American Finance Association

Review
Reviewed Work(s): Money and Capital in Economic Development by Ronald McKinnon
Review by: Rolf Luders
Source: The Journal of Finance, Vol. 29, No. 1 (Mar., 1974), pp. 298-300
Published by: Wiley for the American Finance Association
Stable URL: http://www.jstor.org/stable/2978253
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298 The Journal of Finance

compliance, increased stability of expectation in the international investment community, and, at the same time, probably not deter the flow of beneficial foreign invest-

ment on a more equitable basis, to the world's developing countries. Moreover, it

would permit investment disputes to be settled within domestic legal systems and
thereby contribute to the strengthening of the international economic and legal order"

(p. 166). The difficulty is, of course, that so often valuations for tax purposes do not
exist owing to the absence of cadastral surveys or they are so out of date as to be quite
inappropriate.

The remaining three essays explore several procedures relating to compensation and
valuation arising out of the recent expropriation of petroleum companies in Bolivia
and Peru and of the American copper companies in Chile. In his essay on "Interna-

tional Law and the Chilean Nationalization: The Valuation of the Copper Companies,"
R. B. Lillich points out that Allende's Marxist regime recognized its obligation to pay
adequate compensation to foreign copper companies on the one hand, but effectively
denied compensation by a "bizarre bookkeeping maneuver" on the other. In the comparsion of the Peruvian government's expropriation of the International Petroleum
Company (IPC) with Bolivia's expropriation of Bolivian Gulf Oil Company (BOx
GOC), D. F. Furnish reaches a rather interesting conclusion. In the IPC case, the

foreign investor received no compensation, but Furnish concludes that "Legal problems were followed throughout the affair if not always with total equanimity. There
is a solid basis in law for all that Peru has done" (p. 84). In the BOGOC case on the
other hand, there was a negotiated settlement with compensation, but according to
Furnish, the Bolivian government had no legal justification for the expropriation.
He therefore, concludes that "the BOGOC affair may make it extremely hard for
Bolivia to entice another foreign oil company into that country of mercurial political
swings on anything but a short-run basis. Peru, on the other hand, appears to have
succeeded in convincing several large foreign petroleum concerns that her atmosphere
is conducive to doing business in spite of what happened to IPC" (p. 85).
The essays in this volume are interesting and informative as illustrations of the problems faced by foreign investors and host countries in compensating for nationalized
properties. But the reader will find few solutions. Nor will he find a rigorous and
structured economic or legal analysis of valuation for purposes of compensation.
RAYMOND F. MIKESELL

University of Oregon

Money and Capital in Economic Development. By RONALD MCKINNON. Washington,

D.C.: The Brookings Institution, 1973. Pp. xii + 184. $2.95.
The principal purpose of this book is to emphasize the importance of the development of national capital markets in economic growth, as well as to outline successful
strategies to achieve the desired development in the financial sector. The author indicates that his point of view contrasts sharply with neo-classical growth theory which
assumes perfectly operating capital markets,* as well as with Keynesian theory which

focuses on other variables. To make his points McKinnon uses several means, espe-

* This is not quite correct, since neo-classical growth theory explicitly recognizes the existence
of differing rates of return for various types of investments, which would not exist if capital
markets would operate perfectly. At least, there would be no point in the neo-classical policy
recommendations to induce shifts of resources from one sector to the other, since the capital
market would take care of that aspect in the event of discrepancies of private rates of return.

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Book

Reviews

299

cially the description of the state of certain economies as well as the results obtained
by alternative policies followed in these same and other developing countries. Also,
an attempt is made to formalize the findings into hypotheses and/or theories.
It should be stated from the outstart that a key element in McKinnon's argument
is the concept of economic development that he uses, namely "(a) reduction of the
great dispersion in social rates of return to existing and new investments under domestic entrepreneurial control." Most readers would agree with me that this definition
is far from conventional. Unfortunately, this review does not allow the exploration
at all its advantages and drawbacks.
Most of the chapters of McKinnon's book are concerned with the problems arising
from fragmented economies and the policies that should be followed to overcome this
fragmentation. Fragmentation is understood to be the fact that different persons perceive different prices for the same goods or services. Chapter 2 describes quite well
the behavioral consequences of entrepreneurs who are, to a large etxent, forced to expand business-through self-financing. Because of the difficulty in obtaining outside
sources of finance for their investment projects, entrepreneurs will tend: (a) to have
consumption patterns which deviate from the optimum; (b) to operate under inefficient methods of production; and (c) to carry either excess or sub-optimum inventories, as well as a long list of other similar problems related to the fact that entrepreneurs cannot borrow funds or place excess cash at attractive rates of return.
Chapter 3 explores the results of the "intervention syndrome" which characterizes
the solutions applied by most LDC's. McKinnon concludes that "appropriate policy
in the domestic capital markets is the key to general liberalization, and particularly
to the withdrawal of unwise public intervention from commodity markets."
Chapters 4 through 8 set out to show-and try to prove-that in the case of f ragmented economies, monetary assets are complements to real assets in private people's
portfolios, as opposed to the conventional neo-classical argument that they are actually
substitutes. Unfortunately, the author's argument is based on an extremely simplified
model which assumes away all financial assets except money (defined so as to include
time and savings deposits). The "proof" is, as can be easily shown, exclusively dependent on this assumption. The question, therefore, becomes one in which McKinnon's "theory" will be valid or not depending on the extent to which a particular less
developed economy has, or has not, financial assets other than money.
In the above chapters McKinnon, however, reiterates the well-known observation
that economies with high rates of inflation tend to have low, and falling, ratios of cash
balances to GNP. More important, he presents an extremely convincing argument to,
the effect that anti-inflationary policies should be aimed at increasing the quantity
demanded of real cash balances at the same time as they try to reduce the rate of increase in the nominal supply of money. By doing this-usually by liberalizing depressed interest rates-the anti-inflationary policy will not produce a credit crunch and
a decline in production of goods and services, but instead will tend to increase the
supply of goods as a consequence of a more ample availability of working capital.
Chapter 9 presents a very simple model illustrating the effect that an optimum
quantity of real cash balances will have on the equilibrium growth rate. McKinnon
shows that the optimum quantity of money will be the one in which the real (marginal) return on holding money (less the marginal cost of banking services) is equal
to the marginal return to investments in the economy. At the optimum quantity of
monetary services-according to McKinnon-we still observe some discrepancy among
different rates of interest.
In the second part of Chapter 9, McKinnon contends that "the use in desired
holdings of real money balances (as a consequence of reforms in domestic money and

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300 The Journal of Finance

capital market policies) not only stimulates savings directly but, once growth begins,
channels even more savings through 'organized' financial processes."
Chapters 10 through 12 are concerned with fiscal, foreign trade, exchange rates, and
foreign indebtedness policies to successfully liberalize the functioning of capital markets. Recommendations on most of these policies follow rather traditional lines, and
are only interesting because McKinnon points out quite well that they are key elements in any policy to de-fragmentize an economy. His conclusion on foreign indebtedness-that less foreign credit rather than more might be advisable-is novel and
very, very convincing. Perhaps the key aspect of his argument is that foreign resources
will relieve "bottlenecks" in a fragmented economy, but not cure the economy of its
ills. The development of the domestic financial sector, and an adequate export policy,
will however reduce fragmentation, and therefore not only supply the needed resources,
but also allocate the available resources more efficiently.

McKinnon's book already has had a considerable impact on economic thought

among development economists in LDC's. Its impact will probably increase as soon
as this book is translated-as it ought to be-into other languages. His key point is
that financial development is essential-if not the most important aspect, in the
economic development of market economies. This is so because in fragmented economies it will increase the efficiency of the use of resources and the amount of savings
forthcoming. This book, together with several others recently published, is opening

up a new way of looking at development strategies. However, several of the ideas

and hypotheses it contains will have to be much more developed and tested before
we can talk of a new theory.
ROLF LUDERS

Organization of American States

Financing Modern Government: The Political Economy of the Public Sector. By

WILLIAM H. ANDERSON. Boston: Houghton Mifflin Company, 1973. Pp. ix + 354.

$11.50.
A bumper crop of both new books and major revisions of well-established textbooks
in public finance have been produced in the past two years. This abundance reflects
the increasing interest of the public and of the economics profession in the area of
public finance, growing in part from the major and controversial public policy issues
involved and in part from a broadening and further development of public finance
as a field of research and study. The new developments are especially in the areas of
budgeting, public choice, and the theory of public goods, together with a reappraisal
as to the effectiveness of fiscal policy.

William H. Anderson, late Professor of Public Finance and Director, Lincoln School
of Public Finance of Claremont Men's College and Graduate School, adds to the
choice available to those of us teaching public finance courses a book which is interesting and distinctive in several ways from most of its competitors. Anderson gives
more attention to the development of economic thought in the fields of public finance
and fiscal policy and to the economic setting for the application of public finance
policy decisions. He combines this valuable background material with contemporary
theoretical material. In areas which are controversial such as "fine tuning" of the

economy and incidence of the corporate income tax, Anderson gives a fair presentation
of the different views, with footnotes as to sources, and then gives his own views.
Professor Anderson wrote the entire manuscript and completed the final revisions

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