Secondary Markets, Financial Development, and
Economic Growth
Burak R. Uras∗
Tilburg University
European Banking Center
Abstract
Advocates of financial development claim that the availability of finance is vital for economic
growth. Although there is ample empirical support for this argument, there is non-negligible
evidence for counterproductive consequences of financial deepening as well. In this paper, I
analyze the long-run interactions between secondary financial markets, financial development
and economic growth and argue that the finance & growth nexus is sensitive to the structure
of secondary markets in a society. In investigating the validity of this hypothesis, I study a
dynamic general equilibrium model where entrepreneurial long-term investment is the engine of
growth in an environment characterized by financial market imperfections. Financial frictions
in the model are twofold: (1) Financial intermediation is limited because financing long-term
investment requires costly enforcement of entrepreneur’s loan repayment; and, (2) Financiers are
short-lived and therefore long-term capital is traded in a secondary market. The key finding of
the paper shows that if the secondary market price of capital rises with financial development,
reducing the cost of intermediation suppresses economic growth under fairly general conditions.
Otherwise, financial development and growth are positively correlated. I present microfoundations
for financial intermediation costs that induce the secondary market price of capital to grow with
financial depth and draw policy conclusions.
Keywords: microfoundations of financial frictions, long-term investment, secondary markets, and
economic growth.
JEL Classification Numbers: E44, G2, O16, 047.
∗
Tilburg University, Department of Economics Room K322B 5000 LE Tilburg,The Netherlands.
r.b.uras@uvt.nl.
1
E-mail:
1
Introduction
The large literature that focuses on long-run implications of financial deepening provide theoretical
foundations to explain why access to finance is important for macroeconomic development1 . However,
a number of empirical studies are skeptical about the growth effects of financial development. For
example, Pagano and Jappelli (1994), Demetriades and Luintel (2001), Castro et al. (2004) and
Masten et al. (2008) show that, depending on country specific context, financial deepening might be
counterproductive for the aggregate economy.
The aim of this paper is to provide a theoretical foundation and uncover the potential non-monotone
growth effects of financial development in a dynamic general equilibrium model with secondary capital
markets. In the model, long-term investment is the engine of economic growth where financial frictions
constrain the capacity to invest long-term. Specifically, (1) financial intermediation is constrained because there is costly enforcement of loan repayment, and (2) financiers are short-lived and therefore,
long-term capital needs to be traded in a secondary market. An important general equilibrium result
from this set-up is the endogenous existence of a non-monotonicity between financial frictions and
steady-state output: Lowering financial intermediation costs is not always associated with a rise in
economic development. This key result hinges on the behavior of equilibrium security prices in the secondary market. Reducing loan enforcement costs stimulates macroeconomic performance to the extent
it mitigates the secondary market price of capital. If the secondary market price of capital rises with financial development, reducing the cost of enforcement suppresses aggregate long-term investment and
might become counterproductive. I provide microfoundations that characterize the behavior of prices
in the secondary market with respect to enforcement costs and draw policy conclusions concerning the
growth effects of financial development.
In investigating the effects of secondary market trading on finance & growth nexus, I study an overlapping generations model with occupation choice and production. In this model, two-period lived
economic agents, in the first period of the life-cycle, endogenously choose an occupation as a worker or
as an entrepreneur to manage a 1-period short-term production plant, or as an entrepreneur to adopt
a 2-period long-term production technology. The occupation choice determines whether an agent becomes a financier (if the occupation selection is a worker or a short-term producer) or a borrower (if
the occupation is the long-term producer).
Long-term investment determines the long-run economic performance through endogenous productivity growth. Aggregate long-term output of today determines the productivity of short-term and
long-term production plants of the future through intergenerational productivity spillovers.
Since long-term investment takes two periods to complete and each financier can save at most for
one period, long-term financial assets (financial returns from long-term investment) are traded in a
secondary market. There is a primary and a secondary financier of each long-term asset. Primary
financiers extend long-term loans (capital) for long-term entrepreneurial production and receive financial claims against next period’s output realization. Secondary financiers purchase these financial
claims from primary financiers and collect capital returns from entrepreneurs upon the finalization of
long-term production.
1
Greenwood and Jovanovic (1990), Bencivenga and Smith (1991), Marcet and Marimon (1992), Banerjee and Newman
(1993), Acemoglu and Zillibotti (1997), Aghion and Bolton (1997), Azariadis and Kaas (2007), Antunes et al. (2008),
and Aghion et al. (2010).
2
Financial intermediation frictions in the form of costly enforcement of loan repayment raise the cost
of finance above the fundamental value of capital services. I study three financial regimes. Financial
Structure 1: Primary financiers enforce loan repayment; Financial Structure 2: Secondary financiers
enforce loan repayment; and Financial Structure 3: A combination of primary and secondary financiers
enforce loan repayment.
The delegation of enforcement to a particular financier group could be related to the securitization
design or the regulatory framework in the society. Specifically, if each primary financier desires to sell
a “bundle” of securities that promise returns from a large collection of long-term projects, then the
institutional set-up might require the loan enforcement of primary financiers. On the other hand, if
each primary financier sells a “single” security with promised returns from a single long-term project
only, then it is more likely to have secondary financiers enforcing the loan repayment. The delegation of enforcement in each case is expected to lower the social costs of financial transactions within
the respective environments: In the former financial regime where “bundled securities” are traded,
secondary financiers as collectors of financial returns would find it hard evaluate the quality of the
complex financial instruments that they buy unless primary financiers provide credible enforcement
mechanisms that guarantee repayment in the future. In the second financial regime, complex financial
instruments are absent at secondary market trade. Therefore, secondary financiers as capital return
collectors arise as natural candidates for the enforcement of loan repayment. Regulatory framework
might also assign exogenously set enforcement roles to a particular group of financiers in the economy.
The key insights developed from each financial regime are as follows.
Financial Structure 1: Primary financiers incur the cost of loan enforcement, and the equilibrium
secondary market price of capital equals to the primary financier’s gross capital return and can be
expressed as R(1 + φ): R is the steady-state rate of capital return to be determined endogenously,
and φ is the capital price wedge implied by the costly loan enforcement. The rate of capital return
for secondary financiers equals to R. With this model specification, a permanent reduction in capital
price wedge φ raises the equilibrium rate of return R and suppresses R(1 + φ). The decrease in
the cost of loan enforcement in turn increases the stock of financial assets since the rate of return
from financing rises; and at the same time the amount of investable funds paid to each primary
financier declines because the secondary market price of capital decreases with financial development.
The former channel causes an expansion in the “financial sector” and fosters financial deepening in
the economy and the latter channel stimulates the “allocative efficiency”. Both channels activate a
rise in “real long-term investment” and aggregate productivity and promote financial deepening to
be growth enhancing. This analytical result confirms with the standard argument about the positive
growth effects of financial development presented by Bencivenga and Smith (1991), Aghion and Bolton
(1997), Azariadis and Kaas (2007) and many others.
Financial Structure 2: Secondary financiers enforce loan repayment, which implies that the secondary market price of capital equals R; whereas, the compensation of secondary financiers is R(1+φ).
In this financial regime, lowering the cost of intermediation φ, increases the stock of financial assets
as in Financial Structure 1, and raises the investable funds that needs to be paid to each primary
financier since the real rate of financial return R rises with financial development. The net effect
of financial development on aggregate long-term investment under fairly general model conditions is
negative: Lowering φ reduces the real investment in long-term projects. Since long-term project investment is the engine of economic growth there exists an optimum level of financial repression that
maximizes the steady-state per-capita output in the economy.
3
There is empirical support for growth reducing financial development experiences. For example,
Pagano and Jappelli (1994) show that financial deregulation and the implied decline in cost of borrowing have contributed to the decline in economic growth rates during the 1980s in OECD countries
and argue for potential optimality of financial constraints.
Another important result from the model emerges when we compare the level of steady-state output
under financial structure 1 against the level of steady-state output with financial structure 2. Holding
everything else constant, shifting the delegation of enforcement from secondary financiers to primary
financiers lowers the long-term project output, simply because the price of long-term claims rises as
primary financiers become more involved at loan repayment enforcement. Since long-term investment is the engine of the productivity growth, the steady-state productivity of an economy governed
by financial-structure-2 is higher than the steady-state productivity of an economy with financialstructure-1. This result suggests that if the introduction of complex financial instruments such as
bundled asset-backed securities shift the enforcement of loan contracts from secondary financiers to
primary financiers, macroeconomic performance might deteriorate.
The insights from financial structures 1 and 2 reveals that microfoundations of financial intermediation costs are important to understand the implications of financial development for macroeconomic
performance. To investigate the contribution of economic development in understanding the financedevelopment nexus, I also analyze an interim case (Financial Structure 3) with heterogenous primary
financiers. In this extension, an exogenously set η fraction of all long-term projects’ loan repayment
is enforced by primary financiers and the remaining fraction by secondary financiers. Comparative
statics in this interim case indicate an interaction between economic development and the potential
growth-reducing effects of financial development. Specifically, in high income countries as an initial
condition a relatively larger share of primary financiers need to be enforcing loan repayment so that
reducing intermediation costs can promote economic growth. This result implies that in high income
countries financial development is more likely to reduce growth rates. Empirical findings from past
research confirm with this result as well. For instance, Castro et al. (2004) measure costly loan repayment with “limited investor protection” and document non-linear growth effects of investor protection.
An important empirical result from their work shows that investor protection and economic growth
exhibit a negative relationship for the sample of high income countries.
The theoretical results from this paper are important for development policy as well. For developing
countries, there are cases where well-intended financial development policies reduced economic growth
rates, such as in Latin American countries during 1990s, whereas similar financial development experiences promoted economic growth in other countries, e.g. Turkey during 1980s. My theoretical results
in this paper draw attention to the characteristics of the financial structure that policy makers might
need to pay attention in order to avoid policies with potential counterproductive consequences.
Related Literature: The paper contributes to the literature on Finance and Macroeconomic Development. Some of the important studies in this literature are Greenwood and Jovanovic (1990), Bencivenga
and Smith (1991), Banerjee and Newman (1993), Antunes et al. (2008), and Aghion et al. (2010).2
This paper is essentially related to the literature that identifies non-monotone real effects of financial
sector development. Some important studies in this area of research are Bencivenga et al. (1995
and 1996), Deidda and Fatouh (2002), Castro et al. (2004), and Uras (2012). In these studies, the
2
There is also a vast empirical literature focusing on the association between the level of financial development and
economic growth. See for example Levine (1993 and 1997), Beck, Levine, and Loayza (2000), Christopoulos and Tsionas
(2004), Castro et al. (2004) and Beck et al. (2008).
4
non-monotonicity between finance and economic development arises if quantities of some particular
macroeconomic variable, such as the steady-state capital stock (Bencivenga et al. (1995 and 1996)) or
the population weight of firms with an access to a long-term production technology (Uras (2012)), do
not reach a critical level. Different from the approach of these studies, in the current paper, the nonmonotonicity between finance and economic development depends not only on the stage of economic
development but also on the structure of the financial sector and the underlying microfoundations that
explain the cost of financial intermediation. To the best of my knowledge the current study is the first
in pointing out this specific issue about the potential counterproductivity of financial development.
The rest of the paper is organized as follows. Section 2 introduces the basic model environment.
Sections 3, 4 and 5 compare the growth implications of financial development across three financial
regimes and draw policy conclusions. Section 6 concludes the paper.
2
The Model Environment
I study an Overlapping Generations model (OLG) with production and occupation choice. Time is
indexed with t and continues forever. There is a single good in the economy, which is produced by
entrepreneurial projects.
Each period a continuum of risk-neutral agents with measure M enter the economy. Agents live for two
periods, denoted as young and old. All young agents are ex-ante identical who at the beginning of their
life-cycle endogenously specialize in one of the following three occupations: Workers, Entrepreneurs
with a Short-term Investment Project, and Entrepreneurs with a Long-term Investment Project. The
endogenous population measures of workers, short-term producers and long-term producers in any
given period t are denoted by Mω,t , Me,t , and ML,t .
Workers supply labor for short-term entrepreneurial projects in the first-period of the life-cycle and
receive real wages wt . The real wage will be determined endogenously. Workers have no labor endowment in the second period of their life-cycle, so that they have to save to finance the old-period
consumption.
Entrepreneurs with a short-term investment project employ labor to produce the consumption
good using a technology that takes one period to complete: Short-term production, for each lt quantity
of labor employed, returns s(lt ) units of the consumption good at the end of the first period of an
entrepreneur’s life-cycle.
Assumption 1. st (lt ) = AS,t ltβ , with 0 < β < 1.
Assumption 1 simply implies a span of control (decreasing returns to scale) with respect to the labor
employed in short-term projects. As,t is a productivity parameter. The process that governs the
time-trend of As,t will be delineated below. Similar to workers, entrepreneurs of short-term investment
projects manage production plants when young and retire when old.
Entrepreneurs with a long-term investment project operate production plants that require a
long-term capital investment. Long-term production takes two-periods to complete, and for each kt
units of capital employed in period t, it returns `t+1 (kt ) units of the consumption good at the end of
5
the second period. As in the short-term production, `t+1 (kt ) exhibits decreasing returns to scale.
Assumption 2. `t+1 (kt ) = AL,t ktα , with 0 < α < 1.
The capital good depreciates completely during production process of a long-term project, and unlike
workers and short-term producers, long-term entrepreneurs manage projects during both periods of
their life-cycle.
Productivity. The productivity of short-term and long-term projects in any given period t is a
function of aggregate output produced by long-term entrepreneurial Rprojects in period t − 1. I denote
the aggregate output produced by long-term projects by Wt−1 ≡ ML,t−1 `i,t−1 di , and formalize the
productivity process in the economy with the following assumption:
Assumption 3. For J ∈ {S, L}, AJ,t = gJ (Wt−1 ) with
∂gJ (W )
∂W
> 0.
This assumption states that there are inter-generational knowledge spillovers in the form of productivity enhancing investment: Long-term output of today determines the aggregate productivity of the
future. With this time-trend of productivity, one can think of the long-term entrepreneurial projects
as an investment opportunity that incorporates R&D or human capital development. Productivity
enhancing long-term investment of this form is a stylized feature of endogenous growth models with
overlapping generations as in Aghion et al. (2010).
Financial Market Transactions. Long-term entrepreneurial capital can be financed only if longterm financial claims can be traded (rolled over) in a secondary capital market between the financiers
of two consecutive generations. In any given period t the sequence of events, that also characterize
financial market transactions and the need for a secondary capital market, is as the following:
1. Young agents select an occupation from the set {Worker, Short-term entrepreneur, Long-term
entrepreneur }.
2. Short-term project entrepreneurs hire labor from workers (young), and
Long-term project entrepreneurs borrow capital from financiers (old).
3. The production output from short-term and long-term projects are collected.
4. Capital and labor gets paid their returns: Old capital providers (financiers) and young workers
are paid.
5. Secondary capital market opens. Short-term producers and workers (young financiers) purchase
financial claims against period t + 1 long-term investment returns. Specifically, old-financier,
who have extended long-term capital to young entrepreneurs at the beginning of the period t,
sell securities to young financiers.
6. Agents consume.
The timing of events imply that there is a primary and a secondary financier of a long-term investment
project: Primary financiers extend long-term loans (capital) for entrepreneurial projects in period t and
receive financial claims against next period’s (t + 1) output realization. Secondary financiers purchase
6
these financial claims from primary financiers in t and collect capital returns from entrepreneurs upon
the finalization of long-term projects in period t + 1.
Financial Frictions. I study the effects of financial intermediation costs on steady-state output and
consumption. Specifically, the two-period capital cost for a long-term entrepreneur equals
RL = Rq(1 + φ),
(1)
where R and q are endogenously determined (net) private returns to capital that accrue to primary
(R) and secondary (q) financiers, and φ ≥ 0 is the cost of financial intermediation, as emphasized in
Demirguc and Huizinga (1999) and Antunes et al. (2007). The novel feature of the current model
is that the financial intermediation costs are micro-founded. Financiers incur a utility loss (cost of
enforcement) that is proportional to the size of the private capital returns from financing long-term
projects which in turn increases the cost of finance for entrepreneurs (RL ) by a capital price wedge
as in (1). The central remark that I aim to deliver is the microfoundations of financial repression
are important to understand the nexus between financial development and economic growth. To
analyze the microfoundations of financial frictions, I investigate financial development experiments
in three different regimes. Financial Structure 1: Primary financiers enforce loan repayment and
suffer a utility loss at extending capital to long-term entrepreneurs that increases RL for long-term
entrepreneurs. Financial Structure 2: Secondary financiers enforce loan repayment, and therefore,
suffer a welfare loss when purchasing financial claims from primary financiers which again increases
RL for long-term entrepreneurs. Financial Structure 3: A combination of primary and secondary
financiers enforce loan repayment.
The delegation of enforcement to a particular financier group could be motivated by the securitization
design in the society. The trade of complex financial instruments, e.g. bundled long-term project
returns, might require the involvement of primary financiers at loan enforcement, whereas enforcement
of secondary financiers is expected to minimize financial transaction costs if simple long-term financial
assets are traded in the secondary market.
As I will delineate in the consecutive analysis, the nexus between financial development and long-run
economic performance is highly sensitive to the mode of financial structure a country exhibits: While
with Financial Structure 1 reducing financial intermediation costs is always growth promoting, in
Financial Structure 2 financial development is likely to be counterproductive. In financial structure 3
the growth effects of financial development is a function of the total number of primary financiers who
are allocated at enforcing the loan repayment.
Preferences. The life-time utility from consumption is specified as
U = cy + β i co ,
(2)
where cy is the youth-period consumption and co is the old period consumption of an agent. The
discount parameter βi is specific to an agent’s occupation and his role in the financial structure.
1
, 1} with φ ≥ 0; and ,
Specifically, βi ∈ { 1+φ
1. βL = 1 for all long-term entrepreneurs (subscript L stands for long-term) in all financial regimes.
2. In financial structure 1, β1 =
and 2 for secondary.
1
1+φ
and β2 = 1 where subscript-1 stands for primary financiers
7
3. In financial structure 2, β1 = 1 and β2 =
1
.
1+φ
4. In financial structure 3, an η fraction of all long-term projects require the enforcement of primary
financiers whereas 1 − η fraction are enforced by secondary financiers. Therefore, for η fraction of
1
all primary financiers in a cohort β1e = 1+φ
whereas for the remaining subset of primary financiers
ne
β1 = 1.
With this utility specification, I incorporate an effort cost (equivalent to loss of utility from consumption) associated with investing for the second period of a financier’s life-cycle. Such enforcement costs
can be rationalized with costly “monitoring” of entrepreneurial projects. In equilibrium the discount
parameter φ will generate a capital price wedge as in (1).
The risk-neutrality implied by the linear utility specification is not important for the qualitative messages that I highlight in this paper. Incorporating risk-aversion, for instance in the form of logarithmic
preferences, would not alter the theoretical contribution.
3
Financial Structure 1: Costly Primary Finance
Financial intermediation costs are incurred by primary financiers. Therefore, primary financiers discount the second period consumption by 1/1 + φ, whereas the secondary financiers value the second
period consumption as much as the first period consumption. I allow any convex combination of the
two investment options (as a primary financier or as a secondary financier) for a particular saver. That
means, a saver can be a primary financier for some long-term projects and at the same time invest as
a secondary financier to some others.
Suppose pt is the price of a one-unit long-term financial claim in the perfectly competitive secondary
market that returns RtL in period t + 1. The private capital return of a primary financier net of cost
pt
. Suppose qt+1 denotes the private capital
of loan enforcement is denoted by Rt and equals Rt = 1+φ
returns for a secondary financier from a one-unit financial claim purchased in the secondary market.
Lemma 1 summarizes the conditions that must hold between R, p and q to guarantee the existence of
an equilibrium with long-term investment.
Lemma 1 (i) An equilibrium with long-term capital investment exists if and only if Rt+1 = qt+1 ≥ 1.
(ii) The unit cost of two-period finance for a borrower equals to Rt Rt+1 (1 + φ).
Proof Denote the two-period cost of finance for a borrower by RtL . Given the secondary market price
RL
of a long-term claim (pt ), qt+1 = ptt . The no-arbitrage condition
RtL
pt+1
=
,
pt
1+φ
|{z} | {z }
=qt+1
=Rt+1
should hold between primary and secondary financier’s capital returns; otherwise, all financiers strictly
prefer to be either a primary financier or a secondary financier, and under either case long-term finance
8
cannot become available for entrepreneurs. Therefore, RtL = Rt Rt+1 (1+φ) holds at interior equilibrium
where long-term investment exists. Finally Rt+1 = qt+1 ≥ 1 should hold. If not, linear life-time utility
implies that all consumption will take place in the first period of the life-cycle which implies zero
long-term investment in the aggregate. An important feature of this economy is that in equilibrium the unit capital return for a financier
(primary or secondary) equals to R. Therefore, variations in financial intermediation costs affect
the life-time value from being a saver only through general equilibrium adjustments in R. In the
consecutive analysis I analyze the behavior of R with respect to φ and study the growth implications
of financial development where financial development will be defined as a permanent reduction in cost
of enforcement, φ.
3.1
Optimizing Behavior
Workers. Risk neutrality implies that workers save the entire wage compensation wt from the youth
period by financing long-term projects as long as the returns from project finance are large enough
(Rt+1 ≥ 1). For Rt+1 ≥ 1 a worker’s lifetime utility equals to Vω,t = Rt+1 wt .
Short-term producers. Short-term entrepreneurs maximize:
max π(lt ) = s(lt ) − wlt .
lt
Denote the optimum quantity of labor employed as a function of the equilibrium wage rate by lt∗ (wt ).
The implied entrepreneurial profit in equilibrium from short-term investment is π(lt∗ (wt )). Due to risk
neutral preferences short-term producers also save the entirety of their profits by lending π(lt∗ (wt )) units
of the consumption good to finance long-term projects if Rt+1 ≥ 1. Provided Rt+1 ≥ 1 a short-term
entrepreneur’s lifetime utility is given by Ve,t = Rt+1 π(lt∗ (wt )).
Long-term producers. An entrepreneur with a long-term project born in period t maximizes:
AL,t ktα − Rt Rt+1 (1 + φ)ktα .
A long-term entrepreneur’s optimal capital demand kt∗ and the associated life-time value function are
given by
1
1−α
αA
L,t
,
kt∗ =
Rt Rt+1 (1 + φ)
α
1−α
αAL,t
VL (kt ) = (1 − α)AL,t
.
Rt Rt+1 (1 + φ)
The financial friction (φ) has a direct impact (as well as an indirect price effect) on a long-term project
entrepreneur’s lifetime value. For constant R the higher φ the lower is the lifetime value from being
an entrepreneur.
9
3.2
Equilibrium
Definition The dynamic general equilibrium of the economy is characterized by an infinite stream
t=∞
), one-period rate of capital returns ({Rt }t=∞
of wage rates ({wt }t=0
t=0 ) and security prices in the sect=∞
ondary capital market ({pt }t=0 ) at which
1. Agents optimize their life-time utility,
2. Life-time returns from the three occupation choices are equalized, such that
V (w ) = V (l ) = VL,t (kt ),
| ω,t t {z e,t t}
(3)
≡VS,t
1
3. The life-time value from being a primary financier (VS,t
) is equal to the life-time value of a
2
secondary financier (VS,t
)
1
2
VS,t
= VS,t
(4)
4. Labor and capital markets clear
Z
Z
s
li,t
(wt )di
Z
d
lj,t
(wt )dj
Me,t
Mω,t
Z
Z
d
ki,t (Rt , Rt+1 )di =
wj,t dj +
=
ML,t
Mω,t
(5)
πj,t (wt )dj
(6)
Me,t
where Mω,t , Me,t , and ML,t are equilibrium measures of workers, short-term entrepreneurs and
long-term entrepreneurs respectively.
The model is recursive. This means, labor market clearance determines the equilibrium wage rate wt ,
and wt in turn pins down Rt+1 that clears the capital market in the next period.
Lemma 2 A unique stationary equilibrium exists.
Proof Denote the steady-state wage rate and the one-period rate of capital by w and R respectively.
In a steady-state equilibrium, endogenously determined fractions of the population select to become
workers, short-term producers and long-term producers. The conditions that need to hold for the
existence of an equilibrium where positive measures of each type of agent exist in the economy is given
by equation (1). The first equality at (1) can be re-written as:
Rw = Rπ(w)
|{z}
| {z }
=Vω
(7)
=Ve
Equation (7) implies that in a steady-state equilibrium w = π(w): Workers and short-term producers
share the returns from short-term technology output with equal shares, equalizing the life-time values
across two occupations such that Vω = Ve ≡ VS . It proves to be useful to define MS = Mω + Me where
MS is the aggregate measure of savers in a cohort.
10
Using the production function specified at assumption 2, the short-term producer’s profit function
β
S 1−β
, where AS is the steady-state level of short-term project
is given by π(w) = (1 − β)AS βA
w
productivity. Since in equilibrium π(w) = w holds:
1
w = AS β(1 − β) 1−β .
Given w, the labor market clearance sets the relative population weights between workers (Mω ) and
short-term producers (Me ), and the second part of equality (1) pins down the general equilibrium rate
of private capital (financial) return R. The rate R in turn determines the invariant distribution between
savers and borrowers (long-term entrepreneurs) in the economy. The saver-borrower distribution in the
economy settles the steady-state short-term (AS ) and long-term (AL ) productivity of entrepreneurial
projects. In a stationary equilibrium the cost of finance for a long-term entrepreneur is stated as:
RL (φ) = R2 (1 + φ).
The price of a long-term claim in the secondary market satisfies:
p(φ) = R(1 + φ).
We can express the occupation choice indifference between being a saver (VS ) and a long-term entrepreneur (VL ) as the following:
wR = (1 − α)AL
|{z}
VS
|
αAL
2
R (1 + φ)
{z
α
1−α
.
(8)
}
VL
Solving for R as a function of φ, one can derive:
1
1+α
R(φ) = AL
1−α
w
1−α
1+α
α
1+φ
α
1+α
.
(9)
R(φ) is a decreasing function of φ. This equilibrium property implies that the life-time value from
being a financier (saver) increases with financial development. Financial development makes the
“finance-sector” attractive. The rise in the rate of return on capital as financial frictions contract is a
standard feature of general equilibrium models of financial development, such as Aiyagari (1994) and
Angeletos and Calvet (2006).
Given R(φ), the two-period cost of finance RL can be expressed as a function of φ:
1−α
RL (φ) = R2 (1 + φ) ∝ (1 + φ) 1+α
(10)
As it can be observed at expression (10) the cost of long-term finance declines with financial development, and stimulates the value from being a long-term entrepreneur. Since agents are ex-ante identical
the life-time value from long-term entrepreneurship increases by the same rate at which financier’s lifetime value rises following a reduction in φ.
11
The secondary market price of a long-term claim, p, can be solved as a function of φ as well:
1
p(φ) = R(1 + φ) ∝ (1 + φ) 1+α .
(11)
The price of long-term claims in the secondary market increases with φ. That p is an increasing
function of φ is important to understand the long-run effects of financial development. In steady-state
a constant amount of per-financier capital is invested in long-term entrepreneurial projects. Denote
this steady-state amount by x. The aggregate capital invested in long-term entrepreneurial projects
then equals to Ms x. The aggregate compensation of primary savers in the stationary equilibrium
should then be equal to MS xp(φ) = MS xR(1 + φ). Since the aggregate capital in the economy equals
to MS w, we can derive x as
w
w
=
.
(12)
x=
1+p
1 + R(1 + φ)
Since the price of long-term claims increases with φ, x rises with financial development. To understand
whether the aggregate capital invested in long-term projects rises with financial development we need
to derive the equilibrium measure of savers in the economy (MS ) as a function of φ. The capital
market clearance condition can be stated as:
1
1−α
w
αAL
MS
= ML
1 + R(1 + φ)
R2 (1 + φ)
1
1−α
αAL
VL
= ML
⇒ MS
R(1 + R(1 + φ))
R2 (1 + φ)
α
1
1−α 1−α
αAL
αAL
1
⇒ MS (1 − α)AL
= ML
R2 (1 + φ)
R(1 + R(1 + φ))
R2 (1 + φ)
Solving for the equilibrium ratio of savers relative to long-term entrepreneurs (MS /ML ) yields:
MS
α 1 + R(1 + φ)
=
ML
1 − α R(1 + φ)
(13)
The equation (13) shows that the MS /ML ratio is a decreasing function of φ. Financial development
stimulates aggregate capital available for long-term projects (MS x) by 2 channels: (1) The total
number of savers (MS ) in the economy rises, and (2) the per-financier amount of savings allocated to
long-term projects (x) increases.
Steady-state Output and Consumption. I measure the long-run performance of the economy by
steady-state consumption (and output) in per-capita. Denoting c as the consumption per-capita in
the steady-state (and per-capita output by y), from equation (8), we can derive:
y = c = wR,
= (AL w)
1
1+α
(1 − α)
1−α
1+α
α
1+φ
α
1+α
.
(14)
Steady-state consumption is a function of AL and w. Productivity of long-term projects and, AL ,
and the real wage rate, w, are both determined by the aggregate output produced by long-term
entrepreneurial projects (W ) which can be derived as:
α
w
MS
W = ML AL
,
1 + R(1 + φ) ML
α
w
1 + R(1 + φ) α
= ML AL
,
1 + R(1 + φ) R(1 + φ) 1 − α
α
w
α
= ML AL
.
R(1 + φ) 1 − α
12
Using z ≡
1−α
α
and MS = M − ML at (13):
zR(1 + φ)
ML
=
,
M − ML
1 + R(1 + φ)
zR(1 + φ)
⇒ ML =
M.
1 + (1 + z)R(1 + φ)
Now W as a function of φ and R can be stated as,
W =
[R(1 + φ)]1−α
AL z 1−α [w]α M,
1 + (1 + z)R(1 + φ)
(15)
or as a function of the secondary market price of capital p:
W =
3.3
p1−α
AL z 1−α [w]α M.
1 + (1 + z)p
(16)
Financial Development and Economic Performance
The output produced by long-term projects determines the steady-state per-capita consumption as
the steady-state productivity depends on the aggregate output produced by long-term entrepreneurial
projects. Although financial development is expansionary for the aggregate capital invested in longterm projects, it also reduces the total number of long-term entrepreneurs in the economy. Therefore,
one needs to check whether the aggregate output produced by long-term projects does in fact rise with
financial development in this “benchmark” specification. I define financial development as an event
that occurs at the beginning of a period τ (at stage-0 of the flow of events presented in section 2) and
reduces the cost of financial intermediation φ permanently.
Comparative statics. Differentiating (16) with respect to φ, and denoting the first partial derivative
of p by p0 (φ), we can show that lowering the intermediation friction φ improves the steady-state
aggregate output produced by long-term projects if and only if:
(1 − α) [p(φ)]−α p0 (φ)[1 + (1 + z)p(φ)] < (1 + z) [p(φ)]1−α p0 (φ)
(17)
Using the definition of z in (17), the condition (17) reduces to
(1 − α)α(1 + (1 + z)p(φ)) < p(φ),
⇒ (1 − α) < p(φ),
⇒ (1 − α) < R(1 + φ)
(18)
The rate of capital return, R, must exceed 1 to induce risk-neutral agents to invest their first period income in long-term projects. Therefore, as long as an equilibrium with long-term investment
exists, characterized by R ≥ 1, the condition at (18) holds for all parameter values: Reducing the
intermediation costs always stimulates the steady-state output from long-term projects.
Proposition 3.1 The inequality at (18) is satisfied for all parameter values that support an interior
equilibrium. Lowering financial intermediation frictions stimulates the aggregate output generated by
long-term projects.
13
Transitory Dynamics. A permanent reduction in φ in a period τ stimulates the aggregate output
of long-term projects in the consecutive period (Wτ +1 ). Since the productivity of short-term and
long-term projects are time-dependent as characterized at assumption 3, a rise in current output from
long-term projects translates into a higher project productivity in the future. Therefore, comparing the
steady-state values of productivity and output for long-term projects (AL , W ) against the productivity
and output in period τ + 1 (AL,τ +1 , Wτ +1 ) shows that AL > AL,τ +1 and W > Wτ +1 .
These results imply that future generations benefit from financial development more than the current
generation who invests in institutions that promote financial intermediation. Going back to equation
(14): The current generation (cohort born in period τ ) clearly benefits from financial development
since for constant w and AL , consumption in period in τ + 1 rises as φ declines. However, the steadystate per-capita consumption, c, is strictly larger than the per-capita consumption in period τ + 1,
cτ +1 , because the rise in W stimulates AL and w in the long-run.
FIGURES 1 AND 2 ABOUT HERE
3.4
Discussion
The current economic framework resembles a two-sector model characterized by the interactions between the “financial-sector” that generates the capital input necessary for the “real investment-sector”.
When intermediation frictions are large the economy exhibits an inefficiently undersized finance-sector
because the rate of capital return is too small. Financial development stimulates the rates of return
on capital causing an expansion in the size of the finance-sector, and an increase in capital available
for the real production sector.
Figures 1 and 2 summarize the results from section 3. Figure 2 draws the net capital returns (R)
and aggregate output produced by long-term projects (W ) in steady-state, and figure 3 draws the
secondary market price of long-term claims (p) together with W . p is decreasing in φ, and so is W
in p; therefore, a decline in cost of enforcement stimulates steady-state output produced by long-term
projects.
The key result that shows the steady-state consumption is a decreasing function of φ has an intuitive
interpretation. Permanent reductions in φ generate three effects on the macroeconomy: (1) The contraction in capital price wedge φ increases the aggregate capital stock in steady-state: The population
share of financiers (MS ) rises as φ decreases. (2) The contraction in φ also mitigates the fraction of
investable funds that needs to be paid to primary financiers in secondary market transactions: p is an
increasing function of φ, and therefore the smaller φ the larger is the fraction of the physical capital
stock that can be allocated to long-term entrepreneurial production. (3) The output produced by
long-term projects rises with the expansion of the capital stock which stimulates the productivity of
short-term and long-term projects in the economy.
The channel 1 fosters the capital deepening whereas the latter two channels stimulate the total factor
productivity by improving the allocative efficiency of capital (channel 2) and as a result stimulating
inter-generational productivity spillovers (channel 3). Institutional development (lowering cost of financial intermediation φ permanently) stimulates the steady-state aggregate product and consumption
through all three channels.
14
4
Financial Structure 2: Costly Secondary Finance
Consider now a financial structure where secondary financiers incur the effort cost of financing longterm projects. The preferences specified in section 2 imply that the secondary financiers discount
the capital returns that will be collected from long-term financial claims purchased in the secondary
market.
Denoting pt again as the secondary market price of long-term financial claims, the private capital
RtL
. As in section 3, Rt
return of a secondary financier net of effort costs is computed as qt+1 = pt (1+φ)
denotes the private capital returns for a primary financier where with Financial Structure 2 Rt = pt .
The following lemma shows that RtL = Rt Rt+1 (1 + φ) continues to hold in equilibrium.
Lemma 3 The unit cost of two-period finance satisfies RtL = Rt Rt+1 (1 + φ).
Proof The no-arbitrage condition
RtL
= pt+1 ,
|{z}
p (1 + φ)
| t {z } =Rt+1
=qt+1
should hold between primary and secondary financier’s capital returns as in Financial Structure 1;
otherwise, all financiers strictly prefer to be either a primary financier or a secondary financier, and with
either case long-term finance cannot become available for entrepreneurs. Therefore, RtL = Rt Rt+1 (1 +
φ). 4.1
Optimizing Behavior and Equilibrium
The optimizing behavior for three occupations and the existence result for the stationary equilibrium
remain the same as in section 3. The occupation indifference condition between being a saver (worker
or short-term producer) and a long-term entrepreneur solves the real rate of capital return, yielding
the same steady-state expressions for R(φ)
1
1+α
R(φ) = AL
1−α
w
1−α
1+α
α
1+φ
α
1+α
,
and for the cost of finance RL (φ)
1−α
RL (φ) ∝ (1 + φ) 1+α ,
as in section 3. Different from the financial structure analyzed in section 3, in this case the secondary
financiers incur the cost of long-term project finance; therefore p = R in equilibrium with
1
1+α
p(φ) = AL
1−α
w
1−α
1+α
α
1+φ
α
1+α
,
which implies that the secondary market price of capital increases with the level of financial development. Denoting the per-saver capital invested in entrepreneurial projects by x, the aggregate capital
15
stock invested in long-term entrepreneurial projects equals to Ms x which implies that the aggregate
compensation of primary savers must equal to MS xp = MS xR. We can derive
w
w
=
,
(19)
x=
1+p
1+R
and observe that x decreases as cost enforcement φ decreases. Each primary financier provides a
relatively smaller fraction of his savings for long-term projects as the financial sector develops. This is
a result highlighted also by Bencivenga, Smith and Starr (1996): If long-term assets need to be rolled
over in a secondary market, reducing the cost of financial transactions lowers long-term investment.
Different from their work, this paper shows that the delegation of loan enforcement is central to
understand the effects of financial intermediation costs on long-term investment.
We can express the capital market clearance condition as:
w
= ML
MS
1+R
αA
2
R (1 + φ)
1
1−α
,
1
1−α
αA
VL
= ML
,
⇒ MS
R(1 + R)
R2 (1 + φ)
α 1
1−α
1−α
αA
1
αA
⇒ MS (1 − α)A
.
= ML
R2 (1 + φ)
R(1 + R)
R2 (1 + φ)
Solving for MS /ML ratio yields:
MS
α
1+R
=
.
(20)
ML
1 − α R(1 + φ)
The equation (20) shows that the MS /ML ratio (similar to the Financial Structure 1 from section 3)
increases as φ declines permanently.
Steady-state Output and Consumption.
The steady-state expression for per-capita consumption remains as before
y = c = wR
= (AL w)
1
1+α
(1 − α)
1−α
1+α
α
1+φ
α
1+α
(21)
The aggregate output produced by long-term projects, which in the long-run determines AL and w
can be derived as the following:
α
w MS
W = ML AL
1 + R ML
α
w
1+R
α
= ML AL
1 + R R(1 + φ) 1 − α
α
w
α
= ML AL
.
R(1 + φ) 1 − α
Using z ≡
1−α
α
and MS = M − ML at (20):
ML
zR(1 + φ)
=
,
M − ML
1+R
zR(1 + φ)
⇒ ML =
M.
1 + R + zR(1 + φ)
16
Then W as a function of R reduces to:
W =
[R(1 + φ)]1−α
AL z 1−α [w]α M,
1 + R + zR(1 + φ)
(22)
W =
[p(1 + φ)]1−α
AL z 1−α [w]α M.
1 + R + zp(1 + φ)
(23)
or in terms of R and p:
An important implication of this model can be observed by comparing the steady-state aggregate
output from long-term projects that we derived at (23) (with p = R), against the aggregate longterm project output at (16) (with p = R(1 + φ)): Holding everything else constant, shifting the
delegation of enforcement from secondary financiers to primary financiers, or in other words changing
the financial structure of the economy such that p1 (= R) goes up to p2 (= R(1 + φ)) lowers the
long-term project output. Financial structure 2 exhibits a long-term intensive composition of output
compared to financial structure 1. Since long-term investment is the engine of the productivity growth
in this economy, the steady-state productivity of an economy governed by financial structure 2 (p = R)
is higher than the steady-state productivity of an economy with financial structure 1 (p = R(1 + φ)).
I summarize this important result with the following proposition.
Proposition 4.1 Ceteris paribus, a financial regime that delegates the enforcement of loan repayment
to primary financiers lower aggregate productivity compared to a regime where secondary financiers
enforce loan repayment.
Referring back to the previous discussion on securitization and the delegation of enforcement; proposition 4.1 suggests that if the introduction of complex financial instruments such as bundled asset-backed
securities over the last two decades shifted the enforcement of loan contracts from secondary financiers
to primary financiers, this financial innovation might have slowed down the economic growth rates in
countries with large volumes of secondary market transactions.
4.2
Financial Development and Economic Performance
I consider again a financial development exercise at the beginning of a period τ that reduces the cost
of intermediation φ permanently. As in section 3, I will first study the effects of financial development
on steady-state output produced by long-term projects and then draw conclusions for the per-capita
consumption in steady-state equilibrium.
Long-term Projects. In order to analyze the effects of a permanent reduction in φ on steady-state
< 0 if and only if:
output, I differentiate the expression at (22) with respect to φ, and show that ∂W
∂φ
⇒
[(1 − α)R−α (1 + φ)1−α R0 + R1−α (1 + φ)−α ][1 + R + zR(1 + φ)] <
[1 + z(1 + φ)R0 + zR][R1−α (1 + φ)1−α ]
(1 − α)R−α (1 + φ)1−α R0 + (1 − α)R1−α (1 + φ)1−α R0 + z(1 − α)R1−α (1 + φ)2−α R0
+R1−α (1 + φ)−α + R2−α (1 + φ)−α + zR2−α (1 + φ)1−α <
R1−α (1 + φ)1−α R0 + z(1 + φ)2−α R1−α R0 + zR2−α (1 + φ)1−α .
17
In this inequality, R0 represents the first partial derivative of R with respect to φ. The inequality
simplifies to:
(1 − α)R−α (1 + φ)1−α R0 + R1−α (1 + φ)−α (1 + R) < αR1−α (1 + φ)1−α R0 + (1 − α)R1−α (1 + φ)2−α R0
|
{z
} |
{z
} |
{z
} |
{z
}
≡X
>0
<0
≡Y
(24)
At inequality (24), all terms with R are negative. Since |Y | > |X| (as defined at nequality (24)),
it shows that the inequality (24) holds only if R < R∗ where R∗ is a critical level of R with R∗ <
1. Therefore, the inequality (24) does not hold for any parameter values that satisfy the interior
equilibrium condition (R > 1).
0
Proposition 4.2 A permanent reduction in cost of intermediation φ lowers the steady-state output
produced by long-term projects for all parameter values as long as R > 1.
There are two counteracting forces that generate the result at proposition 4.1. (1) The permanent
reduction in φ increases the aggregate capital stock in steady-state: The population share of financiers
and hence the aggregate size of the financier-sector rises (MS ) as φ decreases. (2) However, the
contraction in φ raises the fraction of investable funds that needs to be paid to primary financiers in
secondary market transactions: R, and p are increasing in φ, and therefore the smaller φ is, the lower
is the fraction of the physical capital stock that is allocated at long-term entrepreneurial production.
The former channel expands the capital deepening in the economy and stimulates the steady-state
output produced by long-term projects whereas the latter channel lowers the total factor productivity
by distorting the allocative efficiency of capital and retards the steady-state output from long-term
projects. The reduced form effect of financial development depends on the relative dominance between
the two channels. In the current framework the TFP channel dominates the capital deepening channel
and thus reducing financial frictions in the form of capital price wedges lowers the output produced
by long-term projects.
Financial development has two effects on steady-state per-capita consumption: (1) The direct (positive)
impact that expands the “financial-sector” and (2) the indirect (negative) impact that contracts the
“real investment” from long-term projects, and suppresses AL and w in steady-state. The net effect of
financial development on steady-state consumption depends on the relative weights between the two
channels.
The level of intermediation frictions that optimize the steady-state consumption can be found by
maximizing (21) with respect to φ subject to (22) and the project productivity processes gJ (W )
described at assumption 3 for both J ∈ {S, L}. Specifically, defining gJ0 as the first partial derivative
of gJ (.), the level of financial repression that maximizes the steady-state consumption (φ∗ ) solves:
0
∂W
1
gS gL + gS gL0
=α
.
(25)
gS gL
∂φ
1 + φ∗
Transitory Dynamics. Following a permanent reduction of φ in period τ , AL and w do not adjust
until period τ + 2. Therefore, per-capita consumption in period τ + 1 rises. Since AL,t and wt steadily
adjust downwards with perpetual contractions in Wt , the per-capita consumption in period τ + 1
exceeds the steady-state per-capita consumption. This is a result contrasting with the transitory
dynamics derived in section 3. Furthermore, depending on the functional form assigned for g(W ) and
18
the parameter values of aJ and µJ for J ∈ {S, L}, per-capita consumption in the new steady-state
following a permanent reduction in the cost of enforcement φ could be lower than the per-capita
consumption in the old steady-state. Figure 3 summarizes the equilibrium implications of financial
development on steady-state output from long-term projects in an economy characterized by a financial
regime with costly secondary finance.
FIGURE 3 ABOUT HERE
4.3
Discussion
Comparing the results from sections 3 and 4 shows that understanding the microfoundations of intermediation frictions are important for uncovering the effects of financial development on steady-state
macroeconomic performance.
This analytical conclusion has important empirical implications and also relevance for financial market
policies. Cross-country empirical evidence suggests that financial development and economic growth
are not always positively associated. For example, Bandiera et al. (2000) suggest that the effects of the
domestic financial liberalization on economic growth are mixed. The authors argue that for 1970-1994
time period, the relationship between banking deregulation and economic performance is negative and
significant in Korea and Mexico3 , whereas it is positive and significant in Turkey and Ghana. Pagano
and Jappelli (1994) show that borrowing limits and economic growth displayed a negative correlation
during 1980s in OECD countries, and Bayoumi (1993) found similar results for the United Kingdom
for the same time interval.
For developing countries, there are cases where well-intended financial development policies reduced
economic growth. For example, the Latin American countries experienced secular banking deregulation
experiences during 1990s, which according to Fostel and Geanakoplos (2008), generated an undersupply of market liquidity and undermined economic performance. The theoretical results presented
in sections 3 and 4 offer an understanding for the conditions that policy makers should pay attention
in order to avoid financial market policies with potential counterproductive consequences, especially
when long-term investment and liquid secondary markets are essential for real economic performance.
5
Financial Structure 3: Heterogeneous Primary Financiers
When all primary financiers are compensated with the capital price wedge as in financial structure 1,
that is consistent with a secondary market price of long-term capital, financial development stimulates
economic growth. When all secondary financiers are paid the capital price wedge, financial development could reduce the economic development. Since these two extreme regimes lead to a bifurcation
concerning the effects of finance on economic development, it would be interesting to study an interim
case.
3
Similar conclusions are reached for Korea by Demetriades and Luintel (2001) and Castro et al. (2004).
19
In this section, I study an extension where an η fraction of all long-term projects require the enforcement of primary financiers whereas 1−η fraction are enforced by secondary financiers. This assumption
implies that the η fraction of primary financiers from a cohort are compensated with the capital price
wedge when settling secondary market payments. I will derive a critical level of η ∗ , and show that
financial development stimulates steady-state aggregate output produced by long-term projects only if
η ≥ η ∗ . I will also analyze the behavior of η ∗ with respect to equilibrium the wage rate, and draw some
conclusions concerning the effects of stage of economic development on finance-development nexus.
5.1
Equilibrium
Denote the steady-state per-saver capital invested in production again by x. The aggregate capital
invested in long-term production equals to Ms x which implies that the aggregate compensation of
primary savers must equal to MS xR(1 + ηφ). We can derive x as a function of R and φ:
x=
w
.
1 + R(1 + ηφ)
The capital market clearance provides
ML =
zR(1 + φ)
.
1 + (1 + z)R(1 + ηφ)
(26)
Using the expression for ML in aggregate production, the steady-state aggregate output produced by
long-term projects can be stated as
[R(1 + φ)]1−α
AL z 1−α [w]α M.
W =
1 + (1 + z)R(1 + ηφ)
(27)
Note that, the real rate of interest R is determined uniquely by the endogenous occupation choice as in
sections 3 and 4. Therefore, ∂R/∂φ < 0 continues to hold. Define R̃(φ) = R(1 + φ) where ∂ R̃/∂φ > 0.
Differentiating W with respect to φ we can show that lowering φ would stimulate steady-state aggregate
long-term project output only if:
h
i1−α
h
i−α
0
0
(1 − η)(1 + z) (R (φ)φ + R(φ)) < R̃ (φ) (1 + z) R̃(φ)
− (1 − α) R̃(φ)
[1 + (1 + z)R̃(φ)] (28)
Proposition 5.1 There exists a critical η ∗ < 1 such that if and only if
η > η∗,
the inequality at (28) is satisfied, and financial development stimulates steady-state aggregate long-term
project output.
With financial structure 1, financial development promotes economic growth whereas with financial
financial structure 2 financial development could be growth-reducing. Proposition 5.1 shows that when
the financial regime is characterized as a combination of the two, the hybrid regime should resemble
20
the financial structure 1 as much as possible in order financial development and economic growth to
be positively related.
Using inequality (28) we can study the behavior of η ∗ with respect to the steady-state wage rate w.
1−α
Note that, R(φ), R0 (φ) and R̃0 (φ) are proportional to w1 1+α . Therefore, it is useful to re-write (28)
as:
0
h
i1−α
h
i−α
R (φ)φ + R(φ)
(1 − η)(1 + z)
≤ (1 + z) R̃(φ)
− (1 − α) R̃(φ)
[1 + (1 + z)R̃(φ)] (29)
R̃0 (φ)
Proposition 5.2 The threshold η ∗ is an increasing function of w.
Proof The left hand-side of (29) is constant in wage rate w whereas the right hand side is a decreasing
function of w. Hence, the threshold η ∗ that satisfies (29) with an equality, increases as w rises. 5.2
Discussion
The steady-state wage rate w is larger in an economy that is at a higher stage of economic development.
To this end, proposition 5.1 provides an important insight concerning the influence of economic development on how finance and economic development might be related: In richer economies, the fraction
of primary financiers who incur the financial intermediation costs must be relatively large compared
to a low income country such that financial development could promote aggregate output produced by
long-term projects. This implies that in high-income countries the chances of financial development
policies to be counterproductive is relatively higher compared to low income countries. This result
matches with empirical findings that point out a potential non-monotone relationship between finance
and economic development: For instance, Castro et al. (2004) measure costly external finance by “limited investor protection” and present empirical evidence for the non-linear growth effects of financial
development. An important empirical result from their work shows that investor protection and economic growth exhibit a negative relationship especially for high income countries. Similar conclusions
are also reached by Reinhardt and Tokatlidis (2005). The authors show that the economic growth
rates in low income countries benefit relatively more compared to growth experiences in relatively
high income countries following the implementation of domestic financial deregulation policies.
6
Conclusion
I studied the interactions between financial intermediation costs, secondary market trading and economic development in an overlapping generations model of occupation choice. The key analytical
finding from the paper is the endogenous existence of a non-monotone effect of loan enforcement costs
on steady-state output. I showed that a large size of secondary market is necessary but not a sufficient
condition for the non-monotone real effects of financial development. I characterized the behavior of
secondary market prices of financial claims and the microfoundations consistent with such behavior
that determine the implications of financial development for economic growth.
21
The key contribution of the paper assigns a central role to the delegation of loan enforcement in explaining the finance & development nexus. Specifically, the results from sections 3 and 4 show that
holding everything else constant, a financial regime that delegates the enforcement of loan repayment
to primary financiers (financial structure 1) is less productive from a macroeconomic point of view
relative to a regime where secondary financiers enforce loan repayment (financial structure 2). Furthermore, comparing the growth rates, under financial structure 1 lowering financial intermediation
costs (cost of enforcement) raises aggregate long-term investment and stimulates productivity growth
whereas with financial structure 2 financial development reduces aggregate long-term investment and
lowers productivity growth. Finally, as presented in section 5, countries with a high level of economic
development are the most likely candidates to suffer from counterproductive financial development
experiences.
The theoretical results presented in this paper provide empirically testable predictions and important
policy conclusions. The regulatory framework as well as the complexity of financial instruments sold
in secondary markets are expected to dictate whether primary or secondary financiers of long-term
assets enforce repayment. The conclusions from my analysis suggests that policy makers need to pay
attention to the effects of financial innovation that shifts the enforcement of loan repayment to primary
financiers in order to avoid banking sector policies with potential counterproductive consequences.
22
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W
W2
W1
W (R, φ) a function of R.
R(φ1 )R(φ2 )
...
...
...
...
...
...
...
...
...
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...
....
...
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....
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6
When φ1 decreases to φ2 ,
R(φ) shifts right from R1 to R2 ,
W (R, φ2 )
W (R, φ1 )
W (R, φ) shifts up to W (R, φ2 ),
W1 increases to W2
-
R1
R
R2
Figure 1. Financial Structure 1: Costly Primary Finance
W
6
W2
W1
W (p(φ)) is decreasing in p(φ),
p(φ2 ) p(φ1 )
...
...
...
...
...
...
...
....
....
....
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......
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.........
p(φ) is decreasing in φ.
⇒ A decline in φ stimulates W .
W (p(φ1 ))
-
p2
R
p1
Figure 2. Financial Structure 2: Costly Secondary Finance
W
6
W1
W2
W (R, φ) ≡ W (R, p),
R(φ1 )R(φ2 )
... ...
... ...
... ...
... ...
... ...
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..
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.
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.
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.
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..
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W (R, p) is decreasing in both arguments.
∂p/∂φ < 0 but ∂p/∂φ > 0.
“R” channel dominates “p” channel,
W (R, φ2 )
W (R, φ1 )
-
R1
R2
R
⇒ As φ1 declines to φ2 ,
W1 decreases to W2 .
Figure 3. Financial Structure 2: Costly Secondary Finance
25