Finance and development in Southeast Europe in the interwar period

Abstract

How do financial systems affect economic growth? How effective were international financial flows in promoting economic development in Southeast Europe in the Interwar Period? A large literature argues that financial systems evaluate prospective entrepreneurs, mobilize savings to finance the most promising productivity-enhancing activities, diversify the risks associated with these innovative activities and reveal the expected profits from engaging in innovation rather than the production of existing goods using existing methods. Important part of the theoretical literature also argues that foreign capital, in contrast to other available sources of funding – like domestic financial sector and state capital - is more effective in monitoring performance, in promoting better corporate governance, promoting technological improvements and ensuring access to export markets for developed and large scale enterprises - but less effective in alleviating asymmetric information problems and ensuring access to funds to small and medium sized enterprises. This paper provides a review of the theory behind the above claims and argues that asking similar sorts of questions in relation to the economic development of the Balkans can be a very fruitful line of research. It proceeds to present aggregate data on international financial flows and their relative importance for industrial growth for the four Balkan countries of Bulgaria, Greece, Romania and Yugoslavia during the 1920s and 1930s.

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Finance and Development in Southeast Europe
in the Interwar Period
Kiril Kossev, University of Oxford∗


Abstract: How do financial systems affect economic growth? How effective were international
financial flows in promoting economic development in Southeast Europe in the Interwar Period? A
large literature argues that financial systems evaluate prospective entrepreneurs, mobilize savings to
finance the most promising productivity-enhancing activities, diversify the risks associated with these
innovative activities and reveal the expected profits from engaging in innovation rather than the
production of existing goods using existing methods. Important part of the theoretical literature also
argues that foreign capital, in contrast to other available sources of funding – like domestic financial
sector and state capital - is more effective in monitoring performance, in promoting better corporate
governance, promoting technological improvements and ensuring access to export markets for
developed and large scale enterprises - but less effective in alleviating asymmetric information
problems and ensuring access to funds to small and medium sized enterprises. This paper provides a
review of the theory behind the above claims and argues that asking similar sorts of questions in
relation to the economic development of the Balkans can be a very fruitful line of research. It proceeds
to present aggregate data on international financial flows and their relative importance for industrial
growth for the four Balkan countries of Bulgaria, Greece, Romania and Yugoslavia during the 1920s
and 1930s.



Key Words: Finance and Growth, Balkans in the Interwar Period, International Capital Flows.

JEL Code: N14, N24, O16;





∗ Kiril Kossev is a DPhil student in Economic History at Nuffield College, Oxford University.

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1. Introduction
Questions surrounding the economic links between finance and growth have occupied scholars for
a long time. As early as 1912, Joseph Schumpeter made a clear theoretical connection between
financial and economic development.1 Other researchers, like Joan Robinson, have considered finance
as a passive factor in the models of economic growth.2 In more recent research, following the
development of information economics and transaction costs economics, the topics of credit provision
by banking and finance have occupied a central role in explaining differences in development and firm
performance.3 The main themes of enquiry ask if finance affects economic growth through improving
efficiency and information provision; if financial systems differ from each other – if so why and what
consequences this has for development. Other important strands of research compare different types of
financing and assess their costs, and crucially, attempt to trace microeconomic effects of these on firm
performance and make inferences to macro-level technological spread and aggregate growth.
Some of the economic ideology that arose from research on the above themes has found its way to
policy makers’ tools, especially in development help to third-world countries over the last half-a-
century and in promoting regulatory regimes, aimed at attracting foreign direct investment.4 These
policies have met with ambiguous results – an outcome matched by the empirical surveys of
economists who tested the finance-growth nexus theories on the aggregate, macroeconomic level.5 New
lines of research, focusing on micro-level effects of financial institutions and flows have proved more
fruitful. Not only are the latter more effective at detecting the direct and indirect benefits of efficient
financial systems and foreign capital influx, but their results may prove more helpful when and if they
make their way to the economic policy toolkit.
Economic history can be very illuminating in the above context. It can provide ideal testing ground
for the theories by allowing us to pick both successful and unsuccessful industrialisers, as well as offer
a comparative setting over the long term. These in turn can illustrate the interaction that financial
systems and international investment have with local institutions, of political, financial or economic
nature.
The Southeast European Region during the first half of the 20th century offers all of the above
together with proximity with the developed European core, common cultural and institutional setting,
as well as sophisticated financial systems. All these factors helped ensure access to technological
innovations, markets for core exports and a stream of foreign investment. While full industrialisation
was achieved in he post-1945 period, by methods of forced saving and far-reaching government
intervention, the initial stages of structural transformation and the origins of an industrial sector were
arguably noticeable during the Interwar Period.6

1 Schumpeter, J., (1912).
2 Robinson, J., (1952).
3 Lescure, M., in Jones, G., Zeitlin, J., Oxford Handbook in Business History, OUP 2007.
4 A policy described as the Washington Consensus by Williamson, (1990), see also Stiglitz et al., (2006).
5 See Easterly, W., (1997, 2002, 2006) for explanations of the failure in growth promotion policies in the developing
world, mainly Africa.
6 Ivanov and Tooze (2007).

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Scholarly work on the region has traditionally stuck by the now classic Guerschenkronian tradition
of explaining any development through the prism of ‘relative backwardness’. It makes largely
unfavourable comparisons with either German or Russian industrialisation form the late 19th century.7
Work of Marxist historians during the post-1945 era has focused its energies on painting a negative
picture of failed capitalist states between the wars. The latter described the Balkan states as mired in
domestic political struggles while gradually succumbing to the influence of German economic
imperialism on the international scene.8
As economic theory has advanced from the neo-classical growth theory, of which most famous is
the Solow growth model, based on exogenous technology, catch up growth and convergence to a long-
term growth path, so has thinking about development in historical perspective. Recent research has
emphasized much more the role of efficiency in the economy, intermediation between savers and
investors, production and innovation in a capital deficient environment, and most of all amelioration of
transaction and information costs.9 The themes of institutions and rigidities, which may slow down
economic development, have long been discussed in the literature. These are major part of scholars’
focus, but now seen through their interaction with financial markets.10 Credit institutions have been
placed at the centre of economic interactions, because of their ability to gather and efficiently process
information about the production process and the economic agents involved in it. They can promote
invention and innovation, spread entrepreneurial risk, but also allow long-term investment in projects
with a higher pay off.11
Older work on the development of the Southeast European region has followed a more narrative
tradition. It has attempted to reconstruct aggregate measures and to provide a subjective vision of
failure or success in industrialisation. The theme of finance and growth, on the other hand, can provide
us with concrete questions as well as testable hypothesis of factors that influence development, thus
throwing light on the intricate interactions between the different modes of the economy.
Scholarly work on Southeast European development can benefit immensely from such a line of
research. The Balkan countries possessed relatively sophisticated financial systems, which have left
behind a wealth of archival information. Following the finance-growth nexus can allow us to track
micro effects and interactions that in turn make it possible to trace structural changes and other trends
that remain hidden on the aggregate level. Uncovering the relationships of credit institutions and
industry and the final effects on productivity can enable researchers to then provide answers to general
questions with greater confidence. They can also provide feedback to current development issues in
third-world economies.
This paper looks at Bulgaria, Greece, Romania and Yugoslavia as these countries formed the core
of the Southeast European region during the Interwar Period. Furthermore, data is most readily
available for them – this being the reason to exclude Albania. Sections two and three look at the new
developments in economic theory concerning information costs, role of finance and the influence of
foreign credit as opposed to domestic sources of finance. Sections four, five and six look at Southeast

7 Jelavich and Jelavich, (1983).
8 Berov, (1989).
9 Parente and Prescott, (2000).
10 Rajan and Zingales, (2004).
11 King and Levine (2002).

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Europe in particular, presenting aggregate data of international capital flows and their tentative
distribution according to industry. The last section concludes.
2. Finance and Economic Development – The Story So Far
The large questions in relation to the economic development of the Balkans are still very much
open. When did structural transformation occur? What drove industrial development? Who financed
enterprise? What role did corporate structures, state role, relationship with foreign trade partners or
investors, play? These are questions that still need clarifying – not only for the benefit of our
understanding of the periphery of industrialised Europe, but also for the purpose of refining our theories
of economic growth.
The point of departure for any work on the mode of development in relative backwardness is the
classic work of Alexander Guerschenkroon. He developed his ideas of economic stimuli substitution
around the historical experiences of late 19th century and early 20th century Germany, Russia and the
Balkans. Latecomers to the industrialisation ‘scene’ usually exhibit capital shortage. To substitute for
this Germany developed large, universal banking institutions that combined both an investment and a
commercial arm, which established long-term relationships with specific industrial clients and
channelled savings to fund their growth. Late 19th century Russia was a step back in its economic,
financial and institutional development, and the role of liquidity provider was taken by the state. The
young Balkan states combined the example of the above two with a strong state presence in industry
and financial sectors as well as universal type banks.
This orthodox view on banking, finance and industrial development has persevered in the
economic and economic history literature, but has not gone unchallenged. Recent work has noted the
underemphasised role of legal and political factors in the Guerschenkronian hypothesis.12 For instance,
the Bubble Act of 1720 and the monopoly of the Bank of England over limited liability banking until
the early 19th century may have kept the majority of the English banks smaller and more conservative
than they would have been in a time of rising demand for industrial finance.13 In contrast the German
Reichsbank both squeezed other banks out of much of the short-term commercial business and
facilitated those banks’ provision of riskier investment services. Regulatory legislation of securities
markets and shareholding companies was also instrumental in the promotion of the universal banking
system.14
Verdier (1997) has directly opposed Guerschenkron’s thesis, suggesting that political structures,
rather than relative backwardness, were more influential in shaping financial systems and subsequently
economic performance. Similarly to other generalising theories, there are two pitfalls with such claims.
Political centralisation was neither the sole factor, not the decisive one in determining the financial
structure of a state. Moreover, political and legal structures are not independent of economic
backwardness – in fact is more likely that they are endogenous to the stages of economic development.

12 Verdier, (1997).
13 Tilly (1994b).
14 Fohlin, (2007).

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Similar problems bedevil the studies by economists and development economists on the
relationship between modern day financial systems and growth. This line of research has caused a
considerable academic debate and consequently a spiralling literature produced by leading scholars in
economics and economic history.15 Recent literature suggests that well-developed financial systems not
only ease the exchange of goods and services, but increase efficiency in information production and
sharing and subsequently in the allocation of capital. They also promote more transparent corporate
governance structures, and help with mobilising and pooling savings.16 Empirical work is less
conclusive as to the positive effects and the line of causality between financial development and
economic growth.
King and Levine have formalised the Schumpeterian view of finance and growth, the idea that
finance ‘lubricated’ the real economy, into a model of endogenous growth.17 They suggest four
channels, through which financial development feeds into growth: screening prospective entrepreneurs
and selecting most promising projects, mobilising capital to fund investment, diversifying investors’
portfolios to eliminate risk and revealing potential benefits of participating in productivity-enhancing
activities.18 Further to that, Fohlin (1998) has provided a summary of recent models of finance and
growth. In a simplified model, per capita growth rate is a function of the savings rate, return on
investment and costs of intermediation: y = f (S,I,Cint).19 The variable cost of intermediation (Cint)
describes the efficiency of the domestic financial system, which in turn is linked to the ability of capital
to reach high-return investment opportunities, thus promoting productivity improvements.
Much of these theoretical cost benefits of financial intermediaries stems from problems of
information asymmetry between entrepreneurs and potential sources of finance. Incomplete or
imperfect information may be a cause of misallocation of resources due to misreporting of returns. A
financial intermediary can alleviate such misallocations most efficiently. Even in a world without
misreporting, the process of intermediation can help diversify the risk of investment, due to unforeseen
exogenous shocks.
When the world is tax-free with free and perfectly competitive markets, and symmetric
information, there is no difference between the choice of financial instruments on offer by
intermediaries. Under such stringent assumptions, Modiglianni and Miller (1958) have proved the
proposition that firms cannot alter the value of their securities by changing the mix between debt and
equity.
In reality, however, such assumptions do not hold. As a consequence, there are a number of
theories, which try to explain firm capital structure, based on problems of asymmetric information,
agency problems and the presence of large transaction costs. Firms that face some of the above
problems may find it least costly to finance investments in the productive process through own savings
and retained profits. External finance is costly and only becomes viable if firms find some mechanism

15 The research agenda on finance and growth is not new – scholars as early as Bagehot (1873) and Schumpeter
(1912) have suggested a role for finance in economic growth. More recently, Goldsmith (1969) and McKinnon
(1973) have been strong proponents of the same idea. On the opposing side has stood Nobel Laureate Lucas (1988),
and more recently Gourinchas and Jeanne (2006), who claimed that the role of finance was overstressed.
16 See summary of theoretical and empirical results in King and Levine (2003).
17 Ibid.
18 King and Levine (1993).
19 Fohlin (1998); p.3.