Archive for January 30th, 2009

Financial development in transition economies

January 30, 2009

In 1990s, there were many economies that moved over from state run economies to private sector driven economies. These economies were called Transition economies.

I came across this interesting paper from Eric Berglof and Partick Bolton. It looks at financial development in these economies and whether it helped them move to a market driven system. They call the transition as the Great Divide and ask whether financial development helped?

Perhaps the main lesson of the past decade of financial transition is the importance of fiscal and monetary discipline at the critical point when the Great Divide opens up. It appears to have been a necessary condition for a successful financial transition. Without fiscal discipline, private investment is crowded out or discouraged by the looming threat of macroinstability. Lack of fiscal discipline has also been a symptom of other ills, like a lack of commitment to close down loss-making firms, poor enforcement of property rights and low tax compliance.

Countries on the wrong side of the divide have been caught in a vicious circle of macro instability and repeated relapses in financial development. Financial development in these countries at best has had little effect on economic growth, and may even have been counterproductive, by making it easier for firms to receive credit and thereby reducing their incentive to undertake needed restructuring.

In the countries that have crossed the Great Divide financial architecture appears to have converged to a bank-based system with substantial foreign ownership. On the positive side, the financial sector in these countries has contributed to the hardening of budget constraints. However, banks have not yet begun extending significant long-term finance nor have they actively promoted restructuring in the industrial sector.

So what is the way forward?

There is a basic complementarity between the macroeconomic notion of fiscal and monetary responsibility and the microeconomic foundations of sound financial institutions, protection of property rights and tax compliance. Writing new laws or transferring them more or less wholesale from abroad is a relatively easy task. Enforcement and the creation of functional institutions is much more difficult. Sound government finances create favorable conditions not only for financial development but also for proper enforcement of the law.

This transfer of foreign code for doing things right was quite fashonable that time. But it did not work. What is also interesting to see is that we need a full list of reforms and right real economy to get financial system working.

How about other recent papers? What do they say? I came across a recent IMF paper which says the story differently- financial development only helps those economies where there are proper institutions in place .

After conducting tests based on alternative empirical approaches and undertaking extensive robustness tests, we conclude that the beneficial effects of reforms on financial deepening have materialized only where the institutional environment was sufficiently favorable. More specifically, the key binding institutional dimension seems to have been the extent to which political institutions protect citizens from expropriation from the state or powerful elites.  We do not find much evidence that other institutional dimensions, such as contractual rights, or features of the macroeconomic environment, such as fiscal prudence played such a pivotal role in shaping the impact of banking sector reforms.

Actually there is a lot of literature on the subject whether financial development leads to growth. One can check Ross Levine’s monumental paper on the same.

What ends recessions? Monetary or fiscal policy?

January 30, 2009

I read this long time pending paperfrom Romer Duo:

This paper analyzes the contributions of monetary and fiscal policy to postwar economic recoveries. We find that the Federal Reserve typically responds to downturns with prompt and large reductions in interest rates. Discretionary fiscal policy, in contrast, rarely reacts before the trough in economic activity, and even then the responses are usually small. Simulations using multipliers from both simple regressions and a large macroeconomic model show that the interest rate falls account for nearly all of the above-average growth that occurs early in recoveries. Our estimates also indicate that on several occasions expansionary policies have contributed substantially to above-normal growth outside of recoveries. Finally, the results suggest that the persistence of aggregate output movements is largely the result of the extreme persistence of the contribution of policy changes. 

I don’t have a free version of the paper (NBER papers are not free for all). In all the paper says monetary stimulus alone is enough to get economies out of recession. Moreover, automatic fiscal policy works better than discretionary fiscal policy. But as the Chief economist for President Obama she is doing the opposite- discretionary fiscal stimulus.

If I add this paper to her Great Depression paper which says monetary policy alone was enough to cure depression, it seems monetary policy has an advantage compared to fiscal policy.

All this brings me back to the point I made earlier- Christina Romer says monetary policy works in research but believes fiscal policy can do the trick in this crisis. But why should this be? What is so different about this crisis that discretionary fiscal stimulus seems to be the answer?

Dissecting the credit crunch in India

January 30, 2009

The media is rife with reports on credit crunch in India. There are assertions from industry that banks are not lending, rates are high etc but banks (esp public sector banks) say they are lending and the main problem is finding right projects.

I was just looking at the recent Monetary policy statement from RBI and it gives some interesting statistics on credit markets in India.


Assorted Links

January 30, 2009

1. MR points if US buys toxic assets it could cost USD 4 trillion

2. Krugman answers Fama back. This is actually getting painful

3. WSJ Blog points saving banks not enough, save others as well. It also summarises the fiscal stimulus debate

4. Mankiw points two more top econs join team Obama


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