Ask Dr. Econ

January 2005

Please explain how financial markets may affect economic performance.

Great question. The simple response is that well-developed, smoothly operating financial markets play an important role in contributing to the health and efficiency of an economy. There is a strong positive relationship between financial market development and economic growth. For example, in Chapter 1 of their 2001 book, Financial Structure and Economic Growth, editors Demirgüç-Kunt and Levine concluded:

In particular, researchers have provided additional findings on the finance-growth nexus and have offered a much bolder appraisal of the causal relationship; firm-level, industry-level, and cross-country studies all suggest that the level of financial development exerts a large, positive impact on economic growth.

Financial markets help to efficiently direct the flow of savings and investment in the economy in ways that facilitate the accumulation of capital and the production of goods and services. The combination of well-developed financial markets and institutions, as well as a diverse array of financial products and instruments, suits the needs of borrowers and lenders and therefore the overall economy.

What are financial markets and institutions?

Financial markets (such as those that trade stocks or bonds), instruments (from bank CDs to futures and derivatives), and institutions (from banks to insurance companies to mutual funds and pension funds) provide opportunities for investors to specialize in particular markets or services, diversify risks, or both. As noted by Demirgüç-Kunt and Levine, together financial markets and financial institutions contribute to economic growth; the relative mix of the two does not appear to be an important factor in growth.

Large financial markets with lots of trading activity provide more liquidity for market participants than thinner markets with few available securities and participants and thus limited trading opportunities. The U.S. financial system is generally considered to be the most well developed in the world. Daily transactions in the financial markets—both the money (short term, a year or less) and capital (over a year) markets—are huge. Many financial assets are liquid; some may have secondary markets to facilitate the transfer of existing financial assets at a low cost. Table I provides a list of several well-known U.S. financial markets, ranked by outstanding assets or liabilities as of 2004.

The U.S. also has a well-developed financial services industry. It includes such familiar types of financial institutions as banks, pension funds, mutual funds, and insurance companies. Table II provides a list of several categories of U.S. financial institutions, ranked by outstanding assets as of 2004.

TABLE I

TABLE II

For comparison purposes: U.S. GDP in current dollars in 2004 was $11,735 billion.

Why are financial markets and institutions important?

Financial markets play a critical role in the accumulation of capital and the production of goods and services. The price of credit and returns on investment provide signals to producers and consumers—financial market participants. Those signals help direct funds (from savers, mainly households and businesses) to the consumers, businesses, governments, and investors that would like to borrow money by connecting those who value the funds most highly (i.e., are willing to pay a higher price, or interest rate), to willing lenders. In a similar way, the existence of robust financial markets and institutions also facilitates the international flow of funds between countries.

In addition, efficient financial markets and institutions tend to lower search and transactions costs in the economy. By providing a large array of financial products, with varying risk and pricing structures as well as maturity, a well-developed financial system offers products to participants that provide borrowers and lenders with a close match for their needs. Individuals, businesses, and governments in need of funds can easily discover which financial institutions or which financial markets may provide funding and what the cost will be for the borrower. This allows investors to compare the cost of financing to their expected return on investment, thus making the investment choice that best suits their needs. In this way, financial markets direct the allocation of credit throughout the economy—and facilitate the production of goods and services.

A recent example: Integrating existing EU financial markets

The European Union, with its single banking market and single currency, the Euro, has created Europe-wide financial markets and institutions. These markets use the Euro to facilitate saving, investment, borrowing, and lending. Euro-denominated stock, bond, and derivative markets serve all of the EU countries that use the Euro—replacing smaller, less-liquid, offerings and products that previously were available mostly on a country-by-country basis.

In addition, the Euro likely increases the attractiveness of Euro-based financial markets and instruments to the rest of the world. Within the EU, the Euro eliminates the cross-border exchange rate risks that are part of transactions between countries with different currencies. The Euro and integrated “Euro-based” financial markets and institutions should make the credit allocation process in Europe more competitive and more efficient in the long run.

What happens without well-developed financial markets?

In many developing nations, limited financial markets, instruments, and financial institutions, as well as poorly defined legal systems, may make it more costly to raise capital and may lower the return on savings or investments. Limited information or lack of financial transparency mean that information is not as readily available to market participants and risks may be higher than in economies with more fully-developed financial systems. In addition, it is more difficult to hold a diversified portfolio in small markets with only a limited selection of financial assets or savings and investment products. In such thin financial markets with little trading activity and few alternatives, it may be more difficult and costly to find the right product, maturity, or risk profile to satisfy the needs of borrowers and lenders.

More evidence that financial development matters

For further research on the topic, you may wish to review a 2002 study of financial structure and macroeconomic performance by Lopez and Spiegel, economists at the Federal Reserve Bank of San Francisco. With respect to the long-run relationship between financial systems and the economy, they reached the following conclusion:

We examine the relationship between indicators of financial development and economic performance for a cross-country panel over long and short periods. Our long-term results are consistent with much of the literature in that we find a positive relationship between financial development and economic growth.

Their findings also shed light on why financial development affects growth:

These results therefore indicate that the primary channel for financial development to facilitate growth over the long run is through physical and human capital accumulation.

References

Beck, Thorsten, Asli Demirgüç-Kunt, and Ross Levine. 2004. “Finance, Inequality, and Poverty: Cross-Country Evidence.” NBER Working Paper No. 10979, December 2004.

Beck, Thorsten, Asli Demirgüç-Kunt, Luc Laeven, and Ross Levine. 2004. “Finance, Firm Size, and Growth.” NBER Working Paper No. 10983, December 2004.

Demirgüç-Kunt, Asli and Ross Levine, editors. 2001, “Financial Structure and Economic Growth,” Cambridge, Massachusetts, The MIT Press. See Introduction, Chapter 1.

Fabozzi, Frank J., Franco Modigliani, and Michael G. Ferri. 1994. “Foundations of Financial Markets and Institutions.” Englewood Cliffs, New Jersey: Prentice Hall Inc., Chapters 1-3.

Levine, Ross. 2004. “Finance and Growth: Theory and Evidence.” NBER Working Paper No. 10766, September 2004.

Lopez, Jose A. and Mark M. Spiegel. 2002. “Financial structure and macroeconomic performance over the short and long run.” Federal Reserve Bank of San Francisco, Pacific Basin Working Paper Series. 02-05. September 2002. See Abstract.

Rose, Peter S. 1994. “Money and Capital Markets.” Burr Ridge, Illinois: Irwin, 5th Edition. See Chapter 1.