Financial Development, Economic Crises and Emerging Market Economies

Faruk Ulgen

• Publisher: Routledge
• Year: 2016
• ISBN:
  9781317301622
• Edition: 1
• Topic: Business
• Subtopic: Business General
• Index: Business

Recurrent crises in emerging markets and in advanced economies in the last decades cast doubt about the ability of financial liberalization to meet the aims of sustainable economic growth and development. The increasing importance of financial markets and financial efficiency criterion over economic decisions and policies since the 1980s laid down the conditions of the development process of emerging market economies. Numerous crises experienced thereafter gave rise to flourishing work on the links between financialization and economic development. Several decades of observations and lessons can now be integrated into economic and econometric models to give more sophisticated and multivariable approaches to financial development with respect to growth and development issues. In the markets-based and private-enterprise dominated world economy, two conditions for a successful growth-enhancing financial evolution can at least be brought fore: macroeconomic stability and consistent supervision.

But even after the 2007-2008 global crisis, economists do not agree on the meaning of those conditions. For liberal and equilibrium-market economists, good finance and supervision mean market-friendly structures while for institutionalists, post-Keynesian and Marxist economists, good finance and supervision must lie in collectively designed and managed public structures. Drawing heavily on the tumultuous crises of the 1990s-2000s, this book argues that those experiences can shed light on such a crucial issue and lead economic theory and policy to go beyond the blindness of efficient free markets doctrine to economic catastrophes. It also points to new challenges to global stability in the wake of reconfiguration of international financial arena under the weight of major emerging market economies.

1
Financial liberalization, crises and policy implications

Philip Arestis

Introduction

In recent contributions, Arestis and Karakitsos (2013, 2015) discuss the origins of the international financial crisis of 2007–2008 and the emergence of the ‘great recession’ by emphasizing the ‘distributional effects’ and ‘financialization’ as the main features of it. A distinction between main factors and contributory factors is made. The main factors contain three features: distributional effects, financial liberalization and financial innovation. The contributory factors contain three features: international imbalances, monetary policy and the role of credit rating agencies. In relation to the term ‘financialization’, it encapsulates the two features of the main factors, namely financial liberalization and financial innovation, since they define it for the purposes of their contribution as the process where financial leverage overrides capital (i.e. equity), and financial markets dominate over the rest of the markets in the economy. Financialization, as it has just been defined, is a broad sense of the term. In this broad sense it has been around for a long time, although the term itself, ‘financialization’, is of a recent origin. Kotz (2011) elaborates on this issue to show the difference in terms of financial dominance of the late nineteenth and early twentieth centuries and financialization as it is used currently. Financialization, in terms of its current usage, is defined by Epstein (2001: 1) as the term that “refers to the increasing importance of financial markets, financial motives, financial institutions, and financial elites in the operation of the economy and its governing institutions, both at the national and international levels”.

In discussing the origins of the current crisis we are very much aware of the limitations of current macroeconomics. Indeed, we agree with Minsky (1982: 60), who argued that “from the perspective of the standard economic theory of Keynes’s day and the presently dominant neoclassical theory, both financial crises and serious fluctuations of output and employment are anomalies: the theory offers no explanation of these phenomena” (see also Arestis 2009; Palley 2012). The ‘great recession’ was caused by US financial liberalization attempts and the financial innovations that followed them. That was greatly helped by significant income redistribution effects from wages to profits of the financial sector. An interesting statistic on this score is reported in Philippon and Reshef (2009) in the case of the United States. This is the pronounced above-average rise in the salaries of those employed in finance. Relative wages, the ratio of the wage bill in the financial sector to its full-time-equivalent employment share, enjoy a steep increase over the period from the mid-1980s to 2006. What explains this development is mainly financial deregulation in a causal way, followed by financial innovation. The deregulation impact accounts for 83 per cent of the change in wages. Indeed, wages in the financial sector are higher than in other sectors, even after controlling for education. A further interesting example in relation to financialization in the United States refers to the size of the financial sector as a percentage of Gross Domestic Product (GDP); it grew from 2.8 per cent in 1950 to 7.9 per cent in 2012. It is also the case that incomes in the US financial sector increased by 70 per cent relative to other sectors over the period from 1980 to 2012.¹ Similar but less pronounced financial shares are relevant in the UK, Canada, Germany and Japan, among others. In China, financial intermediary shares to GDP increased from 1.6 per cent in 1980 to 5.4 per cent in 2008 (Greenspan 2010: 15).

It is the case that ever since both developing and developed countries adopted the essentials of the financial liberalization thesis, banking crises have been unusually frequent and severe. The World Bank (1989) demonstrates the magnitude of the crises over the period – early 1980s – at least two-thirds of the International Monetary Fund (IMF) member countries experienced significant banking-sector crises. A further relevant observation is that beyond the financial costs of banking crises, not just for the local economies involved, they have exacerbated downturns in economic activity, thereby imposing substantial real economic costs (Honohan and Klingebiel 2000; see also Arestis 2004, 2005). In this chapter, we discuss further the financial liberalization aspect of crises, emphasizing two examples that led to crises (the South East Asian crisis and the August 2007 international financial crisis that led to the ‘great recession’). We then turn our attention to, and discuss, the economic policy implications, emphasizing recent experience with the great recession. Finally, we summarize and conclude.

Financial liberalization

Theoretical aspects of financial liberalization

The financial sector of an economy provides real services, whereby financial instruments, markets and institutions arise to ameliorate market frictions: they can mitigate the effects of incomplete information and transaction costs. In fact, Levine (2004: 5) suggests that the financial system provides the following functions: to “produce information ex ante about possible investments and allocate capital; monitor investments and exert corporate governance after providing finance; facilitate the trading, diversification and management of risk; mobilize and pool savings; ease the exchange of goods and services”. Also, Levine (2005) in his extensive review of the empirical literature concludes that:

A growing body of empirical analyses, including firm-level studies, industry-level studies, individual country-studies, time-series studies, panel-investigations, and broad cross-country comparisons, demonstrate[s] a strong positive link between the functioning of the financial system and long-run economic growth. While subject to ample qualifications and countervailing views noted throughout this article, the preponderance of evidence suggests that both financial intermediaries and markets matter for growth even when controlling for potential simultaneity bias. Furthermore, microeconomic-based evidence is consistent with the view that better developed financial systems ease external financing constraints facing firms, which illuminates one mechanism through which financial development influences economic growth. Theory and empirical evidence make it difficult to conclude that the financial system merely – and automatically – responds to economic activity, or that financial development is an inconsequential addendum to the process of economic growth.²

(Levine 2005: 921)

It is also true that more recently, further studies have accounted for other real sector variables in the relationship between finance and growth. Such variables include the pattern of countries’ trade balance and changes in income distribution and poverty levels (see, for example, Beck 2012).³

Even so, there are studies that would argue for a weak relationship between finance and growth. Lucas (1988: 6) dismisses finance as an ‘over-stressed’ determinant of economic growth, while Robinson (1952) assumes a passive role for finance, with financial development simply following economic growth. At the other extreme, Miller (1998: 14) suggests that whether financial markets “contribute to economic growth is a proposition too obvious for serious discussion”. The middle ground is covered by the idea that the relationship between finance and growth cannot be safely ignored without endangering our understanding of development and economic growth (Bagehot 1873; Schumpeter 1911; Gurley and Shaw 1955; Goldsmith 1969; McKinnon 1973; Shaw 1973). In this respect, the results of the study by Arestis et al. (2015) are relevant. Those authors conduct a meta-analysis of the existing empirical evidence on the effects of financial development on growth. They conclude that:

[O]ur meta-regression analysis shows that the type of data employed, and the different variables used to measure financial development in the literature can constitute sources of heterogeneity. Specifically, the usage of market-based proxies of financial development seems to result in lower correlations than the usage of either liquid liabilities or market-based variables. On the other hand, the estimated coefficients of bank-based measures and complex indices are found statistically insignificant in all specifications. This is robust evidence on the fact that the kind of financial variable used plays an important role. Additionally, panel data, which are frequently used from the late 1990s onwards, produce smaller correlations. The same seems to hold for time series. Furthermore, taking into [account] endogeneity and using a specific set of regressors seem to explain part of the heterogeneity. Overall, the meta-regression analysis produces evidence suggesting that the empirical literature on the finance–growth nexus is not free from publication bias. Beside this bias, however, the results suggest the existence of a statistically significant and economically meaningful positive genuine effect from financial development to economic growth.

(Arestis et al. 2015: 557–560)

It is also the case that other studies also question the link between finance and growth. The argument is that the finance–growth link has become weaker over time (Beck et al. 2013; see also Rousseau and Wachtel 2011), and the financial sector is “a drag on productivity growth” (Cecchetti and Kharroubi 2012: 14).

Interest in these matters emanates from the fact that a number of writers question the wisdom of financial repression (the practice of administering interest rates), arguing that it has detrimental effects on the real economy. On the whole, the financial liberalization literature portrays regulation and control over interest rates as suppressing savings, investment and thereby growth. More concretely, Goldsmith (1969) argued that the main problem with financial repression was its negative effect on the efficiency of capital. McKinnon (1973) and Shaw (1973) stressed two other problems: first, financial repression affects negatively the efficient allocation of savings to investment; and second, through its effect on the return to savings, it has a restraining influence on the equilibrium level of savings and investment. In this framework, therefore, investment suffers not only in quantity but also in quality terms, since bankers do not ration the available funds according to the marginal productivity of investment projects, but according to their own discretion. Under these conditions, the financial sector is likely to stagnate. The low return on bank deposits encourages savers to hold their savings in the form of unproductive assets such as land, rather than the potentially productive bank deposits. Similarly, high reserve requirements restrict the supply of bank lending even further while directed credit programmes distort the allocation of credit since political priorities are, in general, not determined by the marginal productivity of different types of capital.

The financial liberalization thesis argues for the removal of interest rate ceilings, reduction of reserve requirements and abolition of directed credit programmes. In short, liberalize financial markets and let the free market determine the allocation of credit. With the real rate of interest adjusting to its equilibrium level, low-yielding investment projects would be eliminated, so that the overall efficiency of investment would be enhanced. Also, as the real rate of interest increases, saving and the total real supply of credit increase, which induce a higher volume of investment. Economic growth would, therefore, be stimulated not only through the increased investment, but also due to an increase in the average productivity of capital. Moreover, the effects of lower reserve requirements reinforce the effects of higher saving on the supply of bank lending, while the abolition of directed credit programmes would lead to an even more efficient allocation of credit, thereby stimulating further the average productivity of capital. Again, however, we point out that these authors have failed to recognize that the core policy combinations of fixed exchange rates and external government debt are themselves inherently repressive, and that liberalizing in these circumstances, therefore, promotes instability.

Furthermore, there is literature that considers the negative effects of financial liberalization in that it creates financial instability and crisis with negative effects on economic growth, thereby creating cycles. The early experience of countries which went through financial liberalization has been reviewed in a number of studies (see, for example, Demetriades and Luintel 1996; Arestis and Demetriades 1997, 1998; Arestis 2004, 2005). Arestis and Stein (2005) pay attention to the linkages between financial liberalization and subsequent financial crisis, when they report on the relevant experience of a total of 53 countries, covering the period between 1980 and 1995, which resulted in financial and banking crises. They conclude that, “On the whole, financial Liberalization in those and other countries had a destabilizing effect on the economy and [was] abandoned” (2005: 384; see also Creel et al. 2014). Those experiences lead to the conclusion that what happened in the relevant economies was that financial liberalization typically unleashed a massive demand for credit by households and firms that was not offset by a comparable increase in the saving rate. Loan rates rose as households demanded more credit to finance purchases of consumer durables, and firms plunged into speculative investment in the knowledge that government bailouts would prevent bank failures. In terms of bank behaviour, banks increased deposit and lending rates to compensate for losses attributable to loan defaults. High real interest rates completely failed to increase savings or boost investment – they actually fell as a proportion of Gross National Product (GNP) over the period. The only type of savings that did increase was foreign savings, i.e. external debt. This, however, made the ‘liberalized’ economies more vulnerable to oscillations in the international economy, increasing the debt/asset ratio and thus service obligations, and promoting the debt crises experienced in the recent past. Financial liberalization thus managed to displace domestic for international markets. Long-term productive investment never materialized either. Instead, short-term speculative activities flourished whereby firms adopted risky financial strategies, thereby causing banking crises and economic collapse.

Despite, though, the early troublesome attempts at financial liberalization, and the increasing problems and scepticism surrounding the financial liberalization thesis over the years since its inauguration, it, nevertheless, had a relatively early impact on development policy. When events following the implementation of financial liberalization prescriptions did not confirm their...

Table of contents

• Cover
• Half Title
• Title Page
• Copyright Page
• Table of Contents
• List of figures
• List of tables
• List of contributors
• Foreword
• Introduction: financial development: the sword of Damocles hanging over the process of economic development
• 1 Financial liberalization, crises and policy implications
• 2 Global financing: a bad medicine for developing countries
• 3 Financial development, instability and some confused equations
• 4 Underdeveloped financial markets’ infrastructure of emerging market economies: assessment of underlying challenges and suggested policy responses
• 5 Towards de-financialization
• 6 A common currency for the common good
• 7 A capital market without banks: lending and borrowing in Hennaarderadeel, Friesland, 1537–1555
• 8 Financial liberalization, financial development and instability in emerging economies: what lessons for the franc zone?
• 9 Depositor myopia and banking sector behaviour
• 10 Dollarization and financial development: the experience of Latin American countries
• 11 Financialization in Brazil: a paper tiger, with atomic teeth?
• 12 National and supra-national financial regulatory architecture: transformations of the Russian financial system in the post-Soviet period
• 13 Minsky in Beijing: shadow banking, credit expansion and debt accumulation in China
• Index