Magazine article Regional Economist

Financial Markets: An Engine for Economic Growth

Magazine article Regional Economist

Financial Markets: An Engine for Economic Growth

Article excerpt

In the aftermath of the 2008 financial crisis, it is natural to wonder about the roles that the highly developed financial sector plays in our economy Some might wonder whether this sector causes more harm than it does good. In this article, I examine data from countries with varying degrees of economic development and argue that developed financial markets are an essential ingredient of long-run economic growth.

Before I begin, let me clarify two things. First, it is not my contention that all financial market activities have a posi- tive impact on economic growth. To the contrary, excesses and abuses in financial markets can be detrimental to economic growth in the long run. Second, developed financial markets provide useful services that do not directly contribute to economic growth. For example, most insurance policies are designed to enhance economic welfare through better allocation of risk, not through the promotion of economic growth. More broadly, the purpose of this article is not to list all the pros and cons of financial market development. Rather, I show the importance of financial markets to economic growth. Knowing the important contributions of well-functioning financial markets will help us figure out (1) which financial market activities to promote and (2) where to direct our regulatory and supervisory efforts.

The Schumpeterian Hypothesis

The nexus of finance and economic growth was first emphasized by Joseph Schumpeter in 1911. In Schumpeter's theory, widely known as the theory of "cre- ative destruction," innovation and entrepre- neurship are the driving forces of economic growth. He viewed finance as an essential element of this process. Innovation and entrepreneurship will thrive when the economy can successfully mobilize produc- tive savings, allocate resources efficiently, reduce problems of information asymmetry and improve risk management, all of which are services provided by a developed finan- cial sector.

The surest way to test such a hypoth- esis would be to perform a randomized, controlled experiment, in which we would improve financial markets in a randomly chosen group of countries and shut down financial markets in the others. Since it is not possible (or desirable) to conduct such experiments on national economies, econo- mists have tried to infer the importance of finance for economic growth from observa- tions on countries with varying degrees of financial and economic development.

The first attempts at empirical evaluations of Schumpeter's hypothesis came in the late 1960s and the early 1970s; these attempts documented close relationships between financial development and economic development across countries.1 However, critics refuted this evidence, rightly, since correlation does not imply causation. Many prominent economists argued that finance simply follows economic development.2

More recently, researchers have responded to this criticism. I highlight three different approaches in this article.

Empirical Patterns across Countries

First, in a 1993 paper, Robert King and Ross Levine addressed the correlation-not- causation issue by showing that countries with higher levels of financial development in 1960 experienced higher rates of economic growth in the following three decades. King and Levine measured a country's financial development in terms of the levels of credit (e.g., bank loans and bonds issued) and stock market capitalization, a metric that is still widely used. Based on their findings, they rejected the idea that finance merely follows economic growth. But their results did not prove-for at least two reasons-that finance causes economic growth.

First, even though a country's financial development in 1960 is a predetermined variable relative to the economic growth in the next three decades, both financial and economic development may still be mere consequences of a common omitted fac- tor. Second, because financial markets are forward-looking, financial development in 1960 maybe the consequence of anticipated economic growth of the next few decades. …

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