Role of Financial Intermediaries

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Chapter 2
(in S. B. Dahiya and V. Orati (eds.) Economic Theory in the Light of Schumpeter's Scientific Heritage, Spellbound Publishers, Rohtak, India, 2001)

THE ROLE OF FINANCIAL INTERMEDIATION IN ECONOMIC GROWTH: SCHUMPETER REVISITED TAPEN SINHA Chair Professor, Instituto Tecnologico Autonomo de Mexico (ITAM), Mexico and Professor, University of Nottingham, UK Email: ABSTRACT Nineteenth Century Classical Economists ignored financial intermediation as an important element in explaining economic growth until Bagehot. Bagehot, for the first time, gives explicit examples of how money market developments in England could make capital flow across the country in search of the highest rate of return. However, analysis of Bagehot was incomplete. It was Schumpeter, who put the role of financial intermediation at the center stage of economic development. Curiously, renewed interest in economic growth in the post Second World War saw a development in the literature that completely ignored the role of financial intermediation. For example, Solow-Swan model of development and growth has no role of financial intermediation. For all practical purposes, the economies were seen to be well approximated by a one good (corn producing corn) model. It took the international financial crisis of Latin America in the early 1980s to force economists to take the role of financial intermediaries seriously. I examine why financial intermediation is important in the tradition of Schumpeter. There are important contributions by banks and other financial intermediaries on the economy. This process can be seen when we examine how the economy is affected when there are banking crises. Latin America provides an extremely fertile test-bed. There are important ways financial intermediaries can contribute to growth by examining the models of new growth theory in the tradition of Arrow-Romer. Elements of these models can be found in the writings of Schumpeter. Current debate about the role of financial intermediation in determining the growth rate misses the central point of Schumpeter. Introduction Classical economists of the Nineteenth Century have paid some attention to the role of financial intermediation in running the wheels of economic growth smoothly. For instance, Bagehot (1873) gives explicit examples of how money market developments in England could make capital flow across the country in search of the highest rate of return. " Political economists say that capital sets towards the most profitable trades, and that it rapidly leaves the less profitable and non-paying trades. But in ordinary countries this is a slow process, and some persons who want to have ocular demonstration of abstract truths have been inclined to doubt it because they could not see it. In England, however, the process would be visible enough if you could only see the books of the bill brokers and the bankers. Their bill cases as a rule are full of the bills drawn in the most profitable trades, and ceteris paribus and in comparison empty of those drawn in the less profitable. If the iron trade ceases to be as profitable as usual, less iron is sold; the fewer the sales the fewer the



bills; and in consequence the number of iron bills in Lombard Street is diminished. On the other hand, if in consequence of a bad harvest the corn trade becomes on a sudden profitable, immediately `corn bills' are created in great numbers, and if good are discounted in Lombard Street. Thus English capital runs as surely and instantly where it is most wanted, and where there is most to be made of it, as water runs to find its level." (Bagehot, 1873, Chapter I, p. 11-12) Further in his exposition, Bagehot becomes even more explicit about the connection between financial development (and trade) and economic growth. " The `loanable capital,' the lending of which caused the rise of prices, was lent to enable it to...
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