Secondary Capital Markets and the Potential Non-monotonicity between Finance and Economic Development Burak R Uras Tilburg University European Banking Center Midwest Economic Theory Conference Uras (Tilburg) Secondary Markets and Financial Frictions St Louis 2012 1 / 33
Motivation How are financial development and economic growth related? Uras (Tilburg) Secondary Markets and Financial Frictions St Louis 2012 2 / 33
Motivation Finance and Economic Development Most models of financial frictions and macroeconomy exhibit a monotone relation between finance and economic development: Reducing financial frictions always improves economic performance Uras (Tilburg) Secondary Markets and Financial Frictions St Louis 2012 3 / 33
Motivation Empirical Evidence Financial development promotes growth Levine (1993 and 1997) Beck et al (2000) Beck et al (2008) Financial development and economic growth exhibit a non-monotone association Pagano and Jappelli (1994) Bandiera et al (2000) Castro et al (2004) Uras (Tilburg) Secondary Markets and Financial Frictions St Louis 2012 4 / 33
Motivation Important Questions to be Answered When does financial development promote growth? When does it reduce growth? Uras (Tilburg) Secondary Markets and Financial Frictions St Louis 2012 5 / 33
Motivation This Paper How does the secondary market trading of capital influence the financial development - growth nexus? An OLG Model of Occupation Choice with Financial Frictions Financial Frictions in the form of financial repression (an external finance wedge) Long-term investment engine of economic development Secondary market trading necessary to make long-term investment possible Uras (Tilburg) Secondary Markets and Financial Frictions St Louis 2012 6 / 33
Motivation Findings A large secondary market trading volume is a necessary condition for financial development to be counterproductive If secondary market price of capital is increasing in financial frictions, reducing financial repression stimulates economic development If secondary market price of capital is invariant with respect to the changes in financial frictions, reducing financial repression might suppress economic development Rich economies more likely to exhibit a negative association between financial frictions and economic development Uras (Tilburg) Secondary Markets and Financial Frictions St Louis 2012 7 / 33
Motivation Non-monotone Real Effects of Financial Development Pagano and Jappelli (1994) Bencivenga, Smith and Starr (1995 and 1996) Castro, Clementi and MacDonald (2004) Jiang, Wang and Wu (2009) Uras (2012) Uras (Tilburg) Secondary Markets and Financial Frictions St Louis 2012 8 / 33
Model Environment 2-period OLG Model Single good Ex-ante identical young agents of measure M with occupation choice: Worker Entrepreneur with short-term production Entrepreneur with long-term production Each young agent is endowed with one unit of labor and one unit of entrepreneurial capital Uras (Tilburg) Secondary Markets and Financial Frictions St Louis 2012 9 / 33
Model Environment - II Short-term production employs labor and entrepreneurial capital to produce the consumption good: s t (l t ) with s t(l t ) > 0 and s t (l t ) < 0 Entrepreneurial Profits Workers earn w t Long-term production employs physical capital and entrepreneurial capital to produce the consumption good Two cases: Benchmark: Entrepreneurial capital investment in period t, physical capital investment in period t + 1 with returns l t+1 (k t+1 ) Extension: Entrepreneurial and physical capital investment in period t that returns l t+1 (k t ) Both cases with l (k) > 0 and l (k) < 0 Uras (Tilburg) Secondary Markets and Financial Frictions St Louis 2012 10 / 33
Model Benchmark Financial Markets - Benchmark Workers and Short-term Producers are savers, Long-term producers are borrowers of investable funds Long-term production with short-term capital investment Transactions between old savers - old borrowers Cost of capital for a long-term entrepreneur: R t (1 + φ) R t : Real rate of interest φ: Exogenous capital price distortion (Financial repression tax) Assumption 1 R t (1 + φ) paid to savers per-unit capital investment Assumption 2 For constant R, variations in φ does not alter the life-time value from being a saver Uras (Tilburg) Secondary Markets and Financial Frictions St Louis 2012 11 / 33
Model Benchmark Optimizing Behavior Short-term entrepreneurs maximize: max l t π t (l t ) = s t (l t ) w t l t Long-term entrepreneurs maximize: max k t+1 π t+1 (k t+1 ) = A L k α t+1 R t+1 (1 + φ)k α t+1 Workers supply their labor endowment inelastically in return for w t Uras (Tilburg) Secondary Markets and Financial Frictions St Louis 2012 12 / 33
Model Benchmark Equilibrium Occupation Choice: V ω (w t ) = V e (l t ) }{{} V S,t = V L (k t+1 ) Market clearance: lt s (w t )di = M ω kt d (R t )di = M L lt d (w t )di, M e w t di + π(w t )di M ω M e Uras (Tilburg) Secondary Markets and Financial Frictions St Louis 2012 13 / 33
Model Benchmark Properties of Equilibrium The equilibrium is stationary Workers and short-term entrepreneurs earn w Life-time value equalization between being a saver and a borrower: ( αal R(1 + φ) }{{} }{{} wr = (1 α)a L =V S ( solves for R(φ) = A 1 α ) ( ) 1 α α α L w 1+φ =V L ) α 1 α The cost of capital for an entrepreneur is R(φ) R(φ)(1 + φ) with R φ R < 0, and φ > 0 V S φ R(φ) (1 + φ) 1 α }{{} G(φ) < 0, and V L φ < 0 Uras (Tilburg) Secondary Markets and Financial Frictions St Louis 2012 14 / 33
Model Benchmark Properties of Equilibrium - II Capital market clearance determines the ratio between savers (S) and long-term entrepreneurs (L) in equilibrium as: ( ) M L 1 α = (1 + φ) M S α A decline in φ stimulates the aggregate stock of investable funds K = M S w Aggregate production as a function of φ: [( )] 1 α 1 α [ W = A L (1 + φ) 1 α α is a decreasing function of φ α α + (1 α)(1 + φ) Proposition 31 A decline in φ stimulates the equilibrium aggregate capital stock and output ] [w] α M, Uras (Tilburg) Secondary Markets and Financial Frictions St Louis 2012 15 / 33
Model Benchmark W and R W R(φ 1 ) W 1 W (φ 1 ) R 1 R Figure 1 Long-Term Investment with Short-Term Borrowing Uras (Tilburg) Secondary Markets and Financial Frictions St Louis 2012 16 / 33
Model Benchmark W and R W R(φ 1 ) R(φ 2 ) W 2 W 1 W (φ 2 ) W (φ 1 ) R 1 R 2 R Figure 1 Long-Term Investment with Short-Term Borrowing Uras (Tilburg) Secondary Markets and Financial Frictions St Louis 2012 16 / 33
Model Extension 1 Financial Markets - Extension 1 Long-term capital investment Transactions between old savers - young borrowers Secondary market trade of long-term capital among savers from two consecutive cohorts is necessary to make long-term investment possible Secondary market transactions with: primary financiers who extend long-term loans to the entrepreneur and secondary financiers who buy claims from primary financiers, and q t as the secondary market price of a unit capital investment Cost of capital for a long-term entrepreneur: R t+1 R t (1 + φ) R t : Real rate of interest φ: Exogenous capital price distortion (Financial repression tax) Assumption 1 R t (1 + φ) paid to primary savers per-unit capital investment q t = R t (1 + φ) Assumption 2 For constant R, variations in φ does not alter the life-time value from being a primary saver Uras (Tilburg) Secondary Markets and Financial Frictions St Louis 2012 17 / 33
Model Extension 1 Optimizing Behavior Short-term entrepreneur s profit maximization problem remains the same Long-term entrepreneurs maximize: max π t+1 (k t ) = A L kt α R t R t+1 (1 + φ)kt α k t+1 Uras (Tilburg) Secondary Markets and Financial Frictions St Louis 2012 18 / 33
Model Extension 1 Equilibrium Occupation Choice: V ω (w t ) = V e (l t ) }{{} V S,t = V L (k t ) Financier s are indifferent from being a primary or a secondary financier: V 1 S,t = V 2 S,t Market clearance: M ω l s t (w t )di = M L k d t (R t, R t+1 )di = lt d (w t )di, M e w t di + π(w t )di M ω M e Uras (Tilburg) Secondary Markets and Financial Frictions St Louis 2012 19 / 33
Model Extension 1 Properties of Equilibrium Life-time value equalization between being a saver and a borrower: ( ) α αal 1 α wr = (1 α)a L R 2 (1 + φ) solves for R(φ) = A 1 ( 1+α 1 α ) 1 α ( ) α 1+α α 1+α L w 1+φ The cost of capital for an entrepreneur: R φ < 0, R 1 φ > 0, and R 2 φ > 0 R 1 (φ) R(1 + φ) (1 + φ) 1 1+α R 2 (φ) R 2 (1 + φ) (1 + φ) 1 α 1+α Uras (Tilburg) Secondary Markets and Financial Frictions St Louis 2012 20 / 33
Model Extension 1 Properties of Equilibrium - II Capital market clearance: M S M L = α 1 + R 1 (φ) 1 α R 1 (φ) A decline in φ stimulates the aggregate stock of investable funds, K = M S w, in this current case also through R 1 Aggregate production as a function of φ: [ R 1 (φ)] 1 α W = 1 + (1 + z) R 1 (φ) Az1 α [w] α M, is a decreasing function of φ for R > 1 Proposition 41 For R > 1, lowering φ stimulates the equilibrium aggregate capital stock and output Uras (Tilburg) Secondary Markets and Financial Frictions St Louis 2012 21 / 33
Model Extension 1 Properties of Equilibrium - III There are two effects that financial development generates on the macroeconomy: 1 The aggregate stock of investable funds rises: Capital Deepening 2 The fraction of investable funds that needs to be paid to primary financiers when settling secondary market transactions decreases: Improves Allocation Efficiency Both channels stimulate the level of macroeconomic development Uras (Tilburg) Secondary Markets and Financial Frictions St Louis 2012 22 / 33
Model Extension 1 W and R W R(φ 1 ) W 1 R 1 W (R, φ 1 ) R Figure 2 Long-Term Investment with Long-Term Borrowing: Case 1 Uras (Tilburg) Secondary Markets and Financial Frictions St Louis 2012 23 / 33
Model Extension 1 W and R W W 1 R(φ 1 ) R(φ 2 ) R 1 R 2 W (R, φ 1 ) R Figure 2 Long-Term Investment with Long-Term Borrowing: Case 1 Uras (Tilburg) Secondary Markets and Financial Frictions St Louis 2012 23 / 33
Model Extension 1 W and R W W 2 W 1 R(φ 1 ) R(φ 2 ) R 1 R 2 W (R, φ 2 ) W (R, φ 1 ) R Figure 2 Long-Term Investment with Long-Term Borrowing: Case 1 Uras (Tilburg) Secondary Markets and Financial Frictions St Louis 2012 23 / 33
Model Extension 1 W and R 1 W R 1 (φ 2 ) W 1 R 1 W ( R 1 (φ 1 )) R Figure 3 Long-Term Investment with Long-Term Borrowing: Case 1 Uras (Tilburg) Secondary Markets and Financial Frictions St Louis 2012 24 / 33
Model Extension 1 W and R 1 W W 1 R 1 (φ 1 ) R 1 (φ 2 ) R 1 W ( R 1 (φ 1 )) R Figure 3 Long-Term Investment with Long-Term Borrowing: Case 1 Uras (Tilburg) Secondary Markets and Financial Frictions St Louis 2012 24 / 33
Model Extension 1 W and R 1 W W 2 W 1 R 1 (φ 1 ) R 1 (φ 2 ) R 2 R 1 W ( R 1 (φ 1 )) R Figure 3 Long-Term Investment with Long-Term Borrowing: Case 1 Uras (Tilburg) Secondary Markets and Financial Frictions St Louis 2012 24 / 33
Model Extension 2 Financial Markets - Extension 2 Secondary market trade between savers from two consecutive cohorts with q t as the secondary market price of a unit capital investment Cost of capital for a long-term entrepreneur: R t (1 + φ) R t : Real rate of interest φ: Exogenous capital price distortion (Financial repression tax) Assumption 1 R t (1 + φ) paid to secondary financiers per-unit capital investment q t = R t Assumption 2 For constant R, variations in φ does not alter the life-time value from being a secondary financier Uras (Tilburg) Secondary Markets and Financial Frictions St Louis 2012 25 / 33
Model Extension 2 Properties of Equilibrium w, R, R 1 and R 2 remain the same as in previous case Capital market clearance: M S M L = α 1 + R 1 α R 1 (φ) Aggregate production function as a function of φ: [ R1 (φ)] 1 α W = 1 + R + z R 1 (φ) Az1 α [w] α M Uras (Tilburg) Secondary Markets and Financial Frictions St Louis 2012 26 / 33
Model Extension 2 Properties of Equilibrium - II Proposition 51 Holding everything else constant, lowering q = R(1 + φ) to q = R increases the aggregate output Proposition 52 For R > 1, Lowering φ stimulates the equilibrium aggregate capital stock, but reduces the aggregate output Uras (Tilburg) Secondary Markets and Financial Frictions St Louis 2012 27 / 33
Model Extension 2 Properties of Equilibrium - III Lowering financial repression: 1 The aggregate stock of investable funds rises: Capital Deepening 2 The fraction of investable funds that needs to be paid to primary financiers when settling secondary market transactions increases: Distorts Allocation Efficiency The 2nd channel dominates 1st channel Uras (Tilburg) Secondary Markets and Financial Frictions St Louis 2012 28 / 33
Model Extension 2 W and R W R(φ 1 ) W 1 R 1 W (R, φ 1 ) R Figure 4 Long-Term Investment with Long-Term Borrowing: Case 2 Uras (Tilburg) Secondary Markets and Financial Frictions St Louis 2012 29 / 33
Model Extension 2 W and R W W 1 R(φ 1 ) R(φ 2 ) R 1 R 2 W (R, φ 1 ) R Figure 4 Long-Term Investment with Long-Term Borrowing: Case 2 Uras (Tilburg) Secondary Markets and Financial Frictions St Louis 2012 29 / 33
Model Extension 2 W and R W W 1 W 2 R(φ 1 ) R(φ 2 ) R 1 R 2 W (R, φ 2 ) W (R, φ 1 ) R Figure 4 Long-Term Investment with Long-Term Borrowing: Case 2 Uras (Tilburg) Secondary Markets and Financial Frictions St Louis 2012 29 / 33
Model Extension 3 Financial Market - Extension 3 Suppose there is a heterogeneity across primary financiers such that q = ηr(1 + φ) Proposition 61 There exists a threshold η < 1 such that lowering φ stimulates steady state output only if η > η For η < η lowering φ reduces steady-state output Proposition 52 The threshold η is an increasing function of equilibrium wage rate w Uras (Tilburg) Secondary Markets and Financial Frictions St Louis 2012 30 / 33
Summary of Key Findings Financial development exercise in a model with secondary market prices Financial development stimulates aggregate economic performance to the extend financial frictions affect secondary market security prices If secondary market prices are insensitive to financial frictions, financial development might reduce aggregate economic performance Financial development more likely to be counterproductive in high income countries Uras (Tilburg) Secondary Markets and Financial Frictions St Louis 2012 31 / 33
Related Empirical Evidence There is empirical evidence that financial development could promote as well as reduce economic performance Furthermore, Castro et al (2004): Investor protection and economic growth are positively related in low income countries whereas the are negatively related in high income countries Fostel and Geanakoplos (2008): Latin American countries experienced secular financial deregulation experiences end of 1980s-beginning of 1990s; an under-supply of stock market liquidity and suppressed economic activity follow these financial development experiences Uras (Tilburg) Secondary Markets and Financial Frictions St Louis 2012 32 / 33
Extensions Capital accumulation: s(k, l) Endogenous security prices Uras (Tilburg) Secondary Markets and Financial Frictions St Louis 2012 33 / 33