Financial Development and Economic Growth: Views and Agenda

Abstract

October 1996

A growing body of theoretical and empirical work would push even skeptics toward the belief that the development of financial markets and institutions is critical to economic growth, rather than a sideshow or a passive response to growth.

Levine argues that the preponderance of theoretical reasoning and empirical evidence suggests a positive, first-order relationship between financial development and economic growth. 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-level, and firm-level analyses document extensive periods when financial development (or the lack thereof) crucially affects the speed and pattern of economic development.

Levine 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. A growing literature shows that differences in how well financial systems reduce information and transaction costs influence savings rates, investment decisions, technological innovation, and long-run growth rates.

A less developed theoretical literature shows how changes in economic activity can influence financial systems.

Without minimizing the role of institutions, Levine advocates a 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. Levine discourages a narrow focus on one financial instrument, such as money, or a particular institution, such as banks. Instead, he addresses the more comprehensive, and difficult question: What is the relationship between financial structure and the functioning of the financial system?

More research is needed on financial development. Why does financial structure change as countries grow, for example? 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 rather than another?

This paper is a product of the Finance and Private Sector Development Division, Policy Research Department.