Introduction

For generations, economists have resorted to blaming ‘imperfections’ in the capital market for a whole host of phenomena, and institutional economists have criticized the relevance of much of traditional neo–classical analysis because of its reliance on the assumption of perfect capital markets. We agree with that criticism. We would argue, however, that economic theory should ‘explain’ institutional structures, at least those that take on the prominence that ‘capital market imperfections’ have. These are matters of more than just academic interest: if the nature of the imperfections are, in some sense, endogenous, then government policies may well affect them; they cannot simply be taken as given.

This paper is part of a research program aimed at explaining certain key elements of the capital market. Many of the central aspects of this market can be understood once the asymmetries of information, and the costs of acquiring information are taken into account. Earlier studies have shown how these informational imperfections may make it very costly for firms to raise funds on the equity market (Greenwald, Stiglitz and Weiss (1984)), and why they may give rise to credit rationing (Stiglitz and Weiss (1981) and (1983)). In particular, in our earlier study, we argued that banks might not raise the rate of interest they charged on loans, even in the presence of an excess demand for credit, because to do so might lower the return they receive.