Economics, Banking and Finance in

Emerging MarketsA collection of my essays focusing

on unique challenges in emerging economies

By Dr Ola Brown, MBBS

Economics, Banking and Finance in Emerging Markets:

A collection of my essays focusing on unique challenges in emerging economies

by Dr Ola Brown, MBBS

Copyright @ 2020 Dr Ola Brown. All Rights Reserved

Cover and Section Illustrations by Caroline Chapple

Layout, Graph & Graphic Design by Iske Conradie

Proofreading by Sarina Cornthwaite

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DEDICATION I dedicate this book to my youngest sister Busola Orekunrin, who died because of what I thought was a broken, under-funded healthcare system.

Now, I realise that the root cause of her death was a complex interplay of fiscal, structural and other economic factors that continues to contribute to underinvestment in African healthcare systems.

Continue to rest in peace, my Angel forever.

I also dedicate this to my husband, David Brown. My best friend; my inspiration: I love you.

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FOREWORD

In recent times, literature in economics has been dominated by academics and policymakers. They typically have a somewhat peculiar way of thinking that can sometimes seem a bit abstract to casual readers, including entrepreneurs. It is what makes books by entrepreneurs all the more interesting, and not just to casual readers, but to economists as well. Ola’s book fits the bill as she explains basic concepts and ideas from the perspective of an entrepreneur trying to get things done in a developing country context.

She straddles various topics, from the micro issues affecting firms such as budgeting, savings, and unions, to more “big picture” issues like taxation, monetary policy, and banking; all written in plain English and with easy to follow diagrams that keep things interesting for the casual reader.

Following Ola’s journey, from a mild curiosity about economics to interest enough to start a Masters in Economics & Finance and write a book, has been a joy to behold. This collection of essays is essential reading for those who just want a casual understanding of some key topics in economics, and also worth it for economists who seek a different perspective.

Nonso Obikili, Ph.D

Development Coordination Officer, EconomistUnited Nations

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ABOUT THE AUTHOR

Dr Ola Brown is the founder of the Flying Doctors Healthcare Investment Group.

The Flying Doctors Healthcare Group invests and operates across the healthcare and wellness value chain in hospital/clinic construction & refurbishment, diagnostics and equipment, health facility management, pharmaceutical retail, drug manufacturing, air ambulance services & logistics, and consulting/healthcare technology.

Academic Background

Dr Ola studied Medicine and Surgery at the Hull York Medical School after which she worked in Acute Medicine in the UK. She was then awarded the Japanese MEXT scholarship which allowed her to further her studies in Tokyo, Japan. The fellowship focused on lab-based research with induced pluripotent stem cells. She is currently completing her Master’s degree in Finance and Economic Policy at the University of London.

Her post-graduate areas of study include Pre-Hospital Emergency care, Healthcare leadership and Healthcare delivery. She has a certificate in Economic Policymaking from IE Business School, Spain, and a certificate in Accounting for Decision Making from the University of Michigan in the United States.

Background in investment and finance

Along with two other directors, Dr Ola runs a leading early stage venture capital firm – Greentree Investment company, which provides growth capital to some of Africa’s most exciting tech start-ups.

Greentree Investment company has invested in start-ups in various sectors including FinTech, media, SaaS, Agri-tech, manufacturing, ecommerce, health tech and Edutech, making it one of West Africa’s leading venture capital firms with a total portfolio value of about $80m.

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Publications: Books & Articles

She has published four books: EMQ’s in Paediatrics, Pre-Hospital Care for Africa, Fixing Healthcare in Nigeria: a guide to public healthcare policy and Banking, and Finance & Economics in Emerging Markets: an essay collection.

She has also written articles published in the British Medical Journal, the Journal of Emergency Medical Services, the Niger Delta Medical Journal, the New York Times, and the Huffington Post.

Awards, Speaker Engagements and Appointments

She is an international speaker who has spoken at the TED global conference, the European Union, the Swiss Economic Forum, the UN, the World Bank, the World Economic Forum, the World Health Organisation, the Massachusetts Institute of Technology, Cambridge University, and the Aspen Ideas Festival. Dr Ola and her work have also been featured by CNN, the BBC, Forbes and Al-Jazeera.

She has received multiple awards and nominations. These include: The Mouldbreaker’s Award, the THIS Day Award, The Future Award as Entrepreneur of the Year, New Generation Leader for Africa, Ladybrille Personality of the Month, Silverbird Entrepreneurship Award, Nigerian Aviation Personality of the Year award, and Vanguard WOW Awards. She is also a TED fellow (see TEDx talk here), a Dangote Fellow, an Aspen Fellow, and has been honoured by the World Economic Forum as a Young Global Leader.

She is a member of the American College of Emergency Physicians, international editor of the Journal of Emergency Services and a LinkedIn Top Ten Global Healthcare Writer.

International Trade & Investment/Policy Roles

Dr. Ola Brown sits on the board of the Professional Women’s Network (Lagos Chapter). She leads the Health as A Business group at the Nigerian Economics Summit Group (NESG); a think tank. She also facilitates trade between Nigeria, the United Kingdom and the United States through her seats on the committee of the British Business Group (Lagos) and the Nigerian-American Chamber of Commerce (Healthcare Section) respectively.

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Foreword . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .About The Author . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Contents . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .How To Read This Book . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Section 1: Microeconomics – Explained . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Chapter 1 (Essay 1 – Microeconomics: traditional vs. behavioural perspectives) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Chapter 2 (Essay 2 – Impact of trade unions on wage structure and work conditions) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Section 2: Macroeconomics – Explained . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .Chapter 3 (Essay 1 – Capital budgeting techniques) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .Chapter 4 (Essay 2 – Monetary policy: the cost capital channel and the credit channel) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .Chapter 5 (Essay 3 – Firms’ investment decisions in emerging markets: cost of capital or quantity of finance available?) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .Chapter 6 (Essay 4 – Assessing fiscal sustainability in emerging economies vs. advanced economies) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Section 3: IMF & Economic Policy - Is The IMF Evil? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .Chapter 7 (Essay 1 – Mundell-Fleming and Polak Models, IMF’s approach to stabilisation) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .Chapter 8 (Essay 2 – Nature of crises in emerging markets and how the IMF handled them, the emerging market crisis of 1997 and the global financial crisis) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Section 4: Banking and Capital Markets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .Chapter 9 (Essay 1 – Viability of Nigeria’s bank oriented economy, role of financialisation in emerging markets, corporate governance) . . . . . . . . . . . . . . . . . . . . .Chapter 10 (Essay 2 – Role of deposit insurance/lender of last resort in the stability of financial systems, McKinnon and Pill Model) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

TABLE OF CONTENTS

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INTRODUCTION

For the past seven (7) years since I moved to Nigeria, I have been taking courses in finance, economics, accounting, and banking. After living in countries like the United Kingdom and Japan, I have been fascinated by the myriad of additional considerations that entrepreneurs and policymakers in emerging markets have to think about in comparison to policymakers and entrepreneurs in advanced countries.

My favourite quote from one of my recently published articles is: ‘In advanced countries, there is only one set of forces that can act on your business- the market forces. However, here in Nigeria, there are two sets of forces that can act on your business- the market forces and the evil forces.’

Emerging markets are much more complex and nuanced, which is why business people, entrepreneurs, and policymakers often find them more difficult to work in. I have been studying at the University of London for my Master’s degree in Finance and Economic Policy over the past year, and I’m surprised that even in a city as diverse as London, most of our reading material focuses on developed markets. We read about the US Federal Reserve, the European Central Bank, the Bank of England, and the Bank of Japan, as well as papers and textbooks mostly produced and written by Western scholars.

If it’s true that business and policy management in emerging markets is more nuanced and complex, then why is so much of economics based around just a few rich countries?

Most of what we see in books and the majority of journals and we read about economics are focused on advanced markets. However, most people in the world do not live in developed countries. It is called the G7 group for a reason- there are only seven countries considered to be extremely wealthy on a global basis, out of 195.

Working one’s way out of poverty is serious business. Still, it becomes even more complicated when we do not have enough academic focus on the strategies, policies, data and research that are needed to do this successfully.

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I have read so much about the Bank of England, the Federal Reserve, the European Central Bank, and even the Bank of Japan. I also want to read just as much about the Central Bank of Nigeria (CBN) in academic literature.

Thus, the purpose of this book is directed towards the dire need to focus on emerging markets. This is because there is very little information on emerging markets, despite their complexities.

From now until the completion of my Master’s degree, I have decided to focus my essays on emerging markets. Either I dwell solely on emerging markets, or I try to contextualise the topics within emerging markets. I hope that this book and similar books written by Nigerians, Kenyans, Bangladeshis and Indians will begin to refocus the world on the complexity of entrepreneurship and policy-making in emerging markets.

I spent a part of my childhood in London in a place called Hackney. At that time, Hackney wasn’t a nice place to live as it wasn’t one of the high-end areas. The bus 38 used to stop outside my house. This bus could take you from Hackney to Piccadilly Circus, one of the nicest parts of London. When I was young, I would get on that bus and ride to Piccadilly Circus. Whenever I was there, I’d begin to wonder why I couldn’t be one of those who lived in that kind of place. I found it difficult to understand why the people in my environment weren’t as affluent as the people just a bus ride away from us. As I moved, I grew up taking my A-levels at a poorly performing public college and thought about it more. How could I compete with the wealthier kids that went to private school when my reality was so different from theirs? When sharing my ideas- I called it the ’38 project’- I tried to get people thinking about questions like: “How do we make our lives better?” “How do we get out of Hackney into Piccadilly Circus?”

This is exactly what emerging markets like Nigeria, Kenya, Congo, and Ethiopia are currently facing. We are trying to play the same game as wealthier countries, but with fewer resources. We want the kind of progress that will get us out of the metaphorical Hackney into our own Piccadilly Circus. We want to have the kind of GDP that can support sustainable growth in our economies. We want to evolve. We want to have our own Google, Facebook, Uber, and Apple. We want to have our own unique forms of innovation.

This book seeks to refocus the world on emerging markets, which are home not only to many of the poorest people, but also to the largest number of people.

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In the global economy, only half a billion people earn above twenty thousand dollars ($20,000) a year. Two billion people earn between three and twenty thousand dollars ($3,000-$20,000) each year. However, the majority- four billion people- earn three thousand dollars ($3,000) or less per year. Most of these four billion people live in emerging markets.

In spite of these statistics, instead of focusing on the needs, wants and desires of the four billion people that make up most of the world’s population, the whole of economics seems to be focused on 0.5 billion people.

Therefore, the aim of this book, Economics, Banking & Finance in Emerging Markets, is to try to push the needs and desires of those four billion people forward and get us all thinking about how we can improve their lives as well.

Economics is so important because it has an impact on everything. A clear understanding of economics affects the way we vote, the way we spend, the type of business we start, and the kind of things we value. It also affects the way we substitute products for others.

I believe that a little bit of understanding of economics in emerging markets can make a big difference to the world’s poorest and most vulnerable people.

(Source: University of Michigan)

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This is particularly important to me because I live in Nigeria, which has more poor people than anywhere else in the world. Nigeria is home to over 80 million impoverished people.

Many people think India is a poor country. However, the truth is only 5.5% of India’s population is classified as extremely poor, compared to over 40% of Nigeria’s population.

Entrepreneurs in emerging markets face a number of challenges that would not be faced if they were in developed countries. These challenges are at least, in part, policy driven.

In ‘Africa Rise and Shine’, a book by one of the most successful bankers in Africa, Jim Ovia, he spoke about the condition of the road to his bank being one of the biggest challenges for him, as customers found it difficult to drive on the road without damaging their cars. So he ended up building a road! In advanced countries, it is almost impossible to hear that owners of American or German banks had to engage in road construction or their businesses, as these things have already existed.

Similarly, if you take a brief look at Aliko Dangote - the richest man in Africa - you will discover that he also encountered a similar problem with infrastructure. He has built and is continuing to build roads and helping to develop ports so that he can get cement materials to and from his factories.

The aim of this book, as reiterated earlier, is to refocus the world’s view of economics. It also seeks to ensure that the intricacies and idiosyncrasies of economic, financial, and business policy in emerging markets are projected. In addition, this book attempts to encourage people to think about innovative, policy-based, business-based, and investment-based solutions that can help lift this important, but often ignored demographic of four billion poor people out of poverty and a bit closer to prosperity.

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HOW TO READ THIS BOOK

This book is divided into four sections- Macroeconomics, Microeconomics, Banking & Capital markets, and the International Monetary Fund (IMF).

Although it is a collection of academic essays, each chapter has an explainer. These explainers are written from a layperson’s perspective.

Some of you reading this book might choose to read the explainers and look at the pretty pictures without going onto the essays... and that’s perfectly fine.

You can pick up the book and say, “You know what? I’m simply going to look at the table of contents, go through the explainers and look at the pretty pictures”.

By doing so, not only have you improved your knowledge of economics and finance, you have also improved your ability to understand the context in which you live, as well as your knowledge of how money, business and investments work in emerging markets- and that could be enough for you.

However, if you feel the need to go further, please note that there are two essays in each chapter. They are my academic work and some of them dig into certain aspects of economics as well as banking and finance. I only focused on a minute area of each, so if you feel the need to dig a little deeper into our world, you are more than welcome to do that. You may want to start with my economic video tutorials on YouTube ; - )

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SECTION 1

MICROECONOMICS- EXPLAINED

Microeconomics is the branch of economics that studies the economy of consumers, households and individual firms. Basically, Microeconomics looks at the day-to-day decisions of individuals and firms.

To start with, I want to give an illustration centred around Hushpuppi. For those who don’t know the story, Hushpuppi (real name: Ramon Olorunwa Abbas) is a flamboyant social media celebrity who was recently arrested by the FBI after investigations revealed that he was a high-profile internet fraudster.

Before his arrest, Hushpuppi was a spendthrift. If you take a look at his Instagram page, you will see how he spent his money extravagantly. He kept chartering private jets, and buying super-expensive cars like Bentley, Rolls Royce and many others. His clothes and shoes were from world-renowned brands like Louis Vuitton and Gucci. Despite the endless speculations that he financed his opulent lifestyle through fraudulent proceeds, he still audaciously posted all his luxurious spending on the internet. He continued to spend flamboyantly until the day of his arrest.

That is an extreme example of microeconomic decisions- decisions made by an individual that seem bizarre and strange, but still happen.

That’s exactly what microeconomics is all about. It studies why we act the way we act, why we think the way we think, and why we spend the way we spend. It also examines the impact of day-to-day decisions made by households and firms.

One of the most interesting things about microeconomics is the relationship between saving and spending. Microeconomics is concerned about the day-to-day spending- how we spend versus how we save money.

In countries like Japan and Germany, there is a high level of savings. That helps those countries because a high level of savings means that banks have a lot of deposits to invest

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in businesses. However, in a situation where a country has a low level of savings, such as in Nigeria, banks have a relatively low amount of money, which makes it difficult for them to invest in businesses.

Many people in this part of the world spend more than save, and this affects us at a much higher level. Countries with a high marginal propensity to save have much more money in their banks while countries with a higher marginal propensity to consume have less money in their banks.

Saving is something that requires a great deal of discipline and the government can encourage us to do certain things to establish this habit. Occasionally, the government can come up with policies that will allow us to change our behaviour and try to push us towards a specific behaviour, however, several economists say that the government is not supposed to do that.

This raises the question of whether or not the government should implement such policies.

According to neoclassical economists, human beings act naturally. They simply do what will benefit them, and only obey their selfish interests. However, over the years, we have discovered that if you actually study human behaviour, you will see that the government can do a few things to nudge us in the direction they want us to go.

Several questions have risen about this lately. One of them is that is it right for the government to compulsively deduct money from every civil servant’s paycheck and put it in a savings account they are unable to access for five years?

I believe it’s a good thing, because it gives people money on a rainy day. But the question is- is it the place of the government to do?

In my last book, Fixing Health Care in Nigeria, I suggested that if we wanted to fix health care in Nigeria, the federal government should make a deal with all providers of telecommunications services and deduct five thousand naira (₦ 5,000) from every citizen’s phone credit for a year.

However, there was a huge uproar. Some people were of the opinion that the government should not have that much power.

I said to most of them: ‘People can’t pay for their health care, so why don’t we just take it and put it in a fund so that when they have an accident or an emergency, it’s easy for them to be treated, without having to pay?’ Even with this argument, many people still said No.

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This is one of the key issues I’ve addressed in the essay section. I’ve provided answers to thought-provoking questions such as:

What is the role of the government?

Why do people do what they do?

Do people serve their selfish interests alone, or are they easier to influence than we think?

Let’s assume that people are easier to influence than we think;

Should the government actually do the influence?

Do they have the right?

Should they have the power to influence that kind of thing?

Another issue I’m going to discuss is the environment. It is not in any of the essays, but it’s crucial because environmental economics is part of microeconomics.

Nigeria has suffered some devastating oil spills in the Niger Delta. We generate a lot of wealth from that region as a nation, but at huge costs. Some fishing communities in the Niger Delta can no longer fish because the fish have died as a result of oil spills.

When a company produces something and an unwanted by-product or harmful effect occurs as a result of that production, it is called a negative externality. Nigeria, for example, has suffered greatly from these negative externalities, especially in the oil-producing region.

Since emerging markets like Nigeria desperately need money from natural resources like oil, we haven’t bothered to put policies to preserve our environment in place. As a result, we have had a lot of environmental degradation.

As I go further in this explainer, I would like to talk about corruption- one of Nigeria’s biggest problems.

Research from the Clayton Christensen Institute explains that as people become richer and the economy develops, corruption naturally decreases. According to him, this has been observed in many countries around the world.

There has been much work on market structures and how they are formed in microeconomics. I’m not going to talk about it in the essays, but I think it’s imperative to mention it when giving an overview of microeconomics.

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Market structures are a crucial part of microeconomics, and the monopoly structure is a market where there is only one influential player with a large market share. They are called price makers because they dictate prices.

In this situation, no matter how expensive a product is, it is almost impossible to substitute.

In emerging markets, corruption tends to bring about some of these monopolies that impoverish people because they provide essential goods at extremely high prices, which has a negative impact on economic development.

Identifying these monopolies, legislating them, and making policies around the formation of monopolies is definitely something that we should look into.

It would not be fair to conclude this explainer without highlighting employment issues. The issue of unemployment would normally be discussed in the macroeconomics explainer. In this microeconomics explainer, I will be talking about employment, although I will be focusing more on why people decide to work as opposed to just resting at home, and what makes them more likely to work.

I mentioned the role of labour unions in my essay on microeconomics. I explained that one of the things that happen in emerging economies is being plagued by low wages. Unions can be a way to raise wages because an average union worker earns more than a non-union worker (references available in the essay).

However, unions may be counterproductive to profitability when they are too strong.

If you look at the trends in union membership, you will see that union membership around the world has decreased significantly in the last ten (10) to twenty (20) years. This is probably due to the impact these unions have on the profitability of companies.

I’m going to talk more about unions in the essay section, however, I want you to understand that while there are good sides to labour unions in terms of actually raising average workers’ wages, they can also be detrimental.

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Thank you for joining me in exploring the wonderful world of microeconomics. At the end, I’m sure you will know why you have a friend who gets her salary and spends it all right away, and why another one tries to invest as much as she can in land, property, shares, and stocks. You will also know why that other friend of yours likes to keep every penny she has in her savings account.

As I explained earlier, microeconomics simply studies why individuals, as well as firms, do what they do.

Thank you so much for reading.

I hope you enjoy the essay!

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Chapter 1

MicroeconomicsStandard neo-classical theory argues that saving and spending behaviour is the product of rational financial planning.

Discuss both traditional and behavioural views of such personal financial decision making, highlighting the policy proposals arising from these approaches. Having high rates of saving is important for financial development in countries like Nigeria. But currently, Nigerians save less than many of our African peers. Can government policy interventions to change consumer behaviour ever be legitimised?

IntroductionThis paper will start by examining both the traditional and behavioural views of personal financial decision making. It will go on to explore how personal financial decisions can affect the economy and whether it is therefore the place of government to design policy to attempt to change consumer behaviour.

Microeconomics is concerned with the behaviour of individuals and firms. This behaviour can be studied from different perspectives among which are the traditional perspectives and the behavioural perspective.

Both are discussed on the next page.

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Figure 1

The traditional view

The origins of the traditional view can be found in the works of philosophers like Aristotle. Aristotle ‘based economics on needs, analyzed their nature and proceeded to isolate the economic goods by which economic needs are satisfied’ (Koumparoulis, 2011).

Views from Aristotle and philosophers like him at the time are called the pre-classical theories.

The pre-classical theory was then superseded by the classical theories. Classical theory was popularised by the world’s most influential economist, Adam Smith. Adam Smith referred to the ‘invisible hand of the market’, explaining that because humans act rationally, there is no need for any central price planning mechanism. This is because the market moves automatically to produce more of what people want. Smith was an ardent proponent of a laissez faire style of governance where demand and supply reigned supreme. He argued that only the free market could bring society into natural harmony (Williams, 1976). To him, government central planning was unnatural and unnecessary (West, 1969).

Introducing ‘Homo Economicus’…

This view dominated the fields of economics, political science, sociology and philosophy for over a century (Anderson, 2000).

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The term ‘homo economicus’ refers to the archetypal classical description of the way human beings act and make decisions.

According to Doucouliagos (1994), Homo Economicus has three main characteristics:

1. He/She acts to maximise personal benefit or pleasure, maximising behaviour.

2. He/She makes every decision rationally and has the cognitive ability to do so.

3. He/She acts in his/her own self-interest – individualistic behaviour.

Smith argues that the main reason for anyone to engage in exchange is ‘self-love’. Homo economicus is fundamentally self-interested. The quote below from his book ‘The Theory of moral sentiments’ exemplifies this notion:

“Every man is no doubt by nature, first and principally recommended to his own care and as he is fitter to take care of himself than any other person, it is fit and right that it should be so. Every man, therefore, is much more deeply interested in whatever immediately concern himself, than in what concerns any other man.’’

(Smith, 1759)

The central tenet of the subsequent neoclassical theory is similarly built around ‘rational choice theory’. This is the idea that human beings act rationally to maximise utility. However, compared to classical theory, neoclassical theory highlights the roles of marginalism and perception.

Marginalism highlights the pleasure/utility experienced from the consumption of one extra unit of a particular product/service. Classical theory also focuses on the idea that price is determined by the costs required to produce a particular good or service. However, neoclassical theory recognises the role of consumer perception in determining the price or demand for goods and services.

Neoclassical theory would also assume that saving and borrowing decisions are largely rational.

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The behavioural viewThe behavioural view challenged the notion of the completely rational homo economicus which previously was the dominant perspective on human behaviour in economics. Justin Fox refers to the emergence of the behavioural view in economics as ‘irrationality’s revenge’ in his Harvard Business Review article (Fox, 2015).

Homo economicus has evolved…

After over a century of believing that human beings are rational, many economists began to find out that in many cases, this was not the case. However, Kahneman and Tversky (1979) were the most influential voices in this movement, explaining how psychological phenomena such as bias, context, framing, and heuristics affect decision-making. When these insights from psychology are taken into consideration, it produces a more realistic picture of what people in the real world actually do (Kahneman, 1979).

Borrowing and saving: Neoclassical vs behavioural perspective

Whilst the neoclassical theory would assume that saving and borrowing decisions are largely rational and based on self- interest, the behavioural theory takes a more nuanced approach.

Why do people save?

Savings move income from the present to the future whilst borrowing moves income from the future to the present.

People save because intemporal income (income distribution over different periods of life) doesn’t match consumption needs. So, during early school years, most children in developed countries don’t work but need to consume food, clothing and other expenses such as school fees. When people reach working age, income rises but declines as people move into retirement. However, retirement expenses may increase due to medical bills.

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There are two classical models that explain how people save:

1. The life-cycle model

2. Permanent income model.

The life-cycle model describes how a person’s savings habits change through different periods of their lives. Dissaving whilst young and dependent on parents, then saving during peak earnings at working age, and then dissaving again through retirement.

The permanent income model, however, postulates that people will spend in anticipation of average level of long term expected income.

Figure 2 [Source: Understanding Financial Accounts (van de Ven &

Fano, 2017)].

Figure 3 (Source: Economics Discussion.net1).

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Consumers must decide how much they want to spend in the present and how much they want to save for the future; this is depicted by the intertemporal budget line. This classical model highlights the role of interest rates in both saving and borrowing decisions.

Browning, 1996 acknowledges these models, but also explores the role of behavioural issues that affect how people save and borrow. Some people have more self-control than others. Some people also possess computational ability—the ability to accurately calculate how much to save or borrow to meet their immediate and future needs (Browning, 1996).

The classical models also don’t take into consideration the effect of economic cycle on saving and borrowing behaviour. People borrow more during economic boom periods and save more during down recessions (Nofsinger, 2010).

Furthermore, individuals may engage in precautionary saving if they feel they might experience a drop in income. So they save when the permanent income model predicts they would borrow. The neoclassical model similarly doesn’t take into consideration those extreme low-income earners that have no access to credit markets in the first place (Jones, 2009).

The effect of personal financial decisions for government‘The financial stability of an economy is significantly influenced by the evolution of household financial behavior.’ (Kłopocka, 2017)

Kauffman (1991) explains how a decline in household savings can affect the level of funds needed for investment. Furthermore, Nofsinger explains how household behaviour can actually exacerbate the entire boom/bust economic cycle. This is because during an economic boom, households are influenced by extrapolation bias and groupthink. Extrapolation bias is the tendency to take a recent experience and believe that same pattern will continue forever. Groupthink is a situation where an entire group of people starts thinking in the same way, not questioning the weaknesses, leading to a dysfunctional outcome (Nofsinger, 2010).

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So since personal financial decisions have such a significant effect on the wider economy, should the government try to influence behaviour through policy?

The role of government policy in changing consumer behaviourAs mentioned earlier, Adam Smith argues that the invisible hand of the market allocates resources in the most effective manner. This therefore negates the need for government intervention. However, Mankiw (2009) argues that the hand of the market is indeed powerful, but by no means all knowing.

Limitations to the hand of the market come in the form of externalities. Externalities are positive or negative consequences of economic output that influences a bystander, who neither pays nor receives any compensation for that effect. An example of a negative externality is pollution. Some industries produce a lot of pollution that affects people in many communities.

Some governments use policy to try to reduce pollution levels and protect citizens from its harmful effects. Economists have argued that private entities are capable of bargaining amongst themselves to counter externalities; this is known as the Coase Theorem, named after the economist who first put this idea forward. Although it sounds logical, it often fails in practice, making a case for some form of government intervention (Mankiw, 2009).

So we have established that in cases like pollution that has widespread effects on our environment, there may be a plausible role for government intervention. In a sense there are already many policy interventions that affect behaviour that are widely accepted. For example, taxation, subsidies, provision of public goods.

In the next section, we consider how and if at all the government should intervene in far more seemingly intrusive matters like our personal finances.

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Should government get involved in how we spend vs when we save?The Boston Federal Reserve published a paper in 2007 (Benton et al., 2007). It studied low income earners and point out how they are disproportionately affected by under-saving and over-borrowing.

They disagree with the classical perspective that humans act rationally when it comes to financial decisions. They also point out how vulnerable low-income earners are when they do not save due to the possibilities of emergencies. The paper also talks about how damaging low credit scores can be for low income earners that borrow unsustainably and are unable to pay back their loans.

At the centre of their argument is the concept of self-control and how a lack of self-control, closely related to procrastination, is one of the factors responsible for over-borrowing and under-saving.

Four policy suggestions are put forward to help. These include:

1. Commitment devices; vehicles that charge high penalties for withdrawal of saved funds

2. Front loaded devices; instruments that deduct savings from wages at source

3. Default saving clubs that participants must deliberately opt out of

4. Promoting bank account products for the unbanked

(Benton et al., 2007)

However, many economists disagree fundamentally with the idea of libertarian paternalism. This is the idea that it’s possible to deliberately channel people to make decisions which are ‘better’ for them whilst leaving them with freedom of choice.

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Although some Economists call the term ‘Libertarian paternalism’ an oxymoron, arguing that the freedom of choice and the steering of one’s choice cannot coexist, there is a great deal of support for this idea as well, simply because so many economists now agree that ‘individuals are often not the best judges of their own welfare’ (Schlag, 2003).

Therefore, some method of guiding people towards the correct choices for them without coercion is inevitable (Sunstein & Thaler, 2003).

ConclusionThe history of economic thought is fascinating. From the early work of Aristotle in 384 BC, the question of how and why people make choices and how to predict them has puzzled economists, philosophers and psychologists.

The pre-classical, classical and neoclassical theories view human beings as rational decision makers. However, insights from the field of psychology reveal how a whole host of factors such as framing, anchoring, bias, and heuristics affect how we make decisions. Humans are rarely completely rational.

Libertarian paternalism has been suggested as a solution to help people navigate the increasingly complex array of savings/investment and loan instruments as well as help people with low levels of self-control make better decisions (Carlin, 2013).

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References• Anderson, E. (2000). Beyond Homo Economicus: New Developments in Theories of Social Norms.

Philosophy & Public Affairs, 29(2), 170–200.

• Benton, M.; Meier, S.; Sprenger, C. (2007). Overborrowing and Undersaving: Lessons and Policy Implications from Research in Behavioral Economics, Federal Reserve Bank of Boston, Community Development Discussion papers, No. 2007-4.

• Browning, M.; Annamaria, L. (1996). Household Saving: Micro Theories and Micro Facts. Open Dartmouth: Faculty Open Access Articles. 2429. https://digitalcommons.dartmouth.edu/facoa/2429

• Carlin, B. I.; Gervais, S.; Manso, G. (2013). Libertarian Paternalism, Information Production, and Financial Decision Making. The Review of Financial Studies, 26(9), 2204–2228.

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• Koumparoulis, D. M. (2011). Aristotle’s Economic Thought, Educational Research, 2(13) pp. 1831-1838.

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Chapter 2

How are wages determined and what role do trade unions play in improving conditions for workers particularly in emerging markets?

Currently, the world is experiencing the first truly global pandemic – an outbreak of the novel coronavirus, COVID-19. This outbreak, along with the chaos and economic strain that has come with it, has left many people asking important questions. Such questions include: Why do we pay footballers and movie stars so much more money than virologists and doctors?

This paper will examine some of the factors that affect the amount people earn and why people work in the first place. Membership of a trade union is one factor that affects how much people earn. Other factors will also be examined before taking a deep dive into the effects of trade unions and trends in trade union membership across the world.

The focus of this paper will be on neoclassical labour theory and the impact of trade unions. Other factors will be touched on briefly towards the end.

1. Demand and Supply

The neoclassical approach to labour views a firm’s decision to hire as a decision based on demand, supply and productivity. It sees workers and firms as completely rational. Firms seek to make the most profit whilst workers seek to maximise utility.

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Figure 1

Figure 1, above, shows the balance between the neoclassical view of the goals of workers and firms.

Neoclassical theory of labour views the labour market as a ‘place’ where buyers and sellers of labour meet to exchange hours of labour for wages, and based on demand and supply, they reach agreement/equilibrium (Fleetwood, 2014).

Each factor of production earns the value of its marginal contribution to the production of goods/services at equilibrium. Neoclassical theory is widely accepted amongst economists as a starting point when trying to understand why people are paid different wages across industries and professions (Mankiw, 2009).

Neoclassical economics views unemployment effectively as a ‘’choice’’. Unemployment is seen as voluntary leisure, chosen over employment when a worker’s reservation wage is not met (Spencer, 2006).

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Figure 3 (Prasch, 2000)

The graph above (Figure 2) shows the classical neoclassical representation of the labour market.

However, the curve can be backward bending (as shown below) when a certain level of income is reached as people that are earning large amounts of money at some point stop working so hard. They typically spend more time doing leisure activities after a certain point. In technical languages, the substitution effect becomes more significant than the income effect.

2. Impact of Trade Unions

This section will explore the impact and influence of trade unions as well as some key features/trends.

Figure 2 (Jean, 2014)

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It’s often assumed that employers have the power to determine wages, but trade unions disrupt this balance by using collective bargaining to negotiate wages on behalf of their members. But there are also less obvious ways that trade unions can influence wages.

Trade unions effect on wages

There are several indirect ways that trade unions can affect wages. Firstly, unions give workers ‘voice’ regarding tenure, training and human development, etc. (Benson, 2009). The threat of unionisation can raise wages in the non-union sector. But also, job losses in the union sector can result in excess labour supply to the non-unionised sector which depresses wages (Bryson, 2014).

The main way trade unions affect wages is directly through their bargaining activities. This can give an estimated wage premium of about 15% according to some research, although there has not been consensus on this (DeFina, 1983 Bargaining activities include strikes (discussed in this section).

Figure 4

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Unions cause wages to rise partly because unionised workers can withdraw their labour en masse, causing massive disruptions to production if their demands are not met. This is called a strike. However, over the past few decades, the number of union-backed strikes and their effectiveness as regards raising wages have changed, so it’s worth spending a little time below to understand the trends.

a) Strikes

Figure 5 shows the decline in number of strikes over the past few decades (Rosenfield, 2014)

Strikes, previously unions most powerful weapon, has declined gradually over the past few decades, despite a massive growth in the labour force. This has happened despite research that shows that unionised workers that strike obtain higher wages than unionised workers that don’t. Some argue that the decline in strike action is because workers and management understand each other better than they did a few generations ago.

Figure 5

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However, there is also evidence that strikes simply don’t accomplish what they did in the past. In the 70s, employers began to ‘strike back’ by hiring permanent replacements and moving operations to non-unionised facilities, making union leaders think more carefully about potential repercussions before using this tool (Rosenfield, 2014).

b) Effect on employment/skills

However, it has been found that unions may cause few people to be employed and cause wages for non-unionised workers to fall because the unions’ demands for higher wages often cause fewer people to be employed as firms tend to employ more people when wages are lower. On the other hand, models show that the stronger the union is, the higher the mark-up over the reservation wage (the lowest salary/wage that an employee would be willing to take for any particular type of job) and the lower the resulting wage level (Tito, 2013). Therefore, unions face a trade-off between increased wages for their members and low unemployment (Creedy, 1989).

Oswald (1982) points out that where unions operated, there is a loss of efficiency because the marginal product of labour for a union worker, assuming the labour market is competitive, differs from that of a non-union worker.

He also points out that whilst the union workers are better off, the non-union workers are poorer, and the firm may or may not be negatively affected (Oswald, 1982). But this wage differential between union and non-union workers is highly dependent on skills of the worker. The more skilled the worker is, the less significant the overall difference in wages is between union and non-union workers (Hirsch, 1998).

This issue has led to internal disputes within unions. Many unions base their arguments around wage differential between highly skilled and low skilled workers, pursuing an egalitarian ideal. This potentially diminishes the premium put on additional skills and may alienate highly skilled workers, causing them to leave the union completely. For example, a famous case in Italy called the ‘marcia dei 40,000’ when middle class/highly skilled workers went on strike against the unions (Tito, 2013).

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c) Income inequality

Most countries strive for higher levels of income equality. A paper by the National Institute for Economic and Social Research explains how income inequality would almost certainly be higher without the bargaining power of unions. Whilst neoclassical theory emphasizes market-driven wages determined by the forces of demand and supply, unions enable workers to extract an above-market premium for their labour.

The influence of unions has decreased over time as indicated in Fig 4; this has led to increased income inequality which is detrimental to workers (Bryson, 2014).

d) Unions as monopolies

Unions do exert some form of monopoly power due to their ‘strike threat system’ described above. They exert some control over the supply of labour; this generates bargaining power which is used to resist downward pressure on wages (Bryson, 2014).

Their actions change both working conditions and wages; this is an evidence of monopoly power, but ‘without coercion’, according to Burkitt (1977). Also, the power that unions wield never becomes all-encompassing like producer monopolies, even when their polices are successful.

Burkitt (1977) argues that “trade unions counter pre-existing market imperfections and eliminate the ‘distortions’ of unorganised labour markets.”

However, Lindbolm (1958) makes an interesting counter-argument. He states that strike action is a form of coercion and that unions can have the same levels of control over the price of labour that private enterprises aren’t allowed over the cost of their products (Lindbolm, 1958).

e) Health and Safety

Unions were at the forefront of pushing for better welfare and health/safety at work. This is particularly relevant in the mining industry where it was worker unions that articulated the link between brown lung disease (a form of respiratory

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illness) and mining. They went on to bargain for better working conditions that have benefited unionised and non-unionised workers alike (Alejandro, 2012).

f) Political support for unions

In the face of globalisation and decreased political support, the membership and impact of trade unions have decreased (see figure 6 below). Laws have been enacted to decrease the power of trade unions. A large group of air traffic control workers were sacked in the United States under Ronald Reagan when they illegally went on strike (Goodwin, 2019).

g) The future of unions

Unions must evolve to take on non-bargaining with greater levels of collaboration with firms. It is realised that a union cannot offer its members any jobs if the firm is bankrupt (Ratnam, 2007). Ashenfelter and Johnson (1969) support this notion by pointing out the effect of asymmetrical information. They argue that there is often asymmetrical information on the part of the unions, that is, the unions may not be able to accurately determine the financial health of the firm (Ashenfelter, 1969).

Figure 6

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Figure 6, on the previous page, shows how union membership has declined over the past few decades (Tito, 2013).

This section has highlighted the fact that unions are powerful institutions that can help workers to obtain higher wages through the power of collective bargaining. But it has also pointed out how unions may decrease the actual number of employment opportunities available, disadvantaging non-union workers. The role of skills was also noted; how highly skilled workers don’t need unions as much as lower skilled workers to negotiate higher wages.

Additionally, the reasons why trade union membership is declining, such as globalisation, politics/law/policy and the rise of the service industry, were examined. Unions are also ageing rapidly and finding it hard to attract and recruit younger members (Tito, 2013). Brief comments on the possible future of trade unions – with an expanded scope and collaborative approach – were also made.

To conclude, it’s important to point out just how revolutionary trade unions have been for mainstream policy. Many of the benefits and innovations that have made workplaces easier to navigate, such as flexitime, sick leave and childcare, were born out of trade unions. These are commonplace now but were once very radical. This is a good example of how the hard work of trade unions over decades has ultimately left society better off (Goodwin, 2019).

ConclusionThere are many factors that affect wages and employment that have been analysed in this paper.

It has been shown that the neoclassical approach may have some merit and that has been considered in depth in this paper. Additionally, it has been revealed that demand and supply do affect how much workers are paid in wages and many human beings make trade-offs between the income effect and the substitution effect when considering their work options.

The type of market a worker operates in may also affect wages. In a perfectly competitive market, the labour curve is perfectly inelastic. This means that any attempt to lower wages will result in workers leaving the firm as the market wage is determined by factors beyond the control of the employer.

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However, in a monopsony, the employer has a lot of control over wages, so therefore, wages can fluctuate and the workers have little power and no alternatives (Manning, 2003).

Neoclassical labour theory teaches us how human beings are rational and the only reason why workers work is to earn a wage to maximise their utility. But there is alternative evidence that this simply isn’t true. A job to many people isn’t just about the money. For many, its central to their identity. Studies by Kaplan (1987) and more recently by Arvey (1996) show that lottery winners don’t typically quit their jobs. Hirschfield (Hirschfeld, 2000) considers this concept of work centrality in his book. He refers to people with a high level of work centrality as “people who consider work as a central life interest, have a strong identification with work in the sense that they believe the work role to be an important and central part of their lives.”

This contrasts directly with the neoclassical approach to the labour market.

Minimum wage legislation, the rise of the gig economy, technology (such as artificial intelligence and robotics) are already affecting wages and will continue to in the future. It is these rapid changes that have fuelled debates around the feasibility of providing everyone with a universal basic income (Downes, 2018). Goodwin (2019) also points out how discrimination based on gender, ethnicity and sexual orientation can also affect wages.

This paper focused on the role of unions, how they influence wages, employment, and how some may view them as monopolies. Although the influence of unions may have declined over the years, their legacy lives on in the form of benefits such as childcare benefits and health that have created happier, safer, more thoughtful workplaces for us all.

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SECTION 2

MACROECONOMICS- EXPLAINED

Macroeconomics, in a broad sense, is the study of what is happening in the economy. It focuses on the aggregate changes in the economy, such as unemployment, growth rate, national income, gross domestic product (GDP), and inflation. In economics, we use the word ‘aggregate’. Although it confuses people, aggregate means total, i.e. an overall picture of what is going on in the economy.

Although macroeconomics studies the economy as a whole, it mainly focuses on the decisions made by governments in two specific areas- tax & expenditure decisions (fiscal policy) and the decisions concerning the control of the banking sector (monetary policy).

Macroeconomics also includes issues related to structural and exchange rate policy. However, in this explainer, I will pay the most attention to fiscal and monetary policies.

The major problem with fiscal policy- a government’s decisions about taxation and expenditure- is poverty.

It is difficult to create an effective tax system in a country like Nigeria. Sixty per cent (60%) of the population is in the informal economy, which means that they do not have a registered business. They also do not have a valid bank account or accurate records of their businesses.

In a complicated situation like this, how would you even know how much they earn? How do you intend to tax people who keep money under their pillows or inside (kolo)? These factors make taxation in Nigeria and other emerging markets complicated.

Taxation is a major source of revenue for governments in advanced countries. Most of the money the government spends comes from taxes. Luckily, here in Nigeria, the government charges a form of tax on the oil sector, which is where we get our oil revenues. However, this is nowhere near the amount of money required to cater for the needs of nearly 200 million people.

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What about countries that do not have as many natural resources like we do? The answer is, most of the time, their government(s) have to rely on their citizens to provide them with money. Obviously, the government needs to spend money on essential things, such as health care, education, roads, security, and so on.

One of the problems in emerging markets is that a significant percentage of the population is too poor to be taxed in most cases. It is even problematic to try to identify them. As a result, the government cannot do much because it does not have enough financial capacity.

In regards to fiscal policy in emerging markets, one of the primary issues to be addressed is innovatively finding out how to identify people. To begin with, the government should help people formalise their businesses and in conjunction with that, institute growth-friendly policies so that they will eventually become rich enough to be able to pay significant taxes.

In Nigeria, there are areas where people spend ninety-five per cent (95%) of their income on food. It is hard to tax people that are starving.

If you take a close look at Nigeria’s poverty rate, you will find that over 40% of the entire population is living in extreme poverty. If over 40% of the population is extremely poor, how do you plan to tax them? Let us assume you devise a strategy; how do you get the money from them? Most of them do not have bank accounts, so do you take the money they owe in cash?

Fiscal policy revolves around the government getting money from citizens and businesses. If the government finds it difficult to get money from the people, it automatically becomes difficult for such a government to spend money on the economy.

It is, however, incomplete to explain fiscal policy without mentioning budgeting.

Have you ever wondered why international banks and financial markets believe in advanced countries enabling them to lend at low rates? It’s not just because of their size or system of government. Rather, this belief is due to the fact that these countries are constantly committed to growth. They keep innovating. They keep building profitable companies. As a result, these banks and financial markets feel comfortable when lending them money, knowing full well that they have the ability and capacity to pay back.

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In emerging markets, it is much more difficult for these international banks and financial markets to lend, and the reason for this is clear. These financial entities do not have as much confidence in emerging markets compared to advanced countries. Since they do not trust us (emerging markets), they charge us high-interest rates, making us get into debt quickly. Once we start piling on debt, other financial entities will no longer believe in our ability to pay back. This makes it even more difficult for us to fund our budget as advanced countries do.

Regarding monetary policy, it simply has to do with the way the banking system is controlled.In advanced countries, the central bank has subtle ways of controlling the way people spend.When the economy is growing too fast (‘overheating’) and everything seems to be out of control, the central bank knows how to rein it in. They can actually decide that they want people to stop spending much money for the time being. They do this efficiently by using a few techniques to keep banks from loaning money to businesses. As soon as they do that successfully, the economy dries up a little bit and stops overheating.

In a situation where the economy is growing slowly- that is, businesses are not doing well- the central bank has a few tips and tricks to speed things up. They can give banks large amounts of money and encourage them to lend more, thereby boosting the economy. This means that central banks have a relatively good amount of control over the economy in advanced countries. When the economy is growing too fast, they can rein it in; when it is going too slowly, they can speed it up.

However, in emerging markets such as Nigeria, where a large number of people do not have bank accounts, thousands of these tips and tricks by the central bank just don’t work as well. Hence, the central bank resorts to other measures when trying to control the economy.

Another critical point to note is the concept of Gross Domestic Product (GDP).

GDP has to do with the total amount of money generated in a country, usually within a year. The equation for calculating GDP is: private consumption + gross investment + government investment + government spending + (exports- imports).

In advanced countries, if you divide their GDP by the total number of people, you will find that each person has a lot of money- that is called GDP per capita.

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Take a brief look at rich countries like Luxembourg- if you divide their GDP by their total population to get their GDP per capita, you will see that it’s more than a hundred thousand dollars ($100,000) each. That is massive! If you do the same thing for the U.S., you are going to get more than sixty thousand dollars ($60,000). Do the same for the U.K., and you will get more than forty thousand dollars ($40,000).

On the other hand, emerging economies and developing countries tend to have relatively low GDPs.

In Nigeria, if you divide the GDP by the total population to get the GDP per capita, you will see that it is just under two thousand dollars ($2000).

There are some countries that once had a very low GDP per capita yet have managed to achieve massive growth, raising their extremely low GDP per capita to a much higher level.

Examples of such countries are South Korea, China and Singapore. These countries and countless others have worked their way out of poverty, increasing their GDP per capita from low to much higher levels.

Consequently, the question that begs for an answer is: how do we get more countries to chart the same course?

Above all, it is essential to note that GDP per capita is correlated with many things. It is positively correlated with life expectancy and negatively correlated with infant mortality and inequality. GDP is a relatively good measure of output, but not welfare. Keep in mind that while GDP is not a measure of economic welfare, it is a critical component of economic welfare.

In fact, there are cities in China that no longer use GDP as a measure of economic welfare. They tend to measure the quality of life of their citizens instead. They also measure happiness, as well as personal well-being.

Angola’s GDP, for example, is very high but many Angolans are living in absolute poverty. Identically, Equatorial Guinea’s GDP per capita is almost the same as some Eastern European countries, yet some of their citizens still live in poverty.

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Another question that every government should ask is: how happy are their people?

Personally, I think that if a country has lower GDP per capita, but the people are doing very well, then that is good.

On a trip to San Francisco- home to the world’s biggest tech companies like Twitter, Uber and Visa- I remember seeing more beggars than I had ever seen in many poorer countries. Being rich does not mean you are a nice person. The fact that a country makes a lot of money does not mean the money will have a positive impact on everyone. This proves that GDP does not necessarily measure welfare. A high GDP per capita does not necessarily mean happiness, although as I said above, a larger GDP per capita is correlated with better outcomes.

This explainer has highlighted a lot, but I am not going to end it without addressing unemployment.

Recent statistics from the National Bureau of Statistics show that our unemployment rate is around 27%. This is a major problem affecting the entire Nigerian economy. When citizens of a country are unemployed or underemployed, GDP is affected. If everyone is productive, the country’s GDP will rise. However if we have low productivity rates, that does not only affect GDP, it also causes poverty.

Over the course of this explainer, I have defined macroeconomics as well as its impact on the economy. I have also explained what fiscal and monetary policy are. I did this effectively by breaking it down in the best way possible so that everyone can understand what both terms mean and how they affect the growth and development of emerging markets, including Nigeria.

It would be great if you kept these ideas in mind so that when you watch Channels TV (or any other Nigerian news channel) or while election season is around the corner and you begin to hear political manifestos, it would be easy for you to understand what is being said. What you have learned here would also help you to understand what the Central Bank means when there is an ongoing MPR meeting and they are cutting- or increasing- interest rates. Take note: all of this has to do with the interplay between fiscal and monetary policies.

Thank you for reading, and I hope you enjoy the essay!

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Chapter 3

How can capital budgeting techniques be used to assess investment decisions and are there any other considerations for emerging markets.

What are Capital budgeting techniques?Capital budgeting techniques are used to aid decision making when deploying investments on projects. Firms use them to obtain a more objective view of a potential investment which, when compared to ‘gut instinct’, is often easier to communicate to stakeholders.

Gitman (2007) defines capital budgeting techniques as the “process of evaluating and selecting long term investments that are consistent with the business’s goal of maximising owner wealth.” They are different from current expenditures because capital budget projects usually require a larger number of resources and have longer pay back periods. Many of these investments are also difficult to reverse.

These techniques have been developed to help decrease the likelihood of resources being wasted on investment projects that do not deliver financial returns.

Two examples of capital budgeting techniques include the following:

1. Net present value

2. Internal rate of return.

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Net Present Value: Net Present Value (NPV) is one of the most commonly used capital budgeting techniques. Investors/teams use it to understand the ‘time value’ of money, based on the premise that money today is of more valuation than the same amount in a few years’ time.

Net Present Value is calculated by comparing the return on an investment in subsequent years to the return on a form of ‘guaranteed’ interest income such as government treasuries.

The formula on the next page is used to calculate NPV where CF is cash flow and r is usually the interest rate on government treasuries.

Internal Rate of return: Internal Rate of Return or IRR is the interest yield on an investment at which the NPV becomes zero. It is also known as ERR or Economic Rate of Return. This can be calculated either via trial and error or by using an excel formula. This is the IRR formula:

The higher a project’s Internal Rate of the Return value, the more desirable it is to undertake that project as the most preferable investment option.

According to Gallo (2016), the best way to use IRR is in conjunction with NPV.

Why are they important?Gitman (1974) highlighted three reasons for investment as:

a. Cost reduction

b. Increasing revenue

c. Legal requirements.

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Therefore, capital budgeting techniques are important as they assist firms in finding the most efficient means of deploying capital and growing their profitability/revenues. This is key for the individual firms, and also more importantly for economic growth across companies.

Investments are an important component of GDP, so investments by more companies increase GDP on a macroeconomic level. Furthermore, increased investments are made with the objective of producing increased cash flows; revenue and profit which usually leads to increased taxable income for governments; increased salaries for workers; and increased consumption, further boosting GDP.

According to Mc Kinsey (2018), if all emerging economies could somehow emulate those emerging markets like South Korea, that have had strong consistent growth, they could generate an additional $11 trillion dollars for the global economy whilst reducing poverty and hunger across the world.

The next section will look specifically at capital budgeting techniques in emerging markets, especially in sub-Saharan Africa.

Implications for developing and emerging markets As can be seen in the diagram on the next page, developing markets in sub-Saharan Africa typically have higher interest rates than most developed countries. This is important to note as these countries usually have very small economies with high levels of unemployment and poverty. They urgently need economic growth to provide better standards of living for their citizens.

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However, interest rates have a significant effect on whether investment projects are executed by firms. Where yields from government bonds/treasuries are high, the time value of money increases. This decreases investors’ ability to justify projects as viable using NPV and IRR.

Their limitationsThe most obvious limitation is that ‘bad data produces bad results’. The cash flow estimates used in calculating the NPV and IRR are estimates based on available information. They are not always accurate.

We have moved from the era of shareholder value to stakeholder value where factors like the environmental impact, employee morale, etc. are increasingly important. Capital budgeting doesn’t measure the value of these returns.

Figure 1

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ConclusionThere are many capital budgeting techniques that can be used to assess investment decisions. Two examples are the NPV and the IRR which both emphasize the time value of money.

They are important as they provide an objective guide to investors and help prevent waste.

Investment is an important component of global GDP and increased sustainable investment is important for long term global growth. This future growth should be driven – at least in part – by emerging markets.

The capital budgeting techniques provide great tools when making investment decisions, but should be viewed as exactly that – tools inside a tool box where there are other tools such as intuition, empathy, environmental concerns, concerns for quality of life for ones employees, and concerns about the communities in which we do business. This will help businesses take holistic decisions about investments which in turn take top line and bottom line growth and financial return into consideration, and also take other factors into consideration.

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References• Gitman, L. J. (1974). Principles of managerial finance. New York: Harper and Row.

• Gallo (2016). A Refresher on Internal Rate of Return. Harvard Business Review.

• Hou, Z., Keane, J., Kennan, J., Massa, I. and te Velde, D.W. (2014) ‘Shockwatch bulletin: Global monetary shocks: impacts and policy responses in sub-Saharan Africa’, ODI Working Paper, March. London: Overseas Development Institute http://bit.ly/1pFOL9Q

• McKinsey & co (2018). Outperformers: High-growth emerging economies and the companies that propel them. September 2018, Report.

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Chapter 4

When it comes to monetary policy, distinguish between the cost capital channel and the credit channel and focusing on Nigeria, explain why this distinction is important.

Monetary policy works!There is empirical evidence dating back to 1964 (Freidman) as to the fact that monetary policy affects output. This is well established. However, the mechanism by which it affects output is still debated amongst economists.

The effects of monetary policy are channelled to firms and households through links known as transmission mechanisms.

Figure 1 above shows a car gear system. On the left-hand side is the hand gear of the car; the part everyone sees, the part we touch and control, the part that we all recognise, the part that some is spoken about on car TV shows and polished to perfection during exhibitions. However, the right side of this system is more complex. It’s the hidden part of the gear system comprising of a set of shafts, flywheels and fluid coupling mechanisms to provide power to move the car.

Figure 1

Source: Wikipedia, Common Creatives License

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Monetary policy transmission systems are not unlike car transmission systems. Central Bankers don’t directly compel firms and households to spend. Instead, central banks have a number of ways that they can try to influence the banks and, hence, the economy to act in a certain way. This is sort of like the car gear example above. Central banks act through metaphorical shafts, flywheels and coupling mechanisms to exert influence over decision making of actors like firms and households in the economy.

Central banks use three main ways to influence lending in the economy. But unlike in cars where the mechanics of how these transmission changes happen are universally accepted, with monetary policy, the role of the cost capital channel and the credit channel are still debated. Before we delve deeper into the importance of distinguishing between the two, we should first look at the tools central banks typical use to influence lending & economic growth.

Tools Used by Central Banks Open Market Operations: Open market operations involve the buying and selling of securities to banks by the central bank. When banks buy securities, they have less liquidity and therefore are less likely to lend. However, when central banks buy up securities from banks, they have more liquidity and therefore are more likely to lend.

Figure 2

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Quantitative easing is a more aggressive form of open market operations typically practised in more developed countries like the United States. This is when central banks buy other assets like real estate, mortgages, etc. from banks, creating a lot more liquidity. The aim of this is to stimulate banks to lend because of the liquidity created.

Reserve Requirement: This is the fraction of the balance sheet that banks have to leave in the central bank. When that fraction rises, banks have less money to lend. When the fractional falls, there is more money for banks to lend.

Discount Rate: This is the interest rate at which banks can borrow from the central bank. When central banks want to encourage banks to lend, they drop the interest rate. When they want to discourage banks from borrowing from them, they increase it.

Earlier in this essay, we discussed the fact that empirical evidence has shown time and time again that monetary policy works. The way central banks apply monetary policy may differ, but the three main techniques above are the most recognisable and the most commonly used.

However, the exact way that these techniques affect what people do is debatable.

The remaining part of this essay will focus on the difference between the cost of capital channel and the credit channel, the evidence base that supports both channels, and how this relates to why the central bank governor in Nigeria has taken up farming.

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Cost Capital Channel vs. Credit Channel

The cost of capital channel focuses on the interest rates, arguing that the more expensive money is, the less firms and households will borrow. Conversely, when interest rates are low, households and firms will borrow more money from the banks as it will be easier to pay back.

Whereas the credit channel looks at the link between monetary policy and the corporate financial system as a whole, beyond just interest rates. When monetary policy tightens, so does asymmetric information. When borrowers, lenders and associated parties don’t make the same market information, i.e. they have asymmetric information, the cost of raising finance rises. This extra cost is called the external finance premium.

Proponents of the credit channel argue that this is different from the direct effect of interest rates described in the cost of capital channel, hence, they need to be described separately.

If under tight monetary conditions the external finance premium rises, this further discourages firms from raising external funds as this phenomenon affects not just the debt, but the equity market also.

In addition to this, banks tend to reallocate capital from small businesses to large businesses during periods of tight monetary policy. They may also call their

Figure 3

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loans earlier (Black, 2007). This places pressure on the profits of firms, making it harder for them to make investments using internal resources.

Whilst the cost of capital channel focuses mainly on the effect of interest rates on investment, the credit channel shows how monetary policy affects the entire hierarchy of finance (retained earnings, bank debt and equity), thereby decreasing investment.

In summary, the cost capital channel and the credit channel are distinct but also complementary.

The introduction of this essay looked at the nature of monetary policy, the evidence behind its efficacy, and the different monetary policy techniques that exist. In the second section, the difference between the credit channel and the cost of capital views was detailed.

To conclude, I will examine how effective these channels have been in Nigeria and why the central bank of Nigeria has taken on a similar role to an agricultural bank.

Why the Governor of the Central Bank of Nigeria is visiting farmers and planting riceThis final section will look at monetary policy in an emerging market context and how the roles of both the capital cost channel and the credit channel change when financial inclusion is low, the formal economy is small, market data is sparse, and the financial markets are shallow.

Since 2015, the Central Bank of Nigeria (CBN) has undertaken a lot of activities that many would class as unorthodox. For example, the CBN was at the forefront of the anchor borrower’s’ scheme which involved the central bank lending directly to over 200,000 farmers1. The CBN’s next big initiative is to start a poultry farm. It will provide the capital and help run the operation2.

1 https://www.cbn.gov.ng/out/2017/dfd/anchor%20borrowers%20programme%20guidelines%20-dec%20%202016.pdf

2 https://guardian.ng/news/cbn-to-begin-poultry-farm-at-fuam/

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In developed countries, this is unheard of, but in Nigeria, this approach to central banking has gathered widespread support. The reasons why this ‘hands-on’ approach to central banking is supported so widely at its most fundamental is because many believe that there is a limited effect that monetary policy alone can have on the Nigerian economy.

This view is supported by Beck et al. (2009) and Beck (2011) which point out how ‘undeveloped financial markets limit the effectiveness of monetary policy’. Similarly, Olivier Blanchard, IMF Chief Economist, argues that ‘the macroeconomics of low-income and of advanced economies are incredibly different’.

But Blanchard (2014) touches on the heart of the matter; the importance of understanding the transmission mechanism when examining the effects of monetary policy in developing markets. The capital cost channel and the credit channel are of particular relevance here.

As discussed earlier, the cost capital market channel explains how a drop in interest rates would encourage firms to lend and even induce households with mortgages to spend more, stimulating growth.

The problem in Nigeria is that the unbanked, untaxed informal sector is 65% of the economy (Medina, 2017). This implies that over half the business activity in Nigeria is not ‘interest sensitive’ due to the fact that these businesses don’t have full access to financial services. According to the World Bank, Nigeria’s financial inclusion rates have stagnated since 2014; only 40% of adults have a formal account3.

The majority of Nigerians (60%) are unbanked, making monetary policy less effective. This is coupled with the fact that according to the CBN, outstanding mortgage loans are only 0.5% of GDP in Nigeria, compared to 77% in the US, 80% in the UK, 50% in Hong Kong, and 33% in Malaysia4.

So much of the effect on household seen in developed countries when interest rates drop will not be seen in countries like Nigeria.

3 https://blogs.worldbank.org/africacan/five-ways-nigeria-can-realize-mobile-technologys-potential-for-the-unbanked

4 https://www.cbn.gov.ng/fss/tue/BSP/Mortgage%20&%20Credit/FSS%202020%20-%20Mortgage%20Presentation.pdf

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When it comes to the credit channel, the effect is a little more relevant. In many markets in sub-Saharan Africa, market data is sparse and there is a high level of asymmetry of information, therefore, the external finance premium is high as most capital flows towards more developed markets. Combine this with the effect of a high corporate tax rate of over 30%, which places further pressure on retained earnings/profits. These external factors blunt the effect of the credit channel, although the balance sheet effect may still be relevant.

Stimulating economic growth in developing countries is complex. There are factors that constrain the transmission systems of monetary policy both in the credit and the cost capital channels. For these reasons, the central bank intervenes in the real sector directly, loaning to or even sometimes having operational oversight over projects.

ConclusionWe know that monetary policy works, but there is debate about the importance of various transmission mechanisms. This essay has outlined the differences between the cost capital channel and the credit channel. They are distinct, with some overlap and commentary.

The latter part of this piece was dedicated to looking at the differences between the effectiveness of these channels in developed and underdeveloped markets.

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References• Black, Lamont K.; Rosen, Richard K. (2007). How the credit channel works: Differentiating the bank

lending channel and the balance sheet channel, Working Paper, No. 2007-13, Federal Reserve Bank of Chicago, Chicago.

• Blanchard, O. (2014). O. Remarks at the “Macroeconomic Challenges Facing Low-Income Countries” Conference. International Monetary Fund, Washington DC, January 30-31.

• Beck, T and R Levine (2002). Industry growth and capital allocation: Does having a market- or bank-based system matter? Journal of Financial Economics 64: 147–180.

• Beck, T.. R. Levine and N. Loayza (2000). Finance and the sources of growth. Journal of Financial Economics 58: 261–300.

• Beck, T., M. Fuchs and M. Uy (2009). “Finance in Africa – Achievements and challenges”, VoxEU, 20 July.

• Medina, L., A. Jonelis, M. Cangul (2017). The Informal Economy in Sub-Saharan Africa Size and Determinants. International Monetary Fund. Working Paper No. 17/156.

• Beck, T. (2009). Financing Africa: New hopes and continuous challenges. VoxEU, 16 September.

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Chapter 5

Some people argue that ‘the cost of capital rather than the quantity of finance available is the most important single factor influencing the firm’s decision to invest.’ Consider this view of firms’ investment decisions in view of the investment environment in emerging markets.

IntroductionEconomists are interested in the factors that make firms invest, because investment is a key component of GDP. Therefore, increasing investment levels can improve overall GDP growth.

When firms are making investment decisions, there are many factors that are typically taken into consideration. This essay aims to ascertain whether it is the cost of capital or the quantity that is the most important factor affecting a firm’s decision to invest.

Aswath Damodaran (2016) calls the cost of capital the Swiss Army knife of finance because people define it differently. But in his words, the ‘cost of capital, in its most basic form, is a weighted average of the costs of raising funding for an investment or a business’.

Cost of capital viewThe ‘cost of capital’ view sees the price of finance as the only important factor in a firm’s decision to invest. This lens sees the amount of capital available as irrelevant, believing that any firm can raise money as long as it is willing to pay the price.

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There is evidence to support this view. The first serious study of influence of capital structure of the company on its activities was conducted by Modigliani–Miller. It stated that ‘in the absence of taxes, bankruptcy costs, agency costs and asymmetric information, and in an efficient market, the value of a firm is unaffected by how that firm is financed’, whether internally or externally.

The Q-model of investment assumes that in the perfect capital market, the internal and external funds are perfect substitutes and therefore, the investment decision of a firm is solely a function of investment opportunities and invariant to the firm’s cash flow (Gupta, 2019).

In this perfect market, a firm’s investment decisions are not influenced by its financial condition (Fazzari), therefore, the only factor affecting a firm’s decision to invest is the cost of capital it wishes to obtain.

However, at very high interest rates, many reputable firms lose interest in lending. As Adam Smith points out, ‘If the legal rate of interest in Great Britain, for example, was fixed so high as eight or ten per cent, the greater part of the money which was to be lent would be lent to prodigals and projectors, who alone would be willing to give this high interest. Sober people, who will give for the use of money no more than a part of what they are likely to make by the use of it, would not venture into the competition’ (Smith,1776).

Stiglitz-Weiss (1981, 1983) developed a theory of credit rationing. Stiglitz argued that banks might not increase the interest rate they charged even in the face of an excess demand for funds, for to do so might reduce their expected rate of return because the probability of default would increase. Two reasons were presented for the possible inverse relationship between the rate of interest charged and the expected return to the bank: higher interest rates reduce the proportion of low risk borrowers (the sorting effect to which Smith had called attention) and higher interest rates induce borrowers to use riskier techniques (the incentive effect).

The work of both Adam Smith and Stiglitz further highlight the importance of the cost of financing to firms.

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Quantity of finance view However, the assumptions made work just like those of Modigliani-Miller (1958) – such as the absence of taxes and perfect access to information, which are atypical of the great majority of real-world investment transactions. When firms invest, they usually don’t have complete certainty or perfect access to information, and therefore, cash flows play a significant role in a firm’s decision to invest.

In most investment transactions, internal and external sources of funding are not perfect substitutes. Friction and asymmetric information make investments from internally generated revenue, such as retained earnings, better than debt of equity. This is called the pecking order of finance which will be detailed later in this essay. But prior to this, it is important to emphasise the impact of asymmetric information. The asymmetric information present in most transactions ensures that internal and external funding are rarely perfect substitutes.

Asymmetric InformationAsymmetric information is a term used to describe the situation when one party to an investment has more knowledge than the other party.

Akerlof (1970) first highlighted the effect of information asymmetry in a 1970 paper entitled “The Market for ‘Lemons’: Quality Uncertainty and the Market Mechanism.” In that paper, Akerlof (1970) stated that car buyers see different information than sellers, giving sellers an incentive to sell goods of less than average market quality.

Akerlof (1970) uses the colloquial term “lemons” to refer to bad cars. He espouses a belief that buyers cannot effectively tell lemons apart from good cars. Thus, sellers of good cars cannot get better than average market prices.

Asymmetric information increases the amounting of external financing a company needs. It can also cause market failure. Two situations that can occur because of asymmetric information are moral hazard and adverse selection.

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These are described below:

Moral Hazard: Moral hazard is when, due to asymmetric information, a person’s behaviour changes after the transaction has been concluded.

Adverse selection: Adverse selection is when one of the two parties has more accurate or different information to the other. This gives the party with superior information an advantage. This problem occurs before the transaction has been done.

So far, this essay has analysed evidence as to why the cost of capital may be the most influential factor in a firm’s decision to invest, then looked at concepts, such as asymmetric information, that may be overlooked in a solely ‘cost of capital’ perspective.

The pecking order of finance theory gives further evidence that the quality, not just the cost of capital, is a major factor that affects a firm’s decision to invest. The pecking order is described below.

The Pecking Order of Finance

The pecking order theory states that the cost of financing increases with asymmetric information.

According to the pecking order theory, financing comes from the following three sources:

1. Internal funds

2. Debt

3. New equity

Financing from internal funds is the most preferred, followed by debt, and finally, equity as a last resort. This is shown in Figure 1 on the next page.

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When you look at what the US non-financial firms do in aggregate, their behaviour supports the pecking order theory. Majority of the US non-financial firms, in aggregate, financed their investments through internal financing. In fact, less than 20% of financing in most years was external and the great majority of that was debt (Myers, 2001).

So it does seem that there is indeed a pecking order and that the quantity of finance is indeed an important consideration for firms when making investment decisions.

So which is most important?Whether a firm considers cost of capital or quantity of capital, the single most important factor in an investment decision seems to depend on a number of factors.

The type of firm matters. For example, high growth, high risk technology firms tend to use equity to fund their investments. In the case of these technology firms, equity financing through venture capital is the preferred and more suitable, compared to debt or internal funding (Gopher 2001, Cosh 2009).

Some firms prefer to use internal funding as it gives tax advantages and it is also lower risk compared to external funding. But only firms that have retained earnings or profits have this option. Therefore, the financial status of the firm plays an important role in determining which form of finance it will take on (Shahnazarian, 2005).

Figure 1 (Dommes et al.,2019)

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There is also evidence in line with the pecking order theory that firms with a larger number of fixed assets are more likely to take on debt compared to equity. Financing preference also varies according to industry (Sinha et al, 1993).

Rajan and Zingales (1995) found that the four most common determinants that determined capital structure in G7 countries were tangibility, growth opportunity, size, and performance. Similar patterns have been seen in developing markets.

The fiscal policy direction in the country that the firm operates is also important. In countries with high levels of government borrowing, the government can take such a large proportion of the loanable funds available that there is hardly anything left for the private sector. The total quantity of credit available to the private sector is reduced. This is known as crowding out.

Figure 2 below shows how if there is an increase in demand for loanable funds driven by government, the opportunity cost for interest sensitive investments like investment by private firms and even consumption increases.

Baumol (2007) makes an interesting point about the effect of government deficits on the bond markets. Savers have a certain amount of money available, when government sells bonds, those bonds then compete for private sector bonds as well as other private sector instruments. This affects private investment because it decreases the total proportion of capital available, i.e. the quantity of finance.

Furthermore, there is evidence that even when interest rates rise, the banks’ behaviour changes. They become choosier about who they lend, affecting the

Figure 2 (Intelligent

Economist, Prateek Agarwal, 2019)

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quantity of credit they make available. This is called credit rationing. Samuelson (1952) referred to this in his testimony before the Patman committee.

Finally, Guttentag (1960) points out that the finance for private investments isn’t just about rates. There are many important terms in a credit agreement that a firm takes into consideration when making an investment decision. Examples of these are the maturity and the debt service to income ratio. These are also terms that financial institutions use to ration the quantity of credit that they disburse irrespective of interest rates.

ConclusionIt is evident from the empirical research presented above that firms take a number of factors into consideration when making investment decisions. Cost of capital is one of the factors and in a perfect market may be the most important factor.

However, most firms exist in imperfect markets and therefore, the quantity of capital becomes just as important as the cost. This is demonstrated by the pecking order of finance and supported by statistics from listed firms in the United States, G7, and developing markets presented in this article.

Fiscal policy also largely affects the quantity of finance. When the government crowds out the private sector, it affects the availability of finance by taking majority of the available loanable funds in the market.

The effect of credit rationing is also important as when interest rates are high, banks don’t make as many loans and ration out credit, lending to only a select few. Therefore, for many customers, credit is not available at any price. This means that the total quantity of credit available decreases.

Investment is a key component of GDP and growth. Understanding how and why firms make investment decisions is important so that pro-growth policies can be created to support them, and in so doing, support the wider economy. The cost of finance is important, but as demonstrated above, the other factors that affect the total quantity of finance available are highly influential when it comes to firms and the decisions they make about investments.

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References• Agarwal, Prateek (2019), Intelligent Economist https://www.intelligenteconomist.com/crowding-

out-effect/

• Akerlof, G. (1970). The Market for “Lemons”: Quality Uncertainty and the Market Mechanism. The Quarterly Journal of Economics. 84(3), 488-500.

• Baumol William, Alan Blinder (2007) Economics: Principles and Policy, pg 695

• Cosh, A.; D. Cumming; A. Hughes. (2009) Outside Enterpreneurial Capital. The Economic Journal, vol. 119, no. 540, 2009, pp. 1494–1533. JSTOR, www.jstor.org/stable/40271400.

• Damodaran, A. (2016). The Cost of Capital: The Swiss Army Knife of Finance http://people.stern.nyu.edu/adamodar/pdfiles/papers/costofcapital.pdf

• Espinosa, C.; C. Maquieira; J. Vieito & M. González (2012). Capital Structures in Developing Countries: The Latin American Case. Investigación Económica, 71(282),35–54.

• Dommes, K.; M. Schmitt & E. Steurer (2019). Capital Structures in German Small and Mid Caps: Does Trade-Off or Pecking Order Theory Explain Current Reality Better? Journal of Financial Risk Management, 8, 147-162.

• Gompers, P. & J. Lerner (2001). The Venture Capital Revolution. The Journal of Economic Perspectives, 15(2), 145-168.

• Gupta, G.; Mahakud, J. (2019). Alternative measure of financial development and investment-cash flow sensitivity: evidence from an emerging economy. Financial Innovation 5(1), 1-28.

• Guttentag, Jack (1960). “Credit Availability, Interest Rates, and Monetary Policy.” Southern Economic Journal, vol. 26, no. 3, 1960, pp. 219–228. JSTOR, www.jstor.org/stable/1054954.

• Modigliani, F. & M. Miller (1958). The Cost of Capital, Corporation Finance and the Theory of Investment. The American Economic Review48(3), 261-297.

• Myers, S. (2001). Capital Structure. The Journal of Economic Perspectives, 15(2), 81–102.

• Rajan, R. & L. Zingales. (1995). What Do We Know about Capital Structure? Some Evidence from International Data. The Journal of Finance, 50(5), 1421–1460.

• Samuelson, P (1952) Monetary Policy and the Management of the Public Debt, Hearings before the Patman Sub- committee on General Credit Control and Debt Management, Joint Committee on the Economic Report (Washington: Government Printing Office, 1952), pp. 695-7.

• Stiglitz, J. & A. Weiss (1981). Credit Rationing in Markets with Imperfect Information.

• American Economic Review, 71(3) 393-410.

• Stiglitz, J. & A. Weiss (1983). Incentive Effects of Terminations: Applications to the Credit

• and Labor Markets. American Economic Review, 73(5), 912-27.

• Stiglitz, J. & A. Weiss (1985). Credit Rationing with Collateral. Bell Communications Research Economics. Discussion paper 12.

• Shahnazarian, H. (2005). Corporate Financial Dynamics: A Pecking-Order Approach. FinanzArchiv / Public Finance Analysis. 61(4), 516–534.

• Sinha, S. (1993). Inter-Industry Variations in Capital Structure. Economic and Political Weekly, 28(35). M91–M94.

• Smith, A. (1776). The wealth of nations. Book II: Of the Nature, Accumulation, and Employment of Stock, Chapter IV: Of Stock Lent at Interest.

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Chapter 6 Macroeconomics

‘A stable debt/income ratio is central to the issue of fiscal sustainability.’

Firstly, is this true?

Is there a difference in what metrics to consider when assessing fiscal sustainability in advanced vs emerging economies?

What is fiscal sustainability?Fiscal sustainability is a measure of how capable a government is to continue its current level of spending, borrowing, taxation and other elements of economic policy in the long run, without either threatening its solvency or defaulting on some of its liabilities and promised expenditures.

There is no real consensus about what an appropriate measure of debt sustainability is. The stability of debt to income ratio is usually considered alongside other metrics, such as interest rates, growth rates, debt to GDP ratios, the condition of the economy and the type of economy (whether advanced or emerging), and what currency the debt is in, as considered below using relevant examples.

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1. Metrics

Metrics such as debt to income ratio and debt to GDP ratio are often used as part of the assessment of fiscal sustainability.

a) Debt to GDP ratio

The debt to GDP ratio compares a country’s sovereign debt to its total economic output for the year. There have been many attempts to establish a debt to GDP ratio threshold beyond which debt becomes unsustainable. It has been argued that when ‘public debt exceeds a certain threshold level (above 55% of the gross domestic product), it is negatively correlated with economic activity’.

The famous Maastricht Criteria are the terms that European Union member states are required to meet in order to enter the third stage of the Economic and Monetary Union (EMU) and adopt the euro as their currency. Amongst other metrics, the Maastricht Criteria require that the debt to GDP ratio of qualifying countries should not be over 60% (Real, 2011). A team from Nigeria argue for a threshold of 70%.

Others argue for a 90% debt to GDP ratio. But Lysandrou (2013) argues that there is no point in having a threshold as it depends on the unique economic situation and that more factors need to be taken into consideration.

The chart 1 below compares the debt to GDP ratio in Nigeria to Japan, the United Kingdom and Morocco. Nigeria’s debt to GDP ratio is comparatively low. However, Chart 2 (Interest payments as a % of GDP) reveals a very different picture, highlighting the fact that debt repayments are becoming an increasingly large proportion of revenues. This shows the weakness of using debt to GDP ratios in isolation, because GDP doesn’t service debts.

Revenue/income does. Unfortunately, many developing countries have lower revenues compared to GDP due to weaknesses in tax collection systems.

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Chart 2 source: data.worldbank.org

b) Interest payments as % of revenue

Income/revenue is important when considering debt sustainability. A stable debt/income ratio gives a good indication of fiscal sustainability. However, rising debt/income ratios are not always a bad thing.

Whilst there are arguments that rising public sector debt/income ratios lead to crowding out of the private sector and higher risk of private sector default, this is only in the short run. In the long run, this effect is not seen. In an underemployed economy, there may even be some benefits to increasing public sector debt which

Chart 1 source: data.worldbank.org

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outweigh any disadvantages. There are alternative arguments that claim that under certain circumstances, rising debt/income ratios are irrelevant (Davis, 1987).

For example, given any debt path, when taxes are distortionary, governments can adjust taxes so as to attain that debt path without affecting equilibrium allocations or prices (Bassetto, 2004).

Metrics often don’t tell the whole story, as argued by Reinhart (2003). Some countries have debt to GDP & debt to income ratios that would be acceptable in advanced economies, but still default. The paper calls this phenomenon ‘debt intolerance’ and therefore concludes that in addition to the traditional metrics, the countries actual track record in paying back debt should be a key consideration (Reinhart, 2003).

2. Type of Economy: Advanced or emerging

Advanced economies are often characterised by low interest rates. Often, the interest rates, for example in parts of the Eurozone, are lower than the rate of economic growth.

‘The change in the debt is a function of the primary balance and (r - g), the difference between GDP growth and the interest rate’ (Ubide, 2019).

Equation 1 above shows that the debt to GDP ratio (d/y) is a function of the past debt ratio, the primary balance (pb), and the relationship between the rate of growth of GDP (g) and the interest rate cost of the debt (r).

When interest rates are lower than the rate of economic growth, then it becomes more sustainable to use debt to fund public services. This is especially true for many Eurozone countries that already have high debt to income ratios. This is because when debt to income ratios are very high, the debt path is actually more dependent on r-g, i.e. the relationship between economic growth and interest rates compare.

Equation 1: Ubide, 2019

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Peter Heller is Deputy Director of the IMF´s Fiscal Affairs Department and he defines fiscal space as the “room in a government’s budget that allows it to provide resources for a desired purpose without jeopardizing the sustainability of its financial position or the stability of the economy” (Heller, 2005). The IMF describes fiscal space as ‘like having money in the bank’5. The more a government is able to increase spending without risking an adverse reaction from financial markets or risking the country’s long-term financial health, the more fiscal space it has. Alternatively, the riskier a country is perceived to be, the less fiscal space it has.

For the most part, developing or emerging economies have less fiscal space because debt vulnerability has been increasing in low income countries substantially.

The reasons for the increased debt vulnerabilities in low income countries as outlined by the World Bank include6:

1. Dependence on external debt

2. Rising cost of debt service

3. Non- traditional and often higher interest debt sources

4. Countries with the fastest rise in debt were often fragile and affected by a combination of conflict, weak governance, or commodity-dependence.

Advanced economies have a lot more fiscal space as they are less fragile, have stronger institutions and more favorably looked upon by international investors. Furthermore, interest rates are very low, often lower than the rate of growth, which provides a more sustainable debt path, referring to equation 1.

In order to examine the assertion that ‘stable debt/income ratio is central to the issue of fiscal sustainability’, we have looked at a number of different factors that affect debt sustainability. We initially explored some of the metrics that influence debt sustainability, such as debt to income ratio and debt to GDP ratio. Then, we explored the role of distortionary taxation that is purported to make increase in debt levels less relevant.

5 https://blogs.imf.org/2018/06/27/economic-preparedness-the-need-for-fiscal-space/

6 http://documents.worldbank.org/curated/en/378031553539256399/pdf/Debt-in-Low-Income-Countries-Evolution-Implica-tions-and-Remedies.pdf

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In the second section, the importance of the level of economic development was highlighted, concluding that low income countries have less fiscal space compared to more advanced countries. This is due to the low interest rates in developed countries which are often lower than the rate of economic growth. In addition to this, there is the reputation and credibility of these markets that allow them to take on higher levels of debt on every metric without an adverse reaction from financial markets.

The third factor that will be considered is currency of the debt and the role of currency in debt sustainability.

3. The Role of Currency There is a great degree of variability in the amount of foreign-currency-denominated debt that countries decide to take on, even amongst developed countries. It broadly ranges from zero % to up to 60%.

Countries like Ireland, Iceland, New Zealand and Canada have foreign currency debt levels greater than 20%, whilst countries like Austria, Australia, the UK and Spain range between zero and 20%. There is a third group of countries that don’t have any foreign currency exposure at all, such as the United States, Germany, Japan and the Netherlands. Foreign currency indebtedness is positively correlated with debt to GDP ratio (Lorenzo, 1998).

Japan has the largest gross debt to gross domestic product (GDP) ratio globally, reaching 230% in 2015. Meanwhile, countries with significantly less debt have experienced debt crises.

The key advantage of Japan’s domestic borrowing is that there is no currency risk for which investors would charge higher interest to cover.

However, Japan was able to pursue this strategy because of its well-developed financial markets and high level of domestic savings. Many countries in Africa have undeveloped financial markets and low levels of saving. Therefore, they must borrow in foreign currency. Rising external debt tends to weaken the economy as foreign debt increases vulnerability to external conditions.

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However, domestic borrowing also has some disadvantages, such as in some economies, it will crowd out the private sector. Nevertheless, currency considerations are important to factor in when looking at fiscal sustainability.

4. Demography and contingent liabilities

The first chapter of a book called ‘Japan: The Precarious Future’ by Sawako Shirahase is called ‘Demography as Destiny’. It looks at the impact of contingent liabilities to the State, such as healthcare and pensions on advanced countries like Japan where the birth rate is falling (Sawako, 2015).

Japan and many other advanced nations face a situation where the number of elderly and the expenses that come with them are set to explode. Yet the working population that ordinarily should support them is shrinking.

Innovations in technology such as robotics and artificial intelligence may not become advanced enough in terms of the additional productivity they provide to an economy to bridge this gap. So economies that have a huge burden of older people and fewer younger people, meaning falling fertility rates, definitely have to consider this when they plan towards debt sustainability.

5. The condition of the economy

My final point with regard to the important factors to consider when making decisions about debt sustainability is the condition of the economy. This is probably the most important point.

When the economy is in recession, regardless of the demography/contingent liabilities, the currency, the debt to income ratio, the debt to GDP ratio, the currency or the type of economy, governments must find a way to stimulate the economy.

When citizens are suffering, battling diseases, and there is unrest due to a deep recession and monetary policy isn’t effective, then, there is usually only one way out—taking on debt and spending it on fiscal stimulus packages to alleviate suffering and to ‘prime’ the economy back into growth.

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We know that the boom and bust is cyclical and in the long run, every economy, even in the deepest and darkest recessions, will self-correct, moving back into growth. But in the words of John Manard Keynes’ most famous quote, ‘in the long run, we are all dead’.

Using monetary policy during recessions is like pushing on a string; it is frequently ineffective (Tenreyro, 2016).7 Fiscal stimulus must therefore be used and this often means taking on debt.

Conclusion

A stable debt/income ratio is a useful metric when considering the issue of fiscal sustainability. But the International Monetary Fund (IMF) doesn’t rely on a single metric; the IMF has expanded its definition of debt sustainability “with high probability” by combining a level assessment (debt to GDP ratio) with a flow assessment (the gross financing needs as a share of GDP).

Debt to income ratio should be considered not only alongside other metrics like debt to GDP ratio, but also other factors like currency, type of economy, interest rate, growth rate, demographics, and the wider condition of the economy when making decisions about debt sustainability.

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References• Ahmad Zubaidi Baharumshah, Siew-Voon Soon, Evan Lau, Fiscal sustainability in an emerging

market economy: When does public debt turn bad? Journal of Policy Modeling, Volume 39, Issue 1, 2017, Pages 99-113, ISSN 0161-8938, https://doi.org/10.1016/j.jpolmod.2016.11.002

• Arai, Real. “Productive Government Expenditure and Fiscal Sustainability.” FinanzArchiv / Public Finance Analysis, vol. 67, no. 4, 2011, pp. 327–351. JSTOR, www.jstor.org/stable/41472631

• Omotosho, Babatunde S.; Bawa, Sani; Doguwa, Sani I. (2016): Determining the optimal public debt threshold for Nigeria, CBN Journal of Applied Statistics, ISSN 2476-8472, The Central Bank of Nigeria, Abuja, Vol. 7, Iss. 2, pp. 1-25. Download: https://www.econstor.eu/bitstream/10419/191686/1/890484406.pdf

• Photis Lysandrou, Debt intolerance and the 90 per cent debt threshold: two impossibility theorem, Journal of Economy and Society, Volume 42, 2013 - Issue 4, Pages 521-542 | Published online: 16 May 2013, Download citation https://doi.org/10.1080/03085147.2012.760346

• Davis EP, Rising Sectoral Debt to Income Ratio; cause for concern? BIS Economic Papers Number 20, June 1987. www.bis.org/publ/econ20.pdf

• Bassetto, Marco; Kocherlakota, Narayana, On the Irrelevance of Government Debt When Taxes Are Distortionary, Journal of Monetary Economics51(2):299-304 · March 2004/ https://www.researchgate.net/publication/222694001_On_the_Irrelevance_of_Government_Debt_When_Taxes_Are_Distortionary

• Reinhart, Carmen M., et al. “Debt Intolerance.” Brookings Papers on Economic Activity, vol. 2003, no. 1, 2003, pp. 1–62. JSTOR, www.jstor.org/stable/1209144.

• Ubide, Angel, Intereconomics, Volume 54, 2019, Number 5, page 279 to 285 Fiscal Policy at the Zero Lower Bound https://archive.intereconomics.eu/year/2019/5/fiscal-policy-at-the-zero-lower-bound/#footnote-017

• Peter Heller, Back to Basics -- Fiscal Space: What It Is and How to Get It. June 2005, Volume 42, Number 2 https://www.imf.org/external/pubs/ft/fandd/2005/06/basics.htm

• Pecchi, Lorenzo; and Andrea Ripa Di Meana. “PUBLIC FOREIGN CURRENCY DEBT: A CROSS-COUNTRY EVALUATION OF COMPETING THEORIES.” Giornale Degli Economisti e Annali Di Economia, 57 (Anno 111), no. 2, 1998, pp. 251–288. JSTOR, www.jstor.org/stable/23248181. Accessed 6 Jan. 2020.

• Shirahase, Sawako. “Demography as Destiny: Falling Birthrates and the Allure of a Blended Society.” Japan: The Precarious Future, edited by Frank Baldwin and Anne Allison, NYU Press, 2015, pp. 11–35. JSTOR, www.jstor.org/stable/j.ctt15zc875.5

• Tenreyro, Silvana; and Gregory Thwaites. “Pushing on a String: US Monetary Policy Is Less Powerful in Recessions.” American Economic Journal: Macroeconomics, vol. 8, no. 4, 2016, pp. 43–74. JSTOR, www.jstor.org/stable/26156440

• See International Monetary Fund: Staff Guidance Note for Public Debt Sustainability Analysis in Market-access Countries, 2013.

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SECTION 3

IMF & Economic Policy - IS THE IMF EVIL?Many people in emerging markets, including Nigeria, see the IMF as an evil spirit that needs to be kicked out of the world by fire. This explainer will try to disabuse you of this idea and clarify how even though the IMF has it’s faults, overall, it’s has been a great force for good in the world.

Before I go on, I will like you to have a glimpse of what the IMF is.

The International Monetary Fund (IMF) is a financial institution that was established to help countries overcome economic difficulties. This means that the IMF has a lot of good intentions. It was created to be a lender to countries in crisis.

But the question is, how did the IMF get this ‹evil› reputation?

First of all, I would like you to know that the IMF is not like your best friend or relative. I suppose if you’re going to lend money from your mother, she will ask you to pay it back whenever you have it, without strings attached. She might even tell you not to worry about the repayment.

Family members can lend you money with no strings attached. They love you. That’s a beautiful thing about family members and close friends.

However, the IMF is not your mum. Therefore, only rarely lends money to countries without conditions. Due to the conditions attached, lending from the IMF remains a politically difficult option in many countries. The IMF is customarily a lender of last resort, and that explains why countries only turn to the IMF when they face substantial financial crises and no longer have any other option.

In the introduction section of this book, I spoke about the fact that so many poorer countries experience financial difficulties. Many of these countries end up having to go to the IMF to obtain financial support. Developing countries around the world have had different types of encounters with the IMF. Some have been good, others bad.

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One of the conditions that the IMF gives countries (and perhaps the number one source of the ‘evil’ reputation) they are lending money to is that they should stop spending much. Let’s assume that you have a friend who spends too much. If you happen to lend her money, you’re probably going to try to warn her about the way she spends it. You might say things like ‘You don’t need a car right now,’ ‘You don’t need to waste money on that house,’ ‘You need to stop eating out.’

But, unfortunately, when you give this kind of advice to countries, it can have a very different result. When the IMF attempts to stop countries from spending too much, it ensures that the government cut costs on various things. This is commonly referred to as austerity.The government is sometimes required to cut costs on education, security, housing, health care, social amenities and a whole lot of things.

This makes it very difficult for politicians running countries who go through IMF programmes to be re-elected, as citizens tend to despise the public spending cuts. As a politician, once you cut spending on essentials such as security, education and social programmes, it becomes extremely difficult to get re-elected.

That’s one of the reasons people think the IMF is evil.

The second reason people think the IMF is evil is that it can create poverty. Cuts to social spending often adversely affect the poor. As a result, people have rioted in some of the countries participating in IMF programmes.

The third reason people think the IMF is evil is that it tends to ‘control’ countries that are part of its programme. People feel that it is an insult for an external institution to come to a sovereign country and start dictating how they should operate, what to spend on, and what kind of policies to implement. It feels intrusive. Their logic is in line with the assertion: that you gave me money does not mean that you’re entitled to control my life. To illustrate, let’s say now that your friend has lent you money, she starts telling you what to eat: ‘Don’t eat chicken…It is too expensive…Take your Jollof rice with eggs instead’. It’s almost as if just because she lent you the money, you can’t eat meat anymore!

See how intimidating and annoying it can be on a personal level? Now imagine how it would be at the national level. This has driven people to see the IMF as an evil force.

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The fourth charge against the IMF is that people think it’s an American institution. America puts more money into the IMF than most other countries. As such, people believe it is an Americanised institution, and that America uses the IMF to give favourable conditions to its foreign relations (friends) or to deal with its enemies by imposing strict conditions on them.

So, is the IMF evil or not?

On a personal note, I don’t believe that the IMF is evil. Most of the countries that turn to the IMF for financial support are already in a devastating situation. They’re already in a situation that’s going to be extremely difficult to get out of.

For example, if someone is on a ventilator in an intensive care unit with a kidney, lung, and heart failure, and a doctor comes in to help the situation. If the patient eventually dies during the treatment process, it is not the fault of the doctor. The doctor tried his/her best but that doesn’t mean the patient wasn’t going to die. The patient was in a dire situation.

Yes, the IMF makes mistakes, but the mistakes of the IMF are not strictly the mistakes of the institution. I think that they are more the mistakes of economics as a science, and as a profession. Economics is a new form of science which is still evolving. And what the IMF did in the 1970s and 1980s was just the latest in economics at the time.

It’s the same thing that happens in medicine. When we didn’t have cardiac intervention procedures in medicine, we just prescribed aspirin to people with heart attacks, because we didn’t know what else to give. Then we evolved into streptokinase. Now, we are doing cardiac intervention.

When economists too didn’t have something sophisticated to prescribe, they were simply prescribing the things they saw in economics textbooks. As a result, the IMF made mistakes. The IMF understands that those old solutions cannot solve new problems.

We understand the mistakes made by the IMF. We should also try to understand that the IMF has evolved and has learned from such mistakes. I think the IMF is a better and stronger institution today than it was 20 years ago.

Do I think the IMF is evil? No, I don’t.

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Do I think the IMF needs reform? Yes. Every organisation needs to be reformed every time. We live in a situation where things are volatile and unpredictable, so we need to be dynamic in our dealings. All organisations, including the IMF, need to be able to adopt constant changes quickly.

Do you still think the IMF is evil?

I invite you to read my essays on the IMF and make up your mind!

Thank you for joining me in this section.

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Chapter 7

“Both the Mundell-Fleming and Polak Models suggest that under fixed exchange rates, an increase in domestic credit will lead to a fall in international reserves.”

Many emerging markets have fixed exchange rates, is this a bad thing? What are the advantages and disadvantages of IMF? How has the IMF been criticised? Is there merit to those criticisms? Has the IMF helped or hurt emerging markets?

Introduction to the Mundell-Fleming and Polak ModelsThe Mundell-Fleming Model (IS-LM-BP Model): The Mundell–Fleming model portrays the short-run relationship between an economy’s nominal exchange rate, interest rate, and output (in contrast to the closed-economy model which focuses only on the relationship between the interest rate and output). Blanchard (2017) provides a textbook treatment on both models, and here we depart from his work to show an overview of the Mundell-Fleming model.

The goods-market equilibrium implies that output depends, among other factors, on the interest rate and the exchange rate:

Where i is the interest rate equal to the policy rate set by the central bank so that.

The interest rate parity condition implies a positive relation between the domestic interest rate and the exchange rate.

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Jointly, these three relations determine output, the interest rate and the exchange rate. The three equations can be reduced to two by using the interest parity condition to eliminate the exchange rate in the goods-market condition:

Once again, the last two equations determine jointly the interest rate and equilibrium output, and using gives us the implied exchange rate.

As seen in figure 1, an increase in the interest rate reduces output both directly (through investment) and indirectly (through the exchange rate). It should be noticed that an interest rate shock not only leads to a decrease in investment, but also to an exchange rate appreciation.

Figure 1. Response to an increase in interest rate

Source: Blanchard

(2017)

Source: Blanchard

(2017)

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An increase in government spending leads to an increase in output, provided that the central bank keeps the interest rate unchanged and that the exchange rate remains unchanged too.

Figure 2. Response to an increase in government spending

However, when the central bank responds to this government spending increase by raising the interest rate, an exchange rate appreciation will occur.

Figure 3. Response to an increase in government spending when the central bank responds by raising the interest rate

Source: Blanchard

(2017)

Source: Blanchard

(2017)

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Now, when we introduce fixed exchange rates, the interest rate parity condition remains.

Let the current exchange rate equal the pegged exchange rate . If financial markets believe that the exchange rate will remain pegged at this value, then market expectations of future exchange rate is equal to , and the interest parity relation becomes:

Therefore, with a fixed exchange rate, the domestic interest rate must be equal to the foreign interest rate. Then, if monetary policy cannot be used under fixed exchange rates, the government needs to use fiscal policy and the effects are identical to the one we see in Figure 2, given that an increase in public spending is not accompanied by a rise in interest rates.

In the context of fixed exchange rates, the central bank buys and sells domestic currency, so that the money supply is equal to reserves plus domestic credit. Since both domestic credit and foreign currency are controlled by the central bank, an appreciation of the domestic currency could be prevented by selling some domestic currency using foreign reserves. Furthermore, in a situation of balance of payments deficit, the country would need to sell reserves to keep the fixed exchange rate.

Polak Model: Polak’s general approach was not new. He helped resuscitate the monetary approach to the balance of payments in the age of Keynes. The Polak Model introduced a quantitative linkage between the domestic money market and the balance of payments. This then formed the basis of many decisions made at the IMF for years to come.

When the IMF first started to offer financial assistance through stand-by agreements to member countries, Polak pointed out that even though the IMF was able to use simple Keynesian models to calculate the domestic multiplier effects, it had the ‘embarrassing inability’ to understand what monetary policy actions should be taken in situations such as devaluation or a major disequilibrium.

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This was ironic, because one of the reasons that member states needed to lend in the first place was due to challenges with external payments, yet there was no standardised way of ensuring that these countries corrected the underlying causes of their imbalances (Boughton, 2011).

Polak was an IMF employee when he designed his monetary model that could calculate the impact of different monetary policy scenario on the balance of payments and on income. It was distinct from the previous Keynesian models as it was so simple, avoiding complex behavioural variables that would be difficult to quantify/apply.

The Model consists of:

1. Two behavioural relationships: the demand for money function and the function of the demand for imports

2. Two identities: for the money supply and for the balance of payments (Nowak, 2012).

The equations used to derive the model focus on describing how the transmission mechanism leads an increase in domestic credit to result in a rise in imports. This then leads to a fall in international reserves (Boughton, 2011).

Figure 4: The Polak Model (Nowak, 2012)

Figure 4: The Polak Model (Nowak, 2012)

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The values of the balance of payments and the change in nominal income are shown at the point of equilibrium between the BP line and the MM line.

The increase in the rate of expansion of domestic credit (a shift of the line MM to the line MM’) causes the balance of payments to deteriorate and nominal income to rise.

The Polak Model forms the foundation of the IMF’s stabilisation programme. The stabilisation programme focuses mainly on the relationship between internal and external stability. The model shows how control over net domestic credit expansion is the key to stabilising the level of foreign currency reserves. This in turn is key to keeping the balance of payments in check (Nowak, 2012).

How the Mundell-Fleming and Polak Models influence the IMF’s approach to stabilisationWhen the IMF gives support to countries, it does so guided by certain governing principles. This is what is referred to as IMF conditionality. The IMF’s approach to stabilisation has a few essential quantitative features. Important metrics like GDP, inflation level & current account balance are considered, and forecasts prepared. The probability of a country being able to secure external financing is also studied to ensure that its external payment position is viable or can become viable.

In addition to this, the IMF usually lends for a specific purpose; this is documented in the IMF’s legal charter under the articles of agreement.

Another important aspect of the IMF’s approach to stabilisation is its quantitative performance criteria. Performance criteria include ceilings and floors for certain metrics. For example, a floor can be set for net international reserves, whilst a ceiling is set for fiscal deficit or the net domestic credit.

These metrics are agreed upon by a process of discussion with the country seeking support (Mussa, 1999).

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However, this was not always the case with IMF support. The first time that an IMF support package included the type of monetary performance criteria that Mundell, Fleming and Polak advocated for was in Paraguay in 1957. Paraguay was asked not to draw off its IMF agreement unless it was able to keep bank credit from rising. Paraguay was also asked not to allow government spending to rise beyond a certain ceiling (James, 2001).

Polak’s most famous argument supporting this line of thinking is below:

“The economic development could have been financed by higher taxes or foreign loan. The factories might have been built by restriction of consumption or by the repatriation of capital. In all these situations, the desire to spend for a particular purpose would not have led to a payments problem. In a real sense, the credit expansion is the cause of payments problem.”

(Polak, 1957).

This was an extremely persuasive argument. It convinced the IMF that domestic credit (of which public sector credit is usually the majority) must be curtailed if a country really wants to achieve its balance of payments targets.

Criticism of the IMF’s approach to stabilisation Some have argued that the IMF, like many other global institutions, has two sets of rules. One set for rich countries with a lot of influence and one set for poorer countries with less influence (Stone, 2008).

For example, it is claimed that the IMF was under political pressure from France not to devalue the CFA, however, Kenya did not receive the same treatment. It is also claimed the United States pressurised the IMF to interpret the loan conditions for Egypt more flexibly because of the pivotal role that the Egypt played for the US economy at the time (Kapur, 1998).

The author of a book called ‘The Poverty Brokers; Latin America and the IMF’ believes this too. He argues that even though the IMF presents itself as a neutral, non-political organisation which makes decisions solely on scientific economic

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theory, they do not believe this is always the case. The book claims that ‘there can be no doubt’ that the IMF’s policy recommendations align with those favoured by large international capital and the multinational organisations that benefit. It also suggests motives for possible political gain as those same multinationals are important political campaign donors (Brett, 1983).

Another big criticism of the IMF, especially prior to the mid-1980s is that the conditions were shallow, and the support was too short-term, especially for poorer countries; the IMF’s main clientele. Some critics complained about how the conditions intruded on national sovereignty. Other critics focused on the work of the IMF’s work in Africa which they claimed ignored the political realities of these countries and did not take into consideration the institutional weakness apparent in many African countries. This resulted in poor outcomes.

The IMF seems to have received the most criticism in the late 1980s over its conduct in Latin America when an increase in repayments coincided with a further contraction in the respective economies. It was at this point that prominent scholars like former Columbia Professor Karin Lisakers, who later became US executive director at the IMF, called it a ‘political organisation’ and implied that it was biased. MIT Professor Stanley Fischer, who later became the first deputy managing director of the IMF, critiqued the lack of debt relief and his critique was supported by none other than Jacques Polak himself! (Kapur, 1998)

Another point is that similar to the situation which tied transfers to the poor, the IMF conditionality introduces additional huge administrative costs and bureaucracy (Dreher, 2004).

Meanwhile, the US has denied bias on IMF loans (Brett, 1983). In contrast to the criticisms above, there are studies that have found the IMF conditionality criteria flexible and able to take into account the political constraints in the countries that they support. Stone (2008) argues that it was when the US pressured the IMF to relax their conditionality criteria that programmes in Russia, Argentina and Turkey failed (Stone, 2008).

It’s not actually the case that the IMF always requires devaluation or movement to a more flexible exchange rate. Admittedly, discussions about exchange rate are common, but devaluation as a pre-condition is not the norm.

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On the issue of bias, it is worth noting that most of the decisions taken by the IMF align with the approaches suggested by common economic decision-making models such as the Mundell-Fleming and Polak Models. They practically are the same as what the average economist/economic adviser/economic consultant would ask a country experiencing severe balance of payments problems to do. Richard Cooper said famously at an 1892 conference that any five randomly chosen economists if asked to design an adjustment programme would come to the same conclusion as the IMF. So these decisions were not based on bias, but on science (Mussa, 1999).

Polak, in a later publication, acknowledges how much the IMF has evolved, sometimes even overlapping with the World Bank in terms of mission. This is reflective of the changes in scope and style that the institution has undergone over time (Polak J. , 1994).

Ukraine Case StudyBoth the Mundell-Fleming and Polak Models show how increased domestic credit, which is usually by the government/public sector, leads to a fall in international foreign reserves.

The Memorandum of Economic and Financial Policies for Ukraine refers to ‘expenditure-led consolidation that targets a smaller and more efficient government. At the same time, we will make the tax system growth-friendly, transparent, and equitable to support private activity’. This sounds good, but the IMF is often criticised for introducing austerity into economic policy. Increasing taxation and government spending on salaries, some would argue, could make a recession worse (IMF, 2015).

The Mundell-Fleming/Polak Models, however, support the reduction of debt as necessary to protect foreign reserves. The combination of restrictions on further credit cuts to government budgets, including social spending and increased taxation, can adversely affect the poor (Nooruddin, 2006).

It should be noted that the memorandum is based under the claim that for the specific case of Ukraine, a flexible exchange rate regime would be needed.

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ConclusionThe Mundell-Fleming and Polak Models provided a foundation for the conditionality of IMF loans. Undoubtedly, these have been helpful to some countries. Studies have actually shown evidence of some countries using the excuse of the conditionality of an IMF loan to push through reforms that would have otherwise made the leaders politically unpopular (Vreeland, 2003). However, there are some criticisms, especially concerning the effects of austerity on the poor.

References• Blanchard, O. (2017). Macroeconomics. 7th edition. Chapter 19. Pearson.

• Boughton, J. (2011). “Jacques J. Polak and the Evolution of the International Monetary System. IMF Economic Review, vol. 59, no. 2, pp. 379–399.

• Brett, E. (1983). “The World’s View of the IMF.” The Poverty Brokers: IMF and Latin America. London: Latin American Bureau.

• Dreher, A. a. (2004). The Causes and Consequences of IMF Conditionality. Emerging Markets Finance & Trade, vol. 40, pp. 26–54.

• IMF (2015). Ukraine: Letter of Intent, Memorandum of Economic and Financial. Kyiv: IMF.

• James, B. (2001). Silent Revolution: The IMF 1979-1989. Geneva: IMF Bookstore.

• Kapur, D. (1998). The IMF: A Cure or a Curse? Foreign Policy, no. 111, pp. 114–129.

• Mussa, M. a. (1999). The IMF Approach to Economic Stabilization. NBER Macroeconomics Annual, pp. 79–122.

• Nooruddin, I. a. (2006). The Politics of Hard Choices: IMF Programs and Government Spending. International Organization, vol. 60, no. 4, pp. 1001–1033.

• Norrbin, M. M. (2017). International Money and Finance. In S. N. Michael Melvin. Elsevier.

• Nowak, W. (2012). Development of the Polak model. Wroclaw review of law, administration and economics, 28-35.

• Polak, J. (1994). The World Bank and the IMF: A Changing Relationship. Brookings Institution Press.

• Polak, J. J. (1957). Monetary Analysis of Income Formation and Payments Problems. Staff Papers (International Monetary Fund), pp. 1–50.

• Stone, R. W. (2008). “The Scope of IMF Conditionality. International Organization, vol. 62, no. 4, pp. 589–620.

• Vreeland, J. R. (2003). “Why Do Governments and the IMF Enter into Agreements? Statistically Selected Cases.” International Political Science Review / Revue Internationale De Science Politique, Vol 24, pp. 321–343.

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Chapter 8

Is the IMF evil?“The IMF not only failed to anticipate both the EME and the global financial crises, but its responses to the former were not always appropriate and proved ineffective in preventing the second” is a common quote.

The way that the IMF has handled and managed crises in emerging markets has been criticised extensively. Here we explore the nature of crises in some emerging markets and how the IMF has handled them.

IntroductionThe IMF is sometimes seen as a ‘guardian’ of sorts to the global financial system as one of its roles is surveillance. This essay assesses the response by the IMF to both the emerging market and global financial crises. Particular focus will be given to the institutions ability to anticipate and respond appropriately and effectively to these crises.

It will also consider whether controls on free movement of capital can limit the damage of a financial crisis.

The EME & Global financial crisesThe emerging market crisis (EME) of 1997 seemingly caught the entire world unaware as it originated in the ‘Asian Tiger’ countries that previously were cited as examples of sound economic management. On the surface, it seemed like they were getting everything right. They had high rates of domestic savings, strong economic growth and prudent fiscal policies (International Monetary Fund, 1998).

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But this superficial picture unfortunately masked some fundamental problems with regulation, currency risk and overheating of the economy.

Most accounts of the crisis report that it originated in Thailand, triggered by Japanese banks pulling their credit lines which in turn caused a devaluation in the Thai currency: the baht. This devaluation then caused liabilities for a large number of Thai firms to skyrocket. Unable to meet these obligations, firms started to fail, which in turn caused greater concern to institutional investors that had extended dollar debt to Thai companies. Eventually, this became a vicious cycle, a contagion which spread across East Asia over the next few months (King, 2001).

Majority of the countries affected had high levels of capital inflow in the years preceding the crisis. This was the case in the worst affected countries: Indonesia, South Korea and Thailand. In fact, in Thailand’s case, it was up to 16% of GDP. This fuelled credit creation and drove up property prices (Joyce, 2000).

Close ties between companies, banks, and the expectation that the government would bail out systemically important banks, increased risk taking across these different stakeholders (Roubini, 2004).

The global financial crisis was in some ways very different from the EME crisis. But there are some similarities.

Both crises were characterised by two key issues:

(i) High levels of debt/unsustainable loans to private sector and households

(ii) Inadequate levels of regulation or understanding by regulators of the levels of risk being taken in (i) above.

Whereas currency devaluation and exchange rate risk played a significant role in the EME crisis, in the case of the global financial crisis, it was the mortgage markets that played a significant role, amongst a variety of other factors. It is also argued that there was a degree of regulatory capture. Regulatory capture is a theory that describes a situation where regulatory bodies become dominated by the interests of those which they are supposed to regulate rather than the wider public interests (Desai, 2011).

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Mary Mellor in her book, ‘The future of money: from financial crisis to public resource’, refers to the mortgage market as the trigger, not the cause of the global financial crisis. The global financial crisis occurred during a period where there was massive expansion in the mortgage market and American mortgage debts were being securitised into financial products which were then traded across the world in different forms.

Unfortunately, the underlying mortgages became increasingly risky. Defaults within the first three months of a mortgage were previously unheard of, but they became increasingly common as the crisis unfolded. This was because more mortgages were being extended to poor families, often using high pressure sales techniques. Mellor (2010) refers to these notorious loans as ‘NINJA’ mortgages, meaning ‘no income, no job, no questions asked’.

There was also a political/policy angle to the crisis. National mortgage agency executives confessed that they recognised problems with the mortgage market relatively early, however, they were under pressure from the US government to grow the number of homeowners in the country, especially the number of homeowners from low income families. Therefore, they felt they had no choice but to continue to extend unsustainable mortgages (Mellor, 2010).

This section has thus far described both the EME and the global financial crises. The next section will evaluate the response of the IMF to these crises.

The IMF response‘Warning member countries about risks to the global economy and the build-up of vulnerabilities in their own economies is arguably the most important purpose of IMF surveillance. This IEO evaluation found that the IMF fell short in delivering on this key objective.’

(Independent Evaluation Office of the International Monetary Fund, 2011)

A report by the IMF’s own independent evaluation office highlighted various challenges at the IMF such as political pressures, group think and intellectual capture. It was found that IMF staff were often intimidated by the scale of resources available to governments, especially in developed countries.

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The report also found that groupthink was an issue at the IMF. Groupthink is a phenomenon where a group of people reaches a conclusion without rigorous questioning/debate or critical thinking around the decision. It is often caused by not wanting to ‘rock the boat’ or upset the balance (Bosco, 2011).

The report also touched on the effects of ‘softer’ issues like the culture at the IMF. According to the report, the culture was intolerant of contrarian views. The IMF was also overconfident about the financial structure of advanced economies. After the East Asian crisis, a vulnerability exercise was carried out which did not involve any advanced countries, indicating that the IMF though that an economic crisis was the preserve of emerging markets only (Independent Evaluation Office of the International Monetary Fund, 2011).

Figure 1 lists some of the complex interacting factors that contributed to the inability of the IMF to predict the EME or the global financial crises.

Nobel prize winner, Paul Krugman seems to echo this in his book. He argues that the global financial crisis was not unheralded. In fact, he details how the previous crises in East Asia, described in the opening section of this essay, as well as the other financial crises of the 1990s, like Japan, Argentina and Russia, provided credible warning signals to America as to how financial crises typically unfold (Krugman, 2009). By the time of the global financial crisis, the IMF knew all the signs, but due to structural and cultural issues, seemed not to be able to respond to them.

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There seems to be widespread agreement on the failure of the IMF with regard to its anticipatory/surveillance role, however, there are more varied opinions on its response once the crises are on-going.

The IMF was censured for its handling of the Asian crisis and came under increased scrutiny. But the same paper also points out how the IMF is limited by its financial resources and influence. Limited financial resources make the institution skew its lending towards larger countries. In addition to this, it cannot be expected to have the same influence across the world as a central bank, so the power of the IMF is also limited (Joyce, 2000).

When analysed over a period of decades, there is evidence that countries participating in IMF-supported lending programs are significantly less likely to experience a future banking crisis than non-borrowing countries (Papi, 2015).

However, it has also been argued that the IMF was at some level responsible for causing the EME crisis in the first place by encouraging countries to liberalise their capital accounts too quickly. It has also been accused of overstepping in terms of jurisdiction by imposing deep structural reforms that impoverish citizens and cause political/social instability (Woods, 2006).

There have been further criticisms of the nature of the IMF’s response to the crisis in Asia as well as deep distrust. Some critics believe that the IMF deliberately underfunded countries like Thailand, Indonesia and South Korea, resulting in prolonged economic turmoil, increased poverty, and extended periods of capital flight. One of the most outspoken critics was Japan’s deputy minister of international finance at the time: Eisuke Sakakibara, who openly warned Indonesia against letting its poorly performing domestic banks fail in line with IMF’s advice. He indicated that it would not be allowed to happen in America and that the IMF was prescribing damaging medicine to Indonesia that they would not prescribe if the United States found itself in a similar situation (Lindblad, 2010). Others argue that reduction in social spending that happens in developing countries due to the conditionality of IMF loans may cause public health problems in recipient countries (Stuckler, 2009).

Apart from the fact that many Asian policy makers feel that the IMF’s advice was either wrong or misplaced, some also felt humiliated by the leaders at the IMF, leading to a lasting ‘IMF stigma’ for the countries that received IMF assistance during the crisis, even though empirically in the long term, there has been no

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difference in the economic outcomes of countries that received assistance and those that did not (Ito, 2012).

A piece in Foreign Policy argues that blaming the IMF for the fact that eventually every country must confront its budget constraints is like blaming the Fund for gravity (Rogoff, 2003). The IMF often has to pass on the bad news that nobody wants to hear and some critics are just shooting the metaphorical messenger.

Thomas Willet (2001) gives a similarly measured opinion in his piece published in the Independent Review. He points out how the IMF has been vilified by both the right and left wing at different times, for different reasons in different countries, but predominantly, overall, it has been a force for good. It is not perfect but should still exist and is in need of reform. Another major issue his piece points out is how IMF responses can be politically motivated by the large shareholders like the United States (Willett, 2001).

The role of controls on the free movement of capital Capital flows have the ability to improve livelihoods and standards of living in so many countries around the world (Joyce, 2000). However, capital flows also have the ability to destabilise those same economies as they are left vulnerable to the whims of foreign investors. These foreign investors sometimes act on the basis of hearsay rather than the fundamentals, causing panicked mass withdrawals of investments from particular countries (Roubini, 2004).

One of the major criticisms of the IMF is around the advice it gives on capital controls. The most publicised work of the IMF is in crisis situations. However, the bulk of the day to day work of the IMF involves travelling to or engaging with member countries to provide advice on how to prevent a crisis in the first place. However, much of the advice is around liberalising capital markets and flows which some senior economists believe planted the seeds of the EME crisis (Lindblad, 2010).

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Rogoff (2003) points out that if East Asian countries had not been so open to borrowing in foreign currency as freely as they did, the huge debts would not have mounted and then there would have been fewer foreign creditors demanding repayments. It also reveals that, apparently, in the months leading up to the crisis, the Thai government were warned by the IMF about the currency risks that were being taken in their financial markets, but at the time, Thailand had the ambition of becoming a global financial centre like Singapore and large foreign currency inflows were an important part of the overall strategy.

Nevertheless, this was not the case in South Korea or Mexico where such warnings were not issued by the IMF. Moreover, the issue around capital controls is complex. In the case of the Asian crisis, countries with relatively closed economies, like China and India, were unscathed for the most part, whilst the contagion spread through the more open economies in Asia. Strikingly, New Zealand’s and Australia’s open, liberal economies where hardly affected by either crisis. This is a result of something that the EME countries lacked – strong regulation; strong exports to be able to pay down debt; and deep, strong domestic markets (Rogoff, 2003).

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Conclusion

In the aftermath of the global financial crisis, a key part of the IMF’s response was reform around scope. The IMF developed more lending programmes targeted at the prevention of a crisis rather than emergency management once a crisis unfolds. Examples of such include the flexible credit line (FCL) and the precautionary credit line (PCL) as well as enhancement of the high access precautionary arrangement (HAPA) (Moschella, 2011).

The IMF failed to fully anticipate both the EME and the global financial crises. But after the global financial crisis, reforms were put in place to ensure that the institution has instruments that can be used to prevent crises as well as try to fix them. Like any complex, large global institution, it has its flaws and there is room for further reform. But overall, it has been a force for good and has shown that it is capable of reflection and improvement.

On the issue of free movement of capital, the advantages appear to outweigh the disadvantages in terms of the amount of prosperity that foreign capital can bring to countries around the world. However, the IMF must temper its advice on liberalisation with warnings on the downsides; the need to strengthen regulations, deepen domestic markets, maintain an independent central bank, and focus on exports.

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References• Bosco, D. (2011, Febuary 10). Why didn’t the IMF predict the financial crisis? Foreign Policy.

• Desai, P. (2011). In Financial Crisis Origin. In From Financial Crisis to Global Recovery (pp. pp. 1-20). New York: Columbia University Press.

• Independent Evaluation Office of the International Monetary Fund (2011). IMF Performance in the Run-Up to the financial and economic crisis. Washington DC: IMF.

• International Monetary Fund (1998). The Asian Crisis: Causes and Cures. Finance and Development, Volume 35, Number 2.

• Ito, T. (2012). Can Asia Overcome the IMF Stigma? The American Economic Review, 198-202.

• Joyce, J. (2000). œThe IMF and Global Financial Crises. Challenge, 88.

• King, M. (2001). Who Triggered the Asian Financial Crisis? Review of International Political Economy, 438.

• Krugman, P. (2009). The Return of Depression Economics and the Crisis of 2008. New York: W. W. Norton & Company.

• Lindblad, J. T. (2010). “IMF: The Road from Rescue to Reform.” In The Asia-Europe Meeting: Contributing to a New Global Governance Architecture: The Eighth ASEM Summit in Brussels. Amsterdam: Amsterdam University Press.

• Mellor, M. (2010). The Future of Money: From Financial Crisis to Public Resource. London: Pluto Press.

• Moschella, M. (2011). The Global Financial Crisis and the Reforms to IMF Lending. St Antony’s International Review, 48-60.

• Papi, L. P. (2015). IMF Lending and Banking Crises. IMF Economic Review, 644-691.

• Rogoff, K. (2003). The IMF Strikes Back. Foreign Policy, 39-46.

• Roubini, N. (2004). Bailouts Or Bail-Ins? Responding to Financial Crises in Emerging Economies. Peterson Institute for International Economics.

• Stuckler, D. a. (2009). THE INTERNATIONAL MONETARY FUND’S EFFECTS ON GLOBAL HEALTH: BEFORE AND AFTER THE 2008 FINANCIAL CRISIS. International Journal of Health Services 39, no. 4, 771-781.

• Willett, T. (2001). Understanding the IMF Debate. The Independent Review, 593-600.

• Woods, N. (2006). Understanding Pathways Through Financial Crises and the Impact of the IMF: An Introduction. Global Governance, 373-93.

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SECTION 4

Banking and capital markets The first essay in this section talks about bank-oriented economies versus market-oriented economies and why the difference is important.

A bank-oriented economy is one in which most people keep their money in banks, while a market-oriented economy is one in which most people keep their money in the stock market.

Looking at the meaning of bank-oriented economies, you’ve probably already guessed that Nigeria is a bank-oriented economy.

Nigerians don’t keep a lot of money in the stock market; most of their money is kept in banks.

America, for example, is a market-oriented economy. You can see that most of their money is in the stock market. In fact, more than 30% of the money that belongs to American households is in the stock market. Knowing this, you can easily conclude that America is a market-oriented economy.

You may be thinking. “Why does it matter if people keep their money in banks or the stock market? Why is this an issue as long as they keep their money somewhere?”

It is an issue because some economists argue that countries with market-oriented economies tend to have more robust innovation levels than bank-oriented economies.

If you go to the bank today to pitch them with a big idea on A.I or 3D printing or something that the bank is not familiar with , they will probably reject it. Bankers are generally old school; they gravitate towards tried and tested business models. In a market-oriented economy, however, if you ask for such an investment from households through the stock market, you are more likely to get it because households tend to be more experimental.

This may partly explain why America has the largest technology companies in the world. Innovative companies like Google, Facebook, Uber, Apple, Tesla and many others are all in America, driven by the stock market.

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This is one of the issues affecting emerging markets, including Nigeria, even though in theory we are more bank-oriented. In practice, we are neither bank nor market-oriented. We are mattress-oriented.

A large percentage of the population does not keep money in the banks. As I mentioned in my essay on microeconomics, we tend to resort to other methods of saving money; while Babajide prefers to keep his money in his trousers, Folakemi may prefer to keep hers under her pillow,. Since people don’t keep their money in financial institutions, there is less money to lend to businesses. This tends to stall productivity in businesses, and deprives the country of the capital vital to growth and development.

Getting the Nigerian Stock Exchange adequately capitalised as well as getting more people to put money in banks are crucial to business growth. This will not only have a positive impact on businesses, but it will also boost the nation’s GDP.

Banks and capital markets play a significant role in changing the status of a country from an emerging market to a developed market.

South Africa’s stock market is over 20 times larger than Nigeria’s. However, in terms of population, there are only about 35 million South Africans, compared to close to 200 million Nigerians.

South Africans have a much more developed market, so it makes sense that it may be easier for a South African entrepreneur to raise capital compared to a Nigerian entrepreneur. However, stock market capitalization in emerging markets is generally smaller compared to more developed countries.

The second issue I will address in this section is how a country develops from a financially repressed economy to a fully international and domestic liberalised economy. During the military era, the government controlled the banks, and therefore, their supply of credit in the economy; many would describe this as financial repression. Liberalisation started when the government privatized the banking industry. Eventually, we became a fully international and domestic liberalised economy where foreign investors could come in and go as they please.

While it’s a good thing that foreign investors can to invest their money, it has also given us problems, as foreign investors sometimes come with ‘hot money’. This means that when they see an opportunity, they invest in it. However, such investments are short-term and risk-averse, so at the first sign of trouble, they all take their money out at the same time. This produces fluctuations in the economy that have led to severe crises in some emerging markets.

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In my subsequent essay, I explained in detail the role the National Deposit Insurance Corporation (NDIC) plays in safeguarding bank deposits.

Many assume that any money you put in any Nigerian bank is 100% insured. This assumption means that if something happens to a bank in which you have kept your money, you can just go to the NDIC and get all your money back.

That’s not exactly true. It is imperative to understand that the NDIC is an organisation primarily concerned with the needs of the masses. This means that they only insure amounts they feel will cover most of the country’s bank deposits without causing too much suffering to the masses.

In Nigeria, the NDIC covers only five hundred thousand naira (₦ 500,000). This means that if a bank goes bankrupt, only ₦ 500,000 of your money is covered. For example, if you have 10 million naira in a bank, and the bank goes bankrupt, you will only be able to get back the ₦ 500,000 covered by the government.

When a bank goes bankrupt, it will lose a lot of money because the NDIC will only give the bank a tiny percentage of what they have in the bank. Therefore, it actually doesn’t give them what we call a moral hazard; the tendency for banks to act irresponsibly just because they have a backup.

The last thing I want to discuss in this explainer- which I believe a lot of young people will be interested in- is about new forms of banking, such as FinTechs, Digital Wallets, and mobile money. It is critical for people to know whether NDIC covers the things they’re putting their money intp.

Organisations such as NDIC and other national deposit insurance companies were formed as a result of the panic caused by failed banking systems. In the past, as soon as anyone discovered that a bank was likely to go bankrupt, everyone rushed to the bank to collect their money.

One thing people need to understand about banks is that if every depositor goes to them today and asks for their money, they (banks) will be in trouble because they don’t actually have it on hand. The money that you see in your account is fictional. They don’t have cash at the bank.

Your money has probably been given out to someone, either as a loan or any other thing they deem fit.

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Your total deposit with xxx Bank is probably with Dangote, and he may not return it anytime soon, depending on their agreement. This is why banks have only a small percentage of the money they can give out on request.

If there was a rumour that a certain bank was about to fail and everyone rushed to collect their money from that particular bank,-even if it was Nigeria’s biggest bank- it would probably fail.

The reason the NDIC was formed (and the reason the CBN also ensures that banks keep some money with them) is to ensure people feel confident that their money is safe. This is good financial practice, as well as being one of the measures that several international organisations encourage countries to take.

Thanks for reading the banking and capital market explainers.

I hope you enjoy the essays.

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Chapter 9

Bank oriented economies vs. Market oriented economies – we look at advanced markets to see how they developed their market orientation.

Nigeria has a very bank oriented economy. Is this working for us? Should emerging markets try to develop both? What is the role of financialisation in emerging markets? How does this affect corporate governance?

IntroductionThis essay will compare the bank oriented financial systems of the world to the market-oriented systems, focusing on the factors that facilitated their development along with their respective strengths and weaknesses.

It will conclude with an assessment of the implications of the two systems for corporate governance.

Bank-oriented vs Market-oriented SystemsFinancial systems do not function in the same way everywhere in the world. There are systematic differences between financial systems that can be classified in different ways. One of such classifications is the division of financial systems into bank- or market-oriented systems.

A bank oriented system is one in which banks play the prominent role in ‘mobilising savings, allocating capital, overseeing the investment decisions of corporate managers, and providing risk management vehicles’ (Demirguc-Kunt, 1999).

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However, a market oriented system is one in which securities markets share a greater part of that role. In market oriented systems, securities markets are more prominent when it comes to getting household savings to firms, influencing corporate control, and providing risk management.

There are several factors that can be used to determine whether a financial system is bank oriented or market orientated. These are:

i. Size of bank assets relative to GDP

ii. Stock market capitalisation relative to GDP

iii. Household portfolio allocation

iv. Sources of finance to industry.

Let us start by looking at bank asset compared to GDP in different countries:

Figure 1 (World Bank, Accessed 2020)

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The data shows how countries like Japan, France and Germany have far higher levels of banking assets compared to GDP than countries like the United States.

However, when we look at the stock markets in those countries, there is a different picture.

Figure 2 (World Bank, Accessed 2020)

When we looked at the United States by deposit money in banks compared to GDP, it was the lowest of all the countries we looked at. But in terms of equity market capitalisation of listed companies as a percentage of GDP, it is the highest! Showing that some countries have an obvious slant towards either banks or markets.

Another criteria analysts look at when trying to determine whether a market is more bank- or market oriented is to observe where households put their money.

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Figure 3 (World Bank, Accessed 2020)

The blue line is for currency and the diagram shows how German and Japanese households keep a significantly larger proportion of their assets in deposits/currency in banks compared to the United States where the reverse is the case.

Consequently, the question we will be tackling in the next section is, ‘Which system, if any, is better?’

Strengths and weakness of both systems (Market-oriented & Bank-oriented)The strengths and weaknesses of each financial system will be considered under three main important functions: innovation/technology, dissemination of information, and ability to restructure. All of these are core functions of a financial system.

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This section will examine what advantages and disadvantages market-oriented/bank-oriented systems bring to the essential roles.

If a company runs into financial problems, it is easier for the company to restructure its debt with a bank than it is with the stock market/corporate bond. The bank is incentivised to help the company restructure. Therefore, under a bank-oriented system, fewer companies have to shut down when they are in financial distress compared to market economies where there are usually more shareholders and renegotiation is usually more difficult/expensive.

It is likely that more businesses are able to overcome temporary financial setbacks by restructuring their debt, hopefully serving the crisis and continuing to grow. This is an advantage for bank oriented financial systems.

However, there are disadvantages too. Companies often know that banks are incentivised to restructure them, so they may take larger, even reckless risks. Also, they may not be as disciplined with cost control. This kind of behaviour is less likely in a market oriented financial system.

One of the most important functions of any financial market is information dissemination. Market oriented financial systems, due to the strict reporting requirements of capital markets, disseminate information more readily. Banks, however, do not need to disclose such information. Therefore, the greater dissemination of information in market-oriented systems is an advantage.

Banks have a less diverse set of people that decide on potential investments, markets provide more diversity of opinion. Therefore, some of the newer technologies/innovations that may not be funded by a bank are more likely to be funded by financial markets. There is also the issue of stability. A study by the bank for international settlements found that when recessions have occurred at the same time as financial crises, the impact on GDP has been three times as severe for bank oriented financial systems as it has for market oriented ones (Gambacorta, Leonardo, & Yang, 2014). These are key advantages for market oriented financial markets.

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Factors that facilitated development of both systemsThis section describes four possible (of potentially many more) factors that could have facilitated the development of both systems:

1. Legal system

2. Special interest groups and politics

3. Enterprise structure/Market need

4. Stage of development

There has been much debate about what factors facilitated the development of these different financial markets in the first place.

One theory focuses on the influence of the type of legal system each country has and the protection that it offers to investors. A study of 49 countries found that countries with civil legal systems (which offer less protection to investors), have smaller capital markets than those with common law legal systems, which offer more investor protection (La Porta, 1997).

However, this argument has its limitations. Firstly, dichotomy between countries that have civil law and common law did not exist in 1913. Common law countries were not more financially developed then. Thus, legal systems may be a factor, but not the entire story.

Rajan and Zingales (2003) argue that the influence of special interest groups must be considered. There are incumbent firms in many countries that may be incentivised to use their political influence to prevent the development of financial markets. These incumbent firms do not have financing challenges. They can either finance growth from their retained earnings or through loans taken from the bank using a collateral. Open financial markets would just allow more entrants to the market that could potentially compete with them. In the situation that access to finance is restricted, even new firms/start-ups must build alliances with the incumbents in order to access finance. In this way, these incumbent firms enjoy a form of ‘rent’. This would not be so in an open financial market (Rajan, 2003).

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Pure structural arguments focus on the role of the legal system. Rajan and Zingales (2003) state that this view is not wrong, but that it’s incomplete. Rather, they highlight the role of special interest groups and politicians/political will.

Horst Siebert (2005) suggests another possible factor that may have facilitated the development of market-oriented vs bank-oriented systems, which is the actual needs of the market. Germany has more small-medium sized businesses which play a greater role in the economy. Therefore, bank finance is better suited to these SMEs as they need smaller amounts of credit. Whereas in America, there is more dominance of mid-sized/larger businesses that need larger sums which capital markets are able to provide (Siebert, 2005).

The final issue considered in this section is the stage of development of the country. A country typically becomes more market based as GDP per capita increases (Demirgüç-Kunt, A, Feyen, & Levine, 2011). Many emerging markets may still be in the ‘bank stage’ of development, and as some of these countries develop and financial needs become more complex, they may evolve. Therefore, development stage may also explain differences.

Implications for corporate governance This article started by comparing market oriented financial systems to bank oriented systems in terms of features, then went on to explore the strengths and weakness of both systems as well as the possible historical reasons why each type of system developed.

This final section will describe the implications that both systems have on corporate governance.

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Are banks better suited to provide corporate governance and oversight?

Some argue that they are, because they are less fragmented than the typical shareholders of a firm on the stock exchange. There is a view that shareholders in capital markets such as those that exist in the American market-oriented system are disaggregated. Therefore, they are unable to form effective coalitions capable of influencing real change within the companies. This makes ‘American shareholders powerless to affect management decisions’ (Macey, 2008).

Also, due to the fragmentation, there is actually little incentive for any one particular shareholder to exercise control. This is known as the free rider problem. Exit is generally cheaper than intervention, especially since if the news of an intervention should spread, it could further decrease the price of the stock (Berle, 1932). Research by Shleifer (1986) shows how large shareholders like banks can reduce/eliminate this ‘free rider’ problem as they are more incentivised to exercise control as their power is more concentrated (Shleifer, 1986).

The American market-oriented system focuses power in the hands of management (Theodor, 1993), often disparagingly referred to as ‘Berle-Means’ corporations. This term describes the typical separation of risk-bearing and control, diffuse shareholding and potential agency conflicts between managers and shareholders (Cheffins, 2018). All these problems further highlight the benefits of corporate governance activities coordinated largely by a single homogenous entity like a bank.

The close relationships between banks and the clients that they finance in countries like Japan give an additional advantage in the form of reduced agency costs. This allows investors to monitor their investments more efficiently than in the United States (Prowse, 1990).

The above points demonstrate the upsides of having banks, as opposed to shareholders in markets, perform corporate governance functions.

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But what about the downsides?

So far, we have assumed that equity holders and banks (fixed claimants) have the same interests. But this is not always the case. In fact, is has been argued that the clear conflict of interests between fixed claimants and equity holders is the primary reason why banks are not the ideal institutions to monitor company performance on behalf of shareholders.

A fixed claimant such as a bank is incentivised to encourage companies to take sub-optimal levels of risk. The aim of the bank is only to ensure that the money that it lent to the company is paid back, not necessarily to increase the value of the company’s shares. This aggregate reduction in the level of risk taking by companies results in a transfer of wealth from the shareholders to the banks.

The very idea that bank-oriented systems are more likely to exercise corporate control does not seem to stand when we look at the data on takeovers. Banks seem to side with management over shareholders. For instance, Germany is a very bank oriented financial system whilst the UK is a much more market-oriented economy, yet, the total number of takeovers during the boom period in the 1980s in Germany was less than half that of the UK.

In fact, as of 2008, there had only been four recorded hostile takeovers in Germany since world war two (Macey, 2008).

Whether a financial system is bank oriented or market oriented seems to have significant implications for corporate governance. Banks may have some advantages over capital markets in terms of corporate governance, but my opinion is that their risk averse nature no longer fits into our fast-paced world of innovation.

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The internet has opened up a world of information and has also given a voice to even the smallest minority shareholders; take for example, the letter8 that Professor Scott Galloway published to Twitter last year on his blog. An excerpt of which I have quoted below:

‘Mr. Kordestani,

A part-time CEO who is relocating to Africa? Enough already.

My name is Scott Galloway (@profgalloway). I am a Professor of Marketing at NYU’s Stern School of Business, an entrepreneur, and a U.S. citizen. As of 12/6 I am the direct and beneficial owner of approximately 334,000 shares in Twitter. I reserve the right to establish a dialogue with like-minded shareholders regarding the nomination of class III directors and/or a resolution of “no-confidence” concerning you and CEO Jack Dorsey for consideration at your annual shareholder meeting in May.’

And so, one letter on an online blog published by a minority shareholder resulted in a media frenzy. The letter was shared multiple times on social media as the post went viral. It was partly as a result of this letter that sweeping changes were made at Twitter.

On a similar note, activist shareholders also affect the firm’s performance positively according to data from France (Souha, 2020).

8 https://www.profgalloway.com/twtr-enough-already/

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Conclusion This article began by describing and comparing bank oriented financial systems with the market oriented financial systems. It then went on to evaluate their strengths and weaknesses.

After which, the historical factors that potentially contributed to the development of each respective system were analysed.

The conclusion directly linked these historical factors to the implications of each system for corporate governance.

Although the focus has been on the difference between market and bank based financial systems, in many advanced countries, there is an overlap. Overall, the trend has been increasing influence of the financial sector on economic policy and the overall economy. This is called financialisation (Minsky, 1992).

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References• Berle, A. a. (1932). The Modern Corporation and Private Property. New York: Macmillan.

• Cheffins, B. (2018). The Rise and Fall (?) of the Berle-Means Corporation. Seattle University Law Review.

• Demirgüç-Kunt, A, E., Feyen, R., & Levine. (2011). The evolving importance of banks and securities markets”. World Bank, Policy Research Working Paper, no 5805.

• Demirguc-Kunt, A. L. (1999). Bank-based and market-based financial systems - cross-country comparisons. Policy Research Working Paper Series 2143, The World Bank.

• Gambacorta; Leonardo, J.; & Yang, K. T. (2014). Financial structure and growth. BIS Quarterly Review.

• La Porta, R. L. (1997). Legal Determinants of external finance. Journal of finance, 1131-1139.

• Macey, J. R. (2008). The role of banks and other lenders in corporate governance; corporate governance promise kept, promises broken. Oxford: Princeton University Press.

• Minsky, H. (1992). The Financial Instability Hypothesis. The Levy Economics Institute Working Paper Collection, Working paper 74, 1-10.

• Prowse, S. (1990). Institutional Investment Patterns and Corporate Financial Behaviour in the United States and Japan. Journal of Financial Economics, 43-66.

• Rajan, R. Z. (2003). The great reversals: the politics of financial development in the twentieth century. Journal of financial economics, 5-50.

• Shleifer, A. a. (1986). Large Shareholders and Corporate Control. Journal of Political Economy, pp. 461–488.

• Siebert, H. (2005). “The Capital Market and Corporate Governance.” The German Economy: Beyond the Social Market, Oxford: Princeton University Press.

• Souha, S. B. (2020). Shareholder activism, earnings management and Market performance consequences: French case. International Journal of Law and Management.

• Theodor, B. R. (1993). Institutional Investors and Corporate Governance. De Gruyter.

• World Bank. (Accessed 2020). World Bank development indicators. Retrieved from http://datatopics.worldbank.org/world-development-indicators/: http://datatopics.worldbank.org/world-development-indicators/

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Chapter 10It is not standard advice for developing countries to have a deposit insurance as well as a lender of last resort function usually performed by the central bank. Nigeria’s deposit insurance organisation was formed in 1989. What is the role of these functions on the stability of the financial system especially in light of the banking crisis of 2007?

As emerging markets liberalise, what risks does the McKinnon and Pill Model highlight? What is the role of moral hazard?

The role of deposit insurance/lender of last resort in the stability of financial systems

Introduction The past few decades have seen a lot of market volatility. Governments have taken aggressive steps in crisis situations. For example, in Argentina in the 1980s, the government used 55% of GDP to ‘bail out’ its banking system (Sleet, 2000).

Deposit insurance and the importance of the role of the lender of last resort as ‘safety nets’ for the financial system reduce the likelihood of the breakdown of a financial system. If breakdown does occur, these schemes limit the damage (Demirguc-Kunt, 2001).

This article explores the role of deposit insurance and lender of last resort in detail using the McKinnon and Pill Model to evaluate the risk of over borrowing and moral hazard.

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The McKinnon and Pill Model The McKinnon and Pill Model explores the complex relationships between economic productivity, economic reforms, behaviour of bankers/households/firms, and productivity.

The model explores the relationship in a number of different scenarios.

The focus of this paper will be on three of the economic scenarios that the McKinnon and Pill Model explores. These are:

1. The financially repressed economy

2. The economy with domestic liberalisation only

3. The fully liberalised economy; international and domestic

(McKinnon, 1997).

Figure 1: The three economic scenarios in the McKinnon and Pill Model

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Scenario 1: The financially repressed economy (FRE)

The initial scenario that McKinnon and Pill consider is the financially repressed economy, where the government policy limits economic activity and, therefore, productivity. Banks in this scenario offer fewer, smaller loans as larger loans go to state owned entities and government.

Figure 2: Equilibrium in the financially repressed economy

(McKinnon, 1997).

As shown in Figure 2 above, despite economic reforms, the economy remains in equilibrium at level A due to the high capital costs of the type of projects that can move the metaphorical needle. This is because in a financially repressed economy as described above, banks do not tend to fund large projects. However, because of the size of the financing required, such projects require external finance which cannot usually be financed by individuals. Consequently, the economy remains close to equilibrium at point A with little or no real change (McKinnon, 1997).

Nevertheless, the story changes when there is liberalisation of the domestic markets as described in scenario two below.

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Scenario 2: The domestically liberalised economy (DLE)

Figure 3: First Best Solution in the domestically liberalised economy

(McKinnon, 1997)

The DLE scenario considers a case where there is real economic reform and unlike in scenario 1 considered earlier, financial repression is absent. The local stock market (bank based) can therefore allocate capital to innovative large-scale projects which it was unable to do in scenario 1 due to financial repression.

However, it is important to note that this happens domestically, so the economy is not open to international capital flows.

If it is assumed that payoffs for investments are known, then this model produces a very good outcome for all citizens. Some agents decide to invest in new technology and innovation, placing them at point A, whilst others remain at point B with older technology. This terms the latter group into savers, even as welfare improves for everyone.

Unfortunately, this is not a typical real-world scenario. Usually, payoffs are not known. In a newly liberalised economy, there is a lot of uncertainty about the level of risks inherent in certain investments and what payoff to expect.

When banks know that there is a government deposit insurance for all depositors’ funds or that there is a bailout plan from a lender of last resort like the central bank, an element of moral hazard is introduced. Under these circumstances,

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banks could lend excessively, taking on unsustainable levels of risk knowing that there is a government-backed fail-safe in place. This has further consequences for the economy because non-bank firms use bank behaviour as a signal that tells them how well the economy is doing. So when banks increase their levels of lending significantly, it signals to firms that reforms are working, returns on investment are excellent and that they (the firms) should borrow even more money and take more risk. They believe these signals because the firms expect banks to have superior knowledge about the state of the economy and rely on them as ‘expert investors’ to indirectly guide their own behaviour. This vicious cycle stemming from the moral hazard faced by the banking sector can snowball into a full-blown crisis.

However, because the economy is effectively closed, the contagion is contained within a single domestic economy. This scenario and the potential consequences contrast sharply with the next and final scenario considered in this paper under the McKinnon and Pill Model (McKinnon, 1997).

Scenario 3: The Internationally liberalised economy (ILE)

In this case, the economy is open to international investors, which opens up challenges with two variables that were not emphasised in scenario 2.

a) The role of interest rates

b) The role of exchange rates.

Figure 4 (Mc Kinnon, 1999)

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The ILE scenario considers a fully liberalised economy open to both local and foreign investors. Interest rates in scenario 2 (DLE) are driven up by demand and a closed, domestic economy reaches a point where many firms cannot borrow. However, in the ILE scenario, the interest rates are not driven up to the same extent as the option/alternative of international capital exists.

Also in the DLE scenario, money is borrowed in domestic currency, whereas in the ILE scenario, borrowing also occurs in foreign currency. This comes with additional risks, the level of which depends on the type of exchange rate regimen the country has in place.

Stanley Fischer, former Deputy Managing Director of the IMF, explained it like this:

‘There is a trade-off between the greater short run volatility of the real exchange rate in a flexible rate regimen versus the greater probability of a clearly defined external crisis or financial crisis when the exchange rate is pegged. The virulence of the recent crisis is likely to shift the balance towards the choice of more flexible exchange rate systems, including crawling pegs with wide bands.’

(Fischer, 1999)

Figure 4 shows the realistic level of lending, considering the economic situation/level of productivity payoff as αFB (FB stands for first best outcome). In this unbiased case, firms and households will borrow from international capital markets at point XFB and consume at CFB. But when banks are affected by moral hazard, knowing that they will be bailed out and knowing that there is insurance for all deposits, they become overly optimistic. They discount the risk of collective failure and start borrowing as if the expected productivity payoff level is at XOB. This leads to overconsumption and overinvestment, represented by W and V respectively on the chart (Mc Kinnon, 1999).

This initial section has explored the McKinnon and Pill Model in detail with respect to the risks of each stage of economic liberalisation with specific emphasis on the role of moral hazard. This analysis, however, has so far generally only highlighted the disadvantages of deposit insurance and lender of last resort facilities and the ways these safety nets can create moral hazard, encouraging over borrowing by financial systems.

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The next section will examine the role of these important financial mechanisms in-depth; why they are so important and the best practices that help policy makers strike a balance between the provision of an essential safety net whilst at the same time limiting the risks posed by moral hazard and excessive risk taking.

Deposit Insurance, lender of the last resort and the stability of the financial systemThis section aims to evaluate the role of deposit insurance and lender of last resort on the stability of the financial system with focus on the role both played during the banking crisis of 2007.

Currently in most countries, there are two main entities that have been established to help prevent bank runs, provide liquidity when bank runs occur, and provide assurance to the public about the safety of their deposits. They are:

a. A deposit insurance organisation that provides partial or total insurance for retail deposits. In some cases, it covers the total deposit; others cover up to a certain amount.

b. A lender of the last resort, usually the central bank that provides loans to banks that have liquidity challenges.

The central bank typically intervenes when there are minor challenges whilst the deposit insurance organisation intervenes when challenges are more serious i.e. in a full-blown crisis (Laeven, 2002). There is also the role of international lenders of the last resort such as the IMF (Nicholas, 1998).

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Deposit insurance and stability of the financial systemDeposit insurance is a pillar of trust working alongside other mechanisms/organisations such as the lender of last resort, but also, liquidity ratios, reserve ratios, and other elements of regulatory oversight. This role has not always been performed by government. By 1910, banks had developed mutual systems of interbank loans and agreements to help each other when they fall into financial difficulty. There were also various state deposit insurance schemes, many of which failed (Calomiris, 1990).

However, the social cost of bank runs was extreme and had far reaching consequences beyond the financial system. After the bank runs of the 1930s that preceded the great depression, the Federal Deposit Insurance Commission was formed to stabilise the banking system (Hogan, 2016).

Since the 1980s, the number of countries with explicit deposit insurance schemes almost tripled, with most OECD countries and an increasing number of developing economies adopting some form of explicit depositor protection. In 1994, deposit insurance became the standard for the newly created single banking market of the European Union. Furthermore, establishing an explicit deposit insurance scheme also became part of the generally accepted best practice advice given to developing economies (Demirguc-Kunt, 2001).

During the Great Financial Crisis, government support of the banking system included the extension of retail deposit insurance scheme. Deposit insurance was increased from $100,000 to $250,000 in the United States. In other countries, such as Germany, all retail deposits were insured during the crisis. These measures formed an important part of the package that helped avoid a meltdown of the financial system. The economic downturn during the great financial crisis was deep, but the deposit insurance helped prevent a collapse in consumption which would have deepened the recession. It is in this sense that deposit insurance revealed its value during the crisis (Carstens, 2018).

It has, however, been argued that deposit insurance creates two opposing forces. On one hand, it is agreed that it removes the incentive for depositors to run on the bank. But on the other hand, it also allows for more recklessness by banks as depositors do not scrutinise them as closely. This is the moral hazard which

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provides the evidence for arguments against deposit insurance. This notion is supported by evidence that strongly suggests that systems with higher levels of government-backed insurance have higher numbers of bank failures (Hogan, 2016).

Lender of last resort and the stability of financial marketsThe lender of last resort function, as outlined in the section above, is usually undertaken by the central bank. Two problems with the response undertaken mostly by the Federal Reserve with assistance from the Treasury have been highlighted in the aftermath of the global financial crisis.

First, the rescue has the potential to create strong adverse incentives. (This problem has been a recurrent theme throughout this article.)

A few American financial institutions were forcibly closed or merged, but most suffered no real repercussions. Early financial losses (for example, stock prices) were large, but were recouped over time for the most part. Hardly any top executives or trades was prosecuted for fraud. And most of those that lost their jobs received large compensation anyway.

A second criticism was that the bailouts were made in secret and even after a freedom of information request was made, the data released was difficult to analyse. Even though both criticisms are from an American perspective, similar scenarios unfolded across the world (Levy Institute, 2013).

George Soros argues that any lender of the last resort activity will result in moral hazard to some degree, but also argues that a world without a lender of the last resort, would be too unstable; this is due to the inherent instability of financial markets in general (Soros, 2001).

This idea of stability as an over-riding goal is important. During normal times, insurance schemes should not get in the way of a wholesale run on an individual institution, as this is part of healthy market discipline. But as the Great Financial Crisis worsened, the drying-up of wholesale funding markets put the entire

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system at risk, threatening overall economic stability. It therefore became important for many central banks to step in as lenders of last resort. At the same time, governments extended guarantees to wholesale funding, and in the United States, even to money market mutual funds (Carstens, 2018).

Deposit insurance post 2007The aftermath of the financial crisis ushered in the era of the FinTechs; many of which have started to provide bank-like intermediation, usually without the provision for deposit insurance. Notwithstanding, in some countries, FinTech firms receive banking licenses. Again, in this scenario, there is no insurance offered for deposits. How digital wallets and other e-money should be insured –or whether it should be insured in the first place – is still subject to debate. What cannot be disputed is that retail customers must be well informed of the extent to which they are – or are not – protected (Carstens, 2018).

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ConclusionThe theme that runs through this article from the beginning to the end is that of moral hazard and the way incentives change behaviour. This is highlighted in the analysis of the McKinnon-Pill Model at the begin of this article which then moved on to evaluate the roles of deposit insurance and lender of last resort on the stability of the financial system in light of the banking crisis of 2007.

Several parallels were drawn between deposit insurance schemes and lender of last resort. Both sustain trust in the financial system by reducing the risk of self-fulfilling runs. But, there are important differences. The role of the lender of last resort – at least in principle – is to address liquidity strains at viable institutions. In the midst of a crisis, it can be a complicated call to make and sometimes ultimately ends up at the central bank’s discretion. However, deposit insurance protects depositors of failing banks, and it is the rules-based nature of deposit insurance schemes that contains uncertainty. As such, last-resort lending and deposit insurance complement each other (Carstens, 2018).

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CONCLUSIONAs I said in the introduction, the world seems to be focusing more on the half a billion people who are doing quite well, rather than paying increased attention to the needs, wants and desires of the four billion people who make up most of the world’s population.

In this book, I have tried to focus on these four billion people. Not only did I highlight their problems, I also offered possible solutions that could help these economies move from poverty, a bit closer to prosperity.

In the first chapter, I explained in detail the role of macroeconomics, government spending, taxation and monetary policy, and how they work in emerging markets compared to advanced countries.

Moving further, I deliberated on microeconomics and how decisions are made on an individual and firm level. I also gave instances of how government policies can affect the level of prosperity in different countries.

Along with that, I highlighted the role of the IMF for countries that run into crisis.

To conclude this book, I addressed the concept of banking and capital markets, specifying the roles as well as the differences that are seen in bank-oriented economies and market-oriented economies.

I believe that in this short book, I have been able to explain in a simple way the different economic principles that affect our daily lives. I have also shed light on things that we as citizens should be aware of.

As citizens, I believe that this book will enable us to ask better questions and to propose better solutions to the problems we face on a daily basis In addition, this book will provide us with a well-informed perspective on what is happening in the economy.

As a final point, take note that economics isn’t something you memorise; it is something you conceptualise. Your job, your business, your possessions, and even your life depends on it!

I hope this book has helped you to understand better.

Thank you for reading!

Economics, Banking and Finance

in Emerging Markets:

A collection of my essays focusing on unique challenges in emerging economies