The Political Economy of Credit Markets – Putting politics back into the credit market!
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International Political Economy -  Agustin Mackinlay
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The Problem…

We now reach a key point in our IPE program! Normally at this stage, instructors would introduce central banks, short-term interest rates, monetary policy. Equipped with these tools, they would perhaps tackle the 2008 financial crisis. But I refuse to take that road. It deviates from one of the key points in today’s IPE scenario: the rise of new Great Powers (BRICs and others). What I have in mind is an altogether more ambitious project: LET US REINTRODUCE POLITICS INTO THE CREDIT MARKET!

What I call the Political Economy of the Credit Market is part of a research project of mine; it is the result of many years of reading and … traveling! South America, Mexico, Central America, Vietnam, The Philippines, Russia, Continental Europe, London, New York, San Francisco, New Zealand and —crucially— The Netherlands. The Political Economy of the Credit Market will help us better understand what David Landes called The Wealth and Poverty of Nations. Why Some are so Rich and Some so Poor (New York: 1998, W.W. Norton).

Consider column [6] in the table. The Netherlands have the largest bond market in terms of GDP (229%), while Peru ranks the lowest (12%). What is a bond? It is a CONTRACTUAL OBLIGATION that specifies the name of the issuer, the size of the issue, the way (and the dates) interest rate and principal payments are to be paid. Companies and governments issue bonds to finance innovation and public spending. 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: Chart the supply of loanable resources in The Netherlands and Peru]
No credit, no entrepreneurship, no innovation; no credit, no infrastructure projects, no development. No credit, no jobs! No credit, no power on the international scene!

Some ideas…

Let me share some thoughts, numbers and books & articles with you on the political economy of the credit markets. Here are some papers that attempt to quantify the link between governance indicators and the size of the credit markets.

[NOT required reading!] 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]

[NOT required reading!] John D. Burger & Francis E. Warnock: “Local Currency Bond Markets”, IMF Staff Papers, Vol. 53, 2006 (only pp. 141-142).

[NOT required reading!] Kee-Hong Bae & Vidhan Goyal: “Creditor Rights, Enforcement, and Bank Loans”, The Journal of Finance, Volume 64, Issue 2, 823–860, April 2009. ABSTRACT: “We examine whether differences in legal protection affect the size, maturity, and interest rate spread on loans to borrowers in 48 countries. Results show that banks respond to poor enforceability of contracts by reducing loan amounts, shortening loan maturities, and increasing loan spreads. These effects are both statistically significant and economically large. While stronger creditor rights reduce spreads, they do not seem to matter for loan size and maturity. Overall, we show that variation in enforceability of contracts matters a great deal more to how loans are structured and how they are priced”.

These papers tend to present econometric models; while 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. 

[NOT required reading!] “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.” [From: 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].

Now from the man himself. Sir Josiah Child and the “miracle” of Dutch interest rates (*):

[NOT required reading!] “The prodigious increase of the Netherlands in their domestic and foreign trade, riches and multitude of shipping, is the envy of the present, and may be the wonder of all future generations: and yet the means whereby they have thus advanced themselves are sufficiently obvious, and in a great measure imitable by most other nations, but more easily by us of this Kingdom of England.

The Dutch trade honestly, and methodically; they wisely teach their children arithmetic and book-keeping in the schools; they encourage inventions and new manufactures; they have set up banks; they have introduced laws under which trade disputes are quickly settled. Most miraculous of all, however, they have succeeded in reducing their rate of interest to three per cent. (as against six per cent. in England). This, in my poor opinion, is the causa causans of all the other causes of riches in that people: and if the interest of money were with us reduced to the same rate as it is with them, it would in a short time render us as rich and as considerable in trade as they are now.

(*) Sir Josiah Child. Brief Observations concerning Trade and the interest of Money (1665), in Charles Wilson. Holland and Britain. London: Collins, no date, pp. 22-23.
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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 (from where William had successfully ejected the French army). The States of Gelderland awarded him the title of Duque. Scandal!

[NOT required reading!] “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.” [From: E. H. Kossmann. Geschiedenis is als een olifant. Amsterdam: Bert Bakker, 2005, p. 166].
In other words, XVIIth century Dutchmen seemed to have detected a relationship between the form of government and financial stability.

The Montesquieu-Smith Approach: Montesquieu

French author Montesquieu (1689-1755) is mostly known for his analysis of the English Constitution in The Spirit of the Laws (1748). 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. Remember that whenever one lends money (or any other real resource), he / she is temporarily ceding the possession of those resources. Throughout the life of the loan –which is a contractual obligation– the lender runs the risk of not being repaid. The more politicized the courts of justice, the higher the risk! (examples a bit later on.)

[Montesquieu - 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” [From: Montesquieu. The Spirit of the Laws, Book XX, chapter 21].

The Montesquieu hypothesis: DESPOTIC GOVERNMENT = UNCERTAINTY OVER THE PERFORMANCE OF CONTRACTS = UNSTALBE PROPERTY RIGHTS = 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. REMEMBER THAT WHEN ONE LENDS RESOURCES, ONCE CEDES (ALBEIT TEMPORARILY) THE POSSESSION OF THOSE RESOURCES TO A THIRD PARTY.

And what is the defining feature of a despotic government in Montesquieu’s analysis? An excessive concentration of political power — most notably the lack of JUDICIAL INDEPENDENCE. Thus we can conclude: no judicial independence, no security about the performance of contracts, no stability in property rights, and hence a contraction in the supply of loanable resources in credit markets. Whenever the judiciary depends on the executive power, HIGH INTEREST RATES and poverty will prevail. Confidence will vanish; corruption will prevail. 

The Montesquieu-Smith Approach: Ferdinando Galiani 

Galiani on interest rates. A great quote from Ferdinando Galiani (1727-1787), a follower of Montesquieu. Galiani writes about interest rates in Della Moneta (1751). He argues that interest rates fell across Europe not because of the abundance of money, but thanks to the effects of moderate government (la dolcezza del governo). Galiani clearly reasons in terms of the supply of loanable resources. Note the comment on the abundance of credit and its impact on poverty. Sadly, I cannot provide a decent translation!

[NOT Required Reading!] Per render bassi gl'interessi secondo l'esposto di sopra basta evitare il monipolio del danaro, e assicurare la restituzione. Perciò non è stata la sola abbondanza de' metalli preziosi che ha sbassate e quasi estinte le usure da due secoli in qua; ma principalmente la dolcezza del governo quasi in ogni regno goduta. Sieno le liti brevi, la giustizia certa, molta industria ne' popoli, e parsimonia, e saranno tutti i ricchi inclinati a prestare. Là dove è folla di offerenti, non possono esser dure le condizioni dell'offerta. Così saranno i poveri trattati senza crudeltà. 

Brilliant! Genius! And he was only 24 when he wrote this! Galiani explains the drop in interest rates in Europe from the Middle Ages to about 1750. He rejects a purely monetary explanation; rather, he adopts a political economy framework: it was not the abundance of money which led to lower interest rates. IT WAS MODERATE GOVERNMENT AND A SOUND JUDICIAL SYSTEM THAT DID IT!

The Montesquieu-Smith Approach: Adam Smith

Scottish philosopher and economist Adam Smith was well aware of Montesquieu’s work. In his 1776 major book, An Inquiry into the ealth of Nations (1776), he further elaborates on the link between interest rates and judicial independence.

[Adam Smith (1) - 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. Interest is raised by defective enforcement of contracts. (Wealth of Nations, Book I, chapter 9). 

[Adam Smith (2) - REQUIRED READING!] 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).

[Adam Smith (3) - Not required reading!] This Separation of the province of distributing Justice between man and man from that of conducting publick affairs and leading Armies is the great advantage which modern times have over antient, and the foundation of that greater Security which we now enjoy both with regard to Liberty, property and Life. It is evident that in quoting præcedents the more directly they agree with the case in hand in all its circumstances it will be so much the better. (Lectures On Rhetoric and Belles Lettres, 1762)

Many points can be made about these excellent passages. Any ideas? My takeaway: (1) The size of the supply of loanable resources depends on the security of property and on trust on the performance of contracts; (2) Trust in the performance of contracts depends on the existence of a well-functioning judiciary; (3) Whenever those conditions are not met, citizens pay an “extra-tax” in the form of higher interest rates! (“The uncertainty of recovering his money makes the lender exact the same usurious interest which is usually required from bankrupts”); (4) Judicial independence is … modernity!

The Montesquieu-Smith Approach: Jacques Necker

A former minister of finance under Louis XVI, Jacques Necker is a fierce opponent of the Napoleon regime. According to Necker, the regime —which rests on an unprecedented concentration of political power — is unsustainable because it leads to much too high interest rates. See Necker’s Dernières vues de politique et de finance (1802):

[NOT Required Reading!] La plenitude du credit [est] incompatible avec l’existence d’un pouvoir sans balance (p. 382). While England pays about 3% on her debt, the lack of confidence in the French regime means that the country pays as much as 9%.

Judicial Independence: the key ingredients

[1] Judges’ nomination process

[2] Tenure on good behavior

[3] Precedents as a source of law

[4] Due process of law

[5] Salaries and budget issues

All of this sounds a bit tedious. So let’s consider a number of recent and historical examples.