FINANCIAL MARKETS AND ECONOMIC DEVELOPMENT: MYTHS AND INSTITUTIONAL REALITY

It is a commonplace that economics is about markets. Among markets the stock exchange has a mythical role as representing the epitome of the operation of perfect competition. Recently, it has also taken on a mythical role as a necessary condition of economic development. Here I attempt to inject some realism into these myths by starting with the idea that Leon Walras, normally vilified as having completely ignored institutions and the evolution of economic systems, should in fact be classified as an institutional economist.

The argument starts by challenging the idea that Walrasian general equilibrium theory is an abstract aberration of a mad French intellectual with no application to the real world. This is just not so, with respect to Walras's original theory, and also with respect to its extensions by Arrow and Debreu. Despite criticisms from post-Keynesians and institutional economists that the theory is devoid of real-world content, and the claims of applied general equilibrists that it can be applied independently of any real-world institutions, the theory of price formation of the Elements (1954) is a rather accurate rendition of operations of a particular institution, the Paris Bourse. If it can be criticized it is because it has little applicability outside of the historical context and particular conditions it describes. It is 'institution-bounded'.

But if the theory is institution-bounded this also calls into question the generally accepted proposition that competitive Walrasian markets allocate resources efficiently and thus promote growth by channelling resources to their most productive uses. Most economists, when pressed for an example of efficient market allocation, refer to the stock market. But the idea of efficient allocation, or a Pareto allocation, is just a description of the distribution of shares after the determination of the equilibrium prices on the Paris Bourse. If Walras's theory of price determination is institutionally bounded, then the concept of an optimal allocation is also bounded to the assets that can be traded in such markets.

What financial markets deal in are legal claims to the income deriving from the ownership of resources; they exist because of the requirement that in a capitalist economy everything must be owned by someone, but it need not be perpetual ownership. Stock markets thus provide for the distribution and redistribution of those claims. But it is not the resources that they distribute amongst users; rather, they distribute the losses and gains that arise from the failure of the market to distribute resources efficiently to the areas of highest productivity. They do this by adjusting the prices of claims so that their returns are equalized, taking into account realized rates of returns and expected future profits. The market allocates capital gains and losses that arise from investment errors, not the resources themselves. If there were no errors, then there would be no gains or losses or price adjustments, since all resources would be allocated so as to produce a uniform return. This is not an unimportant task, simply a rather different one than is usually claimed for financial markets.

Having challenged two of the myths surrounding the operation of stock markets, we can consider the myth that Walrasian financial markets are more efficient at channelling new resources to investment, and thus contribute positively to growth and development. This myth has gone so far as to be used to justify the creation of securities markets in developing countries and the Central and Eastern European transforming economies in order to increase their efficiency in the use of their scarce available resources. Even sub-Saharan Africa has become a target, and countries such as Ghana, Nigeria and Botswana have recently created stock markets in the hopes of stimulating their development efforts.

The experience of the now developed countries suggests that it is not financial markets, but banks that determine the allocation of resources through the creation and allocation of credit. Banks not only provide the positive impetus to growth by overcoming liquidity constraints, but are also crucial to the creation of the financial markets in general and stock markets in particular.

In this context we can deal with an associated myth: that 'markets' might some day produce enough disintermediation to replace banks. Since most organized markets could not exist without bank credit (the Walrasian market providing an important exception to this rule), banks and markets should be considered as complements, not substitutes. Remember that J. P. Morgan managed to control US financial affairs without ever setting foot on the floor of the New York Stock Exchange. Indeed, some say he professed not to know where it was, despite his office being just across the street.

The rest of this chapter will start from the provocation that Walras should in fact be considered an honorary, if posthumous, member of EAEPE, and that the recognition...