FRBSF Economic Letter
2003-18; June 27, 2003
Financial Development, Productivity, and Economic Growth
Policymakers and economists generally agree that financial developmentthat
is, well-functioning financial institutions and markets, such as commercial
and investment banks, and bond and stock exchangescontribute to
economic growth. More debatable, however, have been issues about how financial
development promotes growth. These issues would have an impact on choosing
the design for financial policies and regulations.
In this Economic Letter, I discuss recent empirical studies on
the relationship between financial development and growth. I begin with
a review of studies indicating that financial sector development does
improve growth. Then I address two fundamental questions. First, does
financial sector development help growth through faster capital accumulation,
or does it also improve sustained productivity growth? Second, what is
the impact of financial regulation on the relationship between financial
sector development and growth? These empirical studies consider a range
of data, including aggregated, national level data (e.g., gross domestic
product and the size of the overall financial sector), and disaggregated,
industry-level and firm-level data (e.g., earnings and borrowing by firms).
Aggregate data are more useful in studying the overall impact of financial
sector development on growth across countries, while the added detail
of disaggregated data is useful in identifying the particular channels
by which financial development affects growth and in studying the importance
of financial regulation.
Does financial development cause growth?
The prevailing view in economics is that financial development contributes
to growth in various ways. For example, financial institutions are better
suited than individuals to identify potentially successful projects because
these institutions are big enough to pay large fixed costs of collecting
information about individual projects and to analyze this information
more efficiently. In addition, once a project has started, they can better
monitor its managers to ensure that savers' resources are used productively.
Financial markets also can enhance growth. First, they help collect resources
from many savers necessary to invest in large projects. Second, they facilitate
the pooling and hedging of risk inherent in individual projects and industries.
Finally, secondary financial markets also reduce securities holders' liquidity
risk by allowing them to sell their securities without affecting firms'
access to the funds initially invested. Thus, well-developed financial
markets and institutions can generate growth by increasing the pool of
funds and by reducing the risk and enhancing the productivity of fund
transfers from savers to investment projects.
Economists have found empirical evidence that countries with developed
financial systems tend to grow faster. King and Levine (1993) find that
growth is positively related to the level of financial development. Looking
at the evidence from 80 countries from 1960 to 1989, they show that the
relative size of the financial sector in 1960 is positively correlated
with economic growth over the period. However, positive correlation may
simply reflect the fact that faster growing countries have larger financial
sectors because of the increase in the number of financial transactions
conducted. By measuring financial sector development at the beginning
of the period, in 1960, King and Levine try to mitigate concerns about
possible reverse causation between financial development and economic
However, this evidence does not necessarily prove that financial development
causes growth. The size of the financial sector in 1960 may depend on
the expectation of future economic growth. Subsequent work using statistical
techniques to control for the endogenous effect of economic growth on
financial development as well as for country-specific factors that are
not explicitly considered, and using both time series and cross-sectional
data to extract more information from the data, has shown that the effect
of financial development is robust (For example, Levine, Loayza, and Beck
2000, Benhabib and Spiegel 2000).
What are the transmission channels?
The economics profession has evolved in its views of the primary factors
driving economic growth. Traditionally, economic growth theory focused
on labor usage and capital accumulation as the main engines of long-run
growth. This approach, however, has been unable to explain sustained growth
without also assuming ongoing productivity growth, because the impact
of capital accumulation is limited by diminishing returns for a given
labor force; each unit of capital added in the economy will have a smaller
marginal improvement on output. Beyond some point, the marginal return
on adding new capital will be smaller than the marginal cost of adding
new capital. Therefore, growth would stop at this point without increases
"New" growth theory has focused on the ongoing technological
change that raises productivity as the main engine of growth. In principle,
technological development could lead to sustained long-term growth because
the increases in productivity would be enough to offset the decreases
in productivity from diminishing returns to capital accumulation. "New"
growth theory models the production of new and better technologies through
research and development in an imperfectly competitive sector, for example.
Thus, it can generate growth as a result of the economic structure. Thus,
it is often termed "endogenous growth theory."
The question then becomes whether financial sector development affects
growth through the channel of capital accumulation, as in the old growth
theory, or through the channel of productivity increases engendered by
knowledge creation, as in the endogenous growth theory. The second channel
is potentially more important because it implies that growth may be sustainable
for long periods. Benhabib and Spiegel (2000) find that both channels
are present: financial development improves capital accumulation as well
as productivity growth.
To assess which channel is more important, it is useful to look at the
relationship between financial development and growth at the industry
and firm level, because it is much more likely that the level of a country's
financial development affects the behavior of particular firms rather
than the other way around. In a study using firm-level data, Rajan and
Zingales (1998) find that younger firms in higher productivity sectors
tend to depend more on external finance and therefore benefit more from
the lower cost of financing in a developed financial system than do more
established firms. This finding suggests that if these younger firms represent
the units of production where new and more efficient technologies are
created, then financial development may improve productivity growth, thus
potentially sustaining long-run growth.
Some economists have focused on events that have led to large changes
in the size and development of the financial sector in a short period
of time to isolate the impact of financial development on growth within
a country over time. These studies are usually called "event studies."
A study by Galindo, Schiantarelli, and Weiss (2002) evaluates whether
financial liberalizations in 12 developing countries are accompanied by
an improvement in the allocation of capital to firms. Of course, because
financial liberalizations usually are not implemented in isolation, it
is important to control for other changes in the economic and legal environment
that also may affect growth. The authors find an increase in the efficiency
with which investment funds are allocated following reform. This effect
holds for most countries in the study and persists after controlling for
other possible sources of improvements of resource allocation, such as
trade reform or other macroeconomic structural reforms.
What is the role of regulation?
How do financial regulations affect the relationship between financial
sector development and growth? A common finding of the studies by Rajan
and Zingales (1998) and Galindo, Schiantarelli, and Weiss (2002) is that
the positive impact of financial development on growth depends on the
quality of financial regulations and supervision. Rajan and Zingales find
the quality of corporate governance predicts higher growth in financially
dependent firms. Galindo, Schiantarelli, and Weiss also find that financial
liberalization has more beneficial effects if there is better regulation
and supervision. Levine, Loayza, and Beck (2000) find that cross-country
differences in legal and accounting systems are important factors in determining
financial sector development. In particular, countries with regulations
that give creditors priority in receiving their claims on corporations,
encourage publication of more comprehensive and accurate financial statements,
and are more efficient at imposing compliance with financial regulations
have better functioning financial systems. They also find that contract
enforcement, for example, in the case of property rights, is even more
important than the formal regulatory code in financial development. Thus,
strengthening financial regulations and enforcement has a positive effect
on long-run growth.
Recent economic literature has documented that financial development
is associated with higher economic growth. Moreover, there is strong cross-country
and industry-level evidence that financial development causes growth through
increases in the rate of capital accumulation and through the allocation
of funds to more productive firms, leading to overall improvement in productivity.
Finally, financial regulation is an important determinant of the development
of the financial sector, which improves the relationship between financial
development and growth.
Understanding how financial development promotes growth is important
for designing financial policies and regulations. For instance, financial
liberalization in emerging markets often is followed by an expansion of
the financial sector. Depending on the channel of transmission between
financial sector development and growth, policies may be designed to make
the channel more effective. For example, if financial sector development
affects growth mainly through improved monitoring of managers of individual
projects, then establishing and enforcing regulations that prevent conflicts
of interest that may arise when a person in charge of evaluating a firm
has a financial stake in the same firm may improve the health of the financial
The long-run benefits of having a better financial system still must
be weighed against possible short-run costs. One way for countries to
develop their financial systems is to open up the sector to foreign competition
and liberalize international capital flows. However, many countries are
reluctant to do so because it also may expose them to more foreign shocks.
Moreover, many economists also argue that if the institutional framework
in which the banks operate is not well enough developed, the costs of
liberalization may be high. A poorly regulated financial system may increase
a country's susceptibility to bank runs and balance of payments crises
(due to more external shocks), crony capitalism (due to poor enforcement
of regulations), and excessive risk-taking by banks (due to implicit government
guarantees). Thus, the costs of having a larger financial system could
overwhelm the benefits from higher growth. However, the strength of the
evidence indicates that financial development, if accompanied by well-designed
regulations and enforcement, plays an important role in channeling savers'
resources to more productive firms, thus resulting in sustainable long-run
Benhabib, Jess, and Mark M. Spiegel. 2000. "The
Role of Financial Development in Growth and Investment." Journal
of Economic Growth 5 (December) pp. 341-360.
Galindo, Arturo, Fabio Schiantarelli, and Andrew
Weiss. 2002. "Does Financial Liberalization Improve the Allocation
of Investment? Micro Evidence from Developing Countries." Working
Paper 503. Boston College.
King, Robert G., and Ross Levine. 1993. "Finance
and Growth: Schumpeter Might Be Right." Quarterly Journal of Economics
108 (August) pp. 717-737.
Levine, Ross, Norman Loayza, and Thorsten Beck.
2000. "Financial Intermediation and Growth: Causality and Causes."
Journal of Monetary Economics 46 (August) pp. 31-77.
Rajan, Raghuram G., and Luigi Zingales. 1998.
"Financial Dependence and Growth." American Economic Review
88 (June) pp. 559-586.