Archive for May 8th, 2007

Financial Markets: If they are important, why don’t they develop?

May 8, 2007

Most of the research on financial markets focuses on capital structure, asset pricing, volatility etc. I used to like this research for some point of time but after understanding that most of the research depends on the time period taken to study and on some fancy model (which mostly doesn’t work when applied) my interests have moved onto something more basic which is financial systems. I have posted about some work on the subject here and here .

I came across this another superb paper from the deadly combo – Rajan and Zingales. It is titled The Great Reversals: The Politics of Financial Development in the 20th Century.

In their typical style they go on and give a very different theory of financial development. The paper is old and was written in 2001 but is very interesting and relevant. The abstract:

“We show that the development of the financial sector does not change monotonically over time. In particular, we find that by most measures, countries were more financially developed in 1913 than in 1980 and only recently have they surpassed their 1913 levels. This pattern is inconsistent with most recent theories of why cross-country differences in financial development do not track differences in economic development, since these theories are based upon time-invariant factors, such as a country’s legal origin. We propose instead an ‘interest group’ theory of financial development. Incumbents oppose financial development because it breeds competition. The theory predicts that incumbents’ opposition will be weaker when an economy allows both cross-border trade and capital flows. This theory can go some way in accounting for the cross-country differences and the time series variation of financial development.”

To understand why the paper is different, we need to understand the papers so far on financial development. The reason attributed initially to financial markets development was common law vs civil law. The countries having former were considered to have better financial systems as they offered better investor protection rights.

The paper which popularised this approach was developed by Shleifer et al and the model was popularly called LLSV (after the first alphabet of the 4 authors’ surname). The paper can be read here

R & Z offer a different explanation. Their idea is that in 1913 Fin Markets in France were more developed than in US. And France had a civil law system, then how come it had a better financial system? Also why it took so long to reach the 1913 levels?

R & Z say it is because people who are already well-off (established indsutrialists etc) do not want reforms as it would lead to competition and eroding of their market shares. Further they say:

“Incumbent interests are least able to co-ordinate to obstruct or reverse financial development when a country is open to both trade and capital flows. When a country is open to neither, they are likely to be able to coordinate to keep finance under heel. Matters are unlikely to be much better when a country is open only to capital flows or only to trade. In the former case, incumbent industrial interests may hold back financial development, fearful of the domestic competition that might be financed, while in the latter case, both industrial and financial incumbents may want to strengthen existing financial relationships to combat the foreign threat. Free access and transparency are likely to get short shrift at such times.”

Well the analysis offers a very realistic explanation of financial sector development. Most papers exclude politics while talking of development and moreso when talking of developments in finance but this paper includes it in a very interesting manner.

The paper clearly forms the basis of their book “Saving Capitalism from the Capitalists” .

The paper also forms the basis for their food for thought paper I reviewed in my previous post. In that paper the idea is different i.e. underdevelopment is due to initital factor endowments but approach is same that people may not be interested in development as it does not help them.

A must read for finance professionals.

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Assorted Links

May 8, 2007

1. Dani Rodrik posts another thought on why trade does not necessarily lead to growth (reduction in poverty etc). This time he goes a step further and presents available literature (read papers) done by him and others saying the benefits of trade are not as large as people as they are made out to be.

Rodrik then looks at one of the papers by Bradford, Grieco, and Hufbauer (subscription needed) that show trade is beneficial and says the models are not robust enough and more so have used wrong numbers which have been picked up from study. Sample this-

The paper also calculates benefits from regional trade agreement and for this it takes a formula from another paper as (exp(1.17)-1»)222%. But BGH use the figure as 118%.

On reading the comments on the pots I came across this fact:
(exp(1.17)-1) ~=222% but a simple misreading could result in
exp(1.17 – 1) ~=118% !!

So we have a classic problem of measurement here. Rodrik begins the article like this:

“Many many years ago when I was a recently minted assistant professor, I heard Gary Hufbauer tell an anecdote at a conference on international trade. A government economist is called in by his superior, who tells him “Look, I have to make a case for this policy in front of Congress, and I need a number real bad.” The economist responds, “well, I haven’t done a proper analysis, so I can give you a real bad number.” Perhaps it was a true story based on Gary’s own government experience. “

This clearly summarises the state of problems.

2. Buffet says index funds are better!

3. Jeremy Siegel’s view on stocks.

4. Josh Lerner’s view on Reverse LBOs

5. Much of the widening gap in incomes reflects the rising payoff for a college education and other skills. Becker and Murphy argue that it is beneficial and desirable.

I don’t really agree to the view point though. It may be ok for a developed/rich economy but may not be the same in a developing economy. As the article is on US, I would like to see how can emerging economies benefit, particularly India and China with huge populations.

6. Crony Capitalism is alive and kicking in India. On one hand we talk about MIFC and on the other we witness this

“Records investigated by The Sunday Express show that the Government has crammed at least 33 of the 37 positions for independent directors (called “non-official” directors, in banking parlance) with men and women known for their allegiance to the Congress party: at least five secretaries of the All India Congress Committee (AICC), a vice-president and a secretary of the All India Mahila Congress (AIMC) and the Sewa Dal — politicians who have lost elections or loyalists to whom the party wishes to dole out a favour. “

Read some reviews here and here

Thanks to Ajay Shah for 6, Finance Professor for 2, Greg Mankiw for 3 and Economist.com for 5.


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