Financial repression

The term "financial repression" (FR) was introduced by McKinnon (1973) and Shaw (1973) in order to analyse State intervention in financial markets. For these authors, banking interest rate regulations (such as corridors limited by ceilings and floors for both loans and deposits), lending rates of development banks or public commercial banks below the "market" rate, reserve requirement ratios or capital controls are some examples of how governments and central banks "repress" free market forces and block the efficient adjustments of the loanable funds market. Of course, the monetization of fiscal deficits is also a type of FR, but because it is related to government expenditures, it has other implications. Let us therefore focus strictly on monetary and financial policies.

FR is largely supported by the Wicksellian approach: any persistent State intervention in order to determine the monetary interest rate below (above) the natural rate of interest (or the natural rate of unemployment in Friedman's approach) generates a cumulative inflationary (deflationary) process. Thus, a persistent expansionary financial and mone- tary policy will be neutral in "real" terms (that is, without impact on productive capacity). Consider a hypothetical developing country whose government (via central bank rediscounts to private banks or directly via commercial and development public banks) provides "subsidized" long-term loans at negative real interest rates to accommodate the credit demand of the emerging industrial sector (manufactured exports share is low). According to the FR literature, this example would reflect discretionary allocations of the (scarce) loanable funds that, in this analysis, promote inefficient "crony capitalism". While competitive sectors (commodity exporters, for example) are forced to take expen- sive credit, inefficient sectors are awarded with cheap credit. Hence, FR would reflect suboptimal and exogenous income redistribution by a sort of taxation that appears with increasing financial costs to competitive sectors.

At some point, FR supposes that "low" (or negative) real interest rates stimulate invest- ment in the short run. However, since this expansionary policy is artificially determined by autonomous forces, it is neutral in the long run. Curiously, although with strong dif- ferent foundations, the Keynesian "euthanasia of the rentier" and the Kaleckian "prin- ciple of increasing risk" also follow a similar short-run analysis, when they point out a negative relationship between the monetary interest rate and investment (Petri, 1993). Given the marginal efficiency of capital and in absence of uncertainty, the entrepreneur should invest when the differential between the profit rate and the interest rate is positive. Thus, as least in analytical terms, by increasing that differential the central bank could achieve full employment. Note that Keynes, in fact, relied more on fiscal rather than monetary policies, or more precisely on the "socialization of investment", to achieve full employment.

Therefore, one could conclude that FR is at least a consistent short-run analysis and the theoretical debate would be shifted to a political level between "repressor" govern- ments and "repressed" bankers and landowners. However, from a post-Keynesian or classical Keynesian approach, it is possible to visualize the theoretical problems of the FR analysis. On the one hand, FR assumes the existence of a "natural" rate of interest that equilibrates investment and saving decisions. A decreasing function of the interest rate is impossible, however, unless one accepts the marginalist principle of substitution (Garegnani, 1978, 1979). On the other hand, in a monetary economy it seems reason- able to assume that as a result of competition the profit and interest rates will tend, over a sufficiently long period of time, to move in step with one another. So, there are no motives to take the marginal efficiency of capital as given but as a residual (Pivetti, 1991).

Hence there are no "real" forces capable of being repressed by exogenous monetary and financial variables. The level of the interest rate is not a (real) objective and endog- enous outcome but a monetary phenomenon determined by a "convention". Thus, as the central bank is a special "agent" regulating financial markets and acting as lender of last resort, it can self-validate its own (conventional) policy rates of interest.

Moreover, since the quantity of money is demand determined and credit driven, the developmental strategies adopted in many countries to provide cheap long-term loans to the industrial sector have been impacting on distributive variables rather than deter- mining the investment schedule (which depends on expected demand, if we consider the principle of effective demand). For development banks, more important than their interest rates, is the amount of long-term credit that they provide as any private banks do. For that reason, in cases where stock markets are small and underdeveloped, only the State can accommodate the long-run credit demand. For example, it would be difficult to explain the Chinese economic growth without the existence of China's public banks or the interaction between public investment and financial policy.

For that reason, one could argue that another type of "financial repression" occurs, in fact, when the financial system is exclusively based on commercial banks, because banks cannot be financial agents of economic development under prudential leverage ratios.

See also:

Capital controls; Corridor and floor systems; Endogenous money; Lender of last resort; Natural rate of interest; Reserve requirements; Wicksell, Knut.