NBER WORKING PAPER SERIES
STOCK MARKETS, BANKS, AND GROWTH: PANEL EVIDENCE
Thorsten Beck
Ross Levine
Working Paper 9082
http://www.nber.org/papers/w9082
NATIONAL BUREAU OF ECONOMIC RESEARCH
1050 Massachusetts Avenue
Cambridge, MA 02138
July 2002
We thank Norman Loayza and two anonymous referees for helpful comments and Steve Bond for the use
of his DPD program. The views expressed herein are those of the authors and not necessarily those of the
National Bureau of Economic Research, the World Bank, its Executive Directors, or the countries they
represent.
© 2002 by Thorsten Beck and Ross Levine. All rights reserved. Short sections of text, not to exceed two
paragraphs, may be quoted without explicit permission provided that full credit, including © notice, is given
to the source.
Stock Markets, Banks, and Growth: Panel Evidence
Thorsten Beck and Ross Levine
NBER Working Paper No. 9082
July 2002
JEL No. G00, O16, F36
ABSTRACT
This paper investigates the impact of stock markets and banks on economic growth using a panel
data set for the period 1976-98 and applying recent GMM techniques developed for dynamic panels. On
balance, we find that stock markets and banks positively influence economic growth and these findings
are not due to potential biases induced by simultaneity, omitted variables or unobserved country-specific
effects.
Thorsten Beck Ross Levine
World Bank Finance Department, Room 3-257
tbeck@worldbank.org Carlson School of Management
University of Minnesota
321 19th Avenue South
Minneapolis, MN 55455
and NBER
rlevine@csom.umn.edu
1
1. Introduction
Theory provides conflicting predictions about both the impact of overall financial
development on growth and about the separate effects of stock markets on growth and banks on
economic growth. Many models emphasize that well-functioning financial intermediaries and
markets ameliorate information and transactions costs and thereby foster efficient resource allocation
and hence faster long-run growth [Bencivenga and Smith, 1991; Bencivenga, Smith, and Starr, 1995;
King and Levine, 1993a]. These models, however, also show that financial development can hurt
growth. Specifically, financial development, by enhancing resource allocation and hence the returns
to saving, may lower saving rates. If there are sufficiently large externalities associated with saving
and investment, then financial development slows long-run growth. Theory also provides conflicting
predictions about whether stock markets and banks are substitutes, compliments, or whether one is
more conducive to growth than the other. For instance, Boyd and Prescott (1986) model the critical
role that banks play in easing information frictions and therefore in improving resource allocation,
while Stiglitz (1985) and Bhide (1993) stress that stock markets will not produce the same
improvement in resource allocation and corporate governance as banks. On the other hand, some
models emphasize that markets mitigate the inefficient monopoly power exercised by banks and
stress that the competitive nature of markets encourages innovative, growth-enhancing activities as
opposed to the excessively conservative approach taken by banks [Allen and Gale, 2000]. Finally,
some theories stress that it is not banks or markets, it is banks and markets; these different
components of the financial system ameliorate different information and transaction costs.
1
Although a burgeoning empirical literature suggests that well-functioning banks accelerate
economic growth, these studies generally do not simultaneously examine stock market development.
King and Levine (1993a,b) show that bank development – as measured by the total liquid liabilities
2
of financial intermediaries (e.g., M3) divided by Gross Domestic Product (GDP) -- helps explain
economic growth in a sample of more than 80 countries. Levine (1998, 1999) and Levine, Loayza,
and Beck (2000) confirm this finding but improve upon King and Levine (1993a,b) by (1) using
measures of bank development that include only credit to private firms and therefore exclude credit to
the public sector and by (2) using instrumental variable procedures to control for simultaneity bias.
2
This literature, however, omits measures of stock market development because measures of stock
market development for a twenty-year period are only available for about 40 countries.
Omitting stock market development makes it difficult to assess whether (a) the positive
relationship between bank development and growth holds when controlling for stock market
development, (b) banks and markets each have an independent impact on economic growth, or (c)
overall financial development matters for growth but it is difficult to identify the separate impact of
stock markets and banks on economic success.
Levine and Zervos (1998) empirically assess the relationship between growth and both stock
markets and banks, but their study suffers from an assortment of econometric weaknesses. Levine
and Zervos (1998) find that initial measures of stock market liquidity and banking sector
development are both strong predictors of economic growth over the next 18 years. To measure bank
development, they use bank credit to the private sector as a share of GDP. They use an assortment of
stock market development measures, including the overall size of the market (market capitalization
relative to GDP), stock market activity (the value of trades relative to GDP), and market liquidity (the
value of trades relative to market capitalization). The ordinary least squares (OLS) approach taken
by Levine and Zervos (1998), however, does not account formally for potential simultaneity bias, nor
does it control explicitly for country fixed effects or the routine use of lagged dependent variables in
1
See, Levine (1997), Boyd and Smith (1998), Huybens and Smith (1999) and Demirguc-Kunt and Levine (2001).
3
growth regressions.
3
Further, while theory stresses the potential relationship between economic
growth and the contemporaneous level of financial development, Levine and Zervos (1998) use
initial values of stock market and bank development. This not only implies an informational loss vis-
à-vis using average values, but also a potential consistency loss.
While recent work has attempted to resolve some of the statistical weaknesses in the Levine
and Zervos (1998) study, statistical and conceptual problems remain. For instance, Arestis,
Demetriades and Luintel (2000) use quarterly data and apply time series methods to five developed
economies and show that while both banking sector and stock market development explain
subsequent growth, the effect of banking sector development is substantially larger than that of stock
market development. The sample size, however, is very limited and it is not clear whether the use of
quarterly data and Johansen’s (1988) vector error correction model fully abstracts from high
frequency factors influencing the stock market, bank, and growth nexus to focus on long-run
economic growth.
Rousseau and Wachtel (2000) make an important contribution to the literature by using panel
techniques with annual data to assess the relationship between stock markets, banks, and growth.
They use M3/GDP to measure bank development and the Levine and Zervos (1998) measures of
stock market size and activity, which they deflate by the price index of the national stock exchange to
eliminate price changes from their measure of how well the stock market functions. Rousseau and
Wachtel (2000) use the difference panel estimator -- developed by Arellano and Bond (1991) and
Holtz-Eakin, Newey, and Rosen (1990) -- that (a) differences the growth regression equation to
remove any bias created by unobserved country-specific effects, and then (b) instruments the right-
2
For time-series evidence that documents the positive impact of financial intermediary development on economic growth,
see Rousseau (1998) and Wachtel and Rousseau (1995).
