Financial Markets and Institutions - Essay Example

Financial Markets and s Contents Contents 2 Introduction 3 Discussion 3 Role of s in the economy 3 Market Regulatory s 5 Market creating institutions 6 Social Insurance Institutions 6 Conflict management Institutions 6 Institutions responsible for Macro-economic stability 7 Conclusion 8 References 9 Introduction Financial Markets and Institutions do have a role to play in the development of less developed regions which results in development of the macro and micro economic factors of a country. These institutions play a multiple role in promoting, supporting, nurturing, monitoring and other range of activities which has been a primary driver of the industrial development. Growth and development of an economy cannot take place in an institutional vacuum. Growth of the markets and economic maturity requires an institutional framework which allows the transactions to take place in a proper manner so that the agents know that the decisions which they take will be protected by law. Investors, savers, consumers, entrepreneurs, consumers, workers and risk takers all needs an institutional framework to make optimizing and rational decisions. They need some kind of guarantee with respect to the economic stability and certainty which can be provided through sound policy making and good governance. The opposite of this state is economic anarchy or failed states. In this report we will discuss about the role of formal institutions in providing economic, social and political environment so that the economy can prosper and flourish and how it creates a relationship between economic development and institutional development. Discussion Role of institutions in the economy The role of institutions in the economic development was first proposed by Douglass North, the Nobel Prize- winning economist. The modern proponents of this theory are Dani Rodrik of Harvard University and Simon Johnson, James Robinson and Daron Acemoglu of Massachusetts Institute of Technology. North has said that it is imperative for the societies to develop an effective low-cost enforcement of contracts, failing which results in underdevelopment in Third World countries (Baer and Villela, 1980, pp. 131-145). He has pointed out that the Third World countries are poor because they face severe institutional constraints which discourage productive activity in an economy. North has given very broad definitions of the institutions known as formal and the informal norms which govern a human behaviour. There are many reasons as to why institutional structures are important for economic activity to flourish. The incentives and price signal which they give are vital to the market economy and it cannot function properly without these institutions. Markets need institutions because they are not self-regulating, self-creating, self-legitimising or self-stabilising (Kuznets, 1971, pp. 165-184). The importance of institutions will vary according to the history of an economy, the stage of development, its geography and its political aspirant that is the type of society its people want. For example in small rural economy, where everyone knows each other, the scope of fraud, cheating and dishonouring of contracts are limited. In such cases, transactions costs like costs of negotiation, information, coordination, enforcement of contracts and monitoring are low. The communities exist by adhering to the rules and procedures of behaviour though the economic development is limited because there is lack of any specialization. In comparison to that, there are large industrial societies where the transactions are impersonal. In such cases there is a widespread scope of opportunism in the economy. Here the both the transaction and production costs are very high. Hence to keep them in check we require the institutional structures like rule of law, enforcement of the property rights, guarantee of the contracts, patent protection, provision of limited liability and so on (Greenwood and Jovanovic, 1990, pp. 1076-1107). Hence with low transaction and production cost, the firms and the markets can concentrate on their job. It is believed that there are no single institutions which will suit in all the countries, and we require at least five main types of institutions for healthy economic growth in the economy. They are Regulatory institutions: Like the market –regulating institutions. Market creating institutions: Ones which creates legally binding contracts and property rights. Market-legitimizing institutions: These are like communal insurance institutions. Market-legitimizing organizations: These are conflict management institutions. Market-stabilizing institutions: These institutions are responsible for macroeconomic stability. We will now take a look at each of them separately. Market Regulatory institutions This type of institutions is very important for basic functioning of an economy. Markets will fail if there is anti-competitive behaviour or fraud. These kinds of regulatory institution are needed for the markets to functions properly. With market liberalization, there is a strong need of these kinds of institutions which can avoid the risky behaviour in the markets like the financial crises which the world witnesses in 2008. It was a result of lack of regulation in the banking system. Such Institutions regulate the capital market imperfections and its coordination failures. They form an integral part of the regulatory framework of an economy thereby prompting growth and innovation. It was seen in Korean and Taiwan where the state intervened to promote the industrial development in during 1960s and 1970s. All major successful economies have many regulatory institutions which overseas different markets like financial markets, labour market and the product markets. It is the developing countries which need such types of institutions because chance of market failures is more for them as compared to the developed countries (Bekaert, 1995, pp. 75-107). Market creating institutions These kinds of institutions are important because if the agents don’t have any control over the return on their assets they will lack the incentive to innovate and invest. Hence Intellectual property rights are very important for the encouragement to the agents. In the market control is more important than the ownership. If there are no control rights then formal property rights does not mean much. It is the control rights which can spur entrepreneurial activity without any property rights. One such example is China which creates such atmosphere for their businesses (King and Levine, 1993, pp. 513-542). Social Insurance Institutions These are mainly required for individuals who are willing to accept change. Progress in any economy requires willingness to take risk. Insurance for crop failures, unemployment and price fluctuations in agricultural commodities are important for the traditional agriculture to transform. The process of liberalization will meet resistance and hence it is imperative to create social security institutions for those who are vulnerable to such change (Bencivenga, and Smith, 1991, pp. 195-209). Hence for a market economy to prosper, cohesion and social stability are required to maintain stability in the economy. Conflict management Institutions Any kind of social conflict damages the economies since it diverts the resources from productive activities and thus creates uncertainty which discourages investments in the economy. Hence to minimize such conflict a range of institutions are required for the economy to prosper both at micro level and at the macro level. These include a fair legal system, existence of rule of law, existence of political voice for minority groups. This ensures that potential losers in the social conflict will be safeguarded and the potential winners will not be benefitted (Demirguc-Kunt and Levine, 1996, pp. 291-322). Institutions responsible for Macro-economic stability For the private investment to flourish, both fiscal and monetary policy institutions are necessary. It provides an enabling environment for them to work. Macroeconomic instability creates uncertainty and risk. For entrepreneurs, this risk minimisation is vital, for them to take informed, long-term investment decisions. Careful supervisions are required since financial markets are unstable which can have damaging effects on it. It is the responsibility of the central banks to develop proper fiscal and monetary policy so that it can result in macroeconomic and micro economic stability (Van Damme, 1994, pp. 14-33). There has to be way to measuring the correlation of economic activity with the institutional quality. There are several measures used to measure it. Some of them are listed below Measuring the property rights and the expropriation risk An aggregate governance directory Political instability An index of political rights, democracy and civil liberties An index of corruption An index of social division Economic freedom Political instability The fundamental reason for differences in the level of development across the world is due to differences in the evolution of institutions (Stern, N. 1989, pp. 597-685). Hence institutions like International Monetary Fund, World Bank, UNICEF, and World Health Organisation etc. are there to remove the inequality across the nations to create stability and development in the world. They have so far achieved significant result and hence they continue to work on their philosophy to make the world a stable economy for the firms to operate. Conclusion The role of this kind of institutions in the development of economies cannot be overemphasized. Over a significant period of time, developing economies have used the help of these kinds of institutions to further the development goals. Institutions have bought around transforming financial structures in some countries which have resulted in long term investment by other countries in the form of FDI and FIIs. FIIs invest in an economy after seeing the stability of the market. This stability can be provided by the financial institutions only which results in growth of the GDP of the economy. Hence the economy as a whole improves. References Baer, W and Villela, A.V. 1980. “The Changing Nature of Development Banks in Brazil”, Journal of Interamerican Studies and World Affairs, Vol. 22(4), pp. 131-145. Bekaert, G. 1995. “Market Integration and Investment Barriers in Emerging Markets”, World Bank Economic Review, Vol. 9(2), pp. 75-107 Bencivenga, V.R. and Smith, B.D. 1991. “Financial Intermediation and Endogenous Growth”, Review of Economic Studies, Vol. 58(2), pp. 195-209. Demirguc-Kunt, A. and Levine, R. 1996. “Stock Market Development and Finanacial Intermediaries: Stylized Facts”, World Bank Economic Review, Vol. 10 (1), pp. 291-322. Greenwood, J. and Jovanovic, B. 1990. “Financial Development, Growth, and the Distribution of Income”, Journal of Political Economy, Vol. 98(1), pp. 1076-1107. King, R.G. and Levine, R. 1993. “Finance, Entrepreneurship and Growth”, Journal of Monetary Economics, Vol. 32(1), pp. 513-542 Kuznets, S. 1971. "Modern Economic Growth: Findings and Reflections", Nobel Memorial Lecture, reprinted in Kuznets (1974), Vol. 3(1), pp. 165-184. Kuznets, Simon (1971), "Modern Economic Growth: Findings and Reflections", Nobel Stern, N. 1989. “The Economics of Development: A Survey”, in: The Economic Journal, Vol. 99(2), pp. 597 - 685 Van Damme, E. 1994. “Banking: A Survey of Recent Microeconomic Theory”, in: Oxford Review of Economic Policy, Vol. 10(4), pp. 14 – 33. Read More