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Financial Development Role of Financial Systems in Economic Growth

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Financial Development Role of Financial Systems in Economic Growth POLICY RESEARCH WORKING PAPER 1678 FinancialDevelopment A growing body of theoretical and empirical work would and Economic Growth push even skeptcs toward the belief that the Views and Agenda development of financial marketsand institutions is critical to economic growth, Ross Levine rather than a sideshow or a passiveresponse to growth. The World Bank PolicyResearch Department Finance and Private Sector DevelopmentDivision October 1996 | POLICYRESEARCH WORKING PAPER 1678 Summary findings Levine argues that the preponderance of theoretical Without minimizing the role of institutions, Levine reasoning and empirical evidence suggests a positive, advocates a functional approach to understanding the first-order relationship between financial development role of financial systems in economic growth. This and economic growth. There is even evidence that the approach focuses on the ties between growth and the level of financial development is a good predictor of quality of the functions provided by the financial system. future rates of economic growth, capital accumulation, Levine discourages a narrow focus on one financial and technological change. instrument, such as money, or a particular institution, Moreover, cross-country, case-study, industry-level, such as banks. Instead, he addresses the more and firm-level analyses document extensive periods when comprehensive, and difficult, question: What is the financial development (or the lack thereof) crucially relationship between financial structure and the affects the speed and pattern of economic development. functioning of the financial system? Levine explains what the financial system does and More research is needed on financial development. how it affects, and is affected by, economic growth. Why does financial structure change as countries grow, Theory suggests that financial instruments, markets, and for example? Why do countries at similar stages of institutions arise to mitigate the effects of information economic development have different looking financial and transaction costs. A growing literature shows that systems? Are there long-run economic growth advantages differences in how well financial systems reduce to adopting legal and policy changes that create one type information and transaction costs influence savings rates, of financial structure rather than another? investment decisions, technological innovation, and long- run growth rates. A less developed theoretical literature shows how changes in economic activity can influence financial systems. This paper is a product of the Finance and Private Sector Development Division, Policy Research Department. Copies of the paper are available free from the World Bank, 1818 H Street NW, Washington, DC 20433. Please contact Paulina Sintim-Aboagye, room N9-030, telephone 202-473-8526, fax 202-522-1155, Internet address psintimaboagye @worldbank.org. October 1996. (76 pages) ThePolicy Research Working Paper Series disseminates the findings of workin progressto encouragethe exchange of ideasabout de-elopmentissues. An objective of the series is toget the findings out quickly, even if thepresentations are less than fully polished.The paperscarry the names of theauthors and should he used and cited accordingly. The findings, interpretations, and conclusions are the authors'own and should not heattributed to theWorld Bank, its ExecutiveBoard of Directors,or anyof its membercountries. Produced by the Policy Research Dissemination Center Financial Development and Economic Growth: Views and Agenda Ross Levine Finance and Private Sector Development Division Policy Research Department World Bank * I thank,without implicating, Jerry Caprio,Maruja Carkovic, David Cole, Bob Cull, Bill Easterly, MarkGertler, John Pencavel, Fabio Schiantarelli,Mary Shirley,Bruce Smith, and Ken Sokolofffor criticisms, guidance,and encouragement. I I. Introduction: Goals and Boundaries "Does finance make a difference ... ?" Raymond Goldsmith (1969, p. 408) Economists hold startlingly different opinions regarding the importance of the financial system for economic growth. Walter Bagehot (1873) and John Hicks (1969) argue that the financial system played a critical role in igniting industrialization in England by facilitating the mobilization of capital for 'immense works.' Joseph Schumpeter (1912) contends that well- functioning banks spur technological innovation by identifying and funding those entrepreneurs with the best chances of successfully implementing innovative products and production processes. In contrast, Joan Robinson (1952, p. 86) declares that "where enterprise leads finance follows." According to this view, economic development creates demands for particular types of financial arrangements, and the financial system responds automatically to these demands. Moreover, some economists just do not believe that the finance-growth relationship is important. Robert Lucas (1988, p. 6) asserts that economists 'badly over-stress' the role of financial factors in economic growth, while development economists frequently express their skepticism about the role of the financial system by ignoring it (Anand Chandavarkar 1992). For example, a collection of essays by the 'pioneers of development economics,' including three Nobel Laureates, does not mention finance (Gerald Meir and Dudley Seers 1984). Furthermore, Nicholas Stem's (1989) review of development economics does not discuss the financial system, even in a section that lists omitted topics. In light of these conflicting views, this paper uses existing theory to organize an analytical framework of the finance-growth nexus and then assesses the quantitative importance of the financial system in economic growth. 2 Although conclusions must be stated hesitantly and with ample qualifications, the preponderance of theoretical reasoning and empirical evidence suggests a positive, first-order relationship between financial development and economic growth. A growing body of work would push even most skeptics toward the belief that the development of financial markets and institutions is a critical and inextricable part of the growth process and away from the view that the financial system is an inconsequential sideshow, responding passively to economic growth and industrialization. There is even evidence that the level of financial development is a good predictor of future rates of economic growth, capital accumulation, and technological change. Moreover, cross-country, case-study, industry-level, and firm-level analyses document extensive periods when financial development -- or the lack thereof -- crucially affects the speed and pattern of economic development. To arrive at these conclusions and to highlight areas in acute need of additional research, I organize the remainder of this paper as follows. Section II explains what the financial system does and how it affects -- and is affected by -- economic growth. Theory suggests that financial instruments, markets, and institutions arise to mitigate the effects of information and transaction costs.' Furthermore, a growing literature shows that differences in how well financial systems reduce information and transaction costs influence saving rates, investment decisions, technological innovation, and long-run growth rates. Also, a comparatively less-developed theoretical literature demonstrates how changes in economic activity can influence financial systems. These frictions include the costs of acquiring information, enforcing contracts, and exchanging goods and financial claims. 3 Section II also advocates the functional approach to understanding the role of financial systems in economic growth. This approach focuses on the ties between growth and the quality of the functions provided by the financial system. These functions include facilitating the trading of risk, allocating capital, monitoring managers, mobilizing savings, and easing the trading of goods, services, and financial contracts.2 The basic functions remain constant through time and across countries. There are large differences across countries and time, however, in the quality of financial services and in the types of financial instruments, markets, and institutions that arise to provide these services. While focusing on functions, this approach does not diminish the role of institutions. Indeed, the functional approach highlights the importance of examining an under- researched topic: the relationship between financial structure -- the mix of financial instruments, markets, and institutions -- and the provision of financial services. Thus, this approach discourages a narrow focus on one financial instrument, like money, or a particular institution, like banks. Instead, the functional approach prompts a more comprehensive -- and more difficult -- question: what is the relationship between financial structure and the functioning of the financial system?3 Part III then turns to the evidence. While many gaps remain, broad cross-country 2 For different ways of categorizing financial functions, see David Cole and Betty Slade (1991) and Robert C. Merton and Zvi Bodie (1995). 3 The major alternative approach to studying finance and economic growth is based on the seminal contributions of John Gurley and Edward Shaw (1955), James Tobin (1965), and Ronald McKinnon (1973). In their formal models, they focus on money. This narrow focus can restrict the analysis of the finance-growth nexus, and lead to a misleading distinction between the "real" and financial sectors. In contrast, the functional
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