Asset Pooling, Credit Rationing, and Growth

I study the effect of improved financial intermediation on the process of capital accumulation by augmenting a standard model with a general contract space. With the extra contracts, intermediaries endogenously begin using roscas, or rotating savings and credit associations. These contracts allow poor agents, previously credit rationed, access to credit. As a result, agents work harder and total economy-wide output increases; however, these gains come at the cost of increased inequality. I provide sufficient conditions for the allocations to be Pareto optimal, and for there to be a unique invariant distribution of wealth. I use numerical techniques to study more general models. Journal of Economic Literature classification numbers: O16, E44, G20, G33. The views are expressed are mine and do not necessarily reflect those of the Board of Governors or its staff. This paper is a substantially revised version of my dissertation. I thank Robert Townsend, Lars Hansen, Derek Neal, and Maitreesh Ghatak for several years of encouragement and support. I also thank Andrew Abel, Mitch Berlin, Ethan Ligon, Dean Maki, Steve Oliner, Wayne Passmore and Ned Prescott for helpful suggestions. I have also benefitted from the comments of seminar participants at the University of Chicago, UIC, Iowa State, Rice, Wharton, University of North Carolina, Tufts, University of Virginia, and the Federal Reserve Banks of Richmond, Philadelphia and Kansas City as well as the Board of Governors of the Federal Reserve System. Financial support from the University of Chicago, the Henry Morgenthau foundation and the Northwestern University/University of Chicago Joint Center on Poverty Research is gratefully acknowledged. Any remaining errors are mine. Does financial intermediation directly cause growth, or is financial intermediation merely a necessary adjunct to growth? In this paper I identify a channel by which a nation's financial structure may directly affect its development experience. I augment a standard capital-accumulation model with a general contracting space. Armed with these extra contractual possibilities, financial intermediaries will endogenously arrange poorer agents into asset-pooling groups, which mimic one type of rosca (rotating savings and credit association) commonly observed in the developing world. Roscas help agents overcome credit rationing, increasing the demand for capital. The market-clearing interest rate increases, as does the average effort level. Output increases, but at the cost of increased inequality. Economies with the extra contracts grow faster to an invariant distribution of wealth with both a higher mean and greater inequality than economies without them. The fact that financial intermediation, particularly asset-pooling contracts like roscas, contributes to inequality may be counter-intuitive. In my model there are two main reasons for this effect. First, asset-pooling groups cause the market-clearing interest rate to increase, thus increasing the premium to wealth. When the interest rate is higher, differences in wealth result in larger differences in consumption. Second, asset-pooling groups allow poor agents to leave their low-return, but safe, option for a highreturn, but risky, option. Because the market-clearing interest rate falls as wealth increases, these factors combine to produce Kuznets-style dynamics in the distribution of wealth, in which inequality is initially increasing and then decreasing. Note that the effect of wealth inequality depends 1 crucially on the financial market structure. Without the asset-pooling contracts, inequality may reduce output. With them, I provide sufficient conditions for wealth inequality to have no effect on output at all. The asset-pooling contracts that emerge endogenously may be interpreted as one-period roscas. Financial intermediaries will pool the wealth of many agents of the same wealth, assign the pool to a certain fraction of the contributors and then make them further loans (if needed). Because in this paper all agents of a given wealth will be identical and live for only one period, the pooled assets are divided with a lottery. Such contracts are known as lot roscas and are observed in the developing world, see for example the reviews of Besley, Coate and Loury (1993, 1994). Further, in a study of Mexican financial institutions, Mansell-Carstens (1993) finds that lot roscas are used by, among others, Volkswagon de Mexico's consumerfinance arm. The extra contractual possibilities may also be interpreted as a joint stock company. All agents (of the same wealth) trade their wealth for one share in an enterprise jointly owned by them all. With the total equity from these shares, the enterprise either directly purchases capital inputs or approaches a bank for further debt financing of even more capital inputs. A certain proportion of the investors, chosen by lottery, are designated as managers. The enterprise allocates the accumulated capital to the managers for use in their projects. Agents, in my model, may only work on their own projects, and their labor effort is privately observed only by them. As a result, the correct level of labor effort is induced with an incentive-compatible