American-Made Financial Repression

HONG KONG – A generation of development economists owe Ronald McKinnon, who died earlier this month, a huge intellectual debt for his insight – introduced in his 1973 book Money and Capital in Economic Development – that governments that engage in financial repression (channeling funds toward themselves to reduce their debt) hamper financial development. Indeed, McKinnon provided the key to understanding why emerging economies’ financial sectors were underdeveloped.

At the end of his life, McKinnon was working on a related – also potentially groundbreaking – concept: a dollar-renminbi standard. In his view, such a system would alleviate the financial repression and fragmentation that is undermining global financial stability and growth. The question is whether the powers that be – particularly in the United States, which has long benefited from the dollar’s global domination – would ever agree to such a cooperative system.

The notion that the dollar’s global dominance is contributing to financial repression represents a significant historical shift. As McKinnon pointed out, the dollar became a dominant international currency after World War II because it helped to reduce financial repression and fragmentation in Europe and Asia, where high inflation, negative real interest rates, and excessive regulation prevailed. By using the dollar to anchor prices and the Federal Reserve’s interest rate as the benchmark for the cost of capital, invoicing, payments, clearing, liquidity, and central-bank reserves all became more stable and reliable.

As long as the US remained competitive and productive, currencies that were pegged to the dollar benefited considerably. For economies in transition – such as Western Europe in the 1950s-1960s, Asia during the growth miracle of the 1970s-1990s, and China in 1996-2005 – the dollar provided an anchor for the macroeconomic stabilization efforts and fiscal and monetary discipline that structural transformation demanded.