Role of Financial Intermediaries

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The importance of financial intermediation in economic growth was disregarded by Nineteenth Century Classical Economists until Bagehot. Bagehot provided examples of how advancements in the English money market could result in capital moving throughout the country to find the highest return rate. However, there was an inadequate analysis of Bagehot’s work. It was Schumpeter who emphasized the significance of financial intermediation in economic development. Interestingly, the literature on economic growth after World War II completely ignored the role played by financial intermediation.

The Solow-Swan model of development and growth did not consider the significance of financial intermediation. Economies were typically seen as adequately represented by a model involving the production of one good (such as corn). However, the Latin American financial crisis in the early 1980s forced economists to recognize the importance of financial intermediaries. In this study, I examine why financial intermediation is crucial within Schumpeter’s theories. Banks and other financial intermediaries have a significant impact on the economy, as demonstrated during banking crises.

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Latin America provides a productive testing ground. Financial intermediaries can contribute to growth by analyzing new growth theory, which is based on Arrow-Romer’s work. Schumpeter’s writings also contain elements of these models. However, the ongoing debate about the role of financial intermediation in determining growth rate overlooks Schumpeter’s main point. In the past, Nineteenth Century classical economists recognized the significance of financial intermediation in facilitating economic growth.

According to Bagehot’s (1873) explicit examples, money market developments in England can cause capital to flow throughout the country in search of the highest rate of return. Political economists claim that capital naturally gravitates towards the most lucrative trades, quickly abandoning less profitable and non-paying trades. However, in typical countries, this process is gradual, leading some individuals to doubt its existence due to the lack of observable evidence for abstract truths.

In England, the bill brokers and bankers display a visible process through their bill cases. These bill cases are typically filled with bills from highly profitable trades while lacking bills from less profitable ones. If the iron trade becomes less profitable, fewer iron sales occur. Consequently, the number of iron bills in Lombard Street decreases.

The passage states that when the corn trade becomes profitable due to a bad harvest, “corn bills” are created and discounted in Lombard Street. This allows English capital to flow to where it is most needed and can be most profitable, similar to how water finds its level. Bagehot further explains that the lending of “loanable capital” caused the rise of prices and was meant to enable economic growth.

According to Bagehot (1873), banks would retain their loanable capital without using it until trade prospered. At that point, they would lend it out to stimulate further economic activity. This lending process would result in additional advancements and the borrowing of more loanable capital, thereby fueling a secondary development of trade that occurred repeatedly in society.

However, classical economists did not place significant emphasis on these evident links between finance and economic growth in their thought process. It was only with the recognition by Schumpeter (1911) that the significance of financial intermediation for economic development was acknowledged.

Although Schumpeter’s Theorie der Wirtschaftlichen Entwicklung was written in 1911, it was not published in English as The Theory of Economic Development until 1934. Despite the German edition being released before World War I, economists who spoke English, such as Keynes (who lived during the same period as Schumpeter), ignored it because of language barriers and the ongoing war. When the English translation became available later on, both England and the United States – which were the main intellectual hubs in the Western World – were experiencing the most severe depression of that century.

The contributions of businessmen to economic growth were not celebrated by politicians and economists, influenced indirectly by Keynes’ influential General Theory published in 1936. However, economists in the 1950s showed renewed interest in studying theories of economic growth. Robert Solow (1956) and T. Swan (1956) developed the Solow-Swan model, a model of economic growth that did not include financial intermediation. It was commonly assumed that economies could be effectively approximated by a one good (corn producing corn) model for practical purposes.

The previous growth model only had two components in production: capital and labor. However, the concept of capital only referred to physical capital, ignoring the roles of financial capital and human capital. Economists soon realized that the Solow-Swan model was inadequate in explaining certain aspects of economic growth, such as the presence of “Solow Residuals”. In 1962, Arrow pointed out that increases in per capita income could not be solely attributed to increases in the capital-labor ratio. It took another 25 years for Arrow’s suggestion to incorporate knowledge into the model to be adopted in Romer’s “new growth theory” in 1986. Then, it wasn’t until another 25 years later that economists began considering models involving financial activities and taking the Solow Residuals seriously. In 1982, a severe financial crisis occurred in Mexico which shook global financial markets and resulted in international loan defaults.

During the 1980s, financial crises hit various Latin American countries, causing a ten-year period of economic stagnation. These nations had experienced impressive annual growth rates of over 6% from 1960 to 1980. However, between 1981 and 1990, their growth rate drastically plummeted to just 1.3% per year. This decline has been dubbed “the lost decade” by economists in Latin America due to its significant impact, demonstrating that a financial crisis can trigger a widespread economic depression akin to the Great Depression.

The policy in numerous countries experienced a change towards the reformation and deregulation of financial institutions. The recognition of the role of financial intermediaries by economists only occurred after the Latin American international financial crisis during the early 1980s. Following Schumpeter’s tradition, I delve into the importance and necessity of financial intermediation. Banks and other financial intermediaries play crucial roles in contributing to the economy, as demonstrated through an examination of how banking crises affect it.

Latin America presents a fertile opportunity for studying how financial intermediaries can contribute to growth by examining the models of new growth theory in the tradition of Arrow-Romer. Schumpeter’s writings also incorporate elements of these models, as he was the first to illustrate the importance of financial transactions in economic growth, using bankers as an example. Rather than referring to economic growth, Schumpeter referred to it as development.

According to Schumpeter (1934, p. 78), the banker plays a vital role in facilitating new combinations and acts as a mediator between those who want to form these combinations and those who own productive means. The banker’s role is essential for driving development and is especially effective in the absence of a central authority overseeing societal processes. By authorizing the formation of new combinations on behalf of society, the banker significantly influences the exchange economy. It has only been in the past decade that Schumpeter’s perspective on how banking, finance, economic development, and growth are interconnected has gained recognition.

This paragraph provides an overview of the literature on Schumpeter’s vision, discussing both its strengths and weaknesses. Schumpeter expanded on his ideas in later writings, particularly regarding business cycles. In one specific writing, he emphasized the significance of comprehending the link between credit creation by banks and innovation within the capitalist engine (Schumpeter, 1939, p. 111). Some argue that financial intermediation becomes redundant in a perfect competition scenario where all traders are price takers with no private information.

The Solow-Swan growth model usually does not consider financial markets, but when market frictions are included, the importance of financial intermediaries becomes apparent. These intermediaries are essential in reducing technological friction and informational asymmetry between investors and firms. By collecting savings from investors and transforming them into stocks and bonds, financial institutions help firms invest in physical assets. So, why can’t investors directly engage in this process?

Financial intermediaries, also known as financial institutions, play a crucial role in reducing the costs related to searching, collecting, and processing information for investors. This role is commonly referred to as the screening function of financial intermediaries. Moreover, these intermediaries facilitate the involvement of small individual savers in large investment projects by pooling funds. Typically, individual investors lack the necessary resources to benefit from undividable large projects individually. However, through the pooling mechanism provided by financial intermediaries, small investors can access such opportunities. Additionally, this pooling mechanism becomes particularly significant when there is an information discrepancy between the small investor and the firm.

Financial intermediaries aid in the diversification of risk for small investors by allowing them to pool risks associated with large and risky investment projects. This enables small investors to form portfolios of such investments, which in turn helps protect them from high levels of risk. By accessing this avenue without bearing excessive risk, small investors are able to participate in long-term investment projects.

Financial intermediation, known as liquidity management, bridges the temporal gap between small investors who prefer short-term investments and the long-term projects that offer higher returns. This process allows ordinary investors to access the benefits of large-scale investment projects through financial intermediaries. Consequently, financial intermediaries aid in the efficient allocation of resources by enabling small-scale investors to participate in long-term investments.

They achieve this through screening, fund pooling, risk-pooling, and financial intermediation. However, problems can arise due to incentive conflicts between savers and firms. Furthermore, firms may have motives to withhold certain information. Since firms have different levels of risk, savers may struggle to differentiate between high and low-risk firms. Financial intermediaries assist in this process and also help monitor firm activities, which can be expensive.

Financial intermediaries can carry out investments on behalf of small investors, who are typically too small to do it individually. These challenges are commonly known as adverse selection and moral hazard issues. In the context of modern growth theory, Becsi and Wang (1997) eloquently explain the connection between finance and economic growth. They state that financial intermediation improves investment efficiency by identifying and directing resources towards high-return projects, as well as enforcing discipline within corporations.

Financial intermediation plays a crucial role in enhancing growth by facilitating innovation and knowledge creation. The level of financial efficiency determines the extent to which countries can benefit from growth. This efficiency depends on the realization of financial economies of scale and the development and innovation within the financial sector. The size of the financial sector can be used as a measure of financial development, as it reflects the extent to which activities transform investment quality.

Moreover, the growth model with financial intermediation highlights the relationship between financial development and efficiency, as evidenced by a decrease in loan-deposit rate spreads. Additionally, the growth model suggests that real interest rates positively impact growth rates while loan spreads have a negative correlation. Furthermore, research has indicated that government intervention can significantly influence the efficiency of financial intermediaries and economic growth, thus affecting these correlations. These findings have spurred modern applications that aim to capture various facets of the interconnectedness between finance and economic growth. (p. 5657)

In economics, there are often connections between economic variables. Establishing these connections through statistics is one thing, but understanding causation is another matter entirely. This is the essence of the ongoing debate surrounding how financial factors impact economic development. Early empirical research by Cameron (1961) and Gershchekron (1962) found that economic development in France was linked to the Credit Mobilier. However, it wasn’t until Goldsmith (1969) published his book that this link was explored across multiple countries simultaneously. Goldsmith analyzed data from 35 countries to further investigate this relationship.

The study by Goldsmith examines the relationship between financial intermediation and economic growth in 67 countries from 1860 to 1963. It reveals a positive correlation between economic growth and financial development over decades. To measure financial development, Goldsmith used the ratio of financial intermediation (total assets of all financial intermediaries divided by GDP for that year). However, Goldsmith’s study has three drawbacks, namely: (1) financial intermediation is not solely carried out by firms, but also by households and governments.

Goldsmith’s discovery suggests that the effect may have originated from other sectors, indicating a possible causation problem. The question of whether financial development leads to economic development or vice versa remains unanswered in Goldsmith’s analysis. In fact, Goldsmith himself doubted if this question could ever be definitively answered. Economic theory suggests that factors like saving propensity, human capital improvement, population growth rate, fiscal and monetary policy, and the rule of law all potentially contribute to GDP growth. Therefore, while Goldsmith’s contribution is significant, it is not comprehensive.

Further investigations were conducted in the tradition of Goldsmith (see Shaw, 1973 and McKinnon, 1973) with some improvements made in the methods employed. However, these investigations did not utilize any advanced econometric techniques, despite the availability and application of such techniques in testing causality elsewhere (see Sims, 1972). Between 1973 and 1993, investigations along this line decreased significantly. For instance, a search using the keywords “financial” and “economic development” yielded only five articles between 1969 and 1980 (from ECONLIT). From 1981 to 1990, ECONLIT listed 144 published articles on the topic.

In the tradition of Goldsmith, Greenwood and Jovanovic (1990) previously published theoretical work. However, it was the availability of large macroeconomic datasets that led to a recent wave of evidence. This prompted King and Levine (1993a, 1993b) to conduct a pioneering empirical study. They utilized four measures to analyze the operations of the financial system:

  1. Liquid liability of the financial system as a percentage of GDP.
  2. Quantity of credit provided to private enterprises.
  3. Share of credit provided by banks.
  4. Share of total credit allocated to private non-financial firms.

The initial two measures examined the extent of financial activities in the economy, while the final two measures appraised the caliber of these activities. Additionally, three indicators were employed to gauge economic growth: (1) the rate at which GDP per capita grows, (2) the rate at which capital stock per capita grows, and (3) the rate at which total factor productivity grows. These indicators were aggregated across countries and time periods to determine averages. Fundamental correlations were calculated by taking into account potential leads and lags to accommodate for non-synchronous links between economic growth and financial development.

In their conclusion, it is stated that financial services contribute to economic growth by increasing capital accumulation and improving capital efficiency (1993b, p. 735). The initial criticism of this finding arose after the publication of King and Levine’s papers. Fernandez and Galetovic (1994) conducted a study demonstrating that the correlations found in King and Levine’s sample are no longer significant for OECD countries when the sample is split between OECD and non-OECD countries. Additionally, Fernandez and Galetovic added more countries to their study and divided the sample into three groups based on per capita income at the beginning of the sample period.

The initial income decrease leads to larger and more significant correlations. DeGregorio and Guidotti (1992) discovered that the correlations become negative when only Latin American countries are included in the sample. It is well-known that banks in Latin America became active lenders in the 1970s. However, they lent more without prudence. As a result, the expansion of the banking sector concealed its true nature. The sector expanded and became more vulnerable and fragile. King and Levine’s considered variables do not account for this type of fragility. Critically, it is important to distinguish between finance predicting economic growth and determining it. King and Levine’s approach follows a post hoc ergo propter hoc approach (Sims, 1972). Further criticisms can still be made. One possibility is that both financial development and growth are influenced by a common unaccounted factor, such as the saving propensity of households in the economy.

The long-term growth rate in the economy is influenced by endogenous saving. As a result, the initial financial development and growth rate may be correlated due to this factor alone. The cross-country regression conducted by King and Levine is insufficient to disprove this argument. Furthermore, there is an issue of anticipation. Financial development, such as credit levels, may forecast economic growth because financial markets anticipate future economic outcomes. Consequently, financial development may primarily function as a leading indicator of economic growth, rather than its cause.

In order to understand the positive correlation identified by King and Levine, it is necessary to determine how financial development impacts economic growth and provide evidence for this relationship. Rajan and Zingales (1998) directly address both of these issues. They propose that the primary function of the financial sector is to facilitate the transfer of funds from individuals who have excess capital but limited investment opportunities to firms that have a shortage of funds relative to their investment opportunities. This suggests that financial development has two distinct effects.

In summary, financial development plays a role in reducing the transaction costs of saving and investing, thereby lowering the overall cost of capital in the economy. Additionally, financial markets and institutions help firms overcome issues of moral hazard and adverse selection, making external finance more cost-effective compared to internal funds like cashflows. Rajan and Zingales investigate whether financial development fosters economic growth by examining the relationship between financial development and reduced costs of external finance for firms.

The authors inquire if countries with more advanced financial markets experience a greater growth rate in industrial sectors that require more external financing. They discover evidence supporting this hypothesis across a diverse range of countries during the 1980s. The authors rule out the possibility that this finding is due to omitted variables, outliers, or reverse causality. La Porta et al. (1998) take an interesting approach and demonstrate that all markets worldwide derive their legal systems from four primary sources: English common law, German, French, or Scandinavian civil laws (excluding Islamic law).

In terms of GDP per capita, the legal system does not consistently differ. However, the legal system does have a significant impact on financial development. Through analyzing a sample of forty-nine countries, the authors demonstrate that countries with weaker investor protections, measured by the nature of legal regulations and the efficiency of law enforcement, possess smaller and more limited capital markets. This finding is applicable to both equity and debt markets. Specifically, countries following French civil law exhibit the weakest investor protections and the least advanced capital markets, especially when compared to common law countries.

According to the findings, it can now be contended that the order of financial development and economic growth can be established by arranging countries according to their legal system origin. The evidence supports this claim. The instrumental variable method, typically used in this field of research, seeks to eliminate simultaneity (as shown by Beck, Levine, and Loayza in 1999). Nevertheless, DeGregorio presents a contrasting perspective. He argues that inadequate attention has been given to the influence of international financial integration on fostering a strong domestic financial market and, consequently, driving economic growth.

Financial integration also enables portfolio diversification, leading to increased profitability of investments and, consequently, higher economic growth rates. The author’s study examines the empirical connections between financial integration and financial development, as well as between financial development and economic growth. Why does this wave fail to capture Schumpeter’s concept? Did Schumpeter envision these types of investigations when discussing the pivotal role of financial intermediaries?

The answer is negative. His concept of the financial intermediary did not involve someone who makes small adjustments. He viewed them as catalysts of transformation that introduce innovative production methods. Therefore, the vital role of a financial intermediary was expected to bring about profound changes by combining various activities. The present wave of research fails to embrace this essence as it frames the entire discussion within the context of a neoclassical growth model. References Bagehot, Walter. [1873] 1991. Lombard Street: A Description of the Money Market.

Philadelphia: Orion Editions. Beck, Thorsten, Levine, Ross and Loayza, Norman. 1999. Finance and Sources of Growth. Unpublished Working Paper. Becsi, Zsolt and Wang, Ping. 1997. “Financial Development and Growth.” Federal Reserve Bank of Atlanta Economic Review 82 (Fourth Quarter) 46-62. Cameron, R. 1961. France and Economic Development in Europe, Princeton University Press, Princeton, NJ. DeGregorio, Jose. 1999. Estudios de Economia, 26(2), December 1999, 137-61. DeGregorio, Jose and Guidotti, Pablo E. 1992. “Financial Development and Economic Growth. International Monetary Fund Working Paper No. 92-101. Fernandez, David G. and Galetovic, Alexander. 1994. “Schumpeter Might Be Right—But Why? Explaining the Relation between Finance, Development, and Growth.” Johns Hopkins University SAIS Working Paper in International Economics. Gerschenkron, A. 1963. Economic Backwardness in Historical Perspective. Harvard University Press. Goldsmith, Raymond. 1969. Financial Structure and Development. New Haven and London: Yale University Press. Goldsmith, Raymond. 1985. Comparative National Balance Sheets.

Chicago: University of Chicago Press. Greenwood, Jeremy and Jovanovic, Boyan. 1990. “Financial Development, Growth, and the Distribution of Income,” Journal of Political Economy, 98(5), Part 1, October 1990, p. 1076-1107. King, Robert G and Levine, Ross. 1992. “Financial Indicators and Growth in a Cross Section of Countries.” World Bank Working Paper No. 819. King, Robert G and Levine, Ross. 1993a. “Finance, Entrepreneurship, and Growth: Theory and Evidence.” Journal of Monetary Economics 32 (December): 513–42.

King, Robert G and Levine, Ross. 1993b. “Finance and Growth: Schumpeter Might Be Right. ” Quarterly Journal of Economics 108 (August): 716–37. La Porta, Rafael, Lopez de Silanes, Florencio, Shleifer Andrei and Vishny, Robert W. “Law and Finance,” Journal of Political Economy, December 1998, 106(6), 1113-1155. McKinnon, Richard I. Money and Capital in Economic Development. 1973. Washington, D. C. : Brookings Institution. Rajan, Raghuram and Zingales, Luigi. 1998. “Financial Dependence and Growth. ” American Economic Review. , 88, 1998, 559-586.

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