estimated at between 7 and 8 percent of GDP in 1987. In Korea, the subsidy provided by directed credit was approximately 1 percent of GDP during the 1980s (Booth at al., 2001). Directed lending requirements in many cases left little power or responsibility on credit allocation to private banks, resulting in low investments in credit assessment and monitoring. Also, extensive refinance schemes at low interest rates reduced the incentives for financial institutions to mobilize resources on their own, leading to a lower level of financial intermediation.

Furthermore, direct government intervention in the operation of financial markets, through directed lending programs, interest rate controls, entry restrictions, and high reserve requirements, has been found to have significant costs in terms of economic efficiency and growth and to stifle, rather than promote, financial development. These policies were initially challenged by Goldsmith (1969) and later by McKinnon (1973) and Shaw (1973), who coined the term “financial repression” to describe them. Goldsmith (1969) argues that the main impact of financial repression is to reduce the marginal productivity of capital. Since interest rate controls keep rates below their equilibrium level, high quality projects with higher returns do not get financed. McKinnon (1973) and Shaw (1973) focused on two other channels. First, financial repression reduces the efficiency of the banking sector in allocating savings, as bankers do not ration credit according to price criteria. Second, by maintaining interest rates below their market equilibrium, financial repression reduces the savings level. These two channels have a negative impact on growth, as too little will be saved and those savings will not be allocated to the projects with the highest marginal productivity.<sup>31</sup> Financial development is also likely to suffer under these conditions, as the low return on financial assets encourages savers to keep their savings outside the financial system.

# **3.2 The Laissez-Faire View**

Over the last decades, mostly as a reaction to the mentioned problems of public banking and direct government intervention in the financial sector, a second, entirely opposite view has gained ground: the laissez-faire view. This view also stems from an increasing awareness of the role played by institutions and market infrastructures in financial development. The laissez-faire view contends that, due to incentive issues, bureaucrats will never be good bankers and that governments can do more harm than good by intervening directly in credit allocation and pricing. According to this view, although there may be market failures in the financial industry, these are not as extensive

> 31 A number of cross-country studies have attempted to measure the impact of financial repression on growth. Most of these papers use real interest rates (or variables based on threshold values of real interest rates) to measure financial repression, as controls on lending and deposit rates resulted in low or negative real interest rates in many developing countries (Agarwala, 1983; Gelb, 1989). These studies tend to find a negative relation between financial repression and economic growth (see, for example, Easterly, 1993; Lanyi and Saracoglu, 1983; Roubini and Sala-i-Martin, 1992; and World Bank, 1989). Galindo, Micco, and Ordoñez (2002) measure the extent of financial liberalization using indices based on financial system regulations and find that financial liberalization, mainly in the domestic financial sector, increases the relative growth rate of those industries that rely more on external finance.

18