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Rethinking Finance for Stability and Development

Final Report Summary - REFIST (Rethinking Finance for Stability and Development)

In the last 30 years the financial systems have grown enormously: new financial instruments have been introduced, intermediaries have expanded their activity well beyond their possibility, exposure to risk has increased almost in every country. The effect of this anomalous expansion of the financial system has been an increase in the perceived systemic risk and more instability. Because of this, finance seems to have become suddenly dangerous and detrimental for growth. And despite the large body of past evidences, many have started to argue that financial development is no longer a positive factor for capital accumulation. Though it is hard to conceive a radical change in the established theory which has highlighted the benefits for the economy accruing from a developed financial system, these events have put forward the need to redefine the role of finance and financial innovation in allocating real resources. By pivoting on four main issues, the objective of the research was to provide an answer to crucial questions that have emerged from recent events:
1. Inequality: The increase in inequality in many countries is thought to have been caused by an abnormal increase in the financial sector. Does finance exacerbate income inequality? To what extent? Or rather easy access to credit reduces poverty, as it has been argued by orthodox theory?
2. Inefficiency: By favoring some industries and sectors more than others, does an excess of growth in the financial system cause misallocation of resources? Does financial growth cause an excess in public spending?
3. Instability: Does the abnormal growth of the financial sector cause instability? Is this instability amplified in a monetary union? Can more stringent regulation and stronger coordination reduce the impact of financial cycle on the economy?
4. Growth and Development: Is finance and financial development really good for growth? To what extent financial development can spur growth and capital accumulation?

Work Performed and Research achieved
Within the fourth years of the project, the research has addressed both at theoretical and empirical level, all the issues from 1 to 4.
The results clearly point out that institutional factors play a crucial role in determining financial instability and that these factors may be considered to be a cause of the recent financial crises. In fact, despite the recurrence of the crisis, governments and public authorities, economic operators and economists were often underestimating the signals of an imminent crisis because they were pursuing the false belief that the mistakes of the past had been included and appropriately corrected and that the financial systems had become more stable. The analyses instead showed that the financial crisis were prominently caused by mistakes and delays of political action and supervision, lack of discipline of economic policies, borrowing excesses, financial opacity, fallacious risk management systems and by the conflicts of interest of credit rating agencies.
Moreover, as it has been asserted in the previous reports, it is also evident that financial institutions and financial markets can strongly influence real resource allocation and affect growth and economic development. Hence, an efficient financial system is a necessary prerequisite of economic stability and it is an important factor to ensure growth and development in all economies. To this extent, financial reforms are necessary to spur growth and to ensure a more fair resource distribution within countries. Yet, if this is true in general, there are differences on the kind of reforms one need to implement in different countries and areas.

Results and Policy Implications
The research focused on three main issues: 1) The role of institutional finance in stability; 2) the linkages between financial innovation, inequality and business fluctuations; 3) the interrelationship between financial development and capital accumulation. The results on each of these issues are the following.
1. The role of institutional finance in stability
The research reconstructed the regimes of regulation operating in USA, the Eurozone and Mexico since the 1930s and proved the effectiveness of the different approaches to regulation (i.e. those based on discretionary direct controls and on market mechanisms) that have been prevailing. Moreover, the research remodeled the actions recently taken by the monetary and regulatory authorities within the international community to deal with the complexities of financial instruments and institutions in order to identify the direction that regulation is currently taking, its consistency with the scientific literature and the lobbying activities that may have influenced these decisions.
2. The linkages between financial innovation, inequality and business fluctuations
The research has tested measures of inequality in regional economic performance in the European regions, based on GDP growth, employment, capital accumulation, and other variables related to the level of economic activity. Those measures were included in the development of an econometric model that relates them to regional differences in credit rationing and the diffusion of financial innovations. The results of the econometric model could assist the elaboration of economic policy recommendations directed towards overcoming the effects of credit rationing and financial innovation on regional inequality.

3. The interrelationship between financial development and capital accumulation
The work tried to specify in theoretical and empirical models alternative channels of interaction between financial variables and the real side of the economy. In the specific the research was expected to deliver macroeconomic general equilibrium models and microeconomic models focusing on the role of institutions, financial integration and geographic factors on growth and development.

The project had a website at the following address