Financial Regulation and Financial Development: Tradeoff or Synergy? a Transaction Costs Approach
Abstract: Despite the critiques of ‘financial repression’, financial regulation can be designed as policy that would accommodate rather than antagonize financial development. This holds true in an uncertain world where incomplete contracting is the norm, since regulation can be linked to building institutional protections for savers/investors. In a governance framework, overcoming financial asset specificity devolves on institutional arrangements that protect asset-holders from contractual hazards by promoting verifiability of returns and confidence. Government regulation can supplement pecuniary with non-pecuniary returns to savers and provide safeguards that gradually increase confidence; this corresponds to a cumulative process of ‘institution-building’. Two issues stand out: fiscal sustainability and time consistency. The provision of safeguards is achieved in a manner that endogenizes fiscal sustainability: benefits bestowed by government to the investing public can be financed by a tax on financial returns. Furthermore, the buildup of an optimum stock of safeguards depends on the government’s rate of “political” time preference which interacts with the time preference of private agents. Since a major outcome of institutional development is the ultimate embodiment of safeguards in the attitudes of agents, consistency of interventionist policy over time is important. In this context, an adverse twist in confidence – as in the occurrence of a crisis - can render the existing institutional edifice inadequate and require new (or renewed) safeguards against rising asset specificity.
