Every financial system is capable of periods of capital misallocation, and this almost always seems to happen during periods of very low interest rates and rapid money expansion, but some financial systems do this more extravagantly than others.
As I see it there are broadly speaking two very different conceptions of the role of a country’s financial systems.
In one, banks act largely as fiscal agents for the government or the economic elite, accumulating savings and deploying capital into projects usually selected for promotion by those elites. Since banks are in the business of taking risk, and since rapid credit expansion is inherently risky, the only way to guarantee financial stability is to extract much or all the risk from the banks and imbed them elsewhere. In practice the only “elsewhere” big enough is the state. In this kind of banking system the state typically socializes credit risk and passes losses onto taxpayers or depositors. This system generates tremendous growth for underdeveloped economies where economic value is easy to identify. Identifying economic value in developed (particularly with respect to infrastructure) economies is more difficult
In that case these kinds of financial systems inevitably run into the problem of capital misallocation. It doesn’t matter if at one point they do a great job of allocating capital and generating real growth. As long as the same allocation process is maintained, it seems, at some point they begin to overinvest. Perhaps this is because the economic sectors that benefit most from the regulatory, credit and economic subsidies, not surprisingly, become increasingly powerful within the political system and increasingly reluctant to allow the system to change.
The other type of system, in which the problem of systematic capital misallocation is much reduced, is one in which banks decide for themselves the kinds of activities they fund, and their shareholders and depositors bear both the rewards and risks of their capital allocation. These kinds of banking system are much more prone to instability, but they are also much more efficient at allocating capital over the long term. In part this is because there is a fairly robust mechanism for recognizing and liquidating poor investment. In the former system, because risk tends to be socialized, there is no obvious mechanism, besides that of an omniscient and disinterested credit committee, for identifying and correcting misallocation.
The prestige of the Anglo-Saxon model soared in the past two decades precisely because its biggest competitor for prestige, the Japanese banking system, collapsed so spectacularly in the 1990s.
In practice of course there is no pure example of one financial system or the other, but as the statement above suggests it is pretty safe to say that Japan during its growth period, and the countries that copied the Japanese model, are closet to the extreme version of the former. The current Chinese financial system, even more than Japan, is clearly one in which the purpose of the financial system is to act as the state’s fiscal agent and in which banking stability is guaranteed by the state. It is also clearly one in which capital misallocation can become a huge problem.
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