Financial Globalization and Developed. Economies: Theory versus Facts
In the first chapter of their jointly edited book,5 which presents an analysis of the interdependencies between the development of financial structures and economic growth, Demirguc-Kunt and Levine introduce their text by referring to these basic conclusions from Goldsmith’s book from 1969. After a review of the topics dealt with in the book, the authors then draw a series of major conclusions. They point out that national financial systems become more complex and more developed as countries become richer. Their second conclusion is that the overall development of the financial system has a positive impact on economic growth, or rather that more-developed financial systems lead to accelerated economic growth, the formation of new firms, and easier access to financing. They stress the fact that data and research show that the efficiency of the legal system, its protection of investors, and the enforcement of contractual obligations are all of great importance for the development of financial systems. The third conclusion is that neither bank-based financial system nor market-based financial system (also called arm’s-length) are a priori superior, so that neither of these two systems offers an in-principle better guarantee of faster economic growth.6
In analysing the links between a given financial system’s degree of development and the rate of economic growth, it is particularly important to keep in mind their second and third conclusions, namely that the degree of development has a positive impact on economic growth, so that more- developed financial systems facilitate faster economic growth. This conclusion is particularly significant for the analysis presented in the preceding two chapters regarding the connections between economic growth and financial openness, as measured both by de jure and de facto measures. The results of our investigations into the relationships between financial openness and the rate ofeconomic growth suggest that the following developed countries were amongst the 50 fastest-growing economies in 1990-2000
(their ranking by growth rate is given in brackets): Ireland (5th), South Korea (7th), Singapore (17th), Israel (18th), Norway (33rd), Portugal (44th), and the Netherlands (47th). The following developed economies were also growing faster than the world average: Spain (53rd), Hong Kong (56th), Denmark (57th), Austria (62nd), the United States (63rd), Australia (65th), the United Kingdom (67th), Cyprus (69th), Belgium (72nd), Finland (74th), Canada (76th), Sweden (78th), Greece (80th), France (83rd), Germany (85th), Iceland (86th), Italy (87th), and New Zealand (90th). Altogether, a total of 172 countries, for which data for the period in question was available, were ranked.7
The financial systems of the five developed countries among the 50 fastest-growing economies (1990-2000) were predominantly bank-based. Of the 18 developed economies included amongst those from rank 50 to rank 90 and thus growing faster than the world average, the economies of the United States and the United Kingdom relied upon market-based financial systems, where capital and money markets played the main role in structuring the sources of financing for the real sector (as well as the costs of financing investment). A particular characteristic of that decade, however, was the positive correlation found in these 23 developed countries between the degree of financial liberalization, further deepening of financial markets (as against the level already attained), and the accelerated rate of economic growth. Consequently, one can confirm for that decade as Demirguc-Kunt and Levine’s basic findings about the causality of development of the financial system and accelerated economic growth.
The results of our analysis of rates of economic growth during the fourteen years to 2014 are suggestive of very different conclusions regarding the connections between the development and complexity of financial systems and their impact on the speed of economic growth. Thus, between 2000 and 2014, the 50 fastest-growing economies included only three developed economies, one of which is not even an independent state: Macao (3rd), Latvia (20th), and South Korea (50th). The only developed economies in next 50 fastest growing (51-100) were Hong Kong (61st) and Singapore (64th). During those fourteen years, only four more developed economies achieved rates of economic growth higher than the world average: Slovenia (107th), Australia (109th), Iceland (110th), and Israel (112th). We may distinguish two subgroups among the remaining developed economies:
• Developed economies with economic growth below world average GDP per capita growth (i.e. relatively falling behind), and
• Developed economies with not merely negative relative rates of growth (a fall in the growth coefficient) but absolute declines (lower GDP per capita in 2014 than in 2000).
The following countries belonged to the first subgroup: Sweden (115th), Germany (121st), New Zealand (122nd), the United Kingdom (125th), Canada (129th), Austria (131st), the United States (133rd), Ireland (134th), Finland (136th), Japan (138th), Switzerland (139th), Malta (140th), Belgium (141st), Norway (142nd), the Netherlands (145th), France (148th), Luxembourg (149th), Spain (152nd), and Denmark (157th). The second subgroup includes: Portugal (164th), Cyprus (165th), Greece (169th), and Italy (176th). The total number of countries included in the ranking for the period from 2000 to 2014, based on available data, was 184.8
In a paper published in 2004, Kiyotaki and Moore presented three groups of economies distinguished by degree of financial deepening.9 Their 0-ф model relies upon a 0 coefficient, which signifies the amount of money investors in the real sector will be willing in future to allocate to pay off liabilities used to finance current investment projects. The coefficient is directly positively correlated to institutional stability and the efficiency of the legal regime (respect for contracts) and is expressed in a value from 0 to 1. A rise in the value of the coefficient means greater potential for economic growth. The ф coefficient is also limited to a range between zero and one. The greater the value of ф the greater the liquidity of the financial market, and so the lower the costs of converting illiquid into liquid financial instruments, which in turn implies a greater degree of financial deepening.
Kiyotaki and Moore distinguish between three phases of financial development depending upon the value of these two coefficients. The first type of economic system is cash-based, with a low level of trust in institutions of the system and in the enforcement of contracts, so that securities issues do not represent a common form of savings ( ф is low). The second type is economies in which there is a high degree of trust in institutions and the legal order, so that the use of money market and capital market instruments, so-called red and blue papers, is both intensive and widespread. Actors in such economies are neither “liquidity constrained” nor “credit constrained”, but this does not necessarily mean that such economies have a higher level of output than those belonging to the next (third) level of financial development. Kiyotaki and Moore refer to this level as economies in which there is a high degree of trust in institutions and in the legal regime, but the cost of converting illiquid instruments into liquid ones is relatively high (ф is significantly less than unity), so that the degree of financial deepening is less than in the foregoing phase of the development of the economy and financial markets. The authors point out that economies in which both coefficients are close to unity and in which, consequently, the costs of converting illiquid to liquid financial assets are not particularly great, are not necessarily economies that are growing faster than those in which 0 is close to unity (institutionally stable economies with relatively stable legal regimes and high rates of economic growth), but where the cost of converting illiquid assets is high.10
This model is useful for understanding the problems that appeared between 2000 and 2008, when internationally active banks were sharply expanding their lending and transactions on derivative markets were expanding even more intensively. In the context of the Kiyotaki-Moore model, transactions on derivative markets (which the authors do not mention in their paper) should represent an additional channel or mechanism for increasing the facility of converting illiquid to liquid financial instruments. On the other hand, too high a value of 0, which, as already pointed out, represents trust in the institutions of the system, would be one of the key reasons for a lack of adequate controls and supervision of financial markets and of the dominant actors on them, of the sort that brought such major “social cost” to all of the developed countries. The potential for misusing financial derivatives for regulatory arbitrage offered by an environment of completely liberalized financial flows contributed to the steep expansion in speculative activities, used much less in the developed economies to finance investment projects, increase average productivity and promote sustainable growth than to insure the major internationally active financial groups against risk and increase their profits. Comparison of the volumes of developed and developing countries’ financial flows in both directions (assets and liabilities in the international investment position) has shown that almost all the developed countries saw their IIP to GDP ratio increase sharply, with falling or negative growth rates, during the last ten, but more particularly the last five years (except for Germany).
To illustrate more clearly the changes in economic power and the financial resources which finance economic growth, the following three graphs show measurements for relative changes in the economic status of the G-10 countries over three sub-periods: 2000-2005, 2005-2009,
Fig. 6.1 Relative economic performance of the G-10 countries: 2000-2005 percentage change in the value of the growth coefficient for the G-10 countries and the threshold percentage change in the value of Cg distinguishing between relative and absolute economic decline Source: Prepared by the author based on World Bank data.
and 2009-2014. These measurements are percentage changes in the growth coefficient for this group of countries, with the horizontal line on each of the three graphs representing the percentage fall in the Cg which marks the “threshold” between those countries experiencing a fall that signifies relative economic decline, as GDP per capita was growing more slowly than the world average, but still growing, and those countries which experienced not just a relative, but an absolute decline. Thus, the countries “below the red line” experienced an actual decline in GDP per capita as measured in constant US$ from 2005 and current prices.
During the first five years of this century, all the G-10 countries experienced economic growth, with GDP per capita (measured in constant US$ 2005) greater in 2005 than in 2000. Figure 6.1 shows that only two were growing at a rate above the world average, however, as indicated by the positive values for the percentage change in their Cg. The greatest “winner” in the group during these first five years was the United Kingdom, followed by Sweden. The other nine were growing at a rate slower than the world average. The declines in the Cg for the United States and Canada were 0.18% and 0.41%, respectively. In other words, their GDP per capita growth was just a bit lower than average
Fig. 6.2 Relative economic performance of the G-10 countries: 2005-2009 percentage change in the value of the growth coefficient for the G-10 countries and the threshold percentage change in the value of Cg distinguishing between relative and absolute economic decline Source: The author’s construction based on World Bank data.
world growth. On the other hand, the G-10 countries with greater relative declines and so falling behind world GDP per capita more significantly during this period included Germany, Italy, and the Netherlands. As we have noted, the horizontal line at the value of (-7.58%) marks the threshold value at which relative decline translates into absolute decline. As the figure shows, during the first five-year period none of these countries experienced the lag behind the world average required to put them in recession, i.e. a lower value of GDP per capita in 2005 than in 2000.
In contrast to these first five years, both the relative and absolute economic standing of the G-10 countries changed significantly over the next four. The threshold value of (-2.4%) for this period marks the difference between countries with a merely relative decline and those which have fallen behind in absolute terms. Figure 6.2 shows that only three members of the group attained rates of GDP per capita growth above the world average (which during this period was 2.58%): the Netherlands, Switzerland, and Germany. The only country in the group to see a reduction in the Cg that was nonetheless still less than the “the threshold decline” was Belgium (a fall of 1.58%). The other seven recorded declines of more than 2.4%, which meant their GDP per capita was lower in 2009 than it had been in 2005 (an absolute economic decline). The countries recording the greatest declines were Italy, Japan, the United States, and the United Kingdom.
Between 2009 and 2014, Germany and Japan were the only two countries from the group with GDP per capita growth faster than the world average rate. Germany’s relative rate of economic growth was 3%, while Japan’s Cg was up 0.18%. The marked expansionary monetary and fiscal policy pursued in the United States and the United Kingdom resulted in the absolute decline both countries faced in 2009 against 2005, which was however mitigated into a relative decline, with GDP per capita growth nonetheless lower than the world average. World average GDP per capita growth during this period was 8.2%.
Canada was also relatively successful in combating recession. In contrast to these countries, Italy and the Netherlands not only fell significantly behind in relative terms, but actually saw GDP per capita fall in 2014 compared to 2009 (Fig. 6.3).
To answer the question of how well the most-developed countries did in overcoming the crisis and in their counter-cyclical economic policies and what level of resources they spent to ensure GDP per capita was higher in 2014 than in 2009 and 2005 (the first year developing countries’ foreign currency reserves outstripped those of developed countries), one
Fig. 6.3 Relative economic performance of the G-10 countries: 2009-2014 percentage change in the value of the growth coefficient for the G-10 countries and the threshold percentage change in the value of Cg distinguishing between relative and absolute economic decline Source: The author’s construction based on World Bank data.
must first compare their levels of public debt in 2005 with those accumulated nine years later (2014). The UK economy increased its level of public borrowing fastest and to the greatest degree. Its public debt to GDP ratio in 2014 was 112.5% higher than in 2005. Over the same period, the country’s GDP per capita rose from $39,935 (in 2005) to $40,968 (2014), or just 2.6%. Consequently, every percentage increase in GDP per capita between 2005 and 2014 was accompanied by an increase in the level of the public debt of 43.3%. Looked at by sub-periods, 2005-2009 and 2009-2014, the level of public borrowing in the United Kingdom rose by 58.3% and 34.2%, respectively.
The G-10 economy with the next biggest increase in the level of public borrowing was the United States. The percentage increase in the value of its public debt to GDP ratio over the nine years in question (2005-2014) was 68.6%, while GDP per capita itself only went up from $44,305 to $46,405 or 4.7%.11 Every percentage point increase in GDP per capita in the United States between 2005 and 2014 was thus accompanied by an increase in the level of the public debt of 14.6%. Between 2005 and 2009, the United States increased its public borrowing by 38.3%, while over the next five years it did so by 34.2%. Amongst EU G- 10 members, it was France and the Netherlands which pushed up public borrowing most by 2014 on 2005 (by 42% and 39.5%, respectively). The most successful EU G-10 country in managing its public debt and the level of public borrowing was Sweden, whose public borrowing was in fact 7.1% lower in 2014 than it had been in 2005. The most successful country from the G-10 on this criterion was Switzerland, whose public debt fell 27.7% between 2005 and 2014.
After changes in the level of public debt and in measuring the effectiveness of the G-10 countries’ economic policies and the financial resources used in their anti-recessionary drive, which necessarily have long-term consequences, we must now look at changes in the NIIP over the same period (2005-2014). With regard to percentage change in the NIIP to GDP ratio (net capital imports), the United States saw the greatest increase during these nine years, of 183%. More than 90% of this increase related to the period from 2009 to 2014. During the same period, the United Kingdom also saw a major increase in the negative value of its NIIP to GDP ratio: from (-8.7%) in 2005 to (-24.1%) in 2014. So, net import of capital to the United Kingdom against GDP was up 177%. In contrast to the United States and the United Kingdom, Germany’s level of public borrowing rose a mere 11.7%, while GDP per capita was up 14.8%, and net export of capital (reflected in the positive value of the NIIP to GDP ratio) to the rest of the world was up 209.8%.