Globalization and its Challenges 357
to intermediaries, or to loan directly to merchant entrepreneurs on the
basis of fi xed-interest debt contracts.■ (^) The emergence of nation - states whose governments were in need of
fi nance for wars or other state activities, but could not raise resources
except by means of fi xed interest-rate contracts which paid an annuity
in perpetuity without the need for governments to repay the principal.
However, this new system was inherently fragile.^3 Toward the end of the
1970s and the early 1980s, the existence of fi nancial intermediaries in gen-
eral, and banks in particular, was justifi ed by their ability to reduce trans-
action and monitoring costs and to manage risk. However, little attention
was paid to the reasons why banks operated on a fi xed-interest system that
rendered the system fragile and unstable and requiring a lender of last resort
to regulate it. With the development and growth of information economics
and agency literature, another explanation was added to the list of reasons
for the existence of intermediaries: they served as delegated monitoring and
signaling agents to resolve the informational problems, including asymmet-
ric information that existed between principals and agents.
Based on the fi ndings of the developing fi eld of information economics,
it is argued that adverse selection and moral hazard effects in a banking
system operating on the basis of fi xed-interest contracts in the presence of
asymmetric information mean that some groups will be excluded from the
credit market even when the expected rate of return for these groups may
be higher than for those with access to credit. Furthermore, it is argued, in the
case of risk/return sharing, contracts are not subject to these effects and that
“the expected return to an equity investor would be exactly the same as the
expected return of the project itself.”
The fragility of a fi nancial system operating on the basis of a fi xed, pre-
determined interest rate was underlined by Stiglitz (1988: 312) who argued:
[I]nterest rate is not like a conventional price. It is a promise to
pay an amount in the future. Promises are often broken. If they
were not, there would be no issue in determining creditworthi-
ness. Raising interest rates may not increase the expected return
to a loan; at higher interest rates one obtains a lower quality set
of applicants (adverse selection effect) and each one’s applicants
undertakes greater risks (the adverse incentive effect). These effects
are suffi ciently strong that the net return may be lowered as banks
increase the interest rates charged: it does not pay to charge higher
interest rates.
The fi ndings of the new fi eld of information economics strengthened the
arguments that a debt - based fi nancial system with fractional-reserve bank-
ing operating with a fi xed, predetermined interest-rate mechanism at its
core is inherently fragile and prone to periodic instability. Stiglitz’s fi ndings
underlined Minsky’s argument that, as returns to banks declined, unable to