Finance and Growth: Schumpeter Might Be Right

Abstract

Joseph Schumpeter argued in 1911 that the services provided by financial intermediaries - mobilizing savings, evaluating projects, managing risk, monitoring managers, and facilitating transactions -stimulate technological innovation and economic development. The authors present evidence that supports this view. Examining a cross-section of about 80 countries for the period 1960-89, they find that various measures of financial development are strongly associated with both current and later rates of economic growth. Each measure has shortcomings but all tell the same story: finance matters. They present three main findings, which are robust to many specification tests: The average level of financial development for 1960-89 is very strongly associated with growth for the period. Financial development precedes growth. For example, financial depth in 1960 (the ratio of broad money to GDP) is positively and significantly related to real per capita GDP growth over the next 30 years even after controlling for a variety of country-specific characteristics and policy indicators. Financial development is positively associated with both investment rate and the efficiency with which economies use capital. Much work remains to be done, but the data are consistent with Schumpeter's view that the services provided by financial intermediaries stimulate long-run growth.

Keywords: Governance Indicators, Achieving Shared Growth, Economic Theory & Research, Inequality, Economic Growth