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