1.1 Introduction1
This chapter investigates the ‘financial liberalization’ thesis, within the growth–finance nexus. This thesis emerged in the early 1970s in view of a number of controls by the central banks on the financial markets, which had been fairly common practice in the 1950s and 1960s. The experience of that era with those controls was challenged by Goldsmith (1969) in the late 1960s and by McKinnon (1973) and Shaw (1973) in the early 1970s. Their argument was essentially that the poor performance of investment and growth, especially in developing countries, was due to interest rate ceilings, high reserve requirements, and quantitative restrictions in the credit allocation mechanism. Consequently, those restrictions were sources of ‘financial repression’, the main symptoms of which were low savings and investment levels. It therefore follows in this view that the focus of financial liberalization should be on the relevant removal of central bank controls over the financial sector, thereby freeing financial markets from any intervention and letting the market determine the allocation of credit.
The experience with financial liberalization as the policymakers in both developing and developed countries adopted the essentials of this thesis, and pursued corresponding policies, has not been what might be expected from this approach to financial policy. This experience points to two striking findings. The first is that over the period of financial liberalization, essentially from the early 1970s and subsequently, there have been banking crises, which have been unusually frequent and severe. The World Bank (1989) indicates that the magnitude of the crises is obvious by the fact that at least two-thirds of the IMF member countries experienced significant banking-sector problems ever since the early 1980s. The second important finding is that there have been exacerbated downturns in economic activity, which have imposed substantial real economic costs for the local economies involved (Honohan and Klingebiel 2000; see, also, Arestis 2004, 2005; Arestis and Sawyer 2005; Arestis and Demetriades 1998).
The international financial crisis of 2007/2008 provides a relevant example of what has just been suggested. In a recent contribution Arestis (2016a) discusses the origins of the international financial crisis of 2007/2008 and the emergence of the ‘Great Recession’, making a distinction between the main factors and contributory factors. The main factors contain three features: distributional effects, financial liberalization, and financial innovation. The contributory factors also contain three features: international imbalances, monetary policy, and the role of credit rating agencies. In relation to the term ‘financialization’, this encapsulates the two features of the main factors, namely financial liberalization and financial innovation, since this term is defined for the purposes of the Arestis (2016a) 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 in a broad sense of the term; it is, nonetheless, consistent with the definition of Epstein (2005), who defines it as “the increasing role of financial motives, financial markets, financial actors and financial institutions in the operation of the domestic and international economies” (p. 3; see, also Palley 2013, and Van Der Zwan 2014).2 It is clear from these definitions that financialization “singles out financial markets and gives them special elevated standing” (Palley 2013, p. 2). Palley (op. cit.) also notes that financialization has had significant impact on income and wealth distribution. Capital’s share has increased whereas labour’s share has decreased. Furthermore, the share of financial sector’s profits to total profits has increased while the non-financial sector’s share of profits has decreased. An important lesson is that financialization increases financial fragility. The 1997 Southeast Asian financial crisis and the international financial crisis of 2007/2008, among other crises, clearly confirmed the financial fragility suggestion.
In discussing the origins of the international financial crisis of 2007/2008, we are very much aware of the limitations of current mainstream macroeconomic analysis. Indeed, we agree with Minsky (1982), who argued over three decades ago 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” (p. 60; see, also, Arestis 2009; Palley 2012). Needless to say that financialization as briefly discussed above, and in relation to the international financial crisis of 2007/2008, is very much along the lines of Minsky’s (1982, 1986) ideas as developed in his financial instability hypothesis; along with the need for a key role for economic policy to thwart instability, and economic policy discretion (see Palley 2013, Chap. 8, for further details on Minsky’s position on all these aspects).
We might add that with the emergence of the international financial crisis of 2007/2008, and the subsequent ‘great recession’, the Minsky (1982) statement, as stated above, is very valid indeed (see, also, Arestis 2016a). To clarify, the ‘Great Recession’ was caused by the US financial liberalization attempts, along with the significant income redistribution effects from wages to profits of the financial sector, and the financial architecture that emerged. A relevant statistic in this respect, and in the case of the USA, is reported in the Philippon and Reshef (2009) study, which relates to the above average rise in the salaries of the finance employees. The share of the ratio of the wage bill in the financial sector to its full-time-equivalent employment enjoyed a steep increase over the period from the mid-1980s to 2006 (wages in the financial sector were higher than in the other sectors, even after controlling for education; see, also Arestis 2016b). What explains this development is mainly financial deregulation (accounting for 83 percent of the change in wages) along with distributional effects in the USA (see, for example, Arestis 2016a, b), in a causal way, followed by financial innovation. Further data-based US evidence suggests that the size of the financial sector as a percentage of GDP grew from 2.8 percent in 1950 to 7.9 percent in 2012; in addition, incomes in the US financial sector increased by 70 percent relative to other sectors over the period 1980 to 2012.3 Similar developments took place in the UK, Canada, China, Germany, and Japan, among others; although the financial shares in these countries were less pronounced, they were still significant.
Ever since both developing and developed countries adopted the essentials of the financial liberalization principle, banking crises have been unusually frequent and severe. The World Bank (1989) publication clearly demonstrates that since the early 1980s, the IMF member countries experiencing significant banking-sector crises amounted to at least two thirds of the total IMF country-membership. It is also true that downturns in economic activity, and substantial real economic costs, emerged as a consequence of the banking crises; this is clearly evident from the experience of the ‘great recession’ that followed the international financial crisis of 2007/2008 (see Arestis 2016a). We discuss after this introduction, Sect. 1.1, and in Sect. 1.2, the historical background, as well as the theoretical and empirical aspects of financial liberalization. Section 1.3 discusses the relationship between financial liberalization and crises, emphasizing two examples that led to crises, the Southeast Asian crisis and the international financial crisis of 2007/2008 that was followed by the ‘Great Recession’. Section 1.4 discusses the economic policy implications of the crises, with an emphasis on the experience of the ‘great recession’, and on financial stability. Section 1.5 discusses relevant proposals for financial stability. Finally, and in Sect. 1.6, we summarize and conclude.
1.2 Historical, Theoretical, and Empirical Background of Financial Liberalization
We concentrate in this section on the theoretical and empirical aspects of financial liberalization. We begin, nonetheless, with a short historical background to financial liberalization.
Historical Background
We may begin with what we might label as the most important intellectual development in terms of the finance–growth nexus, which came from Bagehot (1873), in his classic Lombard Street. In that contribution, Bagehot (op. cit.) highlighted the crucial importance of the banking system in promoting economic growth. Indeed, Bagehot (op. cit.) highlighted the circumstances when banks actively spur innovation and future growth by identifying and funding productive investments. The work of Schumpeter (1911), is also important in that financial services are paramount in promoting economic growth, since production requires credit to materialise. Indeed, one “can only become an entrepreneur by previously becoming a debtor. ... What [the entrepreneur] first wants is credit. Before he requires any goods whatever, he requires purchasing power. He is the typical debtor in capitalist society” (p. 102). In this process, the banker is the key agent.
Keynes’s (1930) A Treatise on Money also highlighted the importance of the banking sector in economic growth. He suggested that bank credit “is the pavement along which production travels, and the bankers if they knew their duty, would provide the transport facilities to just the extent that is required in order that the productive powers of the community can be employed at their full capacity” (vol. II, p. 220). Robinson (1952) clarified by suggesting that financial development follows growth. However, Robinson (op. cit.) does not preclude the possibility that the causation may be bidirectional, in that growth may be constrained by credit creation in less developed financial systems. In more sophisticated systems, however, finance is viewed as endogenous responding to demand requirements. It therefore follows that the more developed a financial system the higher the likelihood of growth causing finance. Furthermore, Robinson (1952) argues that finance responds positively to technological innovation and development. All in all, Robinson’s (op. cit.) argument is that “where enterprise leads finance follows” (p. 86).4
More recently, however, McKinnon (1973) and Shaw (1973) put forward the ‘financial liberalization’ thesis. Their argument is that government restrictions on the banking system restrain the quantity and quality of investment. Even more recently, and with the development of the endogenous growth literature, the suggestion has emerged that financial intermediation has a positive effect on steady-state growth (see Pagano 1993, for a survey); and of equal importance from this argument’s point of view, government intervention in the financial system has a negative effect on the equilibrium growth rate (King and Levine 1993b). There is also the view that finance and growth ar...