The experience of the sample of developed countries being considered here captures the positive role that finance can play on both these counts. As Chart 4 illustrates, the annual rate of growth of private consumer expenditure has been well above average in both the US and the UK, moderately positive in France and Germany, and extremely poor in Japan. This explains in large part the relative performance of these countries, since computations made by the OECD Secretariat (Table 1) suggest that changes in final domestic demand, rather than increases in inventories or net exports, tend to explain almost all of GDP growth in the world's leading nations.
Chart 4 >> Table 1 >>
 
Being the hub of global finance, by virtue of being home to the world's reserve currency, the US epitomizes the impact that the rise of finance can have on private consumer expenditure and the real economy. Firstly, the US was the one country in which, through the 1980s and 1990s, credit helped fuel a consumption and housing expenditure boom. Secondly, a combination of higher interest rates and confidence in the dollar, due to the US being the leader and the dollar serving as the world's reserve currency, resulted in a preference for dollar-denominated assets among the world's wealth-holders.
 
The consequent flight to the dollar, in a world of mobile finance, was self-reinforcing. To start with, the flow of capital into the US strengthened the dollar, delinking its value from real factors such as the competitiveness of US manufacturing and the deficit on the current account of US balance of payments. The stronger the dollar became, the greater was the attractiveness of US financial assets as safe investments. Further, once a significant share of the world's financial wealth was invested in dollar-denominated assets, the greater was the pressure worldwide to prevent any downturn in US financial markets and any sharp fall in the value of the dollar. Even when evidence accumulated that US financial markets were witnessing an unsustainable speculative boom, the prime concern of international finance and international financial institutions was to ensure that the necessary correction took the form of a 'soft landing' rather than a crash.
 
The movement in the New York Stock Exchange's composite index during the periods 1971-85 and 1986-91 captures the impact of these developments on the performance of US financial markets (Charts 10 and 11). In the upward climb of the NYSE index which began in the early 1980s, the annual closing high and low values of the index rose by just 50 per cent between 1980 and 1985. Maintaining a similar growth path, between 1986 and1994 these indices rose by a further 84 and 106 per cent respectively. However, during the speculative boom of the late 1990s, the high and low indices rose by 148 and 137 per cent respectively in a short span of five years, between 1994 and 1999. Subsequently, the boom tapered off, but there was no major corrective collapse in the NYSE indices during the slump years of 2000 and 2001. This partly helped prevent a collapse in the real economy, for the reasons detailed below.
Chart 10 >> Chart 11 >>
 
It is now widely accepted that, because of the direct (through investments) and indirect (through pension funds) involvement of US households in the stock market, the boom in those markets substantially increased their financial wealth. This in turn is seen to have had a 'wealth effect', as a result of which households, feeling that they had saved substantially more for the future than initially planned, resorted to a splurge in consumption. Thus, in the US, the rise of finance spurred consumption directly by fuelling credit-financed spending, and indirectly through the wealth effect. As a result, the personal savings rate in the US collapsed from 8.7 per cent in 1992 to 1 per cent in 2000 (Chart 5), reflecting the growth in consumption expenditure that helped sustain the boom in the real economy. It was in this manner that the deflationary consequences of reduced government spending were more than neutralized in the US.
Chart 5 >>
 
If everything else had remained constant this private consumption expenditure-led boom in the US should have triggered growth in the rest of the world as well. Inasmuch as US demand is serviced through imports from abroad, this is what should be expected. And both relative competitiveness and the strength of the US dollar should result in some leakage of US demand abroad. That this did happen is suggested by the facts that the boom years were ones in which world trade volumes grew at above average or remarkably high rates (Chart 7) and the deficit on the US current account widened substantially (Chart 8). In fact, there is reason to believe that the export success of individual countries like China depended on the benefits they derived from the booming consumer market in the US. But to the extent that the US remained a major player in frontline sectors like information and communication technologies and the new services, that US firms restructured themselves to improve their competitiveness and foreign firms chose to set up capacities in the US to cater to the local market, the consumption boom resulted in a real boom in the US as well.
Chart 7 >> Chart 8 >>