provide other stimuli to growth and productivity. Stock markets can help
investors to monitor managers. Investors can compare share prices of different
firms in the same industry. Poorly performing firms can be taken over by more
efficient managers, through buying sufficient shares to gain control. These
arguments have been the central consideration of much IMF and World Bank
lending to developing countries since the 1980s. The corresponding policy
advice has focused on liberalizing the financial sector by privatizing state-
owned banks, allowing the entry of foreign financial firms, removing restric-
tions on the free setting of interest rates, facilitating the growth of a stock
market, and removing political interference in the lending and borrowing deci-
sions of firms and banks.
There is a general, and after the recent global financial crisis growing,
acceptance that the state must retain a role in monitoring and regulating the
private financial sector. In any fractional-reserve banking system (whereby the
banks lend out a multiple of the financial reserves they keep in their vaults) there
is the possibility of a run on deposits which cannot be met by available reserves,
leading to a collapse of the financial system. This creates needs for: regulation
to ensure that banks control lending risks; deposit insurance; and a Central Bank
to act as a lender of last resort if banks get into financial difficulties.
The problem with these ‘liberalize, invest and grow’ arguments is that, after
the early 1980s,developing countries did much liberalizing but experienced
little evident boost to investment and economic growth. All countries in Latin
America significantly liberalized international trade, external capital flows and
the domestic financial sector. The results were disappointing. While GDP per
capita increased by 2.7 per cent annually between 1950 and 1980 it declined by
0.9 per cent in the 1980s. A key reason for the stagnation after 1980 was the
failure of investment (and savings) to increase in response to liberalization
(Ocampo,2004). Broader data from developing countries across all continents
shows that average per capita income growth fell from 2.5 per cent between
1960 and 1979 to 0.0 per cent between 1980 and 1998. This reduction in
growth occurred despite ‘improved’ liberalization across developing countries,
as measured by financial depth, trade liberalization, price and exchange rate
liberalization and removal of controls on the setting of interest rates (Easterly,
2001b). The two key reasons why liberalization failed to generate higher
investment and growth are credibility and expectations.
How the free market can fail
Policy reforms intended to boost investment, such as devaluation or reduced
profit tax will only work to the extent that private entrepreneurs consider them
‘credible’. Trade liberalization, including currency devaluation, will make
exports more competitive, but this will only work in the longer term if it stim-
ulates private sector investment in new capacity to produce goods and services
for export. Entrepreneurs will not invest in new capacity if there is a likelihood
that the liberalization-devaluation could be reversed and exporting ceases to be
70 Sources of Growth in the Modern World Economy since 1950