Financial Development, Economic Growth,
As we have seen, developing the institutions that allow a financial system to overcome the problems created by asymmetric information is challenging. Indeed, recent research finds that an important reason why many developing countries and transition (i.e., ex-communist) countries like Russia experience low rates of growth is that their financial systems are underdeveloped, a situation referred to as financial repression.1 We can understand why this is so by returning to the metaphor of the financial system as the brain of an economy: just as repressing the activity of the human brain (say, by the use of drugs or alcohol) seriously impairs a person's ability to carry out even simple tasks, financial repression is a severe impediment to economic growth and the reduction of poverty.
Growth Linked? The Evidence
The evidence that financial development, often called financial deepening, and economic growth are linked is quite strong. (I am using the term deepening to refer to financial development that includes not only expansion in the financial sector but also improvement in institutions, so that the financial system can allocate capital to its most productive uses more efficiently.)2 A pioneering study by Robert King and Ross Levine using a sample of eighty countries found that those with larger financial sectors back in 1960 experienced greater economic growth over the subsequent thirty years.3 Later studies using more