Financial Globalization and Economic Growth - Literature Review with Comments

Seminal Works on Financial Structures and Liberalization

Theoretical discussion of how financial systems and financial liberalization affect economic growth started in the 1960s and 1970s with works by such authors as William Goldsmith,¹ Edward Shaw² and Ronald McKinnon.³ For William Goldsmith, the basic point was that financial structures are an integral aspect of market economies and so play a very important role in enabling higher growth rates: More developed financial systems foster faster economic growth.

Edward Shaw and Ronald McKinnon argued that financial liberalization’s impact on economic growth would be positive. They distinguished between financially repressed and financially liberalized economies and identified the difference as lying in deregulation, the removal of interest rates ceilings, the liberalization of both short and long-term capital flows, and the elimination of state interference in bank decision-making over which sectors to lend to and at what terms. They held that withdrawal of the state from interest rate regulation and the public ownership of banks and consequently higher interest rates on deposits would allow financial systems to attain higher savings levels. Higher savings would mean more investment and more efficient lending to higher-return sectors. From a macroeconomic perspective, they expected this to foster higher growth rates and more rational use of savings over the longer term.

© The Author(s) 2017

F. Causevic, A Study into Financial Globalization, Economic Growth and (Inequality, DOI 10.1007/978-3-319-51403-1_2

The proponents of financial liberalization also argued that removing obstacles to international capital flows, by opening-up their financial systems rapidly towards relatively capital-rich countries (with high levels of savings), would mean savings were deployed much more productively, as investing in countries with poorer access to capital and labour would yield higher returns, as well as making capital-poor developing countries more attractive to capital inflows. Financial liberalization would thus be a win-win game: The owners of capital in developed countries receive higher returns on capital abroad, while income from labour in the newly opened-up developing countries is rising, thanks to the improving capital/labour ratio and higher wages.⁴

The next major theoretical advance was due to Hyman Minsky, who developed his financial instability hypothesis in a number of publications through the 1970s and 1980s,⁵ arguing, against mainstream economics, that financial systems should not be considered a neutral sector in macroeconomic models. Far from just transferring savings to borrowers, managers of financial institutions have an autonomous incentive as managers to innovate in financial products and financial institutions. The financial sector is a creator of deposits thanks to its ability to create them through the banks’ core business - extending credit. In periods of take-off, expanding credit becomes an endogenous creator of new deposits. Innovation by financial institutions means speculative and Ponzi-style institutions play an ever-increasing role in the structure of highly developed economies, thanks particularly to the intensive use of financial leverage. This promotes both financial instability and the instability of the developed economies more generally. Contrary to standard equilibrium-based models of supply and demand for financial resources, developed economies therefore need Big Government because of their inherent tendency towards instability.⁶