Impact of financial systems on economic cycles

Every country has different financial system. Even if they have a market based system the degree of how much markets intermediate savings differ.

This summaryfrom IMF is an excellent one which explains how different financial systems efect various economic cycles. The shorter versionis also available. Basically it is a part of IMF’s World Economic Outlook where apart from the general outlok it discusses some important research findings.

This research focuses on developed economies and analyses whether a system is more at arms’ length or less. Arms length financial transaction means either it is between 2 unaffiliated parties or even if it is between 2 related parties (say between 2 subsidiaries) it is done in a manner as if they are unrelated (i.e. fair pricing etc). The opposite of it is relationship based fin system in which transactions are done on the basis of relationship. Rajan and Zingales have another excellent anslysis of the two kinds of systems.

The consensus is that most countries are and should move towards arms length fin systems as it is more transparent and thereby efficient. Hence the paper focuses on which advanced countries have more arms’ length systems or less and their impact on economy.

The broad ideas that emerge are:

1) Differences in financial systems among advanced economies affect the behavior of economic cycles.

2) Households in so-called “arm’s length” financial systems (including the United Kingdom and the United States) can borrow more to support consumption, but higher debt makes them more vulnerable to rising interest rates and declining asset prices.

3) The more “relationship-based” financial systems in Europe are less well equipped to transfer resources from declining to growing economic sectors,thereby hampering efforts to boost productivity and respond to technological change and globalization.

Nice study. Highly recommended.


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