Academic journal article
By Ozawa, Seiji
Journal of Economic Issues , Vol. 33, No. 2
In any market economy, banks play a key role in money creation and investment. They are the single most important intermediary for indirect finance across the world. The securities (such as stocks and bonds) market is also another ubiquitous presence for direct finance. The latter, however, normally develops and gains in importance pari passu with economic development; in general, the higher the per capita income, the greater the role of securities (vis-a-vis bank loans) as a source of external funds for business investment [Levine 1997]. Securities involve greater financial risks than bank loans.
The American economy has become more dependent on securities than on bank loans for business finance.(1) In large measure because of pension funds and mutual funds, more than half of American households are estimated to be shareholders in one way or another.(2) America's financial industry is the world's undisputed leader in innovations in the areas of derivatives and securitization, all adding to the rapid growth of the securities market. In these respects, American capitalism can be appropriately called "securities-market capitalism."
In contrast, Japan's financial industry, although it was actually remodeled on the American system after World War II, has been sui generis in many respects. It is dominated by banks to such an extent that Japanese-style capitalism can be characterized as "bank-loan capitalism," especially in light of the relatively insignificant role played by the corporate bond market. Bank loans have been critical in financing Japan's phenomenal economic growth in the postwar period - and ironically, because of this importance of the banking sector, the entire Japanese economy was affected all the more during the recent banking crisis and severe credit crunch.
Any rapidly developing economy requires increased finance. How to organize this is a critical issue in formulating a successful strategy for rapid industrialization.
In essence, two possible solutions exist. One is to borrow from overseas by running a current-account (CA) deficit (since CA = domestic savings - domestic expenditures). This, however, makes a debtor country vulnerable to the vagaries of hot global money, as has been so painfully experienced by beleaguered emerging economies in the present global financial crisis. The other is to create credit internally through a country's banking system with the help of its central bank. This second approach is self-reliant in development finance and allows the country freedom from dependence on foreign capital. The first approach may be identified as "CA deficit-based finance," and the second as "central bank-based finance" [Ozawa 1998].
Japan has relied more heavily on the second approach by minimizing borrowing from overseas. It also promoted domestic savings as much as possible in part to enhance bank liquidity. In fact, this self-reliant approach of financing economic development has been an ingrained policy ever since the start of Japan's modernization in the mid-nineteenth century.(3)
In reconstructing its war-torn economy after World War II, Japan pursued central bank-based finance. The only way for Japan to create loanable funds without much borrowing from overseas was to make the most of the banking industry's credit-creating capacity with the help of its central bank.
As is well known, the banking industry can create demand deposits (bank money) by a multiple out of any initial injection of liquidity into banks' reserves, a phenomenon known as bank money multiplication under a fractional reserve requirement.4 The discount window is another channel through which additional liquidity can be created. The reserve requirement may also be lowered to allow the banks to have excess reserves. All these liquidity-creating facilities can be extended for the purpose of providing long-term credit for capital formation in the course of industrialization. …