Sylla R. (2002) Financial sytems and economic growth

Sylla, Richard (2002) “Financial Systems and Economic Modernization”, The Journal of Economic History, 62/2, 277-292.

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Introduction

The author answers the age-old question, “why isn’t the whole world developed?” by arguing that development differences can be explained by the “spread of modern financial systems, which serve to facilitate the acquisition and application of both nonhuman and human capital”. And the “key institutional components” necessary to describe what is a modern financial system are: “sound public finances and public debt managements; stable monetary and payment arrangements; sound banking system (more generally, institutional lenders); an effective central bank; and sound insurance companies (more generally, institutional investors)” (p.280).

Finance first

These features can be found is the successful nation-state economies of modern economic history (17th-century Netherlands, 18th- and 19th-century United Kingdom, and 19th- and 20th-century USA). All experienced Financial Revolutions, which created those six key features before they became economic leaders (p.281). Even early Meiji Japan underwent its own financial revolution. On the other hand, the rest of the world did not acquire these key components before the late 20th century and, as a result, lags behind.

The table shows, for instance, how the Dutch economic leadership  (as estimated by the real GDP per capita relative to the world average) in the years 1600-1820 closely followed the financial innovations that occurred in the Low Countries during the 1500s (p.282). In the second half, of the 19th century Japan, Germany and France experienced a fast round of financial modernization, which allowed them to catch up with the British, then the world leaders.

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The rise of these united states

In the US, the so-called Federalist financial revolution happened quick in the early 1790s. After the constitutional convention of 1787, public finances were in turmoil, the country lacked monetary unity (p.283), the banking system was in limbos (at best), there was no central bank, no local securities market to speak of, and no institutional investors.

In the following decade, under the leadership of Alexander Hamilton, the Treasury Department – backed by Congress – strengthen the government’s taxing powers, reconstructed national debt, made the US dollar the national currency, and created a central bank. The states also chartered new banks ending the country’s crisis of liquidity. The creation of the central bank and the new federal debt system allowed the rise of organized securities markets in several cities. In addition, new insurance companies and corporations channelled private savings to the productive sectors of the economy (p.284).

After the revolution

Public and private trading quickly took off ($120 million worth of securities in 1803), which allowed the transfer of foreign capital to the US and explains how the country went from nearly bankrupted in the late 1780s to possibly the world fastest growing economy ever in less than 15 years. Despite countless crises, bubbles and crashes, the 19th-century US financial system still managed to fuel a breathless rate of capital formation and economic growth. It allowed a small modern sector (finance, manufacturing, transportation) confined in New England to become the country’s economic core (p.285).

“I suspect that most successful cases of modern growth in economic history involve an initially tiny ‘modern sector’ that begins grow rapidly, but is surrounded by a vastly larger ‘traditional sector’ – usually the agricultural sector – that grows at a far less rapid rate if at all. As the initially small but rapidly growing modern sector becomes an increasingly larger part of an economy, overall growth gradually accelerates and eventually becomes sustained at higher levels that we call ‘modern’” (p.286). Thanks to the adoption of European state-of-the-art financial institutions and the adjunction of home-brewed innovations, parts of the US economic system (namely New York) astonished foreign observers as early as the 1820s (p.287).

Asia’s rising sun

How to develop the rare, precious and most-needed financial institutions? For Sylla, strong leaders matter a lot. Post-1868 Japan had a lot in common with the early United States. The groundwork for the Japanese economic growth was broken by the civil servant-then-finance minister-then-prime minister Masayoshi Matsukata in the 1870-90s. This savvy former military reformed the central government’s revenues system by replacing in-kind rice tax by a money tax on land and introducing taxes on sake and tobacco. Even though the attempt to establish a central bank and to restructure the debt led to inflation, but also allowed the rise of securities markets. The creation of stock exchanges in 1878 gave a much needed liquidity to these new securities.

Directly influenced by the European model, Matsukata managed to end inflation and restore currency convertibility in the 1880s by decreasing government spending (p.289), increasing taxes and privatizing the state-owned corporations. In 1882, the Bank of Japan was established and in 1885 it could issue notes convertible to specie, thus restoring monetary stability. In the next decade, the country shifted to gold standard and could access international capital market via the issue of bonds. “Almost immediately Japan began to grow and became a major player on the world’s stage” (p.290).

Conclusion

“In history, when the state got right its own finances, stabilized its currency, and had an effective central bank, then securities markets, banks, and other financial intermediaries usually flourished. Conversely, there do not seem to be cases in which banks and stock markets flourished when public finances and the currency were weak” (p.291).

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