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Liberalization of Finance and Its Impact

It could be argued that the financial sector performed these functions relatively well both in developing and developed countries in the post-World War II period. Domestic financial sectors were relatively small and fairly tightly regulated, partly because after the Great Depression a number of regulatory measures were applied, including the Glass-Steagall Act which separated investment and commercial banking as well as the existence of requirements for liquidity. At the same time, capital accounts were relatively closed, especially in developing countries. Developed countries liberalized their capital accounts, but most did so very slowly (Griffith- Jones et al. 2003).

However, from a policy perspective there were concerns that “financially repressed” systems, as they were then called, did not deliver sufficient finance to important sectors at low enough cost and at long enough maturity. From a more theoretical perspective, the idea that financial markets were efficient encouraged financial liberalization, with either light or no regulation. This covered both domestic and external liberalization. Latin America was a first mover on liberalization in the late 1970s, especially in the Southern Cone. This process was followed by frequent and costly crises, including the major Latin American debt crisis, which led to the so-called “lost decade” in terms of growth and development. Diaz Alejandro (1985) already then perceptively synthetized this as: “Good-bye financial repression, hello financial crisis.” Increasingly frequent crises in different parts of the developing and emerging world followed, including the East Asian crisis, which involved some of the most successful developing countries.

The idea that these crises were transitory problems, which would be overcome once these financial markets matured and deepened (and became more like those of the developed countries, especially the US and the UK ones) was profoundly challenged when a major crisis hit the developed countries. This had started in 2007 in the USA, which had the most liquid and deepest financial market in the world, before spreading to the other developed area in the world, the European Union, and from there on to the rest of the world.

Furthermore, increased sustainable access to credit at low cost did not seem to improve as expected as a result of financial liberalization, especially for SMEs and for long-term investment (e.g., in infrastructure). Indeed, during and after crises, credit channels became blocked, especially with regard to long-term credit to the private sector. The procyclical nature of domestic finance, as well as of capital flows, became extremely evident.

An early insight on why liberalized financial and poorly regulated financial markets can be particularly damaging, and to a much greater extent than the liberalization of other markets, comes from Stiglitz (1994), who argues that market failures in financial markets are likely to be endemic as those markets are particularly information-intensive, thus making information imperfections and asymmetries as well as incomplete contracts (Stiglitz and Weiss 1981) far more important and disruptive than in other economic sectors. Therefore, in important parts of financial markets, market failures tend to be greater than government failures. In such cases, government interventions are more desirable than in other sectors (for example, via the regulation of domestic financial markets and banks, as well as the management of the capital account, but also via the creation of public development banks), if their benefits outweigh their costs.

This approach to finance can be consistent with far freer markets in the rest of the economy, in sectors where markets are more efficient than governments. Indeed, it can be argued that the prevalence of market failures in financial and banking markets makes sufficient financial regulation a key precondition for the successful operation of the market in the rest of the economy. Furthermore, the gaps in private financial markets, for example in the provision of sufficient long-term finance, essential for structural transformation(especially but certainly not only in LICs), makes a strong case for the need of having well-run public development banks, that can provide such funds.

 
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