Financial Development and Economic Growth in Underdeveloped Countries

Hugh T. Patrick

Economic Development and Cultural Change, Vol. 14, No. 2. (Jan., 1966), pp. 174-189.

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FINANCIAL DEVELOPMENT AND ECONOMIC GROWTH

IN UNDERDEVELOPED COUNTRIES*

Hugh T . P a t r i c k Y a l e U n i z ~ e r s i t y

An observed characteristic of t he process of economlc development over time, In a market- oriented e c m o m y us ing the price mechanism t 3 a l l oca t e resources . 1s an inc rease In t he num- ber and variety of f lnancia l institutions and a subs tant la l r i s e in t he p r ~ p o r t l o n not only of money but a l s o of the to ta l of a l l f inancial a s s e t s re la t lve to GNP and to t a n g ~ b l e weal th . However, t he causa l nature of th is relatlonshlp betfveen financlal development and economic growth h a s not been fu l ly explored e i ther theoretically or empirically.

Demand-Following and Supply-Leading Phenomena

Typlcal s ta tements lndlca te tha t t he f ~ n a n c l a l sys tem somehow accommodates-or, t o t he extent tha t ~t malfunctions, ~t restricts-growth of real per caplta output. For example,

It s eems to be the c a s e tha t where enterpr lse l eads f inance follows. The same impulses wlthin an economy whlch s e t enterpr lse o n foot make owners of wealth venturesome, and when a strong impulse to Inves t i s fe t te red by lack of f inance , dev lces a r e invented to r e l e a s e i t . . .and habi ts and lns t i tu t lons a r e developed

Such an approach p l aces emphasis on the demand s lde for f inancia l services ; a s t he economy grows i t genera tes addit ional and new demands for t h e s e services, whlch bring about a sup- ply r e sponse in t he growth of t he financlal sys tem. In t h i s view, t he lack of f inancia l ins t i - tutions in underdeveloped countries i s simply an indication of t h e lack of demand for the i r s e rv i ces .

W e may term a s lldemand-following" the phenomenon in which the creation of modern financial ins t i tu t ions , their f inancial a s s e t s and l labi l l t les , and related financial s e rv i ces i s in r e sponse t o the demand for t h e s e s e rv i ces by inves tors and savers in t he r ea l economy. In th is c a s e , the evolutionary development of t he f inancia l sys tem 1s a continuing consequence of t he pervasive, sweeping process of economlc development. The emerglng f lnancia l sys tem IS shaped both by changes in objec t ive o?portunltles-the economic environment, t he ins t i tu-

* T h i s paper h a s b e n e f ~ t t e d from comments b) R ~ c h a r d Pa:ter. Lona!d \ lead . L e s t e r Chandler . and t h e par t tc lpanta In t h e Conferznce on Banklng In the E a r l ) S t a t e s of l n d u s t r ~ a l l r a t i o n h e l d a t B e l l a g i o , August 1964

1. See . for example , the work of Raymond Goldamlth . p a r t ~ c u l a r l \ lh~a l : ~ n a r ~ c i u l I n f e r n i e d i a r i r s in t h e lrnerican t , c o n o r t i ~ s i n c e 1900 ( P r l n c s t o n Pr inceton U n i v z r a ~ t y P r e s s . 19581, and " t71nanc~al St ructure and Econon:lc Growth In 4 d v a n c e d Coun- t r ~ e s . " In l l o s e a 4brarnovltz. ed , ( u p r l a l tornlaf io t i a n d I:cononiic Growth ( I ' r ~ n c e t o n P r ~ n c e t o n Univers i tv P r e s s . 1955) F o r an einptrtcal t rea tment for J a p a n s e e David J Ot t . "The FTtnancial L)evelopment of J a p a n . 1878-1958," J o u r n a l u! P o l r t i c u l I l c o n u m ~ . LXIX. No 2 I ' i p r ~ l 1961)

2 . J o a n R o b ~ n s o n , " T h e Genera l iza t ion of the Genera l Sheory." In T h e Kure o f I r ~ r e r e s r a n d Other I:sauv.s (London \ l a c \ l ~ l l a n . 1952). pp 86-87

P A T R I C K 175

t lonal framework-and by changes in sublect ive responses-individual motivatlons, a t t i tudes , t a s t e s , preferences.

The nature of the demand for flnancial servlces depends upon the growth of rea l output and upon the commercialization and monetization of agriculture and other traditional subsls t -ence sectors . The more rapid the growth r a t e of r ea l national income, t h e greater will b e the demand by enterprises for external funds ( the savlng of o thers) and therefore flnancial ~ n t e r - medlatlon, s lnce under most circumstances firms wi l l be l e s s ab le to finance expansion from internally generated depreciation allowances and retained proflts . (The proportion of external funds ln the to ta l source of enterprise funds will r i s e . ) For the same reason, with a given aggregate growth ra te , the greater the variance In the growth ra tes among different sectors or indust r ies , the greater wi l l be the need for financlal intermediation t o transfer savlng to fas t - growing industries from slow-growing Industries and from individuals. The financlal system can thus support and sus ta in the leading sectors In the process of growth.

The demand-following supply r e sponse of the growing financlal system 1s presumed to come about more or l e s s automatically. I t i s assumed that t he supply of entrepreneurship in the financlal sector i s highly e l a s t i c re la t ive to the growing opportunitles for profit from pro- vision of financial services , s o that t he number and diversity of types of flnancial lnsti tutlons expands sufficiently; and a favorable legal , insti tutional, and economlc environment ex i s t s . The government 's attitudes, economic goa l s , and economic pol ic ies , a s wel l a s t he s i z e and ra te of increase of the government debt, a re of course important influences in any economy on the nature of the economic environment. As a consequence of rea l economic growth, f lnancial markets develop, widen, and become more perfect, thus increasing the opportunities for acquiring llquidlty and for reduclng r isk , which ln turn feeds back a s a st imulant t o r ea l growth.

The demand-following approach implies that f inance i s e s sen t i a l ly pass ive and permissive In the growth p rocess . Late eighteenth and early nineteenth century England may be cited a s a historical example. In f ac t , the increased supply of financial services in r e sponse to de- mand may not be a t a l l automatic, f lexible , or inexpensive In underdeveloped countries. Examples include the res t r ic t ive banking legislation in early nineteenth century France, reli- gious barriers agains t loans and in teres t charges, and Gerschenkron 's ana lys i s of t he abortive upswing of I ta l ian industrial development in the 1880 ' s "mainly, l t i s believed, because the modern investment bank had not ye t been es tabl lshed In I ta ly . ! I 4 In underdeveloped countries today, similar obs t ac l e s , together with imperfections In t h e operation of the market mecha- nism, may dic ta te an Inadequate demand-following r e sponse by the financial system. The lack of f lnancia l services , thus , in one way or another res t r ic ts or inhlblts effective growth patterns and p rocesses .

Less emphasis has been given in academic d i scuss lons (if not in policy act ions) t o what may be termed the "supply- leadingt phenomenon: the creation of financial insti tutions and the supply of their f inancial a s s e t s , l iabi l i t ies , and re la ted financlal services in advance of demand for them, especia l ly the demand of entrepreneurs In the modern, growth-inducing sec to r s . "Supply-leadingH h a s two functions: t o transfer resources from tradltional (non- growth) sec to r s to modern sector^,^ and to promote and stlmulate an entrepreneurial r e sponse

3. Cf W . 4rthur L e w ~ s , The Theory o f t c o n o m ~ c Growth (London. George 411en & G n w ~ n ,1959 , pp. 267-86

Alexander Gerschenkron, Economrc Backwardness In Hls for~cal Perspective-4 Book o f Essays (Cambr~dge Harvard U n ~ v e r s ~ t yPress , 1962), p. 363. See a l so Ch. 4.

5. The difference between trad~tronal and modern sectors I S that the former are domrnatea by elements (attitudes, forms of economrc organrzation, production technology) inherited from the pre-modern economy, whereas modern sectors are domi- nated by ~ n t e m a t ~ o n a l l y modem technology, r a t~ona l i ty (maxrmrzatron behavior and attitudes) and modern rnstrtutrons and other forms of econor r~~c organrzation. See, for example, K Ohkawa and H Rosovsky, "A Century of Japanese Economrc Growth," in W . N. Lockwood, ed . , The State and Econom~c knterprlse ~n tlodern Japan (Princeton Prrnceton Gniversity P ress , forthcomrng).

4

176 E C O N O M I C D E V E L O P M E N T A N D C U L T U R A L C H A N G E

in these modern sectors . Financial intermediatlon which transfers resources from traditional sectors , whether by collecting wealth and saving from those sectors In exchange for i t s de- posi ts and other financial l labi l i t les , or by credit creation and forced savlng, i s akin to the Schumpeterian concept of innovation financing.

New a c c e s s to such supply-leadlng funds may in Itself have substant ia l , favorable ex- pectational and psychological effects on entrepreneurs. I t opens new horlzons a s to poss ible alternatives, enabllng the entrepreneur to "think blg. ' I This may be the most significant ef-fec t of all , particularly in countries where entrepreneurship 1s a major constraint on develop- ment. Moreover, the top management of finan- a s has been emphasized by Rondo ~ a m e r o n , ~ c i a l insti tutions may a l s o serve a s entrepreneurs in industrial enterprises. They a s s i s t in the establishment of firms In new industries or in the merger of firms ( the advantages of econ- omles Of s c a l e may be more than offset by the establishment of restrictive car te ls or monop- o l i e s , however), not only by underwriting a substant ia l portlon of the capi ta l , but more impor- tantly by assuming the entrepreneurial ~ n i t i a t i v e .

By i t s very nature, a supply-leading financial system init ially may not be able to operate profitably by lending to the nascent modern sectors.7 There are , however, severa l ways in whlch new flnanclal institutions can be made viable . First , they may be government instl tu- t ions , us lng government capi ta l and perhaps receiving direct government subsidies . This i s exemplified not only by Russian experience in the latter half of the nineteenth century, but by many underdeveloped countries today. Second, private financial insti tutions may receive direct or indirect government subsidies , usual ly the latter. Indirect subsidies can be provided in numerous ways . Commercial banks may have the right to i s s u e banknotes under favorable collateral conditions; th is technique w a s more important in the eighteenth and nineteenth centuries (national banking in Japan in the 1870 's ; wildcat banking in the United S ta t e s ) than i t i s l ikely to be in present underdeveloped countries, where th is right i s reserved for the central bank or treasury. Nonetheless , modern equivalents ex i s t . They include allowing pri- vate financial insti tution to create deposi t money with low (theoretically, even negative) re- serve requirements and central bank rediscount of commercial bank loans a t interest r a t e s effectively below those on the loans . Third, new, modern f inancia l insti tutions may init ially lend a large proportion of their funds to tradit ional (agricultural and commercial) sec tors prof- itably, gradually shifting their loan portfolio t o modern indust r ies a s t h e s e begin to emerge. This more c losely resembles the demand-following phenomen; whether such a financial ins t i - tution i s supply-leading depends malnly on i t s att i tude in searching out and encouraging new ventures of a modern nature.

I t cannot be sa id that supply-leading finance i s a necessary condition or precondition for inaugurating self-sustained economic development. Rather, i t presents an opportunity t o induce rea l growth by financial means. I t thus i s l ike ly t o play a more significant ro le a t the beginning of the growth process than la ter . Gerschenkron implies that the more backward the economy re la t ive to others in the same time period (and the greater the forced-draft nature of the economic development effort), the greater the emphasis which i s placed on what I here term supply-leading finance. ' At the same time, i t should be recognized rhat the supply- leading approach to development of a country's f inancial system a l s o has i t s dangers, and they should not be underestimated. The u s e of resources , especia l ly enterpreneurial ta lents and managerial sk i l l s , and the cos t s of explicit or implicit subsidies in supply-leadlng devel-

6. Rondo Cameron, "The Bank as Entrepreneur," Explorations in Ent~.rprm~urial Hisfor),,Series 2 , I , No. 1 (Fall 1963), 50-55.

7. Except in the extreme case where inherent profit opportunit~es are very high, and supply-leading stimulates a major entrepre- neurial effort.

P A T R I C K 177

opment must produce sufficient benefits in the form of stimulating rea l economic development for t h i s approach to be justified.

In ac tual practice, there i s l ike ly to be an interaction of supply-leading and demand- following phenomena. Never theless , t he following sequence may be postulated. Before sus ta ined modern industrial growth ge t s underway, supply-leading may be ab le to induce r ea l innovation-type investment. As the process of rea l growth occurs , t he supply-leading impetus gradually becomes l e s s important, and the demand-following financial response becomes dominant. This sequential process i s a l so l ikely to occur within and among speci f ic indus- t r ies or s ec to r s . One industry may in i t ia l ly be encouraged financially on a supply-leading b a s i s and a s i t develops have i t s f inancing shift t o demand-following, while another industry remains in the supply-leading phase . This would be related to the timing of the sequential development of indust r ies , particularly in c a s e s where the timing i s determined more by gov- ernmental policy than by private demand forces .

Japan between the 1870 's and the beginning of World War I presents an excellent example of the sequence of supply-leading and demand-following f i n a n ~ e . ~A modern banking system w a s created in the 18701s , subsidized by the right t o i s s u e banknotes and by government deposi ts . These banks, in the absence of large-scale industrial demand for funds, init ially concentrated their funds on financing agriculture, domestic commerce, and the newly impor- tant foreign t rade . However, they a l s o became the locus for much of the early promotional and entrepreneurial ta lent which init iated the industrial spurt beginning in the mid-18801s, especia l ly in railroads and in cotton text i les ( a t f i rs t import-competing, and later export- oriented). The banks a l s o became an early important source of industrial funds, a lbei t v i a an indirect route. The modern financial sys tem thus w a s not only created in advance of J apan ' s modern industrialization, but, by providing both funds and entrepreneurial ta lent on a supply-leading bas i s , contributed significantly to the init ial spurt . By the mid-18901s, the emphasis apparently moved from supply-leading to demand-following in the financing of the text i le and other consumer goods indust r ies . On the other hand, the financing of most heavy manufacturing indust r ies continued on a supply-leading bas i s perhaps until World War I , with a considerable portion of external funds provided through the long-term loans of spe- c i a l banks es tabl ished a t government in i t ia t ive and uti l izing government funds.

Finance and the Real Capital Stock

The nature of t he connection between financial growth and economic development may be examined from a somewhat different approach. One can conceive of a variety of re la t ionships between the financial system and growth-producing real fac tors . However, probably the most important i s the relationship of t he s tock of financial a s s e t s and l iabi l i t ies to the rea l capi ta l stock-its optimal composition and r a t e of growth and i t s efficient allocation and uti l ization. I a s sume the relationship between the capi ta l stock and real output i s strong, direct, and m o n o t ~ n i c . ' ~The growth object ive of t he f inancia l sys tem i s t o achieve the structure and ra te of growth of various f inancia l a s s e t s and l iabi l i t ies which a re consonant with and even induce the optimal character is t ics of the rea l capi ta l s tock.

There are three major ways in which the financial system can influence the capi ta l s tock for growth purposes . First, f inancia l insti tutions can encourage a more efficient allocation of a given to ta l amount of tangible wealth (capi ta l in a broad sense ) , by bringing about changes in i t s ownership and in i t s composition, through intermediation among various types

9. For greater deta l l on the J a p a n e s e c a s e , s e e Hugh T. Patr ick, "Japan," In Rondo Cameron, ed. , Bankrng rn the Early S tages uf lndustrrairzatron (Oxford University P r e s s . forthcoming).

10. 1 do not here consider in other than broad out l ine *hat const i tu te the optimal characteristics of the capi ta l s tock for gro*th.

ECONOMIC D E V E L O P M E N T A N D C U L T U R A L C H A N G E

of asse t -holders . Second, financial insti tutions can encourage a lliore efficient allocation of new investment-additions to capi ta l stock-from relatively l e s s to relatively more productive u s e s , by intermediation between save r s and entrepreneurial inves tors . Third, they can induce an increase in t h e ra te of accumulation of capi ta l , by providing increased incent ives to sa':e, inves t , and work.

These effects can be analyzed by an approach blending the Gurley-Shaw model:' with a portfolio ana lys i s of the behavior of saving-type and investing-type a 'sset holders. The com- posit ion of individual weal th portfolios cons i s t s of non-reproducible tangible a s s e t s (land and precious metals), reproducible tangible a s s e t s (producer durables, consumer curables , and inventories), and financial a s s e t s (currency, deposi ts , bonds, stock, loans , insurance, e t c . ), minus financial l iabi l i t ies . Individual uni ts hold varying proportiors of rea l and financial a s s e t s (and financial l i a b i l l t i e ~ ) ~ based on their own preferences and on an a s s e t ' s speci f ic character is t ics of safe ty , liquidity, and yield (of money income and/or rea l services) Most theoretical work on portfolio ana lys i s has focused on the composition of financial a s s e t s , with l i t t le emphasis on t h e choice between financial and real a s s e t s . " This latter choice, of course, i s of prime importance for growth.

Allocation of a Given Amount o f Tangible Wealth

In th i s section, the focus r e s t s on changes in a given aggregate amount of tangible wealth under the assumption of no net additions to th i s s tock. Unfortunately, definit ive capi ta l stock or wealth es t imates are not yet avai lable for any underdeveloped country over time, or even for any s ingle point in tin?e.l3 gone the le s s , flow character is t ics of saving provide some indication of stock character is t ics of weal th . For example, the findings for a s a n p l e of underdeveloped Asian countries t h a ~ between one-half and two-thirds of gross saving i s done by households, and that between one-half and three-fourths (and perhaps more, due to under-reporting of increases in tangible d s s e t s ) of household net saving i s In the form of inc reases in tangible assets,14 probably wel l ref lec ts t he structure of ownership and composition of weal th for t h e s e countries. I t i s notable that most 01 the a s s e t s held by savers are under their own direct control. In general, t he composition of individual rea l wealth holdings in underdeveloped countries typically cons i s t s mainly of land and land im- provements, simple agricultural and handicraft tools, l ives tock, inventories (notably food- s tuf is ) , and durable consumer goods (especia l ly housing? but In some countries precious

11 See John G. Gurley and E S. Shau, " F i n a n c ~ a l \ spec t s of Econom~c L>evelopment:' i r r~ericai~! coriomic Rei'iew. XLY. No. 4 (September 1955): " F l n a n c ~ a l Intermediaries and the Saving-Investment Process ." Jourrlal of t inurice. XI. No. ? ('.lay 1956). and Iloney in a Tileor? uf Firiance (liashington Brookings Institution. 1960) For expl ici t adap ta t~ons 2nd developments of t h ~ s model to the process of growth. see Rondo Cameron, "l'heoretlcdl Bases of a Comparat~ve Stud) of the Role of Financial l n s t ~ t u t ~ o n s in the Conference of Fconom~c H~s to ry . Ax-en-Provence, France. 1962, and Kobert I Bennett, "Financial lnnovat~on and Structural Change In the Early Stages of Indus t r~a i~za t ion? lex~co . 1915-59.' .lourriul of Finarice. XVIII. No. 3 (December 1963).

I ? . See, houever , James 'l 'ob~n. " A dynam~c t lggregat~ve Ilodel." Jo i~ rna l o f Poi i t icai tcononz>. LXIII. No. 2 (4pr1l 1055). James Tobln and W ~ l l ~ a m and the E f f e c t ~ v e n e s s Imerii.unBra~nard. " F l n a n c ~ a l I n t e r m e d ~ a r ~ e s of Ifonetar) Controls," tcononzic Review, LIII. No ? (\lay 19631, and P K Brahmanand, "Some I s sues of llonetary Theor) and P o l ~ c y In a R ta l Llquidltv Conscious Economv." Co,rlrnerce [ l n d ~ a ] (1960 annual specla1 issue)

13 Est imates have been made for I n d ~ a . cf "Est imates of Tangible heal th in Indra." Reserve Bank of lndra Buiiet i~l (Januarv 1963). pp. 8-19. Gold. sllver. aod jeuelry are not lncluded (thev are approximatel) 10 percent of total t ang~b le uealth), and the inventory estimates are crude. For a c r ~ t i c ~ s m of these est imates see Uma Datta, "The Capital Structure of the Economy." kcono~ri ic Ili,iakly, XVI. Nos. 5-7 annual Issue (Februar) 1961). 301-10.

14. UN ECAFE. "hleasures for Ilobilizing Domestic Savlng for P roduc t~ve Investment." t;coriomic Builetiri for 4sia and r!ir .Far c a s t , XIII, No 3 (December 19621, 3-8 of savlng sources I SThe c l a s s ~ f ~ c a t i o n Into government. government enter- prlse, private corporate, and household sectors. s o households Include un~ncorporated enterprises and farming. For our purposes, this does not pose a major problem.

PATRICK 179

metals15 and jewelry, a s we l l ) . The sha re of producer durables i s re la t ively low, lbwhile tha t of tradit ional consumer durables may be re la t ively high.

In part , t h i s composition of weal th r e su l t s from a lack of productive investment oppor- tuni t ies or ignorance of their ex i s t ence . As t h e economy undergoes change and brings out productive investment opportunities, pressures develop to improve the wealth composition. Moreover, while an individual ' s in i t ia l portfolio composition may be inefficient In terms of the poss ibi l i t ies for se lec t ing among a full range of f inancia l a s s e t s a s des i rable a l ternat ives , the composition may not be inefficient re la t ive to the a l ternat ive f inancia l a s s e t choices which actual ly exis t . Thus, creating additional types of f inancia l a s s e t s and making them avai lable to potential holders provides the opportunity for more efficient portfolio se lec t ion.

A considerable portion of tangible weal th in underdeveloped countries i s held in forms unproductive of sus ta ined growth. Some can fairly readily be transformed into productive capi ta l goods. This i s especia l ly true of precious metals, excess holdings of inventories, and the replacement in an aggregative context of t he depreciating portion of the capi ta l stock The amounts involved could be significant. I t i s not unreasonable to think of ra t ios of tan- g ib le wealth to GNP, even excluding land, of 2 or 3 . A re-allocation of a s much a s 10 per- cent of t h i s wealth to more productive forms would be equivalent to 20 or 30 percent of GNP and would r a i s e the level of output by about 1 0 percent.I7 I t should be recognized that changes in the composition of a given s tock of weal th to more productive forms are a once- and-for-all adjustment, even though'they may t ake some time, s o that the level of output i s r a i sed , but continued growth does not resul t .

In many underdeveloped countries, wealth i s held in t h e form of inventories of foodstuffs, other primary products, and, i n some c a s e s , even finished manufactured goods, in amounts considerably in excess of normal consumption or production requirements. An important rea- son'' for t h i s behavior i s that , in t h e absence of sui table financial a s s e t alternatives, inventories are the only a s s e t s which a re relatively l iquid, d ivis ib le , and offer some protec- t ion agains t general consumer good price inflation. On the other hand, s torage and spoi lage c o s t s are high, and, for individual commodities, r i sks ( a s measured by variance) of price fluctuation a re high.

I conjecture that in the early s t a g e s of development individuals shift their a s s e t port- folios, relatively, f ron holding inventories in excess of their normal production or consump- tion requirements to holding newly-created financial a s s e t s which have more a t t rac t ive terms. In rea l terms, t h e s e inventories are freed to be transformed into productive fixed capi ta l goods, either via t h e foreign trade route, or a s consumer goods for workers who produce the capi ta l goods.19 This hypothesis i s virtually impossible t o verify by direct empirical evi- dence, s ince sa t is fac tory da ta on inventories in underdeveloped countries do not ex i s t . Consequently, i t i s poss ible that there i s some overestimation of gross domestic investment

15. P r e c ~ o u smetals may be processed Into jei+elry a s a consumer good, a s well a s being held In bulk form a s a store of value. Cf. Hugh T . Patr ick, "The Mobllizat~on of P r ~ v a t e Gold Holdings." lridian Econonlrc Journal, XI. No. ? (October-December 1963). P r ~ v a t e f o r e ~ g n exchange and other forelgn a s s e t h o l d ~ n g s should be Included In real wealth, slnce they represent a dlrect c l a m on fo re~gn goods, probably netted agalnst t h ~ s should be foreign c l a m s upon the country.

16. See Raymond W . Goldsmith, The .Vatlonal llealth of the C'nited Stutes in the Postwar Period (Princeton. P r~nce ton University Press , 1962), pp. 96-97, for cross-country comparisons.

17. Based. obviously. on h ~ g h l y simplistic assumptions that the marglnal capital-output ratlo for such reallocated capital 1s on the order of 2 to 3. and that thls heal th prior to reallocation made no contrlbutlon to output; a more general assumption uould be that the difference betueen the capital-output rat ios of thls capital before and after reallocation \%auld be 2 to 3

18. Probably the most important reason i s the inadequacy, and e s p e c ~ a l l y the uncertainty. of supply I lnes. Thus. Improve- ments in distribution systems probably are the most important s ~ n g l e factor in making feasible a reduct~on In holdings of Inventories.

19. There 1s also the danger that after f i n a n c ~ a l Intermediation the ~nven to r i e s u i l l simply continue to be held. but by a dif. ferent group (speculators) , uho flnance the11 holdlngs by bor rou~ng (short-term) from the financial ~ n t e r m e d l a r ~ e s .

E C O N O M I C D E V E L O P M E N T A N D C U L T U R A L C H A N G E

in such developing economies, s ince s t a t i s t i ca l coverage i s l ikely to be more complete for fixed investment than for inventories, especia l ly where there may be widespread small de- c l ines in inventory holdings by a large number of individual unl ts . Part of the recorded fixed investment i s thus derived from and offset by unrecorded decl ines In inventories.

Individual holdings of precious metals and foreign exchange and other foreign a s s e t s a l so can be transformed directly into socia l ly productive fixed a s s e t s by the foreign trade route, with imports of capi ta l goods being paid for by a reduction in the net domestic holdings of precious metals or foreign exchange. An important mechanism in t h e pas t , whereby countries have freed domestic holdings of precious metals, has lain in the shift from a currency system based in effect upon a commodity (such a s spec ie ) a s money (where i t s value in exchange a s a monetary unit i s equal t o i t s value in alternative u s e s ) t o a system based on token currency (where the value in exchange i s derived from a guarantee by government or private financial insti tution, and the value of the token in alternative u s e s i s negligible re la t ive to i t s mone- tary value). A further refinement i s t he development of deposi t money. Such token money has the advantages of very low resource cos t s of production and of greater potential for con- trol over i t s e las t ic i ty of supply. At the same time, i t f rees the commodity ( spec ie ) for a l - ternative u s e s ; using commodities a s a domestic means of payment has a high opportunity cos t .

An example of such a transformation in the composition of weal th i s Japan at t he begin-ning of i t s modernization effort. Between Japan ' s opening to foreign t rade in 1853 and 1881, almost a l l of t he domestic supply of gold and silver, which had gradually accumulated through limited domestic production during 250 years of isolation for u s e a s circulating coin, w a s shipped abroad to pay for a substant ia l lmport surplus . Good es t imates of J apan ' s stock of gold and sllver a s of 1853 do not exis t , and the da ta on t h e net outflow of spec ie in the turbu- lent years of foreign trade prior to the Restoration in 1868, and even durlng the early years of the new government, are inadequate. Between 1872 and 1881, the net outflow of specie amounted to 71 million yen, 21 percent of to ta l imports during the ?eriod. For the entire p e n - od, t he outflow was on the order of 220 million yen. This w a s equivalent t o perhass half of her national income in an average year during th i s period!'

I t could be argued that a simllar shlft in the composition of wealth i s not open to contem- porary underdeveloped countries, s ince in virtually a l l countries spec le has been eliminated a s circulating medium and token money has been substi tuted. While th ls i s true, in some countries (notably India, but ?robably a l so Burma and Pakis tan) immense amounts of gold and silver are held by indlviduals, in part a s a t t rac t ive a s s e t s , rather than sole ly for consunption purposes. In other countries, especia l ly in Latin America and the Mlddle East o i l countries. r ich indlviduals evidently hold a considerable portion of their weal th in the form of liquid foreign a s s e t s , a t yields below what could be (socia l ly) achieved by stimulating domestic economic development. One of the problems (from a growth perspect ive) in such a transfor- mation of inventories, p e c i o u s metals, foreign exchange, or other liquid a s s e t s into other forms i s that , sos s ib ly , they will be used for consumption purposes , with a net dec rease in the wealth stock, rather than for creating new productive capi ta l goods. Such llvlng off a country's wealth stock i s difficult to document, except i n blatant c a s e s . For example, even the u s e of exports of such a s s e t s to finance the import of consulnptlon rather than capi- t a l goods does not necessar i ly mean that consumption inc reases a t t he expense of wealth s tocks , s ince the lmported consumption goods may replace domestic consumption goods pro- duction, thereby freeing domestlc resources for production of capi ta l goods or exports.

20. T h ~ sp r o c e s s u a s p a r t ~ c u l a r l y important In the n l n e t e e n t h century . Cf Rober t T r ~ f f i n . Tile Evolut ion of tile International Llonetar). S ~ ' s t e m : Historical Reappraisal and Future Per spec t i ve s , Princeton U n ~ v e r s ~ t y E s a a y a In In ternat ional F i n a n c e (1964).

2 1 Cf P a t r ~ c k . "Japan" op ci l

PA T R I C K

With reference again to the Japanese c a s e , 1853-81, init ially, a high proportion of J apan ' s imports were manufactured consumer goods, especia l ly cotton text i les , which sub- st i tuted for domest ic handicrafts. I t i s not c lear where and how the domestic handicraft re- sources found productive a l ternat ive u s e s . The sha re of investment goods did r i s e s teadi ly , from 5 percent of imports i n 1868-72 to 10 percent of a much larger volume of imports in the next five-year period.'' More important, perhaps, J apan ' s s tock of spec ie provided the new growth-oriented government with a breathing period, during which the country's balance of payments pressures were l e s s severe than they might have been and the government's posit ion could be consolidated.

A more pervas ive mechanism whereby the composition of a given s tock of wealth i s altered to produce a higher level of output i s through the investment replacing the annual amount of depreciation. While in aggregative terms the wealth s tock does not change, in micro terms the replacement investment i s often in new sec to r s , for new u s e s , and with a higher embodied technology, s o i t i s more p-oductive than the depreciated portion of the wealth stock had been. Measurement of t he extent of t h i s a l locat ive effect i s extremely dependent upon the definition used for capi ta l consumption a l lowances . However, the importance of capi ta l consumption and i t s reslacement i s wel l recognized and does not require further comment here.

By what means does the development of financial a s s e t s a s s i s t in th i s process of trans- formation of a given to ta l amount of tangible a s s e t s in to more productive form? The main point i s tha t individuals who hold tangible a s s e t s capable of being transformed are not neces - sar i ly those who are will ing to hold productive fixed a s s e t s . The ownership of productive fixed a s s e t s in underdeveloped countries usual ly enta i ls entrepreneurial and managerial functions a s wel l , especia l ly s ince equi t ies markets are not wel l developed. Not a l l wealth- holders are will ing to engage in t h e s e functions. The opportunity t o hold financial a s s e t s of superior character is t ics to inventories and spec ie a s a s tore of wealth enables holders of such tangible a s s e t s t o give them up for f inancia l assets,13 and for others to arrange the transformatiqn of t h e s e freed, tangible a s s e t s into a more productive form. What i s crucial i s , on the one hand, substi tuting financial a s s e t s for rea l a s s e t s in the por t fo l iosef certain individuals and, on the other, permlttlng entresreneurs t o incur financial l iabi l i t ies in order to enable them to hold a larger amount of productive a s s e t s than they could have otherwise.

In th i s context, t he important point i s t he substi tution between real a s s e t s and financial c la ims. Substi tutions among various kinds of f inancia l a s s e t s i n portfolios of individuals are re la t ively l e s s important. Their main function 1s to enhance the efficiency of financial markets by developing various alternative financial a s s e t s and l iabi l i t ies with differing character is t ics t o meet t he variegated preferences of individuals.

In summary, while data are not sufficient t o provide an adequate t e s t , I suggest that in the early phases of development such an improvement in t h e composition of wealth can be quite important. I t i s one aspect of taking up the s l ack , a s Ranis had aptly phrased it; out- put i s increased by moving toward exis t ing production frontiers through the improved alloca- tion of resources , including tangible a s s e t s . This more efficient composition of r ea l wealth i s obtained through the creation of f inancia l a s s e t s and l iabi l i t ies which provide the incentive for savers to hold (a t l ea s t ?art of) their weal th In financial form and investors to hold more productive r ea l a s s e t s than they could have in the absence of a financial sys tem.

2 2 . See V. S h ~ n o h a r a , "Economlc Development and Foreign T r a d e in Pre-War J a p a n , " In C. D. C o u a n , e d . . The Economlc Development o f Chinu and Japan (London George Al len & U n u i n , 19641, p . 234

23 . T h e point should b e emphasized that . In order for s u c h a s u b s t i t u t i o n t o t a k e p l a c e . t h e f l n a n c l a l a s s e t s m u s t h a v e suff l - c ~ e n t l y d e a l t a b l e c h a r a c t e r ~ s t i c s of s a f e t y , l iquid i ty . a n d y le ld .

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More Ef f ic ient Al location of lnvestment

The foregoing d i scuss ion on increas ing t h e l eve l of output by improving t h e composition of a given amount of weal th through the subs t i tu t ion of f inancia l a s s e t s for relatively unpro-duct ive tangible a s s e t s 1s e s sen t i a l l y an extension of t h e Gurley-Shaw ana lys i s of t h e ro le of f inancia l intermediation in Improving t h e efficiency of investment. In th is sec t ion , empha- s i s 1s ? laced on the flow of gross addit ions to the capi ta l s tock through t h e process of savlng and Investment out of current production. The Gurley-Shaw theory r e s t s on two important assumptions: individual s ave r s (surplus s?ending un l t s ) a re not a l l t h e most efficient inves- tors (def ic l t spending un i t s ) , i n terms of t he optimum allocatlon of lnvestment; and save r s a r e not wlll ing t o make t h e full amount of their saving (in e x c e s s of t h e n own efflclent In- vestment) d i rec t ly avai lable t o t he most efficient inves tors .

The reason that t he distribution of saving dlffers from the most efflcient dlstr lbution of investment i s t ha t saving depends primarily upon income, whlle efficient Investment depends upon entresreneurial t a l en t s , knowledge, and willingness t o t ake r i sk . Several corollaries follow. Savers in underdeveloped countr ies , e spec i a l ly in rural a r eas , tend to i nves t in r ea l a s s e t s , often of re la t ive ly low soc i a l productlvlty. 24 Contrari ly, efflcient inves tors a r e not ab l e t o i nves t a s much a s t hey would l ike; in portfolio terms they a re unable to i nc rease sufficiently their holding of productive tangible a s s e t s and their i s suance of f inancial l labl l - i t i e s . In other words , s ave r s a r e not entrepreneurs, and entrepreneurs cannot s a v e enough t o self-finance their des i red investment expenditures. Consequent ly , marginal r a t e s of return a r e not equated for different u s e s or among different u s e r s . Thls def ic iency could he remedled wlthout recourse t o f lnancia l lntermediatlon l f savers were wlll lng to purchase the primary secur i t ies from ( i . e . , make loans t o or purchase the bonds or s tock o f ) efficient entrepreneurs. However, t he character is t ics of primary securities do not coinclde fully wlth t h e preferences of s ave r s , e s sec i a l ly in terms of liquidity, safe ty , d iv is ib i l i ty , dlverslflcation of a s s e t s , and the spec i a l s e rv i ces s s e c i f i c f lnancia l a s s e t s provide ( e , g . , money a s the medlum of e x - change, insurance , e t c . ).

Under t h e s e c i rcumstances , f inancia l intermedlaries have a n important functlon In s ro- viding a market mechanism for t he t ransference of c la ims on r ea l resources from savers t o t h e most e f f l c i en t inves tors . The more se r f ec t a re f inancia l markets, t he more nearly optimum al locat ion of lnvestment 1s achieved. In t h i s way, t he f inancla l sys tem accommodates eco- nomic growth; on the other hand, to t he extent tha t t he f lnancla l sys tem i s underdeveloped and/or inefficient, i t r e s t r i c t s growth below what optimally could be achieved. The mechan- ism whereby financial institutions effect t h l s transfer i s to i s s u e thelr l iabl l i t les ( s e l l lndirect s ecu r i t i e s ) t o s ave r s , in exchange ult imately for their r ea l savlng ( a s s e t s ) or monetary claims upon such a s s e t s , and to provide t h e a s s e t s s o accumulated to inves tors by purchasing their primary secu r i t i e s . The f inancia l sys tem can crea te a wide variety of f lnancia l c l a m s (indi- rec t s ecu r i t i e s ) to s e rve a s a s s e t s for s ave r s , with claims differentiated by l lquldlty, y ie ld , maturity, divisibility, r i sk of default or change in value , and other s e rv i ces . In t h l s way, t h e f inancla l sys tem obta ins c l a m s t o resources whlch i t provides, dnder o?timal market conditions, to t h e most efficient u s e r . Hence , t he most efficient al locatlon of investment r e su l t s .

In addit ion to t h i s major functlon, f inancla l institutions can achieve economies of s c a l e in t he c o s t s of transferring saving t o inves tors through t h e pooling of default r i s k s of indi- vidual deficit spending uni ts , in carrylng out inves t iga t ions of t h e character ls tcs of deficlt spending uni ts in order t o determine the most approsrlate terms of I s suance , and In engaging

24 For example. rural savlng in lndla 1s predomlnantl) In kind. The re I S a tendency to hold Increased savlng In the form of foodstuffs In e x c e s s of normal consumption demand, in order that 11 may be used la ter to pay for the purchase of durable c a p ~ t a l goods or to allow extra consumption (such a s for f r s t ~ v a l s ) la ter . Cf. Wilfred hlalenbaum. Prospect !ur l r~diur i Devriopment (London: George Allen & U n u ~ n .1962) . p , 142. See a l so L'N ECAFE. op , cit.

P A T R I C K 183

in t ransact ions among saving and spending uni ts of d iverse location, s i ze , or other character- i s t i c s . These economies offse t t he net r i sk the financial institution usual ly a s sumes by purchasing di rect securities of higher r i sk than the indirect secur i t les i t c reates and s e l l s . The margin between the in teres t ra te a t which i t buys primary secur i t ies and a t which i t s e l l s indlrect secur i t les i s t he compensation a financial insti tution recelves for ~ t s services .

Hence, an important function of the f inancia l sys tem i s t h e transmutation of relatively safe , liquid, short-term financial claims into r i skier , l e s s l iquid, longer-term rea l a s s e t s . We must distinguish between the degree of r i sk for individuals and for socie ty a s a whole in examining speci f ic projects, and a l so between two types of risk-insolvency and il l iquidity. For both ty?es the degree of r i sk i s l e s s for soc ie ty than for individuals. Risks of insolvency (unprofitability) of s sec i f i c investment projects are pooled for socie ty , but not for ( a l l but t he weal th ies t ) individuals, un le s s by financial intermediaries. Rlsks of i l l lquidlty in the economy can be eliminated or substantially reduced by a;s;sropriate action of the monetary authorities a s the lender of l a s t resor t . Accordlngly, f inancia l intermediation allows socie ty to assume the appropriate degree of r l sk , which would be too high if i t were assumed directly by saving individuals. At the same time, financial intermediation provides the mechanism for the re-allocation and spreading of r i sk among individuals.

As an underdeveloped country grows, the composition of i t s tangible wealth i s altered t o a more growth-productive mix, both by the once-and-for-all sh i f ts and by the differential composition of the gross additions to weal th . With the growth of financial ~ntermedia t ion, during the neo-class ica l growth phase (in whlch the major problem 1s t o increase the supply of productive capl ta l and other fac tors of production), funds are channeled m a n l y to finance productive industrial and infrastructural investment. Accordlngly, the proportion of producer durables and business structures in to ta l wealth r l s e s , whlle land and consumer durable a s s e t s decl ine . Later, i n what may be termed the Keynesian growth ;shase (ln which the major problem 1s to a s su re adequate demand for output), a higher pro;sortlon of funds may be chan- neled into financing the purchase of (new-style) consumer durable^,'^ and their ?roportion r i s e s in to ta l r ea l a s s e t s . This i s particularly l ikely to be the c a s e where the government malntalns aggregate demand by techniques which directly encourage consumption ( such a s reductions in se r sona l income t a x e s ) rather than investment. However, a country ' s economy wil l have to be re la t ively advanced before th is phase i s l ike ly to be reached; in t h e interim, investment in consumer durables wi l l com;sete d i rec t ly with productive investment for growth.

Provision o f Incentives to Growth

I t i s asser ted that t he development of a f inancia l system and the a s soc ia t ed provision of financial claims and se rv ices h a s posi t ive incent ive ef fects for growth, though these ef fects have not been analyzed in great deta i l . The standard approach has been to point out that f inancial intermediation narrows the differential between the in teres t ra te savers receive and that which investors have to pay.

Gurley and Shaw suggest that by offering a wide array of f inancia l a s s e t s , f inancial in- s t i tu t ions stimulate saving, '' but without further elaboration. A higher, and r is ing, saving ra te re la t ive to GNP corre la tes wel l , for a sample of Asian countries, with an inc rease in the proportion of saving held in the form of financial a s s e t s re la t ive to tanglble asse ts ." Pre-

25. Cf . Harry T . Oshima, "Consumer A s s e t Fo rma t~on and the Future of C a p ~ t a l i s m , " Econom~c Journul. LXXI, No. 281 (\larch 1961), 20-35. For example. Oshima e s t ima te s that consumer a s s e t formation in the la te 1950's was 12 percent of GNP In the Uni ted S t a t e s and 3 percent In J apan .

2 6 . Money In a Theory o f Finance, p. 55

27. U S ECAFE, op. ci t . , p. 8 . The causa l r e l a t ~ o n s h ~ p however, both the saving ra te and proportion held in 1s not e x ~ l a ~ n e d , f i n a n c ~ a l form may be a consequence of the level and ra te of economic g rou th .

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sumably, the major rationale ot the stimulus t o saving i s that with new a s s e t s having hlgher yield, lower risk, and/or other des i rable character is t ics , the return on saving i s higher than i t w a s heretofore. With the terms of the trade-off ( the exchange ratio) between saving and present consumption re la t ively more favorable to the former, individuals subst i tu te increased saving for consumption out of current income.2a

Offsetting somewhat th i s favorable substitution effect on savlng are the effects of in- creased real income (or weal th) derived from having a wider se lec t ion of a s s e t s in which to hold wealth. Having the additional a l ternat ive of holding financial a s s e t s makes an individual better off, and he l ikely wl l l u t i l ize some of th i s increased income In the form of consumption. This i s especia l ly important where t h e individual i s a target s ave r .Z9 Target saving 1s a shorter-run character ls t ic of some rural savers in underdeveloped countries. The ( subs i s t - ence ) farmer wants to be certain of adequate saving to provide for consumption until h is next crop i s harvested, plus a margin t o cover the possibil i ty of adverse crop c ~ n d i t i o n s . ~ h o w - ever, in the longer run, the horizon of conceivable a l ternat ives expands, targets are ra ised, and the beneficial substi tution effects on saving wi l l probably substant ia l ly outweigh offset- ting income effects .

The speci f ic character is t ics of certain financial a s s e t s may re su l t in increased to ta l saving. For example, term l i fe insurance may not be sold," s o that t h e buyer has to purchase an annuity a s well a s pure l i fe insurance when h e wan t s to obtain l ife insurance coverage. In th l s c a s e , the lack of a perfect market-the tying of financial services to saving, rather than separating them-encourages additional saving, even though l e s s of the services may b e bought, s ince the price i s higher.

Financial intermediation a l so provides a variety of incent ives to inves tors . The reduction in the effective in teres t ra te reduces the cos t of investment; t he strength of t he demand re- sponse depends on the e las t ic i ty of t he marginal efficiency of capi ta l schedule. I t should be pointed out that f inancial intermediation does not mean that ' l t h e ' l in teres t ra te necessar i ly decl ines over time, s ince in a growing economy investment demand may become increasingly strong. '' However, increased effective financial intermediation will produce a narrowing of the dispersion of interest r a t e s among different types and levels of credltworthlness of u se r s , among geographical regions, and over periods of s easona l fluctuation. This i s a consequence of the improvement in financial markets. The development of a wide array of financial a s s e t s (and primary secur i t ies) provides a more flnely delineated spectrum of a s s e t alternatives, with greater poss ibi l i t ies for substi tution among a s s e t s ( s ince there can be a se r i e s of shi f ts among c lose subst i tu tes) . This allows an increased supply of funds to use r s who had been starved for funds under imperfect market conditions and who would be willing to pay relatively high interest r a t e s .33

28. It should be noted that this i s different from the hea l th (or l i q u ~ d asse t ) effect on consumption. In the a n a l y s ~ s of which i t i s usually assumed that there are no changes In the exchange ratio betueen saving and present consumption.

29. By improving the return on saving, the target saver i s encouraged to save relatively l e s s and to consume more. At the I~mi t . the target saver would not ~ n c r e a s e h ~ s saving, but would consume h ~ s full increase In uelfare resulting from opportunltles of f~nanc ia l ~ntermediat ion.

30. H a v ~ n g the poss ib~ l i ty of holding even currency. rather than a s p e c l f ~ c foodgrain, improves a farmer's position under condl- tlons of general price stability, s ince he can reduce storage and s p o ~ l a g e costs (for u h ~ c h there are cconomles of scale) and protect himself against r e l a t ~ v e prlce movements in the speclf ic commod~ty he holds.

31 Th i s apparently Is the case In many underdeveloped countrles

32, That i s , the amount of s h ~ f t of the investment schedule to the right per unlt of time becomes increasingly large. for a varlety of reasons.

33. Th i s assumes that funds do become decreaslngly rather than ~ncreas lng ly compartmentalized. as a consequence of inter med ia t~on . The latter i s a real poss~b i l i ty , however: r~sk-avert ing bankers in underdeveloped countrles may eff ic~ently collect savlng through d e p o s ~ t s and use the funds to invest in prime commerc~al b ~ l l s or fo re~gn llquid a s s e t s .

P A T R I C K

For many entrepreneurs, the increased availability of funds a s a result of financial inter- mediation may be considerably more significant than simply the reduction in costs.)' This i s probably particularly h e in underdeveloped countries, where most markets are much l e s s perfect than in developed countries. The availability of funds from financial institutions enables the efficient entrepreneur to assume a greater debt position than he could otherwise and concurrently to engage in a larger amount of productive investment. Moreover, a s noted earlier, newly developed access to funds on reasonable terms from financial institutions can induce or encourage entrepreneurs to expand their horizon of conceivable opportunities. Not simply access to funds, but the entire financial milieu, and the rationalism it implies, triggers creative entrepreneurial responses.

This i s true not only in industry, but a lso in other, more traditional sectors. A simple but highly important example for underdeveloped countries i s the monetization of subsistence sectors, notably in rural areas . Monetization encourages the shift from subsistence to com- mercial production, with attendent increases in output due to specialization, increased work efforts (and increased saving and investment), emphasis on high-income crops,35 and en- hanced responsiveness to changes in relative prices of different crops. The opportunities of commercial production, a t least in the early phases of development, improve the terms of the trade-off between income from work and leisure and result in increased labor input^.'^

Financial institutions provide services that reduce the r isks or increase the profitability of productive real investment projects. Insurance i s an obvious example. In underdeveloped countries, another important example i s the service related to the financing of trade, a s one aspect of the provision of readier access by producers to markets, both domestic and foreign.

Development of the financial system in these ways not only accommodates but even in- duces growth, by generating incentives to savers to increase their rate of saving, to entre- preneurs to invest more, and to producers to work harder.

Financ ia l Po l icy and F inanc ia l Institutions

As outlined above, the basic objectives of financial policy for economic growth are to encourage savers (asset-holders) to hold their saving (asse t s ) in the form of financial rather than unproductive tangible asse t s ; to ensure that investment (capital stock) i s allocated efficiently to the socially most productive uses; and to provide incentives to induce increased saving, investment, and production. To achieve these objectives, policy-makers must en- courage the proper foundation and expansion of financial institutions.

Of fundamental importance for any country i s the establishment of a unified, efficient, inexpensive medium of exchange (money), capable of e last ic changes under the control of (wise) monetary authorities." Sufficient flexibility i s required for the money supply to be

34. While availability can be thought of in cos t terms (an infinite interest rate at the limit), this resul ts in misplaced emphasis on the actual behavior of lenders, who certainly u s e credit-rationing criteria, a s dis t inct from interest-rate criteria, in the allocation of funds.

35. See, for example, Walter P. Falcon, "Farmer Response to Price in a Subsis tence Economy: The Case of West Pakistan," American Economic Review, LIV, No. 3 (May 1964).

36. T h i s i s not true, of course, where the supply schedule of labor i s backward-bending. For peasant agriculture this does not seem frequently to be the case . Good examples are the response of Japanese farmers to possibi l i t ies of export of silk and of Nigerian farmers to the export of cocoa.

37. It can be argued that, where the monetary authorities are particularly unwise, some arbitrary rules or even haphazard sys- tems such a s wildcat banking may be preferable. The problem of evaluation may be obscured by authorities. For example, criticism of the 19th century monetary pol icies a s growth-inhibiting may be misplaced, when the desired object ives were not s o much growth a s price stability.

186 E C O N O M I C D E V E L O P M E N T A N D C U L T U R A L C H A N G E

ab le to expand just consonant with the demand for money, given the des l red ra te of change of price level . In partlcular, the money supply should be e l a s t i c enough to meet sudden (and extreme) shi f ts in preferences of asse t -holders , especia l ly between deposi ts and currency. Otherwise, conditions of extreme il l iquidity may develop. In such monetary panics , there should be a lender of l a s t resor t capable of and wllling to create the types of financial a s s e t s individuals want to hold and make them readily avai lable through financial ~ n s t i t u t i o n s , by rediscounting or accepting a s collateral for loans a s wide a varlety of financial or rea l a s s e t s a s are needed to sa t is fy the panic demands of individuals. The init lal problem In such a si tu- ation i s t o hal t t he panic and to res tore confidence; only later should those Imprudent flnancial insti tutions whose a s s e t s are worthless be l iquidated.

The monetary authorities have an important institution-building role in encouraging the establishment of a wide array of financial markets (and financlal insti tutions to operate in t h e s e markets) which a l locate saving competitively to the most productive inves tors . 38 One important approach 1s to encourage the prlvate development of the financial system, in re- sponse to the demand for i t s .services, by clearing away impeding Insti tutional and other obstacles of a legal or customary nature. The flnancial authorit ies can create an environment which i s conducive to growth both of the rea l economy and of the financial system. In th is situation, re l iance i s placed upon the private market incent ives to achieve an efficient alloca- t ion of resources .

In some ins t ances , however, t he private entrepreneurial r e sponse In the financial sec tor may not be adequate, or poss ibi l i t ies of external economies may ex i s t . For example, finan- c la l markets may develop on a compartmentalized bas i s , with l i t t le integration among them. On the other hand, deliberate creation of the supply of financlal services may have favorable a l locat ive and incentive ef fects . Under these circumstances, l t may wel l be des i rable for t he government to es tabl ish i t s own financial insti tutions or to subsidize private financial ins t i tu t ions . Nonetheless, a supply-leading approach should be handled warily and cautious- ly, with emphasis placed primarily on elimlnatlng bottleneck a reas In the provision of finan- c i a l s e rv ices . Polit ical pressures , bureaucratic ~ne f f i c i ency , conuption, e t c . , can dlstort the flow of funds under government programs away from optimal allocation patterns.

The appropriate specl f lc insti tutional arrangements for the flnanclal system depend upon the particular character is t ics of a given country. This Includes such matters a s the timlng, s ize , and distribution of t a x payments, the degree to which deposi t money i s accepted, and, more broadly, the particular nature of individual preferences a s reflected in the terms of trade-off 's among yield, safety, and liquidity. Developing countries should avoid the danger of being trapped into applying thoughtlessly the conventional ru les of thumb of other countries (such a s customary or legal ly determined deposit-loan, liquidity, or other ratios; restriction to certain kinds of lendlng-such a s the short-term, self-l iquidating commercial loan dogma- e t c . ), without considering their own needs .

I have emphasized the efficiency of financial intermedlation through the private market mechanism In Improving the allocation of s ca rce capi ta l to i t s most productive u s e s . There are some conditions under which the private optimal allocation diverges from the soc ia l opti- mum. In the financial sphere, insti tutions may conceive of their function only narrowly, or they may be greater r l sk avoiders than i s socia l ly des i rable . The monetary authorit ies should encourage financial insti tutions to a l locate their funds into those kinds of investment activity where the soc ia l marginal productivity i s relatively high. Which sec to r s deserve relatively greater encouragement depends upon the country, though in many underdeveloped countries private industrial plant and equipment investment and productive agricultural investment (fert i l izers and land improvements) are starved, re la t ive to commerce and government. In partlcular, there ex i s t s a need for t he effective provision of long-term funds to finance such productive fixed investment. If there i s an effective long-term capi ta l market in which indi- vldual and insti tution save r s are ab le and willing to purchase long-term secur i t ies (equi t ies

38. For more de t a i l , s e e Edward Nevin, Capi tal Funds In Underdeveloped Counfrres (London: Macmillan, 1961)

P A T R I C K

and bonds), most of t he problem i s solved. However, i t i s extremely unlikely tha t strong individual participation in capi ta l markets can be achieved early in the development process in underdeveloped countries, s o f inancia l intermediation i s even more important in carrying out the functions of t he capi ta l market.

The centra l bank can di rect ly aid in making such investment ac t iv i t ies relatively more a t t rac t ive by various measures-open market purchases , or accepting a s collateral for loans to financial insti tutions their holdings of industrial bonds, long-term loans , or even equi t ies , or loans for productive purposes in a g r i ~ u l t u r e . ~ ~ I t can indirectly aid by a s s i s t ing in the development of financial insti tutions with spec ia l function^,'^ such a s long-term credit devel- opment banks , agricultural and industrial credit cooperatives, and savings insti tutions, a s wel l a s regular commercial banks, in order to be sure a full spectrum of financial services a re avai lable .

The monetary authorit ies could a l s o t ake s t e p s to make financial a s s e t s more a t t rac t ive to individual s ave r s . A bas i c requis i te i s to develop and maintain full public confidence in the f inancla l system and i t s ins t i tu t ions . Means include legal sanct ions on and regular, thorough inspection of f inancia l insti tutions and government insurance agains t default of certain types of financial claims, such a s deposi ts , savings and loan shares , or even other a s s e t s . Additionally, the f inancia l authorit ies should encourage the creation of those flnan- cia1 a s s e t s that wi l l compete effectively with unproductive rea l a s s e t s . The competitive power of financial a s s e t s depends not only on their safety and liquidity, but, importantly, on their y ie ld a s wel l . Some underdeveloped countries today misguidedly pursue low interes t r a t e pol ic ies , which effectively prohibit f inancial a s s e t s from competing with r ea l a s s e t s , a s wel l a s encouraging unduly capi ta l - in tens ive techniques of production."

In underdeveloped countries, probably, a considerable portion of the savlng used relative- ly unproductively i s done by large numbers of relatively poor people. To real locate such saving more productively requires financial a s s e t s which can be in very small uni ts (divisi- bil i ty), slmple and convenient t o use , and readily avai lable in rural a r eas . Bank offices may be too expensive t o operate re la t ive t o the deposi ts attracted In rural a r eas or small towns until agricultural incomes r i s e substant ia l ly . Under such circumstances, pos ta l savings programs, uti l izing the large number of post offices that ex i s t even in an underdeveloped country, may be for some time the cheapest and most practical way to channel small rural wealth and saving into financial a s s e t form.

Furthermore, i n both rural and urban a reas in underdeveloped countries, there a r e a large number of moneylenders, pawnbrokers, rotating credit a s ~ o c i a t i o n s , ~ ~ and even commercial bil l d iscounters carrying on many of the functions of modern financial insti tutions. In fac t , they probably meet most of t he financial needs of smal l -scale production and commerce. Such tradit ional financial ins t i tu t ions have usual ly been strongly crit icized for being in monop- o l i s t i c posit ions and thereby charging extremely high in teres t r a t e s (in excess of the presum- ably high r isk premiums and high cos t s of developing knowledge of borrower creditworthiness).

39. The private f inanc~a l system. In i ts d e s ~ r e for satisfactory collateral for loans, may not be able to overcome fullv the gap between the owners of wealth and i t s most efficient users . T h ~ s 1s particularly true where the most acceptable f i rms of collateral are traditional items of wealth, such a s land, precious metals, or ~nventories . In these c a s e s , programs to encourage f i n a n c ~ a l intermediary acceptance of collateral arrangements w h ~ c h f a c i l ~ t a t e productive f ~ x e dinvestment can be especial ly useful.

40. Alternat~vely, the monetary authorities could encourage f inancial ~ns t i tu t lons to undertake a wtde varlety of f u n c t ~ o n s , the economies of spec ia l~za t ion appear to argue more for the former ins t i tu t~ona l setup, a s long a s compartmenlal~zation and Impediments to flows of funds among different types of financial institutions do not resul t .

41. Les te r V . Chandler, Central Banking and Economic Development (Bombay: U n ~ v e r s ~ t y of Bombay Press , lq621, pp. 11-51.

42. See Clifford Geertz, "The Rotating Credit Assoclatlon, A 'Middle Rung' In Development," Economic Developrnent and Cultural Change, X , No. 3 (April 1962). Geertz makes the polnt that such institutions. based on members who know and trust each other, are an intermediate step between a t r ad~ t iona l agrarian and a modern commercial economy.

188 ECONOMIC D E V E L O P M E N T A N D C U L T U R A L C H A N G E

A probably more significant criticism from the viewpoint of growth i s that a substantial pro- portion of the loans of traditional financial intermediaries are used to finance consumption rather than investment expenditures. These institutions transfer the net saving of one group to finance the net dis-saving of other groups. Modern financial institutions in underdevel- oped countries do not typically make consumer credit loans or otherwise directly finance much consumption expenditure. However, for a variety of reasons," underdeveloped coun-tries have not had a great deal of success , particularly in the short run, in eliminating such traditional financing institutions by attempting to substitute new financial institutions. More should be done to explore the possibilities of utilizing these traditional financiers for productive purposes, while reducing their monopolistic powers through increased competition.

In order to encourage financial intermediation a s a means of obtaining more resources for economic growth and of allocating those resources more efficiently, the monetary author- i t ies have to pursue broad economic policies which not only directly promote growth, but which also enhance public confidence in the financial system. Two general policy areas are particularly relevant: the country's financial relationship with the rest of the world, and the level (and rate of change) of domestic prices.

A country's foreign monetary policy for growth has, on the one hand, the objective of enabling the country to take full advantage of the opportunities offered by foreign trade, via specialization on the basis of dynamic comparative advantage, and by foreign capital (and skilled labor) markets, and, on the other, the objective of minimizing external restrictions on domestic growth. A decision has to be made on what extent to encourage or discourage the inflow of foreign capital; non-economic (xenophobic) a s well a s economic reasons loom important in this decision. Further, a foreign exchange policy has to be devised which en- courages exports (given the rising import requirements for growth in developing countries), which minimizes the amount of reserves the country naeds to hold, and which handles prob- lems of balance of payments disequilibria. A general foreign exchange rate policy cannot be enunciated without knowledge of the price elasticity of foreign demand for exports, do- mestic factor mobility, opportunities for efficient import-competing industrial activity, etc. For many underdeveloped countries, an exchange rate policy which over time allows for the possibility of depreciati0n"may be the best means of mitigating balance of payments con- straints on growth and inducing import-competing and export-oriented industrial development.

Equally a s important a s the counlry's exchange rate policy for minimizing balance of payments constraints on growth i s i ts domestic price policy. Fiscal and monetary authorities have a wide range of alternative rates of change of the price level-from negative, to zero, to positive-from which to select, explicitly or implicitly. Empirical evidence on the rela- tionship between the rate of growth of real output and the rate of price changes in different countries has not demonstrated beyond doubt the superiority of any particular policy of price level changes. Certain policies-hyperinflation and extreme deflation-have been shown to be inferior policies. The main argument in favor of severe deflation has been a s a relatively short-term measure to eliminate the inefficient users of resources, to induce others to use resources more efficiently, and to encourage the modernization of plant and equipment. Yet the ability to survive such abnormal conditions i s not necessarily highly (or even positively) correlated with efficient production in more normal periods. Moreover, whatever net positive allocative effects there are may well be more than outweighed by decreased real output, in-creased unemployment, and unfavorable expectation effects in a real world of substantial downward wage and price inflexibility.

43. Such a s lack of borrower trust, lack of lender knowledge of creditworthiness of individual borrowers and high cos t s in ob- taining this knowledge, the convenience of multiple f u n c t ~ o n s (engaging in commerce and rental, e t c . , a s well a s financing) of traditional f inanciers , and capture of new institutions by these financiers.

44. A further i s sue i s whether depreciation should be implemented by flexible exchange rates or fixed but adjustable rates . Given the administrative problems and time-lags in policy formulation and administration in underdeveloped countries, u se of the market mechanism via flexible rates i s likely to be more efficient.

P A T R I C K 189

While it can reasonably be argued that deflation tends to slow down the growth rate, i t does not follow that mild (or even more rapid) inflation speeds up the rate of growth. The relationship between inflation and growth evidently depends, importantly, upon the individual behavioral patterns and the structural and institutional rigidities within the particular econ- omy. Inflation probably increases entrepreneurial demand for real investment. It conceivably may also increase the saving rates of individuals, though more often the increase in the ag- gregate saving ratio i s deemed to come from a redistribution of income and wealth from spenders to savers. 45 However, inflation changes the effective yields on various asse t s , tending to raise yields on relatively unproductive investment, such a s holding of inventories, residential construction, etc. Since most financial asse t s are predicated upon a reasonable degree of price stability, inflation discourages the holding of financial asse t s and encourages a return to the holding of socially unproductive real asse t s . '' If an inflationary policy i s to be adopted, it would behoove the financial authorities to develop financial asse t s whose yield and value will not be hurt by price r i ses .

45. Th i s does not necessari ly mean a distribution from poorer to richer, s ince there may exist profligate rich (rentiers, nobility) and thrifty entrepreneurs of only moderate incomes. The usual emphasis i s , of course, upon the (temporary) distribution from worker to owner of productive real a s s e t s . At any rate , inflation i s a particularly erratic and capricious tax in i t s incidence; cf. Chandler, op. cit., p. 36.

47. Kesse l and Alchian have pointed out that a real cos t of inflation i s that of producing real a s s e t s to be hoarded a s subst i tutes for money (and, by extension, other financial a s se t s ) . See their "Effects of Inflation," Journal of Pol i t ical Economy (December 1962).