How Capital Markets Enhance Economic Performance and Facilitate Job Creation

How Capital Markets Enhance Economic Performance and Facilitate Job Creation

BY WILLIAM C. DUDLEY

US CHIEF ECONOMIST GOLDMAN, SACHS & CO.

BY R. GLENN HUBBARD

DEAN COLUMBIA BUSINESS SCHOOL

NOVEMBER 2004

How Capital Markets Enhance Economic Performance and Facilitate Job Creation

BY WILLIAM C. DUDLEY

US CHIEF ECONOMIST GOLDMAN, SACHS & CO.

BY R. GLENN HUBBARD

DEAN COLUMBIA BUSINESS SCHOOL

Introduction

Our main thesis is that well-developed capital markets generate many economic benefits, including higher productivity growth, greater employment opportunities, and improved macroeconomic stability. To focus on these significant benefits, we examine three issues: (1) the importance of capital markets in facilitating superior economic performance, (2) how the capital markets foster job creation, and (3) the necessary preconditions for the development of well-functioning capital markets. Our analysis focuses on two particular sets of comparisons. First, within the United States, how has macroeconomic performance improved over time as the capital markets have become more dominant? Second, across countries, can one explain the superior macroeconomic performance evident in recent years in countries that have well-developed capital markets such as the UK and the US relative to countries such as Germany and Japan, in which the capital markets are much less developed? We highlight the impact of capital market development on the economic performance of the United States because the capital markets are most well-developed in this country. Lessons from the US experience are nonetheless indicative to other economies of the value of well-functioning capital markets.

Executive Summary

The ascendancy of the US capital markets -- including increasing depth of US stock, bond, and derivative markets -- has improved the allocation of capital and of risk throughout the US economy. Evidence includes the higher returns on capital in the US compared to else- where; the persistent, large inflows of capital to the US from abroad; the enhanced stability of the US banking system; and the ability of new companies to raise funds. The same con- clusions apply to the United Kingdom, where the capital markets are also well-developed.

The consequence has been improved macroeco- nomic performance. Over the last decade,

US labor productivity has risen and the United States has outperformed economies dominated by banking-based systems. Because market prices adjust instantaneously to new informa- tion, the development of the capital markets has introduced new discipline into policymaking. As a result, the quality of economic policymaking has improved over the past few decades.

The development of the capital markets has provided significant benefits to the average citizen. Most importantly, it has led to more jobs and higher wages.

By raising the productivity growth rate, the development of the capital markets has enabled the economy to operate at a lower unemploy- ment rate. In addition, higher productivity growth has led to faster gains in real wages.

The capital markets have also acted to reduce the volatility of the economy. Recessions are less frequent and milder when they occur.

As a result, upward spikes in the unemploy- ment rate have occurred less frequently and have become less severe.

The development of the capital markets has also facilitated a revolution in housing finance. As a result, the proportion of households in the US that own their homes has risen substan- tially over the past decade.

Effective capital markets require a firm founda- tion. This includes the enforcement of laws

and property rights, transparency and accuracy in accounting and financial reporting, and laws and regulations that provide the proper incen- tives for good corporate governance. A well- developed financial system is a spur to growth, macroeconomic performance, and more rapid growth in living standards.

Acknowledgement

We thank Sandra Lawson for her work on Section IV: What's Required for Successful Capital Markets, as well as for her expert editorial assistance; Themistoklis Fiotakis and Peter Stoute-King for their work in gathering and analyzing much of the data used in this paper; and the many others in the Goldman Sachs Economics Group who helped with the data and provided thoughtful comments and guidance.

Section I: The Dominance of Capital Markets

Modern capital markets have two related parts: (1) the debt and equity markets that intermediate funds between savers and those that need capital, and (2) the derivatives market that consists of contracts such as options, interest rate, and for- eign exchange swaps, typically associated with these underlying debt and equity instruments. The debt and equity markets help allocate capital within an economy. The derivatives market helps investors and borrowers to manage the risks inherent in their portfolios and asset/liability exposures (see the boxes on pages 7-8 for a

more detailed discussion of these markets).

In the United Kingdom and in the United States, both of these parts have grown very rapidly over the past few decades. The capital markets in the United