GOVERNMENTS of most developing countries seek to encourage the establishment and growth of financial intermediaries (defined as all financial institutions except commercial banks) by all kinds of legislative and financial aid. The ultimate success and independent development of financial intermediaries depends, however, on far more than just government assistance. The economic environment must be suitable to long-term financial activity in that income earners must be willing to save in monetary form over long periods, potential borrowers must be willing and able to invest in long-term productive (as opposed to speculative) activity; the rate of interest must be positive and reflect the cost of capital in that country, and the sectors in which the intermediaries are expected to specialize must not be throttled by price controls or unwarranted neglect. In most economies these conditions can be taken for granted; in a few, those that suffer from considerable inflation, they cannot.
Inflation damages all the basic conditions of success for financial intermediaries. It reduces savings as a whole by introducing uncertainty about future prices and increasing the burden of consumption costs for people whose income declines in real terms, and it substitutes nonmonetary savings, which are useless for productive investment, for monetary savings, which can be productively employed. It enhances the attractiveness of short-term speculative investment while decreasing that of long-term productive investment. It damages the essential allocative function of interest by lowering or nullifying it in real terms, so that credit is rationed haphazardly and with little relation to its true value. And often it causes the government to impose price controls on selected sectors of the economy, especially agriculture and public utilities, in order to control inflation, thus leading to a reduction in activity in these sectors. All this results in the uneconomic allocation of whatever short-term monetary savings take place, with an unwarranted redistribution of value in favor of the borrowers, while long-term monetary transactions are severely constricted, both because the value of money declines and because the rate of decline is itself uncertain.
It is clear that financial intermediaries would find it difficult to thrive under these conditions if not permitted to protect themselves by raising interest rates or by other measures. The best remedy would of course be to halt inflation, and as difficult as this task is, countries do succeed in it, even if the success can never be regarded as final. Countries suffering from the severer forms of inflation, however, will not be able to stop it suddenly without suffering major dislocations in their economies, and may only be able to tackle it slowly over a period of years. And some countries may experience a new bout of inflation or a resurgence of partly controlled inflation. If inflation is accepted for these countries as a fact of economic life for some time to come, the best method of counteracting its ill effects would be to reproduce somehow the conditions that would obtain under stability—that would, in other words, enable the intermediaries to attract long-term savings by offering stable value as well as a positive rate of interest in terms of real value (the purchasing power of money), and to lend for long periods with stable real value at an appropriate real rate of interest so that capital is used where most needed for productive purposes. Such a method would enable long-term financing to take place in the sectors selected without most of the deleterious effects arising from inflation.
Various techniques for counteracting inflation may be suggested which more or less approach the ideal. They can be classified broadly into two types: techniques that adjust the financial transactions to the actual rate of inflation and techniques that do not. Let us start with the latter.