Department of Economics, Delhi School of Economics, University of Delhi

THE PROBLEM OF FINANCING OF ECONOMIC DEVELOPMENT

Author(s): M. Kalecki
Source: Indian Economic Review, Vol. 2, No. 3 (February 1955), pp. 1-22
Published by: Department of Economics, Delhi School of Economics, University of Delhi
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 THE PROBLEM OF FINANCING OF
ECONOMIC DEVELOPMENT

By M. Kalecki

The present article is a summary, revised by the author,

of the lectures which he gave in the Centro de Estudios Moneta*
rios Latinoamericanos, Mexico City, in August, 1953. The
author was at that time an official of the Department of Econo?
mic Affairs of the United Nations ; the points of view expressed
in the article should, however, be considered as his own, without
committing the above organization in any way. The article
was published in Spanish in the October-December issue of
El Trimestre Economico, Mexico.
I
At the first stage of our analysis we shall deal with a
simplified model. We shall assume that the economic system
is closed and that government expenditure and revenue is
negligible. This obviously does not correspond to the real
situation in under-developed countries. Such countries usually
depend to a great extent on foreign trade, and public expendi?
ture and revenue are not less important than in developed
countries. It will be seen, however, that from the considera?
tion of such a simplified model conclusions may be derived
elucidating the mechanism of financing of investment in the
course of economic development. It will be seen, moreover,
that it is rather easy to amend these conclusions when simpli?
fied assumptions are dropped by stages.
We shall distinguish in our model the following social
classes: capitalists, workers and small proprietors. The last
group includes poorer peasants, artisans, small shopkeepers, etc.
It will be assumed that both small proprietors and workers dp
not save, and that their consumption is equal to their income.
While the assumption of no saving is realistic for this group,
it may happen frequently that some dis-saving takes place. This
may be especially true of poorer peasants. For the sake of
simplicity we shall, however, abstract from this factor and thus
we shall assume that workers and small proprietors consume

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 2 M. KALECKI

all their income and no more.1 Under this assumption the total
saving is equal to the saving out of profits of the capitalists.
We shall sub-divide the economy into two sectors produc?
ing investment and consumption goods respectively. In each
sector we shall include the production of the respective com?
modities from the lowest stage. Thus, production of raw
materials and fuel will be allocated between the two sectors
according to the uses that are made of them in the produc?
tion of final products. We shall denote the investment goods
sector as Department I and the consumption goods sector as
Department II.
Investment stands here not only for the production of
investment goods for the sake of replacement and expansion of
plant and equipment,, but also for the accumulation of invento?
ries. We shall include the production corresponding to the
accumulation of inventories, even of consumption goods, in
Department I. This somewhat artificial classification is introduced
to make coincide investment and consumption with the output of
Department I and Department II respectively which simplifies
considerably the subsequent argument.
We shall now derive the basic exchange interrelation bet?
ween the two departments. Let us consider these departments
in a given unit period (e.g. in a given year). In both depart?
ments a part of the value of product will be consumed and
part will be saved. We shall also include in saving deprecia?
tion funds, so that our saving means gross saving just as our
investment means gross investment. In this way the value of
production of each sector will be split between consumption,
which we denote by Cx or C2 and saving which we denote by
Sj or S2. Thus, the value of production of Department I will
be equal to Cj + Sj, i.e. the sum of consumption and saving
derived out of incomes received in Department I. And similarly^
the value of production of Department II will be equal to
C24-S2. Consumption in Department I, Clt is of course sup-'
plied out of the production of Department II. This happens
as follows. Part of the production of consumption goods in
Department I is consumed in that department by workers,

r. This does not involve an assumption that the indebtedness of small

proprietors does not increase, because such an increase may occur as a
result ol investment financed by credit.

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 THE PROBLEM OF FINANCING OF ECONOMIC DEVELOPMENT 3

small proprietors and also capitalists. But as the latter do not

consume all their profits, there is produced a surplus of con?
sumption goods in that department corresponding to the unconsumed
part of profits, that is, to the saving in this department, S2.
It is obvious, therefore, that consumption in Department I is
equal to the saving in Department II :
Cx?Sz
In other words, the surplus of consumption goods in Depart?
ment II is sold to the workers and capitalists in Department I.
(The accumulation of unsold goods in Department II cannot
interfere with this equation because by definition the accumu?
lation of inventories is included in Department I.)
This basic equation can be found in the discussion of
expanded reproduction schemes by Marx. It may be also shown
that this equation is equivalent to the equality between savings
and investment. Indeed, if to both sides of the equation we
add savings in Department I, Slt we have:
Cj 4- S\=Sg -f- S i
Now, the left-hand side is nothing else but the value of
production of Department I or investment I. The right-hand
side of the equation is the sum of the savings in both depart?
ments or the total saving S. Thus, the last equation is equivalent to
I=S
This equation shows that in a sense investment finances itself.
Indeed, imagine that investment in the course of its execution is
financed by banking credit or out of liquid reserves of firms ; it
will be seen that investment as it is carried out creates its counter?
part in saving. A part of saving arises directly in Department I.
The second part of saving is the equivalent of the selling of the
surplus of consumption goods of Department II to workers and
capitalists in Department I. These savings which accrue to entre?
preneurs who profited from the demand generated by higher
investment accumulate as deposits. If investment is financed out
of liquid reserves of the entrepreneurs concerned the process will
result in a shift of deposits from these entrepreneurs to other
capitalists. If investment is financed by short term bank credit,
the savings accruing in the form of deposits will be available for
absorption of the issue of debentures and shares by the investing
entrepreneurs. Thus the latter are able to repay in this way the

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 4 M. KALECKI

bank credits involved. Finally, if investment is financed by long

term bank credit, the saving being the counterpart of the higher
investment will swell the deposits or will be used for repayment of
bank credits.
There are no financial limits in the formal sense to the volume
of investment. The real problem is whether this financing of
investment does or does not create inflationary pressures. For
the consideration of this problem the most convenient is our first
equation, C? = S2.
It is easy to show that the crucial point in the problem of
whether a certain level of investment creates or does not create
inflationary pressures are the possibilities of expansion of supply
of consumer goods in response to demand. To elucidate this
problem let us consider two extreme cases. Let us assume, first,
that while investment is increased, output of consumption goods
cannot be stepped up because the productive capacities are fully
utilised at the beginning of the period considered and no expansion
in these capacities has taken place in this period. In such a case
the increase in demand for consumption goods in Department I
would cause an increase in prices of these goods. The prices will
rise up to the point where the saved profits, S2, will be equal to Cx
and real wages will fall. (Small proprietors in Department II
will also not necessarily profit from the rise in prices because the
profits may accrue to the capitalists on whom they depend, i.e.,
merchants, money-lenders, etc.). This is the case which is some?
times called in economic writings "forced savings". The reaction
of workers to the reduction of real wages will be a demand for
higher money wages, and thus a price-wage spiral will be initiated.
Let us now consider another extreme case. Let us assume
that sufficient capacities are available to meet the increased demand
for consumption goods from Department I. This may be the case
either because at the beginning of the period in which the increase
in investment takes place there were adequate productive capacities
in Department II1 or because in the course of this period there had
been adequate additions to these capacities resulting from the
process of economic development. In such a case it will be not
the prices but production that will be pushed up to the point where'

I. It should be noted that despite the small volume of capital equipment in

relation to labour force in under-developed countries, such equipment as
exists is frequently under-utilized.

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 THE PROBLEM OF FINANCING OF ECONOMIC DEVELOPMENT 5

is equal to Cv In other words, the output of Department II

will increase to such an extent that the surplus in this department
corresponding to the part of profits that is not consumed, S2, will
be equal to the increased Ct at constant prices.
: In the next section we shall consider in more detail the
problem of inflationary pressures generated by investment. Prior
to this, however, we shall generalize somewhat the above argument
by dropping one of the simplifying assumptions. We have assum?
ed so far that government expenditure and revenue is negligible.
We shall allow now for public investment. Since we shall assume,
however, for the time being that it is fully financed by government
loans we shall continue to abstract from government revenue as
well as from government administrative expenditure.
We shall allow for loan-financed public investment by modi?
fying the meaning of L In what follows it will stand not only
for private investment but also for public investment and the
respective production will be assumed to be included in Department
I. It is easy to see that despite this modification of the meaning of /,
the preceding equations and in particular the equality between invest?
ment and saving, will hold good if public investment is fully finance
by loans. The process of such financing will indeed not differ from
that of private investment. The increase in production of Depart?
ment I on account of public investment, will push production or
prices in Department II up to the point where the increase in con?
sumption Cj in Department I will be equal to the increase in saving
Sz in Department II. Public investment, if financed by loans,
will thus generate just as private investment its counterpart in
saving. Let us assume that the government finances investment
initially by loans from the banking system. The disbursement of
the respective sums will generate an equal amount of liquid saving
which will then be available for taking up government securities
and thus will make possible the founding of the loan. If, however,
such securities are not issued, this saving will swell the deposits
or will be used for repayment of private bank credits. Here again
the problem of inflationary pressure will depend merely on the
conditions of supply of consumption goods.
These results are of considerable importance. We concen?
trated above on the subject of repercussions upon the economy
of an increase in private investment, especially on the problem
under what conditions this increase does or does not give rise to

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6 MP KALECKI

inflationary pressures. It should be noted, however, that

problem of the "danger of inflation" may not arise at all bec
the entrepreneurs may for various reasons tend to keep th
investment at a low level. Investment may be limited not bec
of the difficulties to finance its increase without causing inflati
but hy unwillingness of entrepreneurs to expand their capi
expenditures. In such a situation public investment acqui
crucial importance for the process of rapid economic developm
and the fact that its repercussions even when financed by lo
do not generate higher inflationary pressures than private inves
ment is highly significant.1
II
We considered above the two extreme cases of the elastic
of supply of consumption goods, which are rather simple. Actua
the situation is more complicated because in some sector
Department II the supply of consumption goods may be elasti
in some it is usually rigid. An important instance of this situat
in under-developed countries is the case where the suppl
industrial consumption goods is elastic because consider
reserves of productive capacity are in existence or because it
not require a very large investment to increase those capacities.
the other hand the supply of food may be fairly rigid. This
depend on the fact that under conditions prevailing in und
developed countries food production expands in response to dem
less than in developed countries.2
One factor seems to make for a relief in the demand pressu
on limited food supplies as a result of increase in indus
employment but this effect proves to be at least in part o
apparent. In under-developed countries the additional lab
force will frequently come from rural districts. In many instan
agricultural production will not fall as a result of the existen
"surplus labour" in agriculture. It may be thus surmised tha
difficulties in supply will arise because the migration from
country-side will leave behind an extra surplus of food which w
find its way to the urban markets. This, however, is not cor
1. It should not be concluded that financing public investment by loan
particularly desirable. We shall argue at a later stage that financing
public investment by taxes on profits is preferable because it help
reduce inflationary pressures.
2. This does not exclude the possibility of a quick expansion of agricultu
under-developed countries if the institutional obstacles are eliminated.

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 THE PROBLEM OF FINANCING OF ECONOMIC DEVELOPMENT

because a large proportion of this extra surplus will frequently be

used for the increase in food consumption of the peasants. In
addition, the standard of living of an industrial worker will be
frequently higher than that of a poor peasant.. Thus the demand
generated by higher employment will only in part be met by the
extra surplus created in the course of migration.
It follows from the above that the rise in investment may
create a strong pressure on the available supplies of food while at
the same time it is possible to increase the production offindustrial
consumption goods in line with demand. It may be shown that in
some instances the rigidity of the supply of food may lead to the
under-utilization of productive facilities in non-food consumption
goods. This will not be the case if the peasants profit from the
increases in food prices, because then they buy more industrial con?
sumption goods out of higher incomes. However, if the benefits of
higher food prices accrue to landlords, merchants or money-lenders,
then the reduction in real wages due to the increase in food prices
will not have as a counterpart the increased demand for mass
consumption goods on the part of the countryside; for increased
profits will not be spent at all or will be spent on luxuries. In
this case the high demand generated by a rapid development
involving large-scale investment will not create a market for
industrial mass consumption goods. As is clearly seen from the
above, two factors will be involved here: (a) the inelastic supply of
food leading to a fall in real wages, (b) the benefit of food price
increases accruing not to small proprietors but to capitalists.
It is of some interest to put this case into a more general
perspective. It should be noted that it is the lack of adequate
markets that was frequently considered the main obstacle of
development rather than the dangers of inflation. The problem
was usually formulated as follows. In view of the small internal
demand there will be no outlet for the products of the newly built
factories; thus industrialisation will prove impossible unless it is
oriented towards external markets. The answer to this problem is
provided by the argument in the previous section. If investment
is sufficiently high, it pushes the demad for consumption goods up
to the point where the surplus of these goods in Department II
meets the higher demand of workers and capitalists in Depart?
ment I. In this way it is the high level of investment itself that
generates demand for consumption goods. It still remains true that

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8 M. KALECKI

the initial impetus for investment comes frequently from external

demand or from government intervention and that even in the
later stages private investment may be supplemented by public
capital expenditure. Assuming, however, a high and rising level
of investment, the problem of the market is solved and there arises,
even on the contrary the problem of inflation if the pace of
industrialization is rapid. But closer analysis indicates in turn that
the "danger of inflation" is by no means incompatible with the
market problem : the latter is apt to reappear if the supply of food
is rigid and the conditions of the distribution of income in;
agriculture are such as described above.
We can conclude that the increase in investment under
conditions of inelastic food supply will cause a fall in real wages and
will generate an inflationary price-wage spiral. Moreover, this type
of inflation may not be associated with any considerable rise in
demand for industrial consumption goods. Thus it is clear from
the above that the expansion of food production, paralleling the
industrial development, is of paramount importance for avoiding
inflationary pressures. Investment in industry, transportation;
public utilities and even long-run development projects in agriculture
should be accompanied by measures which would expand agri?
cultural production in the short period. These measures range
from land reform and cheap bank credit for peasants to improve?
ments in the method of cultivation, small-scale irrigation, and cheap
fertilizers.1
While an adequate supply of food is of basic importance
for preventing inflation, in the course of economic development
the increases in industrial productivity work in the same direc?
tion. There is, however, an important difference. An increase
in the supply of food tends, to raise real wages at a given , level
of non-agricultural employment. On the other hand, an increase
in productivity tends to increase real wages through a reducn
tion of the level of employment corresponding to a given level

I. It should be noted that after the problem of rigidity of the supply of food
has been overcome, the problem of sunply of industrial consumer goods
becomes usually more acute. Indeed, if the rise in food prices involves a
shift in distribution of income towards big landowners, money lenders or'
mtrchants, the prevention of such a price rise will tend to increase the,;
demand for industrial mass consumption goods This is a special case of an
economic law : the elimination of scarcity prices in one sector, through a ?
higher supply, increases the probability of appearance of scarcity prices in
another sector.

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 THE PROBLEM OF FINANCING OF ECONOMIC DEVELOPMENT 9

of non-agricultural production. Let us now consider the latter

process in more detail.
Imagine that there is a significant increase in productivity
throughout the non-agricultural sector both in Department I and
Department II. As a result, employment corresponding to a
given level of production in that sector will fall in inverse
proportion. This will cause a proportionate fall of the wage bill
at given wage rates. The demand for food will thus be reduced
proportionately and food prices will decline. If the distribution
of income between capitalists and workers in industry will remain
unchanged, prices of industrial products will also decline roughly
proportionately to productivity. The final result will thus be a
fall both in industrial and agricultural prices with given wage
rates and thus a rise in real wages. It is of course clear from
the above that at the same time the process of transfer of labour
from agricultural to industrial sector will be slowed down.
In order to put the effect of changes in productivity into
? proper perspective it may be useful to consider two extreme
examples. Let us first assume that agricultural production
remains stationary and that all increases in industrial production
are achieved by using more capital per worker which results in
a rise in productivity. In such an economy the problem of
inflation will not arise. The prices of industrial goods will
tend to fall because ?f the rise in productivity. The conse?
quent rise in real wages will increase the demand for food, and
that will cause some rise in food prices. But this rise cannot
be so high as to eliminate the increase in real wages, since then
the very cause of the higher demand for food would disappear.
Thus, the real wages will rise to some extent ; so will peasants'
incomes, because of higher prices of agricultural products1 and
lower prices of industrial commodities. But the situation is not
so favourable as would appear from this description, because
there would be no shift of population from the countryside to
the town, which is one of the main causes of the increase in
the standard of living in the course of economic development.
Disguised unemployment would not be reduced, and the country
would be split into two sectors of primitive agriculture and
modern industry. The other extreme is the case where produc?
tivity does not increase at all and the increase in industrial
i. Unless this will benefit only rural capitalists.

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 10 M. KALECKI

production is achieved merely through a shift of population

from the rural to the urban districts. In such a case, disgui?
sed unemployment would be diminishing radically, but at the
same time considerable inflationary pressures are likely to develop,
because it may be difficult to expand agricultural production
so as to satisfy the rapidly rising urban demand. The optimum
pattern falls usually between these two extremes: the increase
in industrial production should be based on the rise both in
productivity and in employment.
In the above argument we made an assumption that the
distribution of income between workers and capitalists in industry
will remain unchanged while productivity increases. This need?
not of course be the case if there will be a rise in the degree
of monopoly which would cause a shift to profits. Such pheno?
menon may, of course, occur quite independently of the increase
in productivity. Since in the course of economic development
there will be a tendency of increased concentration in industry,
a rise in the degree of monopoly may easily take place. More-s
over, if development involves considerable direct investment by,
foreign capitalists, the practices of industrial monopolies or quasi
monopolies' are brought from developed to under-developed
countries. What will be the repercussions of an increase in the
degree of monopoly ? The rise of prices in relation to wages
will reduce effective demand and prevent the full utilization of
industrial facilities. It is true that this decline in real wages,
will diminish the pressure on agricultural supplies; but the
ensuing fall in food prices cannot be so great as to restore the
real wages because otherwise its very cause would disappear.
The final result will be a shift in the distribution of income
from wages and agricultural incomes to industrial profits. The
case shows some analogy to that considered above where real
wages fell because of the increases in food prices while bene?
fits of these increases accrued to merchants, landlords or money
lenders. In both cases, the process tends to keep down the
demand for industrial mass consumption goods 'as a result of
a shift to profits in the distribution of income. However, in
the present case it is the monopolistic industrialists that will
reap the benefit.
In the above analysis the inelasticity of supply in agricul?
ture and the monopolistic tendencies in industry emerge as

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 THE PROBLEM OF FINANCING OF ECONOMIC DEVELOPMENT H

important factors underlying inflationary effects in the course of

rapid economic development. The rise in productivity mitigates
inflationary pressures, but at the same time it slows down the
rate at which surplus rural labour is absorbed into industry.
Ill
The above considerations were based on the following
simplifying assumptions: we abstracted (a) from foreign trade
and (b) from government administrative expenditure and revenue;
public investment was assumed to be financed by loans. We
now shall introduce in our model foreign trade but we shall
assume for the time being that it is balanced, i.e., that exports
are equal to imports. We shall also allow for government
administrative expenditure but we shall again assume that it is
balanced by government revenue so that public investment will
continue to be loan-financed.
Let us allow first for balanced foreign trade. For this
sake we shall modify our model as follows. We split all export
industries proportionately to the imports of investment goods
and consumption goods which are obtained in exchange for
exports ; we next allocate these two parts to Department I and
Department II respectively. Thus Department I will now include,
in addition to the industries producing investment goods, also
export industries which produce exports of the value equal to
the imports of investment goods. Similarly, Department II will
include the production of consumption goods plus the produc?
tion of export goods for providing for imports of consumption
goods. It is clear that also in this model there will hold good
the equality between consumption in Department I and saving
in Department II:
Ql = S2
and thus the equality of investment and saving
I=S
It will be easily seen that the relation between employ*
ment in Department I and the volume of investment will
depend now not only on the productivity of labour but also
on the terms of trade The better are the terms of trade the
higher will be ceteris paribus the volume of investment in rela?
tion to employment in Department I. And similarly, the supply
of consumption, goods in relation to employment in Department II

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12 M. KALECKI

will be the higher the better are the terms of trade. Thus to
the same level of employment there corresponds a higher invest?
ment and a lower pressure of demand. It follows directly that
an improvement in the terms of trade will reduce inflationary
pressures corresponding to a giveft level of investment.
It _ should be noted that an even more important aspect of
the better terms of trade is their contribution to the equilibrium
between imports and exports. Indeed rapid economic develop?
ment is apt to create a strain in foreign balance. Imports will tend
to increase for various reasons: (a) the rise in investment will
require considerably higher imports of capital goods which cannot
be produced at home; (b) the increase in total industrial produc?
tion will involve higher imports of foreign raw materials and semi?
manufactures ; (c) the difficulty of increasing food production
pari passu with demand may also necessitate importation of food.
An offsetting factor is the increased self-sufficiency with regard
to industrial mass consumption goods but this will hardly com?
pensate for the higher demand due to the above factors especially
in the first stage of the accelerated development. At the same time
it may be difficult to increase exports in step with imports. First,
such an expansion may require considerable capital resources and
thus with a given level of investment would slow down the
development oriented toward the internal market. Second, it
may by no means easy to enter foreign markets on a larger scale
without causing a deterioration in terms of trade. Because of the
strain in the balance of payments resulting from all these factors,
import restrictions designed to minimize importation of non
essentials are almost inevitably a concomitant of vigorous econo?
mic development.
We shall next introduce in our model government expendi?
ture and revenue. Let us introduce first the administrative budget
which we assume to be balanced, i. e., we assume that administra?
tive expenditure is, equal to revenue. We shall, moreover, assume
for the sake of simplicity that all the administrative expenditure is
on the salaries of officials and that these officials do not save, so
that there consumption is equal to their salaries. Let us denote
the total tax revenue by T and the taxes, both direct and indirect,
paid by Department I (i.e. by capitalists, small proprietors and
workers of this department) by T2 and all taxes paid by Depart?
ment II by T8. Total consumption of the officials will be, according

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 THE PROBLEM OF FINANCING OF ECONOMIC DEVELOPMENT 13

to the above, equal to the total amount of tax revenue 77

Therefore, the demand for consumption * goods coming from out?
side of Department II, is equal to Cj (consumption in Depart-^
ment I) plus T (total tax revenue). On the other hand, the surplus
of consumption goods over the consumption in Department II is:
now equal to T2 + S2, because now this surplus corresponds not
only to savings of capitalists of Department II but also to taxes
paid by this department. As a result, our previous equation Cl=S2
is now modified into an equation
d + T= T2 + S2
If we deduct T2 from both sides of the equation, we shall obtain
Cl + Tt= S2
because T is equal to T, + T2t If, moreover, we shall add to both
sides- of the equation the saving.in Department I, we shall obtain
Cx + 7Y+ S, =. S2 + -St
The left hand side of this equation is nothing else but the total
value of production of Deparment I or investment J. The right
hand side of the equation is equal to the total saving S. We
therefore obtain again the equality between investment and saving :
I = S
Thus, in this case again the process of investment creates auto?
matically a counterpart in saving. Production of consumption
goods or their prices will be pushed up to a point where the sur?
plus of consumption goods in Department II, equivalent to taxes
paid there and savings of capitalists of that department, will equal
the demand for consumption goods coming from Department
I and from Government officials.
It is clear that the higher the government expenditure and
revenue, the lower will be ceteris paribus the real wages after taxa?
tion. This is clear in the case where the taxes are paid directly
by workers or in the case of indirect taxation. But this will be
true even in the case of direct taxes paid by capitalists. These"
taxes will partly come out of capitalists' saving, and to this extent
the demand for consumption goods will not be reduced, and an
additional pressure on the available supply of consumption goods,
will be generated.
Thus lower government administrative expenditure and
revenue will mitigate inflationary repercussions of rapid economic
development and consequently the reduction of the administrative
budget will tend to benefit the process of developments It should

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 M. KALECKI

be noted, however, that the cuts in expenditure should not impair

the functioning of economic agencies which are necessary for
furthering this process.
The model which we have built up gradually is characterized
by a balanced foreign trade, a balanced administrative budget, and
by public investment financed fully by loans. This model is very
much closer to reality than that adopted as a first approximation.
However, even the present model may still require modifications.
The foreign trade may not be balanced, since imports may exceed
exports because of the import of capital. Moreover, tax revenue
may exceed administrative expenditure so that a part or all of public
expenditure is financed by taxation. In both cases the modifica?
tions in question would tend to relieve inflationary pressures which
may be caused by rapid economic development. We shall there?
fore consider the problems involved in some detail.
IV
We shall discuss below the effect of the capital import, which,
as said above, tends to relieve inflationary pressures corresponding
to a given level of investment.
Let us denote the import of capital which is equal to the
deficit in foreign trade by F. If the import of capital is used for
purchasing abroad investment goods, it is clear that the same
amount of investment will be achieved by a smaller production of
investment goods at home and thus the pressure on the supply of
consumption goods would be pro tanto relieved. If we denote the
total investment by J, we shall have the equation
7= S + F
which shows that a smaller amount of saving is now necessary to
finance a given amount of investment.
If the import of capital is used for purchasing abroad con?
sumption goods, it appears that the same equation holds good.
Indeed, for the case of balanced trade we had above the equation
d + T = T2 + Sz
Since now there will be available an additional supply of consump?
tion goods equal to the foreign trade deficit F, we shall have :
C, + T = T2 + S2 + F
From this follows, taking into consideration that the total taxes T
are equal to Tx + T2*
Q + T^Sa+F
Adding Sj to both sides of the equation, we obtain

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 THE PROBLEM OF FINANCING OF ECONOMIC DEVELOPMENT 15

Cl + Tl + S1-Sr+Sl+.F
Or, finally,
I = S + F
In the case of using the capital import for purchasing abroad
investment goods, the amount of investment goods to be produced
at home in order to achieve a given level of total investment is
pro tanto reduced, and the pressure of demand on supply relieved
from demand side. In the case of using the capital import for
purchasing abroad consumption goods, the pressure of demand on
supply is reduced from the supply side. In both cases, however,
the amount of home saving necessary to finance investment is
reduced by the total amount of import of capital and thus infla?
tionary pressures are correspondingly relieved .
Another function of import of capital is to relieve the shortage
of foreign exchange. Indeed, as mentioned above, the process of
development tends to strain the balance of payments by raising
the requirements for imports of capital goods as a result of higher
investment; the requirements for imports of industrial raw
materials because of growing industrial production; and the require?
ments for imports of food if home production lags behind the
demand.
The above shows the advantages of import of capital for the
rapid development of a country. In practice, however, this way
of financing econonomic development presents problems which
are frequently insuperable. From a purely economic point of view,
the interest paid on the imported capital will burden the balance
of payments in the future which means both a loss of resousces
and also a risk of balance of payments difficulties. This problem
is, of course, the more acute, the higher the rate of interest. But
even more important is the question of availability of foreign capi?
tal which would not involve problems of more basic nature.
- 3The import of capital may take three forms : grants, loans or
direct investment. It is clear that from the purely economic point
of view grants would be the most preferable type because they
would not raise the economic difficulties mentioned above. How-;
ever, some political strings would usually be attached to such grants
?s would be available on a large scale and this may adversely affect
the whole course of development.
Let us consider in turn the problem of direct investment. It
is sometimes maintained that such investment is preferable to loans

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 16 M. KALECKI

because the rate of dividend on shares is flexible according to the

business situation while the rate of interest on bonds is not. It
should be noticed, however, that this is offset by the fact that the
former rate is usully on the average much higher than the latter.
More important still are the general economic and political aspects
of direct investment. Direct investment frequently takes place in
certain branches of the economy, such as production of raw
materials for export which may not be in line with a reasonable
plan for the development of the resources of a country. It will
give to that development a one-sided twist. But apart from that,
the big concerns engaged in this investment will inevitably acquire
a considerable political influence upon the governments concerned,
and the consequences of this may easily vitiate the process of
economic development.
Thus, the most suitable type of import of capital for the
development of a country are foreign loans obtained on a purely
commercial basis; but such loans may have the economic dis
advantage of a rather high rate of interest and would be hard to
obtain because of the danger of future difficulties in the balance of
payments which may render the transferability of the interest and
amortization impossible. These difficulties may be perhaps,
remedied in some instances in the following way. Transactions
may be imagined where investment goods from abroad are obtained
on loan, the repayment of and the interest on which takes the form
of future exports of specific commodities produced in the under?
developed country in question. In this way the future balance-of
payments difficulties connected with amortization and interest
payments on loans are eliminated to some extent because the
foreign exchange for the respective payments need not be obtained
in the world market. Such arrangements may be of advantage to
the lending country which on the one hand has an unutilised
capacity in the manufacture of investment goods, and on the other
hand is keen on securing the future flow of raw materials.
The above makes clear the difficulty of securing import of
capital from developed to under-developed countries on acceptable
terms. Perhaps a partial substitute may be found in preventing the
export of capital from under-developed to developed countries which
is by no means negligible. Not only visible capital flight must be
taken into consideration here but the hidden transfers as well which
are frequently of even greater importance. A common practice, for

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 THE PROBLEM OF FINANCING OF ECONOMIC DEVELOPMENT 17

instance, of circumventing exchange restrictions is to understate the

export prices and to overstate the import prices. (The same
practice is frequently used especially by foreign companies in order
to make the export profits appear lower.) The elimination of such
abuses may indeed yield sizable amounts of ''foreign capital' \
The other similar way of securing foreign capital is to cut down
the transfers of dividends abroad by existing foreign enterprises.
This in fact has been done in many countries by taxation of
export profits in this or other form; by blocking the transfers of
dividends abroad partly or fully; and in some cases by nationali?
zation of the enterprises concerned. The argument frequently
used against such policies is that it discourages direct foreign
investment. If, however, a rather sceptical attitude is taken, as
above, with regard to the role of direct foreign investment in
economic development, this argument loses much of its weight.1
The difficulties of securing foreign capital in a form favourable
to development explains the importance which is attributed in
underdeveloped countries to the improvement in the terms of trade.
We have already considered briefly its significance for economic
development. It is interesting to look at it now from the pointos
view of comparison with capital import. Any improvement in
terms of trade may be considered equivalent to the import of capital
without the difficulties accompanying the latter. This is obvious
with regard to the supply of foreign exchange, because all the
additional amount of exchange which is obtained through the
improvement in terms of trade, may be mobilised by a government
for additional purchases essential for development. As to the
internal repercussions, they may be rendered identical with those of
foreign loan by imposing export duties when the improvement in
terms of trade is due to the rise in export prices, or import duties
when it is due to the fall in import prices. If the duties in
question are exactly equal to the change in foreign prices, they

I. It should be perhaps noted that the policies of reducing or eliminating

dividend transfers cannot be always considered as aiming solely at
immediate improvement of the balance of payments. In many instances
these policies may be mainly a manifestation of the fight of an under?
developed country with the political influences of foreign companies. The
retaliation of these companies by maneuvers to impair the exports of the
products concerned may even temporarily lead to the weakening of the
balance of payments position. Such will be especially the case when one
or a few companies play a dominant role in the foreign trade of the country
involved.

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 18 M. KALECKI

clearly leave the internal situation unaffected, while investment

increases by the amount of gain in foreign exchange.
The last stage of the argument leads up to the problem of
the influence of taxation upon the repercussions of investment
undertaken in the course of economic development. We shall now
deal with this problem.
V.
We shall now deal with the subject of taxation as an anti
inflationary measure. It has been assumed so far that the adminis?
trative budget was balanced and that public investment was fully
financed by loans. We shall now consider the repercussions of
financing government investment partly or fully by taxation. It is
easy to show that the amount of saving corresponding to a given
level of investment (private and public), will be reduced by the
amount of additional taxation. Indeed, our equation of the demand
for and supply of consumption goods can be written now if we
abstract from capital import, as follows :
d + T = T2 + T'f + S2
where T'2 are the additional taxes raised in Department II, or
d + T, - T\ + S2
because T is the total tax covering the administrative expenditure
and Ti and T2 its parts raised in Departments I and II respectively.
Let us now add on both sides T\ -f- Sx where T\ is part of
additional tax raised in Department I :
Cx + Tx + T\ + SX = T\ +T'a + S1 + S2
The left-hand side is nothing but the value of production of
Department I or investment (private and public) I. The right
hand side is equal to Ty, i.e. the total additional tax plus 5, the
total saving :
I = T + S
It is easy to show that if capital imports F are taken into conside?
ration this formula will change to :
I = V + S 4 F
It can be seen from this equation that investment will always
generate saving necessary to finance it in excess of taxation and
import of capital.
Although taxation reduces the amount of saving which is
generated by a given level of investment, this will not necessarily
mean a reduction in pressure on real wages. (We have dealt already

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 THE PROBLEM OF FINANCING OF ECONOMIC DEVELOPMENT 19

with a similar problem when discussing the consequences of an

increase in the balanced administrative budget.) Direct taxation on
lower income groups, or indirect taxes, will mean of course a
reduction in real wages. As to taxes on capitalists, they will be
met only in part by a reduction in their consumption, while in part
they will be paid at the expense of their savings. In the latter case
there is only a shift from savings to taxes without any change in
prices.
Nevertheless, reduction of capitalists' consumption achieved
by taxation of profits will help mitigating inflationary pressures. It
is true that no essential commodities will be released in this way.
The capitalists will not eat less under the impact of taxation. But
as a result, to a given level of investment there will correspond a
lower level of industrial employment, because less will be produced
for capitalists' consumption, and this will reduce inflationary
pressures caused by rapid development. Moreover, in the longer
run this policy will help to shape the development in the direction
of the expansion of essential industries. It is true that this can be
achieved through enforcing an appropriate investment plan by
direct means, e.g. licensing of investment, but it is clear that
without a parallel tax policy this might involve considerable
difficulties. Indeed, prices of non-essential consumer goods would
increase under pressure of demand and thus create a strong
tendency for investment in the respective industries which it might
be difficult to control.
The reduction of capitalists' consumption will be also
bebeneficial from the point of view of balance of payments
because it will reduce the demand for imported luxuries. It is
true that import restrictions can cope with this problem but
here again the reduction of demand for such imports will faci?
litate the enforcement of restrictions.
In addition to limiting capitalists' consumption financing
public investment by taxation presents still another advantage.
It reduces the creation of liquid assets. This may be unimpor?
tant if there is no tendency towards inflation. If, however, as a
result of an inadequate suply of consumption goods an inflationary
sipiral has been for some time in existence, the large amount of
lquid assets will stimulate speculative hoarding and thus will help
to aggravate the primary inflationary process.1
i The reduction in the creation of liquid assets will also facilitate the control
of the structure of investment by direct means, e.g. licensing.

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20 M. KALECKI

In the light of the above, financing public investment by

taxation of profits appears to be a sound policy. It should be
noticed that in this way only such profits would be taxed away that
are in fact created by public investment. Indeed, if taxtation in
excess of the administrative budget is exactly equal to public
investment, the preceding formula will become
I?r = S + F
where lPr stands for private investment. For if we substract V
from the previous equation we obtain on the left-hand side private
investment Ipr because we assume that public investment is equal
to T\ It follows that if public investment is fully financed by
taxation, the savings and profits generated are such as would obtain
if public investment were not in existence. 1 Thus an increase in
public investment accompanied by a correspondingly higher revenue
from taxation of profits would not have an adverse effect on incen?
tive to private investment.
The above puts the role of financing of public investment by
taxation of profits into proper perspective. This taxation will
prevent public investment from increasing profits and capitalists'
consumption. There will remain, however, the effect of higher
investment upon the demand of workers for consumption goods.
It follows that while balancing public investment by taxation
of profits appears to be a sound policy it will not fully ''neutralize"
the inflationary impact of such investment. It may be shown that
such monetary measures as banking restrictions are also inadequate
for dealing with the problem of inflation resulting from a high
level of investment.
Let us consider the significance of banking credit restrictions
as anti-inflationary measures. The main anti-inflationary influence
of credit restrictions is exerted obviously through depressing the
level of investment. Now the reduction of investment in fixed
capital will obviously upset the pace of development. Thus infla?
tionary pressure resulting from rapid development would be cured
by slowing it down. If this is deemed necessary, however, it may
be done by more direct means of either reducing public investment
I. It should be noted that if public investment is increased considerably in a
short period the rise in taxes on profits necessary to finance it is likely to be
less than the increment in public investment, unless other taxes are reduced.
Indeed, the resulting upswing in economic activity will raise the revenue from
' old" taxes while the administrative budget is not likely to expand much in a
short period. Thus a part of the increase in public investment will be cover?
ed by tax revenue automatically.

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 THE PROBLEM OF FINANCING OF ECONOMIC DEVELOPMENT 21

or licensing private investment The latter will help to reduce

private investment on a selective basis. To the same end may
be used of course selective restrictions of long-term bank credit
for financing private investment. This, however, would not
exclude unessential investment financed from the firm's profits.
There still remains the effect of credit restrictions upon
investment in inventories. As long, however, as there is not tend?
ency for hoarding, only limited reductions in investment in inven?
tories can be achieved without hampering the expansion of
production.
We may conclude that credit restrictions can play an impor?
tant anti-inflationary role only when directed against hoarding of
commodities which is a secondary effect of already advanced in?
flation. When applied in such a case it must be on a highly
selective basis so as not to impede the process of development
itself.
Such a system, however, may be rather difficult to operate. A
credit given for an essential purpose may frequently be used at least
indirectly for speculative hoarding: indeed such a credit may release
the firm's own funds and thus make them available for speculative
activity. The system of selective credit restrictions may have to be
very complicated in order that it could be run effectively. For
this reason another way may be preferable for combating tend?
encies for hoarding commodities if an inflationary spiral is in exis?
tence. This system was applied for the first time, and with success,
in Chinese People's Republic, for putting a stop to hyper-inflation
which was inherited from the previous regime. It consist of
maintaining the real value of deposits, government bonds and bank?
ing credits by revaluing them continuously according to established
price indices. This prevents a tendency to convert money and
other liquid assets into commodities, and at the same time dis?
courages borrowing for speculative purposes. 1
Neither this method nor selective credit restrictions can of
course cope with what we called above "primary" inflation. Their
only purpose is to prevent the aggravation of this primary inflation
by speculative hoarding. The primary inflationary pressure
I. It should be noted that the application of this measure would cause a fall in
the values of private securities which would not be ''insured" against the rise
in prices. This feature is in fact common to all monetary measures against
hoarding of commodities. In fact5 credit restrictions would cause a fall in
values of both government and private securities.

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22 M. KALECKl

experienced in the course of rapid economic development is, as

shown above, the result of basic disproportions in productive
relations. Thus these pressures cannot be prevented by purely
financial devices. The solution of the problem must be based on
economic policies embracing the whole process of development.

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