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The Financial System, Business Cycles and Growth
Joseph Stiglitz, Senior Vice President and Chief EconomistThe World Bank
Outline of the Talk
• Financial Markets
• Finance and Fluctuations
• Finance and Growth
• International Capital Flows
The Importance of Financial Markets
• Collecting and Aggregating Savings• Brain of the Economy
– Allocating capital– Monitoring
• Other Functions– Reducing risk– Increasing liquidity– Conveying information
Why The Financial Sector is Different
• Concerned with intertemporal trades with uncertain returns
• Importance of information• In general, markets with incomplete information
are not constrained Pareto efficient• Government plays an important role in all
successful financial systems
Equity
Advantages:• Risk sharing• No costly bankruptcies
Disadvantages:• Adverse selection• Moral hazard• “Equity rationing”
Forms of Finance
Forms of Finance
Short-term Bank Loans
Advantages• Effort incentives aligned• Close monitoring by bank
Disadvantages• Different risk incentives• Adverse selection• Moral hazard• “Credit rationing”
Forms of Finance
Bonds
They are in between equity and short-term bank debt.
Primary vs. Secondary Markets
Benefits of Secondary Markets:• Increasing liquidity• Facilitating diversification• Conveying some information
Costs of Secondary Markets:• Inefficient expenditures of effort in “private rent
seeking”
Traditional Keynesian Macroeconomics
M? r? I? Y?
Empirical Failures:
• Persistence and fluctuations• Effects of supply shocks• Differential sensitivity of sectors• “Perverse” movements of inventories (exacerbated
rather than smoother downturns)• Variable effects of monetary policy
Theoretical Failures:
Unconvincing microfoundations
Two separate theories:
• Full employment (where neoclassical principles hold economic efficiency)
• Unemployment (massive inefficiencies associated with underutilization of resources)
Basic Lesson: Cannot summarize impact of financial markets in a money demand equation
Traditional Keynesian Macroeconomics
Key Ingredients of Finance-Based Model
Equity Rationing
Risk averse firm (incomplete futures markets).
Implication
Investment depends on:
• Equity net worth (lowers risk or bankruptcy, therefore more investment)
• Cash flow (reduces borrowing needs, therefore less risk of bankruptcy)
In contrast, only the interest rate and productivity matter in the neoclassical model.
Implications of the Enhanced Investment Function
• Explains propagation and persistence. Changes to equity are long-lived, with long-lived consequences for investment.
• Explains importance of redistributive supply shocks.
• Explains why some sectors are so sensitive (more equity/credit rationed).
Banks and Credit Constraints
Assumptions
• Banks are also risk averse
• Credit rationing is pervasive
• Bank debt is an imperfect substitute for other debt
Banks and Credit Constraints
Banks and Credit Constraints
Implications
• Monetary policy works through a “credit channel”
• Theoretical basis for monetary channel questioned–Money bears interest–Most transactions are asset exchanges, not income generating–Money not required for most transactions
• Interest rate - output relationship will vary
• Can see large output movements with little movement in real interest rate
Average Growth in Selected Countries,
1976-1993
0
0.5
1
1.5
2
2.5
3
3.5
Low High Low High
Ave
rage
Gro
wth
Initial Conditions
Stock Market Liquidity Financial Depth
Calculations by Ross Levine, World Bank
Finance and Growth
Cash flow, equity, and uncertainty affect:
• Research and development
• Learning by doing
• Investments in improved management.
Therefore they affect long-term growth.
Mild Financial Restraint
Can be good for growth:
• Increases firms’ net worth and thus their investment.
• Lowers interest rates, leading to safer mix of applicants, better risk profile, and thus safer banks.
• Improves franchise value of banks and thus leads to more prudential behavior.
• Basic lesson: Issue not whether there should be government regulation, but what form it should take.
Evidence on Capital Account Liberalization
• Increases risks• No discernable benefits for growth or investment• Short-term flows
– Volatility– High costs of economic disruption– Cost of sterilization
Long-term Capital Flows to Developing Countries
0
50
100
150
200
250
300
1980 1985 1990 1995
Bil
lion
s of
US
$
PrivateOfficial
1997
SOURCE: Global Development Finance 1998
5
Economic Growth, Investment, and Capital Account Liberalization
-8
-6
-4
-2
0
2
4
6
8
-1 -0.5 0 0.5 1 1.5
Degree of Capital Account Liberalization
GD
P G
row
th 1
978-
1989
-15
-10
-5
0
5
10
15
-1 -0.5 0 0.5 1 1.5
Degree of Capital Account Liberalization
Inve
stm
ent/
GD
P 1
978-
1989
SOURCE: Dani Rodrik (1998). These are the residual growth and investment/GDP that are not explained by per-capita income, secondary education, quality of government institutions, and regional dummies for East Asia, Latin America and Caribbean, and Sub-Saharan Africa.
Fis
cal C
osts
of
Sel
ecte
d B
ank
ing
Cri
ses
(per
cen
tage
of
GD
P)
Cou
ntry
(D
ate)
Cos
t (p
erce
ntag
e of
GD
P)
Arg
entin
a (1
980-
82)
55.3
Chi
le (
1981
-83)
41.2
Uru
guay
(19
81-8
4)31
.2Is
rael
(19
77-8
3)30
.0C
ote
d’Iv
oire
(19
88-9
1)25
.0S
eneg
al (
1988
-91)
17.0
S
pain
(19
77-8
5)16
.8B
ulga
ria
(199
0s)
14.0
Mex
ico
(199
5)13
.5H
unga
ry (
1991
-95)
10.0
Fin
land
(19
91-9
3) 8
.0S
wed
en (
1991
) 6
.4S
ri L
anka
(19
89-9
3) 5
.0M
alay
sia
(198
5-88
) 4
.7N
orw
ay (
1987
-89)
4.0
Uni
ted
Sta
tes
(198
4-91
) 3
.2
Sou
rce:
Cap
rio
and
Kli
ngeb
iel 1
996.
GDP Growth Before and After Banking Crises, 1975-1994
0
0.5
1
1.5
2
2.5
3
3.5
OECD crisis countries Non-OECD crisiscountries
Non-crisis countries
Five years before crisis
Five years after crisis
Mea
n G
DP
gro
wth
(an
nual
per
cent
)
SOURCE: Caprio 1997
Policies to Reduce Vulnerability to Capital Volatility
Traditional policies:
• Good macroeconomic policy
• Sound financial regulation and oversight
• Transparency
Policies to affect composition of flows:
• Eliminate distortions favoring short-term
• Prudential regulations about exposure
• Better designed risk-based capital adequacy standards
• Possible Chilean-type restrictions
• Tax policy
Policies to Reduce Vulnerability to Capital Volatility
Managing Crisis
Expected Return=Promised Return x Probability of Repayment
Additional considerations:
• Risk adjustment
• Insiders vs. outsiders
• Adverse selection and credit rationing
• General equilibrium credit crunch
Key parts of the strategy:
• Maintaining credit flows
• Not depleting net worth
• Preserving information and organizational capital
Financial and Corporate Restructuring During A Crisis