Bernanke answers my problem finally

I have often wondered and asked this question elsewhere as well (here and here) that why finance has not been given its due in discussion on growth and development.

I had read number of papers on the subject which said why finance is important for growth and number of ways it helps but none which said why finance has been ignored after all in growth literature.

Bernanke in his latest speech answers the same in his usual simple yet profound style:

Economists have not always fully appreciated the importance of a healthy financial system for economic growth or the role of financial conditions in short-term economic dynamics.  As a matter of intellectual history, the reason is not difficult to understand. 

During the first few decades after World War II, economic theorists emphasized the development of general equilibrium models of the economy with complete markets; that is, in their analyses, economists generally abstracted from market “frictions” such as imperfect information or transaction costs.  But without such frictions, financial markets have little reason to exist.  For example, with complete markets (and if we ignore taxes), we know that whether a corporation finances itself by debt or equity is irrelevant (the Modigliani-Miller theorem).

Then how did all of it begin?

The blossoming of work on asymmetric information and principal-agent theory, led by Nobel laureates Joseph Stiglitz and George Akerlof and with contributions from many other researchers, gave economists the tools to think about the central role of financial markets in the real economy.  For example, the classic 1976 paper by Michael Jensen and William Meckling showed that, in a world of imperfect information and principal-agent problems, the capital structure of the firm could be used as a tool by shareholders to better align the incentives of managers with the shareholders’ interests.  Thus was born a powerful and fruitful rejoinder to the Modigliani-Miller neutrality result and, more broadly, a perspective on capital structure that has had enduring influence.

Hmm, so the assumption of perfect markets was the main reason why finance was never considered important.  A great thought. Thanks a ton Ben. Your team at Fed is superb at speeches and educating people like us. Read this for how finance helps:

Economic growth and prosperity are created primarily by what economists call “real” factors–the productivity of the workforce, the quantity and quality of the capital stock, the availability of land and natural resources, the state of technical knowledge, and the creativity and skills of entrepreneurs and managers.  But extensive practical experience as well as much formal research highlights the crucial supporting role that financial factors play in the economy.  An entrepreneur with a great new idea for building a better mousetrap typically must tap financial capital, perhaps from a bank or a venture capitalist, to transform that idea into a profitable commercial enterprise. To expand and modernize their plants and increase their staffs, most firms must turn to financial markets or to financial institutions to secure this essential input.  Families rely on the financial markets to obtain mortgages or to help finance their children’s educations.  In short, healthy financial conditions help a modern economy realize its full potential.  For this reason, one of the critical priorities of developing economies is establishing a modern, well-functioning financial system.  

The speech is a super-one and helps one understand/revise his concepts of finance. He further says he looked at two channels in 1983 by which the financial problems of the 1930s may have worsened the Great Depression:  

The first channel worked through the banking system.  By developing expertise in gathering relevant information, as well as by maintaining ongoing relationships with customers, banks and similar intermediaries develop “informational capital.”  The widespread banking panics of the 1930s caused many banks to shut their doors; facing the risk of runs by depositors, even those who remained open were forced to constrain lending to keep their balance sheets as liquid as possible.  Banks were thus prevented from making use of their informational capital in normal lending activities.  The resulting reduction in the availability of bank credit inhibited consumer spending and capital investment, worsening the contraction.

The second channel through which financial crises affected the real economy in the 1930s operated through the creditworthiness of borrowers.  In general, the availability of collateral facilitates credit extension…… However, in the 1930s, declining output and falling prices (which increased real debt burdens) led to widespread financial distress among borrowers, lessening their capacity to pledge collateral or to otherwise retain significant equity interests in their proposed investments.  Borrowers’ cash flows and liquidity were also impaired, which likewise increased the risks to lenders.  Overall, the decline in the financial health of potential borrowers during the Depression decade further impeded the efficient allocation of credit……

He goes on to explain the concept of external finance premium, Financial Accelerator, Monetary Policy and credit channel, all very useful concepts. Must read for a finance professional (those with non-finance background can go through it as well).

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One Response to “Bernanke answers my problem finally”

  1. A short note on Finance and Growth « Mostly Economics Says:

    […] of my favorite topics- How finance leads to growth. I have posted many a times on the subject ( see this for […]

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