Internal and external constraints: economic development without currency crisis

Simply speaking, development macroeconomics can be summarized as the challenge of improving productivity and production capacity in poor countries. This involves the conditions that need to be fulfilled for a development process to start as well as the policy framework and instruments that support it. Heterodox approaches consider the state’s role in steering productivity growth as essential (Cardim de Carvalho, 1997). Markets may be able to exploit price signals and adjust resource allocation correspondingly. However, they guarantee neither sufficient profitability of key sectors nor the demand for the goods produced. Both the profit rate and effective demand are conditions for investment to take place (Oberholzer, 2020). It is thus up to the government to make public investment in priority sectors and to apply instruments such as taxes and subsidies in ways that simultaneously allow for economies of scale, higher productivity large-scale employment and demand. This is what is generally referred to as industrial policy (see for example Chang, 2006; Oqubay, 2018).

But this is not everything. Policymakers have to pursue such a development strategy in face of an (often permanent) shortage of foreign currency. While domestic currency can be generated via the domestic banking system including public development banks, the availability of foreign currency is limited unless a country is able to increase exports or restrict imports. Since larger export capacity and a higher degree of import substitution are long-term goals, the current account is determined by domestic and foreign economic growth. This insight has come to be known as the balance-of-payments-constrained model or Thirlwall’s law, respectively (Thirlwall, 1979, 2013): it is reasonable to assume that demand for a country’s exports grows in income in the rest of the world while imports increase with domestic economic growth because a part of increasing incomes is reliably spent on imported goods. Therefore, stability in the balance of payments requires that imports do not grow faster than foreign exchange earnings via exports allow. A limit to the growth of imports implies a limit to the country’s economic growth, hence the balance-of-payments-constrained growth rate.

These two essential problems of development macroeconomics can be denoted as the internal and the external constraint. Industrial policy has to remove the internal constraint by developing production capacity. However, overcoming the internal constraint does not necessarily overcome the external constraint of foreign exchange shortage. In other words, even the best industrial policy might become rather modest because it is subject to the shortage of foreign currency, that is, the external constraint.

Unless a country runs a continuous structural current account surplus, a strategy that is logically not feasible for all developing countries simultaneously (Blecker & Razmi, 2008), it almost inevitably features phases of (potentially large) deficits during certain stages of its development strategy. Such deficits may be due to the urgency to relieve the most extreme poverty as fast as possible and also the need to import capital goods that are necessary for technological catch-up. However, as explained by Thirlwall’s law the balance-of-payments constraint does not allow for deficits because they involve accumulation of foreign debt and often also boom-bust cycles of capital flows eventually giving way to exchange rate depreciation and currency crisis. The external constraint becomes even tighter when ambitious economic policies, which entail public investment, income redistribution and other measures that might be perceived to threaten private profits trigger capital flight, hence an additional loss of foreign currency.

There is a solution to the external constraint, which is rarely discussed in the literature even though it contains many elements of Keynes’s proposal of an international clearing union suggested in the Bretton Woods negotiations after World War II (Keynes, 1942/1980). Adding insights by E.F. Schumacher (1943) and, notably, Bernard Schmitt (2014), we get to a policy proposal that can be implemented individually by a single country. To briefly explain it, imagine what happens when a resident of a country pays for imports that are not matched by exports of an equal amount: the resident pays in domestic currency while the foreign payee receives a payment in international currency, that is, usually US Dollars. The country thus has to go in debt in order to get access to the Dollars required. At the same time, the payment in domestic currency is lost to the economy because it is just crossed out of the double-entry bookkeeping system (indeed, nobody currently receives these domestic monetary units as a payment). The loss in domestic currency is tantamount to a loss in domestic effective demand and, eventually, a loss in output. Combined with the accumulation of foreign debt this means, in fact, that an international payment is made twice. Deficit countries thus continuously lose economic resources whereas. In a sound system, by contrast, they should have the chance to build up economic resources in order to prevent the accumulation of external debt.

A country may decide to reform its international payment system as follows (Schmitt, 2014; Oberholzer, 2020): first, it sets up a new institution, which may be either independent or linked to the government or the central bank. This institution is responsible for the settlement of all international payments. When an importer gives her bank the payment order, the payment in domestic currency is received by the new institution, which completes the transaction by accessing a foreign loan and paying the foreign exporter in Dollars. We see that the monetary units in domestic currency are not lost anymore. Instead, and this is the second step, the institution can make use of them and spend them for productive investment in the domestic economy, which creates both demand and production capacity. Now, the institution’s foreign loan is backed by a real asset. It can issue bonds and sell them abroad in order to repay the foreign loan. This implies that neither the institution nor the country is a net debtor anymore. There is no pressure on the exchange rate and the country is able to enlarge the pool of its economic resources to strengthen export capacity and import substitution. It can sustain ‘current account deficits’ on its growth trajectory without running into currency crisis.

In addition to this blueprint, a unilateral reform of international payments must take into account many institutional and macroeconomic aspects, which are described in more detail in Oberholzer (2020). Moreover, many technical details would certainly arise once a country implements it. Yet, it seems clear that such a reform is a key element of a successful macroeconomic strategy for developing countries. By strongly relaxing, if not removing, the external constraint, it enables industrial policy to be ambitious again such that the internal constraint can be overcome.


Blecker, R.A. & Razmi, A. (2010). Export-Led Growth, Real Exchange Rates and the Fallacy of Composition. In M. Setterfield (ed.), Handbook of Alternative Theories of Economic Growth, Cheltenham, UK and Northampton, MA, USA: Edward Elgar Publishing (pp. 379–396).

Cardim de Carvalho, F.J. (1997). Economic Policies for Monetary Economies: Keynes’s Economic Policy Proposals for an Unemployment-Free Economy. Revista de Economia Política, 17(4), 31–51.

Chang, H.-J. (2006). The East Asian Development Experience: The Miracle, the Crisis and the Future. London, UK; New York, USA; Penang,Malaysia: Zed Books and Third World Network.

Keynes, J.M. (1942/1980) The Collected Writings of John Maynard Keynes, Vol. XXV: Activities 1940–1944. Shaping the Post-War World: The Clearing Union, London and Basingstoke: Macmillan.

Oberholzer, B. (2020). Development Macroeconomics: Alternative Strategies for Growth. Cheltenham and Northampton: Edward Elgar.

Oqubay, A. (2018). Industrial Policy and Late Industrialization in Ethiopia. In F. Cheru, C. Cramer and A. Oqubay (eds.), The Oxford Handbook of the Ethiopian Economy, Oxford University Press, (pp. 605–629).

Schmitt, B. (2014). The Formation of Sovereign Debt: Diagnosis and Remedy. Available at 13679.

Schumacher, E.F. (1943). Multilateral clearing. Economica, 10(38), 150–165.

Thirlwall, A.P. (1979). The Balance of Payments Constraint as an Explanation of International Growth Rates Differences. Banca Nazionale del Lavoro Quarterly Review, 32(128), 45–53.

Thirlwall, A.P. (2013). Economic Growth in an Open Developing Economy: The Role of Structure and Demand, Cheltenham, UK and Northampton,MA, USA: Edward Elgar Publishing.

Basil Oberholzer is a macroeconomist working in the field of development macroeconomics, ecological economics and sustainable development who received his PhD at the University of Fribourg (Switzerland). He tweets at @basiloberholzer.

Photo by Darío Martínez-Batlle on Unsplash.

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