Current Issues in Financial and Monetary Economics

Financial institutions that borrow from ultimate lenders and lend to ultimate borrowers are prominent features of any modern economy, yet present an apparent paradox. The lenders could lend directly to the borrowers without the use of the intermediary, and indeed many do. The purpose of this chapter is to contribute to the understanding of the workings of financial institutions and the benefits that they provide to lenders and borrowers. A number of issues relating to financial institutions and their functioning are examined. Why do financial institutions exist? What functions do they perform? Why do some borrowers and lenders use the services of financial institutions while others do not? Do different types of financial institutions serve different functions?

It does not take too much research to identify the most topical issue concerning the behaviour of financial markets. The question crops up in some form on the financial pages of the newspapers every day. The question, of course, is the extent to which financial markets are too volatile when left to themselves and, consequently, the extent to which the authorities should intervene to change the situation.

A number of significant changes have taken place in domestic and international financial markets over the past two decades. The introduction of a host of new financial products, an influx of numerous and more diversified types of financial firms and expanding use of computers and communications technology have combined to produce a revolution in financial services. As with all revolutions, there is considerable interest in what caused this one and what changes it has produced.

If the US economy has performed so remarkably for seven years, its banking system has surely been an embarassment. How can an economy that has grown consistently for more than seven years have a banking system in such disarray? In 1988, the sixth year of an expansion, the economy generated 3.6 million new jobs — over 300 000 each month.² In the same period, 200 commercial banks failed — a post-war record. Concomitantly, 12 per cent of the nation’s savings and loans were insolvent according to generally accepted accounting principles. The nation’s thrift industry is being all but nationalised in the process.

There is a strong presumption that policies work better when they are more credible. Impressive support for this is not difficult to find and one case in particular has received considerable attention of late. Consider a government embarking on a programme of disinflation. Such a programme might involve either a short period of severe monetary restraint (the ‘cold turkey’ approach) or else a less radical policy aimed at reducing monetary growth more slowly over time (the ‘gradualist’ plan). The relative merits of these schemes rest ultimately upon the speed of market adjustment. Regardless of which one is adopted, the success of either in bringing down inflation at little or no cost to the real economy depends crucially upon the programme being credible. If, for whatever reason, the public is sceptical about the policy, the economy will experience the familiar output-inflation trade-off, being plunged into a recession by high inflationary expectations. Only if the public has confidence in the programme will the danger of sliding down the Phillips curve be somewhat mitigated. Moreover, to the extent that inflationary expectations partly influence the actual inflationary process, a believable disinflation has the added bonus of contributing to the disinflation itself.

A conspicuous feature of the post-war period has been the sustained tendency for the international economy to become increasingly interdependent. The general reduction in trade barriers and the almost complete removal of capital controls have resulted in highly integrated production activities, trade and financial flows with dramatic consequences for domestic-demand management. Persistent trade imbalances together with recent large-scale fluctuations of the major trading currencies have highlighted the international character of the linkages between domestic policy implementation and the economic performance of the main industrial nations, and many would now argue that these international links have become so strong as to impose severe limits on the degree of control and the scope for independent policy action on the part of individual governments.