Financial Development and Economic Growth

Among the most striking empirical macroeconomic relationships uncovered in the past decade is the apparently causal link between financial development and economic growth. This chapter begins (Section 2) with a brief account of the key methodological elements underlying this discovery.

In modern economies finance underpins virtually every economic transaction that takes place. When we go to the supermarket, we usually pay using credit or debit cards issued by commercial banks (or the supermarkets themselves). Even when we pay using cash, we have to first find an ATM in order to withdraw the necessary bank notes. The banking system, which includes commercial banks as well as the central bank (the Bank of England in the United Kingdom), provides the payments system which makes economic exchange possible. It is hard to imagine what economies would look like without ‘money’ — broadly defined as anything that is used in exchange for goods and services and the settlement of debt. Besides providing the means of payment, which underpins all economic transactions, the financial system provides a link between current and future output and consumption. When we borrow from a bank to buy a car, we are essentially bringing forward consumption against future income. This is made possible because financial intermediaries, like banks, raise funds from surplus units (those economic agents whose income is greater than their current expenditure) and pass them on as loans to deficit units (those economic agents whose income is less than their current expenditure).

Competition in the financial sector matters for a number of reasons. As in other industries, the degree of competition in the financial sector can affect the efficiency of the production of financial services. Also, again as in other industries, it can affect the quality of financial products and the degree of innovation in the sector. Specific to the financial sector is the link between competition and stability that has long been recognized in theoretical and empirical research and, most importantly, in the actual conduct of prudential policy towards banks. Importantly, it has also been shown, theoretically as well as empirically, that the degree of competition in the financial sector can effect the access of firms and households to financial services and external financing. The direction of the latter relationship is, however, unclear. Less competitive systems may lead to more access to external financing since banks are more inclined to invest in information acquisition and relationships with borrowers. When banking systems are less competitive, however, hold-up problems may lead borrowers to be less willing to enter such relationships. Furthermore, less competitive banking systems can be more costly and exhibit a lower quality of services thus providing less financing and encouraging less growth. These effects may further vary by the degree of a country’s financial sector development.

A growing and deepening divide has opened up between transition countries where economic development has taken off and those caught in a vicious cycle of institutional backwardness and macroeconomic instability. This “Great Divide” is visible in almost every measure of economic performance: GDP growth, investment, government finances, growth in inequality, general institutional infrastructure and increasingly in measures of financial development. Strategies for financial development have differed dramatically across countries and over time, offering interesting opportunities to study the links between real and financial sector development.

Economies are built upon people buying and selling, lending and borrowing. The beauty of the market is that, when it works well, sellers are matched to buyers and lenders are matched to worthy borrowers. But when the market does not work well, goods go unsold and promising investment projects go unfunded. We understand why markets fail - the economics of information provides rigorous underpinnings for why credit markets, in particular, are so problematic.¹ The challenge has been to move from diagnosis to prescription. The challenge is particularly great in poorer regions, where individuals may have workable ideas and relevant experience but lack collateral. Even a £100 loan can make a difference to a small-scale shopkeeper or craftsperson in countries like Nepal or Uganda, but formal sector banks have steered clear, focusing instead on larger loans to better-established, wealthier clients.

Institutional investors comprise pension funds, insurance companies and mutual funds. A salient feature of many OECD countries, and some Emerging Market Economies in recent years, is growth of such institutional investors, notably in the wake of pension reform shifting retirement income provision from pay-as-you-go to funding. Table 6.1 shows the size of pension fund sectors in selected countries where radical pension reform has taken place.² The ongoing ageing of the population and financing difficulties of pay-as-you-go systems suggests that such reforms will become yet more common in the future. Accordingly, it is important to analyse the impact of institutional investment on the economy.

Let me start with a sweeping assertion. Sustainable growth primarily depends on three main factors; these are good governance, technological development and efficient markets. I put good governance first, because in its absence technological development and markets will be blighted, distorted and misused.