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![Page 1: The Financial System, Business Cycles and Growth Joseph Stiglitz, Senior Vice President and Chief Economist The World Bank.](https://reader035.fdocuments.in/reader035/viewer/2022062221/56649e405503460f94b31a2a/html5/thumbnails/1.jpg)
The Financial System, Business Cycles and Growth
Joseph Stiglitz, Senior Vice President and Chief EconomistThe World Bank
![Page 2: The Financial System, Business Cycles and Growth Joseph Stiglitz, Senior Vice President and Chief Economist The World Bank.](https://reader035.fdocuments.in/reader035/viewer/2022062221/56649e405503460f94b31a2a/html5/thumbnails/2.jpg)
Outline of the Talk
• Financial Markets
• Finance and Fluctuations
• Finance and Growth
• International Capital Flows
![Page 3: The Financial System, Business Cycles and Growth Joseph Stiglitz, Senior Vice President and Chief Economist The World Bank.](https://reader035.fdocuments.in/reader035/viewer/2022062221/56649e405503460f94b31a2a/html5/thumbnails/3.jpg)
The Importance of Financial Markets
• Collecting and Aggregating Savings• Brain of the Economy
– Allocating capital– Monitoring
• Other Functions– Reducing risk– Increasing liquidity– Conveying information
![Page 4: The Financial System, Business Cycles and Growth Joseph Stiglitz, Senior Vice President and Chief Economist The World Bank.](https://reader035.fdocuments.in/reader035/viewer/2022062221/56649e405503460f94b31a2a/html5/thumbnails/4.jpg)
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
![Page 5: The Financial System, Business Cycles and Growth Joseph Stiglitz, Senior Vice President and Chief Economist The World Bank.](https://reader035.fdocuments.in/reader035/viewer/2022062221/56649e405503460f94b31a2a/html5/thumbnails/5.jpg)
Equity
Advantages:• Risk sharing• No costly bankruptcies
Disadvantages:• Adverse selection• Moral hazard• “Equity rationing”
Forms of Finance
![Page 6: The Financial System, Business Cycles and Growth Joseph Stiglitz, Senior Vice President and Chief Economist The World Bank.](https://reader035.fdocuments.in/reader035/viewer/2022062221/56649e405503460f94b31a2a/html5/thumbnails/6.jpg)
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”
![Page 7: The Financial System, Business Cycles and Growth Joseph Stiglitz, Senior Vice President and Chief Economist The World Bank.](https://reader035.fdocuments.in/reader035/viewer/2022062221/56649e405503460f94b31a2a/html5/thumbnails/7.jpg)
Forms of Finance
Bonds
They are in between equity and short-term bank debt.
![Page 8: The Financial System, Business Cycles and Growth Joseph Stiglitz, Senior Vice President and Chief Economist The World Bank.](https://reader035.fdocuments.in/reader035/viewer/2022062221/56649e405503460f94b31a2a/html5/thumbnails/8.jpg)
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”
![Page 9: The Financial System, Business Cycles and Growth Joseph Stiglitz, Senior Vice President and Chief Economist The World Bank.](https://reader035.fdocuments.in/reader035/viewer/2022062221/56649e405503460f94b31a2a/html5/thumbnails/9.jpg)
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
![Page 10: The Financial System, Business Cycles and Growth Joseph Stiglitz, Senior Vice President and Chief Economist The World Bank.](https://reader035.fdocuments.in/reader035/viewer/2022062221/56649e405503460f94b31a2a/html5/thumbnails/10.jpg)
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
![Page 11: The Financial System, Business Cycles and Growth Joseph Stiglitz, Senior Vice President and Chief Economist The World Bank.](https://reader035.fdocuments.in/reader035/viewer/2022062221/56649e405503460f94b31a2a/html5/thumbnails/11.jpg)
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.
![Page 12: The Financial System, Business Cycles and Growth Joseph Stiglitz, Senior Vice President and Chief Economist The World Bank.](https://reader035.fdocuments.in/reader035/viewer/2022062221/56649e405503460f94b31a2a/html5/thumbnails/12.jpg)
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).
![Page 13: The Financial System, Business Cycles and Growth Joseph Stiglitz, Senior Vice President and Chief Economist The World Bank.](https://reader035.fdocuments.in/reader035/viewer/2022062221/56649e405503460f94b31a2a/html5/thumbnails/13.jpg)
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
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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
![Page 15: The Financial System, Business Cycles and Growth Joseph Stiglitz, Senior Vice President and Chief Economist The World Bank.](https://reader035.fdocuments.in/reader035/viewer/2022062221/56649e405503460f94b31a2a/html5/thumbnails/15.jpg)
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
![Page 16: The Financial System, Business Cycles and Growth Joseph Stiglitz, Senior Vice President and Chief Economist The World Bank.](https://reader035.fdocuments.in/reader035/viewer/2022062221/56649e405503460f94b31a2a/html5/thumbnails/16.jpg)
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.
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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.
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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
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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
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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.
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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.
![Page 22: The Financial System, Business Cycles and Growth Joseph Stiglitz, Senior Vice President and Chief Economist The World Bank.](https://reader035.fdocuments.in/reader035/viewer/2022062221/56649e405503460f94b31a2a/html5/thumbnails/22.jpg)
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
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Policies to Reduce Vulnerability to Capital Volatility
Traditional policies:
• Good macroeconomic policy
• Sound financial regulation and oversight
• Transparency
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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
![Page 25: The Financial System, Business Cycles and Growth Joseph Stiglitz, Senior Vice President and Chief Economist The World Bank.](https://reader035.fdocuments.in/reader035/viewer/2022062221/56649e405503460f94b31a2a/html5/thumbnails/25.jpg)
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
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Key parts of the strategy:
• Maintaining credit flows
• Not depleting net worth
• Preserving information and organizational capital
Financial and Corporate Restructuring During A Crisis