RDP 9213: The Impact of Financial Intermediaries on Resource Allocation and Economic Growth 1. Introduction

Interest in the theory of economic growth and the theory of the operation of financial markets has increased significantly in recent years. This has led to a greater appreciation of the role of knowledge accumulation in the growth process and deeper understanding of the incentive problems that plague financial markets. The advances in these two important areas of economic theory have, however, occurred essentially independently of one other^[1]. Typically, in the new growth models, financial markets are implicitly assumed to operate smoothly in the background. There is little consideration given to the implications for resource allocation of imperfect information, asymmetric pay-offs and financial market legislation. This is an important omission as resource accumulation does not occur independently of the financial system. The activities that lead to the accumulation of technology and knowledge involve risk and often require external finance. The availability of that finance and the conditions under which it is obtained help determine the nature of resource accumulation. In general, the incentives that financial intermediaries face do not guarantee the socially optimal accumulation of the key resources that propel sustained growth. These incentives are distorted both by regulation and by the very nature of loan contracts. This paper explores some of the relationships between the nature of a country's financial markets and the allocation of its financial resources and thus ultimately the country's rate of economic growth. As a case study, the paper also examines some of the effects that the financial deregulation which took place in Australia in the 1980s has had on the allocation of resources within Australia.

It has long been recognised that the financial system influences economic development through two key mechanisms. The first is the ability of the financial system to transfer resources from those who wish to delay consumption today to those who wish to bring future consumption or investment forward to today. Without this transfer, all investment would have to be self-financed. This would necessarily constrain investment as many investment projects are beyond the resources of individuals. As a result, the capital stock would be lower, as would per-capita incomes. Second, and even more fundamentally, the financial system provides the economy with a medium of exchange that is universally accepted. Without it, the degree of specialisation would be constrained and barter would be the predominant form of trade.

These two basic functions of the financial system are well understood. For an economy to achieve sustained growth there must be confidence in the payments system and the financial system must be able to transfer resources from savers to investors. As McKinnon (1986) argues, for the system to be able to perform these tasks effectively, the inflation rate should be low and there should be confidence in the banking system. This requires a central bank that is essentially independent and cannot be forced into inflationary finance of government budget deficits. It is key that the government maintain strict control of the country's fiscal position. Failure to maintain this control can undermine the willingness of individuals to hold currency, increase uncertainty in the economy and lead to significant misallocation of resources. It is also important for the currency to be convertible. Convertibility increases confidence in the payments system, facilitates international trade and prevents the costs associated with black markets and substitute currencies.

Taking these conditions as given, this paper examines some of the factors that determine the efficiency with which the financial system transfers funds from savers to investors. The rate at which an economy grows is a positive function of the efficiency of this process. While a number of nations have been able to achieve considerable expansion of the capital stock through domestic savings, not all of these nations have experienced the expected high economic growth. Part of the problem is in the allocation of savings. Financial resources have been used by governments for political purposes, to promote income redistribution and for social goals. Equally importantly, the allocation of resources by financial markets has not always been socially optimal because of financial market regulation, problems induced by asymmetric information between borrowers and lenders, and the inability of financial intermediaries to screen and monitor loans effectively.

Both Stiglitz (1989) and King and Levine (1992) argue that one of the key roles of financial intermediaries is the choosing between competing sectors of the economy, between competing firms and between competing investment projects. If intermediaries operate under restrictive regulations then this “choice” is affected by how the regulations impact on the incentives of the intermediary. Even in deregulated financial markets, intermediaries retain a role in “choosing” between conflicting demands because the allocation of savings on the basis of price is not always possible. The work of Stiglitz and Weiss (1981) highlights one of the problems. With a loan contract the borrower does not repay the loan if the investment is a failure, but gets to retain the profits (less the agreed payments to the bank) if the project is a success. This asymmetry means that the borrower will be willing to borrow at interest rates that make the project have negative expected social value. If the bank is unable to screen its customers then it may well lend to customers who are undertaking such inefficient projects. In the context of endogenous growth models, inefficiencies in financial markets slow the rate at which society accumulates knowledge and thus also slow the economy's rate of growth.

The following sections of the paper explore various aspects of the impact that financial intermediaries have on economic growth through their role of allocating savings. Section 2 begins by presenting Romer's (1989) model of endogenous growth. In this model the accumulation of knowledge leads to economic growth. While consumer preferences, the current state of technology and the stock of skilled labour all influence the rate at which knowledge accumulates, no role is given to the financial sector. However, in reality there are likely to be important interactions between the financial system and the nature and extent of resource accumulation. These interactions are explored in Section 3.

Ideally, it would be useful to undertake some formal testing of the models that predict a link between financial structure and economic growth. This, however, is a difficult task. The models make predictions concerning steady-state growth rates. They typically say nothing about the transition phase to a new steady state; this transition phase could, however, take many years. It is difficult to test the models using data for a single country because datasets with the required variables are generally of insufficient length. More support for these models has been found using cross-country studies. King and Levine (1992) report results that suggest that the scale and efficiency of financial intermediation are robustly and significantly correlated with economic growth in a cross-section of countries. Again, however, this work is not without its problems. Foremost amongst these, is the general sensitivity of the results of studies of growth rates to the inclusion/exclusion of particular variables. More convincing formal econometric support for the various theories appears to require either longer datasets or an improvement in econometric techniques. Thus, rather than embark along the road of formal empirical tests, Section 4 examines some of the implications of the liberalisation of financial markets that occurred in Australia in the 1980s.

Australia makes an interesting case study of the consequences of financial deregulation. Until the 1980s, the Australian banking sector was subject to considerable regulation. Controls were placed on both lending and deposit rates and on the growth of bank balance sheets. These controls were primarily used as a macro-economic management tool. However, as the financial system developed, the regulations became increasingly ineffective. The adverse resource allocation effects of the regulations also came to be more appreciated. As a consequence, the regulations were removed in the first half of the 1980s. Section 4 reviews some of the implications of this liberalisation. Finally, Section 5 summarises and concludes.

Footnote

Recent research has made some attempt to connect these two areas. Endogenous growth models with some type of financial sector (either financial intermediaries or a stock market) have been developed by Greenwald and Stiglitz (1989), Greenwood and Jovanovic (1990), Bencivenga and Smith (1991) and Levine (1991). These models focus on the “liquidity insurance” that a financial sector provides. In contrast, work by King and Levine (1992) focuses on the role that intermediaries play in project selection. [1]