INTRODUCTION TO THE LITERATURE
The McKinnon and Shaw publication of what was dubbed “Financial Repression” in 1973, triggered off a global scholarly debate over financial liberalization and the widespread policy implications among governments in the developed world, and perhaps even most crucially for the developed countries. The lifting of restrictions on the global capital transactions did result into multiple growth and efficiency opportunities for the United Kingdom, opportunities that however, been tempered by the widespread financial instabilities that have destabilized global economies, with a growing magnitude.
These difficulties are perhaps best evidenced by the recent global financial crisis that emanated from the US’s subprime mortgage market, as well as the 1997 Asian Financial crisis that had equally far-reaching financial and economic effects across the globe, Barrell & Davies (2009). It is not readily possible to determine whether the changes have had a positive impact on the United Kingdom economy, without a closer examination of the impacts on the different sources of growth, as well as the destabilizing effects of the frequent crises on the financial sector and the economy. This paper reviews the existent literature in a bid to determine the varied effects of financial liberalization on the UK economy, and a limited extend on the economies of the Kingdom’s close trading partners, that has an effect on the bilateral and multilateral trade as well as on other sectors of the economy.
EFFECTS OF FINANCIAL REBERALIZATION
Financial Liberalization & Growth
Growing scholarly attention has been paid to identification of the financial liberalization on the expansion of the UK’s GDP. According to Arestis (2005), this increased scrutiny has largely been driven by the theoretical ambiguities surrounding the subject, with some literatures pointing to resultant effect of promoting risk diversification in the UK as well as across the world, coupled with increased economic specialization, which must necessarily spur growth and economic stability. In addition, economic liberalization is theoretically expected and has been empirically proven to boost efficiency in the allocation of capital, while at once promoting more efficient domestic financial systems that have increased the capacity of the UK economy, to better mobilize savings for investments. These benefits can however only be realized, without the economic distortions that are characteristic absence of financial restrictions. Empirical literature has equally not resolved the theoretical ambiguity. A number of studies have established that effect on growth is limited if any at all, while Arestis & Caner (2009), determined that the effect could well be detrimental.
There is however, a convergence in the literature showing heterogeneous effects on the UK economy depending on the different times of the economy and the policies implemented by successive governments, as indeed across the world, depending on every country’s individual state of development, coupled with the policy and the institutional arrangements, Acemoglu, Aghion, & Zillibotti (2010). As such, the effects of liberalization on the UK has been mixed, depending on the country’s fiscal and monetary policies at different times since financial liberalization, with the deepest reaching effects (whether negative or positive) being dependent on the government’s ability to effectively deal with the external pressures on the economy, Barrell & Davies (2009). Most recent literatures that point to this possibility, have highlighted the recent financial crisis and the expansionary monetary and fiscal policies undertaken by the UK government, such as Bank of England’s base interest rate cuts among others, as perhaps the best examples of how the UK can make good or worse, the opportunities presented by liberalization. These ambiguities have effectively been addressed by various scholars separately, leading to the existence of different strands of literatures and bodies of knowledge, that address specific effects on not only the UK economy, but multiple other economies as well, Acemoglu, Aghion, & Zillibotti (2010).
Cobham (2004) sets out five different results of liberalization on the UK’s Total Factor Productivity (TFP) included the assertion that the effect is positive and pronounced on the TFP, but has a weaker effect on the total on the country’s investments, Barrell & Davies (2009); Turne (2010). This is not least because it increases the ease and efficiency of financial intermediation in the UK, but perhaps most crucially, reduces the returns on local investmtns due to global competition, trade fluctuations as well as general economic instabilities. Secondly, the book asserts that finacial liberalization affects growth levels, implying a possible positive effect of the UK GDP, occassioned by liberalization both in the short run, and perhaps most crucially in the long term. The long term positive effect on the economy is perhaps the strongest recommendation for liberalization, which serves to militate against the limited number of economic stabilities that can be prevented, albeit with some difficulty, and if not, its effects can be comfortably be contained by the use of fiscal and monetary policies, Acemoglu, Aghion, & Zillibotti (2010). The ease and importance of controlling the financial sector instabilities is emphasized by the lessons learnt from both the Asian and the subprime mortgage crises. An understanding of the nature of these crises, reveal that better management would have, will in the future, help avert the negative effects of financial liberalization, Turne (2010).
Financial Liberalization & The Banking Crisis
The UK has experienced continued positive growth rates, close to the country’s historical average of 5.5% (since 1955) since the emergence of financial liberalization, coupled by minor instabilioties stemming from the banking crises. Arestis (2005) asserts that the increased regulation of the financial sector in Britain, complete with the projects that these industries engage into has the capacity to limit the effects of financial industry instabilities on the economy. This, according to Kentikelenis (2009), is in line with Gordon Brown’s nationalization of Northern Rock, coupled with even more stringent Bank of England’s controls of over the country’s financial sector, that have seen increased efficacy of both the monetary and fiscal policy initiatives by the UK governemnt, that have been instrumental in mitigating against the worst effects of the global economic crisis that stemmed from financial liberalization. Kentikelenis (2009) reviewed the literatures on the subject, and assessed them against the empirical findings on the same, with the view of ascertaining the conclusions arrived at by Mckinnon & Shaw. To establish this, the paper explored the link between savings and financial liberalization.
The investigations revealed that the effects of deregulation were largely as predicted by theory i.e. (a) the link between the savings in the UK and financial liberation remains unclear, not least because far too many variables paly a crucial part depending on the political, social and economic circumstances in the country (b) liberation boost credit vailability, that eats into the UK domestic savings, but without a significant effect on the overall savings while (c) there is need for the UK to careful manage the implications of financial liberation, in order to minimize its effects and maximeze the gains attained as well as the potential, Turne (2010).
The banking difficulties hurt the country’s productivity and capital accumulation, which can be minimized by economic diversification. It is the effect of, or through the banking crises that has drawn the firce opposition to financial liberalization from a section of scholars. The banking crisies and its effects on the economy in the UK have long been the subject of empirical and theoretical investigation, that have in turn yield a great majority of academic literature. These go as far back as Keynes’ Treatise on Money, which effectively asserted that the banking industry is a channel to fuel investments in an economy, that ultimately leads to the expansion of the economty, both in the short term as well as in the long run, Turne (2010). Keynesian economists believe in the role of the bakning sector in financing growth, despite their scepticism of the role of monetary policy as an engine for growth. The emergence of the endogenous growth literature and the assertion that financial intermediation has a necessarily ositive impact on the economy’s expansion, in line with the assertions that run as far back as 1958, When Modigliani & Miller, that while the ease of availability of financing helps economic growth, the finance industry is independent from the other industries in the UK and thus the difficulties with the finance industry, may only affect the finance industry. Acemoglu, Aghion, & Zillibotti (2010), this view downplay the negative efffects of banking crises on the economy, instead blaming ill information and panic as the actual causes of the negative effects on growth. This view has been widely criticized.
Acemoglu, Aghion, & Zillibotti (2010) established that financial liberation and the effciecny implications have effectively relieved the risky innovations from the traditional constarants to accessing capital and financing, which effectively boosts both innovation, technological change and development. In addition, the article argues that deregulation fosters growth through it effect on increasign economic participation of the population, coupled with increased risk pooling. The analysis of the effects of banking crises and financial liberalization on the varied growth sources is associated with the literatures on the banking sector fragility. Some scholars have pointed to models that have multiple equilibria, with financial liberalization boosting the prices of assets, incomes and investments in countries, which serves to create income and wealth disparities, that are detrimental to growth. In Smith & Searle (2007), attributes banking difficulties to excessive growth in countries that exibit many imperfections in the credit market, as perhaps best exemplified by the Asian Financial Crisis in 1997.
Liberalization according to this strand of the literature, promotes credit accessibility, whiile at once increaseing the fragility of the industry. A study of more than nine countries indicated that liberation has had predictable, effects on the finacial markets of any individual country, but further asserts that the negative effects only last for a few years following the adoption of financial liberalization, while positive impacts follow in the later years. This view has been multiply been disproved by the negative effects that have been continually been suffered by countries in the successive global financial crashes.
Finacial Liberalization & Consumption
Changes in consumption attracts greater investments in the economy, which combine through the multiplier mechanism to boost economic growth, which results into long term development. The ease of credit availability as pointed out in the review, have a positive impact on the economy. Barrell & Davies (2009) reviews multiple empirical works in seven OECD countries, according to the life cycle theory, that makes planned consumption a function of non human as well as human capital stock in the economy, that in turn gives a helpful indication as to whether income and wealth changes affect the consumption expenditure. This relationship was used by Barrell & Davies (2009) to formulate hypotheses that facilitated the study of the effects of financial liberalization on the economy. Other scholars did use the quarterly long-run consumption in different countnries, that established statistically considerable income and wealth effects on the levels of consumption.
Barrell & Davies (2009) adopted relationships founded on the cointegration vector that contained non stationary variables’ logs (income, net wealth measures and consumption), to obtain Log approximations to identify and measures the effects of the variables on one another. There are other branches of literature that are founded on the Euler Equation, that aggregate the maximum attainanb;le intertemporal consumption decisions of sampled consumers, who are assumed to exercise rational expectations. As such consumption decisions are made randon, albeit with discounting factors that serve as driving variables. These studies established that consumption can be easily be forecast, with the help of additional lagged variables, as a function of waelth and economic expansion, Smith & Searle (2007). Given the positive impact on the economic expansion, it can be safely concluded that increased consumption and investments lead into further multiplier effects, that emphasize the effects of financial deregulation. An investigation by Barrell & Davies (2009) revealed that real interest rate, wealth and income have an aggreagte negative effect on the United States, the United Knigdom, Canada, Sweden as well as Japan, effectively implying that financial liberalization leads to a decline in thr income and wealth gaps in the economy.
On the other hand, according to the OECD, increased liquidity of assets and wealth, cpoupled with the reduction of multiple liquidity constraints results in increased, and amplified effects of short term asset values as well as increased exposure to the effects of real rates of interest, OECD (2009). There is a convergence in the literature, in line with the theoretical prediction that financial liberation, increased availability of credit and the ease with which assets may be liquidized, lead to an upward shift of the consumer spending behavior. Typically, this does involve fast adjustment in consumption to fit the expected long run levels consumption, Smith & Searle (2007). As such, the economy’s marginal propensity of consuption will increase, beyond the ratio expected at the current level of growth and incomes, which will spur greater growth.
Keynesian & Neoclassical Economic Theories
Neoclassical growth literatures welcome increased liquidity and availability of credit in economies, which accelerate growth and development, by making markets more efficient and complete; not least because these literatures are themselves founded on the assumption of perfectly competitive markets, which are devoid of government controls. The assumption provides that freely competitive markets neocessarily result into increased efficiency, provided that the markets have all the elements to render them complete, Smith & Searle (2007). Complete markets are attained when, among others, markets are able make and complete contracts that relate the present and the future, while at once keeping the labor, commodity and services markets in tandem. It therefore follows that increased efficiency of the finacial markets, due to financial liberation,will effectively lead to an more efficient economic system, Arestis (2005).
This is not lease because liquid and efficient futures markets for commodities allow producers and consumers to efficiently hedge the production risks, which allow then to more stably increase their output and consumption, Arestis (2005). In addition, efficient financial systems permit corporate debt issuers and investors continuosly attain and adapt to the optimal risk profiles. There are further benefits that did emerge in the ninties as a result of increased financioal liberalization across the world. These according to Turne (2010) and Arestis (2005) included (a) the possibility of investors selecting the cominations of liquidity, returns and risks that best suit their varied preferences, (b) increased options of intermediation between the demand and supply for financing, which allows investors and the market to more efficiently allocate capital resources and (c) increased financial innovation leads to a better attainment of more complete, thus efficient financial markets. The lower the level of regulations the more pronounced these benefits would be, which are made even more efficient by opennong up cross country, financial movements. Neoclassical literatures do however require regulation in order to minimize market imperfections, in order to attain perfect markets in all markets.
Keynesian economic literatures on the other hand, recognize the need for regulation of not only the financial markets, but the entire economy, coupled with regular government interventions in order to kinimize market imperfections caused by the free operation of the market, as envisaged by the Neoclassical literatures. Turne (2010) asserts that liquidity of finacial markets is not necessarily a guarantee for allocative efficiency, led by rational expectations anticipated by Neoclasicals, but are limited by oother self reinforcing effects. Market speculation and uncertainity are on their own, able to create instabilities in the market, which would distort prices and lead to innefficiencies, Arestis (2005). As such, the effects of financial liberalization are acknowledged by both Keynesian and Neoclassical economic literature, but with the former schoolof thought being more sceptical about the benefits.
RESEARCH METHODOLOGY
There methodology adopted will seek to asses the effects of financial liberalization on the UK economy, by providing a measure fo the overall effect on the economy, but perhaps most crucially providing methodologies to assess the effects of financial liberation, on the channels through which it acts. These include its effects on (i) productivity, (ii) banking industry instabilities, (iii) capital accumulation and (v) consumption, as a selection of the major variables that in turn have far reaching effects on the UK economy, OECD (2009). There are multiple other variables that will not, and have not been covered in this literature, review, that have varied effects on the economy as a consequence of financial liberalization, that have not however, been included in this methodology section, due to wide variations. In addition, literature review has widely been used by many scholars, and it will as w ell provide an important research tool in the bid to establish the effects of financial liberalization on the UK economy. A review of the literature on the various aspects higlited in the above literature, with an emphasis on the banking industry, economic productivity and consumption among others will offer a great indication of the overall effects.
However, the first measure will adopt the IMF method (0-1 indicator) to assess the existence and scale of economic liberalization in the United Kingdom, by reference to the IMF reports as a basis for further analysis of the effects of liberalization on the country’s economy, World Bank (2007).
Financial Liberalization
The research will employ two, 0-1 financial liberalization indicators thata are based on the de-iure criteria. One of the indicators will serve as a dummy, which will assume the value of 0 in the case the United Kingdom does have capital account restrictions on the transactions, during any year in the past decade. If not there were no restrictyions, then the indicator will assume the value of 1. This methodologyu is widely adopted by the Interneational Monetary Fund, which classifies countries on the 0-1 base, in its annual report on exchange arrangements and restrictions (AREAER). These annual reports are available for upwards of 212 IMF member nations, for the time period ranging from 1967 to 1996, effectively offering a common, and relaible liberalization measures, World Bank (2007). The initial indicator is coupled by a further measure that uses the liberalization of equity markets (Equity Market Liberalization), provided in multiple finacial liberalizationn literatures. The indicator assumes the value of zero (0), if there are global equity trading in the United Kingdom and the value of one, if there are no global equity trading. The Equity market liberalization indicator, changes as soon as a country opts for financial market liberaliztion, and once it changes, it may not be reversed, as against the first measure, (Arestis & Caner, Financial Liberalization and the Geography of Poverty, 2009).
UK Capital Accummulation as a Result of Finacial Liberaization
The study will come up with several measures of the country’s stocks of capital, by firstly estimating the UK’s initial capital stock K(i), by using the formula I(i)/(g+d), where the initial stock is estimated at the time when the country adopted liberalization. In the formula, I represents the level of investments during the initial period (the base period), while g represents the geometric rate of growth of investments in the UK, in the initial ten years, after the base period. The base period will be selceted at any time when the (0-1) indicators were both had the value of 0, while the final period shall be selected be 10 years after the initial period. The d is the rate of depreciation of various depreciable investments made in the UK, Barrell & Davies (2009). Once the initial capital stock has been computed, it will be possiblt to compute the United Kingdom’s capital accumulation as a result of liberalization, it will be necessary to compute the level of capital stock in the UK by using the formula K(f)= (1-d)K(f) +I(f).
For comparison purposes, and in order to minimize the effects of other factors on capital accumulation from clouding the results, the capital stock in the period of ten years from the initial period backwards will as well be computed. The rates of capital accumulation in the two separate ten year periods will then be assessed against each other.
Effects on the UK Economic Productivity
The research will seek to detetminer the TFP by using the Cobb Douglas function of production i.e. Y= AKJ(HL)1-j.
K represents the United Kingdom’s total stock of capital, while the L represents the country’s stock of both human capital and labor. The function does as well have the efficiency factor, providing a an indicator of the country’s efficiency in the use of its productive factors. The differences in the efficiency coefficient (A) offers a great measure of measure of the level of efficiency in different economies, OECD (2009). The variable j is equal to 1/3, and is generally considered constant across all the economies. The research will seek to identify the average productivity of a worker in the UK and the ration o labor and capital. Once these are d etermined, the initial level of productivity will be computed by the use of the formula, where the initial period is given be the period (i) used in the computation of capital stock. The final period (f) is the time period, ten years following the initial period. Once again for comparison purposes, the time period, ten years befor the initial period of the study (i) will as well be computed. These will then be coupled with an assessment of the two rates of growth in the productvity of production factors, following the introduction of financial liberalization measures.
Consumption Changes as a Result of Financial Deregulation
Consumption spending is an important influence on the UK economy’s health and growth, which points to the increases incomes, ease of credit availability as well as multiple other factors. To determine the effects of finacial deregulation on the consumption behavior and levels in the United Kingdom. The method adopted for estimating these effects is derived from Barrell & Davies (2009), which presumes that planned consumption is not by default not equal to the actual level of consumption. It then becomes possible to assess the long term relationship between between actual and desired levels of consumption in the future, followed by a computation of the correctionary factor betweent the actual and planned consumption.
The UK economy’s consumption income may be distinguished from from the country’s real wealth in the future, by treating them differently, World Bank (2007). This may be attained by differently treating the tangible wealth changes from the changes in financial wealth. The Euler appraoch does as well enable the testing of the effects to the consumption behavior and the overall economy.
Banking Crisis
The classifications of different crises varies from economy and time period to another, but also according to the cause and magnitude, However, for the purposes of the study, the data in Caprio & Klingebiel (2003), of non systemic and systemic banking difficulties for several decades beginning in the early seventies. In the absense of a banking crisis, the banking crisis indicator assumes the value of zero, while it assumes the value of 1 or 2, in the event of borderline or systemic difficulties in the country’s banking sector respectively. The indicators are taken every given year. Systemic banking problems occur when the country’s banking sector suffers the exhaustion of the entire capital (run on banks), as against much more mild, effects on the industry, such as the difficulties experieced by the industry, following the dry up of credit, at the onset of the 2007 global economic crisis, OECD (2009). The harsher the effects of banking the crises, the more difficult the negative impacts on the country’s economy are expected to be.
Estimation of the Effects of Liberalization
As indicated priorly, the effects of financial liberalization are complex, and affected by a multiplicity of factors. However, for the purposes of this study, the measures obtained from the consumption, capital stock accumulation, increased productivity and banking sector shocks will be assessed for correlations with not only the values prior to liberalization, but perhps must tellingly, with the economic perfomance growth figures over the same duration. Theoretically, the positive consumption growth, should be accompanied by increased productivity and output, with an inverse expansion of the banking crisis indicator.
References List
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Arestis, P., June, 2005, Financial Liberalization and the Relationship between FInance and Growth. CEPP Working Paper Series No 5/05.
Arestis, P., & Caner, A., 2009, FInancial Liberalization and the Geography of Poverty. Cambridge: Cambridge University Press.
Barrell, R., & Davies, P., 2009, FInancial Liberalization, COnsumption and Wealth Effects in 7 OECD COuntries. NIESR DIscussion paper No 257.
Caprio, G., & Klingebiel, D., 2003, Episodes of Systemic & Borderline Financial Crisis. Mimeo.
Cobham, D. P., 2004, The making of monetary policy in the UK, 1975-2000. London: John Wiley & Sons.
Kentikelenis, A. E., 2009, Assessing the Link between Financial Liberalization and Saving. ESDS International Case Study.
OECD., 2009, Main Economic Indicators . Manchester: ESDS International, University of Manchester.
Smith, S. J., & Searle, B., 2007, The Blackwell Companion to the Economics of Housing: The Housing Wealth of Nations. London: John Wiley & Sons.
Turne, A., 2010, Feb 12, After the crises: assessing the costs and benefits of financial liberalisation. Retrieved November 24, 2011, from FSA: http://www.fsa.gov.uk/pages/Library/Communication/Speeches/2010/0215_at.shtml
World Bank., 2007, August 18, FInance for All? The Pitfalls of Expanding Access. World Bank Policy Research Report.