The advent of the Euro is the latest phase in the financial integration that is sweeping across Europe. Earlier events of special significance were the promulgation of the Second Banking Coordinating Directive, allowing banks to branch across national boundaries, and the establishment of the Financial Services Policy Group, designed to study inter-country issues arising from financial integration. It is clear that a unified continental financial services market is emerging in Europe. As that market develops, important questions will arise concerning the kind of market structure that will emerge, its appropriate size, and its organization. In many ways, both the developments and questions concerning them parallel those that have arisen in the United States over the last two decades with the increasing degree of financial integration taking place there. In both Europe and the United States, there are related questions concerning the public policies that should be enacted to guarantee that the resulting financial services industry is socially optimal - policies concerning mergers, types of services that can be offered by various types of institutions, capital adequacy requirements, and so on.
In this paper, we address a theoretical question that is important both for the positive and normative analysis of the financial industry, namely, what is the optimal size of that industry? This seems an obvious question for policy analysis, which concerns intervention in the financial industry precisely to guarantee some sort of social optimality, but the question also is important for a positive analysis, for determining the optimal size of the industry is closely related to analyzing the size that will emerge in competitive equilibrium. Thus the subject of this paper would seem important to several groups, including students of the financial industry, that industry’s regulators, and both macroeconomists and macroeconomic policy makers. However, it is only recently that economic theory has begun to address this important issue. This is, in large part, due to the fact that the financial sector has occupied a rather secondary position in formal macroeconomic theory for most of the past few decades. In Patinkin’s (1965) neo-classical framework, the financial sector was limited to the demands and supplies of money and bonds; financial institutions played no significant role. Subsequent developments, such as Brunner and Meltzer (1968) and Tobin (1969), continued to assign to financial institutions only a minor role in determining macroeconomic equilibrium.
An important issue in international economics concerns the size of benefits from diversifying over securities in foreign countries, especially securities in emerging markets. In theory, if foreign securities do not perfectly correlate with U.S. securities, domestic investors gain from international diversification. However, the magnitude of the diversification benefits in general depends on various portfolio constraints, such as investors ability to take short positions.
The world has entered a global recession that is causing widespread business contraction, increases in unemployment, and shrinking government revenues. Some of the largest and most venerable banks, investment houses, and insurance companies have either declared bankruptcy or have had to be rescued financially. Nearly all industrialized countries and many emerging and developing nations have announced economic stimulus and/or financial sector rescue packages, such as the American Recovery and Reinvestment Act of 2009 (P.L. 111-5). Several countries have resorted to borrowing from the International Monetary Fund as a last resort. The crisis has exposed fundamental weaknesses in financial systems worldwide, demonstrated how interconnected and interdependent economies are today, and has posed vexing policy dilemmas.
The process for coping with the crisis by countries across the globe has been manifest in four basic phases. The first has been intervention to contain the contagion and restore confidence in the system. This has required extraordinary measures both in scope, cost, and extent of government reach. The second has been coping with the secondary effects of the crisis, particularly the global recession and flight of capital from countries in emerging markets and elsewhere that have been affected by the crisis. The third phase of this process is to make changes in the financial system to reduce risk and prevent future crises. In order to give these proposals political backing, world leaders have called for international meetings to address changes in policy, regulations, oversight, and enforcement. On April 2, 2009, heads of the G-20 nations met in the Leaders’ London Summit and announced measures to bolster international financial institutions, stabilize the world economy, and reform and improve the financial regulatory system.
