Thursday April 15, 2010
IPE Leiden

Agustin Mackinlay

Credit markets & the rule of law
. In 1998, David Landes publishes. The Wealth and Poverty of Nations. Why Some are so Rich and Some so Poor (New York: W.W. Norton). While we will not solve this problem today, we will tackle it from the credit markets perspective

. Consider column [6] in the table. The Netherlands boast the largest bond market in terms of GDP (229%), while Peru ranks the lowest (12%). What is a bond? It is a CONTRACT that specifies the name of the issuer, its size, the way (and the dates) interest rate and principal payments are to be paid. What is GDP? The value of all goods and services produced in a given year.

. If the Netherlands’ GDP amounts to $650 billion, then the size of its bond market is about … $1488.5 billion. (Peru numbers: $250 bn GDP; $30 bn size of bond market). No wonder the Netherlands are considered one of the wealthiest countries on the planet!

. [DIAGRAM]. A stylized presentation of the credit market in the Netherlands and in Peru with a simple supply & demand chart

. No credit, no entrepreneurship (in terms of scale); no entrepreneurship, no innovation; no credit, no infrastructure projects, no development. No credit, no power on the international scene!
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. Let me share some thoughts, numbers and books & articles with you on the issue of the Wealth of Nations from the credit market perspective.

. The first thing to note is that most economics textbooks do not even mention the obvious differences in credit markets across the world. They are mostly published in OECD countries!

. Two recent papers attempt to describe the link between governance indicators and the size of the credit markets: John D. Burger & Francis E. Warnock: “Local Currency Bond Markets”, IMF Staff Papers, Vol. 53, 2006 (especially pp. 141-142); Philip Keefer: “Beyond legal origin and checks and balances: Political credibility, citizen information and financial sector development”, in Stephen Haber, Douglass C. North & Barry Weingast (eds). Political Institutions and Financial Development (Stanford University Press, 2008) [available at Google Books]

. Both papers present econometric models; while very valuable, they provide little information about cause-and-effect relations. My first approach was to tackle the issue from the historical point of view. It turns out that the Netherlands has been at the forefront of financial development since the … XVIIth century! It has always been a low-interest rate country:

In 1665 Sir George Downing, writing in England, pointed out that it was possible for merchants to borrow in Amsterdam at 4 per cent or even 3 per cent, and in 1688 Sir Josiah Child took 3 per cent as normal. Rates of 2 ½ per cent are even mentioned. [NOT required reading! Peter Spufford: “Access to credit and capital in the commercial centres of Europe”, in Karel Davids & Jan Lucassen (eds.) A Miracle Mirrored. The Dutch Republic in European Perspective. Cambridge University Press, 1995, p. 305].

. But how do we account for the Dutch miracle from the credit market perspective? This quote from Dutch historian Ernst Kossmann contains an important clue. In 1675, William III had accepted the sovereignty over Gelderland (where Willaim had led the repulse of the French invasion). The States of Gelderland awarded him the title of Duque (“hertog”):

Even his most unconditional supporters were alarmed; the fury was so great that William felt obliged to refuse the award. In Zeeland he was told by his own supporters that an arbitrary government, the unavoidable consequence of a one-headed system of government –the standard argument of Dutch republicans– would undermine confidence in the commercial and financial institutions of the Republic, which in turn would destroy Dutch prosperity [NOT required reading! E. H. Kossmann. Geschiedenis is als een olifant. Amsterdam: Bert Bakker, 2005, p. 166].


The Montesquieu-Galiani-Smith approach

. French author Montesquieu (1689-1755) is mostly know for his analysis of the English Constitution in The Spirit of the Laws. But he was an economist too. John Maynard Keynes, in the foreword to the French edition of his General Theory, calls Montesquieu “the greatest French economist of all times”. Montesquieu establishes a link between the type of government, interest rates and the size of the credit markets:

[REQUIRED READING!]
Poverty and the uncertainty of fortunes naturalizes usury in despotic states, as each one increases the price of his silver in proportion to the peril involved in lending it. Therefore, destitution is omnipresent in these unhappy countries; there everything is taken away, including the recourse to borrowing (Book V, chapter 15). In moderate states, it is entirely different. Confiscations would render the ownership of goods uncertain; they would despoil innocent children … In these countries of the East, most men have nothing that is secure; there is almost no relation between the present possession of a sum and the expectation of having it back after lending it; therefore, usury increases in proportion to the peril of insolvency (Book XX, chapter 19). These continual changes [in legislation regarding loans in the Roman republic], both by laws and by plebiscites, naturalized usury in Rome, as the creditors who saw in the people their debtor, their legislator, and their judge no longer had trust in contracts (Book XX, chapter 21).

. The Montesquieu hypothesis: DESPOTIC GOVERNMENT = UNCERTAINTY OVER THE PERFORMANCE OF CONTRACTS = SMALL SIZE OF CREDIT MARKETS = POVERTY & USURY!

. [DIAGRAM]. The Montesquieu hypothesis. In despotic governments, the supply of loanable resources is much lower than in moderate regimes.

. TRUST IN THE PERFORMANCE OF CONTRACTS: this is the key to increase the supply of loanable resources! To people living in OECD countries, all of this seems a bit strange; we tend to take the performance of contracts for granted. But look at the two Financial Times articles attached: “Iranians switch to informal savings funds as loans dry up” (March 13) and “Bonds and barter in the sauna” (March 28).

. [DISCUSSION OT TWO FINANCIAL TIMES ARTICLES]

. Russia: contract enforcement, judicial independence & interest rates

(a) The Khodorkovsky affair (Yukos)

THE PERFORMANCE OF CONTRACTS, LADIES & GENTLEMEN!!! What happened to those who supplied credit to Mr. Khodorkovsky? Did their ever recover their money? Not very likely!
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(b) The Shell-Sakhalin-2 scheme. Shell was forced by the Russian government to hand over its controlling stake (55%) in the world's biggest liquefied gas project to something close to 25%. The Anglo-Dutch company was threatened with having its operating licence withdrawn. “In the current situation Shell will not be able to defend its economic interests in a civilised process with the Russian authorities, so they will be obliged to give up control if they want to save at least some adequate part of the project,” said Vladimir Milov, Russia's former deputy energy minister. Bob Amsterdam, the lawyer of the jailed oil oligarch Mikhail Khodorkovsky, said the Kremlin was once again using legal pretexts to cover what was essentially an expropriation of private resources in the energy sector.

THE PERFORMANCE OF CONTRACTS, LADIES & GENTLEMEN!!! Would you lend money to smaller oil companies operating under the radar of Gazprom? If so, at what rate of interest? A low one, or a high one?
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(c) The $250 million Hermitage Capital scandal. Lawyer Sergei Magnitsky found dead in his cell. Says Hermitage Capital’s Bill Browder: “Now, you have a bunch of law enforcement people who are essentially organised criminals with unlimited power to ruin lives, take property and do whatever they like and that's far worse than I have ever seen in Russia before. Russia is essentially a criminal state now.” From an unnamed senior banker in Mosow: “Russia's judicial system is totally compromised. It is strangling entrepreneurship. What happened is a clear impediment for investments coming in, not just for foreing investment but even for local ones”. (Catherine Belton: "Questions remain about Russia tax fraud", Financial Times).

THE PERFORMANCE OF CONTRACTS, LADIES & GENTLEMEN!!! Whatever happened to those who supplied loanable resources to Hermitage Capital companies?

. What we see very clearly (especially in the case of Russia) is the link between concentrated power –and especially the lack of judicial independence– the performance of contracts, and the overall stability of property rights. One of the most important followers of Montesquieu was none other than Scottish philosopher & economist Adam Smith:

[REQUIRED READING!]
When the law does not enforce the performance of contracts, it puts all borrowers nearly upon the same footing with bankrupts or people of doubtful credit in better regulated countries. The uncertainty of recovering his money makes the lender exact the same usurious interest which is usually required from bankrupts. Among the barbarous nations who over-ran the western provinces of the Roman empire, the performance of contracts was left for many ages to the faith of the contracting parties. The courts of justice of their kings seldom intermeddled in it. The high rate of interest which took place in those ancient times may perhaps be partly accounted from this cause. In Bengal, money is frequently lent to farmers at forty, fifty and sixty per cent and the succeeding crop is mortgaged for the payment (Wealth of Nations, Book I, chapter 9).

When the judicial is united to the executive power, it is scarce possible that justice should not frequently be sacrificed to, what is vulgarly called, politics. But upon the impartial administration of justice depends the liberty of every individual, the sense which he has of his own security. In order to make every individual feel himself perfectly secure in the possession of every right which belongs to him, it is not only necessary that the judicial should be separated from the executive power, but that it should be rendered as much as possible independent of that power (Wealth of Nations, Book V, chapter 1).

And that leads us to a more detailed discussion of the table.

. The meaning of governance indicators

From Burger & Warnock (2006): "The importance of institutional and policy settings suggests that even emerging economies have the ability to develop local currency bond markets. Emerging market economies are not predestined to suffer from original sin. To gauge the importance of various factors, our estimates in column 1 of Table 3 imply that (other things being equal) if Brazil had Denmark’s rule of law, its bond market as a share of GDP would be 43 percentage points higher. If Brazil had Denmark’s inflation history, its bond market would be 42 percentage points (of GDP) larger. These amounts are both economically significant—Brazil’s local currency bond market is currently only 22 percent of GDP—and suggest an important role for creditor-friendly policies in emerging markets. The results suggest that the determinants of the size of government and private bond markets are quite similar: Countries with better inflation performance and stronger rule of law have larger sovereign and corporate bond markets".

Think about it! Brazil’s GDP is about $1.27 trillion. Now, 43 percentage points would mean that no less than $546 billion of additional credit that could be made available to entrepreneurs and/or to the government (poverty reduction, etc).

. The ingredients of judicial independence

. Interest rates, wages & human capital risk ( brain drain)

. Political culture, judicial independence and … interest rates (Russia, Latin America)

. Does freedom of the press has anything to do with … credit?

From Philip Keefer (2008): "When average citizens do not believe the promises of political competitors to provide such public goods as secure property rights or are unable to monitor the fulfillment of such promises, financial sector development slows (p. 23). Strong evidence is found for this: the continuous years of competitive elections and newspaper circulation, proxies for the credibility of pre-electoral political promises and voter information, are both significant determinants of financial sector development (p. 35).

. Thomas Friedman: idealism –i.e, good governance– is the new realism (on power) [see]

. Africa

. China & the rule of law

. The sheer complexity of credit markets!

. Micro-credit & property rights

. Why do traditional economics textbooks fail to grasp the differences in credit markets?

. The curse of raw materials: Argentina, Russia, Venezuela, Africa, Bolivia, Canada, Norway

. How to read newspapers!
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