A re-assessment of national credit policies for

A re-assessment of national credit policies for economic development with global markets

by Guadalupe Mántey and Noemí Levy National Autonomous University of Mexico E-mails: [email protected] [email protected]

Paper presented at the Cambridge Journal of Economics Conference 2003 Economics for the Future Cambridge, U. K., September 17-18, 2003.

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A re-assessment of national credit policies for economic development with global markets By Guadalupe Mántey and Noemí Levy Introduction A developing country is often characterised as one which is endowed with abundant labour, exhibits a dualistic structure of production, is heavily dependent on imports of capital goods and technology, and lacks capital enough to fully employ its labour force in productive activities (Taylor 1983). Neo-classical economists explain unemployment in the short run on account of high wages; and in the long run, as a result of low savings and high interest rates (Robinson 1969a). Hence, policies to increase the level of employment involve adjustments in factor relative prices, which eventually bring about the redistribution of income that raises the average propensity to save. It is to be noticed that conventional theory, by assuming perfectly competitive markets, has been unable to deal with dual structures of production, which are typical in developing countries. Following the Classical tradition, the earliest growth models for developing economies assumed labourers were paid subsistence wages, and profits arose from surplus value. The challenge for development was to allocate this surplus value in productive investments, so that the real wage rate equalled the marginal product of labour in the primary sector as well as in the industrial sector (Lewis 1954, Ranis and Fei 1961). Nevertheless, from Keynes onwards, capital scarcity has ceased to be considered an un-surmountable constraint to full employment of labour. An efficient banking system might create short term finance to mobilise idle productive resources, and generate the income and savings required to fund the full employment level of investment (Davidson 1986). Provided the financial system was furnished with the institutions and mechanisms to collect the liquid savings generated by short term banking credit, and allocated them in long term productive investments, full employment growth with stability could be achieved, without the requirement of prior savings (Studart 1995). But if Keynesian theory provided powerful arguments to raise the level of employment in developed countries, by means of flexible monetary and credit policies, its framework was not so well suited to analyse the structural constraints to full employment that are observable in developing countries. In the early 1960s Chenery showed that developed countries growth models were inadequate as a basis for development policy, because they focused attention exclusively on the savings-investment relation and labour-capital substitution, neglecting other important questions which constraint growth in developing economies, such as the changing pattern of demand, foreign trade

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structural imbalances, and the divergence between labour supply and labour requirements (Chenery and Bruno 1962). In his well known two-gap growth model, he introduced the balance of payments constraints, characteristic of developing economies, jointly with the investment-savings relation. Since the end of the 1940s, a group of economists working for the United Nations Commission for Latin America (CEPAL) had realized that the development process in backward economies could not be explained as a stage of capitalist development, following the same path of early industrialized nations. Their analysis was based on the historical evolution of economic relations between rich and poor countries, and the specialisation in foreign trade that ensued (Bielchowsky 1998). Centre-periphery models emphasised differences in product ion patterns, resulting from less developed countries’ technological backwardness, which made them heavily dependent on imported capital goods and intermediates, particularly in the early phases of industrialisation. They also stressed the fact that industrial goods produced and traded by rich countries had higher income elasticities of demand, as compared with goods produced and traded by poor countries; being this asymmetry the main cause of developing countries structural disequilibrium in the current account of the balance of payments (Prebisch 1983, Rodríguez 1980). Latin American structuralists argued that the export capacity of backward economies was limited not only because the supply of primary products was inelastic in the short-run, but also because any significant increase in the aggregate supply of raw materials and commodities would bring about a fall in their international prices which would neutralise the effort. Under this approach, technological dependence, jointly with a high income elasticity of imports, and an inelastic supply of exportable commodities, made exchange rate adjustments strongly inflationary. The basic forces that caused structural inflation, as this phenomenon was called, could not be imputed to monetary expansion; rather the increases in money supply, which accompany currency depreciation, should be considered a mechanism by means of which developing countries solve the distribution conflict brought about by the exchange rate adjustment (Lustig 1988). Recently, other authors have recollected these ideas and, on the basis of endogenous money theory, they have emphasised causality goes from exchange rate depreciation to money supply increases, and not the other way around, as the monetarist approach to balance of payments postulates (Camara and Vernengo 2001). From this it follows that the adjustment of factor relative prices, recommended by Neo-classical economists to tackle the unemployment problems in less developed countries, would be ineffective. As a matter of fact, McCombie and Thirlwall (1994) have demonstrated that changes in factor relative prices have not been an efficient balance of payments adjustment mechanism; and that differences in income growth between countries can be better explained by the ratio of their respective income elasticities of demand for imports and exports, in accordance with Thirllwall’s Law (Thirlwall 1999). This brief glance at alternative approaches to economic development reveals that development economics is challenging conventional wisdom in 3

economics on important issues, such as inflation determinants, income distribution, balance of payments equilibrium, etc. In this paper, we attempt to combine into one single model the contributions of a number of theoreticians who, in our view, have provided the most realistic explanations to the behavioural traits of a developing economy. On the basis of this model, we propose a development strategy, which could be implemented with only minor changes in present day institutional framework, characterized by widely open national financial markets. The paper is divided into five sections. In the first one, we collect the contributions of endogenous money theorists and other writers who, dissatisfied with the assumption of perfectly competitive markets, have abandoned the quantity theory of money and marginalist income distribution theory, in favour of a mark-up approach to pricing and a conflict theory of distribution. In this framework, we explore the inflationary potential of bank credit expansion, exchange rate adjustments, and wage bargaining. In section 2, we introduce the peculiarities of a developing economy in the analysis. We assume an excess supply of unskilled labour; a strong dependence on imported capital goods and technology; and we incorporate the main propositions of segmented labour market, on skilled and unskilled workers wage determinants. In section 3, we extend the model in order to study the effects of increased international capital mobility, and speculative investment, on income distribution. The last two sections present empirical evidences from the Mexican economy, which support the conclusions derived from our model. They exhibit the distinct roles of wage rates, credit expansion and exchange rate variations on the inflationary process of a developing economy, as compared with conventional beliefs in developed countries. 1. Inflation, growth, and distribution under imperfect competition Endogenous money theory has debased the quantity theory of prices. If money creation by the banking system depends on credit demand, the price level is not any more the variable that equilibrates the money market, and it becomes indeterminate. Post-Keynesian writers have asserted that institutional changes, during the post-war period, reversed the causality between money and income assumed by the quantity theory of money, making the money supply dependent upon nominal income growth. Among the most noticeable events that accounted for this result, they mention: I) the responsibility assigned to central banks on the level of economic activity and employment at the end of the second world war, and their commitment hitherto to perform the lender of last resort function before a liquidity crisis sprouts; ii) the opening of interbanking markets for reserves, that has lessen commercial banks dependence on the monetary authority supply of reserves; and iii) financial deregulation, that has enabled bankers to engage in liability management operations (Minsky 1984, Chick 1990, Wray 1990, Palley 1994). Empirical research provides support to this contention. In the late fifties, the Radcliffe Committee acknowledged there was not any empirical limit to money 4

velocity in Britain, and admitted the endogeneity of the money multiplier (Wray 1990). Later on, in 1970, Kaldor exhibited proofs that the stability of income velocity, in Friedman and Schwartz’s money demand equation, was accounted for the Bank of England’s policy of stabilising the rate of interest; so that it should be interpreted as an evidence that changes in the demand for money called forth changes in its supply. In 1991, Hendry and Ericsson corroborated these statements, when they published the results of their estimates for the same function, using the method of cointegration. In their report, they indicate that the rate of inflation not only was weakly exogenous in the equation, but it was superexogenous; accordingly, the equation could not be inverted, and the constancy in the estimated parameters should be interpreted as an evidence that the demand for money created its supply. Dissatisfaction with the quantity theory of prices advanced in parallel with disbelief on the marginalist theory of distribution. Sraffa’s attack to the inconsistencies in the theory of capital, and to the lack of realism in its assumption of perfect competition, led economists to work out alternative approaches to price determination and income distribution. The pioneering work of Kalecki (1977) has ever since inspired a long stream of mark-up pricing models, which aim to explain the behaviour of firms under monopolistic competition. The essential elements in these models are: i) the existence of a gap between normal and operating capacity; ii) constant variable costs over the relevant size of plant; iii) an institutionally determined nominal wage rate; iv) unit prices determined by a mark-up over variable costs; and v) the mark-up depending upon the firm’s desired accumulation of capital. Mark-up pricing models have gained acceptance for various reasons. First, because they skew the problem of capital valuation in determining the share of profits in income. Second, because empirical studies of firms’ pricing behaviour have revealed that the stylised facts these models depict are realistic (Hall and Hitch 1939, Sylos-Labini 1965, Andrews and Brunner 1972, Brown 1985). Mark-up pricing models under oligopoly also involve a theory of growth and a theory of distribution. The implicit growth and distribution theories are akin to Kaldor’s and Robinson’s approaches in two senses: first, because the desired rate of accumulation and the propensities to save determine the ratio of profits to wages; and second, because capital accumulation plays a defensive role in firms’ strategy for survival. In mark-up pricing models, entrepreneurs do not aim to maximise profits in the short run, but their long-run rate of growth. For our immediate purpose, which is to disclose the inflationary potential of credit, wages, and exchange rates under imperfect competition, and assuming endogenous money, we shall base our analysis on Eichner’s model, on account of its explicit consideration of the role of credit in pricing under oligopoly. Since other authors have as well chosen this model for discussing incomplete exchange rate pass-through and wage bargaining phenomena (Arestis and Skuse 1991, Arestis and Milberg 1993), its advantage will be twofold. 1.1 Credit expansion and inflation

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Eichner, likewise Kalecki, assumed economic activities could be roughly divided into competitive and oligopolistic; the former being exemplified by agriculture, and the latter by manufacturing industry. From his research on the United States economy, he observed price behaviour in response to changes in demand differed between sectors: prices in agriculture had varied with demand conditions, whereas manufacturing prices had increased continuously, with independence from income changes (Eichner 1973). This early finding was contrary to what conventional theory of pricing under monopolistic competition would anticipate (Robinson 1969b, Chamberlin 1938); and from it, he developed a theory to explain the behaviour of the price leader, on the basis of mark-up pricing. He assumed that the price leader would decide the quantity supplied within the interval in which his demand curve was inelastic; since his rivals neither would be able to sell their products at a higher price, nor would be willing to start a price war, that would be the market price for the industry. His main concern was to explain what determined the leader’s mark up over unit costs. He postulated that the mark-up would be dependent upon the firm’s demand for investing resources and supply conditions of additional finance. The leading firm would be planning its investment outlays on the basis of new assets marginal productivities; and in so doing, it should decide how much of the required finance would come from retained earnings, and how much it would raise from financial markets. On account of its market power, the firm is able to increase the mark-up in order to finance its desired investment. Nevertheless, this option would involve costs in the future, to the extent that its customers find substitutes for the product; new competitors enter the market; or the government decides to raise the tax levy. Eichner assumes these trade offs can be estimated by the leader, who eventually will resort to internal finance up to the point where its expected cost equals the market rate of interest. One implication of this model is that an expansionary monetary policy, that lowered the rate of interest, under oligopolistic competition, may actually be deflationary, and not inflationary as mainstream economic theory postulates. Credit availability, at moderate interest rates, would discourage firms with market power from raising funds internally, thereby contributing to stabilise prices. 1.2 Exchange rate pass-through under imperfect competition Firms’ pricing behaviour under imperfect competition has received renewed attention, on account of the unexpected effects of exchange rates variation on import and export prices, and on the trade balance of major industrial countries (Krugman and Baldwin 1987). Empirical evidence indicates that pricing to market is a common practice for multinational enterprises in international trade. Accordingly, flexible exchange rates may be ineffective to correct balance of payments disequilibrium, and they may induce unforeseen (and even undesired) changes in income distribution. Arestis and Milberg (1993) studied this phenomenon within the framework of Eichner’s model; and notwithstanding they were primarily concerned with foreign

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firms pricing behaviour in developed countries, we believe their conclusions have far-reaching consequences for the theory of economic development. Following Eichner, they define the price charged by an individual firm (P) as the sum of average variable cost (AVC), plus fixed costs (FC) and the corporate levy (or internal finance, CL) per unit of output:, assuming the firm operates at normal capacity. Normal capacity is defined as the product of the standard operating ratio (SOR) times the engineering rated capacity (ERC): P = AVC + [(FC + CL)/ (SOR*ERC)] For a foreign firm operating in the domestic market, the right hand side of the above equation would have to be multiplied by the exchange rate (e). Variations in the exchange rate would translate into price changes in proportion to their effects on: i) average variable costs; ii) the firm’s projects for expansion, as well as the required financing to carry them out; and iii) domestic interest rates. Eventually, the pricing decision for the foreign firm, as well as for the national corporations, will depend on average variable costs expressed in the local currency, the level of desired investment, the implicit cost of internal funds (i.e. by raising the product price), and the interest rate on borrowed funds. Depreciation of the local currency brings about a rise in the implicit cost of internal funds for the foreign firm, since its average variable cost and overheads expressed in the local currency increase, and its competitive position vis a vis rival domestic corporations deteriorates. A rise in the internal cost of funds, in this model, would lead to a fall in the mark-up; that is, to a limited exchange rate passthrough. The foreign firm would try to finance its new investments by means of additional borrowing in financial markets, unless interest rates in the domestic market soared. If aggregate demand in the local market shrank in response to the currency depreciation, the cost of internal funds for all corporations would rise further, markups would fall to a larger extent, and the exchange rate pass-through would still be more limited. It is to be noticed that if the foreign firm were the price leader, and the local currency depreciation induced a rise in domestic interest rates, the exchange rate pass-through would not be limited, but rather it would be magnified. We shall deal with this possibility later, when we analyse the effects of technological dependence in developing countries, and structural inflation. 1.3 Wage bargaining and mark-up pricing Mark-up pricing models assume wage bargaining is carried out in nominal terms, even though labourers strive for a target real wage (Arestis and Skuse 1991, Sawyer 1982). Among the variables that influence labour demands, they consider market conditions, price expectations, a desired real wage rate, and prevailing wage differentials among different groups of labourers. Eventually, however, it is mark-up pricing what determines income distribution.

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Following Eichner’s model, and assuming the corporate levy represents the objective variable for the firm, the rate of inflation would depend on the expected profitability of new assets, the market rate of interest, and unions bargaining power. If the marginal productivity of investment rose (i. e. because embodied technical progress involved increased efficiency, product differentiation, etc.), and everything else remained the same, the mark-up would widen and real wages would fall. Since labourers expectations would be disappointed, at the following wage negotiation, labour unions would exert pressure on firms’ management in order to get a share in productivity gains. The important question here, in order to disclose the effect of nominal wage rates on inflation, is to what extent unions become satisfied when they hit the real wage rate target and/or maintain wage differentials with other labour groups. If these are their main objectives, as several authors affirm, then it is irr elevant that wage bargaining is conducted in money terms; for the real wage rate would eventually be historically determined (Arestis and Skuse 1991). In Joan Robinson’s opinion, trade unions are not always conscious of the extent to which wages should rise, provided they rise at all. Accordingly, when technical progress, by lowering average costs, enables innovators to pay wages above market rates, she pointed out the latter may become the allies of trade unions, even though eventually, the degree of monopoly might rise (Robinson 1966, p. 94). J. Robinson’s scepticism about the bargaining power of labourers to share the benefits of technical progress was also grounded on the bias towards the use of labour-saving technologies, that arises from an asymmetry in the accelerator mechanism in response to either low, or high real wage rates. Since real wages usually rise after a period in which the capital stock has been growing faster than population, new investment decisions are likely to involve higher degrees of mechanisation. Contrariwise, when effective demand has been growing slowly, and real wages fall, entrepreneurs’ animal spirits are low, and there is little hope that low wages induce new investments in labour-using techniques. It is evident that Dobb arrived to similar conclusions, when he stated “…(monopoly) capitalism has acquired the power to negate the growing influence of trade unionism over money wages, and the ability to tolerate conditions in which the industrial reserve army no longer play its former stabilising role” (Dobb 1973, p. 269). Classical writers, as well as Marx, explained profits as a surplus grounded on a labour theory of value. They envisaged competition as an overwhelming force which would determine conditions of production in the long run. Contrariwise, Kalecki and Schumpeter, in different ways, developed the idea that profit is a monopoly rent. For Kalecki (1965), the degree of monopoly enables the firm to exact a mark-up on prime cost by raising the price. For Schumpeter (1974), entrepreneurship was neither a productive factor, nor even a lasting condition. Only when a producer decides to undertake a new combination of the two ultimate elements of production, labour and land, he becomes an entrepreneur; otherwise, his function is not essentially different from that of any other labourer. He is not entitled to receive a portion of the product on account of the capital committed, because bankers create the means of payment 8

that enable producers to demand the productive factors required for a new combination. In Schumpeter’s model, there is always a monopoly element in profits; because when a new product enters the market, lack of competitors enables the entrepreneur to fix its price according to monopoly principles. Nevertheless, as soon as a new combination enters the market, growing competition erodes profits, raising wages and rents, until profit vanishes. Only if a new combination is undertaken, higher profits can be exacted. Kaldor and Mirrlees (1971) also believed profits tend to fall, as a consequence of wages catching up with productivity increases brought about by machines from earlier vintages; this being the main stimulus for carrying out new investments. In this certainly incomplete and fragmented review of theoretical approaches to income distribution under imperfect competition, one finds two pervasive ideas. First, that in oligopolistic product markets, capital accumulation is a defensive policy by means of which the price leading firm strengthens its market power. Second, that the productivity gains from embodied technical progress are initially appropriated by the oligopolistic entrepreneur, who shares them with their employees only later, and always in a discretional manner (i.e. since eventually real wages depend on mark-ups), either under the pressure of labour unions, or by his own initiative. As a matter of fact, these two ideas are at the core of segmented labour market theory. Segmentationists claim that oligopolistic firms establish institutional constraints to wage behaviour, and create job structures internal to the firm, in order to protect their profits from the ebb of market forces (Leontaridi 1998). Labour market segmentation also responds to entrepreneurs interest on minimising absenteeism and turnover in those activities where on the job training is important. As a result of this behaviour, labourers in oligopolistic firms are not paid according to their productivity or skills, but on the basis of institutional seniority privileges and custom (Gordon 1972). The proponents of this approach distinguish two types of labour markets: the primary market, which encompasses the best jobs, characterized by high wages; on the job training; economic security and career advancement; employment relations governed by formal rules previously agreed with labour unions, and isolated from outsiders competition. By contrast, the secondary market clusters the worst jobs, that is those which do not require special skills. In this market, wages are determined by supply and demand; individual incomes depend more heavily on variations in working hours than in wages; working conditions are unfavourable; discipline is harsh and arbitrary; employment is variable; and there are little opportunities for advancement (Piore 1971) Since training costs differ among industries and firms, the primary market is balkanised (Leontaridi 1998); each oligopolistic firm builds up its internal job ladder and wage structure, which are connected with the external market through only a few “ports of entry”. At these points, the labourers recruited by the oligopolistic firm are paid a wage above the market rate, and also above their marginal productivity; 9

but as the labourer is trained and upgraded, his salary rises according to the institutional rules set by the firm, which involve a redistribution of income. It can be seen that nominal wage increases in the primary market cannot be a source of inflationary pressures, since they are administered by the firm on the basis of its target profit margin and its desired rate of accumulation. Nominal wage increases in the secondary market might have inflationary effects, to the extent that they exert pressure on wages at primary markets’ ports of entry. Nevertheless, since at these points the oligopolistic firm actually bids up the external market rate, and there is scope to adjust the starting wage at higher levels of the internal wage structure, its impact on the average variable cost will be limited. Therefore, we may conclude that under conditions of oligopolistic competition and segmented labour markets, skilled labour nominal wage increases are not a source of inflationary pressures; but rather they come about from the redistribution of the productivity gains from technical progress discretionary decided by the oligopolistic entrepreneur. From this point of view, primary labour markets would behave as buffers that mitigate the distributive conflict that brings about inflation. 2. Distribution conflict and inflation in a developing economy In the first part of this paper, we argued that credit expansion and skilled labour nominal wage increases are not sources of inflationary pressures in economies with endogenous money, that operate under oligopolistic competition. We also claimed that the degree of exchange rate pass-through is dependent upon the effects of exchange rate variation on aggregate demand, interest rates, oligopolistic firms’ investment projects and their average cost, both expressed in the national currency. In this section, we shall qualify the previous results by introducing in our analytical framework two peculiarities of the developing economy: i) an excess supply of unskilled labour; and ii) a high degree of dependence on imported capital goods and technology. Having in mind a model akin to Eichner’s, but enlarged with segmented labour market theory postulates and endogenous money, in which: i) the mark-up is dependent upon the price leader requirements of internal funds to carry out his planned investment; ii) market power is based upon imported technology and capital goods; and iii) secondary market wages depend on unskilled labour supply and demand; we shall investigate the inflationary effects of bank credit expansion, exchange rate depreciation, and skilled labour wage bargaining. 2.1 Credit expansion and inflation In our model, bank credit expansion, by lowering the loan rate, would diminish the maximum cost the oligopolistic firm would accept to incur, when raising the funds required for investment from its earnings (corporate levy). Since the mark-up depends positively on the corporate levy, prices would tend to fall. 10

In this framework, bank credit cannot be inflationary for two reasons: first, because under oligopolistic competition there is always excess capacity; and second, because the bank credit likewise granted to oligopolistic firms would be allocated in new investment projects. The deflationary role of a flexible monetary policy has been stressed by neostructuralist writers, notably by Taylor (1983,1992). Since they also assume conditions of oligopolistic competition and mark-up pricing, a tight monetary policy that raised the rate of interest would increase financial costs and average total cost; if the mark-up remained unchanged, that policy would cause inflation. Furthermore, Taylor claims that under monopolistic competition, as the interest rate rose and economic activity fell, the mark-up over unit cost would increase. In this case, the direct impact of a tight credit policy on inflation would be stronger. Notwithstanding that in our model credit expansion has a negative effect on prices (on account of its inverse relation to interest rates), it is important to notice that it may actually become inflationary in an indirect way, if it brings about an excess of imports over exports, and a currency depreciation ensues. We analyse this issue in the following section. 2.2 Currency devaluation and inflation When technical progress is embodied in capital goods, and these are imported, currency depreciation brings about an amplified effect on inflation, for the following reasons: -because it raises the cost of investment projects expressed in local currency, and therefore the corporate levy. -because it also raises the costs of imported inputs which form a part of the variable cost. -because the importing firm market power increases, as devaluation reduces the competitive advantage of foreign producers. When currency depreciation has a strong impact on the rate of inflation, and the monetary authority is moved to raise the rate of interest in response, inflation accelerates. From this it follows that, in a developing economy, currency devaluation does not contribute to stabilise the balance of payments; rather it starts a devaluation-inflation-devaluation spiral. Latin American structuralists arrived at the same conclusion, though they explained it on different grounds, as the result of an inelastic supply of tradable primary goods and commodities in the short run, and an inelastic demand for imports during the early stages of industrialisation (Prebisch 1983, Rodríguez 1980). In their opinion, these two phenomena accounted for what they called structural inflation. They emphasised structural inflation was not a monetary phenomenon; neither it was the result of demand pressure. Structural inflation was the effect of a rapidly changing production structure, which characterises the import substitution phase of industrialisation. However, structuralists did not completely abandon the quantity theory of money, for they maintained that credit expansion was an element in the propagating mechanism; neither they rejected cost-push theory of inflation, 11

because they also considered wage increases and currency devaluations as part of the propagating mechanism (Noyola 1957, Pinto 1975). 2.3 Wages and inflation Finally, we shall use our extended model to analyse the effects of skilled labour wage bargaining on the inflation rate of the developing economy. We refer to skilled labour wages in particular, and not to the average wage rate, for two reasons: first, because it is usually assumed that in developing economies the shortage of educated manpower causes inflationary pressures, as economic activity grows and entrepreneurs bid up for white collar employees. Second, because we intend to disclose the influence that the excess supply of unskilled labour exerts on the secondary market wage rate, and there from, on the distribution of income in the oligopolistic firm. On the basis of segmented labour market theory, one would expect that an excess supply of unskilled labour would keep real wage rates in the secondary market at a very low level. Eventhough this theory rejects the possibility of arbitrage between the two markets, it is conceivable that what people considers a “fair wage” for a skilled labourer is related in some way to the average wage for unskilled workers. From here it would follow that the wage rate at the lowest port of entry to the internal wage structures of oligopolistic firms would also be low. If workers and unions behaved as it is usually assumed they do, that is: i) if they were mainly concerned with achieving a target real wage rate, which is proxied by the largest one they got in the past; and ii) if they aimed to maintain their wage differentials with respect to other groups of workers; oligopolistic firms would have wide scope to let skilled labourers share in the productivity gains from technical progress, without impairing their growth prospects. Since the recruiting wage rate at the bottom of the internal to the firm job structure would be permanently pulled down by the (low) average wage in the secondary market, the latter would operate as a nominal anchor for every wage structure in the primary market. In countries where market forces, if left free, would drive the un skilled labour wage rate below a tolerable level, a minimum wage is usually enforced by law, and this institutionally determined wage rate fulfils the anchor function for the two segments of the labour market. It is conceivable that the portion of the productivity gains from technical progress that the oligopolistic firm resolves to distribute among its employees will be dependent on the corporate levy; that is, on the amount of internal funds that will be required to finance the planned investment. Since the corporate levy will be positively associated to the loan rate of interest, one should expect that skilled labour wage differentials with respect to unskilled labourers will be inversely dependent on interest rates and credit availability. It can be seen that, in a developing economy, the role of primary labour markets as buffers that lessen the impact of class conflict on inflation is enhanced. This is so, because the excess supply of unskilled labour keeps the secondary 12

market wage rate at a permanently low level, thereby setting a nominal anchor to firms’ internal wage structures. Such sort of natural advantage enables the oligopolistic firm to reward its personnel according to the established rules, without compromising a large portion of the productivity gains from technical progress. Since firms administer the gains from productivity in a discretional manner, and after subtracting the internal funds that will go to finance their new investments, there is no need for increasing the mark-up. The main conclusion that we derive from this analysis is that the process of skilled labour wage determination, by its nature, is not a source of inflationary pressures. Causality would go in the opposite direction: from price rises brought about by an increasing degree of monopoly, to skilled labour administered wages. Skilled labour wage rises are not inflationary, because they are paid from total factor productivity gains, on the basis of employers’ discretion. If productivity had not grown, skilled labour wages would not have been raised. Since productivity growth depends on embodied technical progress, one may anticipate that skilled workers wage differentials, with respect to unskilled labourers, will be positively associated with investment behaviour, and negatively affected by financial market conditions. Hence, productivity gains and the labour sharing factor are a direct function of investment growth and credit availability. From this point of view, credit expansion and economic growth could actually be deflationary, and reduce income inequalities, provided imports do not exceed export capacity. This brings our model close to Thirlwall’s growth model (Thirlwall 1999) in two important issues: first in the sustainability of economic growth, which according to Thirlwall’s Law would be dependent upon the income elasticities of exports and imports. Second, on the positive effect of aggregate demand on labour productivity, which would account for a negative relationship between investment and inflation (i.e. Verdoorn’s Law). In essence, Thirlwall’s Law provides a mathematical expression to Latin American structuralists’ contentions; for they maintained that the low income elasticity of exports relative to the high income elasticity of imports was the main cause of developing economies’ structural imbalances. Nevertheless, our model differs from these two approaches in three points: i) its explicit consideration of firms’ market power based on imported technology and capital goods; ii) the assumption of an excess supply of unskilled labour and segmented labour markets; and iii) the adoption of Eichner’s theory of the determinants of firms’ mark-up under oligopoly. These elements, as we have already shown, bring about two distinct conclusions on the role of wages and exchange rates on inflation and income distribution in developing economies. 3. Capital mobility, speculative investment and the desired rate of accumulation In Eichner’s model, the firm’s planned investment is exogenously determined, and therefore it is neither affected by the market rate of interest nor by the cost of internal funds. Obviously this is an unrealistic assumption. 13

In any open economy, speculative investment in foreign assets, and capital gains on financial assets (brought about by changes in domestic and international interest rates, as well as in the exchange rate) determine changes in productive investment decisions. In a developing economy, where exchange rate and interest rates variations are usually large, speculative investment is a substitute for plant investment in business administration. Taking into account that the ongoing process of financial deregulation and innovation has increased capital mobility, we may assume that through speculative investment and arbitrage it has led to the establishment of a minimum profit margin on international financial investments, which sets a floor to productive investment profitability; and we may expect that a relationship exists between this minimum profit margin and interest rates in the international financial market. If our assumptions are not far from reality, there would be an inverse relationship between the oligopolistic firm’s desired investment in plant and expected exchange rate variations, since the profitability of foreign assets would be significantly increased by currency devaluation. In a developing economy, where currency depreciations are followed by large increases in prices and interest rates, and a decline in economic activity, asset substitution would be more intense. Therefore, we may postulate that desired investment in plant is dependent upon the expected exchange rate, the normal profit margin in international financial investments, and the marginal return of productive assets; assuming further that in the open economy, domestic interest rates would also be influenced by exchange rate expectations and international interest rates. With this amendment to our previous model, we now are able to analyse the income distribution effects caused by financial capital mobility and fixed labour. In the last section, we concluded that skilled labour wage rates were administered prices in the oligopolistic firm, and behaved like buffers in resolving the conflicting claims on income. Seeing that labour immigration confronts political opposition in almost every country, while international capital flows are usually welcome, we believe that the passive role of wages in the inflationary process is reinforced by this asymmetry. Three decades ago, Dobb argued that while it may have been legiti mate, at an early stage of capitalism to accept that wages were determined competitively, and the surplus was a residual, this approach had lost relevance in the stage of monopoly capitalism, when oligopolistic firms are endowed with the power to enforce a minimum profit margin. In such circumstances, he claimed, real wages would be the residual variable, rather than profits (Dobb 1973, p. 267). Sraffa arrived at the same conclusion, and admitted that in his model the rate of profit could be postulated as the independent variable, determined from outside the system of production by the level of the money rate of interest, so that the real wage rate would become the endogenous variable (Sraffa 1960, p. 33). Nuti (1971) also remarked that the real wage rate should not be taken as exogenously determined, fixed at the subsistence level, in conditions of elastic labour supply; neither it could be settled directly by class struggle, because wage bargaining establishes money wages, but the real wage is brought about by the behaviour of the price level.

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In fact, the threat posed by international capital mobility has led developing countries to undertake economic policies and institutional reforms which lower the risks and enhance the profitability of foreign investments; and presently, a second generation of reforms is under way, among which labour market deregulation is given priority (Alvarez 2002). From the model we have developed so far, it is evident that labour market flexibility plays a key role in the competitive strategy of oligopolistic firms in developing countries, mainly when anti-inflationary policies have been sustained on exchange rate overvaluation. In the following two sections, we shall present empirical evidence on prices and wages behaviour in the Mexican economy, which cannot be satisfactorily explained by other approaches to income distribution and inflation, but that are consistent with the conclusions derived from the model worked out in this paper. 4. Structural inflation and unit labour costs in a developing economy Mexico is a typical example of a developing economy subject to structural inflation (see Graph 1). The exchange rate elasticity of inflation is above unity, while imports share in gross domestic product is less than one third. Granger causality tests systematically indicate that exchange rate variations anticipate consumer price changes, and not the other way around, as relative purchasing parity theory holds. (Insert Graph 1 hereabout) In addition, labour organisation in Mexico has been traditionally weak. In manufacturing industry, only 20 per cent of firms report unionised labour (López and López 2003); and a tripartite body, in which representatives of the government, the entrepreneurs and labour unions participate, settles the minimum wage rates for blue and white collar activities, which operate as guidelines for industry and firm wage contracting. These elements, as we shall see, account for the unusual inverse relationship that Graph 1 reveals, between the rate of inf lation and changes in unit labour costs in manufacturing. These two phenomena contrast sharply with developed countries experience, where exchange rate movements have usually small effects on the inflation rate, and the latter is heavily influenced by unit labour costs. We argued earlier that the magnified response of inflation to exchange rate variations, in a developing economy, was a result of its dependence on imported technology, and of domestic firms’ market power being based upon imported capital goods and intermediates. Since these issues have been largely studied by Latin American structuralists, we shall concentrate here on explaining the inverse relationship between unit labour costs and inflation. Unit labour costs vary directly with wage rate changes, and inversely to labour productivity growth. In Mexico, fixed investment, gross domestic product, and the marginal output/capital ratio are highly correlated (see Graph 2), thereby indicating not only the effectiveness of the investment multiplier, but also the generation of productivity gains from embodied technical progress. (Insert Graph 2 hereabout)

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Fixed investment is inversely related to exchange rate behaviour, as we anticipated on the basis of speculative investment in foreign assets being a substitute for the firm’s investment in plant (see Graph 3). (Insert Graph 3 hereabout) Therefore, when the national currency appreciates, and the rate of inflation falls, investment flourishes and total factor productivity increases. Under these circumstances, according to our model, the price leader shares a part of the productivity gains with his skilled labourers, so that the average real wage increases; but since wages rise only after productivity gains have been realized, a change in investment is followed by a change in the same direction in unit labour cost. Conversely, when fixed investment falls, and productivity growth declines, skilled labour real wages stagnate, and unit labour costs tend to fall. These lagged responses are noticeable in Graph 4, with the exception of year 1995, in which the country went through a twin exchange rate -banking crisis. (Insert Graph 4 hereabout) Hence, currency depreciation coincides in time with a rise in the inflation rate, and also with a fall in unit labour costs; while currency appreciation, stabilises domestic prices, and brings about a rise in unit labour costs. From Graph 1 one may appreciate, however, that the leading force in the inflationary process comes from the rate of exchange; whereas labour unit costs not only vary over a much smaller range, but exhibit a weaker influence on the inflation rate. 5. Wage differentials, bank credit and degree of openness We have argued that, in a developing labour surplus economy, heavily dependent on imported capital goods and technology, the labour market operates like a buffer that absorbs the shocks that otherwise would lead to an inflationary solution to conflicting claims on income. In our model framework, we shall consider two types of shocks: one coming from trade openness, and currency overvaluation; the other coming from tight credit policy. From the early eighties to mid nineties, the Mexican economy went through a swift process of deregulation and opening, in which the real exchange rate varied widely, often exposing domestic industry to foreign competition in unfavourable terms. Under these circumstances, manufacturing firms were compelled to increase labour productivity, and they actually did, as Graph 5 reveals. (Insert Graph 5 hereabout) While output per worker in manufactures increased by more than 40 per cent in real terms from 1980 to 2002, the institutionally determined minimum wage lost two thirds of its purchasing power in the same period. The average unskilled labour real wage in that sector also halved; and the skilled labour real wage showed the largest swings, ending slightly above its 1980 level (see Graph 6). (Insert Graph 6 hereabout) From Graph 6 we appreciate that labour productivity and skilled labour average real wage have upward trends; while on the contrary, the minimum real wage and unskilled labour average real wage bend downwards.

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We also observe that the three wage rate series exhibit similar behaviour with respect to their turning points; whereas labour productivity behaves differently, its turning points not always being coincidental with the former. These preliminary results are consistent with the assumptions whereon we worked out Eichners’s model: they suggest that, in the wage bargaining process, labour unions prime concern is to defend wage differentials; and also that firms share productivity gains with white collar workers on a discretional basis. Turning points in real wage rates are directly associated with gross fixed investment cycles, and they are inversely related to the degree of openness in the economy. Graph 7 illustrates the combined effect of these two forces on unskilled labour real wages. (Insert Graph 7 hereabout) Two stages in the opening process of the economy are noticeable from Graph 7 The first one took place by mid eighties, during the external debt renegotiation that followed the 1982 exchange rate crisis. The second one occurred in 1994, as a result of North American Free Trade Agreement (NAFTA) enforcement. In both cases, real wage rate respons iveness to fixed investment lessened; this suggests that unskilled labour wage rates are a residual variable, which compensates for other competitive disadvantages. Skilled labour wage rates exhibit the same pattern of twists as unskilled labour wages, but they have not been pulled downwards by the institutional minimum wage. Accordingly, skilled workers wage differentials have widened; in fact, they have been positively affected by the process of financial deepening. Gaph 8 exhibits the parallelism in the ratio of skilled over unskilled labour wage rates, and the financial multiplier (i.e. the ratio of the broadest monetary aggregate M4 over the monetary base). (Insert Graph 8 hereabout) The latter result supports our contention that credit availability does not bring about changes in the mark-up, as Eichner maintained, on the basis of developed countries competitive labour markets; but rather that, in a developing economy, financial costs are transferred backwards, to the labour market, on account of unions conventional behaviour. Concluding remarks We have attempted to demonstrate that two traits of a developing economy, namely its dependence on imported technology and capital goods, and its excess supply of unskilled labour, bring about significant differences in the way the price level responds to exchange rate variations, bank credit expansion and wage rate increases, as compared with a developed economy. It has been argued that in a semi-industrialised economy, local currency depreciation has a large inflationary effect because domestic firms’ market power is entrenched in imported capital goods; and because this inflationary response induces tight credit policies that raise interest rates. We contended that, as a result of the increased international mobility of financial capital and the fixity of labour, in an open economy profits are the prior deduction in income distribution, and wages are the residual. In conformity with segmented 17

labour market theory, we concluded that price leading firms discretionally share amongst their skilled workers the productivity gains from embodied technical progress. Therefore, skilled labour wage increases should not be considered a source of inflationary pressures. We maintained that when the loan interest rate and a desired rate of accumulation determine firms’ mark.-up over costs, expansionary credit policies may actually become deflationary. Only when flexible credit policies bring about an excess of imports over exports that leads to currency devaluation, they become inflationary. Hence, for a developing economy the limit to credit expansion is given by Thirlwall’s law. From these premises it follows that a developing economy may achieve higher rates of growth, and a more equitable distribution of income, by means of an expansionary credit policy, provided it satisfies the following conditions: i) Credit finances investment projects that increase total factor productivity. ii) Credit is allocated in activities that lower the income elasticity of imports and/or raise the income elasticity of exports. iii) The financial structure efficiently transforms short term bank credit into long term investment funding. In a retrospective look at the industrialisation policies implemented in South East Asia and Latin America, it is clear t hat in the former region these three conditions were adequately met, from mid sixties onwards (Lall S. 1997, Bustelo 1992). Latin American countries, by contrast, failed to link their credit policies to a long-run industrialisation strategy; they regulated bank loans mainly as a means to stabilise the trade account of the balance of payments (Studart 1998). It is not surprising, thus, that the former region had registered much higher rates of growth and lower degrees of income inequality than the latter, during the last three decades. References Alvarez A. (2002), “La inestabilidad financiera internacional y sus implicaciones en México”, in G. Mántey and N. Levy (Eds.), Globalización Financiera e Integración Monetaria: Una Perspectiva desde los Países en Desarrollo, UNAM-M. A. Porrúa, México. Andrews P. W. S. and E. Brunner (1972), Studies in Pricing, Macmillan, London. Arestis P. and W. Milberg (1993), “Degree of Monopoly, pricing and flexible exchange rates”, Journal of Post-Keynesian Economics, Vol. 16, No. 2, Winter. _______ and F. Skuse (1991), “Wage and price setting in a Post-Keynesian theory of inflation”, Economies et Societés, Série Monnaie et Production, MP No. 8, Nov.Dec. Bielchowsky R. (1998), “Cincuenta años del pensamiento de la CEPAL: una reseña”, en Cincuenta Años de Pensamiento en la CEPAL: Textos Escogidos, Fondo de Cultura Económica-CEPAL, Santiago.

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