1. The Financial System, Business Cycles and Growth Joseph Stiglitz, Senior Vice President and Chief Economist The World Bank

2. Outline of the Talk Financial Markets Finance and Fluctuations Finance and Growth International Capital Flows

3. The Importance of Financial Markets Collecting and Aggregating Savings Brain of the Economy –Allocating capital –Monitoring Other Functions –Reducing risk –Increasing liquidity –Conveying information

4. Why The Financial Sector is Different Concerned with intertemporal trades with uncertain returns Importance of information In general, markets with incomplete information are not constrained Pareto efficient Government plays an important role in all successful financial systems

5. Equity Advantages: Risk sharing No costly bankruptcies Disadvantages: Adverse selection Moral hazard “Equity rationing” Forms of Finance

6. Short-term Bank Loans Advantages Effort incentives aligned Close monitoring by bank Disadvantages Different risk incentives Adverse selection Moral hazard “Credit rationing”

7. Forms of Finance Bonds They are in between equity and short-term bank debt.

8. Primary vs. Secondary Markets Benefits of Secondary Markets: Increasing liquidity Facilitating diversification Conveying some information Costs of Secondary Markets: Inefficient expenditures of effort in “private rent seeking”

9. Traditional Keynesian Macroeconomics M?  r?  I?  Y? Empirical Failures: Persistence and fluctuations Effects of supply shocks Differential sensitivity of sectors “Perverse” movements of inventories (exacerbated rather than smoother downturns) Variable effects of monetary policy

10. Theoretical Failures: Unconvincing microfoundations Two separate theories: Full employment (where neoclassical principles hold economic efficiency) Unemployment (massive inefficiencies associated with underutilization of resources) Basic Lesson: Cannot summarize impact of financial markets in a money demand equation Traditional Keynesian Macroeconomics

11. Key Ingredients of Finance-Based Model Equity Rationing Risk averse firm (incomplete futures markets). Implication Investment depends on: Equity net worth (lowers risk or bankruptcy, therefore more investment) Cash flow (reduces borrowing needs, therefore less risk of bankruptcy) In contrast, only the interest rate and productivity matter in the neoclassical model.

12. Implications of the Enhanced Investment Function Explains propagation and persistence. Changes to equity are long-lived, with long-lived consequences for investment. Explains importance of redistributive supply shocks. Explains why some sectors are so sensitive (more equity/credit rationed).

13. Banks and Credit Constraints Assumptions Banks are also risk averse Credit rationing is pervasive Bank debt is an imperfect substitute for other debt Banks and Credit Constraints

14. Implications Monetary policy works through a “credit channel” Theoretical basis for monetary channel questioned –Money bears interest –Most transactions are asset exchanges, not income generating –Money not required for most transactions Interest rate - output relationship will vary Can see large output movements with little movement in real interest rate

15. Average Growth in Selected Countries, 1976-1993 Average Growth Initial Conditions Stock Market Liquidity Financial Depth Calculations by Ross Levine, World Bank

16. Finance and Growth Cash flow, equity, and uncertainty affect: Research and development Learning by doing Investments in improved management. Therefore they affect long-term growth.

17. Mild Financial Restraint Can be good for growth: Increases firms’ net worth and thus their investment. Lowers interest rates, leading to safer mix of applicants, better risk profile, and thus safer banks. Improves franchise value of banks and thus leads to more prudential behavior. Basic lesson: Issue not whether there should be government regulation, but what form it should take.

18. Evidence on Capital Account Liberalization Increases risks No discernable benefits for growth or investment Short-term flows –Volatility –High costs of economic disruption –Cost of sterilization

19. Long-term Capital Flows to Developing Countries 1997 SOURCE: Global Development Finance 1998

20. 5 Economic Growth, Investment, and Capital Account Liberalization SOURCE: Dani Rodrik (1998). These are the residual growth and investment/GDP that are not explained by per-capita income, secondary education, quality of government institutions, and regional dummies for East Asia, Latin America and Caribbean, and Sub-Saharan Africa.

21. Fiscal Costs of Selected Banking Crises (percentage of GDP) Country (Date)Cost (percentage of GDP) Argentina (1980-82)55.3 Chile (1981-83)41.2 Uruguay (1981-84)31.2 Israel (1977-83)30.0 Cote d’Ivoire (1988-91)25.0 Senegal (1988-91)17.0 Spain (1977-85)16.8 Bulgaria (1990s)14.0 Mexico (1995)13.5 Hungary (1991-95)10.0 Finland (1991-93) 8.0 Sweden (1991) 6.4 Sri Lanka (1989-93) 5.0 Malaysia (1985-88) 4.7 Norway (1987-89) 4.0 United States (1984-91) 3.2 Source: Caprio and Klingebiel 1996.

22. GDP Growth Before and After Banking Crises, 1975-1994 Mean GDP growth (annual percent) SOURCE: Caprio 1997

23. Policies to Reduce Vulnerability to Capital Volatility Traditional policies: Good macroeconomic policy Sound financial regulation and oversight Transparency

24. Policies to affect composition of flows: Eliminate distortions favoring short-term Prudential regulations about exposure Better designed risk-based capital adequacy standards Possible Chilean-type restrictions Tax policy Policies to Reduce Vulnerability to Capital Volatility

25. Managing Crisis Expected Return=Promised Return x Probability of Repayment Additional considerations: Risk adjustment Insiders vs. outsiders Adverse selection and credit rationing General equilibrium credit crunch

26. Key parts of the strategy: Maintaining credit flows Not depleting net worth Preserving information and organizational capital Financial and Corporate Restructuring During A Crisis