RDP 9213: The Impact of Financial Intermediaries on Resource Allocation and Economic Growth 5. Summary and Conclusions

In order to sustain steady-state growth, an economy must be able to continually improve its technology, to increase its stock of human capital and to accumulate production know-how. To use the terminology employed in this paper, the economy must be able to continually accumulate knowledge. Much of the new endogenous growth literature highlights the fact that this accumulation does not occur by accident. It is the result of incentives that face individuals. This literature also highlights the fact that, in general, these incentives will not lead to the optimal accumulation of knowledge.

Knowledge accumulation does not take place independently of the financial system. The activities that lead to this accumulation are risky and often require external finance. The availability of this finance, and the conditions under which it is extended, depend upon the incentives of the borrower and of the financial intermediary. These incentives are a function of a variety of factors including the extent of regulation of intermediaries, the legal system, the capital structure of intermediaries, the riskiness of projects and the ability of intermediaries to screen and monitor loans. Just as private incentives do not necessarily lead to the optimal accumulation of knowledge, the incentives that operate in financial markets do not necessarily lead to the optimal allocation of a country's savings.

The task of policy-makers is to design an institutional framework in which the financial system ensures that savings are allocated to projects that maximise social welfare. Such a framework must be based on a stable legal system and widely accepted accounting and disclosure rules. Financial intermediaries must also have the independence and skills to evaluate projects. In the early stages of the development of a financial system these skills may be under-developed and intermediaries may have insufficient capital. This can lead to poor project selection. If this is the case, there is a potential role for government in determining the allocation of savings. However, such a role is only valid if the government has a better screening technology than the developing financial intermediaries and if the incentives which face government are not distorted by political or other considerations.

The Australian experience demonstrates that as the financial system develops, and the economy becomes increasingly integrated in the world economy, the ability to effectively regulate the system through non-price mechanisms declines. It also suggests that regulation distorts the allocation of resources as financial intermediaries are forced to ration credit. When credit is rationed intermediaries have an incentive to lend only for safe projects. If the activities that lead to accumulation of knowledge are relatively risky, the misallocation of savings by financial intermediaries not only has static efficiency costs but it also slows the growth rate of the economy.

Finally, experience also suggests that financial liberalisation is not without its dangers. If the banking system ineffectively screens projects, a poor allocation of funds will result. In addition, individuals and firms private incentives to acquire debt may lead to debt levels that are greater than are socially optimal. As a result, the economy becomes more sensitive to shocks and this increases the difficulty of operating monetary policy. Notwithstanding these dangers, the liberalisation of Australian financial markets has improved resource allocation and made possible a faster rate of economic growth than would have been possible had the regulated system continued.