Joseph Schumpeter argued in 1911 that the services provided by financial intermediaries - mobilizing savings, evaluating projects, managing risk, monitoring managers, and facilitating transactions -stimulate technological innovation and economic development. The authors present evidence that supports this view. Examining a cross-section of about 80 countries for the period 1960-89, they find that various measures of financial development are strongly associated with both current and later rates of economic growth. Each measure has shortcomings but all tell the same story: finance matters. They present three main findings, which are robust to many specification tests: The average level of financial development for 1960-89 is very strongly associated with growth for the period. Financial development precedes growth. For example, financial depth in 1960 (the ratio of broad money to GDP) is positively and significantly related to real per capita GDP growth over the next 30 years even after controlling for a variety of country-specific characteristics and policy indicators. Financial development is positively associated with both investment rate and the efficiency with which economies use capital. Much work remains to be done, but the data are consistent with Schumpeter's view that the services provided by financial intermediaries stimulate long-run growth.

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Finance and Growth: Schumpeter Might Be Right

Does finance affect economic growth? A number of studies have identified a positive correlation between the level of development of a country's financial sector and the rate of growth of its per capita income. As has been noted elsewhere, the observed correlation does not necessarily imply a causal relationship. This paper examines whether financial development facilitates economic growth by scrutinizing one rationale for such a relationship; that financial development reduces the costs of external finance to firms. Specifically, we ask whether industrial sectors that are relatively more in need of external finance develop disproportionately faster in countries with more developed financial markets. We find this to be true in a large sample of countries over the 1980s. We show this result is unlikely to be driven by omitted variables, outliers, or reverse causality.

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Financial Dependence and Growth

The author argues that the preponderance of theoretical reasoning and empirical evidence suggests a positive first order relationship between financial development and economic growth. There is evidence that the financial development level is a good predictor of future rates of economic growth, capital accumulation, and technological change. Moreover, cross-country, case-style, industry level and firm-level analysis document extensive periods when financial development crucially affects the speed and pattern of economic development. The author 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. A growing literature shows that differences in how well financial systems reduce information and transaction costs influence savings rates, investment decisions, technological innovation, and long-run growth rates. A less developed theoretical literature shows how changes in economic activity can influence financial systems. The author advocates a 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 systems. The author discourages a narrow focus on one financial instrument, or a particular institution. Instead, the author addresses the more comprehensive question: What is the relationship between financial structure and the functioning of the financial system?

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Financial development and economic growth : views and agenda

Explaining cross-country differences in growth rates requires not only an understanding of the link between growth and public policies, but also an understanding of why countries choose different public policies. This paper shows that ethnic diversity helps explain cross-country differences in public policies and other economic indicators. In the case of Sub-Saharan Africa, economic growth is associated with low schooling, political instability, underdeveloped financial systems, distorted foreign exchange markets, high government deficits, and insufficient infrastructure. Africa's high ethnic fragmentation explains a significant part of most of these characteristics.

https://williameasterly.files.wordpress.com/2010/08/17_easterly_levine_africasgrowthtragedy_prp.pdf

Africa's Growth Tragedy: Policies and Ethnic Divisions

Examining the correlation between trade and income cannot identify the direction of causation between the two. Countries’ geographic characteristics, however, have important effects on trade, and are plausibly uncorrelated with other determinants of income. This paper therefore constructs measures of the geographic component of countries’ trade, and uses those measures to obtain instrumental variables estimates of the effect of trade on income. The results provide no evidence that ordinary least-squares estimates overstate the effects of trade. Further, they suggest that trade has a quantitatively large and robust, though only moderately statistically significant, positive effect on income. (JEL F43, 040)

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Does Trade Cause Growth

A vast amount of literature uses cross-country regressions to find empirical links between policy indicators and long-run average growth rates. The authors study whether the conclusions from existing studies are robust or fragile when small changes in the list of independent variables occur. They find that although"policy"appears to be importantly related to growth, there is no strong independent relationship between growth and almost every existing policy indicator. They also find that very few macroeconomic variables are robustly correlated with cross-country growth rates. They clarify the conditions under which one finds convergence of per capita output levels and confirm the positive correlation between the share of investment in GDP and long-run growth. They conclude that all findings using the share of exports in GDP could be obtained almost identically using the total trade or import share and also that few commonly used fiscal indicators are robustly correlated with growth. Finally, the authors highlight the importance of considering alternative specifications in cross-country growth regressions.

A sensitivity analysis of cross-country growth regressions

A vast literature uses cross-country regressions to search for empirical linkages between long-run growth rates and a variety of economic policy, political, and institutional indicators. This paper examines whether the conclusions from existing studies are robust or fragile to small changes in the conditioning information set. The authors find that almost all results are fragile. They do, however, identify a positive, robust correlation between growth and the share of investment in GDP and between the investment share and the ratio of international trade to GDP. The authors clarify the conditions under which there is evidence of per capita output convergence.

In recent years, economists have developed new models of endogenous economic growth that consider policy influences on growth and divergent outcomes among countries. These models deal with such issues as growth, the operation of financial markets, trade policy, government expenditures, and taxation. Using the standard neoclassical growth model as a point of departure, the author reviewed important recent developments in growth theory. He analyzed the methodology of several endogenous growth models and examined models aimed at particular policy issues. One reason for the success of the standard neoclassical growth model, is that it provided a convenient tool for organizing data on the sources of economic growth. The model left much of the growth unexplained, however. Cross-sectional analysis has provided some useful insights into the growth process. Economists working in this area should target their work directly to the analysis of policy options in developing countries. More work is also necessary at the sectoral level. The new models of growth have not adequately described the issues of structural transformation and disequilibrium in factor markets. Policymaking generally will benefit from empirical results generated from more carefully constructed structural economic models.

David Renelt

Papers

A sensitivity analysis of cross-country growth regressions

A sensitivity analysis of cross-country growth regressions

Economic growth : a review of the theoretical and empirical literature