The Dual Role of Financial Markets

in Economic Development:
Engine of Growth and Source of Instability
A survey of economic theory
with reflections on the East Asian financial crisis

IPC Working Paper No. 18

Dr. Adalbert Winkler

Frankfurt, June 1998

A shorter version of this paper will be published under the title

”Financial markets and economic development” in:

Menkhoff, L. and B. Reszat (eds.),

Asian Financial Markets - Structures, Policy Issues and Prospects,
Baden-Baden, Nomos Verlag
 The Dual Role of Financial Markets
in Economic Development:
Engine of Growth and Source of Instability
A survey of economic theory
with reflections on the East Asian financial crisis
IPC Working Paper No. 18

Abstract

In recent years an increasing amount of attention has been devoted to the connection between financial markets
and economic development. New insights in growth theory and the theory of finance establishing a link
between ”finance and growth” as well as the results of a large number of empirical studies suggest that
financial markets can be regarded as an engine of growth. However, the empirical evidence also shows that
crisis-like developments in the financial markets have occurred with increasing frequency in recent years, and
that such phenomena at least temporarily limit the scope for economic development. How can one explain the
fact that a sector which can be regarded as being at least partially responsible for a successful course of
economic development is at the same time considered to be responsible at least for triggering crises which slow
down economic development, often causing ground to be lost which it takes the economy years to regain?

The paper surveys how economic theory has dealt, or is dealing, with the dual impact of financial markets on
economic development. Four theories have been selected for consideration - neo-classical and Keynesian
theory, the New Development Finance approach and the new theory of finance which is grounded in the
economics of information. Each emphasises different aspects of the relationship between financial markets and
economic development, but so far it has proved impossible to arrive at a consensus view. Accordingly, the role
of financial markets in economic development is still a controversial issue - and with good reason, as is shown
by the Asian example of smooth financial development and extraordinary growth (1960 - 1996), followed by a
severe financial crisis (1997). This is why, in the concluding section, the question is turned around: Does the
Asian example - seen against the background of this theoretical surveys - give an indication of the direction in
which theoretical research should move if it wishes to better explain the dual impact of financial markets
outlined above? The answer is a clear Yes, pointing to the need for a more detailed analysis of the monetary
aspects of the relationship between financial markets and economic development and of financial development
itself.
Contents

1. Introduction 1

2. Financial markets and economic development: 2

An initial approach to the topic based on a flow-of-funds analysis

3. Neo-classical theory as a point of departure for the theoretical analysis 5

4. Schumpeter and Keynes: Financial markets as monetary markets 8

5. McKinnon and Shaw: New Development Finance 13

6. The theory of finance which is grounded in the economics of information 17

7. Conclusion: 23
Financial markets and economic development - the Asian example
 1

1. Introduction1

In recent years an increasing amount of attention has been devoted to the connection
between financial markets and economic development. New insights in growth theory and
the theory of finance establishing a link between ”finance and growth” or ”finance and
development”2 have spurred interest in this topic, as has the appearance of a large number of
empirical studies which have demonstrated a clear positive correlation between indicators
providing a quantitative measure of activities of and on financial markets3 and quantitative
indicators of the level of economic development.4,5 However, the positive connotation
suggested by this literature represents only one side of the coin. The empirical evidence also
shows that crisis-like developments in the financial markets have occurred with increasing
frequency in recent years, and that such phenomena at least temporarily limit the scope for
economic development.6 The East Asian financial crisis is the latest and most severe
example. How can one explain the fact that a sector which can be regarded as being at least
partially responsible for a successful course of economic development is at the same time
considered to be responsible at least for triggering crises which slow down economic
development, often causing ground to be lost which it takes the economy years to regain?

This is a question for economic theory, and it is not the first time it has been asked, given
that this dual impact of financial markets characterises the economic development of
basically any country. Thus, after creating a uniform basis and standard for comparison
using a flow-of-funds analysis (Section 2), the following survey will seek to describe how
economic theory has dealt, or is dealing, with the dual impact of financial markets on
1
I would like to thank Katrin Berensmann, Andrea Schächter, Reinhard H. Schmidt, Marcel Stremme and
Marcel Tyrell for valuable suggestions. It goes without saying that any errors or shortcomings exhibited by
this paper are the sole responsibility of the author.
2
See Gertler, M. (1988), Galetovic, A. (1994), Berthélemy, J.-C. and A. Varoudakis (1996), and Levine, R.
(1996).
3
As used in the following, the term ”financial markets” is broadly defined. In other words, it encompasses
not only markets in the narrow sense (e.g. bond or stock markets), but also the activities of financial
institutions which serve as intermediaries. Accordingly, financial markets are ”the markets - i.e. the supply,
demand and the co-ordination thereof - for the services provided by financial institutions to the non-
financial sectors of the economy.” Krahnen, J.P. and R.H. Schmidt (1994), p. 4.
4
In the following the development of economies will be measured in terms of real per capita GDP.
Selection of this yardstick, and its application in an empirical context, reflects the evolution of economic
theory over the last 20 years. Since the late 1970s, growth theory has come to be regarded as a more useful
approach to the theory of development than that formulated by the branch of economics which had dealt
more explicitly, and narrowly, with this topic and which was associated with such names as Myrdal,
Hirschmann and Lewis. (see Lucas, R. (1988), Krugman, P. (1993) and Klump, R. (1996).
5
The positive correlation between financial system development and economic growth can be measured
with the help of variables which capture the level of financial asset formation in the banking system (see
Goldsmith, R. (1969), King, R.G. and R. Levine (1993), De Gregorio, J. and P. Guidotti (1992), Gelb, A.
(1989) and/or with various indicators of stock market development like size, liquidity and risk
diversification (see, for example, Atje, R. and B. Jovanovic (1993) and Levine, R. and S. Zervos (1996).)
6
Caprio speaks of a ”boom in banking crises”, see Caprio, G. (1997), p. 2 and Johnston, B.R. and C.
Pazabasiogly (1995), Mishkin, F.S. (1996), Caprio, G. and D. Klingebiel (1996).
 2

economic development (Sections 3 - 6). Four theories have been selected for consideration -
neo-classical and Keynesian theory, the New Development Finance approach and the new
theory of finance which is grounded in the economics of information. Each emphasises
different aspects of the relationship between financial markets and economic development,
but so far it has proved impossible to arrive at a consensus view. Accordingly, the role of
financial markets in economic development is still a controversial issue - and with good
reason, as is shown by the Asian example of smooth financial development and
extraordinary growth (1960 - 1996), followed by a severe financial crisis (1997). This is
why, in the concluding section, the question is turned around: Does the Asian example - seen
against the background of this theoretical surveys - give an indication of the direction in
which theoretical research should move if it wishes to better explain the dual impact of
financial markets outlined above? The answer is a clear Yes, pointing to the need for a more
detailed analysis of the monetary aspects of the relationship between financial markets and
economic development and of financial development itself.

2. Financial markets and economic development: An initial approach to the topic

based on a flow-of-funds analysis

The empirically observable correspondence between the development of the financial

markets and that of the real economy comes as no surprise. Indeed, in textbooks on
macroeconomics and the theory of finance one need look no further than the introductory
sections on the topic of financial markets to find explicit mention of the very close
connections between economic activities and events in the financial markets: ”Financial
markets are important because they are intimately linked to every other market and every
individual in the economy. ... The importance of financial markets therefore lies in their
linkage with all our spending decisions, both in our personal lives and in the business
world.”7

Carrying out a flow-of-funds analysis is perhaps the easiest way of highlighting this close
interlinkage of financial and real activity. Such an analysis posits that for each economic
agent, i.e. at the level of individual economic units (micro level), the savings accumulated in
a given period, in other words the increase in net worth, are equal to the sum of investment,
i.e. the increase in real capital, plus the increase in financial assets. The term FSMicroor, as the
case may be, ∆FAMicro may be either positive or negative depending on whether the
economic agent in question shows a financial surplus or deficit during the relevant period.

7
Campbell, T.S. (1982), p.1. One finds a similarly worded passage in Burda, M. and C. Wyplosz (1993), p.
344.
 3

(1) SMicro = IMicro + FSMicro

or
(1a) SMicro = IMicro +∆FAMicro
where:
S = savings = ∆ net worth
I = investment = ∆ real capital
Micro = at the disaggregated level (micro level)
FS = financial surplus, if SMicro > IMicro, and financial deficit, if IMicro > SMicro, and
FS = ∆ FAMicro, where FA = financial asset

Using equation (1), the central function and central characteristic of financial markets can be
illuminated: Financial markets

- perform one primary function, namely, that of intertemporal and interpersonal resource
transfer,8

- have the attribute of being monetary markets, i.e. the transactions on financial markets
involve claims to the future payment of money, financial as opposed to real assets.9

Due to the fact that financial markets have the attribute of organising an interpersonal
resource transfer, precisely this attribute recedes from view if the focus shifts to the level of
the economy as a whole. Given that an economic agent or a group of economic agents - e.g.
all private households or firms - can only show a financial surplus (or incur a financial
deficit) if at least one other economic agent or group of economic agents has incurred an
equal financial deficit (or accumulated an equal financial surplus), at the aggregate level the
following applies:

(2) ∑ FSMicro= ∑ ∆ FAMicro = ∑ FAMicro = 0

Equation (2) contains the well-known condition that the sum of all financial balances, and
thus the total net monetary assets of all economic agents in an economy, must work out to
zero. Accordingly, aggregate savings are equal to aggregate investment, as is specified in
equation (3):

(3) S=I

8
See Merton, R.C. and Bodie, Z. (1995), p. 12.
9
The link between the markets’ monetary character and their function of effecting an intertemporal resource
transfer emerges most clearly in a description of their function provided by Tobin: ”Financial markets
allow inside assets and debts to be originated and be exchanged at will for each other and for outside
financial assets.” Tobin, J. (1987), p. 341.
 4

Thus, the preceding discussion may be summed up as follows:

- Financial balances, stocks of monetary assets and changes in these quantities are a
manifestation of an interpersonal resource transfer.

- Financial balances, stocks of monetary assets and changes in these quantities are a
manifestation of an intertemporal resource transfer on a disaggregated level. For the
individual economic agent, they represent an additional means of increasing net worth
(S) or of financing real capital (I). Because the formation of real capital is - apart from
technological progress - the most important variable affecting economic development,
and, as a result, equations (1) - (3) underscore the close relationship between financial
markets and economic development.

- Financial balances, stocks of monetary assets, and changes in these quantities are
monetary variables which are clearly linked, via a flow-of-funds relationship, to the
formation of real capital when a disaggregated view of the economy is taken. On the
aggregate level, however, financial balances, credits and debts are cancelled out, making
it impossible to establish a direct connection between financial and real variables.

Thus, ever since economic theory began to study the nature of the connection between
financial markets and economic development, the focus has been on three questions:

1) Is the interpersonal resource transfer growth-promoting? And if so, why?

2) Is the market relationship underlying this resource transfer particularly problematic? And
if so, why?

3) Does the creation of stocks of monetary assets which takes place in financial markets
impart to the savings/investment process a particular quality (leaving open for the
moment the question of precisely how this quality might be defined) in the sense that
monetary factors exert an influence on economic development? And if so, how is this
influence exerted?

A review of the history of economic theory shows that neo-classical and Keynesian theory,
the New Development Finance approach and the new theory of finance which is grounded in
the economics of information provide four different combinations of answers to these three
questions (see Chart 1.).
 5

Chart 1: Main characteristics of theories of financial-market and economic

development

Neo-classical Keynes New Theory of

economics Development finance grounded
Finance in the economics
of information

Interpersonal resource transfer

promotes economic development Yes Yes Yes Yes

Interpersonal resource transfer is

problematic No Yes No Yes

Formation of stocks of monetary

assets imparts a particular quality No Yes Yes/No No (?)
to investment/savings process

Source: own compilation

A feature common to all theories is their a priori presumption that the interpersonal resource
transfer promotes development. They differ, though, as to whether this interpersonal
resource transfer is inherently problematic, and whether the form in which it occurs imparts
a specific quality to the investment/savings process.

3. Neo-classical theory as a point of departure for the theoretical analysis

Modern neo-classical theory analyses economic activities from the perspective of a single,
representative agent, comprising all private households as well as firms. The model provides
– under certain assumptions: competitive markets, constant returns to scale, homogenous
agents and goods, perfect foresight and information – a precise analysis of the optimality
conditions of the intertemporal resource transfer, i.e. of the extent to which the
representative agent should forgo consumption, accumulate capital, and allocate resources
over time. Accordingly, this model provides the basis for an explanation of differences in
development and growth among nations and economies world-wide.10 However, the model
forgoes an analysis of the interpersonal resource transfer because, by definition, a

10
See Barro, R.J. and X. Sala-i-Martin (1995), p. 10 and p. 59ff.. The following statement by Arthur Lewis is
regarded as a classic definition of the problem: ”The central problem in the theory of economic
development is to understand the process by which a community which was previously saving and
investing 4 or 5 percent of its national income or less, coverts itself to an economy where voluntary saving
is running at about 12 to 15 per cent of national income or more. This is the central problem because the
central fact of economic development is rapid capital accumulation (including knowledge and skills with
capital).” Lewis, W.A. (1954), Economic development with unlimited supplies of labour, in: Manchester
School, Vol. 22, p. 155; cited in: Stern, N. (1989), p. 625. The validity of this statement has been
confirmed by a large number of cross-country growth regressions which invariably show the investment or
savings rate to be a significant factor in explaining the level of (the growth rate of) real per capita income.
 6

representative individual cannot undertake an interpersonal resource transfer. Strictly

speaking, this implies that the interpersonal resource transfer which takes place on financial
markets is of negligible importance as a determinant of growth.11

This is, to be sure, a very extreme interpretation. It is generally agreed that the neo-classical
assumptions of homogenous economic agents and homogenous goods are not valid, which
means that, by virtue of their function of effecting an interpersonal resource transfer,
financial market foster economic development in four ways:

a) they transfer resources to those economic agents who have access to investment
opportunities which are more productive than those available to other economic agents;

b) they render investments feasible which, while comparatively productive, are indivisible,
and thus are such that a single economic agent will not by itself have access to the
resources needed to carry out the investment (lot-size transformation);

c) they render investments feasible which, while comparatively productive, are intended to
yield a return over the long term, and thus are such that a single economic agent will
decide not to take advantage of these investment opportunities because it is uncertain as
to when it would like to consume (maturity transformation); and

d) they render investments feasible which, while comparatively productive, are also very
risky, which means that a single economic agent would decide against carrying out these
investments (risk transformation).

There are two reasons why the relationship between financial markets and economic
development is nonetheless either regarded as insignificant or as a factor whose importance
is highly overestimated:12 For one thing, economic theory can tell us little a priori about the

11
”The representative agent or firm approach to understanding macroeconomics is liable to leave key actors
out of the play.” Calomiris, C. W. (1993), p. 80; see also Tobin, J. (1980), p. 26 and Gertler, M. (1988), p.
565.
12
See Stern, N. (1989) and Lucas, R.E. (1988). In the meantime, the new empirical research on growth has
identified around 60 variables which have been found to be significant in at least one cross-country growth
regression (see Sala-i-Martin (1997), p. 178), including the above-mentioned indicators which measure in
quantitative terms the level of activity on financial markets. However, it is not possible to determine by
empirical means the relative importance of financial markets as an engine of development because
developed and developing economies such as those in East Asia not only have developed or developing
financial markets. In the other areas which economic theory has identified as potential determinants of
growth they are also at a considerably more advanced stage than underdeveloped countries, having
gradually reached this higher plateau as a direct result of the growth process. It can be assumed that, ”as a
rough approximation, those countries that do things right do most things right, and those countries that do
things wrong do most things wrong.” Mankiw, N.G. (1995), p. 304; see also Berthélemy, J.-C. and A.
Varoudakis (1996), p. 23.
 7

size of differences among agents that invite mutually beneficial transactions on financial
markets.13 For another thing, from the point of view of neo-classical theory there is nothing
to indicate that the resource transfer on financial markets represents an economic problem.
Accordingly, the best-known implication of neo-classical theory for the theory of finance,
namely that which can be drawn from the Modigliani-Miller theorem, is that there is no such
thing as a ”financing problem”.14 At the macro level, the Ricardian equivalence theorem has
the same implication in so far as it posits that the way in which the government finances its
expenditures is irrelevant for economic activity and development.15

A similar approach is used when dealing with the monetary character of financial markets
and the assets or, as the case may be, debt instruments which are traded on them. In line with
the neutrality theorem of money, the analysis of what happens on financial markets
concludes that transactions on these markets are merely manifestations of transactions in the
real economy, i.e. the intertemporal resource transfer discussed above. The supply on
financial markets is seen as part of aggregate savings, i.e. as a supply of real capital, and the
demand on these markets is seen as part of aggregate investment, i.e. as a demand for real
capital.16 This implies that financial markets can be analysed in the same way as the market
for any other good without having to pay particular attention to their monetary character:
”borrowing and lending can be specified in ”real” terms ... . Awkward financial details such
as the rate of price inflation, the demand for money, foreign exchange rates and the precise
nature of banking intermediaries can all be suppressed in favour of a ”perfect” national (or
international) capital market with a single uniform rate of interest at which debt contracts
are absolutely enforced.”17

13
See Tobin, J. (1987), p. 344.
14
See Modigliani, F. and M.H. Miller (1958), pp. 261 - 297.
15
See Barro, R. J. (1974).
16
This also implies that a decline in the level of activity on the financial markets is equated with a decrease
in savings and investment.
17
McKinnon, R.I. and H. Pill (1994), p. 7.
 8

4. Schumpeter and Keynes: Financial markets as monetary markets

It was Joseph Schumpeter who first questioned the fundamental validity of the assumption
made by neo-classical theory that financial markets play only a passive role in economic
development, and he did so by choosing the relationship between financial markets and
economic development as the starting point for a theory of economic development.18 In the
form of credit and equity, the financial markets - personified by the ”banker” and the
”capitalist” - place the capital at the disposal of entrepreneurs which the latter need to
perform their function in the economic process as defined by Schumpeter - namely, that of
introducing new combinations of products and means of production. Functioning financial
markets are thus a central prerequisite for economic development because they furnish
capital to those economic agents who can put capital to the most productive uses - namely,
entrepreneurs.

This basic proposition, with which - as has already been mentioned - almost all economists
would probably agree, was, however, embedded by Schumpeter in a macroeconomic system
based on a theory of capital, money and credit which stood in fundamental contradiction to
the then prevailing neo-classical theory of capital, money and credit, which is still the
dominant theory.19 This is manifested in Schumpeter’s hypothesis that

- financial markets do not organise the co-ordination of savings (supply) and investment
(demand), but rather the co-ordination of the supply of and demand for money; and that,

- the interest rate is not determined by factors in the real economy, but rather by monetary
factors.20

Schumpeter's ideas did not, however, become generally accepted in economic theory, and
there were two main reasons for this lack of acceptance. For one thing, he did not present his
ideas in the form of a mathematical model.21 For another, he emphasised almost exclusively
the positive effects of financial markets on economic development. But this one-sided
positive assessment was increasingly at odds with empirical reality. Even during
Schumpeter's time, i.e. during the latter half of the 19th and the early years of the 20th
century, it was no longer possible to ignore the negative consequences of financial crises for

18
See Schumpeter, J.A. (1998).
19
Schumpeter himself speaks of ”heresy”; see p. 140.
20
The emphasis on - in some cases indeed the glorification of - the role of the entrepreneur (in contrast to
neo-classical economics, which stresses the role of the private household as the central economic actor)
and the emphasis on the market form of imperfect competition with its accompanying phenomenon of
”creative destruction”, represent further theoretical elements of Schumpeter's model economy which for a
long time were not incorporated into mainstream neo-classical economics. Only in recent years, with the
emergence of the new, endogenous growth theory, have attempts been undertaken to design macro models
on the basis of imperfect competition; see, in particular, Grossman, G.M. and E. Helpman (1991).
21
See Heertje, A. (1987).
 9

the process of economic development - negative consequences which would eventually (i.e.
during the Great Depression) trigger an economic crisis of almost unfathomable depth and
severity.22

In this situation, Keynes proposed a macro model which is similar to that of Schumpeter;
however, he changed the emphasis and thrust of the ideas. As in Schumpeter's model, the
rate of interest is a monetary phenomenon, and the money market becomes the capital
market,23 while equilibrium between investment and savings is achieved not through
changes in interest rates, but rather through changes in income. The IS/LM model formally
incorporates these relationships, and, in addition to its timeliness given the prevailing
economic climate (Great Depression, global economic crisis), this is surely the principal
reason why the Keynesian model was able, at least temporarily, to displace the neo-classical
model.

Unlike Schumpeter, though, Keynes also formulated a theory which characterises the
interpersonal resource transfer that takes place on financial markets as inherently
problematic precisely because it is monetary in nature. This emerges most clearly in chapter
12 of the General Theory.24 Here Keynes focuses initially on the positive aspect of financial
markets, i.e. maturity transformation, which, at the macro level renders the financing of
long-term, very productive investments possible because, at the micro level agents are given
a chance to opt out of the financing relationship prior to the end of the life of the
investment.25 This positive attribute of financial markets is placed in an unambiguously
monetary context because, ”so long as it is open to the individual to employ his wealth in
hoarding or lending money (Keynes' italics), the alternative of purchasing actual capital
assets cannot be rendered sufficiently attractive (...), except by organising markets wherein
these assets can be easily realised for money.”26

22
See, for example, Mishkin, F. (1991).
23
In addition to the points on which they agreed, Keynes and Schumpeter were separated by substantive
differences; for a discussion of the relationship between Schumpeter and Keynes, see Riese, H. (1986).
24
A cursory examination of the various drafts of the General Theory and of the papers Keynes wrote directly
after the publication of the General Theory, most of which dealt with the theory of interest rates, shows
that he discusses the relationship between financial markets, investment activity and economic
development (or ”wealth owners and entrepreneurs”, as he put it, personifying the relationships involved
in much the same way as Schumpeter had) at length; see the various drafts presented in Moggridge, D.
(1973a), as well as the essays ”Alternative Theories of the Rate of Interest”, ”The 'Ex Ante' Theory of the
Rate of Interest” and ”Mr. Keynes' ‘Finance’” reprinted in: Moggridge, D. (1973b), pp. 201 - 215, pp. 215
- 223, and pp. 229 - 233.
25
”Investments which are ”fixed” for the community are thus made ”liquid” for the individual.” Keynes,
J.M. (1964), p. 153.
26
Keynes, J.M. (1964), pp. 160f.
 10

The problematic aspects begin to emerge when one considers the process by which prices
are determined on financial markets. Keynes dismisses rational expectations as the basis of
price determination, not only because in the real world the prerequisites for the formation of
rational expectations are not given; he also stresses the fact that because of its liquid
character, the investment can be sold by the investor at any time. Consequently, ”they [the
investors – author's note] are concerned, not with what an investment is really worth to a
man who buys it ”for keeps”, but what the market will value it at, under the influence of
mass psychology, three months or a year hence. ... This is the inevitable result of investment
markets organised with a view to so-called ”liquidity”.”27

The prices arrived at under these conditions are, however, the measure of the profitability of
new investments, ”for there is no sense in building up a new enterprise at a cost greater than
that at which a similar existing enterprise can be purchased; ....”28 For this reason, Keynes is
the first economist to posit a kind of dilemma which characterises the relationship between
financial markets and economic development: Do the advantages of maturity transformation
via financial markets outweigh the disadvantages of the specific pricing mechanism which
operates in those markets? The answer is Yes, provided monetary policy is invariably able to
ensure that an interest rate level is maintained which, for a given set of prices in the financial
markets, provides the incentive needed to cause a volume of investment to be undertaken
which is sufficient to render a satisfactory course of economic development possible. Only if
this is not (or no longer) the case does it become the task of the state to take ”an ever greater
responsibility for directly organising investment”29 - a policy recommendation which may be
valid in a situation of severe financial crisis like the one in the 1930s.

The preceding discussion makes it clear that Keynes placed the role of financial markets in
the process of economic development firmly in a monetary, macroeconomic context.
However, this aspect of his thought was largely ignored in the post-war discussion of
macroeconomic theory. The reason for this is that Keynesianism

- was applied by its proponents primarily to the real economy ("income-expenditure-

model"), with the ineffectiveness of monetary policy, which had been derived for a

27
Keynes, J.M. (1964), pp. 154f. See also his classic comparison of the process of price determination on the
stock market with a competition ”in which the competitors have to pick out the six prettiest faces from a
hundred photographs, the prize being awarded to the competitor whose choice most nearly corresponds to
the average preferences of the competitors as a whole; ... .” (Keynes, J.M. (1964), p. 156.) This creates a
situation in which each competitor's list will be topped not by the face which it personally feels to be the
prettiest. Rather, each member of the ”jury” will choose the particular face which, in its view, has the best
chance of being regarded by each of the other members as the one which is most likely to be chosen as the
prettiest by everyone else on the jury.
28
Keynes, J.M. (1964), p. 151.
29
Keynes, J.M. (1964), p. 164.
 11

specific case - namely, that of the financial crisis ("liquidity trap")- being generalised,
which in turn meant that the part of the General Theory dealing with the theory of money
and the theory of finance was, for all practical purposes, ignored;30 and that it

- was attacked by the exponents of the neo-classical-monetarist counterrevolution because

of its central tenet that the interest rate is determined by the interplay of the supply of and
demand for money, and not by the interplay of investment and savings, and in essence
reduced to the assumption of price rigidities on labour and product markets.

It is well-known that the latter criticism, as embodied in neo-classical equilibrium theory and
the postulated dichotomy of markets, became the basis for the generally accepted theoretical
position. The price level was once again seen as something that is determined by the money
market; output (taking into account the production function) and employment were once
again regarded as variables determined in the labour market; and saving and investment
were once again equilibriated by interest rate movements on financial markets. In this
theoretical setting, the irrelevance of finance was once again a given, making the connection
between financial markets and economic development a rather uninteresting subject of
inquiry for economic theory.31

As a result, few if any attempts were made to design a detailed model of the relationship
between financial markets and the level of economic activity - i.e. to determine whether the
”financial structure”32, about which Keynes said practically nothing, was relevant or
irrelevant - on the basis of Keynesian theory. With one important exception - that of James
Tobin33 - mainstream economists in effect ignored this area of inquiry, leaving it to be
explored by the so-called post-Keynesians34 and ”macroeconomic outsiders” such as

30
Leijonhufvud had already criticised this misinterpretation of Keynes in the late 1960s (Leijonhufvud, A.
(1968)). This dominance of the real economy in the thinking of those who interpreted and applied Keynes's
ideas was reflected in an excessive emphasis on fiscal policy - a tendency which was further reinforced by
the so-called fiscalism vs. monetarism debate. On these points, see also Winkler, A. (1992). Seen in this
light, Gertler's criticism of the neo-classical synthesis (1988, p. 560), which he faults for having ignored an
essential part of Keynes's message, is justified.
31
The following passage from Laurence Weiss (1988) exemplifies the thinking behind this point of view:
"..., if there is a subject called macroeconomics, and I emphasis "if", then it must have something to say
about the financial system. Macroeconomics, as we all learned it, has something to say about savings and
investment and the difficulty of getting these two to agree. As an undergraduate, I remember being told
with great weightiness that one of Keynes's insights was that savings and investments were undertaken by
different people with very different motivations and that somehow this was a very difficult co-ordination
problem. It was never really explained, however, why this co-ordination problem was any different from
the co-ordination problem of getting buyers and sellers of bread to agree on the quantity." Weiss, L.
(1988), p. 594.
32
See Goldsmith, R. (1969).
33
See, in particular, Tobin, J. (1982), pp. 171 - 204, Tobin, J. (1980).
34
The post-Keynesian approach is perhaps best exemplified by the work of Hyman P. Minsky and Jan
Kregel.
 12

Goldsmith or Gurley and Shaw.35 However, given the conceptual distance that separated
their work from the prevailing macro theory, their efforts to gain acceptance for the link
between financial markets and economic development as a subject of research had little
chance of success.

Moreover, in view of their still-fresh memories of what had happened in the wake of the
financial crises of the late 1920s and early 1930s, the proponents of both Keynesianism and
monetarism in any case agreed that the activities on financial markets should be severely
restricted through corresponding regulations in order to ensure that financial turbulences
would not again undermine the efforts of macro policy to fulfil its tasks of securing full
employment and price stability.36 This view was supported by the empirical evidence, given
that, at least in the Western industrial countries, the financial markets proved to be extremely
stable up until the mid-1970s, with the data showing at the same time that, by historical
standards, the values for key macroeconomic indicators were excellent. Although the
quantitative significance of financial relationships emphasised by Gurley and Shaw was
undeniable, as were both the diversity and the complexity of the observable forms of finance
and institutions providing finance, the time was not yet ripe for an examination (or re-
examination) of the subject of financial markets and economic development.

35
See Gurley, J.G. and E.S. Shaw (1955), Gurley, J.G. and E.S. Shaw (1956), Gurley, J.G. and E.S. Shaw
(1960).
36
See, for example, Milton Friedman's plan to introduce a 100% minimum reserve requirement in order to
make it impossible for commercial banks to impede the implementation of a stability-oriented money
supply policy, as set forth in Friedman, M. (1948). Shaw sums up the approaches to financial-sector issues
taken by the two competing macroeconomic theories, neo-classical monetarism and Keynesianism, as
follows: ”The doctrines ... are not the stuff, to put it mildly, from which financial liberalisation evolves.”
Shaw, E.S. (1973), p. 105.
 13

5. McKinnon and Shaw: New Development Finance

Accordingly, the modern theoretical explanation of the relationship between financial-

market development and economic development begins with McKinnon and Shaw.37 This
breakthrough was possible because, particularly in developing countries, macroeconomic
management was associated to an increasing degree with higher inflation rates and declining
economic growth. This led to a re-evaluation of the regulatory regimes which had governed
the activities of the financial markets in both the industrial and the developing countries
since the beginning of the post-war period. They were no longer seen as a protective shield
for a macro policy geared to promoting economic growth, full employment and price
stability, but rather as an instrument for the repression of financial markets which impeded
the formation of real capital. In particular the practice of setting ceilings for nominal interest
rates became the focus of criticism because, in a high-inflation environment, such ceilings
imply strongly negative real interest rates, a decline in demand for financial assets, and thus
disintermediation. This in turn means that liquid funds are no longer invested in the formal
financial system, which is reflected, on the one hand, in stagnant, or even declining, values
for the indicators used to measure the level of activity on the financial markets, and, on the
other, in decreasing savings and hence a decline in investment and economic growth.

In addition, McKinnon and Shaw provide a theoretical framework within which growth
effects of financial-system development can be derived. Their point of departure is a critique
of monetary growth theory38 which postulates that a rise in real balances (M/P), i.e. an
increasing level of monetisation in an economy, is accompanied by a declining rate of
economic growth. The reason for arriving at this conclusion is that real balances represent an
asset, the acquisition of which serves, at both the micro and the macro level, as a substitute
for the acquisition of real capital. Every economic agent will, when making its investment or
saving decision, compare the return on real capital, which is determined by marginal
productivity, with the return on real balances, which consists of the nominal interest rate,
which for cash is set equal to zero, a non-pecuniary marginal return due to the
”convenience” associated with holding money, and the rate of inflation or, as the case may
be, deflation.

If the return on real balances rises, economic agents will increase their demand for money.
This implies that

- real income increases by the amount of the increase in real balances; this in turn means
that for a given savings rate (s = S/Y) the rate of accumulation of real capital increases
(income effect).

37
See Shaw, E.S. (1973), McKinnon, R.I. (1973).
38
See McKinnon, R.I. (1973), Chapter 5; Shaw, E.E. (1973), Chapter II, especially pp. 34ff. For an overview
of the evolution of monetary growth theory in the 1960s, see, for example, Stein, J.L. (1970).
 14

- some savings are not used to accumulate real capital, because they are utilised to build up
real balances (substitution effect).

Because with a savings rate of s < 1 the substitution effect must always be greater than the
income effect, the net effect of an increase in demand for real balances is to reduce the level
of investment and thus of the equilibrium growth rate. Accordingly, the theory provides a
rationale for an inflationary macro policy and a repressive policy towards the financial
markets because any reduction in the return on real balances will have positive effects on
investment and growth.39

McKinnon emphasises that the validity of this policy recommendation depends crucially on
the assumption that there is a uniform market for real capital in the economy. On this
market, economic agents can invest surplus income at a uniform interest rate of r or, as the
case may be, borrow funds at the uniform interest rate of r if they wish for their expenditures
to exceed their income. Its existence enables every economic agent to accumulate savings
and undertake investments exhibiting a uniform marginal productivity of r. However, such a
market cannot be assumed to exist in underdeveloped economies, which is why McKinnon
calls them ”fragmented economies.”40 It can be shown that in a fragmented economy the
substitution relationship between real capital and real balances which is postulated in
monetary neo-classical growth theory is for all practical purposes replaced by a relationship
of complementarity between the two types of assets.41 Accordingly, an increasing degree of
monetisation is accompanied not by lower, but by higher growth rates. In this respect, two
different stages in the development of an economy can be distinguished: first, that of
monetisation, which is followed by the development of financial markets.

39
”No wonder ... development enthusiasts in Latin America and elsewhere have felt little academic restraint
against pursuing inflationary policies as a response to capital scarcity.” McKinnon, R.I. (1973), p. 52. It
should be noted, however, that this theoretical outcome and the policy recommendation derived from it
were also criticised in the literature on growth theory; see Johnson, H.G. (1969) and Moroney, J.R. (1972).
40
Shaw uses the term ”lagging economies”; see Shaw, E.S. (1973), p. 48.
41
On this point Shaw is more clear-cut. Proceeding from the insight that, at the level of the economy as a
whole, it is not possible for either money or other financial assets to serve as a substitute for the acquisition
of real capital, he states: ”money is not wealth and ... there is no substitution effect. Money is debt, and
growth in the real stock involves intermediation by the monetary system between savers and investors.”
Shaw, E.S. (1973), p. 93.
 15

a) Barter vs. Monetary economy

In the extreme case of a fragmented economy there is no capital market at all. Accordingly,
every economic agent which plans to buy a capital good whose value exceeds the value of its
savings is compelled to make use of the opportunities to save that are available to it. In a
barter economy there is only one such option available - namely, storage of the goods
produced by the agent. However, if a farmer can only save by accumulating the goods he
produces, e.g. by storing rice, ”part of which is eaten by mice”,42 the return on this form of
saving will not be r. Rather, it will be negative. This means that it may take a very long time
for the farmer to finance the purchase of the capital good which will increase his
productivity, i.e. a point where he has accumulated a sufficient quantity of rice to be able to
exchange it for a machine.43

If an alternative savings option is available in the form of money and the policy
recommendations implied by monetary growth theory are followed, the same negative
outcome will be achieved. For if the real return on monetary saving is negative due to high
inflation and ceilings on nominal interest rates, the farmer will either decide not to hold
money at all or be constrained in his ability to finance a planned investment via the internal
accumulation of capital to much the same extent as he would be in a barter economy.
However, if the interest rate on monetary assets is positive in real terms, this will promote
the formation of productive real capital because it improves the quality of internal financing
options, thus accelerating the future acquisition of productive real capital.44 Thus, the
relationship between monetary asset accumulation and real capital formation is one of
complementarity and not one of substitution, and increasing monetisation promotes rather
than hinders the accumulation of real capital and the process of economic development.

b) The origins of financial markets

The positive effects of monetisation are reinforced if stocks of monetary assets are
accumulated not only in the form of cash but also, for example, in the form of bank deposits.
If the bank uses the liquid funds placed at its disposal to extend credits to other economic
agents, which are then in a position to carry out their planned productive investments sooner.
Accordingly, in addition to the positive growth effects due to an improved quality of internal
finance, the positive growth effects of financial markets which were enumerated above (see
Section 3), and whose existence is acknowledged by all theories, can be achieved.
42
McKinnon, R.I. (1973), p. 13.
43
Note how important it is to discard the assumption of homogenous goods: in order for the example to be
valid it must be true that the individual ”saver-investor, being limited to self-finance, wants to purchase
physical capital of a type that is different from his own output.” McKinnon, R.I. (1973), p. 57.
44
”Average cash balance holdings, therefore, are positively related to the propensity to invest (save) under
the formal constraint that all investments are ”self-financed” - ... .” McKinnon, R.I. (1973), p. 58.
 16

A comparison with the Keynesian approach shows that the proponents of the New
Development Finance approach also emphasise the monetary character of financial markets,
which indeed appears to play a constitutive role in the organisation of capital markets. For
this reason, all measures which would undermine the monetisation of an economy, i.e.
measures leading to negative real interest rates as well as an inflationary macro policy, are
rejected. It should be noted, though, that this emphasis on the monetary character of
financial markets does not cause the neo-classical notion of the dichotomy of markets to be
regarded as problematic. Financial markets continue to be seen as an embodiment of the neo-
classical capital market where savings (supply of real capital) and investments (demand for
real capital) come together and can be equated with the supply of and demand for credit.45
Moreover, because there is no apparent reason to regard the interpersonal resource transfer
on financial markets as problematic, the implications for economic policy are clear: the
financial markets should be liberalised, above all to increase the accumulation of savings via
positive real interest rates, and by so doing to increase investment. When implementing
liberalisation measures, macroeconomic conditions and/or the institutional characteristics
and potential of financial markets (in the narrow sense) and financial institutions need not be
taken into account: "We suggested keeping positive and more uniformly high real rates of in-
terest within comparable categories of bank deposits and loans by eliminating undue reserve
requirements, interest ceilings, and credit subsidies on the one hand, while stabilising the
price level through appropriate macroeconomic measures on the other. Then, savers and
investors would better "see" the true scarcity price of capital, and thus reduce the great
dispersion in the profitability of investing in different sectors of the economy."46

This policy recommendation was implemented in many developing countries, especially in

Latin America (but not, it is important to note, in East Asia), not least because it had also
come to be seen as the appropriate course of action by the international financial
organisations.47 The consequences are well-known: attempts to bring about macroeconomic
stabilisation and financial-sector liberalisation correlated with extremely high real interest
rates. Financial crises once again became an important economic phenomenon, and often

45
The following statement by Shaw is typical of using the terms ”savings”, ”lending” and ”deposits” - and
”investment”, ”borrowing” and ”credit” - as synonyms: ”Because savings are scarce, credit is rationed loan
by loan.” (author's italics) Shaw, E.S. (1973), p. 12. Only rarely is a clear distinction drawn between the
formation of real and monetary assets, as, for example, Shaw does when he discusses the problematic
effects of subsidised interest rates exclusively in terms of monetary savings; see p. 133. As a consequence,
the results of empirical tests, which are usually unable to demonstrate the existence of a correlation
between the savings rate and monetary asset formation, are seen as contradicting not only McKinnon's
complementarity hypothesis but also the basic message of the New Development Finance literature. See,
for example, Fry, M. J. (1978), p. 473.
46
McKinnon, R.I. (1989), p. 99.
47
”During the 1970s and 1980s, the financial liberalisation school received much attention and the policy
implications of its models were appreciated in political circles and in the IMF and the World Bank.”
Hermes, N. (1994) p. 7.
 17

they had a dramatic impact on output, employment and inflation in the respective
countries.48

6. The theory of finance which is grounded in the economics of information

In light of the failure of the policy of financial market liberalisation to achieve its intended
goals, economists analysing the links between financial market development and economic
development began to give consideration to a theoretical approach which characterises the
interpersonal resource transfer on financial markets as problematic. In the economics of
information transactions between economic agents are analysed under the usual neo-classical
assumptions, but with one exception: instead of the assumption of complete, uniformly
distributed information, the assumption that information is asymmetrically distributed
among agents is introduced. The focus here is on the uncertainty regarding the quality of the
product to be transferred which characterises one side of the market and which implies that
the market cannot organise the resource transfer by relying exclusively on the price as an
instrument for balancing the interests of the parties to transactions.49

The uncertainty as to the quality of the product to be traded in financing relationships is an

outgrowth of their intertemporal character, which entails the risk that the behaviour of the
borrower (agent), during or after the implementation of an externally financed investment,
will not be congruent with the interests of the lender (principal), giving rise to moral hazard
and adverse selection problems. This means that the interpersonal resource transfer which is
effected on financial markets might have not only positive, but also negative consequences
for economic development. Thus, it may even be advantageous to limit the scope for such
transactions, or to forgo them altogether.50

This introduces a qualification which must be borne in mind when discussing the potentially
positive effects of financial markets on economic development: transactions on financial
markets promote economic development if, and only if, mechanisms are employed which
mitigate or resolve the incentive- and information-related problems that characterise such
transactions. However, unlike Keynes, who likewise formulated a qualification (see Section
4), the proponents of the theory of finance grounded in the economics of information do not
(initially) derive the rationale for this limitation from the monetary character of financial
markets and its macroeconomic implications. Nonetheless, their view is at odds with the

48
See Diaz-Alejandro, C. (1985).
49
For a classic discussion of this point, see Akerlof's analysis: Akerlof, G.A. (1970); for a brief overview of
the topic, see also Stiglitz, J.E. (1987) and Schmidt, R.H. (1990), p. 19ff.
50
This might actually be a market result; see Stiglitz, J.E. and A. Weiss (1981).
 18

neo-classical view that financing relationships, their design and institutionalisation, may be
irrelevant, as is implied by the Modigliani-Miller theorem.

Accordingly, research in the framework of the new theory of finance is aimed at identifying
the specific forms of finance and/or the specific types of financial institution which can
render it possible to overcome information and incentive problems. The starting point in this
analytical undertaking is the type of finance in which, by definition, neither moral hazard nor
adverse selection problems can occur because lender and borrower are identical: internal
financing.51 Accordingly, any external financing relationship will be characterised by some
mechanism which imitates the situation which prevails in the internal financing
”relationship”. The mechanisms involved here are screening, self-selection, and monitoring,
which – by putting (potential) borrowers in a situation where they must relinquish something
which forms part of their "inner life", either information (e.g. balance sheet ratios, business
plans, data on market position, socio-economic position) and/or assets (collateral,
participation using own funds) - mitigate moral hazard and adverse selection problems.52

However, the use of these mechanism gives rise to costs. Thus, it comes as no surprise that
most corporate investment is internally financed, with external financing playing a
comparatively minor role.53 Moreover, the new theory of finance succeeds in explaining the
dominance of financial intermediaries, and of banks in particular, over financial markets in
the narrow sense, when it comes to shaping external financing relationships. Three different
approaches to formal modelling are employed in this endeavour.54 The first approach focuses
exclusively on the notion of intermediation, specifying the advantages of financial
51
This does not mean that, from the standpoint of the economics of information, internal finance is a
completely unproblematic form of finance. Particularly in cases where the owners of a firm (principal) and
its managers (agent) may be represented by different persons, a high proportion of self-financing in total
financing can create a situation in which managers use the available funds for relatively unproductive
investments, which hinders growth and development. See Jensen, M.C. (1986).
52
See Gertler, M. and A. Rose (1994), p. 25. Thus, the objective of these mechanisms can be described as
that of creating between lender and borrower ”a strongly interdependent utility function.” Merton, R.C.
and Z. Bodie (1995), p. 9. By far the most important, and most frequently used, option is the provision of a
suitable form of loan security; see Terberger, E. (1987). An analysis of various financing forms which
focuses on this aspect is provided in Schmidt, R.H. (1981).
53
See Mayer, C. (1989), Corbett, J. and T. Jenkinson (1996). In terms of equation (1), Section 2, this implies
that the enterprise sector, the sector which contributes the most to real capital formation, and thus to
economic development overall, often does not use the financial markets at all when financing its
investments. Accordingly, the notion that investment by firms is financed primarily with external capital
provided by private households - which is suggested not least by the lack of clarity as regards the meaning
of the terms ”savings”, ”lending”, ”investment” and ”borrowing” - is, at least in the western economies,
incorrect, and historically this is also a misconception (see Edwards, J. and S. Ogilvie (1995). However,
while the significance of internal financing is also great in developing countries, self-financing is not as
dominant in such nations as in the western industrial countries; see Singh, A. and J. Hamid (1992). In the
”miracle economies” of East Asia as well, the internal finance ratio was often less than 50%; see World
Bank (1993), pp. 224f.
54
Fairly non-technical surveys of the new microeconomic banking theory literature are provided by Van
Damme, E. (1994) and Rühle, I. (1997), who gives a comprehensive overview.
 19

intermediaries over financial markets in the narrow sense in terms of their ability to
overcome information and incentive problems that arise between lenders (or, as the case may
be, depositors) and borrowers (economic units borrowing from banks or, as the case may be,
banks).55 However, it is not claimed that banks render investments possible which are more
productive than those facilitated by financial markets in the narrow sense. But this is
precisely what is postulated by the second approach, which identifies the ability of financial
intermediaries to render possible long-term investments, which are presumably
comparatively productive ones, despite the fact that the group of borrowers is heterogeneous
(some are ”good”, others are ”bad”), as the decisive advantage of financial intermediaries.56
Here the focus is not the intermediation function, but rather on the selection and monitoring
functions performed by banks. The third approach differs from the other two in so far as
attention centres not on financial institutions but on forms of financing. It demonstrates that
external equity financing via markets is subject to specific information and incentive
problems which make this form of financing rather unattractive.57

Thus, the new theory of finance succeeds in ordering and analysing the insights yielded by
the empirically-oriented work of Gurley, Shaw and Goldsmith, and in accounting for the
diversity and complexity of forms of financing, financial institutions and financial markets
in the narrow sense in a rigorous theoretical framework. It leads to the following conclusion:
Financial markets foster growth and development by carrying out an intertemporal,
interpersonal resource transfer, if they are characterised by institutions and by the use of
financial instruments which are able and designed to overcome information- and incentive-
related problems which are associated with this resource transfer.

The little word ”if” is crucial here. Indeed, given that various structural weaknesses of
financial markets are regularly identified and diagnosed, especially in the aftermath of
financial crises, the question of whether financial markets actually overcome these problems
must be regarded as moot. This question must be answered before new growth models which
focus on the growth-enhancing attributes of financial markets58 can be used by economic
policymakers as the basis for a strategy which assigns to the financial markets an important,
active role in the process of economic development.

As was already mentioned in the introduction, the answer to this question given by the
empirical data is often negative, and of late it has been an increasingly unambiguous No.
Particularly during the last fifteen to twenty years, there has been a pronounced increase in

55
See Diamond, D. (1984) and Diamond, D. and P. Dybvig (1983).
56
See Von Thadden, E.-L. (1995) and Dewatripont, M. and E. Maskin (1995).
57
See Myers, S.C. and N.S. Majluf (1984), as well as Greenwald, B., Stiglitz, J.E. and A. Weiss (1984).
58
See, for example, Bencivenga, V.R. and B.D. Smith (1991), King, R.G. and R. Levine (1993).
 20

the number of bank failures and financial crises in both the industrial and the developing
countries.59 The reasons are well known: macroeconomic and terms-of-trade shocks as well
as ”poor banking” contributed to the rise in the number of bank failures. Viewed from the
perspective of the new theory of finance, this means that

a) the legal, socio-economic and regulatory parameters which shape the environment in
which financing takes place do not provide sufficient opportunities and/or incentives to
lenders - that is to say, to depositors as lenders to banks and to banks as providers of
finance to firms - to minimise moral hazard and/or adverse selection behaviour on the
part of borrowers;60

b) key elements of the macroeconomic environment created by implementation of a

restrictive monetary policy intended to stabilise the inflation rate and/or the exchange
rate, e.g. extremely high real interest rates,61 in effect invite the actors in the financial
markets to forgo use of the mechanisms for the mitigation of asymmetric information
problems that have been identified.62 On the other hand, drops in income and prices may
make it impossible for economic agents to create efficient financing relationships
because many borrowers are no longer creditworthy as a result of ”drastic redistributions
of wealth.”63

Based on this diagnosis, one can formulate a clear policy recommendation: Until such time
as all of the legal, socio-economic and regulatory parameters - and the macroeconomic
prerequisites - have been created which must be given if information- and incentive-related
problems are to be taken into account in the process of organising the intertemporal,
interpersonal resource transfer, a policy of financial market liberalisation of the type which

59
See Sundararajan, V. and T.J.T. Balino (1991), Caprio, G. and D. Klingebiel (1996), Caprio, G. (1997)
60
For a discussion of the significance of legal parameters for the organisation of the interpersonal resource
transfer on financial markets, see Sirri, E.R. and P. Tufano (1995), p. 82ff.; La Porta, R., Lopez-de-Silanes,
F., Shleifer, A. and R.W. Vishny (1997); the importance of socio-economic factors like the concentration
of wealth, income and the ownership of non-financial and financial firms as well as the presence, and
effective functioning, of corporate governance in financial and non-financial firms are stressed by Caprio,
G. (1997) and Winkler, A. (1997); an in-depth analysis of the regulatory framework of banking and
financial markets based on the economics of information has been provided by Dewatripont, M. and J.
Tirole (1996).
61
The World Bank assumes that with real interest rates running at between 10% and 15% p.a., only
optimistic speculators or borrowers with intent to defraud will still exhibit a demand for credit. See World
Bank (1989), World Development Report 1989 (German edition), p. 104.
62
See McKinnon, R.I. (1989). Conversely, the presence of financial markets which forgo the mechanisms
that can be employed to mitigate information- and incentive-related problems limits the ability of
macroeconomic stabilisation policy to achieve its objective. On this point, see Udell, G.F. and P. Wachtel
(1995).
63
Calomiris, C. W. (1993), p. 73. The negative impacts of deflation on the design of financing relationships,
and thus on the level of economic activity were first emphasised by Fisher well over 60 years ago; see
Fisher, I. (1933).
 21

was advocated as a logical consequence of the NDF approach would be inappropriate.

Rather, what is needed is a policy of ”financial control”64 which

- clearly gives precedence to macroeconomic policy over financial sector reforms aimed at
liberalisation because in an unstable macroeconomic environment the danger of moral
hazard behaviour on the part of borrowers is too great. The goal is to create the
prerequisites for price stability, in particular via a restrictive fiscal policy, so that
monetary policy can maintain real interest rates at positive levels which, however, are
both low and stable, thus at least permitting internal financing to be carried out
efficiently (see Section 5).

- in essence limits the range of financing options open to firms to internal financing and
external financing via the non-bank capital market by limiting the range of investment
options open to banks more or less exclusively to the purchase of government debt
instruments or the placement of funds in accounts at the central bank (the narrow bank
proposal). Again, the idea is to allow on the one hand the collection of deposits from the
private sector, which is regarded (see section 5) as an important part of a growth-
promoting strategy because it offers investors a relatively efficient means of self-
financing larger, and thus more productive, investments via the internal accumulation of
financial assets; on the other hand, such an approach is intended to prevent banks whose
corporate governance structure is inadequate from engaging in types of asset-side
business in which the possibility of moral hazard and adverse selection cannot be ruled
out.

The idea behind this restrictive policy is not only to protect the financial markets from self-
inflicted damage by ensuring that an ”over-borrowing syndrome”65 does not set in, but also,
at the same time, to increase the chances that the information- and incentive-related
problems which are inherent in financial-market transactions can be overcome in the future.
By limiting firms' financing options more or less exclusively to internal financing during an
initial period, a ”thick core of creditworthy borrowers”66 is created because, over time, the
firms which operate successfully in the product markets accumulate a net wealth position
which can be used as collateral for future external financing (borrowing), thus making it
possible for an effective demand for external finance to arise. On the supply side, it is
assumed that within the nonbank capital market new institutions will arise which exhibit a
suitable corporate governance structure. Because they grant loans or undertake equity capital
participations using own resources, it is highly probable that they will employ the above-

64
See McKinnon, R.I. (1992).
65
See McKinnon, R.I. and H. Pill (1994)
66
Gertler, M. and A. Rose (1994), p. 45.
 22

mentioned mechanisms to alleviate information and incentive problems. The most successful
of them will then accumulate experience and a considerable amount of net wealth which will
enable them - after a few years - to apply for a banking licence, thereby endogenously
contributing to a more stable financial environment.

This is why the net wealth position of (potential) borrowers becomes the focus of efforts in
the realm of economic policy. It is seen as the decisive measure of their creditworthiness
because it guarantees the identity of interests between lender and borrower when the
financing relationship is initiated and over the life of this relationship.67 The same idea forms
the basis of the concept of ”financial restraint,”68 an approach to financial-sector policy
which is presented as an alternative to both financial liberalisation and financial repression:
regulation of the financial markets, and especially restrictions on competition effected by
regulating entry into the banking market and controlling the deposit rate, should be designed
and implemented in such a way as to contribute to an increase in the net wealth of the
licensed banks. This is intended to reduce the danger of moral-hazard and adverse-selection
behaviour on the part of the banks vis-à-vis their depositors, which also means that, in
dealing with their borrowers, the banks for their part will make use of the appropriate
mechanisms to overcome information- and incentive-related problems. In contrast to an
interventionist financial-sector policy which, for various reasons - and not least because
insufficient information is available on the banks and their activities - cannot safeguard the
stability of the banking system, the concept of ”financial restraint” thus relies on the use of
intelligent regulations to create incentives for bank owners and managers to act on their own
to create stable financial institutions, and, by extension, to strengthen the financial markets.
Moreover, in contrast to a policy of financial repression, an inflationary macro policy is
rejected, with the maintenance of interest rates at levels which, while low, are still positive
in real terms, being recommended as the appropriate goal for monetary policy.

This highlights the fact that, by taking into account issues raised by the economics of
information, the proponents of the New Development Finance approach have modified their
policy recommendation in both of the areas in which it relied most heavily on the neo-
classical view of financial markets and economic development. For one thing, the idea of
financial market regulation is no longer rejected as a matter of principle. Indeed, such
regulation is now accepted as beneficial provided it is designed to address the information-
and incentive-related problems which are an inherent part of every financing relationship,
67
”the behaviour of borrower net worth is at the core of the link between finance and economic activity. This
includes being a factor that determines the extent of [incentive compatible - added by author]
intermediation. ... The borrower's accumulated net worth depends both on past earnings and on anticipated
future prospects.” Gertler, M. and A. Rose (1994), p. 28 and 30. See also Leland, H.E. and D.H. Pyle
(1977)
68
See Hellmann, T., Murdock, K. and J.E. Stiglitz (1997). Fundamentally similar ideas are advanced by
Caprio, G. and L.H. Summers (1993) and Demsetz, R.S.; Saidenberg, M.R. and P.E. Strahan (1996).
 23

and especially of that between depositor and bank. For another, the activities on financial
markets are again placed in a macroeconomic, monetary context, although, the neo-classical
dichotomy of the markets is retained, at least in the formal models.69 This is reflected in the
recommendation that financial-sector policy be tailored to each country's specific
macroeconomic situation and to the particular institutional configuration and ”landscape”
found in its financial sector, with attention being focused above all on the role of monetary
policy and the central bank.70 And thus, in what could almost be regarded as a return to the
Keynesian tradition, the possibility that interest rates may be determined by monetary policy
is implicitly acknowledged, as is the possibility that, in a financial crisis, monetary policy
may no longer be able to influence the development of the real economy to any appreciable
extent.71

7. Conclusion: Financial markets and economic development

- the Asian example

The approach to understanding the link between financial markets and economic
development which is grounded in the economics of information represents the most recent
attempt to describe the complex interplay of factors in the real economy and the financial
economy and its significance for the process of economic development. And although the
basic concept involved here - namely, that of the problematic nature of transactions under
asymmetric information - has in the meantime become part of the standard tool kit of
economic theory, this cannot be said of the ”order of liberalisation” which is recommended
by McKinnon as a development strategy and whose core element is a policy of financial
control, nor it is true of the financial-sector strategy favoured by Hellmann, Stiglitz and
Murdock, i.e. financial restraint.72 Indeed, given the basic tenets of neo-classical theory,
these strategies have rather radical implications. After all, in essence McKinnon and
Hellmann/Murdock/Stiglitz are saying that, at least temporarily, a prohibition of financial
intermediation in the classic sense - that of banks mobilising savings mainly from private
households in order to channel them to productive enterprises - and/or measures to restrict
competition and control prices are necessary in order to foster financial markets capable of
69
Generally speaking, little has been done so far to develop the conceptual links between the new theory of
finance and monetary theory, although there have been repeated calls for the kind of research efforts
needed to establish these links (see Gertler, M. (1988), p. 582 und Schmidt, R.H. (1990), pp. 31ff.), and
although indications of the nature of such links have been given in isolated remarks and discussions
through statements to the effect that money is a good whose value is ”a matter of common knowledge”
(Calomiris, C.W. (1993), p. 67), i.e. that money is a good whose quality is known to everybody with
certainty. A formal model which makes use of this idea is specified by Williamson, S. and R. Wright
(1994).
70
See Goodhart, C.A.E. (1987).
71
See McKinnon, R.I. (1992), Calomiris, C. W. (1993), pp. 73f. and Greenwald, B.C. and J. Stiglitz (1988),
pp. 154f.
72
Fry speaks of the ”Stiglitz controversy”; see Fry, M.J. (1997), p. 759ff.
 24

promoting economic development.73 While the above policy recommendations would not
appear to be particularly problematic from a Keynesian point of view74 (the only point on
which they would clearly be at odds with a Keynesian economic policy is their firm rejection
of an expansive fiscal policy), one must, however, ask here whether, and to what extent, an
approach which is grounded more in microeconomics can yield the insights needed to devise
an effective response to what is a macroeconomic, monetary problem.

It should be noted, though, that financial control and financial restraint are seen by their
advocates as being more than just the result of a process of theoretical analysis. In fact, they
are considered to be first and foremost the product of an empirical analysis of the
consequences of incorporating the financial markets into the development strategy of the
East Asian ”miracle countries”, which was considered a successful approach prior to the
current financial crisis.75 After all, while the Asian financial markets had clearly experienced
their share of crises and crisis-like situations, the magnitude of these shocks, and the extent
of the economic damage they caused, was limited, especially in comparison with other
developing countries.76 This made the positive correlation between the various indicators of
financial development and real per capita income, or, more specifically, its rate of growth,
seem all the more striking (see, for example, the data in Table 1).

The most recent turbulences on East Asian financial markets underscore, however, that in
Asia as in the rest of the world, the links between financial-market development and general
economic development are such that the financial markets do not always have a benign
influence on the course of economic development. Indeed, the negative effects on output and
growth which are anticipated as a result of the current financial crisis have caused estimates
of real GDP growth rates to be revised downward by a substantial margin, with the
correction amounting to as much as 5 percentage points for some countries.77 Moreover, the
crisis is considered to be in large measure an outgrowth of the fragility and basic structural

73
With regard to the transition economies of Eastern Europe, for which McKinnon had recommended this
policy of financial control, critical assessments of this approach are to be found in Cornelli, F., Portes, R.
and M.E. Schaffer (1996), p. 10, and Caprio, G. and R. Levine (1994).
74
See, for example, Tobin, J. (1987a), and Tobin, J. (1987b), which demonstrate that, with regard to
financial markets, the policy implications of Keynesian economics and the economics of information are
quite similar.
75
”These ideas are influenced by a stylised analysis of the policies pursued by a number of high-performing
East Asian economies, and in particular, by the Japanese post-war experience (...).” Hellman, T.; Murdock,
K. and J. Stiglitz (1997), p. 163. ”Japan, after 1949, exemplified a poor country embarking on rapid real
economic growth while keeping suitable financial constraints in place. ... . ..., Japanese financial policy and
the similarly successful experience of Taiwan a decade or so later are reviewed in order to establish
historical benchmarks of countries that did get their order of liberalisation more or less ”right”.”
McKinnon, R. I. (1992a), p. 10.
76
See World Bank (1993), pp. 214f. and 249ff.
77
See IMF (1997), p. 58.
 25

weaknesses of the financial markets in the East Asian countries.78 While a detailed analysis
of its causes would be beyond the scope of this theoretical survey, it seems appropriate to
devote the final portion of the discussion to a consideration of whether the East Asian
financial crisis represents a failure of the policy of financial control or, as the case may be,
financial restraint (if it does, then the validity of the underlying theoretical positions would
be called into question), or whether governments in the region deviated from this policy in
the years prior to the crisis, and by so doing created an environment which was conducive to
the type of financial crisis which eventually materialised.

Table 1: Ratio of M2 to GDP and average log per capita growth rates of GDP* in
selected East Asian economies, 1960 - 1990

Country 1960 1965 1970 1975 1980 1985 1990

M2/GDP 0.6 0.78 0.74 0.85 0.86 0.97 1.18

Japan
GDP growth p.c. n.a. 10.29 9.85 2.90 3.58 2.95 3.90

M2/GDP n.a. 0.13 0.10 0.16 0.17 0.25 0.43

Indonesia
GDP growth p.c. n.a. -1.15 3.12 4.23 4.97 2.95 4.21

M2/GDP 0.11 0.12 0.33 0.31 0.34 0.39 0.40

Korea
GDP growth p.c. n.a. 3.47 7.65 6.96 5.87 6.72 8.66

M2/GDP 0.24 0.28 0.35 0.46 0.53 0.68 0.67

Malaysia
GDP growth p.c. n.a. 3.54 3.21 4.42 5.90 2.31 3.95

M2/GDP n.a. 0.56 0.66 0.61 0.66 0.70 0.96

Singapore
GDP growth p.c. n.a. 2.08 9.93 7.16 6.79 3.43 5.67

* 1961 - 1965, 1966 - 1970, 1971 - 1975, 1976 - 1980, 1981 - 1985, 1986 - 1990
Source: Galetovic, A. (1994), p. 9; World Bank National Accounts Statistics; own calculations

If one begins with the macroeconomic factors, then a brief examination of the data is
sufficient to show that in some countries - in particular, Indonesia, Korea, Malaysia and
Thailand - the crucial change in the 1990s was the abandonment of the policy of financial
control with respect to the external balance, while with regard to the domestic economy this
policy continued to be pursued, as is shown by the figures for the general government
balance (see Table 2).

78
See, for example, Diehl, M. and R. Schweickert (1998), especially pp. 29ff, as well as IMF (1997), in
particular pp. 3 – 40.
 26

Table 2: Current Account (CA) and General Government Balance (GGB) (in percent of
GDP) in selected East Asian economies, 1983 - 1997

Country 1983 1990 1991 1992 1993 1994 1995 1996 1997
-
1989

CA 3.0 1.5 2.0 3.0 3.1 2.8 2.2 1.4 2.2

Japan
GGB -0.4 2.9 2.9 1.5 -1.6 -2.3 -3.7 -4.1 -2.9

CA -3.5 -2.8 -3.4 -2.2 -1.5 -1.7 -3.3 -3.3 -2.9

Indonesia
GGB -1.3 1.3 0.0 -1.2 -0.7 0.0 0.8 1.4 2.0

CA 2.5 -0.9 -3.0 -1.5 0.1 -1.2 -2.0 -4.9 -2.9

Korea
GGB -0.3 -0.6 -1.6 -2.6 -1.0 1.0 0.0 0.0 0.0

CA -0.7 -2.1 -8.8 -3.8 -4.8 -7.8 -10.0 -4.9 -5.8

Malaysia
GGB -4.0 -2.2 0.1 -3.5 -2.6 2.5 3.8 4.2 1.6

CA 1.8 8.3 11.2 11.3 7.4 17.1 16.9 15.0 14.0

Singapore
GGB 4.8 11.4 10.3 11.3 14.3 13.7 12.0 8.4 8.3

CA 12.9 6.7 6.7 3.8 3.0 2.6 1.9 5.2 4.1

Taiwan
GGB 1.3 0.8 0.5 0.3 0.6 0.2 0.4 0.2 0.2

CA -3.2 -8.3 -7.7 -5.6 -5.0 -5.6 -8.0 -7.9 -3.9

Thailand
GGB -3.0 4.4 4.2 2.6 2.1 2.0 2.6 1.6 -0.4

Source: IMF (1997), pp. 85 - 88

In certain countries (above all in Indonesia and Malaysia, but also in Korea, although not to
quite the same extent), the net inflow of foreign capital, which gives rise to a corresponding
current account deficit, was accompanied by a relatively large increase in bank lending to
the private sector, which did not, however, lead to a significant rise in the inflation rate.79
Thus, in macroeconomic terms the overall situation can be summed up as follows: with the
internal equilibrium under strain, most of the countries experienced an increasingly large
external disequilibrium.

79
See IMF (1997), pp. 85ff.
 27

As regards the source of the increasing external imbalances, most observers agree that they
were largely attributable to the surge in capital inflows. Two reasons are mentioned: For one
thing, since the beginning of the 1990s the scope of liberalisation in the financial markets
appears to have expanded, making it easier for foreign investors to shift capital into the
emerging markets of East Asia, where growth prospects and the chances of obtaining a good
return on investments were estimated to be relatively good.80 For another, as these countries'
current account deficits widened, the share of GDP accounted for by consumption did not
rise - as it had, for example, in Mexico during the crisis of 1994/95. Indeed, in the
economies in question, where the savings rate was in any case comparatively high, the
investment rate continued to rise. Thus, there is considerable evidence that, at least with
regard to the external sector, countries were deviating more and more from a policy of
financial control, with this approach eventually being abandoned altogether and causing the
”over-borrowing syndrome” from which Mexico had suffered to appear in East Asia, albeit
under a different set of domestic economic conditions than had obtained in Mexico.
Accordingly, the financial crisis of 1997 cannot be cited as an unambiguous proof of the
inadvisability of implementing the policies of financial control and financial restraint. On the
contrary, it could be argued that a premature liberalisation of the capital account and the
financial markets in general was a major factor in bringing the crisis about.81

However, two questions remain. First, if a different macroeconomic policy had only been
pursued, would this have not enabled the countries in question to avoid ”overborrowing”,
thus demonstrating that the liberalisation policy in the financial markets can at most be
regarded as only an indirect cause of the crisis? Of course, a different macroeconomic policy
might have made a difference. But with financial liberalisation, the room for manouveure in
macro policy was in any case rather limited. With fixed nominal exchange rates and a
domestic economy which was tending toward overheating, monetary policy was not in a
position to take measures to lower domestic interest rates, and thus curb the inflow of
capital. Like their counterparts in other parts of the world, Asian macro policymakers are
unable to ”master the impossible trinity: open financial markets, fixed exchange rates, and
monetary independence (...).”82By the same token, it remains doubtful whether an early
reduction in the nominal exchange rate would have been feasible and/or would have
decreased the inflow of capital, just as doubts are in order as to whether adoption of a policy

80
”..., sometimes a country’s difficulties originate in part from external disturbances, including irrational
optimism or unwarranted pessimism in global financial markets.” IMF (1997), p. 66. See also Diehl, M.
and R. Schweikert (1998), p. 6.
81
The IMF states in its Interim Assessment that ”the financial difficulties in Asia are likely to stimulate
renewed interest in the question of whether capital controls (on inflows, outflows, or both) may help to
moderate the build-up of external imbalances and reduce the risk of financial crisis.” IMF (1997), p. 67.
Bearing in mind the discussion presented above in Section 4, the actual description of the crisis strikes a
very Keynesian note, speaking as it does of ”disruptive changes in investor sentiment” (p. 61).
82
Diehl, M. and R. Schweikert (1998), p. 3.
 28

of flexible exchange rates would, in itself, have been sufficient to focus investor sentiments
on the inherent risks of capital flows to the area.83 An appropriate, and rather uncontroversial
response, would probably have been to implement a substantially more restrictive fiscal
policy.84 However, it is generally acknowledged that it is quite difficult to restrain spending
when tax revenues are plentiful. Thus, the Asian example demonstrates once again that, in
principle, successful macroeconomic management is a question of ensuring that monetary
policy can do its job properly. However, if financial markets are open and there are interest
rate differentials between the various countries participating in these markets due to the fact
that they are in different positions with regard to the business cycle, the ability of monetary
policy to function properly is severely restricted. And this is precisely the situation in which
some East Asian economies found themselves beginning in the early 1990s.

Second, assuming that a policy of financial control and/or financial restraint was followed in
East Asia, one must ask, Precisely when is a point reached where liberalisation of the
financial markets can no longer be characterised as ”premature”? After all, it seems to be
universally agreed that the financial markets and financial infrastructure in the respective
countries exhibit serious structural weaknesses, and thus that they at least contributed to the
development of the crisis. Although this question brings us back to the fundamental issue
which this survey seeks to address, it is difficult to answer in an unequivocal,
straightforward manner. Of course, it could be argued that the challenge faced by the Asian
financial markets as a result of the strong capital inflows was so great that, if confronted
with the same challenge, even highly developed financial markets would have found it
difficult ”to allocate financial resources efficiently on the basis of market principles and ....
withstand shifts in market sentiment.”85 An examination of the various financial crises that
have occurred in western countries since the early 1980s, which in some cases have been
attributable in no small measure to the effects of currency crises and the volatility of
international capital flows, suggests that this answer cannot be entirely wrong.

Nonetheless, it cannot be regarded as a satisfactory answer because there seems to be little

doubt that the rapid financial development, as documented by the various quantitative
indicators, was not accompanied by an equally rapid process of qualitative development.

83
Diehl and Schweikert think that this approach would have worked; see Diehl, M. and R. Schweikert
(1998), p. 29.
84
ibid., p. 10 and p. 22.
85
IMF (1997), p. 68. For example, this is the view taken by Patrick in his assessment of developments in the
Japanese financial system: ”The problems and difficulties the Japanese financial system and its banks face
in the 1990s ... do not undermine the fundamental lessons of the Japanese case. What that experience
demonstrates is that even strong systems and institutions, not only banks but their regulators, can fall prey
to collective myopia, and that greed in periods of speculative mania can outweigh rational, conservative
calculation of project viability, borrower creditworthiness, and collateral value.” Patrick, H.P. (1994), p.
41.
 29

When it comes to interpreting this phenomenon, there are basically two options. The first is
to question whether it is even appropriate to characterise the financial sector policy pursued
in East Asia as ”financial restraint”. After all, it can also be argued that this financial sector
policy had a great deal in common with a policy of financial repression with heavy
government intervention.86 And as it turns out, the main difference between the East Asian
system and the ”classic” Latin American version of financial repression would seem to be
the difference in the macroeconomic environments in which the two approaches to financial
sector development were implemented. This would, in turn, lead one to conclude that the
Asian example underscores the clear dominance of macroeconomic factors as determinants
of economic development, whereas the design and development of the financial structure is
of only secondary importance provided the macroeconomic fundamentals - the inflation rate,
the government balance and the current account balance - are sound and the real interest rate
is moderately positive. The second option is to admit that, at least as far as the type of
financial control and financial restraint which Asian countries attempted to implement is
concerned, this approach to financial sector development has (so far) shown itself to be
incapable of fostering the qualitative development of financial markets, which of course
raises the question of what kind of financial sector policy would be capable of accomplishing
this task.

In summary, it is fair to say that, in so far as the direction of future theoretical research is
concerned, two conclusions may be drawn from an examination of the connection between
financial markets and economic development which have been observed in East Asia. First,
the links between macroeconomic, monetary factors and the financial markets are even
closer than is suggested by an assessment which combines the insights and approaches of
NDF and the new theory of finance. Second, it is apparent that, despite the great strides that
have been made in relevant areas of economic theory, it is still very difficult to say with any
certainty ”how and why specific financial markets arise and develop, and whether their
development follows some sort of standard sequence.”87 Thus, it comes as no surprise that
we find it even more difficult to determine whether economic policy is able to promote the
development of financial markets, and if so, how. Therefore, shedding more light on this
crucial area, e.g. through analysis of the historical process by which financial markets in the
western industrialised countries developed,88 may be regarded as a second urgent task for
macroeconomic theory and the theory of finance which is suggested not only by the results
of the theoretical survey presented here but also by recent developments in the East Asian
financial markets.

86
See, for example, the discussions of this point in Fry, M.J. (1995), pp. 45ff. and M. Diehl and R.
Schweikert (1998), pp. 29ff.
87
Pagano, M. (1993), p. 621.
88
See, for example, Caprio, G. and D. Vittas (1997).
 30

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