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Milton Friedman is one of the well-known economists who developed numerous theories aimed to explain financial and economic relations inside the states, between the state and business institutions, between the states and citizens and international financial system. In one of his thesis, Milton Friedman states that if it is so desired, policies which are designed and implemented to resolve the problem of financial crisis can be complemented with a policy which will require banks to place a sum of their deposits equal to the size of bad loans in non-interest-yielding reserves. Thesis statement Friedman develops an outstanding economic philosophy based on a combination of free market initiatives and effective methods for market restructuring in times of crisis.
The main theories developed by Friedman are the quantity theory of money and the Phillips Curve. According to the theory of money is based on the following equitation: MV = PT, In this formula
“M is the amount of money in circulation
V is the velocity of circulation of that money
P is the average price level and
T is the number of transactions taking place” (Becker, 2007, p. 43).
The theory provides a means for analyzing and improving control systems, for measuring the efficiency with which feedback information is used, and for determining the costs of system response time in terms of computers. This thinking is reflected in the economists’ notion of control. economists’ view the control function in terms of the current state of a system, a desired state, the number of periods in which the desired state is to be reached, and the "driver" necessary to get the system there. The driver in marketing may be thought of as the marketing mix or part of it (Becker, 2007).
The Phillips Curve aims to reduce inflation and shows a direct correlation between unemployment and inflation. On the other hand, when no such binding constraint exists, there are two forces in operation; first, the portfolio tax effect of the bad loans, which induces banks to increase deposit-taking; and second, the net return reduction from inflation, which tends to reduce deposit-taking. The analysis then showed that, contrary to the presumptions of the literature, there exist values for the size of bad loans which imply that in equilibrium the banking sector will hold a larger volume of deposits, but provide a lower volume of loans to private borrowers, offering a higher interest on deposits and charging a higher interest on loans than it would in the absence of inflation. This result is entirely driven by the portfolio tax effect of bad loans. The main policy implication from this analysis relates to the latter effect. That is, to the extent that the government is interested in increasing the volume of funds intermediated through the official banking sector and keeping afloat some in order to ease the social tension of the transition, constraints on the portfolio of banks, which eliminate the negative effects of bad loans on bank returns, but retain the expansionary effects on deposits, have a useful role to play. An example of such a policy instrument would be a policy of zero- interest reserve requirements on bank deposits that the government may decide to vary at its own discretion (Friedman and Friedman, 1990).
While financial laws and regulations and their enforcement are fundamental to the development and functioning of sound financial markets, the post-communist countries launched their transition to a market economy with no such institutions. While there was simply no need for them under central planning, the question remains as to what are the legal and regulatory arrangements towards which the transition economies should be moving. Just as there is no archetype for a market economy, there has historically been no unique set of laws and regulations and mechanisms for their enforcement that underpin sound finance: indeed, there is wide variation in these institutional arrangements and practices in market economies worldwide (Becker, 2007).
Applied to modern economic situation, it is possible to say that the elimination of bad loans would then clean bank balance sheets, restoring the efficiency of the banking sector in the process of financial intermediation, but the government would also be able to maintain a source of implicit revenue through a portfolio tax on banks. At a minimum, such a tax would secure the same level of deposits as government borrowing at a market rate financed from an explicit fiscal tax on financial intermediation, while if the interest payments are financed from a tax revenue raised outside the banking system, the reserve requirement results in a larger volume of deposits than in its absence. The analysis was based on the following premises. The banking sector lacks access to a large open securities market where it always deals as a rate-taker, while the government is assumed exogenously to set the size of the bad loans in order to assist ailing state-owned Enterprises. By reducing the size of bank portfolio that can be profitably invested, bad loans impose a lump-sum tax on the banking sector. Furthermore, recognizing the damage that bad loans may do to the ability of the banking sector to intermediate funds between savers and investors and allocate credit efficiently to the most profitable uses, bad loans are modelled to directly reduce the net return per unit of banking activity. The latter influence is unlike other taxes on financial intermediation and obviously stacks the deck against the use of bad loans as a policy instrument (Friedman, 1994).
In general, Friedman did not share the idea that fiscal policy is a good method to manage demand. This is in a sense a costly process due to the fact that financial intermediates will take their share and interest at market rates will have to be paid by the taxpayer. The remaining part of the budget deficit will have to be financed by rearranging the state budget, namely reducing public investment as well as pension benefits (which has already been done). In evaluating this irrevocable shift to the FF system which countries made, it is important to assess the net present value of pledged state pension benefits. In theory the new system is supposed to produce cheaper and better pensions and take the burden of pension provision from the state. However, it is clear even now that the operating costs of the new FF system are high, which is partially related to the transfers of members' accounts between the different fund management companies (Friedman and Friedman, 1990).
In sum, these theories are significant in the sense that they suggest that deferred tax can arise and that accounting profit cannot be assumed to be the same as taxable profit. The disclosure of the reconciliation mirrors a requirement in Spanish legislation when that country moved from an accounting system based on fiscal imperatives to one where there was a clearer separation of accounting and tax matters. Whether, in practice, this separation will be achieved in will depend heavily upon the behavior of the tax authorities with respect to accounting records and statements and also the behavior of enterprises. One acid test for the influence of tax upon accounting is in the calculation and treatment of depreciation of fixed assets. The first lies in the undeveloped character of the securities markets in the region. The second relates to the changes in consumer behavior after the collapse of the centrally planned economy system, where the changing pattern of consumer spending took place, leaving the habit of saving in the past. Legal structures and institutions serve as the underlying framework for the operation of modern financial markets and are important elements underpinning their development. Transition economies, however, by definition did not need such structures and institutions, but rather functioned (although not well) through central planning and administrative fiat. Today, legal structures and institutions are seen as necessary both to establish and maintain the rules by which participants in the market must play and to build confidence in the financial environment and thereby encourage finance and investment. In order to be meaningful, such international principles must be implemented through legal reform, encompassing broad legislative, institutional and cultural changes. Legal reform in transition economies raises special challenges because the transition countries have begun from a starting-point of essentially non-functioning legal systems and general lack of understanding and regard for the role of law in a market economy.