In their somewhat recent publication “This Time is Different: 5 Centuries of Financial Folly” Harvard Professors Kenneth Rogoff, and Carmen Rhinehart developed a number of interesting conclusions regarding financial crises, macroeconomics, and the business cycle. Notably, they came to the conclusion that downturns in the economic cycle that were characterised by widespread financial stress would engender much slower recoveries. Speaking with Joshua Bolten just this year Ben Bernanke affirmed that this was, broadly speaking, due to the fact that after a crisis, it takes some time for the financial sector to return to normal operations (in particular, risk evaluations) even as the rest of the economy pulls out of the headwinds. In these testimonies Bernanke, Rogoff and Rhinehart all implicitly note that finance plays an important role in growth trends. Yet whilst the role of a healthy financial sector has been widely identified for its importance to short-term recoveries, the wider role of finance in longer term growth paths has been grossly underrated.
This brings us to the central role of banking and finance in an economy. For continued economic growth to be a reality, investment demand and savings supply must be in equilibrium.* That is a central premise of modern macroeconomics. Logically, investment and savings cannot be unequal, or else the economy will fall into a disequilibrium of frothy expansion, or rapid contraction. The role of financial institutions in a modern economy, is to ensure that this relationship is upheld. By establishing a financial equilibrium between lenders and borrowers through interest rates, the financial sector ‘recycles’ the supply of savings and liquidity in the economy into lending and investment. This is known as ‘financial intermediation’, and without it, economic savings would show up as leakages from the flow of income, serving to depress the forces of economic growth.
Under the current situation, the financial sector in the US has acted as a constraint on economic recovery to some extent by failing to mediate savings and liquidity with investment at levels associated with higher growth. This is basically because since the fall of 2008, financial institutions have placed an enormous price on risk, refusing to recycle savings and money into credit and investments that appear dangerous. Whilst this phenomenon is a bonus for financial stability, allowing these firms to clear up their balance sheets, it also means that monetary policy needs to take an almost impossibly expansionary position to ward off deflation.
Yet compared to the position of many emerging markets and developing economies, even over the long term, the risk appetite and lending availability in US financial markets appears almost surreal. Even in times of stable leverage, a sturdy macroeconomic policy mix, and microeconomic innovation, banking systems in emerging markets are inefficient, sluggish, and cronyist. In these circumstances, with corporate relations extending well into the sphere of policymakers and state owned enterprises, profitability can be assured without institutions having to make full use of their capital buffers. In other words, there is almost always a barrier to the proper intermediation of savings and investment in the less advanced economies. This also happened in the old industrial economies of the post-war era. Whilst corruption in this instance was not key, a lack of technological capacity meant a perfect intermediation of capital throughout the economy was impossible; even as monetary policy was similarly hampered by ‘liquidationist’ doctrines that refused to expand liquidity as compensation.
With this in mind it should come as no surprise that until humanity began to develop prototype financial institutions, production never really rose above subsistence levels. Without financial development, if enough income was generated to create a pool of savings, that income would essentially be destroyed as it was taken out of the circulation of spending. Hence, society would invariably revert to agricultural barter and underdevelopment. Taken to its logical conclusion, an understanding of the role of finance across economies also helps clear up a lot of the muddled empiricism levelled at various economic policies. For example, the vast majority of literature emanating from the Washington Consensus on economic growth would seem to indicate that Cuban economic policies tinker on the brink of disaster. Yet Cuba enjoys one of the highest standards of living in all of Latin America. Whilst policies like land-reform inspired urban gardening, and universal healthcare are obviously beneficial, the policy mix of other states should imply a better performance relative to Cuba. A performance that is yet to arise.
But although policy mixes are indeed important, they are essentially secondary to institutional functionality. With Cuba the counterfactuals are not obvious, however, the Castro dictatorship has proven adept (when compared with Argentina, and Bolivia) at rooting out and persecuting corruption, whilst implementing heavy penalties on inefficient workers. As a result, it is likely, that despite widespread misallocation of production, there is less financial resistance force on the Cuban economy when compared to less militaristic parts of South America.
In this context, if one takes the framework of modern macroeconomics seriously, financial innovation and efficiency plays a huge role in human and economic development. Societies that find themselves with stagnant growth despite conventional policy mixes and concentrated industrial policies should often look to the most basic elements of macroeconomic theory. Financial intermediation is one such element whose place in the short-term needs to be extended to long-term development. Bernanke and the intellectual giants of our age implicitly recognise this issue, but for much of the debate on development policy, it is overlooked.
*Note that the premise that savings must be ‘lent out’ towards investment, so as to create a macroeconomic equilibrium, is not completely accepted by the Post-Keynesian schools of economic thought. I share the Post-Keynesian concerns that there are incompatibilities between the ‘loanable funds’ mechanisms of savings-investment intermediation, and the modern functioning of a monetary economy. Nevertheless, I have not been able to logically prove the Post-Keynesian case to myself, and thus remain in the orthodox camp for the time being.