More on Finance and Growth: More Finance, More Growth? Ross Levine obel Prize winners disagree about the impact cross-country, panel, and microeconomic-based of the financial sector on economic growth. studies. Also, this paper does not discuss the theory NSome do not even consider finance worth surrounding the role of financial contracts, markets, discussing. A collection of essays by the “pioneers and intermediaries in economic growth.1 of development economics”—including three win- The growing body of empirical research, using ners of the Nobel Prize in Economics—does not different statistical procedures and data sets, pro- discuss finance (Meier and Seers, 1984). At the other duces remarkably consistent results. First, countries extreme, Nobel Prize winner Merton Miller (1998, with better-developed financial systems tend to grow p. 14) recently remarked “that financial markets faster—specifically, those with (i) large, privately contribute to economic growth is a proposition owned banks that funnel credit to private enterprises almost too obvious for serious discussion.” As a and (ii) liquid stock exchanges. The levels of banking third view, Nobel Laureate Robert Lucas (1988) development and stock market liquidity each exert holds that the role of finance in economic growth a positive influence on economic growth. Second, has been “over-stressed” by the growth literature. simultaneity bias does not seem to be the cause of Resolving the debate about the importance of finan- this result. Third, better-functioning financial sys- cial development for economic growth is important tems ease the external financing constraints that for distinguishing among theoretical models. More impede firm and industrial expansion. Thus, access importantly, information on the importance of to external capital is one channel through which finance for growth will affect the intensity with financial development matters for growth because which researchers and policymakers attempt to it allows financially constrained firms to expand. identify and construct appropriate financial sector Each of the different statistical procedures that reforms around the world. have been brought to bear on the finance-growth This paper selectively discusses recent empirical debate has methodological shortcomings, which work on the controversial issue of whether financial emphasizes the need for additional research to systems play a critical role in determining long-run clarify the relationship between finance and growth. rates of economic growth. Building on work by Moreover, data problems plague the study of finance Bagehot (1873), Schumpeter (1912), Gurley and Shaw and growth in general. Perhaps the biggest data (1955), Goldsmith (1969), and McKinnon (1973), problem involves the empirical proxies of “financial recent research has employed different econometric development,” because it is difficult to construct methodologies and data sets to assess the role of accurate, consistent measures of financial develop- the financial sector in stimulating economic growth. ment for a broad cross-section of countries. Thus, I will focus on three classes of empirical studies: more microeconomic-based studies that explore (i) pure cross-country growth regressions, (ii) panel the possible channels through which finance influ- techniques that exploit both the cross-country ences growth will foster a keener understanding of and time-series dimensions of the data, and (iii) the finance-growth nexus. Without ignoring the microeconomic-based studies that examine the weaknesses of existing work and the need for future mechanisms through which finance may influence research, the consistency of existing empirical results economic growth. Thus, I will largely ignore country across different data sets and statistical procedures case studies and purely time-series investigations, suggests that finance plays an important role in the which generally confirm the conclusions from the process of economic growth. The body of existing work motivates research Ross Levine holds the Curtis L. Carlson Chair of Finance at the University of Minnesota. The author thanks Luigi Zingales for helpful 1 comments. For a review of the theory of finance and growth and a discussion of the time-series and case-study literature, see Levine (1997 and © 2003, The Federal Reserve Bank of St. Louis. 2002a). JULY/AUGUST 2003 31 Levine R EVIEW Table 1 Growth and Financial Intermediary Development, 1960-89 Dependent variables Real per capita Real per capita GDP growth capital growth Productivity growth DEPTH 2.4** 2.2** 1.8** (0.007) (0.006) (0.026) R2 0.50 0.65 0.42 NOTE: Observations: 77. **Indicates significance at the 5 percent level; p-values are in parentheses. Variable definitions: DEPTH = liquid liabilities/GDP; productivity growth = real per capita GDP growth – (0.3)*(real per capita capital growth). Other explanatory variables included in each of the nine regression results reported above: logarithm of intial income, logarithm of initial secondary school enrollment, ratio of government consumption expenditures to GDP, inflation rate, and ratio of exports plus imports to GDP. King and Levine (1993b) define 2 percent growth as 0.02. For comparability with subsequent tables, we have redefined 2 percent growth as 2.00 and adjusted the coefficients by a factor of 100. SOURCE: King and Levine (1993b, Table VII). into the determinants of financial development. If black market exchange rate premia, government financial development is crucial for growth, how spending, openness to trade, and political instability. can countries develop well-functioning financial Furthermore, they examine whether financial systems? What legal, regulatory, and policy changes development is associated with productivity growth would foster the emergence of growth-enhancing and capital accumulation, which are two channels financial markets and intermediaries? While I do through which finance may influence economic not discuss this emerging literature, I point to some growth. recent work on this question in the conclusion. King and Levine (1993b) (henceforth KL) study The remainder of the paper proceeds as follows. 77 countries over the period 1960-89. To measure The next section discusses cross-country studies of financial development, KL focus on DEPTH, which growth. The third section reviews panel studies of equals the size of the financial intermediary sector. growth, and the fourth section analyzes industry- It equals the liquid liabilities of the financial system and firm-level research on the finance-growth nexus. (currency plus demand and interest-bearing liabili- ties of banks and nonbank financial intermediaries) CROSS-COUNTRY STUDIES divided by gross domestic product (GDP). An impor- Financial Intermediaries and Growth tant weakness of this measure of financial develop- ment is that DEPTH measures the size of the financial I first examine the application of broad cross- intermediary sector. It may not, however, represent an country growth regressions to the study of finance accurate proxy for the functioning of the financial and growth. These studies aggregate economic system. It may not proxy for how well bank research growth over long periods, a decade or more, and firms exert corporate control or provide risk manage- assess the relationship between long-run growth ment services to clients. KL experiment with alter- and measures of financial development. King and native measures of financial development that are Levine (1993a,b,c) build on earlier cross-country designed to gauge who is conducting credit alloca- work by Goldsmith (1969). In particular, King and tion, i.e., whether it is banks or the government, Levine (1993a,b,c) more than double Goldsmith’s and to where the credit is flowing, i.e., to the private (1969) sample of countries, study growth over a sector or to the government and state-owned enter- 30-year horizon, and systematically control for many prises. They obtain similar results with these alterna- possible determinants of economic growth such as tive indicators of financial development (also see initial income, educational attainment, inflation, La Porta, Lopez-de-Silanes, and Shleifer, 2002). 32 JULY/AUGUST 2003 FEDERAL RESERVE BANK OF ST. LOUIS Levine Table 2 Growth and Initial Financial Depth, 1960-89 Dependent variables Real per capita Real per capita GDP growth capital growth Productivity growth DEPTH 2.8** 1.9** 2.2** (0.001) (0.001) (0.001) R2 0.61 0.63 0.58 NOTE: Observations: 57. **Indicates significance at the 5 percent level; p-values are in parentheses. Variable definitions: DEPTH = liquid liabilities/GDP; productivity growth = real per capita GDP growth – (0.3)*(real per capita capital growth). Other explanatory variables included in each of the nine regression results reported above: logarithm of intial income, logarithm of initial secondary school enrollment, ratio of government consumption expenditures to GDP, inflation rate, and ratio of exports plus imports to GDP. King and Levine (1993b) define 2 percent growth as 0.02. For comparability with subsequent tables, we have redefined 2 percent growth as 2.00 and adjusted the coefficients by a factor of 100. SOURCE: King and Levine (1993b, Table VII) and Levine (1997, Table 3). KL assess the strength of the empirical relation- percent of countries is about 5 percent per annum ship between DEPTH averaged over the 1960-89 over this 30-year period. Thus, the rise in DEPTH period and three growth indicators also averaged alone eliminates 20 percent