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Faclt.ty Working Paper 91-0165 
 
 330 ^TX 
 
 B385 
 
 1991:165 COPY 2 
 
 Can Increased Intermediation Impede Growth? ~ Revised 
 
 The Library of the 
 NOV 1 6 1991 
 
 Unh^rsfty of iitlnots 
 of Uitana-Champaigit 
 
 Jorge R. Friedman William F. Maloney 
 
 U.C. Berkeley and Department of Economics 
 
 I LADES/ Georgetown University of Illinois 
 
 Bureau of Economic and Business Research 
 
 College of Commerce and Business Adminislralion 
 
 University of Illinois at Urbana-Champaign 
 
BEBR 
 
 FACGLTY WORKING PAPER NO. 91-0165 
 
 College of Commerce and Business Administration 
 
 University of Illinois at Grbana-Champaign 
 
 September 1991 
 
 Can Increased Intermediation Impede Growth? -- Revised 
 
 Jorge R. Friedman 
 
 G.C. Berkeley and 
 
 ILADES/Georgetown 
 
 William F. Maloney 
 
 Department of Economics 
 
 University of Illinois 
 
Can Increased Intermediation Impede Growth? 
 
 Jorge R. Friedman 
 
 U.C. Berkeley and 
 
 ILADES/Georgetown 
 
 William F. Maloney 
 
 Univ. of Illinois 
 Urbana-Champaign 
 
 June 11, 1991 
 
 The regulation of intertemporal consumption decisions may be as critical a function 
 of a growth promoting financial sector as the efficient allocation of savings between 
 investment projects usually cited. Using standard analytics the paper begins by 
 establishing the possible incompatibility of pareto optimality and growth. It then 
 demonstrates using a two period dynamic model in a Nash framework that in an 
 economy where agents earn their incomes from differing endowments of labor and 
 capital, increases in investment by "capitalists" will be partially offset by an increased 
 desire for consumption by wage earners. It follows that development policies 
 designed to increase capital accumulation will be frustrated by this offset, and that 
 a sudden liberalization of consumption borrowing may result in dramatic falls in 
 savings rates. The paper draws on experience from Europe, the U.S., Japan, and 
 Chile. 
 
 Our appreciation to Salim Rashid for comments on previous drafts. 
 
I. INTRODUCTION 
 
 The literature on financial liberalization has focused primarily on how increased 
 intermediation leads to more efficient allocation of savings between investment projects and thus 
 promotes growth.^ It is less often noted that freeing capital markets also permits agents to smooth 
 consumption patterns over time more easily. While, like the investment allocation effect, this 
 neglected intertemporal smoothing effect of liberalization represents a movement toward greater 
 efficiency, we argue that its implications for growth are likely to be adverse. 
 
 Using relatively simple analytics, we begin by showing that unrestricted "intertemporal trade" 
 can be growth reducing under a variety of assumptions about technology, endowments and agents' 
 preferences that are by no means pathological. Put differently, pareto optimality and growth can be 
 incompatible objectives. The core of the paper then demonstrates the existence of a savings reducing 
 "externality" arising from the accumulation process itself. In the absence of institutional constraints 
 on consumer borrowing, this externality is likely to impede growth. In an economy where otherwise 
 identical agents earn their income from differing endowments of labor and capital, increases in 
 investment by rent-earners (capitalists) will be partially offset by a desire to consume against future 
 income by wage earners who see both a rise in the marginal product of their labor and a fall in the 
 return to investment (savings). This savings offset which we term "consumption crowding out" will 
 frustrate development policies designed to increase capital accumulation. Regulating intertemporal 
 consumption decisions may therefore be a critical function of a growth promoting financial sector. 
 
 The current world-wide concern with liberalizing financial sectors and with deficient rates of 
 savings makes the results we derive more than theoretical curiosities. Numerous studies have now 
 documented declining savings rates concomitant with the release of constraints on consumer and 
 mortgage borrowing. Lehmussaari (1991), reports dramatic falls in net savings as a percent of net 
 disposable income in Denmark from 13.3% in 1984 to 4.1% in 1986 and in Norway from 9.5% to 
 -1.8% across the same period, attributable partly to "the release in pent up household credit demand, 
 
 ^ See Fry (1980, 1982,1989), Galbis (1977), McKinnon (1973, 1976) for discussion of how financial liberalization may 
 enhance average productivity of investments. 
 
2 
 primarily for durable goods and real and financial assets, brought about by the end of [credit] 
 
 rationing."^ Bouvenberg and Evans (1990) explain part of the fall of U.S. personal savings from 5.3% 
 
 to 3.4% from 1980-89, again, by increased consumer access to financial markets allowing them to 
 
 smooth consumption and reduce the need for target savings required for purchases of major consumer 
 
 durables.^ A recent OECD study (Dean et al, 1990) finds the rapid build up of gross personal debt 
 
 in recent years in the U.S., U.K., Australia, Sweden, Finland and Norway "closely related to an easing 
 
 of borrowing constraints associated with significant financial market liberalization and innovation.""* 
 
 It is likely that the institutional barriers to borrowing now being removed in the U.S. and 
 Europe have been as critical to East Asia's high savings rates as the frequently invoked cultural 
 characteristics. The Japanese case is illustrative. The existence of Saraldn (informal credit markets) ^ 
 exhibiting very high real interest rates suggests that central bank policies restricting consumer and 
 mortgage borrowing were binding and that demand existed for credit that would have competed for 
 investment resources critical to the accelerated growth strategy the country pursued.^ The recent 
 surge in Japanese consumer spending has been attributed partly to the spending of savings which, in 
 the absence of mortgage finance, were accumulated for future housing purchases now made infeasible 
 by astronomical real estate values.^ The suggestion by the Japanese representative at the April 1990 
 bilateral trade talks that the U.S. restrict consumers to only two credit cards represents the logical 
 extension of consumer credit rationing to managing balance of payments deficits. 
 
 Evidence for our second effect, that a perceived increase in capitalist investment and hence 
 future income may decrease worker savings, is preliminary but also provocative. In the U.S. a 
 consistent inverse relation between corporate and personal savings has become known as "Denison's 
 Law" of constant private savings as a fraction of GNP (Denison 1958). David and Scadding (1974) 
 
 ^ Lehmussaari (1990a) p 16. 
 
 ^ Bovenberg (1990) p. 11. 
 
 "* Dean, et. al (1990) p. 42. 
 
 In the high growth i>ericxl of the 1970's, the share of installment mortgage and consumer credit in GNP totaled 17.5% 
 compared to 70.1% in the U.S.. Sakakibara and Feldman (1983). 
 
 •* Feldman (1985), Suzuki (1986), Cargill and Royama (1988). Greenwood (1988). 
 
 ^ The Economist, September 9, 1989. 
 
3 
 confirmed Denison's work for the 1868-1968 period and in addition documented a secular shift away 
 from personal savings toward corporate savings within gross savings. On the assumption that corporate 
 saving is capitalist saving both patterns are predicted by our model. 
 
 The Chilean liberalization experiment of the 1970's provides a more dramatic example. After 
 three years of rapid GDP growth following extensive structural reforms, national savings plummeted 
 to a historic low in 1981 ^ concomitant with a volcanic surge in consumer borrowing.^ Graph 1 
 indicates that increases in real consumer borrowing of up to 22% per month was associated with the 
 sharp rise in real interest rates to over 40%, far above any feasible return to productive capital. 
 Several Chilean economists ^^ find the source of this consumption boom in the reigning ambiance 
 of "triumphalism" or the conviction that Chile had overcome a decade of stagnation and "in ten years 
 would be a developed nation... where 70% of the population would have color TVs." ^^ This feeling 
 was only heightened by the vast inflows of capital from abroad that made tangible the international 
 community's praise for Chile as a growth miracle. That a desire to consume against this brighter 
 future reduced available savings, increased competition for investable resources and ultimately helped 
 undermine the reform effort is, perhaps to an exaggerated degree, exactly the "consumption crowding 
 out" effect we have in mind. ^^ We are not arguing that other reasons for high interest rates 
 during this period such as desperation borrowing by firms, speculative borrowing for real estate or 
 financial assets, expectations of devaluation, or monetary contraction, are not important, but only that 
 
 a 
 The government was running a budget surplus during this period. 
 
 Compare the rise in consumer borrowing as a share of total bank lending in 1981 alone from 8.1% to 11.3 in one year 
 to the rise from 5.7% to 8% in Japan for the entire decade 1975-85. 
 
 ^^ Zahler (1985), Schmitt-Hebel (1987), Barandiaran (1987), Eyzaguirre (1988). Corbo (1985) focuses more on perceived 
 increases in wealth, particularly due to the stock market boom. 
 
 Labor Minister Jose Pinera to 3,000 union leaders, 1980. Also of interest was Minister of the Treasury Sergio de Castro's 
 1980 state of the economy speech. " The chart indicates a change which few will dare not to recognize. The economy is growing 
 in such a way that in 11 years income per capita will double in contrast to past circumstances where this would have been 
 achieved only after 46 years of waiting. Taken from Eyzaguirre (1988). 
 
 12 
 
 Dombusch (1985) has suggested that consumption of imports represents a form of speculation against the peso that was 
 
 expected to devalue soon. Such expectations seem improbable given that no black market emerged, capital inflows remained 
 
 strong and reserves increased until end 1981. Even if evidence of expected devaluation were clear, that Chileans would speculate 
 
 in household appliances and breeding stock instead of more orthodox forms of capital flight familiar to Latin America also seems 
 
 unlikely. The increase in imports, like the increase in consumption of consumer durables and boom in real estate, is probably 
 
 better explained by an excessive faith in the government's model, rather than the reverse. 
 
CHILE: Indicators of Consumption Borrowing and Spending 
 
 
 1977 
 
 1978 
 
 1979 
 
 1980 
 
 1981 
 
 1982 
 
 GDP Growth 1/ 
 
 9.4 
 
 9.6 
 
 9.9 
 
 9.7 
 
 5.4 
 
 -15.1 
 
 Private Consumption as % GDP 2/ 
 
 71.8 
 
 72.3 
 
 71.1 
 
 70.5 
 
 76.2 
 
 76.1 
 
 Consumer Durables Sales Index 3/ 
 
 79.0 
 
 92.0 
 
 97.0 
 
 124.0 
 
 130.0 
 
 71.0 
 
 National Savings as % GNP 4/ 
 
 8.7 
 
 8.2 
 
 11.7 
 
 13.7 
 
 5.3 
 
 .4 
 
 National Savings as % GNP 5/ 
 
 10.2 
 
 10.6 
 
 13.5 
 
 15.8 
 
 7.3 
 
 2.6 
 
 Consumer Borrowing as % Total 6/ 
 
 N/A 
 
 N/A 
 
 6.0 
 
 8.1 
 
 11.3 
 
 N/A 
 
 As % 1979 Borrowing 
 
 N/A 
 
 N/A 
 
 6.0 
 
 15.9 
 
 30.8 
 
 N/A 
 
 1/ Corbo(1985), 21, 3/ Banco Central de Chile, Boletin Mensual, 4/Economic Commission for Latin Axnenca, 5/ Oficina de 
 Planificacion Nacional, 6/ Superintendencia de Bancos. 
 
 60 
 
 Graph 1 
 
 Chile: Consumer Credit, Interest Rates 
 
 50- 
 
 40- 
 
 30 
 
 20- 
 
 10- 
 
 
 
 Annualized Real 30-90 Day 
 Interest Rates 
 
 Monthly Real Change 
 in Consumer Credit 
 
 ■10 
 
 1 I I I I I I I I I I I I I I I I I I I I I I I I I I I r 
 
 1980 7 1981 7 1982 
 
4 
 the boom in consumption borrowing seems a hitherto neglected but empirically significant influence 
 that our model can explain. 
 
 Both theory and experience, then, suggest a tension between pareto optimality and growth 
 that seems to present policy makers with a difficult normative judgement of how much to regulate 
 consumption. The conflict is probably more apparent than real. Because of the impossibility of 
 incorporating future generation's preferences over the present capital stock, the market handles 
 intergenerational welfare questions with difficulty and only in a tautological sense generates an 
 "optimal" level of savings. It is possible to imagine an efficient outcome where rational actors 
 concerned only with themselves consume the entire capital stock and leave nothing to posterity. 
 Under these circumstances, a social planner maximizing a welfare function that includes the yet 
 unborn might choose to intervene. Even if agents do consider the well-being of future generations, 
 Sen (1984) argues that their sacrifice of consumption may not be justified unless the entire generation 
 does the same. In this case, restrictions on consumption smoothing could be seen as a mechanism 
 of coordination, in the same way that mandatory education and accompanying deferral of leisure and 
 income is perceived to cany compensating social benefits despite its compulsory nature. 
 
 n. FINANCIAL INTERMEDIATION 
 
 The literature frequently assumes a unitary representative agent, the archetypal capitalist, or 
 multiple agents with homogenous preferences who allocate an initial endowment across time subject 
 to expected returns to investment. However, only with differentiation of actors either in endowments, 
 technology or preferences are there gains from financial intermediation. Drawing on relatively simple 
 analytics, it is straightforward to illustrate the efficiency gains on which McKinnon based his advocacy 
 of increased intermediation through the financial sector. These efficiency gains he saw as critical to 
 economic development which he defined as "reducing the great dispersion in social rates of return to 
 investment" visible in most LDCs.^-^ Graph 2 shows how both the efficiency of capital and the 
 
 ^^ McKinnon (1973) p.9. 
 
Graph 2 
 
 Financial Intermediation luith 
 
 Differing Technologies 
 
 C^Loss 
 
 c. 
 
5 
 welfare of two identical agents facing different technologies or endowments can be enhanced by 
 "intertemporal trade." It is also clear that this pareto improvement does not necessarily imply higher 
 levels of growth. Depending on the preferences of our identical individuals and the particular 
 technologies, the losses in second period consumption, C2 may exceed gains. 
 
 A case more relevant to our argument is that of a thrifty agent with strong preference for 
 second period consumption and a greedy agent favoring consumption this period facing identical 
 technologies. Again, as Graph 3 shows, intermediation allows both agents now reach a higher level 
 of utility but the quantity of second period consumption, C2 may fall. This effect becomes more 
 dramatic with the introduction of a second period endowment or more generally, an alternative source 
 of income to capital rents. As Graph 4 shows, our greedy agent can now dissave. In arguing for 
 greater intermediation, we generally envision only the isolated entrepreneur now able to realize 
 investment plans because of increased access to credit. Just as easily, however, we may find consumers 
 with rates of subjective time preferences exceeding any feasible return to capital now competing for 
 investible resources who previously would have been forced to live within their means each period.^"* 
 Increased financial intermediation in this context may lead to a pareto superior outcome, but may not 
 deliver the higher growth rates promised. 
 
 The model presented in the next section shows how in the normal process of capital 
 accumulation a class of greedier actors with second period "endowments" naturally arises. Within a 
 general equilibrium framework we add to our archetypal capitalist a second actor with identical 
 preferences who derives his second period income not only from capital rents on first period 
 consumption deferred, but also from returns to his labor, effectively a second period endowment. His 
 optimal, rational behavior will tend to offset increases in investment by capitalists because of a 
 resulting double disincentive to savings: a fall in the marginal return to first period consumption 
 
 Thaler and Shefrin (1981) cite estimates of subjective rates of discount between 25-122%, far above a relevant rate of 
 interest. They argue that self-imposed or institutionally imposed borrowing constraints such as Christmas clubs or bonus pay 
 schemes in Japan serve to keep savings rates higher than would be expected given estimated SRD's. 
 
Graph 3 
 
 Financial Intermediation mith 
 
 Differing Preferences 
 
 C2Loss< 
 
 CGain <^ 
 
 2 
 
 Ci 
 
Graph 4 
 
 Financial Intermediation mith 
 
 Differing Preferences and 
 
 2nd Period Endowment 
 
 Endowment 
 2nd Period 
 
 Ci 
 
6 
 deferred and an expected rise in future income from wages. We further argue that in situations 
 where consumer access to markets has historically been denied, an accumulated repressed demand for 
 consumption credit may suddenly compete with investors upon liberalization of financial markets that 
 may lead to a substantial fall in savings and net investment that dwarfs expected efficiency gains. 
 
 III. A DYNAMIC TWO AGENT MODEL 
 
 i 
 A. The General Case 
 
 Our economy is populated by two representative agents who live for two periods and differ 
 only in initial endowments of capital and labor. They either consume or invest the single good in 
 period one and consume everything in the second period. The agents exhibit identical utility and 
 perfect foresight, but derive their income in different proportions from capital and from wages. The 
 agents' decisions to accumulate capital or consume are interdependent since both depend on the 
 marginal product of the total stock of capital which includes investment of both labor and capital. 
 Following Sargent (1987) we derive the Nash equilibrium. - 
 
 We assume an aggregate well behaved production function exhibiting constant returns to scale 
 in its two inputs, capital (K) and labor (L). 
 
 (1) 
 <? - FiKJ.): m - 0, /«) - oo, /- > 0, /(«) - 
 
 Labor (L) supplies L units of labor in period 1 and period 2 and begins with no capital but can 
 accumulate Kjl during period 1 by consuming less than it earns. The Capitalists (K) possess no labor, 
 Kq units of capital and may accumulate in the same manner K^^^. Both are also subject to the 
 constraints: 
 
7 
 Total first period output goes either into first period consumption by labor or capitalists (Cjj^.Cj^ ) 
 or investment (output carried over to period 2) by labor or capitalist (Kj^^.K^J and 
 
 Second period output is consumed by capitalists C2K or labor C^^- Both agents maximize their 
 identical intertemporal utility functions in first and second period consumption C^j and €21 and the 
 subjective rate of time preference r}^ 
 
 U(C^) + PU(C^ i - {KM (4) 
 
 U' > 0, U' < 0, f/'(0) - « (5) 
 
 given L and Kq and the investment choices of the other agent. Given Kj^. each choice of K|j^ will 
 imply a different C|l and that given K|j^, each choice of K^^ will imply a different Cjj^. Our 
 particular version of a Nash equilibrium will assume that labor takes capital's actions as given and 
 beyond its influence and vice versa. Both agents seek to maximize their consumption with respect to 
 their investment in period 1 conditioned on the other agents decision which allows the first and 
 second period material balance equations to serve as budget constraints. Combining equations (2) 
 and (3) with the standard Euler equation gives symmetrically for each: 
 
 U'WiK^) - K^-C^- K^. fiU'[FiK,JJ) - C^*F^ 
 
 (6) 
 
 It has been established that for the kinds of problems we are studying the maximization problem the planner faces is 
 identical to the one each a representative consumer faces, thus the solutions reached by the planner or the single agent are equal 
 (a presentation of this can be found in Milton Harris, 1987). We can restrict the analysis to the problem the planner faces 
 without loss of generality. 
 
8 
 where F' j^2 '^ ^he marginal product of capital in period two given the capital stock carried over, 
 Kj = Kjj^ + KjL- To find the consistent equilibrium we derive the reaction functions Kj[^(Kjl), 
 ^il(^ik) ^^^ ^°^*^ capitalists and labor. At the Nash solution each set of agents is behaving optimally 
 given the other's actions. 
 
 1. Derivation of the Investment Reaction Function for Capitalists 
 
 Assigning to each agent his marginal product implies that capital's second period consumption 
 is 
 
 F{K,X) - C,^ -K^*Fj^ 
 
 (7) 
 
 and we can rewrite equation (6) as 
 
 An additional unit of investment by labor lowers next period's return on investment F ' ,Q2This lowers 
 both capital's income next period and return on investment. The income effect makes capitalists 
 increase investment to equalize the marginal utility of tomorrow's income with today's while the 
 substitution effect lowers it by making investment less profitable. We will assume, as is common in 
 the literature, that the substitution effect dominates. 
 
 2 Derivation of the Investment Reaction Function for Labor 
 
 Labor's problem differs critically because workers receive income not only from savings 
 (investment) that it carries from period 1 to 2, but also from wages, the marginal revenue product of 
 labor. Therefore 
 
and we can rewrite equation 8 as 
 
 U'[F{K^) - K,^ - C^ - K^] - fiU'[K,^*F„^ + L*F'iJ*F,r., 
 
 (9) 
 
 (10) 
 
 Investment by the capitalists brings about an increase in F ' , 2 2nd a fall in F ' j^2 which increases 
 labor's income next period and lowers next period's return on investment. Assuming that labor's 
 second period income (LHS term in brackets) is more affected by the former effect than the latter, 
 then both effects of capital's investment together unequivocally reduce labor's investment: 
 
 *^'^ < (11) 
 
 fi^ix 
 
 This offsetting behavior by labor \s> the effect we desire to contrast to the case of homogenous 
 agents, where investment by one implies investment by all. It is emphatically not the case that people 
 are myopic and do not see that their future income is contingent on their rate of savings now nor is 
 it an externality in the strict sense of the term. Rational agents, observing increased investment by 
 capitalist upgrade their estimate of next period's incomes and consume more now. 
 
 B. Nash Solution with Cobb-Douglas Production Function and 
 Logarithmic Utility Function 
 
 Employing Cobb-Douglas Technology and logarithmic utility yields particularly transparent 
 
 reaction functions and permits simple graphical analysis. Let 
 
 F{KX) - A:"L'-« (12) 
 
10 
 and 
 
 U(C) - log(0. (13) 
 
 1. Optimal Investment Reaction Function for Capitalists 
 
 Equation (6), the Euler equation for the capitalists, now has the form 
 
 
 c,x — — (14) 
 
 As before, in the first period capitalists consume the residual of investment by both actors and 
 consumption by labor 
 
 ^ir " l^^ ^ix ~ ^\L ^xu 
 
 and in the second, both the return and their actual capital. 
 
 (15) 
 
 C2r - ^,r*^i;2 " K^^olKI'l'" d^) 
 
 Equation (14) can now be re-written as 
 
 K,.*aKV^O- 
 
 [K'L'-'-K,^-C,,-K^ - ^ ^\ , (17) 
 
which implies that 
 
 11 
 
 P 
 
 ^uc ~ 71 ^*f^^ " ~ ^ix. ~ ^iJ 
 
 (l^P) 
 
 (18) 
 
 and that 
 
 bK, 
 
 \K 
 
 S^li. 
 
 (1-P) 
 
 6C, 
 
 li 
 
 SA", 
 
 \L 
 
 bK,, 
 
 SA", 
 
 11 
 
 - 
 
 (19) 
 
 Note that SC-^iJ 6K-^i^ is equal to -1 because every unit labor invests in period 1 must be matched with 
 an equal reduction in their consumption that period. aK^j^/SKj^ = implies that under the current 
 specifications of the production and utility functions, investment of capitalists does not depend in the 
 investment pattern of labor. This is reflected in Graph 5 as the vertical line R'^. The decrease in 
 F' j^2 resulting from an increase in investment by labor that might lead to an increase in consumption 
 in period 1 is exactly offset by the increase in utility resulting from the fall in income in period 2. 
 
 2. Optimal Investment Reaction Function for Labor 
 
 An almost identical derivation yields the reaction function for labor. The Euler equation 
 
 '2L 
 
 u. 
 
 /iaK''^L^-' 
 
 (20) 
 
 combined with 
 
Graph 5 
 
 Nash Equilibria 
 
 Reaction Functions for Labor and Capital 
 
 Kl 
 
 
 
 rl 
 
 R^ 
 
 r! 
 
 B 
 
 
 R! 
 
 
 
 
 \ 
 
 ) Labor Dissaves 
 
 Kk 
 
 
 
 
 
 ^ 
 
 
 R —Reaction function for Labor 
 R —Reaction functions for Capital 
 
can be re-written as 
 
 which implies that 
 
 ^[Kf^L ' - K^[^ - Cjjp - K^ - K^^ 
 
 (l-a)^i 
 
 Noting that 5Cjj^5Kjj^ = -1 we get: 
 
 12 
 
 ^iL ~ f^^ " ^li " ^ix ^irl 
 
 (21) 
 
 "-If !-• 
 
 C^ - [^,^*Fjf^ + £*F^ - [^j^*a^, 'L'- + L*(l-a)^"L-«] 
 
 (22) 
 
 '•-•r 1 
 
 [AJjL " K^^ C,^ Aj^J 
 
 
 (23) 
 
 or 
 
 ^.t- 
 
 (/Ja*l) 
 
 a 
 
 (25) 
 
 iK, 
 
 IL 
 
 a-1 
 
 SJ^Ti^ ^a-^1 
 
 < 0. 
 
 (26) 
 
 This algebraically confirms our previous intuition that for labor the combined effect of a decrease in 
 returns from capital and increase in the wage is negative, and the resulting reaction function, depicted 
 as line R^ in Graph 5, must have a negative slope. Labor can invest all of its period 1 earnings or 
 
13 
 earnings or can incur consumption debts which they pay off in period 2 with wages received even if 
 they invest nothing in period 1. 
 
 3. Equilibrium 
 
 The intersection of R and R*^ defines the unique Nash equilibrium. It is immediately 
 apparent that labor saves (invests) less as capital saves (invests) more and that there exists a level of 
 investment by capitalists sufficiently large, at point B, that labor's optimal reaction is to invest zero 
 and beyond this point, to borrow against future earnings. 
 
 Investment increasing policies, be they increasing foreign aid, liberalization of the financial 
 sector, or tax reforms, that seek to promote investment or shift the R*^ line to the right are bound 
 to be frustrated to the degree that workers react by reducing their savings or by borrowing to 
 consume, represented by the slope of Rk This can be shown to be less than 45 ° independent of the 
 specific formulation of the production and utility functions so investment can never be more than 
 "crowded out" though it could be completely offset. From equation (26) we see that the offset effect 
 under Cobb-Douglas technology falls in absolute value as capital share in output rises. Intuitively, 
 this makes sense since the larger the share of output is paid in wages, the more savings will vary with 
 a change in the marginal product of labor. It is also straightforward to incorporate cultural 
 determinants of savings through the subjective rate of discount parameter. A large beta, representing 
 perhaps a thrifty traditional society valuing next period's consumption heavily, would rotate the R^ 
 curve up decreasing consumption and increasing worker investment for every level of capitalist 
 investment. Such economies would enjoy a long period of investment by capitalists before demands 
 for consumer credit begin to compete for investment funds. Conversely societies strongly affected by 
 the "demonstration effect" or a low beta may find themselves short on savings early in the 
 development process. 
 
14 
 C. Policy Options 
 
 What policies are available to prevent such an offset? Clearly, a tax on wages to maintain 
 them at present levels forever would remove the wage effect though it would seem at odds with the 
 overall goal of raising incomes. Returning the taxes with interest at a later date would work only if 
 agents could not borrow against these earnings in the capital markets. This seems to be the case in 
 Singapore where social security taxes amount to a large fraction of earnings and can only be borrowed 
 against in small amounts for housing purchases? ^^ A subsidy on savings, or maintaining interest 
 rates artificially high to counter the wage effect and fall in marginal product would shift both the R^ 
 and R^ curve to the right, delaying, but never eliminating the offset or the eventual borrowing against 
 future earnings by workers. Credit rationing seems a more direct approach but cannot attack the 
 offset when the equilibrium falls to the left of B where labor still saves and is not borrowing. 
 However, to the right of B where borrowing against future income occurs, a policy of restricting 
 consumer credit forces consumers off their reaction function to where they must live within their 
 means each period. From the earlier discussion of how savings fell with the release of borrowing 
 constraints in Europe and the U.S., it is clear that such restrictions can be effective. 
 
 IV. CONCLUSIONS 
 
 Once the decision has been made to pursue a high growth strategy in spite of possible welfare 
 losses to the current generation, the financial sector becomes an important tool for ensuring a 
 compatible intertemporal allocation of investment resources. This is not to deny the importance of 
 increased intermediation in unifying the returns on investment projects and promoting productive 
 efficiency. Rather, we have argued that the "optimal" saving level may not be generated by an 
 unrestricted market and we have demonstrated that there is a natural tendency toward lower savings 
 rates as the accumulation process proceeds due to a "consumption crowding out" effect. Further, our 
 
 ^<^ Krause (1987). 
 
15 
 model argues that if financial markets are liberalized when there exists a sizable pent up demand for 
 consumer credit, a loss in investable resources may result that offsets increases in efficiency. These 
 concerns about the impact of easier consumption smoothing with liberalization have thus far been 
 addressed solely, and inadequately in the debate about whether market determined interest rates 
 promote higher savings. Our analysis suggests that the issue is more complex and that retaining 
 restrictions on consumer and mortgage borrowing would seem a prudent departure from complete 
 liberalization of the financial sector. 
 
16 
 
 V. REFERENCES 
 
 Barandiaran, Edgardo, "La Gran Recesion de 1982" in Del Auge a La Crisis de 1982. Institute 
 Interamericano de Mercados de Capital, ILADES-Georgetown, Santiago, Chile. 
 
 Bovenberg, A. Lans, "Why has US Personal Saving Declined?," Finance and Development, June 1990. 
 
 Bovenberg, A. Lans and Owen Evans, "National and Personal Saving in the United States: 
 Measurement and Analysis of Recent Trends," IMF Staff Papers, Vol. 37, No 3., Sept. 1990. 
 
 Cargill, Thomas and Shoichi Royama, The Transition of Finance is Japan and the U.S., A Comparative 
 Perspective, Hoover Press, 1988. 
 
 Corbo, Vittorio, "Reforms and Macroeconomic Adjustments in Chile during 1974-84," World 
 Development, Vo\. 13, No. 8, August, 1985. 
 
 David, P. A and J. L. Scadding, "Private Savings: Ultrarationality, Aggregation, and 'Denisons's 
 l^v^',' Journal of Political Economy, March/ April 1974. 
 
 Dean, Andrew, Martine Durand, John Fallon and Peter Hoeller, "Saving Trends and Behaviour in 
 OECD Countries," OECD Economic Studies, No. 14, Spring 1990. 
 
 Deaton, Angus, "Saving in Developing Countries: Theory and Review," Discussion Paper #144, 
 Woodrow Wilson School, Princeton University, March, 1989. 
 
 Eyzaguirre, Nicolas, " La Deuda Interna Chilena: 1975-1985, in Carlos Massad and Roberto Zahler 
 ed. Deuda Interna y Estabilidad Financiera, Vol. II, CEPAL, Grupo Editor Latinoamericano, 
 Buenos Aires, 1988. 
 
 Feldman, R. Al., Japanese Financial Markets, Deficits, Dilemmas and Deregulation, Cambridge, The MIT 
 Press, 1986. 
 
 Fry, Maxwell, J., "Financial Development: Theories and Recent Experience," Oxford Review of 
 Economic Policy, 5(4), Winter 1989. 
 
 Fry, Maxwell J., "Models of Financially Repressed Developing Economies," World Development 10, 
 September 1982. 
 
 Fry, Maxwell J., "Savings, Investment, Growth and the Cost of Financial Repression," World 
 Development, Vol. 8, April 1980. 
 
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