Archive for the ‘State of the Art’ Category

Financial Sector and its growing excesses

August 22, 2008

While leading economists discuss about the future of financial regulation in Lindau, Germany (see this WSJ Blog post for various viewpoints), the concerns over financial sector excesses continue.

I had pointed earlier to a superb lecture on Inequality in US by Frank Levy where he said:

When we say that the top one percent of tax filers now receive something over 17 percent of all taxable income, it will not surprise you that a significant fraction of that top 1 percent comes from the financial sector.

I had covered the concerns from various angles financial innnovation, my views on modern finance and then this one on political economy of finance where I pointed to a comment from Liz Warren (Harvard Law Professor)

The consumer financial services industry has been the single biggest contributor in the 2000 election cycle, in the 2002 election cycle, and they’re on target to do it again in the 2004 election cycle. George W. Bush’s single biggest contributor to his [2000] presidential campaign was MBNA, the second biggest credit card issuer in the country.

And now I came across this superb lecture from Kemal Dervis, Administrator of the United Nations Development Programme. (I came to know about the lecture from this superb Dr Virmani presentation). The lecture is on developments in World Economy and Mr Dervis touches on financial sector as well.

It seems clear that the last two decades have been characterized by rapid and accelerating world growth, with the trend interrupted three times: around 1997, around 2001 and now again around 2008, although we do not know yet how serious this interruption will be. These recent interruptions are not associated with wars or periods of trade disintegration. Instead all three of them have been caused by financial sector difficulties of a more or less global nature.

The causes..irrational exuberance

In all three cases it was a certain “irrational exuberance” in the financial sector that led to the shock. The Asian crisis was caused by excessive private capital flows to the emerging markets with very open capital accounts and excessive appreciation of assets in or relating to these emerging markets.

The dot com crisis was caused by a similar type of exuberance, but this time focused on the new high-tech and start up enterprises linked to the information technology revolution, mostly in the United States. When the bubble burst the crash was quite severe in that sector.

In the ongoing crisis we have seen enough irrational exuberance (call it greed). What about the policy responses?

Moreover, as had been the case with the Asian crisis, there was a vigorous policy response in the form of greatly expansionary fiscal and monetary policies in the United States. The fiscal balance changed from a 2.4 percent of GDP surplus in 2000 to a smaller surplus of 1.3 percent in 2001 and deficit of 1.5 percent in 2002 and almost 3.5 percent in 2003 (US CBO 2008). The federal funds rate set by the US Federal Reserve was lowered from 6 percent in early January of 2001 to 3.75 percent in late  une of 2001 to 1.25 percent by November of 2002 and further to 1 percent by June of 2003.

It is important to note whereas Asian policies are always criticised, the developed world is no better. As I always say, in times of crisis all policymakers act in a similar way with monetary easing and fiscal stimulus. However, in developed we call this “prudent policies” and for others it is called “careless polices”. The latter are called careless as no lessons are learnt (moral hazard) …we don’t see any lessons learnt in former as well. Above all by cutting interest rates, they lead to huge inflows in emerging economies.

Back to finance

Over this period capitalism in the rich countries has increasingly changed its nature from one where the lead sector was manufacturing, to one where the role of traditional industries has declined, the share of services has increased and the financial sector is playing a leading role. Figure 4 presents a rather amazing picture. In the early 1980s the share of the financial sector in both, corporate value-added and profits in the American economy, was about 5 to 6 percent. The share of financials in value added has steadily increased and has reached about 8 percent in 2006-2007. The share of profits, however, climbed to reach an extraordinary 40 percent and more!

At the end of the day, the rate of return on financial assets on average and over the long term, must reflect the rate on return in the real economy. That rate of return can be higher than the growth rate, but it cannot be expected to be multiple times the real growth rate of GDP. If real growth in an economy is 3 percent, which is the maximum rate at which most analysts say potential output can grow in the most advanced economies, than it is simply not reasonable to insist on 12 or 15 percent profit rates.

Yeah 40%. So out of every $ 100 of profits, 40 go to the finance sector in US. He also suggests that financial sector is important but what we see is short termism in the financial transactions:

Many believe that this much increased role of the financial sector works in favour of greater efficiency, by forcing out lethargic managers, encouraging a relentless search for greater productivity and profits, and allowing a constant restructuring and adjustment that increases flexibility and innovation throughout the economy. All this may be quite true but the pre-eminence of the financial sector also imparts a greater amount of “short-termism” to the system with immediate profits a more important driver than long term considerations.

So what do we do? Regulation

To avoid this constant repetition of the same scenario, it would seem to be highly desirable to regulate and supervise the financial sector in such a way that incentives become more symmetric, so that losses also have serious personal financial consequences for those whose decisions cause them, and that rewards are tied to long term success, rather than quick short term gains. This requires a degree of intrusive public policy that is not necessary in other sectors and will be resisted.

Finally, a superb food for thought

The fact, however, is that the financial sector can never be a purely private affair. It is at the heart of the modern market economy and plays an organizing role that is a public good. Its failure affects the whole economy and all citizens. The public policy maker cannot let the financial sector fail in a systemic manner and has to, in one way or another, rescue it. It is important and fair, therefore, that it is regulated in a way that encourages responsibility, a longer term horizon and an evaluation of risk by its managers, that is not truncated by the unavoidable need for the socialization of large losses.

Great speech, with lots of insights. Highly recommended.

More on Capital Flows and growth

May 28, 2007

I had posted earlier on this topic here and here. The last one was a summary of an excellent survey (which is a summary of the empirical work done so far) which showed capital flows do not help in growth as theory suggests. It also showed that equity flows are better than debt flows.

I came across this another State of the art paper by Eswar Prasad, Raghuram Rajan and Arvind Subramanian titled Foreign Capital and Economic Growth. It has looked at some very interesting arguments:

“Developing countries that have relied more on foreign finance have not grown faster in the long run, and have typically grown more slowly. By contrast, we find that among industrial countries, those that rely more on foreign finance do appear to grow faster.”


First, the positive correlation between current account balances and growth is stronger among less financially developed countries

. In these countries, the range of profitable investment opportunities, as well as private consumption, for those that experience growth episodes, may be constrained by financial sector impediments, so investment can be financed largely through domestically generated savings.

Second,a developing country may actively choose not to absorb too much foreign capital in order to avoid exchange rate overvaluation. In turn, this ensures that the country’s manufacturing/tradable goods sector is competitive, thus allowing it to play its customary important role in fostering growth.

The paper is different as it mentions the role of financial system in absorbing capital flows which has been missing in previous papers (as finance has never been really thought as important in most previous work on economics). This paper attempts at correcting that biased viewpoint.

Further the paper adds:

The apparent perversity of overall foreign financing is even more dramatic when one examines the allocation of capital across developing countries……within this group capital should flow in greater amounts to countries that have grown the fastest, that is, countries that are likely to have the best investment opportunities. Does it?

Their research shows that it doesn’t infact capital flows mostly to medium and low growth developing countries!! Another puzzle is that when we look at FDI it does flow to top performing developing countries.

It is an excellent analysis once again from the team. However, the paper is a bit confusing as somehow the flow is not as clear-cut as it is in most Rajan papers. Perhaps it is missing Zingales (Rajan’s co-author in most papers) factor.

Summary of all papers I have read so far including this one: There is no relationship between openness of an economy to economic growth.  

Do Capital flows help?

May 22, 2007

I happened to read another excellent survey last week. This time it was on Financial Globalization and it covers all the studies that have been done so far to understand whether capital flows have resulted in economic growth. I had posted on the same topic earlier as well.

It has been done by a very influential team of Economists – Ken Rogoff, Eswar Prasad etc and is aptly titled Financial Globalization: A reappraisal This paper is interesting in many aspects:

1. Effects on Growth: It says the evidence so far has been mixed as some papers have used de jure (as per the law) measures of financial openness and some have used de facto (as per practice) measures. Here is a summary:

“By both measures, advanced economies have become substantially integrated into global financial markets. For emerging market economies, average de jure openness has not changed much based on the IMF measure, but de facto integration has increased sharply over the last two decades. For other developing economies, de jure openness on average rose sharply over the last decade, to a level higher than that for emerging market economies, but the de facto measure has stayed flat over this period.

Further, the paper has a very interesting table which summarises most of the research on the subject so far and just a rough counting tells me out of 26 cited studies 18 show mixed evidence.

2. Effects on Volatility: The paper suggests more research in this area and says “there is little empirical evidence to support the view that capital account liberalization by itself increases vulnerability to crises. Indeed, the literature on the effects of financial integration on volatility (and crises) is much sparser than the literature on its growth effects. Further research is warranted in this area.”

3.Composition of Capital Flows: This is the most interesting part of the paper. The basic idea is that it is not right to dump all kinds of flows (i.e. equity vs debt, Portfolio investment vs FDI) as one and analyse the impact. Here are some major findings:

a) Impact of FDI on growth: The usual belief is that FDI is beneficial for growth as it has a positive impact on productivity through transfers of technology and managerial expertise. It has also been argued that FDI is less volatile than other inflows, making countries less vulnerable to sudden stops or reversals of these flows.

But empirical evidence does not show the effect. Out of 11 studies in the paper 10 show mixed effect where FDI alone could not be held responsible for growth.

Even empirical evidence on horizontal spillovers ( i.e. from a foreign company to another company in the same sector) is inconclusive, however, in case of vertical spillovers ( i.e. from the foreign company to its suppliers etc) we have some positive evidence.

 b) Impact of Portfolio Equity flows on growth: Most papers cited show that evidence is positive i.e. equity flows lead to growth.

c) Impact of Debt flows on growth: Well, this is an interesting finding. The paper says that debt flows are the riskier variety-

The procyclical and highly volatile nature of these flows, especially short-term bank loans, can magnify the adverse impact of negative shocks on economic growth. Debt flows lack the positive attributes of equity-like flows. They do not solve certain agency problems, can lead to inefficient capital allocation if domestic banks are poorly supervised, and generate moral hazard as debt is implicitly guaranteed by the government (in the case of corporate debt) and/or international financial institutions (both corporate and sovereign debt).The empirical literature on financial globalization is decisive that debt flows generate the greatest risks from financial openness. In particular, there is a systematic empirical link between exposure to short-term debt and the likelihood (and severity) of financial crises.”

This also explains why RBI has put a cap on the amount Foreign investors can invest in government and corporate bonds. To argue whether the limit should be increased is another issue,

4. The paper further discusses a new framework to understand the impact of capital flows.


“A key component of our argument is that it is not just the capital inflows themselves, but what comes along with the capital inflows, that drives the benefits of financial globalization for developing countries.

The paper says that there are many indirect benefits of financial integration which they call “collateral benefits” –development of the domestic financial sector, improvements in institutions, better macroeconomic policies etc. These collateral benefits then result in higher growth, usually through gains in allocative efficiency.

Overall, it is an excellent summary of the work done on the subject so far. A Must read!