Financial Liberalization, Financial Restraint, and Entrepreneurial Development by M. Shahe Emran and Joseph E. Stiglitz :: NEUDC 2007 Papers :: Northeast Universities Development Consortium Conference :: Center for International Development at Harvard Un

This paper considers the interactions between financial sector reform and entrepreneurial development with a focus on identifying policies appropriate for fostering entrepreneurial discovery and learning. Using a simple model of occupational choice with moral hazard, it analyzes the effects of Financial Liberalization policies (McKinnon, 1973) on the development of industrial entrepreneurship. The analysis shows that in a fully liberalized and competitive banking economy (i) banks may fail to finance potential industrial entrepreneurs because of poaching externality, and (ii) systematically favor short-term projects with front-loaded returns at the expense of projects with strong learning effects. Policies of temporary entry restraint and deposit rate control as advocated in the Financial Restraint paradigm can be effective in encouraging banks to experiment with new industrial entrepreneurs. While deposit rate control can encourage entrepreneurial discovery even in a competitive banking economy, it is not effective in weeding out short-termism in project choice. Entry restraint can be especially useful for reducing the bias against the projects with low initial returns but strong learning and productivity gains later. Our analysis shows that a dual-track policy where entry restraint is implemented in the industrial sector lending but competition is preserved in the lending to the competing economic activity (like agriculture) can be useful to tackle the problems of poaching externality and short-termism in project choice. JEL Codes: G2, O16, E4, L26 This is a substantially revised version of the paper circulated earlier under the same title and supersedes the earlier version. We would like to thank Fahad Khalil, Chris Snyder, Stephen Smith, Albert Park, Ahmed Saber Mahmud, Amit Bubna, Shabbir Jilany, and Forhad Shilpi for useful discussions and/or comments on earlier versions of the paper. The usual discalimers apply. Email for correspondence: [email protected].