Finance and Economic Development

PUBLIC POLICY The new Reserve Bank Governor explores the role of finance in economic development and growth – and says the RBA will be keeping an eye on corporate debt. Glenn Stevens Glenn Stevens was appointed Governor of the Reserve Bank of Australia (RBA) during 2006 – the seventh governor since the RBA was established in its Finance and current form in 1959. This article is a transcript of Glenn Stevens’ speech to CEDA’s annual dinner, 12 December 2006 economic development It is a great pleasure to be invited to address the development and growth? How does the financial Annual General Meeting of CEDA, continuing a system contribute? How can financial events some- long tradition of such addresses by Governors of times be detrimental to economic growth? What the Reserve Bank of Australia (RBA). can be done to ameliorate those risks? What risks CEDA – the Committee for Economic Develop- do we face at present? ment of Australia – began in 1960, an initiative of D.B. Copland. Copland, one of Australia’s most History remarkable economists of the Depression era, was The growth we take for granted in the modern a member of “Giblin’s Platoon”, whose history is world is actually a fairly recent phenomenon in recorded so nicely in the recent book of that name human history. Prior to the industrial revolution in (Coleman, Cornish & Hagger 2006). Over the western Europe, living standards rose very slowly, if years CEDA has made a substantial contribution at all. According to Angus Maddison’s data, the real to debate in a number of fields, from trade policy per capita GDP of the United Kingdom rose to taxation policy, from Indigenous affairs to infra- between 1500 and 1820 at an average rate of only structure. 0.27 per cent per annum (Maddison 2003). At that Interestingly enough, the list of publications on pace, living standards doubled about every CEDA’s website does not include any which are 250 years. In other words, a person would not live overtly financial in their focus. I do not say this as all that much better than their grandparents – a criticism – perhaps the reason you have invited assuming they could discern any difference. central bank governors to speak so regularly is to From 1820 to 1913 the rate of increase rose to cover that very set of issues! 1.15 per cent. That’s a very big change. At that But it seems appropriate, given CEDA’s core pace, living standards doubled in about 60 years. focus on economic development, to address the In the 20th century, despite wars, the Great questions: what is the role of finance in economic Depression, the Great Inflation and various other 48 australian chief executive PHOTO: CEDA/YUSUKE SATO problems, growth per head rose further. Australia’s large scale machinery, however, called for capital on per capita growth was 1.70 per cent in the 20th a different scale, and financial development was century, according to the same data set, for a key to providing it. doubling in living standards about every 40 years. The economic historians suggest that a number The difference between my living standards and of innovations were important. The development those of my grandparents in the mid 1940s when of the limited liability corporate structure allowed they were as old as I am now – a trebling – is proprietors to take risk without facing complete remarkable. personal ruin if the venture failed. Banking corpo- There is a vast literature on what accounts for rations efficiently pooled the resources of a large this growth, and there has been a long debate in number of savers, the more so as they developed economics about whether the development of into joint stock ownership structures, as opposed What is the role of financial institutions and markets followed or led to purely private ones. Before central banks devel- finance in economic the developments in the real economy. Some, such oped fully these organisations also provided circu- development and as Joseph Schumpeter, Sir John Hicks and Walter lating monetary assets for the community, which Bagehot, argued that financial development facilitated exchange. Markets for the trading of growth? actively fostered innovation and entrepreneurship. claims against future income flows – what we know “ Others, including Joan Robinson, argued that today as stock and bond markets – allowed the finance passively followed in the wake of real side providers of capital to retain their wealth in a more development.1 liquid form, thus encouraging them to commit ” Surely both components were necessary, and more capital to long term ventures. In other words, neither alone would have been sufficient. Techno- the development of financial markets and institu- logical advance provided the potential for a marked tions was an integral part of the industrial revolu- acceleration in productivity. In the early age of tion. It remains a key facilitator of the growth we industrialisation the steam engine and electricity enjoy today. were two obvious examples. Without those oppor- Yet such progress was not without its occasional tunities, such financial capital as was available for problems, in the form of periodic panics. deployment would probably have struggled to find Commodities markets had a certain tendency a useful outlet. towards occasional instability. Optimism and greed But equally, the potential technological advance could push prices to extreme levels, following would have remained just that – potential, rather which a loss of confidence typically precipitated a than actual – had there not been a capacity to crash. The Dutch tulip bubble of the 1630s mobilise the financial resources needed to invest in occurred without the aid of the highly developed the equipment embodying the new technology. set of financial intermediaries that came later, The capital required for an economy based on agri- though it did achieve considerable added fizz via a culture and artisan based manufacturing had been futures market for tulip bulbs – derivatives allow in the form of land, seed, basic tooling and the like. leverage, which is almost always a key element of Traders needed working capital in order to the latter stages of speculative manias (Sykes 2003). purchase goods in one place and move them to But the growth of a modern banking system in another for sale, and various financial devices arose England by the late 18th century, whose liabilities to assist this. The need to sink very big sums into were effectively financial claims against assets that 49 FEBRUARY 2007 PUBLIC POLICY could not be quickly realised if suddenly called, brought heightened risks. Banking is, after all, a business that involves leverage and liquidity and credit risks. There was always the possibility of a financial panic that could, if unchecked, threaten not only the financial institutions but the course of the real economy. The question facing public policy, then, was how to find a set of arrangements that would allow the necessary credit extension to support capital investment in pursuit of new technological opportunities, yet provide a stable monetary standard and a financial system in which the public could have confidence. We should record that in the same era, questions of a qualitatively similar nature arose in the fledg- ling colonies of the Antipodes, even if they were, to begin with, at a lower level of sophistication. The Colonies needed both a system of mobilising capital and a means of making payments other than circulating paper claims over goods – be it PHOTO: CEDA/YUSUKE SATO rum or something else. We are all aware of Gover- nor Macquarie’s ingenious attempt in 1813 at central bank fully evolved into the current form, keeping metallic money in the colony of New even in the most advanced economies. In our own South Wales, by making two coins out of each case, the central bank did not really have a fully Spanish dollar, thus rendering them at once more developed public policy mandate until after the useful in NSW and much less useful elsewhere. 1930s, and arguably was not a purely policy insti- But Macquarie’s initiatives in granting a charter tution until the separation of the Reserve Bank to the Bank of New South Wales in 1817, and from the Commonwealth Bank in 1960. those of Governor Darling in rescuing it from Through the 20th century, of course, views about disaster in 1826, were perhaps more important the appropriate role of a central bank changed a milestones in the early financial development in good deal, as did views about the appropriate this country. According to Trevor Sykes’ (1988) extent of official intervention in financial markets account, both of these actions were contrary to the and institutions generally. The Great Depression of policy of the British government. These appear to the 1930s occasioned new ideas about macroeco- have been occasions when the lags in implementa- nomic policy, which envisaged more official inter- tion of official policy – measured by the time taken vention in economic matters. This was followed by for a request for instructions to reach London by a very large increase in the government sector’s sailing ship, be considered and then answered by command over economic and financial resources, return ship, too late to influence the decision – of necessity, to conduct the Second World War. helped to produce a superior outcome! Hence by the end of the 1940s the landscape had Around the world, governments groped towards changed a great deal in comparison with 1930. The a sustainable solution for combining the benefits of financial systems of many countries found them- financial intermediation with stability. Progress selves subject to much more regulation, and central was not necessarily always steadily in the right banks with more regulatory powers and more direction,2 but one of the key developments was explicit mandates for macroeconomic stabilisation, the gradual evolution of the institution we would than had previously been the case.

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