditor, then a real appreciation (coin-
cident with greater wage-​share) reduces the stream of income denominated
in domestic currency from interest revenues, and a depreciation (falling wage-​
share) increases that same flow. That means, if b is positive, the economy is more likely
to be profit-​led, and vice versa.
But how do net assets/​liabilities evolve? As mentioned before, net asset/​liabil-
ities accumulation in La Marca’s model is a function of the imbalance between
 Kaleckian models of growth and distribution 201
domestic savings, investment, net exports and interest revenues/​payments. After
compiling and substituting the relevant variables and equations, foreign-​priced
assets/​debt is ruled by the following equation, which replicates Equation (18)
of La Marca (2010):

(s )
− α πu + sh ψu − γ
b =
p

ξ
( )
− g − sp j b (6)

It is easy to see that, as long as savings react stronger than investment to

∂b
increments in capacity utilisation, will be positive. It is also readily clear
∂u
that a condition for stability is that g > s p j , so that increasing foreign assets
stimulate investment more than savings, and the imbalance is reverted.This con-
∂b
dition also causes that, for sufficiently high-​levels of b and ψ , is positive.
∂ψ
La Marca focuses his attention on the case of an export-​led economy, which
is expected to be a net creditor and a profit-​led demand regime. With these
conditions, and with the classical savings pattern of no savings by workers and
sp = 1 by firms, the model is able to replicate Goodwin (1967)-​type cycles,
with interactions between capacity utilisation and the wage-​share, which fur-
ther impact on the exchange rate and net external asset accumulation.
La Marca (2010, 146) stresses that different outcomes can be obtained with
different extensions of the model, that incorporate other social and economic
institutions and policy orientations. In this sense, the model sets a precedent for
further work, which took some time to develop.

3 External debt sustainability and devaluations

Köhler (2017) follows a different approach. The objective of his model is to
analyse external debt sustainability and to evaluate how a devaluation may kick
external debt out of that stable path, when that debt is denominated in a for-
eign currency. In the model firms can borrow both from domestic banks and
from international lenders, so that strong negative balance sheet effects on firms
may counteract the positive impact of a devaluation on the trade performance.
The goods market is depicted in a usual Kaleckian fashion. Prices are set
with a mark-​up over (labour) costs. The mark-​up determines the profit share
and the wage share. The real exchange rate may affect the mark-​up in either
direction, according to the bargaining power of capital and labour, as in Blecker
(2011).
Firms may borrow from domestic banks (B) or from foreign lenders ( eB f ) ,
while banks accept deposits from foreign investors (D). While Köhler assumes
that B f is always positive, it can be the case that B becomes negative, and even
202 Pablo G. Bortz

that eB f + B < 0 , in which case domestic banks would actually have a creditor
position with the rest of the world, and a debtor position with regards to firms.
Let us call λ the ratio of external indebtedness to the nominal capital stock
eB f B
( = e r λ ), τ the ratio of domestic debt to the capital stock ( ) and r
pK pK
R
the profit rate ( ). Savings arise out of profits minus interest payments, as in
pK
Equation (7):

S πu f
s= = r − i f e λ − iτ = − i e λ − iτ (7)
pK v

Investment depends, as in most Kaleckian models, on capacity utilisation and

the profit share. But also the external-​debt-​to-​capital ratio exercises a depressing
influence on investment. Due to currency mismatch, devaluations may end up
deteriorating the balance-​sheet of firms:

I
g= = go + g1u + g2 π − g3e r λ (8)
K

The balance of trade, in turn, reacts to domestic and foreign capacity utilisation,
and to the real exchange rate:

NX
b= = bo u f + b1e r − b2u (9)
pK

However, it is not assumed a priori that the influence of the real exchange
rate will be positive, i.e. whether b1 is greater than zero. It may or may not,
depending on whether the Marshall-​Lerner Condition holds or not. The usual
Keynesian stability condition, in turn, requires that savings and the balance of
trade react stronger to changes in capacity utilisation than investment.
In this short-​term model, external debt has detrimental impact on the equi-
librium levels of capacity utilisation and growth, the intensity of the impact
depending on the reaction of investment to external debt g3. External debt can
also counteract the eventually positive impacts of real devaluations on capacity
utilisation, if the Marshall-​Lerner Condition holds.
So far, this is a traditional short-​r un Kaleckian model. But in the medium-​
run, the external-​debt-​to-​capital ratio becomes and endogenous variable.
This rises up the question of how firms fund their investment plans. They
have three alternatives: either through retained earnings, through domestic
 Kaleckian models of growth and distribution 203
debt or through foreign debt.The latter is somewhat cheaper than the former,
because of a liquidity premium usually charged on domestic borrowing ρ0 .
Lenders are also concerned about booming debt, and increase their lending
rates accordingly, though the sensitivity of domestic and external rates can be
different:

i = iBf + ρ0 + ρ1e r λ (10)

i f = iBf + ρ1f e r λ (11)

There are a couple of issues to keep in mind. Debt dynamics is not only affected
by retained earnings and investment funding, but also with the repayment of
principal and interest. Second, in the model, there is a preferential order with
regards to the sources to fund investment and interest payments: retained
earnings and external debt borrowing take primacy with regards to domestic
debt, which accommodates any difference between required funds, retained
earnings and external debt:

B = pI − R + ei f B f + iB − eB f (12)

The reason behind is that external debt is usually cheaper than domestic
borrowing, as mentioned in Equations (10)–​ (11). Third, external currency
amounts to a proportion of total investment, but that proportion is not con-
stant. In fact, it changes with the difference in the relative costs of both types of
borrowing. In linear terms, we have:

eB f = ( φ0 + φ1e r λ ) pI
(13)

Where φ0 includes the liquidity premium ρ0 and φ1 the relative sensitivity of

domestic and external rates to rising external indebtedness. The dynamics of
the ratio is explained by Equation (14):

 eB f 
d
 pK  eB f
dt
= er λ =
pK
( )
+ er λ er − g = g * φ0 + e r λ (φ1 − 1) (14)

The last part of equation (14) makes use of the fact that er is equal to zero
(because the exchange rate is fixed and inflation is assumed away), that g
reached its short-​run equilibrium value g *, and of Equation (13).
204 Pablo G. Bortz
The other state variable is the domestic-​debt-​to-​capital ratio τ. As said in
Equation (12), domestic debt accommodates the differences between financial
needs (investment and interest payments), retained earnings and external debt.
The equation describing the dynamics is:

 B  B
 pK  = τ = pK − τ g − τ pˆ (15)

Making use of Equation (12), Equations (10) and (11) for the interest rates,
Equation (13) for the dynamics of external debt, and noting again that inflation
is assumed away, we obtain (15’):

( ) ( )
τ = τ iBf + ρ0 + ρ1e r λ − g * + g * (1 − φ0 − φ1e r λ ) + iBf + ρ1f er λ er λ − r * (15’)

Now we have a two-​dimensional dynamic system on e r λ and τ :

 ∂e r λ ∂e r λ 
 
 ∂e r λ ∂τ   J 11 J 12 
=
 ∂τ ∂τ   J 12 J 22 
 
 er λ ∂τ 

Calculations are easier once we realise J 12 is zero. So we are interested in the

signs of J 11 and J 22 , both of which have to be negative in the surroundings of
equilibrium for stability purposes. The sign of J 11 is negative if:

g ** ( φ1 − 1) < 0

So, as long as the equilibrium growth rate is positive, and domestic rates are
not too sensitive to external indebtedness (low value of φ1 ), then external debt
is stable. What is the reasoning behind this relation between domestic rates and
external indebtedness? It may be the case that, concerned by high external
indebtedness, foreign investors leave the country and the central bank is
forced to increase interest rates, therefore increasing the financial needs of
firms. This is the instability case. In normal times, as long as money flows in,
J 11 is negative.
In turn:

ρ1φ0
J 22 = iBf + ρ0 + − g **
1 − φ1
 Kaleckian models of growth and distribution 205
For stability, the equilibrium growth rate must be greater than domestic interest
rate, the usual condition for public debt sustainability. In this model, however,
things might be somewhat out of the control of central banks: a shock to the
liquidity premium might send the system into unstable territory. Also a high
 ρ1φ0 
debt ratio  and high sensitivity of domestic rates to the steady state
 1 − φ1 
external debt ratio ( ρ1 ) may complicate the stability of domestic debt.
An interesting question Kôhler (2017) addresses is the effect of cur-
rency devaluations on the sustainability of external debt. As long as a devalu-
ation stimulates capital accumulation, the effect will reinforce the stability
of the system. But if they depress investment (say, because they are strongly
contractionary), the effect is the opposite, even if the balance of trade improves.
In that sense, the wage-​led or profit-​led nature of the demand (and growth)
regime has an important bearing on the results of the model. Debt crises out
of devaluation episodes can also happen even when the balance of trade moves
into surplus.

4 External flows and financial instability

The primordial role of growth in any debt sustainability analysis is in part
related to the importance of sales revenues and internal financing for ‘healthy’
balance-​sheet positions. Kalecki (1971) underscored the relevance of internal
finance as one of the majour constraints on investment, while Minsky (1986)
reflected on the tendency of firms to rely increasingly on external financing
(debt), which would lead to financial fragility. Lavoie and Seccareccia (2001),
however, doubt that this ‘Financial Instability Hypothesis’, which could be valid
at the firm level, still holds at a macroeconomic level. They warn of a possible
fallacy of composition. In the upward phase of the cycle, as firms fund their
increasing investment with borrowing, so will aggregate profits increase; while
in a downturn, though firms try to decrease their leverage, aggregate profits
will fall, making the whole effort futile. The argument is known as the ‘paradox
of debt’.
Guimaraes Coelho and Perez Caldentey (2018, GCPC from now on)
develop an interesting Kaleckian model that is flexible enough to accommo-
date both regimes, while including the possibility of credit rationing due to
increased liquidity preferences of financiers. In an open economy setting that
focuses on emerging economies, the possibility of financing current account
deficits depends on the availability of external financing in foreign currency.
The financial needs are measured, in GCPC model, by the current account def-
icit, which is in turn influenced by the international liquidity, the technological
gap and income distribution, among other factors.
In order to review the open-​economy model, it is convenient to do a quick
summary of the mechanisms it presents in a closed-​economy setting.The open-​
economy version is just an expansion of the former.
206 Pablo G. Bortz
As it is usually the case in Kaleckian models, the key innovation lies in the
investment function. The one presented by GCPC is as follows:

g i = a0 + a1h + a2u + a3 IF + a4 f b (16)

Where h is the profit share, u is the capacity utilisation rate, IF captures the
influence of internal funds on investment, and f b captures the influence of
external finance, mostly banking finance in this closed-​economy model. How
do these last two variables behave? What is the economic intuition behind them?
Internal funds capture the difference between gross profits and the cost of
debt. The major point that GCPC try to convey is that the sensitivity of gross
profits and the cost of debt to cyclical fluctuations may be different, depending
on whether the financial fragility hypothesis holds, or whether the paradox of
debt holds. The equation is as follows:

IF = α1hKu − α 2iθu (17)

In this setting, K represents the capital stock, i represents the interest rate and θ
represents the leverage ratio. If α1hK is greater than α 2iθ , then internal funds
would respond stronger than indebtedness to the business cycle (captured by u)
and the paradox of debt holds if the other case holds, then internal funds decrease
as the economy grows, and we are in the financial instability hypothesis scenario.
∂IF
This is reflected on the sign of the differential : if positive the paradox
∂u
of debt holds, if negative the financial instability hypothesis does. What about
external finance? The following equation captures its behaviour:

∂IF
f b = b1 − b2d0 h (18)
∂u

b1 captures the liquidity preference of banks: the lower the preference, the
higher the value of b1 . d0 is a dummy variable that captures the phase of the
business cycle. If the cycle is in the upward phase, d0 is worth 1, while if we
are in the downward phase d0 is worth zero, meaning a cease of external finan-
∂IF
cing. The other crucial variable is . If its sign is positive (a paradox of debt
∂u
case), then in the upward phase of the cycle bank borrowing falls, as firms are
more reliant on internal financing to fund investment (and therefore a greater
∂IF
importance of sales revenue, and consumption). If the sign of is negative,
∂u
then as the cycle progresses firms demand more and more borrowing, driving
most units towards speculative and Ponzi positions.
 Kaleckian models of growth and distribution 207
So there are four possible scenarios, on top of the wage-​led or demand-​led
nature of the demand regime: a) an expansionary scenario where the paradox of
debt holds; b) an expansionary scenario where the financial instability hypoth-
esis holds; c) a downward scenario with paradox of debt; and d) a downward
scenario with the financial instability hypothesis.
GCPC make some assumptions to arrive at only two ‘equilibrium’ cap-
acity utilisation rates, for the upward and the downward phase of the cycle,
respectively.4 However, the wage-​or profit-​led nature of the demand regime
is affected by the validity of either the paradox of debt or the financial
instability hypothesis. Why? In the upward phase under a paradox of debt
scenario, firms become more sensitive to internal finance (and therefore con-
sumption) than to external lending. Therefore, under a paradox of debt scen-
ario the economy is more likely to be wage-​led, in the upward phase; while
if the financial instability hypothesis holds, the economy is more profit-​led.
But the exact opposite happens in a downward phase, which by assumption
involves a shortage of external funding. In this case, the fact that firms are
less sensitive to falling sales revenues and internal funding (as in the financial
instability hypothesis scenario) makes the demand regime more wage-​led,
and vice versa in the paradox of debt scenario. But how do we include capital
flows in this story?
Some considerations are due at this point. First, GCPC take the current
account balance as the measure of external financing. Second, this finance is
partly explained by the liquidity conditions in international markets (again,
through the b1 parameter in Equation (18)). Third, the current account
balance is also affected by the technological gap and income distribution,
though the latter is not determined a priori. If redistribution benefits workers,
their import demand will rise, but that of capitalist will fall. GCPC assume
that the latter effect will prevail, because of the capitalists’ high demand for
luxury goods.5
There are some equations therefore to include and some to modify. First,
Equation (18) now has to include the determinants of the current account.
GCPC use the ratio of income elasticity of exports and imports, weighted by
the state of capacity utilisation:

∂IF e
f b = b1 − b2d0 h + b3 u (18’)
∂u π

Where e is the income elasticity of exports, and π is the income elasticity of

imports. But as we said, GCPC postulate that the majour determinants of that
ratio are the technological gap and income distribution:

e
= x1 + x 2 (1 − h ) + x3T (19)
π
208 Pablo G. Bortz
Where T captures the technological gap, and (1–h) represents the wage share.
If we replace (19) into (18’), we get (18’’):

∂IF
f b = b1 − b2d0 h + b3 x1u + b3 x 2 (1 − h ) u + b3 x3Tu (18’’)
∂u

And then substitute it into the investment Equation (16).

The logic regarding the nature of the demand-​regime in this open economy
setting remains virtually unchanged when compared to the closed economy
framework. A paradox of debt scenario, in the upward phase of the cycle,
attaches greater influence to internal funds over external lending, making
the economy more wage-​led, and the opposite with the financial instability
hypothesis. The eventual illiquidity in international financial markets, in a
downward phase, would make the financial instability hypothesis case a more
wage-​led regime, because in this scenario firms would be less sensitive to falling
internal resources.
GCPC model is a step forward in the sense that it includes the effects of
changes in international liquidity conditions, and analyses different ‘financial
regimes’. However, it is still locked in the analysis of net capital flows. The next
model to review breaks with that cage.

5 Gross financial flows, income distribution and growth

Bortz, Michelena and Toledo (2018, BMT from now on) try to integrate the
analysis of three ‘stylised facts’ of the last decades: a rise in global financial flows;
an increase in income inequality; and a slowdown of global growth compared
to the post-​war period. The model recognizes the importance of gross finan-
cial flows (Ahmed and Zlate 2014), particularly through their influence on
firms’ balance sheets. The main features of BMT can be summarized in a few
equations.
First, given that financial flows have a much higher order of magnitude than
trade flows, the model takes for granted that the nominal exchange rate moves
with financial flows, which are reflected in the (public and private) external
debt d (normalized by the capital stock):

Eˆ = ωdˆ (20)

Second, as for the drivers of financial flows, BMT distinguish endogenous

and exogenous factors, or ‘pull’ and ‘push’, as they are called in the literature
(Calvo et al. 1996). Among the former, the state of aggregate demand is iden-
tified as a preponderant variable (Nier, Sedik and Mondino 2014; Yildirim
2016), and BMT use capacity utilisation as a proxy variable. Regarding
‘push’ factors, which are the main determinants of global financial flows6,
BMT adopt a literature which identifies heterogeneous agents in the foreign
 Kaleckian models of growth and distribution 209
exchange market, usually called ‘chartists’ and ‘fundamentalists’.7 The former
follow the short-​term movement of the exchange rate, which is usually
influenced by interest-​rate differentials. The latter follow some rule, which
in this model is determined by the difference between external indebtedness
and some assessed, conventional, tolerable indebtedness level, called d * . This
is represented in Equation (21):

dˆ = du u + µ (i − i f ) + (1 − µ ) (d − d * )
(21)

The second major axis refers to income distribution. The model, just like
La Marca’s, captures wage-​setting and price-​setting behaviour by workers
and firms, respectively. They both have a wage-​share target, which may not
be mutually compatible. In particular, the wage-​share targeted by firms are
influenced by their external borrowing costs. Now, there is a thing with rising
indebtedness and its impact on the exchange rate. On the one hand, the
volume of borrowing (and its cost in foreign currency) rises. But on the other
hand, the exchange rate appreciation makes it cheaper to borrow abroad, and
therefore the costs measured in domestic currency fall. Though BMT say that
they believe the first effect will prevail (the build-​up of debt), the movement
of the wage-​share targeted by firms takes into account both counteracting
tendencies:

ψ f = −d1d (δ − ω )
(22)

Where ψ f is the wage-​share targeted by firms; d1 is the share of private external

debt over total external debt; δ captures the impact of rising external debt,
and ω captures the effect of the exchange rate appreciation. As mentioned,
BMT believe that, though in the short-​run it may be the case that ω is greater
than δ , in the medium to long-​run the experience tells us that the opposite is
more likely to happen. Therefore, the ‘normal’ impact of rising external (pri-
vate) debt on income distribution is to lower the wage share.
The same counteracting forces influences productive investment. Rising
debt volumes may put pressure on firms’ balance sheet and restrict investment,
but an appreciating exchange rates makes external borrowing more attractive,
on top of lowering the costs of imported capital goods. On top of capacity
utilisation and the profit share, the investment function accounts precisely for
those forces:

g f = g0 + gu u + g π π + gi d1d ( δ − ω )
(23)

These configurations of income distribution and effective demand can give rise
to alternative distributive, financial and demand regimes, which are summed up
in Table 14.1 (which replicates Table 4 in BMT [2018]).
210 Pablo G. Bortz
Table 14.1 List of alternative regimes

Derivative Regime Mathematical Meaning

expression

∂ψ̂ Exchange-​rate ∂ψ̂ Wage-​share reacts positively to

driven >0 increments in foreign indebtedness.
∂d ∂d
Debt-​service ∂ψ̂ Wage-​share reacts negatively to
driven <0 increments in foreign indebtedness.
∂d
∂û Debt-​led ∂û Economic activity reacts positively to
>0 increments in foreign indebtedness.
∂d ∂d
Debt-​burdened ∂û Economic activity reacts negatively to
<0 increments in foreign indebtedness.
∂d
∂û Wage-​led ∂û Economic activity reacts positively to
>0 increments in the wage share.
∂ψ ∂ψ
Profit-​led ∂û Economic activity reacts negatively to
<0 increments in the wage share.
∂ψ

Source: Bortz, Michelena and Toledo (2018, 9).

The reaction of the wage share to movements in external debt can be called
the distribution regime; debt-​led or debt-​burdened are characteristics of the
financial regime, and wage-​led or profit-​led are alternative demand regimes.
But which combination of these regimes is stable? Table 14.2 (which replicates
Table 5 in BMT [2018]) lists all the possibilities, together with the equilibrium
value of capacity utilisation in each of the demand regimes.
What BMT call the ‘normal’ regime is the combination of a debt-​service
driven distribution regime with a debt-​burdened financial regime. In this case,
increments in external debt lead to falling wage-​share and falling aggregate
demand, which is exacerbated if the demand regime is wage-​led, mainly due to
rising debt service payments and its pass-​through to prices.
The ‘strange’ case is the combination of an exchange-​rate driven distribu-
tion regime (in which rising debt causes strong exchange rate appreciations
and rising wage-​share) with a debt-​led financial regime (in which external
borrowing is cheaper and stimulates investment).
The ‘conciliating-​debt’ regime, finally, is a peculiar combination of an
exchange-​ rate driven distribution regime and a debt-​ burdened financial
regime. In this case, the exchange rate appreciation rises the wage share, but is
not enough to stimulate aggregate demand (mainly because of the deteriorating
trade balance).
 Kaleckian models of growth and distribution 211
Table 14.2 Stable regime combinations

Case Equilibrium capacity


∂ψ ∂û utilization
∂d ∂d

NORMAL -​ -​ Wage-​led: Higher

Profit-​led: Lower
STRANGE + + Wage-​led: Higher
Profit-​led: Lower
CONCILIATING-​DEBT + -​ Wage-​led: Higher
Profit-​led: Lower

Source: Bortz, Michelena and Toledo (2018, 9).

The model can be accommodated to include income policies. In an extension

of the model, BMT (2018) presents the feature of a Tax-​based Income Policy
(TIPs), in which the government sets targets for the wage-​share and imposes them
through marginally increasing tax rates on workers and firms.8 Therefore, the wage
share is less sensitive to exchange rate movements and to external debt fluctuations.
The nature of the distribution regime does not change, but its magnitude shrinks,
both for the exchange-​rate driven or the debt-​service driven. The economy is
more likely to be wage-​led, however, in the case of progressive taxation.
One could also extend the model to incorporate some government-​spending
rule, as do Bortz, Michelena and Toledo (2019). With an anti-​cyclical govern-
ment spending rule the paradox of thrift is still maintained, but its impact is sub-
stantially mitigated. When the rule takes into account fluctuating international
financial conditions, government spending becomes more pro-​cyclical, leading
to periods of ‘excessive’ spending and ‘excessive’ austerity. In sum, the model is
flexible enough to accommodate different features and policies.

Notes
1 A revision of Kaleckian models of growth and distribution can be found in Blecker
2002), Hein (2014) and Bortz (2016), among others. Lavoie (2014, ­chapter 6) reviews
several topics addressed through extended versions of Kaleckian models.
2 A revision of this literature can be found in Köhler (2017, 489–​490). See as well
Lavoie (2014, 532–​540).
3 See Lavoie (2014, ­chapter 3) for a detailed exposition and related references.
4 They assume that, in an upward scenario with paradox of debt, the increase in b1
will overcome the negative effect on external finance of rising internal funds ∂IF∂u,
as can be seen in Equation (18).
5 Carrera et al. (2016) find opposing results for a sample of 60 countries, including
35 emerging economies. One could only speculate, but the diffusion of consump-
tion patterns through new communication outlets in the last decades may have
homogenized consumption patterns across different social classes.
212 Pablo G. Bortz
6 Among others, see Forbes and Warnock (2012), Ahmed and Zlat (2014), Aizenman
et al. (2016) and Bruno and Shin (2017).
7 Among others, see Frankel and Froot (1990), Harvey (1993), Lavoie and Daigle
(2011), and Chutasripanich and Yetman (2015).
8 A similar logic would apply if the government opts for a subsidy policy instead of a
tax policy.

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Part V

Policy implications
15 
Implications of modern money
theory on development finance
Yan Liang

Introduction
The great development economist Joseph Schumpeter once said,

[G]‌ranting credit … operates as an order on the economic system to

accommodate itself to the purposes of the entrepreneur, as an order on the
goods which he needs: it means entrusting him with productive forces. It
is only thus that economic development could arise.
(1934/​1983, 107)

In other words, financing or credit is indispensable for advancing economic

development because it allows entrepreneurs to command existing resources
they could organize in most productive ways. However, one of the significant
predicaments facing developing countries is the lack of financing to support
capital accumulation and technical change. The challenge of securing devel-
opment financing has provoked much academic research and debate. The
mainstream approach to development finance conflates credit with savings,
or financing with funding, believing that saving must be accumulated before
investment could take place.This misunderstanding also leads to wrong-​headed
policy recommendations, for example, the advocacy to lift ‘financial repression’
whereby raising interest rates to encourage savings, or by liberalizing the cap-
ital account to attract foreign savings. But decades of development experience
around the globe have shown that these policies only led to insufficient invest-
ment, slow growth or unstable financial order. By contrast, the Modern Money
Theory (MMT), with its genuine understanding of the nature of money and
credit, sheds constructive light on how developing nations could attain devel-
opment financing. It is often argued that MMT applies only to advanced coun-
tries, like the United States that enjoys an ‘exorbitant privilege’ where the US
dollar is an internationally accepted reserve currency (Epstein 2019). However,
this is based on a faulty understanding of the MMT and in particular, the pre-
condition to have a ‘sovereign currency’,1 defined as a country’s currency of
which the government has a public monopoly (Wray 2012).
218 Yan Liang
To demonstrate the relevance of the MMT on development finance, the
chapter is organized as follows. The second section provides a critical examin-
ation of the mainstream approach to development finance, followed in the third
section by an exposition of the basics of MMT and its implications on devel-
opment finance. The fourth section offers some empirical case studies where
MMT principles are applied through developmental institutions to create
financing, while the last section provides concluding remarks.

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 cap-
ital (Kregel 2004a, 281). The need for financing/​credit is often conflated with
the need for savings. According to this view, developing nations must accu-
mulate 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 funds 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), par-
tially 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 neoclassicals believe. Given a monetary production
economy, it is through investment and income growth that savings are made
 Implications of modern money theory 219
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 finan-
cial 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 for-
eign capital may not be used to finance investment but promote consump-
tion 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 coun-
tries, 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) mod-
eling 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
220 Yan Liang

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 main-
stream approach to development finance paves the way for alternative para-
digm, to which we now turn.

Modern money theory and development finance

Modern money theory
Modern Money Theory (MMT) provides an empirically grounded and logic-
ally consistent account of the nature of money as well as the implications thereof.
According to this theory, money is a state creature. State/​authority chooses the
unit of account in which taxes (and other obligations) are denominated and
the State names what is accepted in tax payments. State spends by issuing its
own money (State money, or High-​Powered Money (HMP)). In the modern
banking and payment system, the State/​treasury/​fiscal authority spends by
crediting bank reserves (or more precisely, the fiscal authority spends and the
monetary authority/​central bank credits the bank reserves); and banks, in turn,
credit accounts of their depositors. As central bank/​monetary authority targets
an overnight interest rate, the State supplies HPM demand to the banking
sector (or withdraws it when excess reserves exist) to hit the interest rate target.
Banks issue credit by leveraging on the reserves. Tax obligations make State
money desirable and the State will never run out of payments. Taking a sec-
toral balance approach, government deficit spending allows the private sector
and the rest of the world to net save. Private sector activities take the form
 Implications of modern money theory 221
of monetary production, that is, private sector starts production by securing
money (finance, credit), then it uses the money to purchase necessary factors of
production and produce, and finally, it sells the products for a larger monetary
amount to cover the production cost and yield profits. In short, the monetary
production follows the Marxian denotation of ‘M-​C -​… P … C’-​M’’, where
M is money, C is commodity and P is production, and C’ is a larger amount of
commodity while M’ is a larger sum of money. Money is fundamental to these
production processes; it cannot be neutral without real influences. The ability
to impose liabilities, name the unit of account, and issue the money used to pay
down these liabilities gives power to the authority that can be used to further
the social good (Wray 2012).
Importantly, the State promises nothing other than taking back the money
(liability) it issues in payment of the obligations it imposes. This means that
State needs to carefully choose the exchange rate systems and capital account
management to ensure that exchange rates target does not undermine the cap-
acity of the State to spend and create State money. For example, if the State
chooses a fixed exchange rate and fully liberalizes the capital account, then it
risks losing the exchange rate target as its currency may depreciate if the State
spends and creates State money and hence increases the supply of home cur-
rency in the international exchange market (Wray 2012, 139, 211). In other
words, MMT takes a step further from the ‘trilemma’, that is, maintaining a
fixed/​managed exchange rate system and free capital flows not only preclude
autonomous monetary policy but fiscal policy as well. The ‘trilemma’ is indeed
a ‘quadrilemma’.
It has been well established that financial development is important in man-
aging risks, allocating resources, mobilizing savings, and monitoring corporate
governance, whereby promoting economic development (Gurley and Shaw
1955; Levine 1997). However, the difficulty is that developing countries (and
even developed countries, for that matter) lack the private financial institutions
that have the ability to perform such an important function. In particular, as
Studart (1995) points out, many of the developmental investments are of long-​
term horizon and with high risks. Without a heavy dose of State support and
involvement, it would be difficult, if not impossible, for the private sector to
single-​handedly develop a well-​functioning financial system, given the lack of
knowledge, experience, institutional foundations and certainty. It is not even
clear, whether financial development drives economic development or the
other way around. By contrast, with the unlimited financing power, the State
could provide the financing and institutional support for the developmental
undertakings by the private sector.

Development banks and development financing

A direct application of the State money in development financing is the estab-
lishment of national development banks.4 The precursors of the modern devel-
opment bank can be traced back to industrial financing institutions in Europe
222 Yan Liang
and the United States hundreds of years ago (Diamond 1957, 19–​37; Institut
d’Etudes Bancaires et Financières 1964, 49–​66). Since the end of World War
II, the number of development banks has increased rapidly. By the mid-​1960s,
there were well over one hundred development banks in a wide range of
developing countries. With the unlimited state financing power and with less
concern on short term profitability, development banks give greater weight
in borrowers’ growth potential and potential benefits of proposed investment
to the economy. Therefore, state-​owned development banks are instrumental
in making long-​term lending not only for large industrial and infrastructure
projects (Gerschenkron 1962), but also for the new ventures by sharing the
costs of discovery of new technologies and productive processes (Hausmann
and Rodrik 2003). Furthermore, state-​ owned development banks finance
projects with negative net present value but provide significant social benefits
(Shapiro and Willig 1990, Yeyati, Micco and Panizza 2004). As Chandrasekhar
(2016, 24) points out, ‘Irrespective of policy orientation, the failure of private
financial markets to deliver adequate long-​term finance forces governments to
rely on development banking institutions.’ National development banks could
perform a host of important functions, including (i) counteracting the pro-​
cyclical behavior of private financing; (ii) promoting innovation and structural
transformation; (iii) enhancing financial inclusion; (iv) supporting the financing
of infrastructure investment; and (v) supporting the provision of public goods
(Griffith-​Jones, Ocampo, Rezende, Schclarek and Brei 2019).
Examining the development experience of South Korea, Shin and Chang
(2003) showed that in the absence of private financial institutions and personal
savings, the development state provided the necessary financing and risk sharing
for heavy capital investments. South Korean’s total savings to GDP ratio was
only 10 percent in the 1962. But a strong developmental State provided ‘the
financing and risk sharing for the heavy capital investments undertaken by
the chaebols through state-​directed banks.’ (Kregel 2004a, 286) The family-​
owned chaebols secured financing through state-​directed banks, and the ‘state-​
banks-​ chaebol’ nexus was essential for South Korea’s industrialization and
development.
China’s Development Bank Corporation (CDB) served as another great
example of a sovereign government using State money to provide develop-
ment finance. CDB was established in 1994. On the inception of the Bank,
it invested heavily in infrastructure projects, including the construction of the
Three Gorges Dam, the Beijing-​ Kowloon Railway, and Shanghai Pudong
International Airport.
China’s use of State financing to support development goes beyond the
national development banks. In fact, the State has controlled the banking
sector to a large extent and directed financing where it is needed. At the onset
of China’s market reform, the State established four State-​owned commer-
cial banks (SOCBs) to provide financing to Chinese firms, and in particular,
State-​owned enterprises (SOEs). Although three policy banks were established
in 1994 to take over some policy-​related lending; SOCBs continue to direct
 Implications of modern money theory 223
40–​60% of their loans to SOEs. As of 2014, large SOCBs and policy banks
accounted for 50% of the total banking assets (the ratio would be even higher
if State share of joint-​stock commercial banks is included). SOEs contributed
significantly to the average 13% annual investment growth (1990–​2015) and to
the over 50% of investment to GDP ratio. Despite the criticisms about political
corruption and micro efficiency of the SOCB loans, State financing effectively
mobilizes resources and propels China’s rapid growth in the past decades.5 Herr
(2008, 145) incisively summarizes,

It [the financial system] stimulated permanently high investment with all

of its multiplier effects for the other sectors of the economy. Due to a high
savings rate, large increases in income led to high savings and not the other
way round.There is paramount evidence that China has managed to create
a Schumpeterian-​Keynesian credit-​investment-​income-​creation process which has
led to economic prosperity.6

Both theoretical reasoning and empirical evidence have lent support to state-​
backed development finance along the prescription of MMT to support infra-
structural and other investments to kick start long term growth. Governments
in developing countries have the public monopoly of their sovereign currencies
and could use their unlimited financing power to support risky, large-​scale
investment projects that are shunned out by the private sector. State money
provides the financial backbone for the development of modern enterprises
that led the process of industrialization. In some cases, even though the Chinese
State did not directly invest or spend out of its fiscal budget, it stood behind the
State-​owned and State-​directed banks to provide guarantees of unlimited finan-
cing and risk-​bearing, which allows the private sector to undertake investments.
Another equally important facet of development finance, in addition to
the above discussion, is for the government to directly use its fiscal spending
and financing power, to utilize all available domestic resources for economic
growth. This is a point we will turn in the next section.

Fiscal spending and employer-​of-​the-​last-​resort

In modern public finance system, fiscal authority holds an account at the cen-
tral bank. Its collection of tax revenues is deposited on the account and it makes
payments through the account. When the fiscal authority spends, the central
bank decreases the balance on its account and increases the balance on a com-
mercial bank’s account. That is, fiscal authority’s spending creates bank money
for the private sector; and public sector debt allows the private sector to accu-
mulate assets and net save.7
Based on the MMT, government spending and taxation should follow what
Abba Lerner proposed as ‘functional finance’ as opposed to sound finance.
Government spending should aim to achieve full employment. If unemploy-
ment exists, it means the government spending is too low (or taxes are too high)
224 Yan Liang
to support a full employment level of aggregate demand. Increasing government
spending in this case will allow the government (or the private sector) to pur-
chase anything that is for sale in domestic currency, including unemployed labor
(Wray 2012; Lerner 1943). As Kregel (2004a) points out, typically, developing
nations’ biggest underutilized resource is their labor; government spending
under the functional finance principle would allow the underutilized labor
to be fully employed. Figure 15.2 shows the unemployment rates by country
income groups. Although low and lower-​middle income countries have lower
unemployment rates, this is largely because the lack of social safety net forces
labor to find whatever jobs available, including informal jobs. When we look
at the employment status by the latest ILO data, as Figure 15.3 suggests, low
and lower-​middle income countries have a greater share of workers who work
in the informal sectors, self-​employing or contributing to family ‘businesses’.

9.
6.8
4.5
2.3
0.
1991 1993 1995 1997 1999 2001 2003 2005 2007 2009 2011 2013 2015 2017
Low income Low middle income Upper-middle income High income

Figure 15.2 Unemployment rates (%) by country income groups.

100%

75%

50%

25%

0%
World: Low income World: Upper-middle income

Employee Employer
Own account workers Contributing family workers

Figure 15.3 Employment status (percentage of employees, employers, own-​ account

workers and contributing family workers) by country income groups, 2018.
Sources: International Labor Organization.
 Implications of modern money theory 225
These informal jobs are usually inefficient, precarious and low pay. In other
words, unemployment and under-​employment in developing countries are
much higher than the official unemployment rates suggest. This means that
the government still has a large role to play to implement functional finance in
order to absorb all the labor that is not employed by the private sector or under-​
employed in the informal sector. Only does the government have the unlimited
financing power to be the ‘employer of the last resort’.
An oft-​cited concern for government spending, particularly pertinent to
developing countries, is problem of foreign debt and currency values. As the
argument goes, developing countries often borrow externally to finance their
imports or government deficits. According to the macroeconomic identity,
(saving-​investment) + (taxes-​government spending) = (exports-​imports) (or,
current account balance). If government spending exceeds taxes, imports would
exceed exports, ceteris paribus; and therefore, current account deficit.The current
account deficit would then in turn be financed by borrowing externally, that is,
a capital account surplus.Typically, developing countries are not able to borrow
in their own currency, in other words, they have to take on non-​sovereign debt,
which is denominated in a foreign currency that they don’t have control over.
Excess government spending could lead to excessive non-​sovereign debt and
hence makes it unsustainable.
Developing countries may well encounter the non-​sovereign debt problem.
But it does not have to be the case. First off, with government spending that
boost jobs and income, taxes could rise to offset government spending; second,
as income rises, savings could grow to generate net private savings. Both
channels could balance out government spending. Indeed, in developing coun-
tries where bottlenecks exist where imports (of raw materials or machinery)
have to rise to support economic activities, this could be fixed by either import
controls (e.g. reducing imports of consumer goods) or by boosting exports.The
bottom line is, developing countries may have more hurdles to increase fiscal
spending, but they could manage trade and non-​sovereign debt to preserve the
policy space.
Another related concern has to do with the exchange rate regime and cur-
rency value. Many developing countries have managed or fixed exchange rate
systems and allow for free capital mobility. In this scenario, fiscal spending,
which credits private sector’s bank account and raises the amount of bank
money denominated in home currency, could put a depreciation pressure on
the home currency and thus miss the exchange rate target. Therefore, in face
of the ‘trilemma’ where policy independence, exchange rate target and capital
mobility cannot be obtained all at once, developing countries may be forced
to forgo the former in order to maintain the latter two. However, while man-
aging exchange rate to facilitate trade is somewhat desirable, full capital account
deregulation is dubiously beneficial. As argued above, relying on foreign capital
inflows could generate more harm than good. After all, attracting net capital
inflows seems unachievable for developing countries as a whole and worse still,
226 Yan Liang
capital account liberalization often entails foreign capital sloshing in and out of
the country and creates financial instability. Therefore, imposing some capital
control seems desirable both to achieve financial stability and to preserve policy
space. As Wray (2012, 217) writes,

[…] many developing nations have fixed or managed exchange rates that
reduce domestic policy space to some degree. They can increase policy
space either through policies that generate foreign currency reserves
(including development that increases exports), or they can protect foreign
currency reserves through capital controls.

Of course, reserving policy space for public spending does not mean all
public spending is created equal. For developing countries, supply-​ side
bottlenecks could generate inflationary pressure if public spending becomes
excessive. Therefore, public spending needs to be shrewdly directed to where
is most needed. In addition, public spending needs to be supplemented with
industrial policies and trade regulations (in addition to the above-​mentioned
capital account regulations) so as to promote industries that are most condu-
cive to technological development and long-​term growth, as well as promotes
exports and reduces the reliance on imports. In short, MMT provides the the-
oretical support to public spending to foster development, but public spending
is not a panacea and its positive effects are much amplified with other supple-
mental policies.

Conclusion
MMT provides an alternative and incisive understanding on the nature of
State money. State money or the sovereign money is a State IOU, issued by
the State and redeemed by the State in payment of taxes and other obligations.
Being the single monopoly of the State money, the State has the unlimited
financing power, that is, it will never run out of money to buy anything for sale
or to pay for any debt denominated in the State money.This understanding has
tremendous implications on development finance.The mainstream economists
insist that countries must first accumulate saving or attract foreign saving in
order to finance investment. Theoretically and empirically, this proposition
does not hold water. Instead, the State has the financing means to provide
direct financing or indirect support (through guarantees, direct credit policies,
etc.) to invest in long term, large scale and risky projects that are indispens-
able for development. Furthermore, the State, through fiscal spending based
on the functional finance principle, is able to employ and mobilize domestic
resources, especially labor, to achieve continued growth. Fixed or managed
exchange rate system and free capital mobility may undermine the policy
space, but this can and should be overcome by prudent capital controls and
trade regulations.
 Implications of modern money theory 227
Notes
1 In this chapter, I will use State money and sovereign currency interchangeably.
2 According to the Neoclassical Marginalism theory, the lower the stock of capital, the
higher the marginal return to capital. As developing countries have relatively lower
stock of capital than developed nations, marginal return to capital is higher in the
former than the latter; therefore, capital flows from developed to developing coun-
tries in search of higher marginal return.
3 Developing countries are compelled to accumulate massive amount of foreign
exchange reserves because they have experienced the problems brought by external
funding and its reversal (in terms of crisis in the late 1990s). Furthermore, most emer-
ging countries adopt a managed floating exchange rate system today. To continue to
attract foreign funding, they need to accumulate foreign exchange reserves to bolster
the market confidence in the value of their currencies.
4 Some development banks are privately owned or funded, but they still heavily
rely on the state’s special assistance in funding, guarantee and other preferential
treatments.
5 Acknowledging the critical and positive role of the Chinese SOCBs does not assume
away the flaws in the system. The state-​dominant bank-​centered financial system
led to problems such as debt accumulation, unequal accesses to finance and micro-​
inefficiency. These flaws should be remedied to improve China’s state-​dominant
bank-​centered financial system but they should not be the reason to ‘throw the baby
with the bath water’.
6 In addition, China has deployed State financing power and played a lead role in
establishing international financial institutions to provide development finance to
other emerging markets, e.g. in financing the Belt Road Initiative. For an overview
of China’s role in building a New Financial Architecture, see Sen (2017) and for a
critique of China’s international financing, see Liang (2020).
7 Because the government has the public monopoly of State money, for the private
sector to obtain State money, the government must first spend it. Taking a sectoral
balance approach, we could divide the economy into three sectors, the public, the pri-
vate and the external sector. The three sectors’ balances must sum to zero, i.e. (taxes-​
government spending) + (saving-​investment) + (imports-​exports) = 0. Assuming that
the external balance is zero, then government deficit (taxes-​government spending
< 0) allows/​offsets private surplus (saving-​investment > 0). Stated alternatively, gov-
ernment spending injects State money to the private economy while government
taxes retrieve State money, in order for the private sector to net accumulate State
money, the government must spend more than it taxes.

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16 
Monetary sovereignty in the
Post Keynesian perspective
In the search of a concept
Daniela Magalhães Prates1

1 Introduction
The current configuration of the international monetary and financial system
(IMFS) has imposed significant constraints to the macroeconomic policy
autonomy (i.e., policy space) of peripheral (or developing) countries that
have joined the financial globalisation process, becoming emerging market
economies. According to Post Keynesian scholars (e.g., Paula, Fritz and Prates,
2017; Kaltenbrunner, 2015), these constraints stem from the position of their
currencies at the lower level of the ‘currency hierarchy’ –​which refers to the
hierarchical structure of an IMFS anchored in a key-​currency, as stressed by
Keynes (1930, 1944). In other words, the higher the position of the currency
at such hierarchy, the greater the policy space of the issuer country.
Following this perspective, by adopting the euro, the peripheral countries
of the European Union would have climbed the currency hierarchy, hence
gaining policy space.Yet, this favourable outcome lasted only until 2008, when
the impacts of the global financial crisis on the euro area brought to light the
negative effects of the loss of monetary sovereignty (MS) on the policy space of
the member countries. Such event has had important theoretical implications
for revealing that the analysis of countries’ macroeconomic policy autonomy in
a given IMFS should consider not only the countries’ position at the currency
hierarchy, but also its degree of MS.
In the Post Keynesian perspective, the debate on MS has been launched
by the Modern Monetary Theory (MMT) or neo-​chartalist approach (Lavoie,
2013) adopted by the so-​called MMTers, such as Bell (2001),Tcherneva (2006),
Wray (1998; 2002; 2015). Long before the euro crisis, they were against the
adoption of euro as it would result in the loss of MS. They argue that the
member countries would become non-​sovereign governments that are forced
to borrow from capital markets to finance their deficits, not having policy space
to achieve goals that are keen to post-Keynesians, as full employment and eco-
nomic growth.
Underlying the concept of MS adopted by MMT, there is a specific approach
to money that is not shared by some PK scholars who put in question its
assumptions on the nature and acceptability of money, on the role of taxes
 Post Keynesian concept of money 231
and of the public debt, and on the relationship between the Central Bank
and the Treasury (e.g., Gnos and Rochon, 2002; Rochon and Vernengo, 2003;
Lavoie, 2013; Palley, 2019). In light of the importance of MS for assessing the
policy space in the current setting, this paper aims at devising a concept of MS
different from the neo-​chartalist one and coherent to the approach on money
supported by these PK scholars and embraced herein. The next endeavour will
be to build a framework on the relationship among the position at the currency
hierarchy, the monetary sovereignty and the policy space in the current IMFS
compatible with such approach.
The arguments are organised as follows. The second section discusses the
controversies related to the concept of MS.The third section presents the MMT
concept of MS. The fourth section summarises the Post Keynesian critiques to
the MMT approach on money and, based on them, put forward what we called
the PK concept of MS. Some final remarks follow.

2 Monetary sovereignty: A multidisciplinary and

controversial subject
The debate on the monetary sovereignty of euro countries has encompassed
scholars from economics and other fields of knowledge –​as sociology (Dodd,
2010), law (Zimmermann, 2013), and international political economy (Cohen,
2012). Despite the broad literature, there is no consensus on the definition of
MS and in many texts the definition is not even presented.
MS is such a contentious subject not only due to its multidisciplinarity, but
also because its constituent concepts –​‘sovereignty’ and ‘money’ –​are con-
troversial. As Oppenheim (1905), one of the founding figures of International
Law, pointed out, there exists perhaps no concept whose meaning is more
controversial than sovereignty. The original and most well-​known definition
is sovereignty as ‘political sovereignty’ (Bodin, 1567/​1964). In that sense, state
and sovereign are synonymous and sovereignty could be defined as the full
right and power of the state to govern its territory without any interference
from outside sources or bodies. The second meaning is sovereignty as the
supreme or absolute power or authority –​which could be the state, god(s),
the church, the people or the community. The third definition is freedom
from external control, i.e., autonomy or independence. In addition to these
aspects, Wallerstein (2004) highlights that sovereignty is a claim that must be
recognised by others if it is to have any meaning, i.e., it requires reciprocal
recognition.2
If sovereignty is one of those concepts that generate intense debates both
from a philosophical and a political point of view, the notion of MS is even
more disputed (Blanc, 2011). This is because, underlying each concept, there is
not only a specific definition of sovereignty, but also an approach on money –​
even if many times implicit.
It is interesting that the first notion of MS emerged at the same time of the
concept of political sovereignty. Indeed, Bodin’s (1567/​1964) concept explicitly
232 Daniela Magalhães Prates
incorporated the royal prerogative to coin money. According to Zimmerman
(2013), he is likely to have been influenced by François Grimaudet (1579/​
1900) who insisted that ‘the value of money depends on the State … which
alone has the right to coin money, or to have it coined and to stamp a valuation
upon it’ (p. 801). Then, in the origin of political science, when the metallic
standard was in force, MS was understood as the prerogative or right of the sov-
ereign state to coin money.
In the field of law, the first modern legal definition of MS was established
by the former Permanent Court of International Justice (PCIJ) set out in
1929 in the judgement of the Serbian and Brazilian loans in the context of
the 1929’s financial crisis. According to the definition of the PCIJ, which has
been adopted in international law thereafter, a state has MS if it is entitled to
regulate its own currency.This concept is much broader than the one proposed
by Bodin and Grimaudet, but it is not clear what regulation means. In the
field of law, more recently, Zimmermann (2013) proposed an even broader
concept of MS in opposition to what he calls the classical understanding of
MS (independence from external interference in the management of a state’s
monetary affairs). His concept encompasses the formal state competences to
create money via the issue of currency and the regulation of credit, to conduct
monetary and exchange rate policies, to determine the appropriate degree of
current and capital account convertibility, and to organise financial regulation
and supervision.
In the economic literature, it is also possible to identify narrow and broad
concepts of MS, which we will call herein stricto sensu and lato sensu concepts,
respectively. In mainstream economics, the topic has begun to receive attention
in the 1960s within the discussion of monetary unions launched by Robert
Mundell (1961). Mundell (1997) resumes this discussion and defines MS as
synonymous of autonomy of monetary policy [the ‘Trilemma view’]. Another
definition that become often-​quoted was proposed by Hirsch (1969) who states
that MS is ‘one of the hallmarks of national sovereignty’ and refers to ‘the right
to create money –​that is for the sovereign to lay down what is or is not legal
tender, to require that it shall be accepted in settlement of debt within the
country’s borders, and to maintain the sole right of issuing this national money’
(p. 22) –​a definition based on the concept of political sovereignty. The con-
cept of MS as the right of the state to issue money and define what shall be
accepted as money within the national borders is quite widespread and could
be classified as narrow or stricto sensu.
While these two concepts could be classified as stricto sensu, also within the
mainstream economics, Steil and Hinds (2010, p. 242) propose a lato sensu con-
cept of MS: a state has MS if it has the capacity to determine the interest and
exchange rates. In other words, MS would therefore require autonomy of both
the monetary and exchange rate policies.
In the Post Keynesian perspective, the MMT proposed a narrow concept of
MS, as detailed in the next section.
 Post Keynesian concept of money 233

3 The MMT concept of monetary sovereignty

The MMT is one version of what Dequech (2013) calls ‘State theory of
money’, centred on the role of taxes.3 The founding father of this theory is
Knapp (1905), who originally proposed that ‘money is a creature of the state’.
Besides Knapp’s (1905) chartalism, MMT also builds on the insights of other
authors, such as Keynes, Marx, Innes, Lerner, Minsky and Godley (Wray, 2015).
This approach also draws on Lerner’s ‘functional finance’ (Lerner, 1943) to
develop the proposal of the employer of last resort (ELR) originally proposed
by Minsky (1965), according to which the state could and should adopt a pro-
gramme to reach full employment along with price stability (Wray, 1998) –​a
discussion that is beyond the scope of this chapter.
MMT has engendered academic and non-​academic supporters and critics
inside the very PK approach (Lavoie, 2013). Since the launch of Wray’s (2015)
book ‘Understanding Modern Money’ in 1998, which he called the first
attempt at a synthesis of MMT, many PKs have written papers and reviews
with a critical assessment of the book and MMT more generally. In response,
Wray and other MMTers have released other papers and books attempting
to clarify concepts and propositions and fill-​ in the gaps pointed out by
critics.
This section firstly presents the main pillars of the MMT approach on
money underlying its concept of sovereign currency and MS mostly based
on Wray (2015). We will also resort to other MMTers’ writings and to Lavoie
(2013) to clarify ambiguous arguments of neo-​chartalism. Besides the ‘para-
doxical statements’ and ‘terminology problems’ (Lavoie, 2013), some MMters
positions have changed, leading to misunderstandings. Next, the MS definition
proposed in Wray (2015) is presented.
Referring to Keynes famous claim in the Treatise on Money,4 Wray (2015,
pp. 1–​2) presents two central propositions of the MMT. The first one concerns
the nature of money: money refers to the money of account and come into
existence when the state creates a unit of account. Government obligations are
then imposed in this money of account. Only after that, the state is able to issue
a currency that is also denominated in the same money of account.
The second proposition relates to the acceptability of money. For MMT,
‘taxes drive money’, i.e., it is because anyone with tax obligations must use the
State currency to eliminate these liabilities that such currency is in demand and
thus can be used in purchase or in payment of private obligations. In Wray’s
(2015, p. 51) words:

It is not necessary to ‘back’ the currency with precious metal, nor is it neces-
sary to enforce legal tender laws that require acceptance of the national
currency (…) all the sovereign government needs to do is to promise ‘This
note will be accepted in tax payment’ in order to ensure general accept-
ability domestically and even abroad.
(p. 51)5
234 Daniela Magalhães Prates
For MMT, sovereignty therefore refers to political sovereignty (see
Section 2). Sovereign governments have a variety of powers (among which
to decide how they will make their own payments) and cannot become
insolvent in their own currency. As monopoly issuers, they are not sub-
ject to the budget constraints (except those they impose on themselves, i.e.,
through budgeting, debt limits, or operating procedures) and, consequently,
not face solvency risk in their own currency. This means that the sovereign
governments do not need neither taxes nor bonds to produce revenues and
to finance their expenses. In Wray’s words (2015, p. 135), such government
‘make any payments that come due, including interest payments on their
debt and payments of principal crediting bank accounts … As bond issues
are voluntary, a sovereign government doesn’t have to let the markets deter-
mine the interest rate it pays on its bonds either. They do no really borrow
their own currency’.
This alleged power of sovereign governments has key implications for the
role of monetary and tax systems and of the monetary and fiscal policies. The
purpose ‘of the monetary system (from the point of view of the ‘currency
issuer’) is to move resources to the government sector; and the purpose of the
tax is to create a demand for currency that is used to accomplish that objective’
(Wray, 2015, p. 51). Consequently, the monetary policy has a fiscal objective
(finance the government) and the fiscal policy (government bonds and tax)
has monetary tasks. As Bell (2000, p. 614) summarises, ‘taxes can be viewed as
a means of creating and maintaining a demand for the government’s money,
while bonds, which are used to prevent deficit spending from flooding the
system with excess reserves, are a tool that allows positive overnight lending
rates to be maintained’. For MMT, taxes also have other roles: they are a mean
to drain reserves of the monetary system and, when the economy is at full
employment they are a tool to contain excess demand.
Wray (2015) stresses that the sovereign government’s power to make its
own payments was obvious 200 years ago, when the national treasury spent by
issuing currency, and taxed by receiving its currency in payment. Nowadays, this
power is not evident because the Central Bank makes and receives payments
for the treasury before the later spends. To call attention to ‘the logic of the
interrelations between the central bank and the Treasury’ (Tymoigne and Wray,
2015, p. 29–​30), the analyses throughout the book are based on the consoli-
dation of the balance sheets of the Treasury and the Central Bank (i.e., the
transactions between these two institutions are ignored). Yet, Wray (2015)
argues that the final result would be the same of dealing with two separated
institutions if there were no self-​imposed constraints. Indeed, such theoret-
ical simplification results in an automatic and unlimited monetary financing of
Treasuries expenses.
According to Lavoie (2013), this is one of the paradoxical statements of
neo-​chartalism, being counter-​intuitive and deprived of operational and legal
realism as in the institutional arrangements currently in force in most coun-
tries the Central Bank is prohibited to buy Treasuries securities in the primary
 Post Keynesian concept of money 235
market. Instead of clarifying, this hypothesis would lead ‘to omitting crucial
steps in analyzing the nexus between the government activities and the clearing
and settlement system, to which the central bank partakes’ (p. 23). Moreover, it
is needless to uphold that ‘a central government with a sovereign currency does
not face a financial constraint’ (p. 8). Indeed, in ­chapter 6 (p. 182), Wray (2015)
dismisses this simplification and states that if there is a coordination between the
Treasury and the Central Bank, a sovereign government with its own currency
‘can always ‘afford’ to make all payments as they come due’. Moreover, Wray
(2011)6 and other MMTers (e.g., Tcherneva, 2011 and Bell, 2000) do not use
this hypothesis and reach the same conclusion.
In our understanding the consolidation hypothesis is not a necessary con-
dition for currency sovereignty (i.e., for MS) in the MMT approach. Yet, if
the Central Bank could not buy Treasury securities at the primary market,
besides the coordination between the Treasury and the Central Bank and the
inexistence of self-​imposed constraints, as Wray (2015) argues, it would neces-
sary that: (i) the treasury succeeds to sell an unlimited amount of bonds to the
private agents in the primary market at the desired interest rate; and (ii) the
Central Bank can buy an unlimited amount of treasury bonds in the secondary
market.
Wray (2015) uses the ‘pyramid of liabilities’ to explain the difference between
sovereign and non-​sovereign currencies (see Figure 16.1).The main underlying
idea is H. Minsky’s statement that ‘anyone can create money, the problem lies
in getting it accepted’. In this perspective, embraced by MMT, money is an ‘I
owe you’ (IOU). As Bell (2001, p.150) summarises, ‘money represents a promise
or IOU held as an asset by the creditor and as a liability by the debtor … the
creation of money is simply the balance sheet operation that records this social
relation’.7
Although government, banks, firms and households can create money
denominated in the unit of account created by the State, these monies are not
equally acceptable. The pyramid is a hierarchical arrangement (for this reason,

Sovereign currency Nonsovereign currency

Precious metals, FX reserves

Govt IOUs
or regional currency

Bank IOUs Govt IOUs

Nonbank IOU Bank IOUs

Nonbank IOU

Figure 16.1 Pyramid of liabilities.

Source: Author´s elaboration based on Wray (2015).
236 Daniela Magalhães Prates
Bell (2001) calls it ‘hierarchy of money’), where the liabilities issued by those
higher in the pyramid are generally more acceptable and have higher credit-
worthiness. In other words, ‘a money place within the hierarchy depends on
the degree to which it is accepted by society’. In the case of a sovereign gov-
ernment that issues a fiat sovereign currency, such currency (the government’s
IOU) occupies the first tier of the hierarchy exactly because it is accepted for
tax payment (Bell, 2001, p. 160).
Bank’ IOUs (demand deposits) are placed in the second tier of the pyramid
and accepted as means of payments as well. According to Wray (2015, p. 5),
such place stems from ‘banks’ promise to exchange their own obligations to the
state’s obligations on ‘demand’’. Bell (2001, p. 160), in turn, states that bank’s
promises are as nearly as liquid as state money and occupy this tier not only
because ‘the central bank guarantees that demand deposits will trade at par with
government currency’, but also because they are accepted in payment of taxes’
as Knapp (1905) argue.8
Although the explanation for bank’s IOU position is not exactly the same
for Bell (2001) and Wray (2015), they agree that as bank money is converted to
bank reserves, in last resort ‘the state actually accepts only its own liabilities in
payment to itself ’ (Bell, 2001, p. 160).9
Hence, a sovereign government issues a sovereign currency that is necessarily
fiat or non-​convertible, being positioned at the top of the ‘pyramid of payments’
as it makes no promise to convert it to precious metal, to foreign currency, or
to anything else. Instead, it promises only to accept its own IOUs in payments
made to itself. Conversely, a government that operates with a foreign currency
or a domestic currency convertible to foreign currency (or to precious metal)
issues a non-​sovereign currency and is subjected to budget constraints and faces
solvency risk. In these cases, only a 100 percent reserve backing allows govern-
ment to avoid default. Thus, convertibility can constrain its ability to use policy
to achieve goals as full employment and economic growth. For Wray (2015),
this would be also the case of Greece and the other peripheral countries that
have joined the euro area: ‘non-​sovereign governments like Greece that give
up their monetary sovereignty do face financial constraints and are forced to
borrow from capital markets at market rates to finance their deficits’ (p. 136).
Summing up, the key assumptions underlying the concept of sovereign cur-
rency (and MS) proposed by Wray (2015) are: (i) sovereignty refers to political
sovereignty; (ii) money refers to the money of account and comes into existence
when the state creates a unit of account; (iii) ‘taxes drive money’, i.e., the aim
of taxation is to create demand for the currency; (iv) the sovereign government
issues a fiat currency denominated in this unit of account positioned at the top
of the ‘pyramid of liabilities’, spends by crediting bank accounts, and can afford
anything for sale in its own currency, facing neither default risk nor budgetary
constraints (except those self-​imposed); (v) hence, such government does not
need neither taxes nor bonds to finance its expenditures; both are methods for
either countering inflation or draining reserves to maintain the overnight target
rate, being bonds an interest-​bearing alternative to reserves.
 Post Keynesian concept of money 237
Table 16.1 Monetary sovereignty, exchange rate regimes and policy space

Nonsovereign currency Sovereign currency

FX, convertible Fixed exchange rate Managed exchange rate Floating exchange
currency and monetary rate
unions*

Degrees of Policy Space

Lower Higher
-​ +

Source: Author’s elaboration based on Wray (2015).

Note: Countries that are members of monetary unions (such as the euro zone), which do not
issue their own fiat currency.

It is important to mention that previous MMters’ works argued that a

country with a fixed exchange rate does not have a sovereign currency (Wray,
1998, 2002; Tcherneva, 2006), leading to Lavoie’s (2013) conclusion that for
neo-​chartalism there would be degrees of monetary sovereignty, the higher one
being achieved in a regime of pure floating exchange rate. In Wray (2015), how-
ever, the exchange rate regime (fixed, managed or floating) affects the degree of
policy space of a nation with a sovereign currency, being the floating exchange
regime the one that provides the greatest degree –​as illustrated in Table 16.1.

3 A Post Keynesian concept of monetary sovereignty

Post Keynesian scholars of various strands hold views on money that are not
homogeneous (Lavoie, 2014), some of which have addressed critical remarks
to what we could call the theoretical pillars of the MMT’s concept of MS. In
this section an alternative concept of MS is devised based on these remarks and
contributions of other PK scholars.
Rochon and Vernengo (2003; based on Wray (1998 and 2003)) agree with
MMT’s emphasis on the money of account and that modern money is ultim-
ately chartal money, but disagree that ‘taxes drive money’, calling attention to
the key role of contracts (instead of taxes) in the acceptability of money (based
on Keynes (1930) and Davidson (1972)).
Keynes (1930) stresses exactly such role: debts and prices and general pur-
chasing power are expressed in the money of account, the primary concept of a
theory of money because money itself, ‘namely that by delivery of which debt
contracts and price contracts are discharged, and in the shape of which a store
of general purchasing power is held, derives its character from its relationship to
the money of account, since the debts and prices must first have to be expressed
in terms of the latter’ (Keynes, 1930, p. 3).
For Keynes, first of all, money is not a medium that emerges from exchange
(as in the orthodox economic theory), but a means for accounting and settling
238 Daniela Magalhães Prates
debts: ‘money of account makes possible price and debts contracts, which are
all that are required for extensive multilateral exchange to take place’ (Ingham,
2004, p. 6). In other words, an abstract money of account is a pre-​condition
for the existence of a monetary economy, thus logically anterior to the other
functions of money.
Davidson (1972) digs deeper into the relationship between money and
contracts. He argues that the ‘synchronous existence of money and money
contracts over an uncertain future is the basis of a monetary system’, because
money could link the present to the future ‘only if there is continuity over
time of contractual commitments denominated in monetary units’ (p. 142)
that ‘permits the sharing of some of the burdens of uncertainty between the
contracting parties’ (p. 146). Yet, the existence of institutions, normally oper-
ating under the aegis of the State, is necessary to enforce the discharge of these
commitments. Indeed, it is ‘with the development of such State sponsored
institutions, that the government appropriated to itself the right to define what
is the unit of account and what thing should answer that definition’.10 Hence,
the sine qua non condition for the existence of a monetary economy is pri-
vate contracts for spot and deferred settlements denominated in the money of
account defined by the State and discharged by the thing the State defined as
the money of the economy (State money and bank money), differently from
MMT’s view that it would be the obligation to pay taxes to the government,
which are debt contracts between private agents and the State.
Another critical point, in Davidson’s (1972) view, is confidence: would
the community lose confidence in the ability of State institutions to enforce
contracts, the monetary system would break down. More broadly, the origin
and acceptability of money also depends on social conventions (also stressed by
Rochon and Vernengo (2003)). As Dequech (2013, p. 253) points out, money ‘is
an institution itself and is closely related to organisations and other institutions’,
among which conventions (…) ‘the conventional character of money is mainly
related to the convention of acceptability’ and was stressed by Keynes (1930 and
1936), Davidson (1972), Harrod (1969) and Chick (1983).
Minsky (1986, p. 55) calls attention to the importance of taxes and bonds as
key pillars underlying the acceptability of the state money. In his view, the pur-
pose of taxes is not to create a demand for currency. Taxes finance government
expenditures and gives credibility to the Central Bank liability because in most
countries the Central Bank assets are mainly Treasury securities that are valu-
able in last resort because the government has a source of revenue, i.e., taxes. In
Minsky’s words:

In truth the government fiscal posture must be in surplus from time to

time (…) as long as Federal Reserve assets are mainly government debt.
If Federal Reserve assets are mainly private business debt, Federal Reserve
and bank money will be valuable as long as business earns sufficient profits
to fulfill its obligations to banks.
(p. 56)
 Post Keynesian concept of money 239
Minsky (1986) also points out the specific roles of the Central Bank as regu-
lator of the financial system and lender of last resort and the one of the Treasury
as the issuer of the government securities –​that are a crucial tool of the big
government not only because these securities finance state’s expenditures in
moments of deficits during recessions, but also because they are acquired by
financial and non-​financial agents to store financing power. As the Central
Bank guarantees the marketability of these securities, ‘the owners of government
securities are assured of the ability to modify their portfolio as their needs or preferences
change’ (p. 36).
Minsky (1986) perspective on the nexus between the central bank and the
treasury (and among taxes, Treasury securities and State money) brings us back
to the MMT consolidation hypothesis. Gnos and Rochon (2002), Palley (2019)
and Lavoie (2013) question such hypothesis, arguing that besides the lack of
realism it does not clarify the ‘foundations of our monetary system’ (Tymoigne
and Wray, 2015).
Although we agree with these critiques, from our point of view such hypoth-
esis is not a necessary condition for MS in the MMT approach (as argued in the
last section). Yet, in the absence of this hypothesis, the aforementioned neces-
sary conditions for a government with a sovereign currency not to face finan-
cial constraints are also unrealistic. Even if the treasury and the central bank
are coordinated and no self-​imposed constraint are in force, both the Treasury
ability to issue an unlimited amount of bonds in the primary market and the
Central Bank ability to buy an unlimited amount of Treasury bonds in the
secondary market is bounded in the current phase of capitalism that Minsky
(1986) calls Money Manager Capitalism.
Since the 1970s or the 1980s, the Central Bank has been prohibited to buy
Treasury bonds in the primary market in most countries and the states have
being under scrutiny of financial markets that are opposed to the idea of mon-
etary financing of public debts and attach great importance to restraint public
borrowing within strict limits. In this setting, to maintain the confidence on
the monetary standard and sustain the private financing of the public debts,
states could not resort to monetary financing and need to comply with what
we could call ‘conventional rules’ (e.g., maximum levels of fiscal balance/​GNP
and public debt/​GNP) that are not self-​imposed but imposed by these markets.
As Palley (2019, p.18) stresses,

sovereign government’s ability to use money financed fiscal policy is

limited by market constraints and reactions which impose costs on govern-
ment. (…) That is not to say sovereign governments have no space to use
money financed fiscal policy, but it does say government are not financially
unconstrained, which contradicts MMT.
(p. 18)

At this point, we have the elements to present what we call a PK concept

of MS (see Table 16.2). As in the MMT concept, sovereignty refers to political
240 Daniela Magalhães Prates
Table 16.2 Concepts of monetary sovereignty in comparison

Post-​Keynesian Neo-​chartalist

Common pillars
Sovereignty

Political National state is the sovereign that defines the money of

sovereignty account and issue the state fiat money that responds to this
definition

Different pillars
Nature of Money of account, credit-​debt
money relation and asset
Money contracts, taxes and
conventions drive money
(state and bank money)
Central Treasury: enforces contracts and
Bank and taxes’ laws; taxes and bonds
Treasury finance government expenses
nexus and give credibility to the
central bank liability (the
state money)
Central Bank: Issues the state
money and guarantees that
bank money will be traded
at par with state money;
responsible for the monetary
policy, lender of last resort
and regulator of the monetary
and financial system; has the
ultimate ability to monetize
the public debt.
Money of account and credit-​
debt relation
Taxes drive money (state and
bank money)
Treasury: has monetary tasks;
spends by crediting a bank
account and faces no
financial constraint; taxes
and bonds do not finance
gov. expenditures, having
only “monetary functions”.
Central Bank: has a fiscal task,
i.e., finances the Treasury
(directly or indirectly)
and determines the policy
rate based on Treasury
bonds (an interest-​bearing
alternative to reserves).

Source: Authors’elaboration.

sovereignty: namely, the nation state is the sovereign that defines the money of
account and also what (the national fiat money) should answer to such defin-
ition. There are, however, divergences regarding the approach on money.
In the PK concept proposed herein, money is a money of account, a credit-​
debt relation and an asset, being accepted because it is both a creature of the
state and a convention. Hence, as in the case of political sovereignty, mon-
etary sovereignty is a claim that must be recognised by others if it is to have
any meaning, i.e., it requires reciprocal recognition. The ability of the state in
making its money and the bank money (convertible at par in the State money)
accepted depends on two intertwined institutions, the central bank and the
treasury that perform complementary functions, which are key for the accept-
ability of money, i.e., for a country to have monetary sovereignty.
 Post Keynesian concept of money 241
The treasury enforces contracts and tax laws and is responsible for the fiscal
policy. Taxes and treasury bonds finance its expenses and, as Minsky argues,
these bonds are counterpart of the Central bank liability (the basic money) that
is valuable in last resort because the government collects taxes. Moreover, in the
money manager capitalism, these bonds are the safe haven for private wealth,
i.e., the lower risk securities demanded for storing financing power.
The national central bank issues the national fiat money at the top of the
hierarchy of money (i.e., the state or basic money) and guarantees that demand
deposits (bank money) will trade at par with such money. It is also respon-
sible for the monetary policy, i.e., for controlling the market of reserves and
determines the policy rate based on a set of instruments, among which Treasury
securities. As Gnos and Rochon (2002, p.53) supports, sovereignty over money
also requires the control of national states over money markets that is grounded
on the central bank’s ability to manipulate interbank settlements. The central
bank is the lender of last resort and the regulator of the monetary and financial
system. Those roles are key for curbing asset price inflations and credit bubbles,
hence ensuring domestic monetary and financial stability and the reproduction
of the convention of acceptability –​pre-​conditions for the stability of money.

5 Final remarks
In social sciences, as in economics, concepts are not neutral, being grounded on
a specific theoretical approach. In this paper, we propose a concept of monetary
sovereignty (MS) alternative to the neo-​chartalist one, and coherent with the
Post Keynesian theory of money and with other key presuppositions of that
approach, especially realism, historical time and the crucial role of institutions
(Lavoie, 2014). That concept draws from PK scholars’ critical remarks to the
pillars of the neo-​chartalist concept of MS and contributions of other PK
scholars, mainly Davidson (1972), Minsky (1986) and Dequech (2013).
Another important issue is the relationship between monetary sovereignty and
policy space.Wray (2015) argues that while the details of government operations
apply in all three exchange rate regimes (fixed, managed and floating exchange
rate), the ability to use them to achieve domestic policy goals differs in each of
those regimes, the floating exchange rate regime ensuring the greatest policy
space for a developing country issuer of a sovereign currency. Wray’s argument
disregards, however, two key research subjects of PK scholars: the currency hier-
archy and the exchange rate dynamics in the post-​Bretton Woods setting.
As Ramos and Prates’ chapter shows, for having low liquidity premiums and
not issuing debt on their own currency, the demand for peripheral currencies
issued by developing countries are vulnerable to changes on international
financial conditions and foreign investors’ liquidity preferences, which result in
high exchange rate volatility. This means that the position of these currencies
at the lowest level of the currency hierarchy in the financial globalisation
setting constraints the policy space of developing countries even with a floating
exchange rate regime.
242 Daniela Magalhães Prates
Notes
1 Senior Economic Affairs Officer at the United Nations Conference on Trade
and Development (UNCTAD); Associate Professor (on leave) at the Institute of
Economics of the University of Campinas (Unicamp).
2 For more details on the concept of sovereignty, see Krasner (2001) and Philpott
(2016).
3 The other version, proposed originally by Davidson (1972), is centred on the role
of contracts (see the next section).
4 ‘The age of chartalist or State money was reached when the State claimed the right
to declare what thing should answer as money to the current money of account –​
when it claimed the right to enforce the dictionary but also to write the dictionary’
(Keynes, 1930 [2013], p. 4).
5 Although in this quotation Wray (2015) states that taxes drive money ‘domestic-
ally and even abroad’, he does not explain how the obligation for paying taxes to a
government in its sovereign currency will result in the acceptance of the currency
abroad. Regarding the acceptance of government currency domestically, Tymoigne
and Wray (2015, p. 29) state that imposing obligations would be a sufficient, but
not a necessary condition. According to them, MMT is agnostic ‘… as it waits for a
logical argument or historical evidence showing that there is an alternative to taxes
(and other obligations)’. Chartalism, in turn, locates the origins of money in the
public sector broadly defined, not exclusively in the role of taxes (Tcherneva, 2006,
p. 70).
6 In this short paper, which aims at presenting a proposal for ending the debt limit
imposed by the congress on the US government, R. Wray explain why the final
result is the same:

the Treasury sells the treasuries to private banks, which create deposits for
the Treasury that it can then move over to its deposit at the Fed. And then
‘Helicopter Ben’ buys treasuries from the private banks to replenish the
reserves they lose when the Treasury moves the deposits. … The Fed ends up
with the treasuries, and the Treasury ends up with the demand deposits in its
account at the Fed –​which is what it wanted all along, but is prohibited from
doing directly.

7 MMT also draws upon Innes (1913) and Keynes (1930) to support that money is a
two-​sided balance sheet operation.
8 It is worth mentioning that Keynes (1930; p. 6) agrees with Knapp: ‘Knapp accepts
as “money” –​rightly, I think –​anything which the state undertakes to accept at its
pay-​offices, whether or not its declared legal tender between citizens’.
9 This kind of statement leads many scholars to understand that for MMT bank
money is not used in payments of taxes.Wray (2015, p. 79) statement that the liabil-
ities at each level of the pyramid typically leverage the liabilities at the higher levels,
i.e. ‘the whole pyramid is based on leveraging of (a relatively smaller number)
government IOUs’. leads to another misunderstanding, i.e., that for MMT the
monetary multiplier holds. The use of the expression ‘leverage’ is one example of
what Lavoie (2013) calls ‘problems of terminology’ of neo-​chartalism.
10 Davidson (1972) is referring to the aforementioned statement of Keynes (1930,
p. 4); see note 7.
 Post Keynesian concept of money 243
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17 
Dealing with global financial
asymmetry
Contributions of regional monetary
cooperation between emerging markets
and developing countries
Laurissa Mühlich and Barbara Fritz

1 Introduction: Global financial asymmetries and restricted

policy space for emerging markets and developing countries
From a Keynesian–​structuralist perspective, emerging markets and developing
countries (EMDC) face disadvantages in the prevailing asymmetric global
monetary and financial order. In the post-​war period, Keynesian-​structuralist
authors, such as Prebisch (1949), identified disadvantageous trade patterns for
peripheral countries specialized in commodity exports, in comparison to cen-
tral industrialized economies. Later, the so-​called centre-​periphery concept was
translated to the financial sphere, i.e. by Ocampo (2013). This was to reflect the
changing nature of the global economy, and to include the increasing relevance
of financial flows and their destabilizing nature, in particular for EMDC.
Global financial asymmetry has two dimensions that are mutually reinfor-
cing each other. First, the monetary dimension is a consequence of the so-​
called currency hierarchy. Currency hierarchy describes a situation in which
currencies are not perfect substitutes, but the use of a currency differs sub-
stantially according to its ability to perform the functions of money at the
international level (Paula et al. 2017). Second, the financial dimension of asym-
metry is augmented by financial globalization: the magnitude and patterns of
international capital flows to peripheral economies, which have become ‘emer-
ging economies’ when they joined the globalized financial markets. Due to
their peripheral monetary status, capital flows towards emerging economies
are mainly determined by exogenous factors that are not directly related to
domestic fundamentals or policy decisions (Rey 2015). Therefore, peripheral
economies are rendered vulnerable to capital flow reversal by virtue of changes
in the monetary conditions of centre countries, as well as by changes in risk
aversion of global investors. Although the volume of capital flows to peripheral
economies is relatively small, compared to global financial flows, their poten-
tially destabilizing effects on their financial markets and exchange rates are sig-
nificant. The capital volume allocated by global investors is not marginal in
relation to the size of these markets. Increasing global financial integration of
246 Laurissa Mühlich and Barbara Fritz
EMDC has been accompanied by a rapid expansion of gross foreign asset and
liability positions far above growth rates of domestic economies. In developing
countries, the sharp increase in capital flows since 1995 has translated into
an eight-​fold increase in their stock of external liabilities and a sixteen-​fold
increase in their stock of external assets (Lane and Milesi-​Ferretti 2018).
Monetary and financial asymmetry implies greater macroeconomic
challenges to peripheral emerging economies than to centre economies at
the top of the currency hierarchy. In consequence, the de facto policy space
of EMDC is severely constrained, compared to advanced economies. Policy
space comprises a broad set of instruments subject to direct control of policy-​
makers within the boundaries of commitments due to international integration
(Mayer 2009).
It is precisely this coincidence of an asymmetric global financial order, higher
exposure to financial shocks and limited policy space at the domestic level that
gives relevance to the regional level.

The increasing occurrence of national, regional, and global financial crises,

together with their rising costs and complexity, have increased calls for
greater regional and global monetary cooperation. This is particularly
necessary in light of volatile capital flows, which can quickly transmit crisis
developments in individual countries to other countries around the world.
(Lamberte and Morgan 2014: 2)

The global financial crisis has provoked an increase in national and regional
self-​insurance mechanisms and in emergency liquidity in general (Kring and
Gallagher 2019). Particularly EMDC at the periphery of the international mon-
etary system experiment with diverse forms of regional monetary cooperation.
We observe a growing variety of aims and forms of regional monetary cooper-
ation mechanisms (Grabel 2018). The monetary cooperation mechanisms are
led by the expectation that south-​south cooperation could enhance member
countries’ national policy space by shielding them from negative repercussions
of the excessive volatility of capital flows. We examine whether and how such
expected stabilizing potential of regional monetary cooperation among EMDC
can be met. While scholars and policy makers are increasingly interested in
exploring the regional dimensions of monetary policy options and proposals
for new regional financial architectures (see, for example, IMF 2017, Ponsot and
Rochon 2010), mainstream economic theory offers little guidance in how to
explore these options for EMDC.
This chapter is organized as follows: Section 2 explains why traditional
regional monetary integration theory is unable to understand potential sta-
bilizing benefits of regional monetary cooperation in EMDC. Section 3
explains theoretically how different forms and aims of regional cooperation
mechanisms may benefit the member countries by increasing their room for
policy space. We include some empirical evidence on existing mechanisms.
Section 4 concludes.
 Dealing with global financial asymmetry 247

2 Traditional optimal currency area theory falls short on

regional monetary cooperation in EMDC
Monetary and financial stability are assumed to be essential in achieving eco-
nomic development.This not only includes price stability. Rather, stable exchange
rates and interest rates are conducive for economic growth and development
(Ocampo 2013, Paula et al. 2017). Stable exchange rates and interest rates are
particularly important when taking into account the specifics of EMDC. From
a heterodox point of view, this requires understanding the intertemporal char-
acter of credit and investment decisions in a Keynesian sense. Post Keynesian
exchange rate theory allows understanding exchange rates as asset prices that
are not only mere expressions of a relative price level but also determined by
expectations on the future development of the asset (i.e. Davidson 1982; Harvey
2009; for a more conventional view of the exchange rate behavior not aligned
with fundamentals but with instable market expectations, see also Obstfeld and
Rogoff 1994). Such broadened understanding of the exchange rate allows to
understand the relevance given to the policy goal of exchange rate stabilization,
for example through a regionally coordinated monetary-​and exchange-​rate
anchor as well as to identify means to achieve this goal (see Chapters 9, by
Herr; 10, by Ramos and Prates, and 11, by Barbosa, Jayme Jr. and Missio in this
volume). Based on modern exchange rate theory, we are able to study monetary
policy strategies, including regional monetary cooperation, not with regard to
their effects on optimal resource allocation but with regard to their effects on
accumulation and distribution of wealth (Buiter 2000, Schelkle 2001).
In contrast, Optimal Currency Area theory (hereafter OCA theory) is based
on the classic and neoclassic assumption of money as being neutral to the
economy. As such, it lacks an explanation for both the motivation of EMDC
to initiate regional monetary cooperation, and the variety of aims and forms of
regional monetary cooperation mechanisms that can be found among EMDC.
OCA theory analysis of the optimality of a currency integration between
different countries focuses on optimal resource allocation of capital and labour
rather than on potential macroeconomic stabilization gains of the member
countries.
In its first generation (Mundell 1961, McKinnon 1963, Kenen 1969), OCA
theory focused on the trade-​offs between the benefits of regional monetary
integration that result from reduced transaction costs for regional economic
transactions and the costs that result from abandoning flexible exchange rates
and supposed sovereignty over monetary policymaking.
OCA theory sets up a set of static optimality criteria that need to be ful-
filled ex-​ante for regional monetary integration to be beneficial: first gener-
ation OCA literature postulates that high levels of factor market integration
and trade integration need to be given for a common currency to be benefi-
cial (Mundell 1961, McKinnon 1963). However, in the majority of developing
regions, intra-​regional trade is too low to meet OCA criteria that are assumed
to be prerequisites for a beneficial regional integration mechanism. Second
248 Laurissa Mühlich and Barbara Fritz
generation OCA theory leaves the static point of view: Frankel and Rose
(1997) and Rose and Stanley (2005) show that economic convergence and
trade integration develop dynamically. They can hence be considered to be
endogenous elements to regional monetary cooperation and integration that
are influenced positively or negatively by means of regional monetary cooper-
ation.Thus, optimality criteria could be met as an effect of the cooperation and
integration process. This holds also for financial and labour market integration
(DeGrauwe and Mongelli 2005). Such perspective is much more suitable to
understanding regional monetary cooperation in the developing world.
Most importantly and in contrast to traditional OCA theory, we find that
costs and benefits of regional monetary cooperation in EMDC are different
from those in industrialized economies. With the aforementioned perspec-
tive of modern, post Keynesian exchange rate theory, stabilizing market
expectations about future exchange rates through a binding regional agreement
on clearing arrangements for regional trade payments, the provision of emer-
gency liquidity, or exchange rate cooperation may entail the benefit of stabil-
izing member countries’ economy and shielding the region against financial
vulnerabilities.
First, OCA theory regards abandoning a floating exchange rate as a major
price paid for monetary integration. However, due to a higher degree of finan-
cial fragility and a lower level of economic diversification, most EMDC carry
higher costs of limited policy space anyway. These countries are more vulner-
able to external shocks: EMDC are exposed to balance sheet effects due to their
inability to indebt themselves abroad in domestic currency (Eichengreen and
Hausmann 2005). Therefore, many EMDC are not in the position to pursue
domestic monetary and exchange rate policies in an autonomous manner (see,
e.g., Han and Wei 2018; Fritz et al. 2018), or have to pursue expensive unilat-
eral insurance strategies against external shocks such as the accumulation of
high levels of foreign exchange reserves (Aizenman et al. 2011). In these cases,
on the one hand, floating exchange rates are a major source of instability that
may produce economic and monetary shocks, mainly due to real and nominal
overshooting, on the other hand, especially in times of crises, these countries’
capacity to combat a crisis with monetary or exchange rate policy instruments
is limited due to their limited policy space. Hence, in EMDC, giving up policy
autonomy reduces only the de jure rather than the de facto monetary policy
sovereignty.
Costs associated with regional monetary cooperation remain, especially
regarding the need to regionally adjust macroeconomic policy, and especially
for countries which are larger or have been able, by means of domestic policies,
to expand their domestic policy space in comparison to the majority of EMDC.
With an increasing depth of integration, there is also a need to cooperate in a
broader range of policy fields, not just monetary policy (DeGrauwe 2009). The
euro crisis demonstrates the high level of coordination requirements for the
case of monetary integration (Mühlich 2014).
 Dealing with global financial asymmetry 249
Second, the argument that flexible exchange rates are not an option for
EMDC is sometimes used to defend unilateral currency unions, i.e. full dollar-
ization. Dollarization would reduce the exchange rate risk to zero. In contrast,
we argue that a unilateral subordination to a key currency entirely detracts the
dollarizing economy from its monetary policy tools, including its lender of last
resort function. Thus, the advantage of eliminating currency risk may be more
than offset by the loss of remaining monetary policy instruments (Acosta 2001).
In general, the costs of regional monetary cooperation vary, depending on
the respective form of monetary cooperation. At the same time, the degree of
intra-​regional asymmetry between the member countries matters. Differences
in their macroeconomic strength, financial market sophistication, economic
diversification, indebtedness in domestic or foreign currency etc. influence the
need to cooperate as well as the need to adjust economically. Such coordination
requirements and the countries’ ability to meet them in turn determine the
effectiveness of regional mechanisms to reduce economic volatility.

3 Regional monetary cooperation as a policy tool for

reducing economic volatility

3.1 Different forms of regional monetary cooperation

How can regional monetary cooperation contribute to reducing economic
volatility? This section systematically addresses this question by analysing pos-
sible channels of action of regional monetary cooperation in EMDC.1
The small body of more systematic literature offers various alternative
ways to classify arrangements of regional monetary and financial cooperation
(Edwards 1985, Ocampo 2006, UNCTAD 2011).
The following three forms of regional monetary cooperation can be iden-
tified according to their respective objectives to influence the behaviour of
macroeconomic variables, such as the nominal and real exchange rate, the nom-
inal interest rate or foreign exchange holdings. It is important to note that
the different forms of regional monetary cooperation have no pre-​determined
sequencing and are not mutually exclusive (Grabel 2018).

Regional payment systems that provide increased self-​ insurance by

sustaining regional trade (see Fritz, Biancarelli and Mühlich 2014),
Regional liquidity sharing mechanisms that increase self-​insurance through
mutual liquidity provision in periods of balance of payments stress (see
Mühlich and Fritz 2018),
Regional monetary and exchange rate arrangements that prevent competi-
tive intra-​regional exchange rate devaluations (see, e.g., Metzger 2006).

While most of regional monetary co-​operation mechanisms are only still

being planned in various developing regions, the former, regional payment
250 Laurissa Mühlich and Barbara Fritz
systems and regional liquidity sharing mechanisms, are actively used by EMDC.
Therefore, we concentrate our analysis on these two forms.

3.2 Reducing transaction costs of intra-​regional trade: Regional

payment systems
Besides trade integration schemes such as customs unions, the mechanism
which directly addresses intra-​regional trade is a regional payment system. The
objective of such a system is to foster trade between member countries by redu-
cing the transaction costs of foreign exchange market operations through the
use of domestic currencies.
According to Chang (2000), a reduction of foreign currency flows and
associated transaction costs is realized mainly in two ways. First, the number of
transactions is reduced to net final settlement at the end of the period, while
transactions of equal value cancel out. Second, temporary liquidity is provided
to the member countries’ central banks, as they allow each other to cancel
mutual obligations not immediately, but only at the end of the clearing period.
Hence, an efficiently run regional payment system in its simple version may
slightly improve the terms of trade for intra-​regional trade transactions and thus
contribute in a modest way to reducing macroeconomic vulnerability (Fritz,
Biancarelli and Mühlich 2014).
Such small-​scale regional cooperation arrangements provide important
learning ground for regional policy coordination beyond intra-​ regional
trade (Birdsall and Rojas-​Suarez 2004). Regional payments systems may
therefore provide an initial step towards further forms of regional monetary
cooperation.
The Agreement on Reciprocal Payments and Credits (CPCR –​Convenio de
Pagos y Créditos Recíprocos) in the framework of the Latin American Integration
Association (ALADI) is the longest standing existing arrangement. Established
in 1966, it serves to reduce transaction costs through settlement of intraregional
trade in domestic currency at the firm level and provides temporary liquidity
during a clearance period at the end of which net amounts of all credits are
settled multilaterally in dollars. The CPCR was important to reduce transac-
tion costs in intra-​regional trade in particular during the debt crises of the
1980s. Since the 1990s, the use and effectiveness of the CPCR has declined
significantly. The CPCR has not been able to keep up with the expansion
of intra-​regional trade since the mid-​1990s. While the share of intra-​regional
trade channelled through this mechanism amounted to an average of almost
90 per cent of total regional trade transactions in the 1980s, it has remained
below 10 per cent since the mid-​1990s. Beyond this, the incentives to use the
CPCR developed asymmetrically among the members, since more and more
diverging creditor and debtor positions developed between the largest member
countries.2
More recently, in 2008, the Mercosur members created the System of Local
Currencies (SML –​ Sistema de Monedas Locales), which allows especially small
 Dealing with global financial asymmetry 251
and medium sized exporters do engage in regional trade without having to face
the high costs of assessing the exchange market. This is especially relevant for
Brazilian firms, who clearly dominate the use of the mechanism.

3.3 Enhancing regional shock buffering capacities: Regional

financial arrangements
Preventing short-​term balance of payments problems is another necessary con-
dition for buffering volatility. Regional liquidity pooling has strong appeal as
an efficient way of self-​insurance against short-​term liquidity shortages and
uncontrolled exchange rate devaluations in periods of massive private capital
outflows.
Pooling national foreign exchange reserves requires a collective commitment
on the part of participating countries to a joint regional contract to provide
liquidity to member countries in times of crisis. As such, regional financial
arrangements may constitute a flexible tool for reserve provision that can be
easier and more rapidly accessible than international mechanisms of liquidity
provision (Mühlich and Fritz 2018).
In contrast to most other forms of regional cooperation arrangements,
regional economic and monetary asymmetries are beneficial to regional finan-
cial arrangements since the participating countries’ demand for liquidity should
differ in time in order to avoid simultaneous drawings which would exceed
the volume of foreign exchange available (Eichengreen 2006, Imbs and Mauro
2007). Hence, regional liquidity sharing may be adopted even at a low level of
regional macroeconomic coordination.When adequately designed with regards
to surveillance and enforcement, regional financial arrangements may play a
complementary role to established international forms of liquidity provision
through the IMF (Mühlich and Fritz 2018). This, however, depends on the
volume of the regional fund and the member countries’ financing needs in
times of balance of payments distress. As a matter of fact, regional funds are con-
siderably smaller than a global liquidity provider as the IMF. Hence, borrowing
requirements of the member countries may easily exceed a regional fund’s
lending volume. At the same time, a voluminous, quick release of third-​party
funds at sensible interest rates is considered crucial to backstop a crisis event
(Obstfeld 1996; Fritz and Mühlich 2019).
Regional liquidity funds between EMDC were founded in two
generations: First, the Arab Monetary Fund (AMF) and the Latin American
Reserve Fund (FLAR, according to its Spanish acronym) were founded in
the 1970s and enhanced the members’ shock buffering capacity during the oil
price crises. The second generation of regional funds was founded in response
to emerging market and advanced economies’ crises in the 1990s and 2000s
(Chiang Mai Initiative Multilateralization (CMIM), and Eurasian Fund for
Stabilization and Development (EFSD)).
The second-​generation regional funds that were founded during the last
two decades in response to emerging market and the global financial crisis
252 Laurissa Mühlich and Barbara Fritz
pooled together significantly higher volumes than those of the first generation.
In the first-​generation funds, most of the member countries cannot find suf-
ficient liquidity to ban a financial crisis with large financial volumes typic-
ally involved nowadays. Nevertheless, they are used by their member countries.
Their frequent use even dominates other options, obviously for other reasons
than volume. For example, on the one hand, AMF member countries with
high financing requirements, such as Egypt or Morocco, tap on their regional
fund for immediate liquidity support as well as structural facilities as they may
gain time to develop a reform program, in case need be. On the other hand,
FLAR member countries with small financing requirements, such as Bolivia
or Ecuador may prefer negotiating a borrowing arrangement with the FLAR
instead of the IMF as the regional fund may appear to be easier accessible and
less stigmatized than an IMF program and at the same time sufficient to bridge
a liquidity shortage for those countries.
In the second-​generation funds, most member countries would find suf-
ficient emergency liquidity. Yet, as mentioned above, especially the CMIM
members do not make use of their regional fund, again for other reasons than
the provided financing volume. For example, EFSD member countries with
small financing requirements that would find sufficient liquidity regionally
make use of their regional fund in a way that combines EFSD with other
sources of lending. Such behaviour may indicate a diversification of borrowing
sources to reduce dependency on one institution’s or lender’s policy (Fritz
and Mühlich 2019). In the case of the most voluminous RFA, the CMIM,
disbursement of more than 40 per cent of a member country’s drawing right
require the involvement of the IMF in the lending facilities, which seemingly
has a detrimental effect on members to make use of the regional fund. Most
scholars mention that the strong link with IMF lending “de-​regionalizes” the
policy conditionality, enforcement mechanisms and so forth in a way that
borrowing is associated with the same stigma as borrowing from the IMF
(Kawai 2015).
Regional financial arrangements can be complements or substitutes to global
liquidity provision by the IMF (IMF 2017). Mühlich and Fritz (2018) find
that the regional funds’ complementary or substitutive use depends not only
on the accessible financing volume, conditionality, timeliness, surveillance and
enforcement rules, but also on the governance of the arrangement itself. With
regards to the former aspects, they find that firstly, only small countries, rela-
tive to the size of the regional arrangement, can exclusively use their regional
fund.They can substitute IMF borrowing because the accessible regional finan-
cing volume is big enough for them; those countries use their regional fund
and the IMF in parallel –​or complementarily –​in fewer occasions than they
apply for financing exclusively from the regional fund. Secondly, those coun-
tries that are privileged to be partner to a new and completely different non-​
institutionalized (McNamara 2016) form of short-​ term liquidity provision
 Dealing with global financial asymmetry 253
through bilateral currency swaps, can substitute IMF financing through such
a bilateral agreement. Thirdly however, most countries are not in the position
to substitute the traditionally conditioned IMF financing, since their financing
requirements are too large for their regional liquidity pool and do not have
other non-​institutionalized forms of emergency financing at hand in times of
crises. For them, regional funds are no substitute since they provide a financing
volume that is too small. In these cases, regional financial arrangements are a
complement, at best.
Mühlich and Fritz (2018) conclude that complementary or substitutive
use of different sources of balance of payments financing may also be related
to the governance of a regional mechanism. The member countries’ inten-
tion to diversify their sources of short-​term debt can be interpreted as a
reaction to, for example, highly hierarchic governance, such as in the case
of the EFSD and/​or surveillance and enforcement rules of the regionally
pooled funds that borrowing members do not consider adequate, such as in
the CMIM. While in EFSD, a highly diversified use of borrowing sources by
the member countries is observable, CMIM is substituted by bilateral cur-
rency swap arrangements.

4 Conclusions
Regional monetary cooperation in EMDC can be considered a valuable tool
for regional macroeconomic stabilization by enhancing regional trade and
the region’s shock buffering capacity. Due to global monetary and financial
asymmetry, most EMDC dispose of a more constrained policy space or, in
other words, a lower capacity to pursue domestic monetary and exchange rate
policies in an independent manner. Modern exchange rate theory allows to
understand that peripheral countries’ higher degree of financial fragility and
their lower level of economic diversification are reasons for EMDC to enhance
regional monetary cooperation: EMDC earn more in terms of macroeco-
nomic stability in regional monetary cooperation than they have to pay in
terms of giving up de jure monetary and exchange rate policy sovereignty.
It is important to note that conventional concepts take a static and linear
approach to regional monetary co-​operation and finally to monetary integra-
tion. In contrast to conventional concepts, we find that a modern exchange
rate theory perspective that is sensible to the effects of global monetary and
financial asymmetry for EMDC allows understanding that even such small
mechanisms as regional payment systems or liquidity funds hold the potential
to contribute to mitigating the effects of exogenous shocks within a region.
Empirically, the observable initiatives show the intended stabilizing effects, but
to highly varying degrees. Their shock buffering capacity depends on their
ability to adjust to changing macroeconomic conditions and requirements of
the member countries.
254 Laurissa Mühlich and Barbara Fritz
We systematized the potential contributions to macroeconomic stability and
coordination requirements of the currently most relevant forms of regional
monetary cooperation from an empirical point of view: First, regional payment
systems represent the simplest form of cooperation by enhancing intra-​regional
trade flows. Second, regional liquidity pools increase the member countries’
counter-​cyclical intervention capacity and provide efficient co-​insurance in the
case of balance of payments problems.
The analysed forms of regional monetary cooperation may or may not
develop into deeper schemes of monetary cooperation and integration that
allow containing uncontrolled devaluations and increasing regional coordin-
ation of macroeconomic policies. The broad variety of forms and aims and
institutional settings within the range of regional monetary cooperation allows
adapting ‘modules’ of cooperation to a region’s asymmetries, co-​ordination and
adjustment capacities, and needs. That is to say, the different forms of regional
monetary co-​operation have no pre-​determined sequencing and are not mutu-
ally exclusive.
It may take a very long time to progress from the first steps of macroeco-
nomic dialogue to stronger forms of regional surveillance, ranging from policy
consultation on explicit coordination of exchange rate and monetary policies
to a common currency. Intra-​regionally stable exchange rates are an important
ingredient to reap potential benefits of even small forms of regional mon-
etary cooperation. While macroeconomic cooperation creates the grounds for
increasing regional shock buffering capacity in general, each form provides a
specific buffering potential for EMDC against negative repercussions of global
asymmetry.

Notes
1 For a more extensive classification, see Fritz and Mühlich (2015).
2 An extensive discussion of regional payment systems is provided in Fritz, Biancarelli
and Mühlich 2014.

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Kring, W.N., Gallagher, K. (2019) ‘Strengthening the Foundations? Alternative
Institutions for Finance and Development’ in Development and Change 50(1),
pp. 3–​23.
Lamberte M.B., Morgan P.J. (2014) Regional and Global Monetary Cooperation.
In: Kawai M., Lamberte M., Morgan P. (eds) Reform of the International Monetary
System – An Asian Perspektiv (Tokyo: Springer), pp. 225–​253.
Lane, P.R., Milesi-​ Ferretti, G.M. (2018) ‘The external wealth of nations
revisited: International Financial integration in the aftermath of the global financial
crisis’, IMF Economic Review, 66(1), pp. 189–​222.
Mayer, J. (2009), ‘Policy space: What, for what, and where?’ in Development Policy Review
27(4), pp. 373–​395.
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pp. 717–​725.
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Tanja A. and Risse, Thomas (eds.): The Oxford Handbook of Comparative Regionalism
(Oxford: Oxford University Press), pp. 351–​373.
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south coordination project?’ in Fritz, Barbara and Metzger, Martina (eds.) New
Issues in Regional Monetary coordination: Understanding North-​South and South-​South
Arrangements (New York: Palgrave), pp. 147–​164.
Mühlich, L. (2014) Advancing Regional Monetary Cooperation –​The Case of Fragile Financial
Markets (Basingstoke and New York: Palgrave Macmillan).
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and the role of regional financial arrangements’ in Open Economies Review, 25(9),
pp. 981–​1001.
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51, pp. 657–​665.
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Paper No. 4693.
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/​Laurissa Mühlich and Barbara Fritz (coord.).
18 
De-​regulation of finance in China
and India
A Post-Keynesian analysis
Sunanda Sen

The background
China and India, the two major Asian economies in terms of population as well
as economic performances, have both gone through significant changes in eco-
nomic policies since the respective beginnings of their new regimes by the late
1940s. For both, tight official controls over domestic as well as external trade
and finance preceded the opening up of their respective economies –​facing
the usual hazards and related crises –​especially with speculation in uncertain
markets.
Opening up with deregulation of markets, as considered in mainstream
neo-​classical economics, is generally expected to ensure an efficient and stable
growth process. The theoretical frame underlying above models, rules out, by
assumption, uncertainty. Policy prescriptions originating from the above frame-
work claim, rather inappropriately, an ability to predict the future by using
numerical calculations of probability which are based on an assumed normal
distribution function of the probability of specific outcomes (Sen 2019).
Limits, both at a conceptual and at an empirical level, are not difficult to be
uncovered in models as above. Those include the underlying assumptions of the
neo-​classical models relating to numerical calculations of probability calculations
which as argued, render the predictions bereft of accuracy under uncertainty
(Bateman 2003; Carvalho 1989). Such issues affect investment decisions as well as
the consequences of deregulated policies in an economy faced with uncertainty.
Instances of the failure of above models to predict the changes in the
economy are many at an empirical level –​as a visible in the recurrences of
crises in deregulated financial markets all over the world. One recalls here the
global financial crisis of 2008–​2009, originating from a mortgage based sub-​
prime crisis in the United States which generated a global financial crisis as well
as downturns in different regions of the world economy.
From a post-Keynesian perspective, interpretations of the recurrent crises
in the financial as well as in the real sectors of economies can dwell on uncer-
tainty for explaining the destabilising forces leading to crises. Interpretations as
above follow the Keynesian notion of ‘animal spirits’ which seeks to provide an
explanation of the instabilities, both frequent and unpredictable, as recur in the
deregulated markets
 De-regulation of finance in China and India 259
Our analysis, in this chapter, highlights the Post-Keynesian emphasis on
uncertainty while probing the evolving pattern of the deregulated financial
markets in China and India over the last four decades. The first part provides
an analysis of China, dwelling on the multiple issues as have come up in the
country since the launch of the market led reforms in 1978 by President,
Deng Xiaoping and the subsequent reforms as came up later with changing
leaderships. We introduce, in the second part, a parallel analysis of the finan-
cial sector reforms in India, emphasising the aspects which are similar as well
as different between the two countries Sen 2014a). The final part concludes
with some observations which confirm the generality as well as the relevance
of the theoretical position of post-Keynesian economics as adopted in this
chapter.

China: From market-​led reforms during the Deng Xiao

Ping regime to the ‘China model’ and ‘new normal’ growth
under Xi Jinping

Market-​led reforms initiated by Deng Xiao Ping

China, to be precise, known as People’s Republic of China since the beginning
of the political system initiated by Mao Zedong in 1949, had been subject to
tight regulations in its economy over the next few decades till Deng Xiao Ping
took over as president in 1978 and reforms were initiated, for the first time in post-​
revolution China. The opening up, however, was a gradualist one, over the first
three decades of reforms. Impact of reforms on the economy, as can be noticed,
included a marked rise in the GDP, supported by large FDI inflows and net
exports of merchandise. FDI inflows, especially over 2009 to 2013, continued
to have a close link to China’s exports which had also been rising on a parallel
basis. A large part of those inflows originated from the non-​resident Chinese
in Hongkong and elsewhere, who had a considerable influence on investment
decisions in the economy. By then, China had become a member of the WTO
in 2001, which considerably eased the entry of foreign capital including foreign
banks to the country (Sen 2007).
The initial years of reforms during the 1980s under Deng provided a pattern
of regulated reforms, which we described in an earlier study (Sen 2007) as ‘guided
finance’. It can be noticed that despite having large measures of deregulation,
finance in China has continued to be managed as a state subject. It needs to
be noticed that some degree of regulation, especially during the initial years of
reforms, aimed to avoid systemic risks in the market by restraining speculative
finance and by steering bank credit flows along productive channels. The four
state owned banks (SoBs) were provided, by the State Council, a directive on
allocation of credit –​in terms of a ‘guide book’ set up for the purpose. This
generated a direct link between banks, the state and industry, which proved con-
ducive to the economy in terms of growth. The SoBs, subject to segregated
banking, were providing between them 80% or more of the aggregate credit
260 Sunanda Sen
flows in the economy.While most of those went to the state-​owned enterprises
(SOEs), the ‘bad loans’ held by banks were taken care of by the state.
Investments in China from overseas turned out as attractive with the enab-
ling conditions in the state-​initiated reforms. The enticements included, apart
from cheap labour, facilities for infrastructure, tax concessions (especially in the
Special Economic Zones), state patronage for industries set up with overseas
capital, low interest rates charged by banks and the fixed exchange rate of the
RMB until 2005. We may mention again the limited role of stock markets in
early years of reforms in the economy.
An investment boom during the Deng regime also brought in waves of
technological innovations, by arranging licensing agreements and sales
of equipment by FDI-​ led foreign companies, as well as by joint ventures
allowing technology transfers. The Chinese domestic market, catering to 1.4
billion consumers, provided opportunities to achieve scale economies while
encouragements within the country were also there to develop R&D rather
than importing those, in effect sharing a pattern of techno-​ nationalism.
Arrangements as above were partly stalled after China entered the WTO and
was incorporating the TRIPS requirements. However, as mentioned above, the
initial round of economic reforms, while effective in initiating large inflows of
FDI as well as net exports, was still maintained a set of regulations, especially on
financial transactions.
As for the stock market it was at a nascent stage in the early years, especially
with two-​thirds of stocks having no capacity to trade and the stock market sub-
ject to bifurcation between the RMB (A) and US dollar (B) shares. Investments
by Foreign Institutional Investors (FIIs), which had been rather limited during
the early years, remained confined to the B (US dollar) shares (Sen 2007).

Changes in leadership since 1992 and deviations from earlier market reforms
China’s economic performance was subject to intermittent reversals along with
the changeover in the respective leadership –​with Jiang Zemin, Hu Jintao
and Xi Jinping, respectively taking over as presidents in 1992, 2002 and 2013.
The Deng – era reforms to initiate the market were somehow modified with
President Jiang Zemin’s public announcement that ‘China is a socialist market
economy’ – ​implying a deviation from the goals of communism. The package
of reforms and some of the regulatory measures introduced since then clearly
deviated from its earlier pattern, especially relating to the management of the
exchange rate and the stock market.

Changes in exchange rate management

Tracing the exchange rate management in China, one can identify at least four
major breaks, which can also be held responsible for generating instability by
instilling uncertainty in China’s financial market. Disruptions in the erstwhile
stable financial market of China started in 2005 when the fixed official parity
 De-regulation of finance in China and India 261
of the RMB at 8.27 to US dollar in March 2005 was replaced by a floating rate
which immediately pushed up the RMB rate to 8.11 per dollar by July 2005.1
While conceding to some extent, to the US lobby which accused China of ‘cur-
rency manipulation’ by keeping the RMB undervalued, the change generated
expectations of further changes in the market, especially of an appreciation of
the RMB against dollar.The next break in China’s currency management came
in August 2007 when foreign currency was allowed, for the first time, to be
privately held. Ending the mandatory sale of foreign exchange, the step enabled
domestic companies and households to hold foreign currency as they wanted.
Thus dollars, if desired, could flow out from private channels and cause deficits
in the capital account, which happened later.
By that time, faced by an expected depreciation of the RMB, domestic
importers did tend to advance payments in dollars, which affected the for-
eign exchange settlement between importers and banks. In addition, domestic
exporters were inclined to hold on to export earnings in dollar rather than
convert them to RMBs, which similarly affected the magnitude of foreign
exchange settlement between exporters and banks. As a result, there emerged
a tendency to short RMB and hold dollar long especially by 2011 when a
possible depreciation of the RMB was officially recognised. By September
2011, an official announcement permitted a ‘two-​way float’ of RMB a measure
accepting, for the first time, possible depreciation of the currency, thus ending
a long-​standing consensus on the one-​way RMB appreciation which prevailed
until then. Changes which pushed the move included a moderate drop in the
trade surplus and in the financial account balance of China.
Conditioned by the above changes, uncertain movements in the exchange
rate, especially the expectations of a depreciation of the RMB, encouraged
corporates as well as other private agencies including traders to hold on to
dollar. Simultaneously external liabilities of the country started moving up with
rising net inflows of portfolio capital from abroad. Policy shifts as above can also
be held responsible for a decline in the official reserves between 2011 and 2012.
As can be mentioned, the drop was caused by a jump in short-​term trade credits
to prepay (for imports) in dollar, a rise in dollar advances from banks and also
withdrawal of dollar deposits from banks, much due to the expectations of fur-
ther declines along with volatility in the RMB rate to US dollar. The exchange
rate of the RMB, however, continued to waver with moderate appreciation
between 2010 and 2014 and followed by bouts of depreciation between 2014
to 2016 and 2018 to 2019 (Jianxin and Sweeney, 2012).
Currency management in China was subject to one more change in April
2012 when the daily trading limit of RMB against dollar was officially widened
from 0.5% to 1%. The move, allowing the rate to move in either direction,
was designed, as held by Chinese experts, to encourage use of the currency in
international markets. Moves as above, while liberalising the transactions, came
with tendencies for speculation in the economy, especially on the RMB rate
which had been subject to depreciation as well as a currency crisis during 2013
to 2015.
262 Sunanda Sen
It is often argued that China, by holding a large stock of US Treasury Bills,
got trapped in the uncertainty around the dollar-​RMB exchange rate. China’s
RMB, while short of attaining the status of a convertible currency, has of late
been in the limelight with its potential to be an internationally acceptable con-
vertible currency (Bloomberg 2018). The currency is already in use to meet a
considerable part of China’s trade, especially with the neighbouring countries,
while using swap arrangements to cover international payments. The PBoC
took a lead in initiating swap arrangements, which preceded the inclusion of
the currency in the SDR basket at the IMF2 (IMF News, 2016). The practice
got reflected in the rising share of RMB in the official reserves held by different
countries.
However, despite the disturbances in the financial market, exchange rate
of the RMB was subject to the on-​going management by the state. One can
mention here the very unique relation between the state and the market in
China with the former continuing to retain its prerogatives in the de-​regulated
markets, especially relating to finance. We find a reflection of above in China’s
stock markets a discussion of which follows.
Relaxations of restrictions also introduced a pattern of instability in China’s
stock markets which witnessed a crash in June and July of 2015, preceded by a
unforeseen boom therein which came along with a fast pace of liberalisation in
the financial sector (Sen, 2015).

The volatile stock market

Before the onset of the crisis, in 2015, a boom had erupted in China’s stock
market, along with rising ratio of stock market capitalisation to GDP, and
the growing contribution of the stock market to circulation of domestic
finance. Deviating from the pattern prevailing earlier, the ratio between stock
By then, market and bank finance moved up from 3.70 in 2013 to 12.42 in
2017. Qualified FII investors (QFIIs) had been allowed to transact ‘A’ (RMB)
shares in 2011–​2012,3 which generated proportionate increases in the market
capitalisations in Shanghai and Shenzen. In the meantime, the real estate and
housing boom had already ended, thus prompting the investors to the market
for financial assets in the stock market.The boom also got reflected in the rising
volume of trading in financial derivatives and the proliferation of financial
innovations, which often entailed leveraged financing, with credit advanced by
financial institutions based on the respective assessments of the fictitious returns
expected under uncertainty. Banks had been providing margin money to large
numbers of young middle-​class traders during the stock market boom (Hunter
2018). Thus, the boom, part financed with borrowed funds, in effect, brought
in a Ponzi mode of finance which crashed as the boom ended by 2014–​2015.
China’s stock markets had, however, by then come to the fore as major financial
institutions, as in advanced capitalist countries with the emulation of the related
repercussions for the economy. Attempt on part of the state to initiate controls
 De-regulation of finance in China and India 263
on margin lending and related shadow banking practices led to major reversals
and further volatility in the stock market (Roach 2019).
As it happened, the boom ended with the stock exchanges of China facing
a downturn by 2015 (Peoples Bank of China 2018: 219). Pulling down the
Shanghai Composite Index from 5120 to 3806 within a month ending July 9,
2015, the index continued to slide between 3500 and 3700 amid fluctuations
despite official interventions (Hunter 2018). The shock wiped out, in less
than a month, more than $3 trillion of stockholders’ wealth, caused by sharp
downturns in stock prices. The downslide as above was even sharper than the
post-​Lehman-​Brothers’ crisis on Wall Street, when US stocks fell by 41%, over
a much longer period, between October 2008 and March 2009 (Sen 2015).
Attempts on part of the state to mitigate the crisis in the financial market
achieved limited success. It may be recalled here that earlier downturns in
China’s stock exchanges, as took place with the global financial crisis of 2008,
were successfully managed, with the state injecting a sum of $585 billion (nearly
7% of China’s GDP in 2008), along with other measures. In contrast, with
de-​regulated finance prevalent during the crisis of 2013–​2015, the state had
limited options for containing the downward trend in the market, as evident,
for example, with the Shanghai composite index continuing to hover around as
low as 2200 by early 2019.4 Developments as above led to a moderate decline in
the stock of official reserves by $930bn between 2016 and 20175 along with fre-
quent downslides in the RMB rate, hitting 6.92 per dollar by October 2018.6
Players in China’s stock market in 2015 included an unusually active but
rather inexperienced retail traders (Roach 2019) – all of domestic origin – a
pattern very different from the international institutional investors. Their brisk
stock trading was visible in the large number of new accounts opened in the
booming period before June 15 and in the sums borrowed as ‘margin money’
to buy stocks in the first half of 2015. This, no doubt, was a precarious if not a
Ponzi game, especially when stock prices had already started tumbling down-
wards since June 2015. Investors, however, were left with little option other
than selling further, which exacerbated the impending crisis starting in mid-​
June of 2015.The consequence was a drop in Shanghai composite index from
5166 on June 12, 2015, to 3507 on July 8 and further down to 2927 on August
26, 2015 (Lee, 2015).
End of the stock market boom as above which came up in 2015 was also
conditioned by the rising uncertainties in China’s financial scene as were caused
by some expected changes in the global status of RMB; possibly with its inclu-
sion in the SDR package of IMF and with China’s attempts to turn RMB a
convertible currency, which was backed by rich households keen on a diversi-
fied portfolio (Sen, 2015).
As with the exchange rate fluctuations, the sharp drop in stock prices led
the Chinese state swing back to action, initiating measures which helped to
arrest the downslides in the market. Preceded by a drop in the stock index from
the high of 5166 on June 12, 2015, to the low of 3052 on September 30, the
264 Sunanda Sen
measures led to recovery at 3580 on November 13, 2015, reaching 2939 by
May 30, 2018.7 The pattern confirm the rather unique relation between the
market and the state in China, with the latter both willing and in a position to
modify the opening up process; especially with measures designed to regulate
the market.

Decelerating growth and financial instability

As for overall growth, shocks experienced by China with the outbreak of the
global financial crisis of 2008 was followed by a smart recovery with the GDP
growth rate touching 10.7% by 2010.8 Efforts on part of the state to revive the
economy by injecting a sum of $585bn (or nearly one-​fifth of China’s GDP)
in 2008, along with other measures worked to recover the growth rate, while
in the stock market the Shanghai composite index also moved up to 3471 by
August 4, 2009. The recovery turned out a short-​lived and by 2011 China
started facing the signs of a weakened investment climate along with a long-​
drawn downswing in the economy. By then the country had entered a phase
where the earlier pattern of an insulated financial sector backed by the high
growth economy had given way to an alternate scenario where instability of
markets and deceleration of output became a reality. By 2012 growth in China’s
GDP had decelerated to 7.9% to be followed by 6.1% and even lower by 2019–​
20209. The declining GDP growth along with the noticeable changes in capital
flows indicated a change in investment climate of the country. By this time
Chinese residents had started investing abroad which resulted in FDI outflows
while net portfolio inflows to China were on the rise, both reflecting a new
wave of speculation in the economy. Increases in speculative activity were also
reflected in the rising levels of derivative trading in the economy.
De-​regulated finance in China was also responsible for steady expansions in
the country’s debt, especially held by the corporate sector.The country’s aggre-
gate stock of debt rose to an astounding 255.7% of GDP by 2017. Of above the
stock owned by corporate sector alone was at 160% of GDP10 (Olsen, 2018).
The debt/​GDP ratio for the economy, which went up by 48.7% between 2012
and 2017, led one of the world’s big three credit ratings agencies, Moody’s, to
cut China’s rating by one notch from Aa3 to A1. Incidentally, it was the first
time that the agency downgraded the country since 1989 (BBC, 2017).
Looking back, the large stimulus package in 2008–​2009, channelled through
the state-​owned banks (SoBs), and used to finance borrowings by local
governments for infrastructure, generated speculation in the real estate and
housing markets by availing easy credit offers from banks. Credit for real estate
transactions, which was not legal for the formal banking sector, were often
met by shadow banks. The changed investment climate also impacted banks
in China which started selling the Wealth Management Products (WMPs) for
the public.
As already mentioned above, the changes as above indicate the advances of
speculation in China –​affecting housing prices, the domestic stock markets and
 De-regulation of finance in China and India 265
the exchange rate of the RMB. That speculation in the economy was already
prominent could also be confirmed in the changing pattern of capital flows to
the country, with inflows of portfolio capital replacing more stable inward FDI
and with increasing FDI outflows by Chinese residents.11 Speculative trading
was also reflected in the rising volume of derivative trading12 by these years.
Incidentally, speculation continued to be rampant in the Chinese economy
despite the official clamp-​down on housing/​real estate markets and on under-
ground credit networks (Yongding 2011).
China’s integration into the global financial network, especially the strong
links to the US economy, made it difficult for the country to have autonomy
in economic policies. The constraining factors included China’s bilateral trade
surpluses with the United States, the FDI (as well as portfolio) inflows origin-
ating from the United States, and the dollar value of China’s official reserves in
US Treasury bonds.Net inflows of foreign currency (especially dollar) with the
twin surpluses in external account, did not, affect the exchange rate of RMB
due to official purchases of US dollar from the market. The proceeds of those
purchases mostly used to purchase US Treasury bonds, while contributing to
the already large official reserves of China, was also responsible for an equiva-
lent release of local currency in the economy –​thus depriving the govern-
ment of monetary autonomy. The policy options as were left to the monetary
authorities in China plunged them to the ‘trilemma’ of a loss of monetary
autonomy when exchange rates are managed in the face of free capital flows.
(Sen 2013: 258–​259). Incidentally, when the three parameters in the ‘trilemma’
(consisting of the exchange rate, capital flows and monetary policy), are all open
to risks under uncertainty possibilities of capital flights generate tendencies, for
emerging economies, to hold excess stocks of official reserves, largely with a
precautionary motive. The dimension, added to the trinity, has been described
as a ‘quadrilemma’ in the literature (Aizenmann 2013).
China too, facing the trilemma, was saddled with too large official reserves in
US dollar, especially as long as the dual surplus in the payments balance could
continue. Additions to official reserves leading to increases in high-​powered
money (M0) were followed by additions to M3. The latter was responsible for
initiating ‘inflation targeting’ on part of the monetary authorities. As confirmed
by statements from the PBoC, with foreign exchange the major source of
base money supply central bank lending to financial institutions accounts for
a smaller share (and) the independence of monetary policy is undermined
thereby. (Xiaolian, 2010).
One can notice that with inflationary tendencies in China, measures were
initiated to curb prices between 2011 and 2012 by using higher interest rates
and reserve ratios along with open market policies. China’s GDP growth met
with a sharp downslide starting in 2011. The drop touching 6.1% by 2019 and
even lower in the current year,13 was related to factors which not only included
the slump in the overseas export market, but also inflation targeting, as above.
With inflation continuing, markets driven by uncertainty along with the RMB
rate subject to US negotiations with China, policymakers there were facing
266 Sunanda Sen
a difficult choice this time, of controlling inflation in an economy with stag-
nant growth performance (Reade and Volz 2012). However, with GDP growth
sliding, less attention, if at all, could possibly be paid to austerity and inflation
targeting in the economy (Sen 2014b). Of course, China in the meantime had
moved to a policy of ‘new normal’ growth (Yesmin 2019) which aimed to avoid
the dependence on the recession-​prone West (as well as Trump-​led trade war).
Difficulties in pursuing an autonomous monetary policy, did surface in China
many a times in recent years, initially with the financial crisis of 2013–​2015
when the exchange rate was sliding down.The problem has been compounded
recently by the US stricture on exchange rate stability of the RMB, which was
announced as a part of the on-​going deal in the Trump-​led trade war (Yongding
2019; Mc Dowell and Steinberg 2019). This has put the policymakers in China
in a quandary, especially with global financial market subject to the uncertain
measures of the Fed regarding the QE. Also attempts by PBoC to maintain a
‘two-​way flexibility’ of the currency since 2011 has turned out as infeasible
(BIS, 2014). Problems at present are aggravated with the out-​break of the novel
Corona virus which affected China severely.
As for managing the RMB, recognised as a potential reserve currency, it’s
movements were under the scanner, especially with a downward trend in the
RMB rate since 2013 when renewed pressures came up from US to avert fur-
ther depreciation; given the earlier US complaints which branded China as a
‘currency manipulation’. It was well recognised that if China ever unloads US
securities, there could be chaos in the financial market, which could even ini-
tiate a drop in the dollar rate.
China’s integration with the global economy, while making way for the
country to attain a major status in the global economy by attaining unpre-
cedented heights of GDP growth, net exports, capital inflows and exchange
reserves, also has brought in a sequence of vulnerabilities which has started
reversing the upward growth path. Of other factors, a major policy move which
can be held responsible for the onset of the retardation in the economy include
the accelerating pace of de-​regulation in the financial sector. We have discussed
above the onset of the destabilising forces in China’s economy, much of which
can be linked to the steady dismantling of regulations in the financial sector,
as pointed out in the post-Keynesian writings on similar issues. Uncertainty
and related risks as followed prepared the grounds for the financialisation of
the economy where real activities gave way to finance as the major form of
activity. Retardation of the economy has been a major consequence of the pro-
cess. While the future path of China’s economy, as with the rest of the global
economy remains an unchartered territory in terms of predictions, it remains to
be seen that policy makers in China are in a better position to fetch the benefits
of favourable geo-​political bonuses in terms of the Belt Road Initiatives and the
related trade and investment prospects. Above, combined with the rising pur-
chasing power of workers having higher wages in the country, may even enable
the domestic market to compensate the shrinking exports in the recession prone
and protectionist overseas market. The revived space of the domestic economy
 De-regulation of finance in China and India 267
may even help in regulating the market and protecting it from the vagaries of
uncertainty as at present. But predictions to that effect remain indecisive which
we refrain from predicting.

India: On track of a de-​regulated economy since the

mid-​Eighties
De-​regulation of markets had an early start in India by the mid-​eighties and
was followed up by a set of wide-​ranging reforms in 1991. Those relating to
the financial sector (Sen 2014b) introduced,14 among others, universal banking
in place of segregated banking, reduced capital requirements and liberalised
interest rates for banks, FII flows to domestic stock markets by 1992, trade in
derivatives at par with securities, in stock markets by 1999 –​which enabled
the setting up of exchange traded derivative markets under the supervision
of the Securities Exchange Board of India (SEBI). Simultaneously the ban on
commodity trading derivatives was lifted and currency futures could be traded
under the newly set up Multi-Commodity Exchange of India (MCX).
The impact of the changes as above included a rise in flows of short-​term
portfolio capital along with a flood of speculation in the economy, which could
be traced in the rising volume of trade in stock markets. Uncertainties in the
economy, generating speculation, also spread to future markets – of commod-
ities and of real estates. An evolving pattern of the financial sector, discussed later
in this chapter, emerged in the management of capital flows, monetary policy
and of the exchange rate. Liberalisation of capital flows, which was initiated in
1992–​1993, witnessed substantial inflows of overseas capital. Catching up with
the volatile pattern of global financial flows, de-​regulated finance in India has
been responsible for accommodating large inflows of speculation-​driven port-
folio capital, the volume of which even exceeded the more steady sources of
net FDI inflows.15 Capital account surpluses as resulted were often in excess
of the current account deficit during the period and thus continued to add
to the official reserves. The pattern conformed to what we discussed above in
the context of the rising reserves in other emerging economies, often held on
a precautionary basis. But unlike China where additions to reserves came with
trade surpluses reserves grew in India with capital inflows, mostly short term,
thus generating vulnerability.
Additions to official reserves took place in China with purchases of foreign
currency on part of the Chinese monetary authorities in an effort to avoid
further appreciations of the RMB. As elsewhere, added reserves (high-​powered
money) were capable of generating monetary expansions, and as held in main-
stream economics, with inflationary consequences. As it was in China, situations
as above often turned India’s monetary policy into inflation-​targeting, and sub-
ject to the exigencies set by the surges and volatilities in overseas capital flows
(Sen 2012). Thus, as in other emerging market economies, experiencing large
and volatile flows of foreign capital, India has also been facing a typical ‘trilemma’
as well as ‘quadrilemma’, which we mentioned above (Aizenmann 2013).
268 Sunanda Sen
As compared to China, policy-​making in India has been further constrained
by different instruments. With fiscal policy, it has been a self-​imposed legal
limit set by the Fiscal Restraint and Budget Management (FRBM) Act passed
in the Indian Parliament in 2003 on fiscal deficit as a ratio of GDP. China, as
a contrast, had full access to using fiscal deficits as an expansionary measure, as,
for example, with the global financial crisis when $586bn was provided from
the fiscal budget as a stimulus package. As in China, the mainstream principles
of monetarism has been guiding monetary policy in India to attain inflation
targeting. Fiscal and monetary policies in India, both targeting austerity, have
been responsible for official disapprovals to expansionary policies for growth
(Sen and Dasgupta 2014).
The monetarist orientation of fiscal-​ monetary policies in India were
combined by official concerns (or fixations), similarly oriented, to abide by the
mainstream norm of free flows of capital –​which, along with official moves to
manage the exchange rate, resulted in a loss of autonomy in deciding on mon-
etary policy tools like the interest rate. The call for austerity which pitched the
interest rate high often coincided with a similar stance in the context of the
trillema (or impossible trinity) (Aizenman 2013), which, as described earlier,
China had also been subjected to.
Capital account liberalisation with the opening of the flows, had sev-
eral implications, in India as well as in China, in terms of their respective
policy spaces As for the Indian economy, there have been at least three major
repercussions: First, the inflows of volatile short-​term capital, contributing to
official reserves, also did set the stage for a potential balance of payments crisis
subject to unpredictable capital flights. Differing from China’s stock of official
reserves which mostly came up by using the capital inflows from the ‘twin
surpluses’ in trade and capital account (the latter with more of FDI flows), offi-
cial reserves for India, largely subscribed by short term portfolio capital, was
open to sudden depletions –​as actually has happened –​with economic or pol-
itical shocks leading to capital flights.
The second aspect of the rising inflows of short-​term capital to India con-
cern it’s deployment in speculation which generated the climate of a typical
bubble economy with short term profit-​bookings at stock markets and with
speculation relating to commodities and real estates. The initial impact of the
financial boom as resulted had little expansionary effects on the real economy.
This has been obvious with the low employment quotient in the finance, real
estate and business services (FINREBS) sectors of the Indian economy (Bose
and Kumar 2018; Sen 2020). Capital gains earned on transactions in FINREBS
has been dealt leniently by tax legislation in India, which makes those earnings
on speculation doubly attractive. Income earned on those transactions include
those on financial assets (equities and derivatives), and short-​term capital gains
from transactions on commodities, property and even currency. China, in con-
trast, has so far continued to rely more on her industrial base which continue
to fetch export earnings.
 De-regulation of finance in China and India 269
That turnovers of financial assets are not necessarily linked to real activities
can also be inferred from the issues of initial primary offers16 which are much
smaller than the turnovers in the secondary stock markets.17 It is common
knowledge that while investments in the primary market go with expansions/​
creation of industrial plants, turnovers in the secondary market consist of the
multiple transactions, geared to profit-​taking, of shares originally sold in the
primary market. Transactions in the secondary markets for stocks are essentially
those guided by the short-​term prospects of profits or losses which rule in the
climate of uncertainty in de-​regulated markets.
The third implication, as can be discussed, of capital account liberalisation in
India, include the opening of opportunities especially for the footloose Foreign
Institutional Investors (FIIs), to transact in the stock markets.The result included
both the rise and the volatility of the FII inflows in Bombay’s secondary stock
markets, along with large transactions in derivative trading. Activities in the sec-
ondary markets for stocks have shown an uptrend over recent years, as is evident
in the rising indices of the Sensex and Nifty over the last few decades18 with
parallel increases in stock market capitalisation.
De-​ regulation, the related uncertainty and the risks generated in those
financial markets turns derivative instruments a lucrative business. Transactions
in futures, options and related instruments acquire a prominence in managing
the unknown prospects as are related to financial assets. Alongside developments
as above with derivatives, stock markets in India have been subject to wide
volatility, much related to the fluctuations in the flow of short-​term capital
led by foreign institutional investors. Contributing to vulnerability, those flows
rendered investments in financial assets relatively attractive as compared to those
for real activities in the Indian economy, thus setting the stage for financialisation
resting on a casino economy.
Derivative instruments including forwards and futures have also been much
used in commodity markets of India. Considered to transfer price risks –​from
market participants in spot markets to agents in future markets – such trading,
in general, is considered to reduce risks by minimising uncertainty with the
related transaction cost. Thus, future trading in commodity markets is expected
to allow risk sharing between farmers and the merchants who trade. But future
contracts can work for ‘price discovery’ only with access to full information
for all in the market and in the absence of big players in control of the market,
both non-​existent in most commodity markets including in India (Sen 2010).
Futures trading in commodities has been in practice over a long period
in India. A major reason behind this has been the volatility in commodity
prices across countries and over time. As in elsewhere, futures trading in India
has not been effective in reducing volatility of commodity prices. Nor have
farmers in India fetched higher prices in the market, which questions the
position taken in the last official committee on futures trading (Government
of India 2008; Sharma 2008). With the opening of markets, commodity prices
in India have also been driven by those in international markets, which are
270 Sunanda Sen
subject to future trading (Unctad 2009). As we argued earlier in a study on
India (Sen and Paul 2010), futures trading in commodity markets, especially
on food related items, has neither helped price discovery nor reduced price
volatility. Instead, we could explain the rise in spot prices for the major food
items by the rising future prices by using a granger causal link from future
to spot prices. The sequence as above disproves the basic idea that future
markets stabilise movements in spot prices. Finally, while there have been
limited attempts in India to control future trade in a few sensitive food items,
the rising prices for essential staples like rice, wheat, pulses, and oilseeds often
lead to an urgency of deliberating on the related issues of speculation in
commodity futures.(Clapp 2014) In short, instead of providing the much
acclaimed ‘market efficiency’, for growers as well as consumers, futures trading
in commodities seem to have provided new avenues of speculation to traders
as well as financiers –​in India and elsewhere.
Liberalisation of the financial sector in India has also influenced the pace of
movements in the exchange rate of the rupee. Despite the attempts at stabilising
sudden fluctuations in the rupee rate by using exchange rate management, the
currency has been subject to volatility, often with unpredictable flows of short-​
term capital. The impact as above, also gets reflected in stock market volatilities
as well as in movements of official reserves.
The fact thus remains that with financialisation under deregulated markets,
official moves to manage and regulate the pace of the related financial
variables have so far been ineffective in ensuring stability. The consequences,
as noted above, have not been favourable either in terms of growth in the real
economy.

Deregulated finance is no panacea for growth via efficient

markets
Little promise, if any, can thus be expected of financial de-​regulation –​especially
as a remedy for real stagnation and the systemic crises affecting an economy.
Despite having the large resource base, especially demographic, and the records
of high growth in the recent past which had surpassed the records for other
economies, neither China nor India have been able to achieve the benefits, as
claimed in neo-​classical economics, of financial liberalisation.
To explain why financial reforms do not succeed in generating invest-
ment decisions to ensure a climate of stable growth, one needs to mention
a few methodological aspects. Those include the limitations in the prevailing
investment practices which rely on an ergodic approach to probability. Those
investments include both new investments in the real sector, investments in
secondary stock exchanges and in derivative trade therein. As we pointed out
in an earlier paper (Sen 2019), investment decisions based on the estimated
probabilities of returns do not stand scrutiny –​not only on methodological
but also on empirical grounds –​as was evident with the global financial crisis
and the consequences thereafter. One may mention, in this context, the initial
 De-regulation of finance in China and India 271
disruptions in the sub-​prime market of 2008 in the United States and its links
to the mortgage based derivatives with asset-​based securitisations (Epstein and
Montecino 2016).
Investment strategies in India’s financial market, closely in line with the
practices common with global investors overseas, remain prone to the hazards
common in such applications. Critiques as follow remain crucial in understanding
the recurrence of the financial boom as well as the turbulences along with the
real stagnation witnessed in recent times.
The position, as above, relates to the experiences of China and India vis-​
à-​vis their de-​regulated finance. Despite the significant differences between
China and India of the evolution and the regulation of their respective
institutions, the two countries share the experiences of the de-​ railed
impact of reforms in achieving a stable growth process. We also point at the
impact of de-​regulated finance on the prevailing institutions and markets.
As we argue, by influencing business concerns and strategies, the chan-
ging institutions have exercised a major role in investment decisions, with a
large part driven away from the real economy in the direction of the high
risk-​high return in the financial sector. With increased uncertainty in the
de-​regulated markets, the related changes that possibly emerge, in essence,
chart out a path that can be identified as one of ‘fundamental uncertainty’,
with concentric or overlapping waves of activities in the market, tending
to reinforce each other. This goes with the fact, as mentioned above, that
with ‘creativity’ of actions by investors, new realities come up as ‘potential
surprises’ (Rosser 2015, p. 547).
Analysis provided in this chapter re-​opens the much-​needed debate on the
on-​going financial sector reforms in the two major emerging market econ-
omies of China and India. The findings as offered, though not designed as con-
clusive, may serve as a template in future studies on emerging markets.

Notes
1 Data can be found at: www.macrotrends.net/​2575/​us-​dollar-​yuan-​exchange-​rate-​
historical-​chart.
2 ‘China Must Avoid Lending to ‘Troubled’ Euro-​Asia Nations, Yu Yongding Says,’
Bloomberg News, September 13, 2011. www.bloomberg.com/​news/​2011-​09-​14/​
china-​must-​avoid-​loans-​to-​troubled-​nationsyongding.html.
3 http://​english.sse.com.cn.
4 Data can be found at: https://​tradingeconomics.com/​china/​stock-​market.
5 Data can be found at: www.safe.gov.cn/​en/​2017/​1228/​1373.html; http://​data.imf.
org/​regular.aspx?key=61468209.
6 Data can be found at: www.macrotrends.net/​2575/​us-​dollar-​yuan-​exchange-​rate-​
historical-​chart.
7 Data can be found at: www.bloomberg.com/​quote/​SHCOMP:IND.
8 Data can be found at: www.imf.org/​en/​Countries/​CHN#data.
9 Data can be found at: https://​data.worldbank.org/​indicator/​NY.GDP.MKTP.
KD.ZG?locations=CN.
272 Sunanda Sen
10 Data can be found at: https://​tradingeconomics.com/​china/​government-​debt-​
to-​gdp.
11 Data can be found at: www.safe.gov.cn/​en/​2017/​1228/​1373.html; http://​data.imf.
org/​regular.aspx?key=61468205.
12 Data can be found at: http://​data.imf.org/​regular.aspx?key=61468205.
13 Data can be found at: www.imf.org/​en/​Countries/​CHN#data and www.
imf.org/​external/​datamapper/​NGDP_​RPCH@WEO/​ C HN?zoom=CHN&
highlight=CHN.
14 Details of financial liberalisation and their impact in India has been discussed in my
article cited above in text.
15 See Reserve Bank of India (2018).
16 Data can be found at: https://​rbi.org.in/​Scripts/​bs_​viewcontent.aspx?Id=3619.
17 Data can be found at: www.nseindia.com/​products/​content/​equities/​slbs/​slbs_​
trades_​archives.htm.
18 Data can be found at: www.nseindia.com/​; https://​www.bseindia.com/​.

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Index
agent-​based models 138–​9, 144–​5
asset prices 3, 9, 43–​4, 70–​81, 90, 103–​5,
110–​12, 247
Balance of Payments Constrained
Growth models 5, 57, 71, 73, 79, 80,
87, 122, 158
Brazil 6, 8, 16, 22, 24, 47, 50–​1, 88, 93,
157, 159, 181, 232, 251
Bretton Woods 101, 106–​9, 129–​30, 137,
142, 146, 167, 241
cambist view 9, 14–​15, 19–​24
capital flows see financial flows
capital account, see financial account
capital controls, 7–​8, 23, 107, 126–​127,
129, 130–​1, 159, 226
carry trade 110, 152, 154, 175, 183, 193
chartist see trading strategy
Chick,V. 90–​3, 238
China 11, 16, 17, 111, 123, 126, 127, 129,
130–​131, 222–​3, 227, 258–​71
compensation thesis 9, 14–​20
commodity 31–​32, 52, 77, 173–​174, 221,
245, 267–​270; and prices 106, 108, 173,
181, 269
covered interest parity 19–​25; see also
interest rate parity and uncovered
interest rate parity
currency hierarchy 7–​8, 10–​11, 44, 46,
49, 58, 99, 116, 125–​7, 130, 142, 152,
230–​1, 241, 245–​6
currency internationalisation 129
current account 5, 7, 9, 24, 35, 44, 46–​8,
50, 59, 61–​2, 64, 70–​2, 74–​81, 108, 109,
131, 151–​2, 165, 198–​200, 205, 207,
225, 267
Davidson, P. 7, 43, 45, 53, 85–​7, 93–​94,
118, 237–​8, 241–​2, 247
deregulation 11, 225, 258–​9
development banks 11, 221–​2
development finance 217–​20, 222–​3,
226–​7
Dow, S. 7, 43, 45, 85–​6, 90–​4, 176
Dutch disease 11, 64, 75, 181–​2
employer of last resort 223, 225, 233
endogenous money 7, 9, 14, 24
exchange rate regime 3, 11, 16–​19,
24, 48, 58–​60, 62, 64, 67, 198, 225,
237, 241
exchange rate theory: advanced
economies see central economies;
emerging economies see
peripheral economies; chartists
and fundamentalists 38; central
economies 139–​42, 155; conventional
theories 150–​2, 159, 7; neoclassical,
see conventional theories; peripheral
economies 142–​6, 155–​6; see also
trading strategies
external debt 3, 51, 27, 60, 62, 64, 66,
198, 201–​5, 208–​11
external vulnerability 8–​9, 43, 44, 47,
50–​51, 65, 109, 157
financial account 19, 58, 192, 127, 131,
151–​2, 159, 198, 225–​6, 232, 261,
267–​9; and liberalisation 11, 74–​75,
108, 112, 129, 181, 192, 217–​218,
221, 226, 268–​9; and management
111, 221
financial asymmetry 144, 245–​6,
253
financial crisis 3–​5, 44–​5, 52–​3, 59,
61–​61, 65, 70, 74, 81, 84, 92, 108, 119,
131, 138, 121, 138, 173–​4, 177, 181,
194, 220, 232, 251, 264, 266; and Asian
59, 74, 94, 178, 194, 252; and global 4,
276 Index
14, 22, 49, 52, 109, 138, 230, 246,
251–​2, 258, 263–​, 264, 268, 270
Financial cycle 8, 44, 49, 76, 184,
187, 189
financial flows 3–​5, 7, 9–​10, 20, 43–​53,
70–​75, 77, 79–​81, 86, 94, 129, 152–​5,
159, 197–​8, 208, 245, 267
financial globalisation 4–​6, 101, 103, 230,
241, 245
financial instability hypothesis 7, 8, 44, 47,
71, 74, 94, 205–​8; see also Minsky
financialisation 49, 108, 111, 182, 266,
269, 270
fiscal policy 17, 67, 110, 193, 221, 234,
239, 241, 268
foreign direct investments (FDI) 4, 64,
75, 77, 107, 141, 182, 187, 259–​60,
264–​5, 267
foreign exchange reserves 14–​16, 18, 20,
24–​5, 46, 48, 50–​51, 60, 62, 64, 75, 112,
128, 167219, 227, 248, 251
fundamental uncertainty 5, 7, 43, 45, 86,
92, 94–​5, 104, 138, 141, 145, 146, 271
fundamentals 35, 44–​6, 49–​50, 62, 151,
155, 157, 188, 189, 245, 247
fundamentalist see trading strategy
global monetary system see international
monetary system
hyperglobalization see financial
globalization
International Monetary Fund (IMF) 8, 11,
52, 107–​10, 124, 128–​129, 131, 137–​8,
147, 171, 173, 251–​253, 262–​263
income distribution 5, 10, 60, 63,
70–​74, 76–​77, 123, 149, 158, 197–​8,
205, 207–​9
inflation 16, 18–​19, 32, 50, 59, 61, 63–​64,
72, 76, 106, 108, 117–​8, 121, 124,
129–​131, 141, 153, 159, 175–​6, 182–​3,
193–​4, 203–​4, 236, 265; and target 67,
103, 265–​8
inflationary pressure 18, 121, 218, 226
institutional investors 137, 263, 269
interest rate parity 6–​7, 9, 62, 120,
152, 175; and covered 19–​25; and
uncovered 32–​4
India 11, 258–​259, 267–​271
international monetary system (IMS) 5,
7–​8, 10–​11, 44, 46, 50, 129, 130–​1, 142,
155, 246
international monetary and financial
systems (IMFS) 137–​138, 146, 230–​1
Kalecki, M. 7–​10, 59–​60, 62, 66, 67, 71,
73–​4, 77, 79–​80, 96, 132, 158, 167–​9,
178–​179, 197–​9, 201–​2, 205–​6, 211
Keynes, J. M. 5, 38, 86, 96, 101–​6, 116,
132, 152, 168, 233
Keynes plan 105
liabilities 3, 4, 16, 22, 48–​53, 61, 89, 94–​6,
139, 144–​6, 149, 155–​7, 178, 183,
199–​200, 221, 233, 235–​6, 242,
246, 261
liquidity preference 7–​10, 17, 43–​7, 90–​2,
94, 96, 101, 103, 112, 139, 143–​145,
154, 205–​6, 241
liquidity premium 8, 10, 46, 49, 103–​5,
119–​22, 124–​26, 130–​131, 139,
142–​146
loanable funds theory 102–​3
Minsky, H. 44, 47, 50, 58, 94–​5, 137, 145,
155, 233, 241
Minskyan 9, 43–​45, 47–​8, 50–​2, 57, 60,
61–​62, 66–​67, 74, 75, 80, 145, 155, 198;
and Minskyan framework 43–​4, 47, 50
Modern Monetary Theory (MMT) 8, 11,
15, 230–​235, 237–​239, 242
monetary policy 8, 31, 33, 46, 93, 104–​5,
112, 125, 150, 155, 159, 176, 182, 193,
221, 232, 234, 240–​1, 246–​9, 265–​268
monetary production economy 90,
102–​3, 116–​19
monetary sovereignty 11, 24, 230–​1,
236–​7, 240–​1
Neokaleckian models 77, 158
optimum currency area theory 11,
112, 247
own rates analysis 8, 44, 45, 103–​5,
149, 153
peripheral economies see emerging
economies
policy space 10–​11, 101, 103, 107,
111–​12, 125, 225–​226, 231, 237, 241,
246–​8, 253, 268
Ponzi 47, 61–​2, 145, 206, 219, 262, 263
portfolio investors 141
portfolio allocation 51, 104, 139,
143–​146, 155

real exchange rate 10, 59, 61, 63–​4, 70–​6,
79–​80, 149, 151, 157, 185, 191, 199,
200–​2, 249
regional liquidity funds 249, 251–​4
regional monetary cooperation 11,
245–​50, 253–​4
stock-​flow consistent models 10, 16–​18,
81, 138
Index 277
structuralism/​structuralist 5, 7–​11, 56,
59, 61, 66, 71, 74, 75, 79, 80, 140,
193, 245
Thirlwall, A. P. 5, 7, 57, 71, 73, 80,
189
trading strategies: chartist 35, 38, 139–​40,
209; fundamentalist 35, 38, 51, 139–​41,
209; see also fundamentals