Increasing returns, long-run growth and financial intermediation

This paper identifies a novel connection between the financial sector and economic growth: Banks facilitate economic growth by internalizing production externalities among firms in a decentralized way. I consider a growth model with the externalities studied in Romer (1986). First I formulate an economy where consumers, firms and an auctioneer interact strategically, following Arrow and Debreu (1954). I show that the Walrasian equilibrium in this economy is not Pareto optimal as Romer (1986) shows. Second I prove non-existence of a Nash equilibrium if an auctioneer is absent from the economy. Third I replace an auctioneer by several banks. Banks strategically intermediate the capital market (they compete in both deposit and loan markets). Again, no Nash equilibrium exists. Fourth I allow banks to use an interbank market and introduce strategic tâtonnement: Banks have a second chance to offer contracts to clear the interbank market. With strategic tâtonnement, a Nash equilibrium exists and it is unique. The allocation is proven to be different from that in the Walrasian equilibrium, and Pareto superior to it in most cases. In particular, it achieves the Pareto optimal allocation in the widely used case where the production function exhibits constant returns to accumulated capital. This result challenges prevailing views in three literatures. The banking literature has usually assumed some frictions in an economy so that banks can emerge endogenously. Here I show that such assumptions are not necessary. The literature on strategic intermediaries argues that the equilibrium achieves the Walrasian equilibrium at best. Here I show that strategic intermediation achieves an allocation that is Pareto superior to the Walrasian outcome. Finally, the literature of new growth theory with externalities has been concerned with the inefficiency of the decentralized equilibrium. This paper shows that a decentralized, competitive economy can achieve the Pareto optimal allocation.