I have to admit, I am a bit puzzled by my friend Franklin Allen’s first entry in this debate. There simply is no evidence—none—in support of his statement that mixed systems of state and private banking tend to be a good idea. And his mention of China is doubly puzzling. China’s state-owned banks have been a disaster, fiscally, allocatively, and socially. They cost the Chinese people hundreds of billions of dollars in bailout costs a decade ago, and, according to most informed observers, may very well soon repeat a similar magnitude of losses. Allocatively, they are famously wasteful of resources, as they have been a political tool for propping up the unproductive state-owned sector, which explains their continuing huge losses (recognized and unrecognized). The internal corporate governance of these unwieldy institutions is a nightmare. The financing arrangements that have succeeded in attracting private capital are well understood to be a political deal between global banks and the Chinese government; global banks invest in the state-owned sector as part of the price they must pay for entry into the Chinese market. And these banks are the central nexus of corruption and influence peddling in Chinese society. China’s growth has occurred in spite of these banks’ distorted lending policies, not because of them.
Some observers have wondered how it was possible for China to grow despite the lack of a deep private formal lending sector. The answer is simple: If a country’s basic economic development is constrained for centuries, then when economic liberalization finally occurs, the marginal product of capital is huge and high returns can be generated from almost any reasonably well-managed enterprise. If retained earnings can reliably earn high annual returns irrespective of how they are invested, growth will be rapid even without a banking system. But that initial bank-independent growth is not sustainable. The Chinese government’s recent financial policy initiatives show that it is well aware that China’s continuing growth is highly dependent on its ability to develop the legal, political, and institutional foundations that will support increasingly selective, private, arms-length lending for productive investments. That transformation of the Chinese banking system is a future prospect, not a current reality, and it is by no means a certainty (see, for example, Minxin Pei’s book, China’s Trapped Transition, or the contributions to my edited volume, China’s Financial Transition at the Crossroads).
Almost two decades ago Charles Himmelberg and I studied the record of industrial directed credit in Japan. Although our study found evidence for success on the part of the Japan Development Bank (JDB) in assisting the growth of Japan’s machine tool industry in the 1960s and 1970s, I came away from that study even more sceptical of state-owned banks than when we had begun, and I advised countries that were contemplating the imitation of Japan that it would be virtually impossible to export the Japanese success to other countries (as the dismal record of state-owned banks then and since has shown).
Japanese industrial directed credit was an exception, both internationally, and even within Japan. No other country of which I am aware was able to match the JDB’s record of success. And other government lending programs in Japan—especially in support of infrastructure projects—were well known as a hotbed of waste and corruption. The JDB’s brief success in the narrow sphere of industrial credit reflected the uniquely Japanese political economy of lending allocation, based on a unique institutional structure comprised of (1) Deliberative councils, which expressed competing industrial demands; and (2) A credibly independent authority, namely the JDB, which jealously guarded its independence over the allocation of funding. That independence translated into lending programs that were capable of selecting viable young firms for loans based on economic criteria, and did not support them repeatedly. In my experience, these factors are not simply rare; they are unique.
At the World Bank there is a new openness to the idea that state-owned banks could be helpful for jumpstarting growth in countries that are still struggling to recover from the recent global economic turmoil. Such advocacy would be short-sighted and irresponsible, since it runs so contrary to clearly observable evidence about the long-run effects of doing so. It would be highly unwise to create wasteful and corrupting fiscal time bombs in the form of state-owned banks out of a desire to temporarily boost aggregate demand during the current lean economic times. The immediate benefits , if any, would be short-lived, and the citizens of countries that take this approach would bear large costs for many years to come.