Summary: Programs to direct credit to industry can be uniquely beneficial if 1) the purpose of government credit is to relax borrowing constraints on firms, as an end in itself, or (2) other government objectives can best be achieved by relaxing firms' borrowing constraints (in which case, product and factor market externalities motivate government credit programs). According to Japanese officials, government involvement is warranted when: 1) investment risk is too high for a particular activity (because it is too large-scale or high-tech, or needs long gestation and market development); 2) there is a big discrepancy between private and social benefits when industries or parts of industries may save foreign exchange, for example, and thus relieve the balance of payments constraint on other growth industries); 3) information problems discourage lending to small and medium-scale industries; 4) infant industries face large social set-up costs. The authors examine the effect of policy-based finance for the period 1963-91 for Japan's machine tool industry, an industry with high potential spillover effects on technological innovation and learning. They found that directed credit may have helped to promote investment among postwar Japanese machine tool producers. Important components of that credit seem to have spurred growth. The government credit programs did not crowd out private funds and did not succeed by providing a permanent lifeline (credit insurance) to firms. But the authors do not endorse government interventions in credit markets. For one thing, the effective operation of industrial directed credit in Japan seems to be an unrepresentative case. In many countries, such government intervention has produced large costs: inefficient borrowers have been funded and public funds have been captured by special interests. In Japan, directed-credit policy is designed to promote investment, crowd in private funds, and avoid the capture of policy funds by particular firms or industries. The priorities of credit policy are determined as part of a national plan with broad participation (rather than by special-interest lobbying), and once industry-level priorities have been established, firm-level lending decisions by agencies are shielded from political pressure. In political systems that cannot implement such effective plans for distributing industrial credit, government-directed credit programs may create more problems than they solve.
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