Financial markets and institutions summary
Topic 1: A brief history of financial development
Finance: the transfer of scare resources over time and across states of nature.
Time is important here because money loses value over time due to inflation and therefore, we need
saving deposits to compensate for this. Also, if you don’t have money immediately but you need it,
you can borrow. Therefore, if you want to transfer resources over time, you need finance!
Across states of nature is important as well because there is uncertainty about certain states of nature.
There may be a flood or something that decreases a farmer’s profits. Insurance helps to get rid of this
uncertainty. This is not only about states of nature, but also your health status, wheater conditions, etc.
The first part of the course focuses on the long run: finance and economic development (both macro-
and microeconomics).
The second part of the course focuses on the short run: financial and economic stability (both macro-
and microeconomics).
Financial development
Domestic credit/ GDP increased from the 70s in almost all countries. There was a lot of demand for
credit and the supply of credit was high (which comes from financial institutions). This means that
more credit can be channelled and more allocation of scarce resources.
This has been occurring for different countries in very early history as well. This has caused financial
development and that is the focus of this topic/lecture.
People become more leveraged (does not say anything about capacity to repay!) led to financial
problems.
Moreover, per-capita GDP of many developed (and developing countries over the last years),
increased substantially from 70s. This means that the standards of living increased as well.
It is important that we understand in what direction the causality holds:
- Does financial development spur economic development? Or: does the allocation of scarce
resources over time across states of nature improve the welfare in societies?
- Or does economic development spur financial development?
The answer to this question is a chicken or the egg problem. We need proper tools. We need a
theoretical framework that we can match with data and then through the interactions that you identify
within that model, you can draw conclusions. Or we need an experiment. Compare treatment and
control group. For example, treatment group is a group that is confronted with financial development.
Then compare the behaviour of the treatment with the control group.
A historical perspective
There are important components of a good financial system throughout the history that helps to
allocate scarce resources over time and across states of nature:
- Stable public expenditures and sound public debt management
- A competitive banking system
- A central bank able to stabilize domestic finances (and oversees the banks)
- Securities markets (bonds or stock markets) direct fashion, no bank needed as
intermediary.
o Crowdfunding and Fintech: a desire to get rid of banks.
Sound public finance and public debt management
Why is the ability to do public finance properly firstly developed and necessary before banks etc
develop?
,CB is part of the government and whatever they can provide in terms of currency has a very important
fiscal component. It is there because someone in the centralized government makes some public
expenditure decisions and there reflects that in the central banking. If the government’s fiscal protocol
is not working properly (and not handled with care), banks cannot develop. Banks (and thus financial
development) only start to develop once the government makes sure that private enterprise and
finance can emerge. With only public finance we cannot talk about financial development and
therefore, we must start by discussing the soundness of the public finance and debt management.
Historically, finance was needed for governments to pay for wars. This led to the emergence of the
first financial systems in the following way:
- Governments issued bonds: Venetian State in 1100 needed money to finance wars. Before
bonds, governments raised money by increasing taxes. Government bonds is a debt
instrument that the public can buy and in return, they get the money back + interest.
- Why are bonds helpful (and thus taxation alone not)? Bonds are more democratic; people can
choose to help the government (but they don’t have to). With taxation, you are obliged. This
also leads to enforcement: people want their money back and will do everything they can to
have it back. People start to take more power to ensure repayment.
- If people have access to a stable currency, we can start talking about the competitive banking
system. If they don’t, the banking system is also not in order and there can be 100% taxation
for example.
- Stability of public finance is very important and due to these bonds, people set and control
adequate government expenditures and respect property rights. Thus, there is a credible
enforcement of public debt repayment institutional development.
Banking system
A banking system makes sure that transforming short-term deposits into long-term assets is possible.
Banks function through maturity transformation: you put your money in the bank account, and you
can’t access it for 2 years for example, then the bank can in the meantime make a loan from your
money.
Banks have tools to make sure that they can follow up with borrowers.
The competitiveness of the banking system ensures that more resources are channelled to investment
and that less monopoly rents are left for individual banks (interest rate is lower with competitiveness).
Central banks
- They stabilize prices and economic fluctuations
- Oversee the soundness of the banking system
- Often a lender of last resort
Securities markets
This is direct exchange without an intermediary. Some financial institutions have developed as more
bank-based and some more as direct exchange institutions over the course of the history.
We will discuss the history of the Netherlands, US and England:
The Netherlands
The Center of European Commerce in late 16th and early 17th century.
Why is everything so easily available in the Netherlands at that time? This is due to the geography,
VOC, and independence of the Netherlands (last one is the main reason). Spain had a huge taxation on
us before and now that was gone.
Finance of government structure of the economy was going in the good direction (first step needed
before we can talk about the other 3 components).
Financial environment:
, - First public debt market: lightened the tax burden (people could choose to help government or
not).
- International Bills of Exchange: to finance trade. This was the emergence of paper-based
trade (that was a promise for gold in that time).
- Wisselbank (bank of Amsterdam: BA) in early 17th century: kind of the first CB.
o CB backed money: A Clearinghouse. They accepted bullion and coin, issued drawing
accounts, and extended large loans to United East India Co (VOC) and to the
government.
o Dutch guilder became stable until end of 18th century. People were able to borrow,
safe, trade, etc.
- More banks started to develop now. Deposits from local households.
- United East India Company in early 17th century issued the first common stock: this eased up
the finance and long-term investment from trade.
Why was a securities market so important and were banks not enough? VOC was built with a lot of
money but in the end, the boat made 0 overseas trips for trade. Therefore, stocks are needed because
then you hold a share of the company. With banks, if the VOC goes bankrupt, the whole loan cannot
be paid back, and they just lost the money. With stocks, if the company goes down, you go down, and
if the company profits, you profit.
All this led to economic development. VOC trade was going up, BA balances goes up and money
exports go up. We put together different elements of financial systems in place, and this may lead to
the rise of economic development. This still does not say something about the causality direction, but
a macroeconomic model that creates these financial systems can help explain how the society is
affected theoretically and then we quantify this with data (this is what we will do in topic 2).
Implications of financial development in Netherlands
The developments stimulated the Dutch prosperity (golden age), and the first modern economy of the
history. Dutch capital and financial expertise started to get exported to the rest of the world English
financial development started to take off.
England
England adopted the Dutch financial system in the late 17 th century and improved upon it. In 1689,
Willem (III) of Orange, became King William the third of England Glorious Revolution in 1688
led to the constitutional monarchy which means more democracy. This also implied more freedom of
capital so that the private enterprises could emerge.
The Dutch financial dominance started to shift to the Britain after this event.
Financial development:
- 1689 Bill of Rights restricted the Sovereign (= freedom, no more bad governance).
- Bank of England (BE) founded in 1964: first modern Central Bank.
o Bank of Amsterdam is set up by private enterprises. They formed a coalition. Bank of
England used experience from Amsterdam and therefore it is organized more
structured. CB emergence and banks emergence goes together.
o Recoined metallic currency, emerged as discount (lending) and issued house
(banknotes), bullion warehouse and safe repository.
o Extended loans to the governments and financed merchants and trading communities.
o Monetized the financial system in a stable manner,
- Pre-existing banks (London Bankers) started to expand around 1750s as well. They financed
trade and working capital for the rising manufacturing sector.
- At the end of 17th century, also a stock exchange emerged. Mainly financed riskier and larger
companies such as British East and West India Companies, South Sea Company, and the
Royal African Company.
, Industrial revolution:
This did not take place in the Netherlands. What is so important about it that we really must talk about
it? (Essential difference between England and Dutch case). This is because of the new form of
production. Labor is not the only production factor, but also capital now. This rapid growth of capital
leads to increase in production and growth.
After the industrial revolution, there was an exponential rise (accelerating in 1780s) in international
trade and industrial production.
Same was happening in Netherlands, but the growth pace is much higher for England. The
implications of finance on economic development will be a lot larger for England than for the
Netherlands if we were to use a theoretical model based on these facts.
Also, financial instruments etc. went up very fast financial development.
USA
Also, the USA became independent, and the capital was freed up.
Financial development:
- Federalist Financial Revolution led to a lot of policy changes
o Following the Federal Constitution in 1788 Alexander Hamilton, first secretary of
Treasury, engineered a series of policies concerning financial development in the
economy
o Transitioned the country from a defaulting debtor into a magnet for international
capital flows.
- Public finances came into place: Federal revenue collection system and debt restructuring
from American Revolution.
o Debt restructuring: Issuance of new federal securities
o Securities markets in New York, Philadelphia and Boston quickly sprung up to
trading these securities. This started to develop a lot faster than ever before because
people really had a huge desire to become free (still the reason why nowadays they
barely have health insurance, etc.).
- First Bank of US along the lines of Bank of England: with state branches.
- States feared public control of the banking system. This stimulated private state banking: total
number of private banks rose substantially.
This all resulted in a rise in trade and private investments. Also, the financial markets started to
develop quickly. Faster growth than Netherlands because Industrial Revolution is also catching in.
Financial leader = economic leader
The world economic leader coincides with the leading finance center:
- 1700-1785 = Netherlands
- 1820-1890 = United Kingdom
- 1890-present = USA
History of financial crisis
- Financial crisis can only occur in countries where some sort of financial development already
took place. They happen because there are still some frictions.
- We will discuss a crisis that happened in the Netherlands: Tulip Mania which was one of the
earliest crashes. The crisis happened by 1636/1637 and the prizes of tulips increased a lot!
After that, the prices also decreased.
- This was important financial event because tulip bulbs were being perceived as commodities
that were traded in markets. Future markets started to arise. They were traded like they were
comparable to gold. The reason why they were becoming important tradable goods is because
they could be stored for a while.
- People gained from this, but when the price crashed back, a lot of people lost their wealth.
