Finance and Economic Growth, Remarks by First Deputy Managing Director John Lipsky
IMF News, October 19, 2009
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- Published: October 19, 2009
Context and Purpose
- Remarks delivered at the Bank of Mexico Conference, "Challenges and Strategies for Promoting Economic Growth", Mexico City, Mexico, October 19, 2009.
- Focus: longer-term issues for sustaining growth; the role of finance in economic growth and implications for financial regulation.
- IMF role highlighted: provide analytical support for the G20 mutual assessment process endorsed at the Pittsburgh Leaders’ Summit and the IMFC.
The Role of Finance in Growth: Intellectual Debate
- Historical shift in views:
- Early consensus treated finance as a second-order consideration; Solow’s 1956 growth model omitted financial variables.
- Gurley and Shaw’s work (1955 article; Money in a Theory of Finance) argued finance was essential to growth.
- McKinnon and Shaw (1973) emphasized financial system importance in promoting growth; Shaw authored Financial Deepening in Economic Development (1973).
- Key conceptual points:
- Focusing on savings-investment flows alone misses:
- Poorly designed incentives for financial institutions (including state ownership) can create inappropriate capital-output ratios and mute growth.
- Failure to develop effective securities markets leads to excessive reliance on traditional banking, systemic inefficiencies, and instability.
- Measurement and consensus limits:
- No clear consensus on precise measurement of financial development’s impact on growth.
- Broad agreement exists on the direction of regulatory reform, but uncertainty remains on the extent reforms will reduce systemic instability.
The 1990s, Financial Innovation, and the Backlash
- By the early 1990s, consensus moved toward seeing modern finance as growth-supportive; empirical research linked financial development (credit, broad money relative to GDP) to growth.
- Research strands noted:
- Rajan and Zingales on availability of "outside" finance influencing industrial development.
- Research on legal origins affecting financial development.
- Financial innovation trends:
- Growth of finance’s share in the US economy and acceleration of securitization and derivatives.
- Arguments for hedging strategies reducing capital cushions (Robert Merton).
- Crisis history and reassessment:
- Warning signs from Mexican crisis (1994-95), 1997-98 Asian crisis, and Long-Term Capital Management were not fully heeded.
- Post-2008-09 crisis: intellectual backlash but reaffirmation that markets are not perfectly self-regulating and require regulation.
Historical Evidence: The American Experience
- Reassessment finds a well-functioning financial sector crucial to early US development (Sylla; Rousseau).
- Key historical facts and figures preserved from the record:
- "Next year will mark the fiftieth anniversary of the publication of Jack Gurley and Ed Shaw’s path breaking monograph, Money in a Theory of Finance."
- US financial system evolution:
- "The US had only 3 state-chartered banks in 1789, but more than one hundred were chartered over the next two decades."
- Banking numbers: "more than 800 by 1840 and to1600 by 1860."
- By 1825, US banks had "nearly 2.5 times the amount of bank capital as their UK counterparts."
- Early openness and diversification: by 1803, more than half of all US securities were held by European investors; by 1825 the number of listed securities in several US cities was approaching that of England.
- Crises and regulatory evolution:
- Financial crises in the 19th and early 20th centuries led to improved regulations and market structures but progress was not steady.
- Theoretical advances grounded in history:
- Diamond and Dybvig (1983) on deposit insurance; Bernanke and Gertler (1989) on accelerators; Bernanke (1983) on non-monetary effects of financial crisis.
General Lessons from the Historical Record
- Three main lessons drawn:
- Financial development is critical for both growth and development; transitions from agrarian economies to sustained diversified growth typically require well-functioning financial intermediation.
- The presence of financial crises, even recurring ones, has not reversed the positive relationship between financial development and economic growth.
- Completely suppressing financial crises requires severe financial sector repression and autarkic policies, which carry clear costs to growth and development.
- Conclusion: core insights from Gurley, Shaw, and McKinnon remain valid fifty years on, though the scale of recent output losses raises questions about policy choices.
Implications for Emerging Markets
- Three reasons leading emerging markets remained confident in growth via open policies plus financial development:
- Structural improvements and better fiscal and monetary management bolstered resilience to external shocks.
- Many large emerging markets have not fully liberalized financial markets; lesson from late-1990s crises: strengthen domestic systems before full exposure to international markets. FSAPs aided this strengthening.
- Recognition of the costs of repressed financial systems based on historical experience.
- Expected trajectory:
- Emerging market authorities likely to adopt a cautious approach to further financial development, but not to return to financial repression.
- A more developed financial system—more complete markets plus strengthened regulation and supervision—is both likely and appropriate.
- The enhanced role of the G20 and the creation of the Financial Stability Board have brought major emerging market authorities into global regulatory and supervisory reform discussions.
Reassessing Mature Financial Systems and Regulatory Reform
- Crisis diagnosis:
- Not all large institutions pursued the risky strategies that fueled the crisis; failures were concentrated in those with flawed strategies and inadequate risk management.
- Poor regulation and/or inadequate supervision were inadequate to prevent some firms from endangering systemic stability.
- Two principal aspects of systemic reform:
- Normal market processes should allow better-managed firms to expand and displace weaker ones.
- Strengthen regulatory and supervisory standards and their application.
- Broad consensus on three key regulatory reform aspects:
- The perimeter of regulation must be redrawn to include all systemically important institutions.
- Regulation must include macroprudential aspects to reduce procyclicality.
- An agreed resolution mechanism is required for institutions with systemic importance and/or operating in multiple jurisdictions.
- On "too big to fail" and limiting institution size:
- Size alone does not determine systemic risk; relatively small but highly interconnected firms can cause major problems.
- No clear guide exists to the optimal size of banks and nonbank intermediaries; the IMF and FSB have begun developing a framework for analysis, but no precise determination is yet possible.
- Caution advised: precipitous action could invite unintended consequences.
- IMF and complementary initiatives:
- Early Warning Exercise (Fund and FSB) to alert authorities to potential risks and encourage contingency planning for tail risk scenarios.
- Review of IMF support facilities: Flexible Credit Line (FCL) and High Access Precautionary Arrangements (HAPA) as new tools for crisis prevention; analysis underway on additional insurance-like facilities.
- IMF asked to study whether financial sector taxation can be improved so that costs of risk mitigation are borne more directly by the sector (analogous to deposit insurance funding).
Concluding Remarks and Research Priorities
- A new global economic and financial system is evolving rapidly; issues addressed at the Pittsburgh Leaders Summit and IMF/World Bank Annual Meetings in Istanbul.
- Restatement: Gurley, Shaw, and McKinnon’s basic conclusion—that financial systems play a key role in economic development and growth—remains broadly accepted.
- Remaining intellectual challenges:
- Need renewed efforts to better understand the relation of financial sector development to strong, sustained and balanced growth.
- IMF Macro/Financial Studies Group in the Research Department is collaborating with the Monetary and Capital Markets Department and external partners; the conference is expected to spur further work.
Remarks by IMF First Deputy Managing Director John Lipsky, October 19, 2009.