By Rajendra Rampersaud
The current financial crisis in the US that quickly spread to other parts of the world has brought the debate on the polemics of financial liberalization to the fore. Improvements in information technology along with the removal of barriers to the free flow of capital across frontiers gave birth to a new paradigm known as financial globalization in the eighties. Financial globalization was packaged into a complete list of liberalization policies famously codified as the “Washington Consensus”. This was the policy prescription handed down by International Financial Institutions (IFI’s) and the rich donor countries (G7) as the panacea for the economic ills facing countries. Today, after more than three decades of financial liberalization the result has been less than satisfactory. Why did financial liberalization that held such promise turn out to be so disappointing is what the article investigates.
Financial liberalization came as a response to the Financial Repression model developed by the Mc Kinnon-Shaw thesis in the eighties. The main contention of this model is that government intervention in the financial sector such as a ceiling on interest rates, high reserve requirements and selected credit policies impacted negatively on savings. Since savings is the main source of investments it means that low savings would impact negatively on economic growth – thus the policy implication was clear liberalize the financial system to improve efficiency and growth.
If financial repression was the scapegoat for the economic ills facing countries that experimented with state intervention, then the list of policy follies implemented under the financial liberalization process in the last three decades should produce better result. However, today more than ever not only the skeptics but strong proponents of financial liberalization have come to agree that financial liberalization did not produce the desired results.
The strong link between financial development and economic growth was based on a groundbreaking study by King and Levine in 1992. Based on a sample of 80 countries they found that financial development was strongly linked to accelerated economic growth. Later studies by Levine, Loayca and Beck (2000) found that doubling the size of private credit is linked to a two percent growth in an economy. However, there are serious ideological and theoretical differences even among to proponents of financial liberalization on the approach to reform like the endogenous financial model.
Empirical evidence on the results of financial liberalization has been disappointing. There have been more than 14 studies on the nexus between financial liberalization and economic growth, eleven of those studies found a weak relationship while only one found some relationship. Perhaps the most striking was the study by Kose, Prasad, Rogoff and Wei (2006) four top economists of the IMF that carefully reviewed the literature and data but concluded that cross country evidence on the benefits of financial globalization was inconclusive and lacked robustness. Then the World Bank in a 2005 publication “Learning from a Decade of Reform” stated that contrary to expectations financial liberalization did not add much to growth and it appears to augment the number of crises –while access to financial services did not improve substantially after liberalization.
Financial liberalization has been one of the reasons for the financial crisis. This had been supported by studies by Kunt and Detrageache in 1998 & 2001 and Kaminsky and Reinhart – the twin crisis in 1999. Since the advent of financial globalization, the world has been rocked by a series of financial crises, namely the Mexican Peso crisis (1994), the Asian crisis (1997) followed by crises in the emerging economies of Russia, Brazil and some Eastern European and African countries in the late nineteen nineties. The new millennium began with a financial crisis in Argentina despite the World Bank (1998) ranking of Argentina second only to Singapore among emerging markets in terms of the quality of its regulatory environment. Moreover the recent financial crisis in the US considered the bastion of financial development has finally brought the chicken to roost.
The question is if financial liberalization promised so much of hope what went wrong. Both the proponents and opponents of financial globalization are back on the drawing table to answer this question. There is now more consensus that the long list of menu measures by the IFI’s and donors – the more the better – was catastrophic and did not tackle the constraints to economic growth in developing countries. Secondly, the inability of the supervisory, regulatory and the econometric models to predict much less to stop the financial crisis leaves much to be desired and left even former Federal Reserve Chairman Alan Greenspan wanting.
The limitation of financial liberalization was a subject of both theoretical and empirical analysis. It was pointed out that financial liberalization seemed to identify exogenous constraints like interest rates and the credit ceiling while largely ignoring endogenous constraints like imperfect information that contributed to greater distortion of the financial market. Asymmetric information in the financial system gives rise to moral hazard and adverse selection that had been the root cause of financial crisis.
Finally, I have absolutely no doubt that financial development is essential for economic growth. However, the means to that end rather than the end in itself is critical. Stiglitz, Hellmann and Murdock (2000) identified limitations in financial liberalization and questioned whether capital requirements are enough to prevent gambling and excessive risk taking by financial markets. They argued that capital requirements should be complemented with other instruments, to name one – risk-based deposit insurance premiums in an effort to increase franchise value and reduce the risk of gambling in the banking system.
In conclusion, I remain optimistic that with the outcome of the US election, President-elect Barack Obama will walk in the footstep of the greats like Franklin Roosevelt whose New Deal Policy put not only America but the world economy on a stronger footing after the great depression and that multilateralism will replace the failed unilateral approach practiced by the current US administration in finding solutions to global problems.
