Development Banks and Preventing Economic Recovery

by André Costa

Development banks are public financial institutions that provide capital to projects run by national companies that would otherwise not be able to obtain those funds from commercial banks. Whilst facing a deep economic recession, various countries may fall into the temptation of creating or expanding development banks in order to increase credits and foster economic growth, as is the case of Portugal, whose government has recently announced the creation of a development bank. Development banks are, however, a bad idea from a theoretical point of view and from the results of past experiences. Besides potential transparency or corruption issues, the economic principles on which the idea is based are also dangerous.

Firstly, it should be noted that income may be directed towards three different ends: consumption, investment, and hoarding. Consumption is the end goal of all production, which makes it only natural that it gets the largest proportion of incomes. Investment exists because by giving up a certain part of possible immediate consumption (saving), it becomes possible to produce tools that will in turn produce a greater amount of future consumption. Hoarding, which can be thought of as keeping money under the mattress, is part of a choice made by each person that the hoarded monetary units find more favorable uses in neither productive resources nor in consumption, a phenomenon that usually occurs in circumstances of economic uncertainty or pessimism.

Now, to illustrate the importance of saving and investing on the rate of economic growth, let us think of a man who lives isolated on an island. Adapting an example from Eugen von Böhm-Bawerk’s Positive Theory of Capital (1889), our Robinson Crusoe spends each of his days fishing three fish with the sole use of his hands and consumes them all. At a certain point, Crusoe realizes that by building a net he can catch 10 fish per day, but to do so he has to stay five days totally focused on the task, without being able to fish. Therefore, Crusoe decides to consume only 2 of the 3 fish for ten days, reducing his consumption and accumulating savings corresponding to 10 fish. Now he can, for five days, continue to consume 2 fish per day of the accumulated stock and, with the free time he acquired, build the net. From then on, he has at his disposal a possible daily consumption of 10 fish instead of the initial 3. So, he gave up 1 fish per day for fifteen days in order to start consuming 7 more fish per day in the future.

The importance of saving (investing) to economic growth in a market economy, where no person lives alone nor produces alone, is still fundamentally similar to the example just set out, although more complex. The main difference is that the decision between consuming the available resources or investing them is made by all households simultaneously and is reflected through the price system. If people in general increase their propensity to consume, consumer goods’ prices increase and investment is directed towards immediate consumption through less roundabout methods of production which are less productive. Moreover, as funds available for investment are reduced as a result of increased consumption, there is greater competition for them, so the rate of interest increases, further discouraging long-term projects; on the other hand, if people in general increase their propensity to save, the prices of consumer goods go down and, as a result of the greater number of bank deposits and investments in the financial markets, the interest rate decreases and there is capital deepening of production methods, which, as already seen, makes them more productive.

All this implies that any society, at any given moment, has a limited level of capital stock to be invested and, ceteris paribus, the higher this collective fund is, the higher will be the level of production, income, and consumption of the society over the following years. In addition to the level of capital stock, it is equally important to know to which investments that stock is channeled to. Ideally, it will be invested by productive companies with solid projects that correspond to consumers’ demand. This is where development banks have undesired negative consequences.

When a development bank grants X million euros in credit, those millions shouldn’t be thought of as being added to the country’s capital stock, because this could only happen through an increase in savings. This public money has its origins in the taxation of productive private agents, so what in fact takes place is a transfer of X million euros that would be managed by a judicious bank, investors, etc. and that are instead managed by the development bank, whose mission is to give out credit to companies that could not get them from such judicious banks. We should have learned this lesson already, as demonstrated by the writings of Adam Smith regarding the development bank of his time, the Bank of Ayr, in Book 2 of his work The Wealth of Nations (1776):

“A new bank was established in Scotland for the express purpose of relieving the distress of the country. The design was generous; but the execution was imprudent. (…) The success of this operation, therefore, without increasing in the smallest degree the capital of the country, would only have transferred a great part of it from prudent and profitable to imprudent and unprofitable undertakings.”

Development banks are a bad idea and especially so in this recession. Unlike other recessions where savings are the most affected component of income due to consumption smoothing, this time around savings have increased like never before. Furthermore, these additional deposits are not being hoarded by commercial banks as credit to the private sector is also increasing and stocks are rising due to savings directed towards the financial markets. To create or expand development banks would risk misallocating productive resources and waste the best opportunity we have at a strong economic recovery.

André Costa studies economics at ISEG in Portugal