American Economic Association
Financial Development and Economic Growth: Views and Agenda
Author(s): Ross Levine
Source: Journal of Economic Literature, Vol. 35, No. 2 (Jun., 1997), pp. 688-726
Published by: American Economic Association
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Journal of Economic Literature
Vol. XXXV (June 1997), pp. 688-726
Financial Development and Economic
Growth: Views and Agenda
Ross LEVINE
Universityof Virginia
I thank, without implicating, GerardCaprio, Maria Carkovic,David Cole, Robert Cull, William
Easterly, Mark Gertler, Fabio Schiantarelli, Mary Shirley, Bruce Smith, and Kenneth
Sokolofffor criticisms, guidance, and encouragement.This paper was written while I was at
the WorldBank. Opinionsexpressedare those of the author and do not necessarilyreflectthe
views of the WorldBank,its staff, or membercountries.
Doesfinance make a difference . . .? RaymondGoldsmith(1969, p. 408)
I. Introduction:Goals and Boundaries
ECONOMISTS HOLD startlingly different
opinions regarding the importance
of the financial system for economic
growth. Walter Bagehot (1873)
and John Hicks (1969) argue that it
played a critical role in igniting industrialization
in England by facilitating the
mobilization of capital for "immense
works." Joseph Schumpeter (1912) contends
that well-functioning banks spur
technological innovation by identifying
and funding those entrepreneurs with
the best chances of successfully implementing
innovative products and production
processes. In contrast, JoanRobinson
(1952, p. 86) declares that "where
enterprise leads finance follows." According
to this view, economic development
creates demands for particular
types of financial arrangements, and the
financial system responds automatically
to these demands. Moreover, some
economists just do not believe that the
finance-growth relationship is important.
Robert Lucas (1988, p. 6) asserts that
economists "badly over-stress" the role
of financial factors in economic growth,
while development economists frequently
express their skepticism about
the role of the financial system by ignoring
it (Anand Chandavarkar1992). For
example, a collection of essays by the
"pioneers of development economics,"
including three Nobel Laureates, does
not mention finance (Gerald Meir and
Dudley Seers 1984). Furthermore,
Nicholas Stern's (1989) review of development
economics does not discuss the
financial system, even in a section that
lists omitted topics. In light of these conflicting
views, this paper uses existing
theory to organize an analytical framework
of the finance-growth nexus and
then assesses the quantitative importance
of the financial system in economic
growth.
Although conclusions must be stated
hesitantly and with ample qualifications,
the preponderance of theoretical reasoning
and empirical evidence suggests a
positive, first-order relationship between
financial development and economic
growth. A growing body of work would
push even most skeptics toward the be-
688
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Levine: Financial Development and Economic Growth 689
lief that the development of financial
markets and institutions is a critical and
inextricable part of the growth process
and awayfrom the view that the financial
system is an inconsequential side show,
responding passively to economic growth
and industrialization. There is even evidence
that the level of financial development
is a good predictor of future
rates of economic growth, capital accumulation,
and technological change.
Moreover, cross country, case study, industry-
and firm-level analyses document
extensive periods when financial development-or
the lack thereof-crucially
affects the speed and pattern of economic
development.
To arrive at these conclusions and to
highlight areas in acute need of additional
research, I organize the remainder
of this paper as follows. Section II 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.1 Furthermore,
a growing literature shows
that differences in how well financial
systems reduce information and transaction
costs influence saving rates, investment
decisions, technological innovation,
and long-run growth rates. Also, a
comparativelyless developed theoretical
literature demonstrates how changes in
economic activity can influence financial
systems.
Section II also advocates the 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
system. These functions include facilitating
the trading of risk, allocating capital,
monitoring managers, mobilizing savings,
and easing the trading of goods,
services, and financial contracts.2 The
basic functions remain constant through
time and across countries. There are
large differences across countries and
time, however, in the quality of financial
services and in the types of financial instruments,
markets, and institutions that
arise to provide these services. While focusing
on functions, this approach does
not diminish the role of institutions. Indeed,
the functional approach highlights
the importance of examining an underresearched
topic: the relationship between
financial structure-the mix of
financial instruments, markets, and institutions-and
the provision of financial
services. Thus, this approachdiscourages
a narrow focus on one financial instrument,
like money, or a particularinstitution,
like banks. Instead, the functional
approach prompts a more comprehensive-and
more difficult-question: what
is the relationship between financial
structure and the functioning of the financial
system?3
Part III then turns to the evidence.
While many gaps remain, broad crosscountry
comparisons, individual country
studies, industry-level analyses, and
firm-level investigations point in the
1 These frictions include the costs of acquiring
information, enforcing contracts, and exchanging
goods and financialclaims.
2 For different ways of categorizing financial
functions, see Cole and Betty Slade (1991) and
Robert C. Merton and Zvi Bodie (1995).
3 The majoralternativeapproachto studying finance
and economic growth is based on the seminal
contributions of John Gurley and Edward
Shaw (1955), James Tobin (1965), and Ronald
McKinnon (1973). In their mathematical models,
as distinct from their narratives, they focus on
money. This narrowfocus can restrict the analysis
of the finance-growth nexus, and lead to a misleading
distinction between the "real"and financial
sectors. In contrast, the functional approach
highlights the value added of the financial sector.
The financial system is a "real" sector: it researches
firms and managers, exerts corporate
control, and facilitates risk management, exchange,
and resource mobilization.
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690 Journal of Economic Literature, Vol. XXXV(June 1997)
same direction: the functioning of financial
systems is vitally linked to economic
growth. Specifically, countries with
larger banks and more active stock markets
grow faster over subsequent decades
even after controlling for many
other factors underlying economic
growth. Industries and firms that rely
heavily on external financing grow disproportionately
faster in countries with
well-developed banks and securities
markets than in countries with poorly
developed financial systems. Moreover,
ample country studies suggest that differences
in financial development have,
in some countries over extensive periods,
critically influenced economic development.
Yet, these results do not imply
that finance is everywhere and alwaysexogenous
to economic growth. Economic
activity and technological innovation undoubtedly
affect the structure and quality
of financial systems. Innovations in
telecommunications and computing have
undeniably affected the financial services
industry. Moreover, "thirdfactors,"
such as a country's legal system and political
institutions certainly drive both financial
and economic development at
critical junctures during the growth process.
Nevertheless, the weight of evidence
suggests that financial systems are
a fundamental feature of the process of
economic development and that a satisfactory
understanding of the factors underlying
economic growth requires a
greater understanding of the evolution
and structure of financial systems.
As in any critique, I omit or treat cursorily
important issues. Here I highlight
two.4 First, I do not discuss the relationship
between international finance and
growth. This paper narrows its conceptual
focus by studying the financial services
available to an economy regardless
of the geographic source of those services.
In measuring financial development,
however, researchers often do not
account sufficiently for international
trade in financial services. Second, the
paper does not discuss policy. Given the
links between the functioning of the financial
system and economic growth, designing
optimal financial sector policies
is critically important. A rigorous discussion
of these policies, however, would
require a long article or book by itself.5
Instead, this paper seeks to pull together
a diverse and active literature into a coherent
view of the financial system in
economic growth.
II. TheFunctions of the Financial
System
A. Functional Approach:Introduction
The costs of acquiringinformation and
making transactions create incentives
for the emergence of financial markets
and institutions. Put differently, in a
Kenneth Arrow (1964)-Gerard Debreu
(1959) state-contingent claim framework
with no information or transaction costs,
there is no need for a financial system
that expends resources researching projects,
scrutinizing managers, or designing
arrangements to ease risk management
and facilitate transactions.Thus, anytheory
of the role of the financial system in
economic growth (implicitly or explicitly)
adds specific frictions to the ArrowDebreu
model. Financial markets and
institutions may arise to ameliorate the
problems created by information and
transactions frictions. Different types
and combinations of information and
transaction costs motivate distinct financial
contracts, markets,and institutions.
4Also, the theoretical review focuses on purely
real economies and essentially ignores work on finance
and growthin monetaryeconomies.
5 The financialpolicy literatureis immense. See,
for example, Philip Brock (1992), Alberto Giovannini
and MarthaDe Melo (1993), Caprio,IsakAtiyas,
and James Hanson (1994), and Maxwell Fry
(1995).
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Levine: Financial Development and Economic Growth 691
In arising to ameliorate transaction
and information costs, financial systems
serve one primary function: they facilitate
the allocation of resources, across
space and time, in an uncertain environment
(Merton and Bodie 1995, p. 12).
To organize the vast literature on finance
and economic activity, I break this
primary function into five basic func-
tions.
Specifically, financial systems
- facilitate the trading, hedging, diversifying,
and pooling of risk,
- allocate resources,
- monitor managers and exert corporate
control,
- mobililize savings, and
- facilitate the exchange of goods and
services.
This section explains how particular
market frictions motivate the emergence
of financial markets and intermediaries
that provide these five functions, and explains
how they affect economic growth.
I examine two channels through which
each financial function may affect economic
growth: capital accumulation and
technological innovation. On capital accumulation,
one class of growth models
uses either capital externalities or capital
goods produced using constant returns
to scale but without the use of nonreproducible
factors to generate steady-state
per capita growth (Paul Romer 1986;
Lucas 1988; Sergio Rebelo 1991). In these
models, the functions performed by the
financial system affect steady-state growth
by influencing the rate of capital formation.
The financial system affects capital
accumulation either by altering the savings
rate or by reallocating savings among
different capital producing technologies.
On technological innovation, a second
class of growth models focuses on the invention
of new production processes and
goods (Romer 1990; Gene Grossman and
Elhanan Helpman 1991; and Philippe
Marketfrictions
- informationcosts
- transactioncosts
Financialmarkets
and intermediaries
Financialfunctions
- mobilize savings
- allocateresources
- exertcorporatecontrol
- facilitateriskmanagement
- ease tradingof goods,
services,contracts
Channelsto growth
- capitalaccumulation
- technologicalinnovation
Growth
Figure 1. A Theoretical Approach to Finance
and Growth
Aghion and Peter Howitt 1992). In these
models, the functions performed by the
financial system affect steady-state
growth by altering the rate of technological
innovation. Thus, as sketched in Figure
1, the remainder of this section discusses
how specific market frictions
motivate the emergence of financial contracts,
markets, and intermediaries and
how these financial arrangements provide
five financial functions that affect
saving and allocations decisions in ways
that influence economic growth.
B. Facilitating RiskAmelioration
In the presence of specific information
and transaction costs, financial markets
and institutions may arise to ease the
trading, hedging, and pooling of risk.
This subsection considers two types of
risk: liquidity and idiosyncratic risk.
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692 Journal of Economic Literature, Vol. XXXV(June 1997)
Liquidity is the ease and speed with
which agents can convert assets into purchasing
power at agreed prices. Thus,
real estate is typically less liquid than
equities, and equities in the United
States are typically more liquid than
those traded on the Nigerian Stock Exchange.
Liquidity risk arises due to the
uncertainties associated with converting
assets into a medium of exchange. Informational
asymmetries and transaction
costs may inhibit liquidity and intensify
liquidity risk. These frictions create incentives
for the emergence of financial
markets and institutions that augment liquidity.
Liquid capital markets, therefore,
are markets where it is relatively
inexpensive to trade financial instruments
and where there is little uncertainty
about the timing and settlement of
those trades.
Before delving into formal models of
liquidity and economic activity, some intuition
and history may help motivate
the discussion. The link between liquidity
and economic development arises because
some high-return projects require
a long-run commitment of capital, but
savers do not like to relinquish control of
their savings for long periods. Thus, if
the financial system does not augment
the liquidity of long-term investments,
less investment is likely to occur in the
high-return projects. Indeed, Sir John
Hicks (1969, pp. 143-45) argues that the
capital market improvements that mitigated
liquidity risk were primarycauses
of the industrial revolution in England.
According to Hicks, the products manufactured
during the first decades of the
industrial revolution had been invented
much earlier. Thus, technological innovation
did not, spark sustained growth.
Many of these existing inventions, however,
required large injections and longrun
commitments of capital. The critical
new ingredient that ignited growth in
eighteenth century England was capital
marketliquidity. With liquid capital markets,
savers can hold assets-like equity,
bonds, or demand deposits-that they
can sell quickly and easily if they seek
access to their savings. Simultaneously,
capital marketstransformthese liquid financial
instruments into long-term capital
investments in illiquid production
processes. Because the industrial revolution
required large commitments of capital
for long periods, the industrial revolution
may not have occurred without
this liquidity transformation."Theindustrial
revolution therefore had to wait for
the financial revolution" (Valerie Bencivenga,
Bruce Smith, and Ross Starr
1966, p. 243).6
Economists have recently modeled the
emergence of financial markets in response
to liquidity risk and examined
how these financial markets affect economic
growth. For example, in Douglas
Diamond and Philip Dybvig's (1983)
seminal model of liquidity, a fraction of
savers receive shocks after choosing between
two investments: an illiquid, highreturn
project and a liquid, low-return
project. Those receiving shocks want access
to their savings before the illiquid
project produces. This risk creates incentives
for investing in the liquid, lowreturn
projects. The model assumes that
it is prohibitively costly to verify whether
another individual has received a shock
or not. This information cost assumption
rules out state-contingent insurance contracts
and creates an incentive for financial
markets-markets where individuals
issue and trade securities-to emerge. In
Levine (1991), savers receiving shocks
6 The financial revolution included the emergence
of joint-stock companies with nonredeemable
capital. The Dutch East India Company
made capital permanent in 1609, and Cromwell
made the Engfish East India Companycapitalpermanent
in 1650. These financial innovations
formed the basis of liquid equity markets (Larry
Neal 1990).
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Levine: Financial Development and Economic Growth 693
can sell their equity claims on the profits
of the illiquid production technology to
others. Marketparticipants do not verify
whether other agents received shocks or
not; participants simply trade in impersonal
stock exchanges. Thus, with liquid
stock markets, equity holders can readily
sell their shares, while firms have permanent
access to the capital invested by the
initial shareholders. By facilitating trade,
stock markets reduce liquidity risk.7 As
stock market transaction costs fall, more
investment occurs in the illiquid, highreturn
project. If illiquid projects enjoy
sufficiently large externalities, then
greater stock market liquidity induces
faster steady-state growth.
Thus far, information costs-the costs
of verifying whether savers have received
a shock-have motivated the existence
of stock markets. Trading costs
can also highlight the role of liquidity.
For example, different production technologies
may have a wide arrayof gestation
periods for converting current output
into future capital, where longer-run
technologies enjoy greater returns. Investors,
however, may be reluctant to relinquish
control of their savings for very
long periods. Thus, long-gestation production
technologies require that ownership
be transferred throughout the life
of the production process in secondary
securities markets(Bencivenga, B. Smith,
and Starr 1995). If exchanging ownership
claims is costly, then longer-run
production technologies will be less attractive.
Thus, liquidity-as measured by
secondary market trading costs-affects
production decisions. Greater liquidity
will induce a shift to longer-gestation,
higher-return technologies.
Besides stock markets, financial intermediaries-coalitions
of agents that combine
to provide financial services-may
also enhance liquidity and reduce liquidity
risk. As discussed above, Diamond
and Dybvig's (1983) model assumes it is
prohibitively costly to observe shocks to
individuals, so it is impossible to write
incentive compatible state-contingent insurance
contracts. Under these conditions,
banks can offer liquid deposits to
savers and undertake a mixture of liquid,
low-return investments to satisfy demands
on deposits and illiquid, high-return
investments. By providing demand
deposits and choosing an appropriatemixture
of liquid and illiquid investments,
banksprovide complete insurance to savers
against liquidity risk while simultaneously
facilitating long-run investments
in high-return projects. Banks replicate
the equilibrium allocation of capital that
exists with observable shocks. By eliminating
liquidity risk, banks can increase
investment in the high-return, illiquid
asset and accelerate growth (Bencivenga
and B. Smith 1991). There is a problem,
however, with this description of the role
of banks as reducing liquidity risk. The
banking equilibrium is not incentive
compatible if agents can trade in liquid
equity markets; if equity markets exist,
all agents will use equities; none will use
banks (Charles Jacklin 1987). Thus, in
this context, banks will only emerge to
provide liquidity if there are sufficiently
large impediments to trading in securities
markets (Gary Gorton and George
Pennacchi 1990).8
7 Frictionless stock markets, however, do not
eliminate liquidity risk. That is, stock markets do
not replicate the equilibrium that exists when insurance
contracts can be written contingent on observingwhether
an agent receives a shock or not.
8 Goldsmith (1969, p. 396) notes that "Claims
againstfinancialinstitutions are generally easier to
liquidate (i.e., to turn into cash without or with
only insignificant delay, formality, and cost) than
are primary debt securities. They have the additional
great advantage of being completely divisible,
whereas primarysecurities are usually issued
in fixed amounts and often in amounts that make
them very inconvenient for purchase and sale
when lenders have small resources and when numerous
individual purchase and sale transactions
are involved."
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694 Journal of Economic Literature, Vol. XXXV(June 1997)
Theory, however, suggests that enhanced
liquidity has an ambiguous affect
on savingrates and economic growth.9In
most models, greater liquidity (a)
increases investment returns and (b)
lowers uncertainty. Higher returns ambiguously
affect saving rates due to wellknown
income and substitution effects.
Further, lower uncertainty ambiguously
affects savings rates (David Levhari and
T. N. Srinivasan 1969). Thus, saving
rates may rise or fall as liquidity rises.
Indeed, in a model with physical capital
externalities, saving rates could fall
enough, so that growth actually decelerates
with greater liquidity (Tullio Jappelli
and MarcoPagano 1994).10
Besides reducing liquidity risk, financial
systems may also mitigate the risks
associated with individual projects,
firms, industries, regions, countries, etc.
Banks, mutual funds, and securities markets
all provide vehicles for trading,
pooling, and diversifying risk.1"The financial
system's abilityto provide risk diversification
services can affect long-run
economic growth by altering resource allocation
and the saving rates. The basic
intuition is straightforward.While savers
generally do not like risk, high-return
projects tend to be riskier than low-return
projects. Thus, financial markets
that ease risk diversification tend to induce
a portfolio shift toward projects
with higher expected returns (Gilles
Saint-Paul 1992; Michael Devereux and
Gregor Smith 1994; and Maurice
Obstfeld 1994). Greater risk sharing and
more efficient capital allocation, however,
have theoretically ambiguous effects
on saving rates as noted above. The
savings rate could fall enough so that,
when coupled with an externality-based
or linear growth model, overall economic
growth falls. With externalities, growth
could fall sufficiently so that overall welfare
falls with greater risk diversifica-
tion.
Besides the link between risk diversification
and capital accumulation, risk diversification
can also affect technological
change. Agents are continuously trying
to make technological advances to gain a
profitable marketniche. Besides yielding
profits to the innovator, successful innovation
accelerates technological change.
Engaging in innovation is risky,however.
The ability to hold a diversified portfolio
of innovative projects reduces risk and
promotes investment in growth-enhancing
innovative activities (with sufficiently
risk averse agents). Thus, financial systems
that ease risk diversification can accelerate
technological change and economic
growth (Robert King and Levine
1993c).
C. Acquiring Information About
Investments and Allocating
Resources
It is difficult and costly to evaluate
firms, managers, and market conditions
as discussed by Vincent Carosso (1970).
Individual savers may not have the time,
capacity, or means to collect and process
information on a wide array of enterprises,
managers, and economic conditions.
Saverswill be reluctant to invest in
activities about which there is little reli-
9The analyses described thus far focus on the
links between liquidity and capital accumulation.
Yet, liquidity may also affect the rate of technological
change if long-run commitments of resources
to research and development promote
technological innovation.
10Similarly, although greater liquidity unambiguously
raises the real return on savings, more liquidity
may induce a reallocation of investment
out of initiating new capital investments and into
purchasing claims on ongoing projects. This may
lower the rate of real investment enough to dece1erate
growth (Bencivenga, B. Smith, and Starr
1995).
11Although the recent uses of options and futures
contractsto hedge riskhave been well publicized,
the development of these financial contracts
is by no means recent. Josef Penso de la
Vega published a treatise on options contracts, futures
contracts, and securities marketspeculation,
Confusion de Confusiones, in 1688!
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Levine: Financial Development and Economic Growth 695
able information. Consequently, high information
costs may keep capital from
flowing to its highest value use.
Information acquisition costs create
incentives for financial intermediaries to
emerge (Diamond 1984; and John Boyd
and Edward Prescott 1986). Assume, for
example, that there is a fixed cost to
acquiring information about a production
technology. Without intermediaries,
each investor must pay the fixed cost. In
response to this information cost structure,
however, groups of individuals may
form (or join or use) financial intermediaries
to economize on the costs of acquiring
and processing information
about investments. Instead of each individual
acquiring evaluation skills and
then conducting evaluations, an intermediary
can do it for all its members.
Economizing on information acquisition
costs facilitates the acquisition of information
about investment opportunities
and thereby improves resource alloca-
tion.
The ability to acquire and process information
may have important growth
implications. Because many firms and
entrepreneurs will solicit capital, financial
intermediaries, and markets that are
better at selecting the most promising
firms and managers will induce a
more efficient allocation of capital and
faster growth (Jeremy Greenwood and
Boyan Jovanovic 1990). Bagehot (1873,
p. 53) expressed this view over 120 years
ago.
[England'sfinancial]organizationis so useful
because it is so easily adjusted. Political
economistssay that capitalsets towardsthe
most profitabletrades, and that it rapidly
leaves the less profitablenon-payingtrades.
But in ordinarycountriesthis is a slowprocess,
. . . In England,however,. . . capital
runsas surelyandinstantlywhereit is most
wanted,andwherethereis mostto be made
ofit, aswaterrunsto findits level.
England's financial system did a better
job at identifying and funding profitable
ventures than most countries in the mid-
1800s, which helped it enjoy comparatively
greater economic success.12
Besides identifying the best production
technologies, financial intermediaries
may also boost the rate of technological
innovation by identifying those
entrepreneurs with the best chances of
successfully initiating new goods and
production processes (King and Levine
1993c). As eloquently stated by Schumpeter
(1912, p. 74),
The banker,therefore,is not so much primarilya
middleman,. . . He authorisespeople,
in the nameof societyasit were, . . [to
innovate].
Stock markets may also influence the
acquisition and dissemination of information
about firms. As stock markets become
larger (Sanford Grossman and
Joseph Stiglitz 1980) and more liquid
(Albert Kyle 1984; and Bengt Holmstrom
and Jean Tirole 1993), market participants
may have greater incentives to
acquire information about firms. Intuitively,
with larger more liquid markets, it
is easier for an agent who has acquired
information to disguise this private
information and make money. Thus,
large, liquid stock markets can stimulate
the acquisition of information. Moreover,
this improved information about
firms should improve resource allocation
substantially with corresponding
implications for economic growth (Merton
1987). However, existing theories
have not yet assembled the links of the
chain from the functioning of stock markets,
to information acquisition, and finally
to aggregate long-run economic
growth.
12 Indeed, England's advanced financial system
also did a good job at identifying profitable ventures
in other countries, such as Canada, the
United States, and Australiaduring the 19th century.
England was able to "export"financial services
(as well as financial capital) to many economies
with underdeveloped financial systems
(Lance Davis and Robert Huttenback 1986).
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696 Journal of Economic Literature, Vol. XXXV(June 1997)
Debate still exists over the importance
of large, liquid, efficient stock markets in
enhancing the creation and distribution
information about firms. Stock markets
aggregate and disseminate information
through published prices. Even agents
that do not undertake the costly processes
of evaluating firms, managers, and
market conditions can observe stock
prices that reflect the information obtained
by others. This public goods aspect
of acquiring information can cause
society to devote too few resources to information
acquisition. The public goods
feature of the information thus disclosed
may be sufficiently large, that information
gains from large, liquid stock markets
are small. Stiglitz (1985) argues that,
because stock markets quickly reveal information
through posted prices, there
will be few incentives for spending private
resources to acquire information that is
almost immediately publicly available.
D. Monitoring Managers and Exerting
Corporate Control
Besides reducing the costs of acquiring
information ex ante, financial contracts,
markets, and intermediaries may
arise to mitigate the information acquisition
and enforcement costs of monitoring
firm managers and exerting corporate
control ex post, i.e., after financing
the activity. For example, firm owners
will create financial arrangements that
compel firm managers to manage the
firm in the best interests of the owners.
Also, "outside" creditors banks, equity,
and bond holders-that do not manage
firms on a day-to-day basis will create financial
arrangements to compel inside
owners and managers to run firms in accordance
with the interests of outside
creditors. The absence of financial arrangements
that enhance corporate control
may impede the mobilization of savings
from disparate agents and thereby
keep capital from flowing to profitable
investments (Stiglitz and Andrew Weiss
1981, 1983). Because this vast literature
has been carefully reviewed (Gertler
1988; and Andrei Shleifer and Robert
Vishny, forthcoming), this subsection (1)
notes a few ways in which financial contracts,
markets, and institutions improve
monitoring and corporate control, and
(2) reviews how these financial arrangements
for monitoring influence capital
accumulation, resource allocation, and
long-run growth.
Consider, for example, the simple assumption
that it is costly for outsider
investors in a project to verify project
returns. This creates important frictions
that can motivate financial development.
Insiders have incentives to misrepresent
project returns to outsiders. Given verification
costs, however, it is socially inefficient
for outsiders to monitor in all
circumstances. With "costly state verification"
(and other assumptions including
risk-neutral borrowers and verification
costs that are independent of project
quality), the optimal contract between
outsiders and insiders is a debt contract
(Robert Townsend 1979; and Douglas
Gale and Martin Hellwig 1985). Specifically,
there is an equilibrium interest
rate, r, such that when the project return
is sufficiently high, insiders pay r to outsiders
and outsiders do not monitor.
When project returns are insufficient,
the borrower defaults and the lenders
pay the monitoring costs to verify the
project's return. These verification costs
impede investment decisions and reduce
economic efficiency. Verification costs
imply that outsiders constrain firms from
borrowing to expand investment because
higher leverage implies greater risk of
default and higher verification expenditures
by lenders. Thus, collateral and financial
contracts that lower monitoring
and enforcement costs reduce impediments
to efficient investment (Stephen
Williamson 1987b; Ben Bernanke and
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Levine: Financial Development and Economic Growth 697
Gertler 1989, 1990; Ernst-Ludwig von
Thadden 1995).13
Besides particular types of financial
contracts, financial intermediaries can
reduce information costs even further. If
borrowers must obtain funds from many
outsiders, financial intermediaries can
economize on monitoring costs. The financial
intermediary mobilizes the savings
of many individuals and lends these
resources to project owners. This "delegated
monitor" arrangement economizes
on aggregate monitoring costs because a
borrower is monitored only by the intermediary,
not all individual savers (Diamond
1984). Besides reducing duplicate
monitoring, a financial system that facilitates
corporate control "also makes possible
the efficient separation of ownership
from management of the firm. This
in turn makes feasible efficient specialization
in production according to the
principle of comparative advantage"
(Merton and Bodie 1995, p. 14). The
delegated monitor arrangement, however,
creates a potential problem: who
will monitor the monitor (Stefan Krasa
and Anne Villamil 1992)? Savers, however,
do not have to monitor the intermediary
if the intermediary holds a diversified
portfolio (and agents can easily
verify that the intermediary's portfolio is
well diversified). With a well-diversified
portfolio, the intermediary can always
meet its promise to pay the deposit interest
rate to depositors, so that depositors
never have to monitor the bank.
Thus, well-diversified financial intermediaries
can foster efficient investment
by lowering monitoring costs.14 Furthermore,
as financial intermediaries and
firms develop long-run relationships, this
can further lower information acquisition
costs. The reduction in information
asymmetries can in turn ease external
funding constraints and facilitate better
resource allocation (Sharpe 1990).15 In
terms of long-run growth, financial arrangements
that improve corporate control
tend to promote faster capital accumulation
and growth by improving the
allocation of capital (Bencivenga and B.
Smith 1993).
Besides debt contracts and banks,
stock markets may also promote corporate
control (Michael Jensen and William
Meckling 1976). For example, public
trading of shares in stock markets that
efficiently reflect information about
firms allows owners to link managerial
compensation to stock prices. Linking
stock performance to manager compensation
helps align the interests of managers
with those of owners (Diamond and
Robert Verrecchia 1982; and Jensen and
Kevin Murphy 1990). Similarly, if takeovers
are easier in well-developed stock
markets and if managers of under-performing
firms are fired following a takeover,
then better stock markets can promote
better corporate control by easing
takeovers of poorly managed firms. The
threat of a takeover will help align managerial
incentives with those of the own-
13 Costly state verification can produce credit
rationing. Because higher interest rates are linked
with a higher probability of default and monitoring
costs, intermediaries may keep rates low and
ration credit using non-price mechanisms (Williamson
1986, 1987a).
14Diamond (1984) assumes that intermediaries
exist and shows that the intermediaryarrangement
economizes on monitoring costs. Williamson
(1986) shows how intermediaries arise endogenously.
Furthermore, I have only discussed models
in which state verification roceeds nonstochastically:if
borrowersdefault, ?endersverify. Stochastic
monitoring, however, may further reduce verification
costs (Bernanke and Gertler 1989; and
Boyd and B. Smith 1994).
15The long-run relationships between a banker
and client may impose a cost on the client. Because
the bank is well informed about the firm,
the bank may have bargaining power over the
firm's profits. If the bank breaks its ties to the
firm, other investors will be reluctant to invest in
the firm. Firms may therefore diversify out of
bank financing to reduce their vulnerability
(RaghurmanRajan1992).
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698 Journal of Economic Literature, Vol. XXXV(June 1997)
ers (David Scharfstein 1988; and Jeremy
Stein 1988). I am not aware of models
that directly link the role of stock markets
in improving corporate governance
with long-run economic growth.
There are disagreements, however,
about the importance of stock marketsin
corporate control. Inside investors probably
have better information about the
corporationthan outsiders. Thus, if wellinformed
owners are willing to sell their
company, less well informed outsiders
may demand a premium to purchase the
firm due to the information asymmetry
(Stewart Myers and Nicholas Majluf
1984). Thus, asymmetric information
may reduce the efficacy of corporate
takeovers as a mechanism for exerting
corporate control. Stiglitz (1985) makes
three additional arguments about takeovers.
First, if an acquiring firm expends
lots of resources obtaining information,
the results of this research will be observed
by other market participants
when the acquiring firm bids for shares.
This will induce others to bid for shares,
so that the price rises. The firm that expended
resources obtaining information
must, therefore, pay a higher price than
it would have to pay if "free-riding"
firms could not observe its bid. Thus, the
rapid public dissemination of costly information
will reduce incentives for obtaining
information and making effective
takeover bids. Second, there is a public
good nature to takeovers that may decrease
the incentives for takeovers. If
the takeover succeeds, and the share
price rises, then those original equity
holders who did not sell make a big
profit without expending resources. This
creates an incentive for existing shareholders
to not sell if they think the value
of the firm will rise following the takeover.
Thus, value-increasing takeovers
may fail because the acquiring firm will
have to pay a high price, which will reduce
incentives for researching firms in
the hopes of taking them over. Third,
current managers often can take strategic
actions to deter takeovers and maintain
their positions.This arguesagainstan
importantrole for liquid stock marketsin
promoting sound corporate governance.
Moreover, liquid equity markets that
facilitate takeovers may hurt resource allocation
(Shleifer and Lawrence Summers
1988; and Randall Morck, Shleifer,
and Vishny 1990). A takeover typically
involves a change in management. Existing
implicit contracts between former
managers and workers, suppliers, and
other stakeholders in the firms do not
bind new owners and managers to the
same extent that they bound the original
managers. Thus, a takeover allows new
owners and managers to break implicit
agreements and transfer wealth from
firm stakeholders to themselves. While
new owners may profit, there may be a
deterioration in the efficiency of resource
allocation. Overall welfare may
fall. To the extent that well-functioning
equity markets help takeovers, this may
allow hostile takeovers that lead to a fall
in the efficiency of resource allocation.
Furthermore, liquid stock markets may
reduce incentives for owners to monitor
managers (AmarBhide 1993). By reducing
exit costs, stock market liquidity encourages
more diffuse ownership with
fewer incentives and greater impediments
to actively overseeing managers
(Shleifer and Vishny 1986). Thus, the
theoretical signs on the links in the chain
from improvements in stock markets to
better corporate control to faster economic
growth are still ambiguous.'6
E. Mobilizing Savings
Mobilization-pooling-involves the
agglomeration of capital from disparate
16 Some research also suggests that excessive
stock trading can induce "noise"into the market
and hinder efficient resource allocation (Bradford
De Long et al. 1989).
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Levine: Financial Development and Economic Growth 699
savers for investment. Without access to
multiple investors, manyproduction processes
would be constrained to economically
inefficient scales (Erik Sirri and
Peter Tufano 1995). Furthermore, mobilization
involves the creation of small
denomination instruments. These instruments
provide opportunities for households
to hold diversified portfolios, invest
in efficient scale firms, and to
increase asset liquidity. Without pooling,
household's would have to buy and sell
entire firms. By enhancing risk diversification,
liquidity, and the size of feasible
firms,therefore,mobilizationimprovesresource
allocation (SirriandTufano1995).
Mobilizing the savings of many disparate
savers is costly, however. It involves
(a) overcoming the transaction costs associated
with collecting savings from different
individuals and (b) overcoming
the informationalasymmetriesassociated
with making savers feel comfortable in
relinquishing control of their savings. Indeed,
much of Carosso's (1970) history
of Investment Banking in America is a
description of the diverse and elaborate
means employed by investment banks to
raise capital. As early as the mid-1880s,
some investment banks used their European
connections to raise capital abroad
for investment in the United States.
Other investment banks established close
connections with majorbanks and industrialists
in the United States to mobilize
capital. And, still others used newspaper
advertisements, pamphlets, and a vast
sales force that traveled through every
state and territory selling securities to
individual households. Thus, mobilizing
resources involved a range of transaction
costs. Moreover, "mobilizers" had to
convince savers of the soundness of the
investments. Toward this end, intermediaries
are generally concerned about establishing
stellar reputations or government
backing, so that savers feel
comfortable about entrusting their savings
to the intermediary (De Long 1991;
and Naomi Lamoreaux 1994).
In light of the transaction and information
costs associated with mobilizing
savings from many agents, numerous financial
arrangements may arise to mitigate
these frictions and facilitate pooling.17
Specifically, mobilization may
involve multiple bilateral contracts between
productive units raising capital
and agents with surplus resources. The
joint stock company in which many individuals
invest in a new legal entity, the
firm, represents a prime example of multiple
bilateral mobilization. To economize
on the transaction and information
costs associated with multiple bilateral
contracts, pooling may also occur
through intermediaries as discussed
above, where thousands of investors entrust
their wealth to intermediaries that
invest in hundreds of firms (Sirri and
Tufano 1995, p. 83).
Financial systems that are more effective
at pooling the savings of individuals
can profoundly affect economic development.
Besides the direct effect of better
savings mobilization on capital accumulation,
better savings mobilization can
improve resource allocation and boost
technological innovation (Bagehot 1873,
pp. 3-4):
Wehaveentirelylostthe ideathatanyundertakinglikelyto
pay,andseen to be likely,can
perish for want of money;yet no idea was
more familiarto our ancestors,or is more
commonin mostcountries.A citizenof Long
in Queen Elizabeth'stime ... would have
thoughtthatit wasno use inventingrailways
(if he couldhaveunderstoodwhata railway
meant),foryouwouldhavenot been ableto
collectthe capitalwithwhichto makethem.
At this moment, in colonies and all rude
countries,there is no largesum of transferablemoney;thereis
notfundfromwhichyou
can borrow,and out of whichyou can make
immenseworks.
17 See Sections II.C and II.D for citations on
the emergence of financialintermediaries.
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700 Journal of Economic Literature, Vol. XXXV(June 1997)
Thus, by effectively mobilizing resources
for projects, the financial system may
play a crucial role in permitting the
adoption of better technologies and
thereby encouraging growth. This intuition
was clarified 100 years later by
McKinnon (1973, p. 13):
The farmercouldprovidehis ownsavingsto
increase slightly the commercialfertilizer
thathe is nowusing,andthe returnon this
marginalnewinvestmentcouldbe calculated.
The importantpoint, however, is the virtual
impossibility of a poor farmer's financing
from his current savings the whole of the balanced
investment needed to adopt the new
technology. Access to external financial resources
is likely to be necessary over the one
or two years when the change takes place.
Without this access, the constraint of selffinance
sharplybiases investment strategy toward
marginal variations within the traditional
technology.
F. Facilitating Exchange
Besides easing savings mobilization
and thereby expanding the of set production
technologies available to an
economy, financial arrangements that
lower transaction costs can promote specialization,
technological innovation, and
growth. The links between facilitating
transactions, specialization, innovation,
and economic growth were core elements
of Adam Smith's (1776) Wealth of
Nations. Smith (1776, p. 7) argued that
division of labor-specialization-is
the principal factor underlying productivity
improvements. With greater specialization,
workers are more likely to invent
better machines or production
processes.
I shall only observe, therefore, that the invention
of all those machines by which labour
is so much facilitated and abridged, seems to
have been originally owing to the division of
labour. Men are much more likely to discover
easier and readier methods of attaining any
object, when the whole attention of their
minds is directed towards that single object,
than when it is dissipated among a great variety
of things. (Smith 1776, p. 3)
The critical issue for our purposes is
that the financial system can promote
specialization. Adam Smith argued that
lower transaction costs would permit
greater specialization because specialization
requires more transactions than an
autarkic environment. Smith phrased his
argument about the lowering of transaction
costs and technological innovation
in terms of the advantages of money over
barter (pp. 26-27). Information costs,
however, may also motivate the emergence
of money. Because it is costly to
evaluate the attributes of goods, barter
exchange is very costly. Thus, an easily
recognizable medium of exchange may
arise to facilitate exchange (King and
Charles Plosser 1986; and Williamson
and Randall Wright 1994).18
The drop in transaction and information
costs is not necessarily a one-time
fall when economies move to money,
however. For example, in the 1800s, " it
was primarily the development of institutions
that facilitated the exchange of
technology in the market that enabled
creative individuals to specialize in and
become more productive at invention"
(Lamoreaux and Sokoloff 1996, p. 17).
Thus, transaction and information costs
may continue to fall through a variety of
mechanisms, so that financial and institutional
development continually boost
specialization and innovation via the
same channels illuminated over 200
years ago by Adam Smith.19
18 This focus on money as a medium of exchange
that lowers transaction and information
costs by overcoming the "double coincidence of
wants problem" and by acting as an easily recognizable
medium of exchange enjoys a long history
in monetary theory, from Adam Smith (1776), to
Stanley Jevons (1875), to Karl Brunner and Allan
Meltzer (1971), to more formal models as reviewed
by Joseph Ostroyand Starr(1990).
19Financial systems can also promote the accumulation
of human capitalby lowering the costs of
intertemporal trade, i.e., by facilitating borrowing
for the accumulationof skills (ThomasCooley and
B. Smith 1992; and Jose De Gregorio 1996). If
human capital accumulation is not subject to diThis
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I Levine: Financial Development and Economic Growth 701
Modern theorists have attempted to illuminate
more precisely the ties between
exchange, specialization, and innovation
(Greenwood and B. Smith
1997). More specialization requires more
transactions. Because each transaction is
costly, financial arrangements that lower
transaction costs will facilitate greater
specialization. In this way, markets that
promote exchange encourage productivity
gains. There may also be feedback
from these productivity gains to financial
market development. If there are
fixed costs associated with establishing
markets, then higher income per capita
implies that these fixed costs are less
burdensome as a share of per capita income.
Thus, economic development can
spur the development of financial mar-
kets.
This approach to linking financial markets
with specialization has not yet formally
completed Adam Smith's story of
innovation. That is, a better market-a
market with lower transactions costsdoes
not stimulate the invention of new
and better production technologies in
Greenwood and B. Smith's (1997)
model. Instead, lower transaction costs
expand the set of "on the shelf' production
processes that are economically attractive.
Also, the model defines better
"market" as a system for supporting
more specialized production processes.
This does not explain the emergence of
financial instruments or institutions that
lower transaction costs and thereby produce
an environment that naturally promotes
specialized production technologies.
This is important because we want
to understand the two links of the chain:
what about the economic environment
creates incentives for financial arrangements
to arise and to function well or
poorly, and what are the implications for
economic activity of the emerging financial
arrangements?
G. A Parable
Thus far, I have discussed each financial
function in isolation. This, however,
may encourage an excessively narrowfocus
on individual functions and impede
the synthesis of these distinct functions
into a coherent understanding of the
financial system's role in economic development.
This is not a necessary implication.
In fact, by identifying the individual
functions performed by the financial
system, the functional approach can foster
a more complete understandingof finance
and growth.
Earlier authorsoften provided illustrative
stories of the ties between finance
and development. For example Schumpeter
(1912, pp. 58-74) and McKinnon
(1973, pp. 5-18) provide broad descriptions-parables-of
the roles of the financial
system in economic development.
Just as Smith (1776) used the pin
factory to illustrate the importance of
specialization, Schumpeter used the relationship
between banker and industrialist
to illustrate the importance of the
financial system in choosing and adopting
new technologies, and McKinnon
highlighted its importance in promoting
the use of better agriculturaltechniques.
However, even Schumpeter and McKinnon
did not amalgamateall of the financial
functions into their stories of finance
and development. Consequently, this
subsection synthesizes the individual financial
functions into a simple parable
about how the financial system affects
economic growth.
Consider Fred, who has just developed
a design for a new truck that extracts
rocks from a quarrybetter than existing
trucks. His idea for manufacturing
trucks requires an intricate assembly line
with specialized labor and capital.
minishing returns on a social level, financial arrangements
that ease human capital creation help
accelerate economic growth.
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702 Journal of Economic Literature, Vol. XXXV(June 1997)
Highly specialized production processes
would be difficult without a medium of
exchange. He would find it prohibitively
costly to pay his workers and suppliers
using barter exchange. Financial instruments
and markets that facilitate transactions
will allow and promote specialization
and thereby permit him to
organize his truck assembly line. Moreover,
the increased specialization induced
by easier transactions may foster
learning-by-doing and innovation by the
workers specializing on their individual
tasks.
Production requires capital. Even if
Fred had the savings, he would not wish
to put all of his savings in one risky investment.
Also, he wants ready access to
savings for unplanned events; he is reluctant
to tie up his savings in the truck
project, which will not yield profits, if it
does yield profits, for a long time. His
distaste for risk and desire for liquidity
create incentives for him to (a) diversify
the family's investments and (b) not
commit too much of his savings to an illiquid
project, like producing a new
truck. In fact, if Fred must invest disproportionately
in his illiquid truck project,
he may forgo his plan. Without a mechanism
for managing risk, the project may
die. Thus, liquidity, risk pooling, and diversification
will help him start his innovative
project.
Moreover, Fred will require outside
funding if he has insufficient savings to
initiate his truck project. There are
problems, however, in mobilizing savings
for Fred's truck company. First, it is very
costly and time consuming to collect savings
from individual savers. Fred does
not have the time, connections, and information
to collect savings from everyone
in his town and neighboring communities
even though his idea is sound.
Banks and investment banks, however,
can mobilize savings more cheaply than
Fred due to economies of scale, economies
of scope, and experience. Thus,
Fred may seek the help of a financial intermediary
to mobilize savings for his
new truckplant.
Two additional problems ("frictions")
may keep savings from flowing to Fred's
project. To fund the truck plant, the financial
intermediaries-and savers in financial
intermediaries-require information
about the truck design, Fred's
ability to implement the design, and
whether there is a sufficient demand for
better quarrytrucks. This information is
difficult to obtain and analyze. Thus, the
financial system must be able to acquire
reliable information about Fred's idea
before funding the truck plant. Furthermore,
if potential investors feel that
Fred may steal the funds, or run the
plant poorly, or misrepresent profits,
they will not provide funding. To finance
Fred's idea, outside creditors must have
confidence that Fred will run the truck
plant well. Thus, for Fred to receive
funding, the financial system must monitor
managers and exert corporate con-
trol.
While this parable does not contain all
aspects of the discussion of financial
functions, it provides one cohesive story
of how the five financial functions may
interact to promote economic develop-
ment.
H. The Theoryof Finance and
Economic Growth:Agenda
In describing the conceptual links between
the functioning of the financial
system and economic growth, I highlighted
areas needing additional research.
Two more areas are worth emphasizing.
First, we do not have a
sufficiently rigorous understanding of
the emergence, development, and economic
implications of different financial
structures. Financial structure-the mix
of financial contracts, markets, and institutions-varies
across countries and
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Levine: Financial Development and Economic Growth 703
changes as countries develop (Boyd and
B. Smith 1996). Yet, we do not have
adequate theories of why different financial
structures emerge or why financial
structures change. Differences in legal
tradition (Rafael LaPortaet al. 1996) and
differences in national resource endowments
that produce different political
and institutional structures (Stanley
Engerman and Sokoloff 1996) might be
incorporatedinto future models of financial
development. Furthermore, economists
need to develop an analyticalbasis
for makingcomparisonsof financialstructures;
we need models that elucidate the
conditions, if any, under which different
financialstructuresare better at mitigating
information and transaction costs.
A second area needing additional
research involves the influence of the
level and growth rate of the economy
on the financial system. Some models
assume that there is a fixed cost to joining
financial intermediaries. Economic
growth then reduces the importance of
this fixed cost and more people join.
Thus, economic growth provides the
means for the formation of growth-promoting
financial intermediaries, while
the formation of financial intermediaries
accelerates growth by enhancing the allocation
of capital. In this way, financial
and economic development are jointly
determined (Greenwood and Jovanovic
1990). Economic development may affect
the financial system in other ways
that have not yet been formallymodeled.
For example, the costs and skills required
to evaluate production technologies
and monitor managers may be very
different in a service-oriented economy
from that of a manufacturing-based
economy or an agricultural-based economy.
Building on Hugh Patrick (1966),
Greenwood and Jovanovic (1990), and
Greenwood and Smith (1997), future research
may improve our understandingof
the impactof growthon financialsystems.
III. Evidence
A. The Questions
Are differences in financial development
and structure importantly associated
with differences in economic
growth rates? To assess the nature of the
finance-growth relationship, I first describe
research on the links between the
functioning of the financial system and
economic growth, capital accumulation,
and technological change. Then, I evaluate
existing evidence on the ties between
financial structure-the mix of financial
markets and intermediaries-and the
functioning of the financial system. A
growing body of work demonstrates a
strong, positive link between financial
development and economic growth, and
there is even evidence that the level of
financial development is a good predictor
of future economic development.
Evidence on the relationship between financial
structure and the functioning of
the financial system, however, is more
inconclusive.
B. TheLevel of Financial Development
and Growth:Cross-Country Studies
Consider first the relationship between
economic growth and aggregate
measures of how well the financial system
functions. The seminal work in this
area is by Goldsmith (1969). He uses the
value of financial intermediary assets divided
by GNP to gauge financial development
under the assumption that the
size of the financial system is positively
correlated with the provision and quality
of financial services. Using data on 35
countries from 1860 to 1963 (when available)
Goldsmith (1969, p. 48) finds:
(1) a rough parallelism can be observed between
economic and financial development if
periods of several decades are considered;
[and]
(2) there are even indications in the few
countries for which the data are availablethat
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704 Journal of Economic Literature, Vol. XXXV(June 1997)
periods of more rapid economic growth have
been accompanied, though not without exception,
by an above-average rate of financial
development.
Goldsmith's work, however, has several
weaknesses: (a) the investigation involves
limited observations on only 35
countries; (b) it does not systematically
control for other factors influencing economic
growth (Levine and David Renelt
1992); (c) it does not examine whether
financial development is associated with
productivity growth and capital accumulation;
(d) the size of financialintermediaries
may not accurately measure the
functioning of the financial system; and
(e) the close association between the size
of the financial system and economic
growth does not identify the direction of
causality.20
Recently, researchers have taken steps
to address some of these weaknesses.
For example, King and Levine (1993a,
1993b, 1993c) study 80 countries over
the period 1960-1989, systematically
control for other factors affecting longrun
growth, examine the capital accumulation
and productivity growth channels,
construct additional measures of the
level of financial development, and analyze
whether the level of financial development
predicts long-run economic
growth, capital accumulation, and productivity
growth. (Also, see Alan Gelb
1989; Gertler and Andrew Rose 1994;
Nouriel Roubini and Xavier Sala-iMartin
1992; Easterly 1993; and the
overview by Pagano 1993.) They use four
measures of "the level of financial development"
to mioreprecisely measure the
functioning of the financial system than
Goldsmith's size measure. Table 1 summarizes
the values of these measures
relative to real per capita GDP (RGDP)
in 1985. The first measure, DEPTH,
measures the size of financial intermediaries
and equals liquid liabilities of the
financial system (currency plus demand
and interest-bearing liabilities of banks
and nonbank financial intermediaries)
divided by GDP. As shown, citizens of
the richest countries-the top 25 percent
on the basis of income per capitaheld
about two-thirds of a year's income
in liquid assets in formal financial intermediaries,
while citizens of the poorest
countries-the bottom 25 percent-held
only a quarter of a year's income in liquid
assets. There is a strong correlation
between real per capita GDP and
DEPTH. The second measure of financial
development, BANK, measures the
degree to which the central bank versus
commercial banks are allocating credit.
BANK equals the ratio of bank credit divided
by bank credit plus central bank
domestic assets. The intuition underlying
this measure is that banks are more
likely to provide the five financial functions
than central banks. There are two
notable weaknesses with this measure,
however. Banks are not the only financial
intermediaries providing valuable financial
functions and banks may simply
lend to the government or public enterprises.
BANK is greater than 90 percent
in the richest quartile of countries. In
contrast, commercial banks and central
banks allocate about the same amount of
credit in the poorest quartile of countries.
The third and fourth measures partially
address concerns about the allocation
of credit. The third measures,
PRIVATE,equals the ratio of credit allocated
to private enterprises to total domestic
credit (excluding credit to banks).
The fourth measure, PRIVY, equals
credit to private enterprises divided by
20 Goldsmith (1969) recognized these weaknesses,
e.g., "there is no possibility, however, of
establishing with confidence the direction of the
causal mechanisms, i.e., of deciding whether financial
factors were responsible for the acceleration
of economic development or whether financial
development reflected economic growth
whose mainspringsmust be sought elsewhere" (p.
48).
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Levine: Financial Development and Economic Growth 705
TABLE1
FINANCIAL DEVELOPMENT AND REAL PER CAPITA GDPIN 1985
Correlation
withRealper
CapitaGDPin
Indictors Veryrich Rich Poor Verypoor 1985 (P-value)
DEPTH 0.67 0.51 0.39 0.26 0.51 (0.0001)
BANK 0.91 0.73 0.57 0.52 0.58 (0.0001)
PRIVATE 0.71 0.58 0.47 0.37 0.51 (0.0001)
PRIVY 0.53 0.31 0.20 0.13 0.70 (0.0001)
RGDP85 13053 2376 754 241
Observations 29 29 29 29
Source: KingandLevine(1993a)
Veryrich: RealGDPperCapita> 4998
Rich: RealGDPperCapita> 1161and<4998
Poor: RealGDPperCapita> 391and< 1161
Verypoor: RealGDPperCapita< 391
DEPTH = Liquidliabilitiesto GDP
BANK= Depositmoneybankdomesticcreditdividedbydepositmoney bank+ centralbankdomesticcredit
PRIVATE= Claimsonthe non-financialprivatesectorto domesticcredit
PRIVY= Grossclaimsonprivatesectorto GDP
RGDP85= RealpercapitaGDPin 1985(inconstant1987dollars)
GDP. The assumption underlying these
measures is that financial systems that
allocate more credit to private firms are
more engaged in researching firms, exerting
corporate control, providing risk
management services, mobilizing savings,
and facilitating transactionsthan financial
systems that simply funnel credit
to the government or state owned enterprises.
As depicted in Table 1, there is a
positive, statistically significant correlation
between real per capita GDP and
the extent to which loans are directed to
the private sector.
King and Levine (1993b, 1993c) then
assess the strength of the empirical relationship
between each of these four indicators
of the level of financial development
averaged over the 1960-1989
period, F, and three growth indicators
also averaged over the 1960-1989 period,
G. The three growth indicators are
as follows: (1) the average rate of real
per capita GDP growth, (2) the average
rate of growth in the capital stock per
person, and (3) total productivity
growth, which is a "Solow residual" defined
as real per capita GDP growth minus
(0.3) times the growth rate of the
capital stock per person. In other words,
if F(i) represents the value of the ith indicator
of financial development
(DEPTH, BANK, PRIVY,PRIVATE)averaged
over the period 1960-1989, GO)
represents the value of the jth growth indicator
(per capita GDP growth, per capita
capital stock growth, or productivity
growth) averaged over the period 1960-
1989, andX represents a matrixof conditioning
information to control for other
factors associated with economic growth
(e.g., income per capita, education, political
stability, indicators of exchange
rate, trade, fiscal, and monetary policy),
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706 Journal of Economic Literature, Vol. XXXV(June 1997)
TABLE2
GROWTHANDCONTEMPORANEOUSFINANCIALINDICATORS,1960-1989
DependantVariable DEPTH BANK PRIVATE PRIVY
RealPerCapitaGDP Growth 0.024*** 0.032*** 0.034*** 0.032***
[0.007] [0.005] [0.002] [0.002]
R2 0.5 0.5 0.52 0.52
RealPerCapitaCapitalStockGrowth 0.022*** 0.022** 0.020** 0.025***
[0.001] [0.012] [0.011] [0.001]
R2 0.65 0.62 0.62 0.64
ProductivityGrowth 0.018** 0.026** 0.027*** 0.025***
[0.026] [0.010] [0.003] [0.006]
R2 0.42 0.43 0.45 0.44
Source:KingandLevine(1993b)
* significantatthe 0.10level,** significantatthe 0.05level, significantatthe 0.01level.
[p-valuesinbrackets]
Observations = 77
DEPTH = Liquidliabilitiesto GDP
BANK= Depositbankdomesticcreditdividedbydepositmoneybank+ centralbankdomestic
credit
PRIVATE= Claimsonthe non-financialprivatesectorto totalclaims
PRIVY= Grossclaimsonprivatesectorto GDP
ProductivityGrowth= RealPerCapitaGDP Growth- (0.3)*RealPerCapitaCapitalStockGrowth
Otherexplanatoryvariablesincludedin eachofthe12regressions:logofinitialincome,logof initialsecondary
schoolenrollmentrate,ratioof governmentconsumptionexpendituresto GDP,inflationrate,andratioof export
plusimportsto GDP.
then the following 12 regressions are run
on a cross-section of 77 countries:
G(j)=ac+fF(i)+yX+ (1)
There is a strong positive relationship
between each of the four financial development
indicators, F(i), and the three
growth indicators G(i), long-run real per
capita growth rates, capital accumulation,
and productivity growth. Table 2
summarizes the results on the 12 ,'s.
Not only are all the financial development
coefficients statistically significant,
the sizes of the coefficients imply an
economically important relationship. Ignoring
causality, the coefficient of 0.024
on DEPTH implies that a country that
increased DEPTH from the mean of the
slowest growing quartile of countries
(0.2) to the mean of the fastest growing
quartile of countries (0.6) would have increased
its per capita growth rate by almost
one percent per year. This is large.
The difference between the slowest
growing 25 percent of countries and the
fastest growing quartile of countries is
about five percent per annum over this
30 year period. Thus, the rise in DEPTH
alone eliminates 20 percent of this
growth difference.
Finally, to examine whether finance
simply follows growth, King and Levine
(1993b) study whether the value of financial
depth in 1960 predicts the rate
of economic growth, capital accumulation,
and productivity improvements
over the next 30 years. Table 3 summarizes
some of the results. In the three
regressions reported in Table 3, the dependent
variableis, respectively, realper
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Levine: Financial Development and Economic Growth 707
TABLE3
GROWTHAND INITIAL FINANCIAL DEPTH, 1960-1989
PerCapitaGDP PerCapitaCapital PerCapitaProductivity
Growth,1960-1989 Growth,1960-1989 Growth,1960-1989
Constant 0.035*** 0.002 0.034***
[0.001] [0.682] [0.001]
Log(RealGDPper -0.016*** -0.004* -0.015***
Personin 1960) [0.001] [0.068] [0.001]
Log(Secondaryschool 0.013*** 0.007*** 0.011***
enrollmentin 1960) [0.001] [0.001] [0.001]
Government 0.07* 0.049* 0.056*
consumption/GDPin 1960 [0.051] [0.064] [0.076]
Inflationin 1960 0.037 0.02 0.029
[0.239] [0.238] [0.292]
(ImportsplusExports)/GDP -0.003 -0.001 -0.003
in 1960 [0.604] [0.767] [0.603]
DEPTH (liquidliabilities) 0.028*** 0.019*** 0.022***
in 1960 [0.001] [0.001] [0.001]
R2 0.61 0.63 0.58
Source: KingandLevine(1993b)
*
significantatthe 0.10level, "*significantatthe 0.05level, significantatthe 0.01level.
[p-valuesinbrackets]
Observations = 57
capita GDP growth, real per capita capital
stock growth, and productivitygrowth
averaged over the period 1960-1989.
The financial indicator in each of these
regressions is the value of DEPTH in
1960. The regressions indicate that
financial depth in 1960 is significantly
correlated with each of the growth indicators
averaged over the period 1960-
1989.21 These results, plus those from
more sophisticated time series studies,
suggest that the initial level of financial
development is a good predictor of subsequent
rates of economic growth, physical
capital accumulation, and economic
efficiency improvementsover the next 30
yearseven aftercontrollingforincome, education,
political stability, and measures
of monetary,trade, and fiscal policy.22
21 There is an insufficient number of observations
on BANK, PRIVATE,and PRIVYin 1960 to
extend the analysis in Table 3 to these variables.
Thus, King and Levine (1993b) use pooled, cross
section, time series data. For each country, data
permitting, they use data averagedover the 1960s,
1970s, and 1980s; thus, there are potentially three
observations per country. They then relate the
value of growth averaged over the 1960s with the
value of, for example, BANKin 1960 and so on for
the other two decades. They restrict the coefficients
to be the same across decades. They find
that the initial level of financial development is a
good predictor of subsequent rates of economic
growth, capital accumulation, and economic efficiency
improvements over the next ten years after
controlling for many other factors associated with
long-run growth.
22 These broad cross-country results hold even
when using instrumentalvariables-primarily indicators
of the legal treatment of creditors taken
from LaPorta et al. 1996-to extract the exogenous
component of financial development (Levine
1997). Furthermore, though disagreement exists
(Woo Jung 1986 and Philip Arestis and Panicos
Demetriades 1995), many time-series investigations
find that financial sector development
Granger-causes economic performance (Paul
Wachtel Rousseau 1995). These results are particularlystrong
when using measures of the valueadded
provided by the financial system instead of
measures of the size of the financial system (Klaus
Neusser and MauriceKugler 1996).
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708 Journal of Economic Literature, Vol. XXXV(June 1997)
The relationship between the initial
level of financial development and
growth is large. For example, the estimated
coefficients suggest that if in 1960
Bolivia had increased its financial depth
from 10 percent of GDP to the mean
value for developing countries in 1960
(23 percent), then Bolivia would have
grown about 0.4 percent faster per annum,
so that by 1990 real per capita
GDP would have been about 13 percent
larger than it was.23Thus, finance does
not merely follow economic activity. The
strong link between the level of financial
development and the rate of long-run
economic growth does not simply reflect
contemporaneous shocks that affect both
financial development and economic
performance. There is a statistically
significant and economically large empirical
relationship between the initial
level of financial development and future
rates of long-run growth, capital
accumulation, and productivity improvements.
Furthermore, insufficient financial
development has sometimes created
a "povertytrap" and thus become a severe
obstacle to growth even when a
country has established other conditions
(macroeconomic stability, openness to
trade, educational attainment, etc.) for
sustained economic development (JeanClaude
Berthelemy and Aristomene
Varoudakis1996).
Some recent work has extended our
knowledge about the causal relationships
between financial development and economic
growth. For example, Rajan and
Luigi Zingales (1996) assume that financial
markets in the United States are
relatively frictionless. This benchmark
country then defines each industry'sefficient
demand for external finance (investment
minus internal cash flow). They
then examine industries across a large
sample of countries and test whether the
industries that are more dependent on
external finance (in the United States)
grow relatively faster in countries that
begin the sample period with better developed
financial systems. They find that
industries that rely heavily on external
funding grow comparatively faster in
countries with well-developed intermediaries
(as measured by PRIVY) and
stock markets (as measured by stock
market capitalization) than they do in
countries that start with relatively weak
financial systems. Similarly, using firmlevel
data from 30 countries, Asli Demirguc-Kunt
and Vojislav Maksimovic
(1996b) argue that firms with access to
more developed stock markets grow at
faster rates than they could have grown
without this access. Furthermore, when
individual states of the United States relaxed
intrastate branching restrictions,
this boosted bank lending quality and accelerated
real per capita growth rates
even after controlling for other growth
determinants (Jith Jayaratne and Philip
Strahan 1996). Thus, using firm- and industrial-level
data for a broad crosssection
of countries and data on individual
states of the United States,
recent research presents evidence consistent
with the view that the level of financial
development materially affects
the rate and structure of economic de-
velopment.
Not surprisingly,these empirical studies
do not unambiguously resolve the issue
of causality. Financial development
may predict growth simply because financial
systems develop in anticipation
of future economic growth. Furthermore,
differences in political systems, legal
traditions (LaPortaet al. 1996), or institutions
(Engerman and Sokoloff 1996;
Douglass North 1981) may be driving
both financial development and economic
growth rates. Nevertheless, the
body of evidence would tend to push
23 These examples do not consider causal issues
or how to increase financialdevelopment.
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Levine: Financial Development and Economic Growth 709
many skeptics toward the view that the
finance-growth link is a first-order relationship
and that difference in financial
development can alter economic growth
rates over ample time horizons.
C. Country-Case Studies
Country-case studies provide a rich
complement to cross-country comparisons.
For example, Rondo Cameron et
al. (1967) dissect the historical relationships
between banking development and
the early stages of industrialization for
England (1750-1844), Scotland (1750-
1845), France (1800-1870), Belgium
(1800-1875), Germany (1815-1870),
Russia (1860-1914), and Japan (1868-
1914). These country-case studies do not
use formal statistical analysis. Instead,
the researchers carefully examine the legal,
economic, and financial linkages between
banks and industry during the industrialization
of these seven countries.
Typically, the case studies start by describing
the political system, economic
conditions, and financial structure at the
start of the period of analysis.Then, they
provide a detailed description of the evolution
of the financial system during a
period of rapid economic development.
Finally, they document critical interactions
among financial intermediaries,
financial markets, government policies,
and the financing of industrialization.
While providing an informative complement
to broad cross country comparisons,
country-case studies rely heavily on
subjective evaluations of banking system
performance and fail to systematically
control for other elements determining
economic development. While emphasizing
the analytical limitations of countrycase
studies, Cameron (1967b) concludes
that especially in Scotland and Japan,
but also in Belgium, Germany, England,
and Russia, the banking system
played a positive, growth-inducingrole.
Debate exists, however. Consider the
case of Scotland between 1750 and 1845.
Scotland began the period with per capita
income of less than one-half of England's.
By 1845, however, per capita income
was about the same. While
recognizing that the "dominantpolitical
event affecting Scotland's potentialities
for economic development was the
Union of 1707, which made Scotland an
integral part of the United Kingdom,"
Cameron (1967a, p. 60), argues that
Scotland's superior banking system is
one of the few noteworthy features that
can help explain its comparatively rapid
growth.24 Other analysts disagree with
the "facts" underlying this conclusion.
Some researchers suggest that England
did not suffer from a dearth of financial
services because nonfinancial enterprises
provided financial services in England
that Cameron's (1967a) measures of formal
financial intermediation omit. Others
argue that Scotland had rich natural
resources, a well-educated work force,
access to British colonial markets, and
started from a much lower level of income
per capita than England. Consequently,
it is not surprisingthat Scotland
enjoyed a period of rapid convergence
toward England's income per capita
level. Finally, still other researchers disagree
with the premise that Scotland had
a well-functioning financial system and
emphasize the deficiencies in the Scottish
system (Sidney Pollard and Dieter
Ziegler 1992). Thus, although Andrew
Kerr first argued in 1884 that Scotland
enjoyed a better banking system than
England from 1750 until 1844, the debate
about whether Scottish banking explains
its faster economic growth over
the period 1750-1845 continues today.
24 It is also worth noting that Scottish banking
was comparativelystable over this period, suffering
fewer and less severe panics than its southern
neighbor. For more on Scottish banking, see Sydney
Checkland (1975) and Tyler Cowen and Randall
Kroszner(1989).
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710 Journal of Economic Literature, Vol. XXXV(June 1997)
The relationship between financial
and economic development has been
carefully analyzed for many other countries.
For example, Stephen Haber
(1991, 1996) compares industrial and
capital market development in Brazil,
Mexico, and the United States between
1830 and 1930. He finds that capital
market development affected industrial
composition and national economic performance.
Specifically, Haber shows that
when Brazil overthrew the monarchy in
1889 and formed the First Republic, it
also dramatically liberalized restrictions
on Brazilianfinancial markets.The liberalization
gave more firms easier access to
external finance. Industrial concentration
fell and industrial production
boomed. While Mexico also liberalized
financial sector policies, the liberalization
was much more mild under the Diaz
dictatorship (1877-1911), which "relied
on the financial and political support of a
small in-group of powerful financial
capitalists"(p. 561). As a result, the decline
in concentration and the increase
in economic growth was much weaker in
Mexico than it was in Brazil. Haber
(1996, p. 40) concludes that "differences
in capital market development had a significant
impact on the rate of growth of
industry. . . . [and that a] lack of access
to institutional sources of capital because
of poorly developed capital markets was
a non-negligible obstacle to industrial
development in the nineteenth cen-
tury."25
Finally, but perhaps most influencially,
McKinnon's (1973) seminal book
Money and Capital in Economic Development
studies the relationship between
the financial system and economic development
in Argentina, Brazil, Chile, Germany,
Korea, Indonesia, and Taiwan in
the post World War II period. McKinnon
interprets the mass of evidence
emerging from these country-case studies
as strongly suggesting that better
functioning financial systems support
faster economic growth. Disagreement
exists over many of these individual
cases, and it is extremely difficult to isolate
the importance of any single factor
in the process of economic growth.26
Thus, any statements about causality
are-and will remain-largely impressionistic
and specific to particular countries
and specific periods. Nonetheless,
the body of country-studies suggests
that, while the financial system responds
to demands from the nonfinancialsector,
well-functioning financial systems have,
in some cases during some time periods,
greatly spurred economic growth.
D. Financial Functions and Growth:
Liquidity and Risk
I now turn to evidence on the ties between
measures of the individual financial
functions and economic growth.
First, consider liquidity. Deposit-taking
banks can provide liquidity by issuing
liquid demand deposits and makingilliquid,
long-term investments. Isolating this
liquidity function from the other financial
functions performed by banks, however,
has proven prohibitively difficult.
In contrast, economists have studied extensively
the effects of the liquidity of an
individual security on its price. Substantial
evidence suggests a positive correlation
between the liquidity of an asset
25 Interestingly, these political and legal impediments
to financial development are apparently
difficult to change. In Mexico, the largest
three banks control the same fraction of commercial
banking activity today, about two-thirds, as
they did 100 years ago. Also, Mexico has the lowest
ranking of the legal protection of minority
shareholder rights of any country in La Porta et
al.'s (1996) detailed comparison of 49 countries,
which may facilitate the concentration of economic
decision making.
26 For more on Mexico see Robert Bennett
(1963). For more on Asia, see Cole and YungPark
(1983), Park (1993), and Patrick and Park(1994).
Fry (1995) provides additionalcitations.
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Levine: Financial Development and Economic Growth 711
TABLE4
STOCK MARKET LIQUIDITY MEASURES: SELECTED COUNTRIES, ANNUAL AVERAGES 1976-1993
Turnover Value PerCapita
Ratio TradedRatio GDP Growth
Low-income
Bangladesh 0.015 0.000 1.89%
Coted'lvoire 0.028 0.001 -2.50%
Egypt 0.060 0.030 3.56%
India 0.537 0.036 2.43%
Nigeria 0.006 0.000 -0.11%
Pakistan 0.105 0.008 3.13%
Zimbabwe 0.059 0.010 -0.97%
Lower-middle-income
Colombia 0.087 0.004 1.95%
CostaRica 0.013 0.001 0.89%
Indonesia 0.193 0.010 4.18%
Jordan 0.154 0.085 3.01%
Philippines 0.250 0.026 0.21%
Thailand 0.739 0.144 5.90%
Turkey 0.207 0.026 2.32%
Upper-middle-income
Argentina 0.266 0.013 0.22%
Brazil 0.355 0.041 0.65%
Chile 0.060 0.021 3.61%
Korea 0.832 0.186 9.67%
Malaysia 0.230 0.243 4.27%
Mauritius 0.059 0.003 1.76%
Mexico 0.498 0.044 0.85%
Portugal 0.108 0.014 2.85%
High-income
Australia 0.256 0.124 1.57%
Germany 0.704 0.156 0.95%
GreatBritian 0.349 0.253 1.75%
HongKong 0.372 0.471 6.20%
Israel 0.669 0.144 1.72%
Italy 0.253 0.028 2.68%
Japan 0.469 0.406 3.42%
Netherlands 0.490 0.123 1.43%
Norway 0.318 0.059 2.48%
Spain 0.216 0.045 1.75%
Switzerland 0.467 0.442 1.16%
UnitedStates 0.493 0.299 1.67%
Sources:InternationalFinanceCorporation,andMorganStanleyCapitalInternational
TurnoverRatio=Valueof DomesticEquitiesTradedon DomesticExchangesDividedbyMarketCapitalization
ValueTradedRatio=Valueof DomesticEquitiesTradedon DomesticExchangesDividedbyGDPIncome
classificationsfromtheWorldBank's1995WorldDevelopmentReport
Low-incomeeconomies= averageGNPpercapitaof $380in 1993
Lower-middle-incomeeconomies= averageGNPpercapitaof $1,590in 1993
Upper-middle-incomeeconomies= averageGNPpercapitaof $4,370in 1993
High-incomeeconomies= averageGNPpercapitaof $23,090in 1993
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712 Journal of Economic Literature, Vol. XXXV(June 1997)
and its price (e.g., Yakov Amihud and
Haim Mendelson 1989; and Gregory
Kadlec and John McConnell 1994). Put
differently, agents must be compensated
with a lower price for purchasing an asset
that is difficult to sell. These security-level
studies of the relationship between
the liquidity of individual
securities and their prices, however, do
not link liquidity with national long run
growth rates.
To evaluate the relationship between
stock market liquidity and national
growth rates, capital accumulation rates,
and rates of technological change,
Levine and Sara Zervos (1996) build on
Raymond Atje and Jovanovic's (1993)
study and focus on two measures of liquidity
for a broad cross-section of 49
countries over the period 1976-1993.
The first liquidity indicator, the value
traded ratio, equals the total value of
shares traded on a country's stock exchanges
divided by GDP. The value
traded ratio measures trading relative to
the size of the economy. While not a direct
measure of trading costs or the uncertainty
associated with trading and settling
equity transactions, theoretical
models of liquidity and growth directly
motivate the value traded ratio (Bencivenga,
B. Smith, and Starr 1995). As
shown in Table 4, the value traded ratio
varies considerably across countries. For
example, the United States had an average
annual value traded ratio of 0.3 during
the 1976-1993 period, while for
Mexico and India it was about 0.04. The
second indicator, the turnover ratio,
equals the total value of shares traded on
a country's stock exchanges divided by
stock market capitalization (the value of
listed shares on the country's exchanges).
The turnover ratio measures
tradingrelative to the size of the market.
It also exhibits substantial cross-country
variability. Very active markets such as
Japan and the United States have turnover
ratios of almost 0.5, while for less
liquid markets, such as Bangladesh,
Chile, and Egypt they are 0.06 or less.27
The turnover ratio may differ from the
value traded ratio because a small, liquid
market will have high turnover ratio but
a small value traded ratio. For example,
India's average turnover ratio of 0.5 over
the 1976-1993 is greater than the
United States', but India's value traded
ratio is about one-tenth the size of the
United States'. These measures seek to
measure liquidity on a macroeconomic
scale: the objective is to measure the degree
to which agents can cheaply,
quickly, and confidently trade ownership
claims of a large percentage of the economy's
productive technologies.28
The researchers then assess the
strength of the empirical relationship
between each liquidity measure and the
three growthindicators:economic growth,
capital accumulation, and productivity
growth. They conduct a cross-country
analysis with one observation per country.
Namely, six basic regressions are
run: economic growth, capital accumulation,
and productivity growth averaged
over the 1976-1993 period are regressed
first on the value traded ratio in 1976
and then on the turnover ratio in 1976
while controlling for various factors associated
with economic growth (initial income
per capita, education, political stability,
indicators of exchange rate, trade,
fiscal, and monetary policy) to see
whether stock market liquidity predicts
subsequent economic growth. Importantly,
the level of banking sector development
(bank credit to private enterprises
divided by GDP) measured in
27 Note, Germany's very large turnover ratio
(0.7) reflects the explosion in stock market transactions
duringunification.
28 Levine and Zervos (1996) also construct and
examine two measures of stock trading relative to
stock price movements: (1) the value traded ratio
divided by stock returnvolatility, and (2) the turnover
ratio divided by stock returnvolatility.
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Levine: Financial Development and Economic Growth 713
TABLE 5
GROWTHAND INITIAL STOCK MARKETLIQUIDITY,1976-1993
Value Traded Turnover
Dependant Variable Ratio Ratio
Real Per Capita GDP Growth 0.098*** 0.027***
[0.003] [0.006]
AdjustedR2 0.33 0.34
RealPerCapitaCapitalStockGrowth 0.093*** 0.022***
[0.005] [0.023]
AdjustedR2 0.38 0.35
ProductivityGrowth 0.075*** 0.020**
[0.001] [0.030]
AdjustedR2 0.21 0.21
Source:LevineandZervos(1996)
*
significantatthe 0.10level,**
significantatthe 0.05level, significantatthe 0.01level.
[p-valuesinbrackets]
Observations = 42
ValueTradedRatio=Valueof domesticequitytransactionson domesticstockexchangesdividedbyGDP
TurnoverRatio= Valueof domesticequitytransactionson domesticstockexchangesdividedbydomesticmarket
capitalization.
Otherexplanatoryvariablesincludedin eachofthesixregressions:
logofinitialincome,logofinitialsecondaryschoolenrollment,initialratioof governmentexpendituresto GDP,initialinflationrate,initialblackmarketexchangeratepremium,initialratioof
commercialbanklendingtoprivate
enterprisesdividedbyGDP.
1976 is included in the regressions to assess
the independent link between stock
market liquidity and growth after controlling
for other aspects of financial development.
The results are summarized
in Table 5. The initial level of stock market
liquidity-measured either by the
turnoverratio or the value traded ratiois
a statistically significant predictor of
economic growth, capital accumulation,
and productivitygrowth over the next 18
years. The sizes of the coefficients also
suggest an economically meaningful relationship.
For example, the results imply
that if Mexico had had the sample average
value traded ratio in 1976 (0.044) instead
of its realized 1976 value (0.004),
per capita GDP would have grown at a
0.4 percent faster rate (0.04*0.098). Accumulating
over the 18 year period, this
implies each Mexican would have enjoyed
an almost 8 percent higher income
in 1994. The results are consistent with
the views that the liquidity services provided
by stock markets are independently
important for long-run growth
and that stock markets provide different
financial services from those provided by
financial intermediaries (or else they
would not both enter the growth regressions
significantly).29
Besides the difficulty of assigning a
causal role to stock market liquidity,
there are important limitations to measuring
it accurately (Sanford Grossman
and Merton Miller 1988; and Stephen
29 Stock market size, as measured by market
capitalizationdivided by GDP, is not robustly correlated
with growth, capital accumulation, and
productivityimprovements.
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714 Journal of Economic Literature, Vol. XXXV(June 1997)
Wells 1994). Theory suggests that economies
will benefit from the ability to
trade ownership of an economy's productive
technologies easily. Stock markets,
however, are only one mechanism
for providing liquidity. Banks and bond
marketsmay also provide liquidity. Thus,
measures of stock market liquidity might
omit important financial arrangements
for providing liquidity. Moreover, the
liquidity indicators measure stock transactions
on a country's national stock exchanges.
The physical location of the
stock market,however, should not necessarily
matter. That is, Californian savers
and firms would probably not have
greater access to liquidity if the New
York Stock Exchange were to move to
Los Angeles. Thus, measures of the trading
of equities on a country's exchanges
may not gauge fully the degree of stock
market liquidity available to the economy.
This measurement problem will
increase over time if economies become
more financially integrated and
firms list and issue shares on foreign ex-
changes.
Besides liquidity risk, the financial system
also provides mechanisms for hedging
and trading the idiosyncratic risk associated
with individual projects, firms,
industries, sectors, and countries. While
a vast literature examines the pricing of
risk, there exists very little empirical evidence
that directly links risk diversification
services with long-run economic
growth. Moreover, the only study of the
relationship between economic growth
and the ability of investors to diversify
risk internationally through equity markets
yields inconclusive results (Levine
and Zervos 1996).
One common weakness in empirical
work on liquidity, idiosyncratic risk, and
economic growth is that it focuses on equity
markets. Bond marketsand financial
intermediaries may also provide mechanisms
for diversifying risk. Indeed, technological,
regulatory, and tax differences
across countries may imply that different
financial structures arise to provide liquidity
and risk diversification vehicles.
For example, in one economy the costs
of establishing an intermediary may be
high while the costs of conducting equity
transactions are low. The reverse may
hold in a second economy. The first
economy may provide liquidity and risk
diversification services primarily through
equity markets, while the second does it
through financial intermediaries. The
first economy has an active stock exchange,
so that existing empirical studies
would classify it as providing substantial
liquidity and risk diversification services.
In contrast, existing studies would classify
the second economy as financially underdeveloped.
Thus, measuring the performance
of one part of the financial
system may generate a misleading indicator
of the functioning of the whole financial
system.
E. Financial Functions and Growth:
Information
Theory strongly suggests that financial
intermediaries play an important role in
researching productive technologies before
investment and monitoring managers
and projects after funneling capital
to those projects. Although it is very difficult
to measure whether a country's financial
system is comparatively adept at
reducing information acquisition costs
firm level studies provide insights into
the role played by financial intermediaries
in easing information asymmetries
(Schiantarelli 1995). Theory suggests
that as the costs to outsiders of acquiring
information about a firm rise, a firm's investment
decisions become more tightly
constrained by retained earnings and
current cash flow. Thus, studies test
whether the investment decisions of
firms with particular traits that proxy for
the costs to outsiders of acquiring inforThis
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Levine: Financial Development and Economic Growth 715
mation are more sensitive to cash flow
than firms without those traits. The sample
selection criterion varies across stud-
ies.
The empirical evidence suggests that
the investment decisions of firms with
more severe asymmetric information
problems are more sensitive to cash flow
than those where it is less expensive for
outsiders to monitor. This conclusion
holds when firms are classified according
to whether they have received bond
ratings (Toni Whited 1992; Charles
Calomiris, Charles Himmelberg, and
Wachtel 1995), whether they are issuing
large or small dividends (Steven Fazzari,
Glen Hubbard, and Bruce Peterson
1988; Hubbard, Anil Kashyap, and
Whited 1995), whether they are large or
small (James Tybout 1983; Gertler and
Simon Gilchrist 1994), whether they
place a relatively high or low shadow
value on internal funds based on their
response to taxes (Calomiris and Hubbard
1995), and whether regulations
restrict bank credit allocation (Fidel
Jaramillo, Schiantarelli, Weiss 1996;
John Harris, Schiantarelli, and Miranda
Siregar 1994). In sum, when outsiders
find it expensive to evaluate and fund
particular firms, those firms find it
relatively difficult to raise capital for investment
and rely disproportionately on
internal sources of finance. Thus, financial
innovations or policies that lower
information asymmetries ease firm financing
constraints on more efficient
firms.
More relevant for this section, a large
body of work shows that when firms have
close ties to financial intermediaries, this
reduces information costs and eases firm
financing constraints. Specifically, firms
with close ties to banks tend to be less
constrained in their investment decisions
than those with less intimate, less mature
banking relationships as shown for
Japan (Takeo Hoshi, Kashyap, and
Scharfstein 1990), Italy (Schiantarelli
and Alessandro Sembenelli 1996), and
the United States (Petersen and Rajan
1994). Furthermore, borrowers with
longer banking relationships pay lower
interest rates and are less likely to
pledge collateral than those with less
mature banking relationships (Petersen
and Rajan 1994; and Allen Berger and
GregoryUdell 1995). Finally, stock price
evidence also indicates that banks produce
valuable, private information about
borrowers. When banks sign loan agreements
with borrowers, borrower-firm
stock prices respond positively (Christopher
James 1987; Scott Lummar and
McConnell 1989; and James and Peggy
Weir 1990). The value of the information
obtained by banks about firms can also
be exemplified by Continental Illinois'
troubles in the mid-1980s. MyronSlovin,
Marie Sushka, and John Polonchek
(1993) show that the banks' impending
insolvency negatively affected the stock
prices of its client firms and that the
FDIC's rescue efforts positively affected
the stock prices of those same clients.
These findings are consistent with the
view that the durability of bank-borrower
relationship is valuable. The evidence
directly indicates an important
role for financial intermediaries in reducing
informational asymmetries between
firm insiders and outside investors.
Indirectly, the evidence suggests
that countries with financial institutions
that are effective at relieving information
barriers will promote faster economic
growth through more investment
than countries with financial systems
that are less effective at obtaining and
processing information.
F. Patterns of Financial Development
I now turn to the question: Does financial
structure change as countries develop
and does it differ across countries?
Again, Goldsmith pioneered the crossThis
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716 Journal of Economic Literature, Vol. XXXV(June 1997)
180-
160-
140-
0120-
0
D100
80-
60-
40-
20-
0- r
Financial
Central Commercial Nonbank StockMarket StockMarket
Depth BankAssets BankAssets Assets Capitalization Trading
LowIncome MiddleIncome HighIncome
Figure 2. FinancialStructurein Low-, Middle-, and High-Income Economies, 1990
Sources: IMF (InternationalFinancial Statistics),IFC (Em-ergingMarketsData Base), andindividual
countryreportsby centralbanks,bankingcommissions,and stockexchanges.
Notes: (1) The dataarefor 12 low-income economies (Bangladesh,Egypt, Ghana,Guyana,India,
Indonesia,Kenya,Nigeria,Pakistan,Zaire,Zambia,andZimbabwe),22 middle-income economies
(Argentina,Bolivia,Brazil,Chile, Colombia,CostaRica,the Dominican Republic,El Salvador,Greece,
Guatemala,Jamaica,the Republicof Korea,Malaysia,Mexico,Paraguay,The Philippines,Taiwan,Thailand,
Tunisia,Turkey,Uruguay,andVenezuela),and 14 high-income economies (Australia,Canada,Denmark,
Finland, Germany,Italy,Japan,The Netherlands,Singapore,Spain,Sweden, the United Kingdom,andthe
United States)datapermitting.In 1990, low-income economies had an averageGDP per capitaof $490;
middle-income economies, $2,740;andhigh-income economies, $20,457.
(2) Non-bankfinancialinstitutionsinclude insurancecompanies,pension funds, mutualfunds,brokerage
houses, andinvestmentbanks.
(3) Financialdepth is measuredby currencyheld outside financialinstitutionsplus demanddeposits and
interest-bearingliabilitiesof banksandnonbankfinancialintermediaries.
(4) For stockmarkettradingas apercentage of GDP,Taiwanis omitted because its trading/GDPratioin
1990 was almostten times largerthanthe nexthighest trading/GDPratio(Singapore).WithTaiwan
included, the middle-income stocktradingratiobecomes 37.3 percent.
country work in this area. He traced the
relationship between the mix of financial
intermediaries and economic development
for 35 countries over the period
1860-1963. The World Bank (1989) and
Demirgu,-Kunt and Levine (1996b) recently
extended Goldsmith's work by
examining the association between the
mix of financial intermediaries, markets,
and economic development for approximately
50 countries over the period
1970-1993. This work finds that financial
structure differs considerably across
countries and changes as countries develop
economically.
Four basic findings emerge from
these studies, which are illustrated in
Figure 2. As countries get richer over
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Levine: Financial Development and Economic Growth 717
time or as one shifts from poor to richer
countries,
(1) financial intermediaries get larger
as measured by the total assets or
liabilities of financial intermediaries
relative to GDP;
(2) banks grow relative to the central
bank in allocating credit;
(3) non-banks-such as insurance
companies, investment banks, finance
companies, and private pension
funds-grow in importance;
and
(4) stock markets become larger, as
measured by market capitalization
relative to GDP, and more liquid,
as measured by trading relative to
GDP, market capitalization, and
stock price variability.
While these "patterns" pose a challenge
to financial theorists, they must be
treated cautiously because the data suffer
from numerous problems. For example,
it is difficult to distinguish private
from public banks and development
banks from commercial banks in many
countries. Similarly, the definition of a
bank and of a non-bank are not always
consistent across countries. Furthermore,
there is nothing causal about these
relationships. These patterns alone do
not suggest that poor countries can accelerate
their growth rates by changing
the structure of their financial systems.
Finally, many differences exist across
countries at similar stages of economic
development (World Bank 1989). For example,
the assets of deposit banks composed
56 percent of financial system assets
in France, while the comparable
number in the United Kingdom was 35
percent. The assets of contractual savings
institutions composed 26 percent
of total financial system assets in the
United Kingdom, while in France the
figure was only 7 percent in 1985. Thus,
while there is a general trend involving
financial structure and the level of GDP
per capita, there are important exceptions
and differences within income
groups. While one must be hesitant in
drawing conclusions about patterns of financial
development, an even greater
degree of hesitancy is called for in linking
financial structure to economic
growth.
G. Financial Structureand Economic
Growth
There exists considerable debate, with
sparse evidence and insufficient theory,
about the relationship between financial
structure and economic growth. After
briefly outlining the major examples
used in discussions of financial structure,
I describe the major analytical limitations
impeding research on financial
structure and economic growth. The
classic controversy involves the comparison
between Germany and the United
Kingdom. Starting early in this century,
economists argued that differences in
the financial structure of the two countries
help explain Germany's more rapid
economic growth rate during the latter
half of the 19th century and the first
decade of the 20th century (Alexander
Gerschenkron 1962). The premise is as
follows. Germany's bank-based financial
system, where banks have close ties to
industry, reduces the costs of acquiring
information about firms. This makes it
easier for the financial system to identify
good investments, exert corporate control,
and mobilize savings for promising
investments than in England's more securities
market oriented financial system,
where the ties between banks and
industry are less intimate. Indeed, quite
a bit of evidence suggests that German
bankers were more closely tied to industry
than British bankers. Unlike England,
nearly all German bankers started
as merchants. The evolution from entrepreneur
to banker may explain the comThis
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718 Journal of Economic Literature, Vol. XXXV(June 1997)
paratively close bonds between bankers
and industrialists. For example, German
bankers frequently "mappedout a firm's
paths of growth, conceived farsighted
plans, decided on majortechnological innovations,
and arrangedfor mergers and
capital increases" (Gerschenkron 1968,
p. 137). Private German bankers also organized
and promoted an impressive array
of major manufacturing companies
during the mid-19th century (Richard
Tilly 1967, p. 179). Besides this entrepreneurial
role, some evidence suggests
that German bankers tended to be
more committed to the long-term funding
of their clients than English bankers.
Short-term credits could be transformed
into longer-term securities more easily
in Germany (Tilly 1967, pp. 178-81).
Thus, various pieces of evidence suggest
a closer relationship between banker and
industrialist in Germany. While bankindustry
relationships may have been
closer in Germany, this does not imply
that the German financial system was
better at risk management, providing
liquidity, or facilitating exchange.
Furthermore, economists disagree over
whether the growth differential between
the two was really very large. Although
German manufacturingproduction grew
noticeably faster than Britain'sin the six
decades before World War I, Germany's
overall per capita GNP growth rate was
1.55 while the U.K.'s was 1.35 over the
period 1850 to 1913 (Goldsmith 1969,
pp. 406-07). Thus, aggregate growth differences
are not very large, the significant
differences that do exist are industry
specific, and other factors besides
differences in financial structure may explain
industry specific growth differentials
over this period.
The debate concerning bank-based
versus market-based systems eventually
expanded to include comparisons with
the United States. German banks are
larger as a share of GDP than U.S. banks
and Germanbankers tend to be more intricately
involved in the management of
industry than U.S. bankers (Randall
Pozdena and Volbert Alexander 1992;
Franklin Allen and Gale 1995; and
Demirgu,-Kunt and Levine 1996a). Furthermore,
historical evidence suggests
that German universal banks were more
efficient (lower cost of capital) than U.S.
banks over the 1870-1914 period and
suffered less systemic problems than the
U.S. bankingsystem (Calomiris 1995). In
contrast, the U.S. financial system is
typically characterized as having a comparatively
larger, more active securities
markets with more equities held by
households. These observations suggest
that the German bank-based system may
reduce information asymmetries and
thereby allow banks to allocate capital
more efficiently and to exert corporate
control more effectively. In contrast, the
United States' securities market-based
financial system may offer advantagesin
terms of boosting risk sharingopportunities
(Allen and Gale 1995). While this
functional approach highlights the relevant
issues, substantially more research
is needed before drawing conclusions
about the dominance of one financial
structure over another.30
Many of the arguments involving
bank-based versus securities marketbased
financial systems have been used
to compare Japanand the United States.
For example, research suggests that
Japanese bankers are more closely tied
to industrial clients than U.S. bankers.
This closer connection may mitigate information
asymmetries (Hoshi, Kasyap,
and Sharfstein 1990), which may foster
better investment and faster growth.
Thus, the structure of the Japanese financial
system is sometimes viewed as
superior to the financial structure of the
30 Park (1993) compares the structure and functioning
of the financial systems of Korea and Taiwan
in relation to their industrialcomposition.
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Levine: Financial Development and Economic Growth 719
United States and an important factor in
Japan's faster growth rate over the last
four decades. Interestingly, however, the
recent banking problems and slower
growth in Japan have led some to argue
that the absence of a credible takeover
threat through efficient stock markets
has impeded proper corporate governance
and competitiveness. These conflicting
analyses highlight the need for
better empirical measures of financial
structure and the functions provided by
financial systems.
There are severe analytical problems
with linking financial structure to economic
performance. First, existing research
on financial structure does not
quantify the structure of financial systems
or how well different financial
systems function overall. For example,
German bankers may have been more
closely connected to industrialists than
their British counterparts, but less capable
at providing liquidity and facilitating
transactions. Similarly, while Japanese
Keiretsu may lower information acquisition
costs between banks and firms, this
does not necessarily imply that the Japanese
financial system provides greater
risk sharing mechanisms or more accurately
spot promising new lines of business.
Furthermore, while Japan is sometimes
viewed as a bank-based system, it
has one of the best developed stock markets
in the world (Demirgu,-Kunt and
Levine 1996a). Thus, the lack of quantitative
measures of financial structure
and the functioning of financial systems
make it difficult to compare financial
structures.
Second, given the array of factors influencing
growth in Germany, Japan, the
United Kingdom, and the United States,
it is analytically difficult-and perhaps
reckless-to attribute differences in
growth rates to differences in the financial
sector. Moreover, over the post
World War II period, the devastated
Axis powers may simply have been converging
to the income levels of the
United States, such that observed
growth rate differentials have little to do
with financial structure. Thus, before
linking financial structure with economic
growth, researchers need to control for
other factors influencing long-run
growth.
A third factor that complicates the
analysis of financial structure and economic
growth is more fundamental. The
current debate focuses on bank-based
systems versus market-based systems.
Some aggregate and firm level evidence,
however, suggest that this dichotomy is
inappropriate. The data indicate that
both stock market liquidity-as measured
by stock trading relative to GDP
and market capitalization-and the level
of banking development-as measured
by bank credits to private firms divided
by GDP predict economic growth over
subsequent decades (Levine and Zervos
1996). Thus, it is not banks or stock markets;
bank and stock market development
indicators both predict economic
growth. Perhaps, the debate should not
focus on bank-based versus marketbased
systems because these two components
of the financial system enter the
growth regression significantly and predict
future economic growth. It may be
that stock markets provide a different
bundle of financial functions from those
provided by financial intermediaries. For
example, stock markets may primarily
offer vehicles for trading risk and boosting
liquidity. In contrast, banks may focus
on ameliorating information acquisition
costs and enhancing corporate
governance of major corporations. This
is merely a conjecture, however. There
are important overlaps between the services
provided by banks and stock markets.
As noted above, well-functioning
stock markets may ameliorate information
acquisition costs, and banks may
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720 Journal of Economic Literature, Vol. XXXV(June 1997)
provide instruments for diversifying risk
and enhancing liquidity. Thus, to understand
the relationship between financial
structure and economic growth, we need
theories of the simultaneous emergence
of stock markets and banks and we need
empirical proxies of the functions performed
by the different components of
financialsystems.
A fourth factor limiting our understanding
of the links between financial
structure and economic growth is that
researchers have focused on a few industrialized
countries due to data limitations.
The United States, Germany, Japan,
and the United Kingdom have
basically the same standardof living. Averaged
over a sufficiently long time period,
they must also have very similar
growth rates. Thus, comparisons of financial
structure and economic development
using only these countries will tend
to suggest that financial structure is unrelated
to the level and growth rate of
economic development. Future studies
will need to incorporate a more diverse
selection of countries to have even a
chance of identifying patterns between
financial structure and economic devel-
opment.
Finally, there are important interactions
between stock markets and banks
during economic development that have
not been the focus of bank-based versus
market-based comparisons. As noted,
greater stock market liquidity is associated
with faster rates of capital formation.
Nonetheless, new equity sales do
not finance much of this new investment
(Colin Mayer 1988), though important
differences exist across countries (Ajit
Singh and Javed Hamid 1992). Most new
corporate investment is financed by
retained earnings and debt. This raises
a quandary: stock market liquidity is
positively associated with investment,
but equity sales do not finance much of
this investment. This quandary is confirmed
by firm-level studies. In relatively
poor countries, enhanced stock market
liquidity actually tends to boost corporate
debt-equity ratios; stock market liquidity
does not induce a substitution
out of debt and into equity finance
(Demirgu,-Kunt and Maksimovic1996a).
However, for industrialized countries,
debt-equity ratios fall as stock market liquidity
rises; stock market liquidity induces
a substitution out of debt finance.
The evidence suggests complex interactions
between the functioning of stock
markets and corporate decisions to borrow
from banksthat depend on the overall
level of economic development. Thus,
we need considerably more research
into the links among stock markets,
banks, and corporate financing decisions
to understand the relationship between
financial structure and economic
growth.
IV. Conclusions
Since Goldsmith (1969) documented
the relationship between financial and
economic development 30 years ago, the
profession has made important progress.
Rigorous theoretical work carefully illuminates
many of the channels through
which the emergence of financial markets
and institutions affect-and are affected
by-economic development. A
growing body of empirical analyses, including
firm-level studies, industry-level
studies, individual country-studies, and
broad cross country comparisons, demonstrate
a strong positive link between
the functioning of the financial system
and long-run economic growth. Theory
and evidence make it difficult to conclude
that the financial system merelyand
automatically-responds to industrialization
and economic activity, or that
financial development is an inconsequential
addendum to the process of
economic growth. I believe that we will
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Levine: Financial Development and Economic Growth 721
not have a sufficient understanding of
long-run economic growth until we understand
the evolution and functioning
of financial systems. This conclusion
about financial development and longrun
growth has an important corollary:
although financial panics and recessions
are critical issues, the finance-growth
link goes beyond the relationship between
finance and shorter-term fluctua-
tions.
Undoubtedly, the financial system is
shaped by nonfinancial developments.
Changes in telecommunications, computers,
nonfinancial sector policies, institutions,
and economic growth itself influence
the quality of financial services
and the structure of the financial system.
Technological improvements lower
transaction costs and affect financial arrangements
(Merton 1992). Monetary
and fiscal policies affect the taxation of
financial intermediaries and the provision
of financial services (Bencivenga
and B. Smith 1992; Roubini and Sala-iMartin
1995). Legal systems affect financial
systems (LaPorta et al. 1996), and
political changes and national institutions
critically influence financial development
(Haber 1991, 1996). Furthermore,
economic growth alters the
willingness of savers and investors to pay
the costs associated with participating in
the financial system (Greenwood and
Jovanovic 1990). While economists have
made important advances, we need
much more research on financial development.
Why does financial structure
change as countries grow?Why do countries
at similar stages of economic development
have different looking financial
systems? Are there long-run economic
growth advantages to adopting legal and
policy changes that create one type of financial
structure vis-a-vis another?
Much more information about the determinants
and implications of financial
structure will move us closer to a comprehensive
view of financial development
and economic growth.
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