Professional Documents
Culture Documents
Journal of Economic Literature, Vol. 35, No. 2 (Jun., 1997), pp. 688-726
Ross LEVINE
University of Virginia
I thank, u ~ t h o u zmplzcat~ng,
t Gerard Capno, iMarza Carkoo~c,Daozd Cole, Robert Cull, WII-
lzam Easterly, Mark Gertler, Fabzo Schzantarellz, Mary Shzfley, Bruce Smzth, and Kenneth
Sokolofffor crztzczsms, guzdance, and encouragement T h ~ ps aper was wrltten u,lz~le I was at
the World Bank Opznzons expressed are those of the author and do not necessarzly reflect the
ozews of the World Bank, zts staff, or nrember countries
lief that the development of financial ing the trading of risk, allocating capital,
markets and institutions is a critical and monitoring managers, mobilizing sav-
inextricable part of the growth process ings, and easing the trading of goods,
and away from the view that the financial services, and financial c o n t r a c t s . V h e
system is an inconsequential side show, basic functions remain constant through
responding passively to economic growth time and across countries. There are
and industrialization. There is even evi- large differences across countries and
dence that the level of financial devel- time, however, in the quality of financial
opment is a good predictor of future services and in the types of financial in-
rates of economic growth, capital accu- struments, markets, and institutions that
mulation, and technological change. arise to provide these services. While fo-
Moreover, cross country, case study, in- cusing on functions, this approach does
dustry- and firm-level analyses document not diminish the role of institutions. In-
extensive periods when financial devel- deed, the functional approach highlights
opment-or the lack thereof-crucially the importance of examining an under-
affects the speed and pattern of eco- researched topic: the relationship be-
nomic development. tween financial structure-the mix of
To arrive at these conclusions and to financial instruments, markets, and insti-
highlight areas in acute need of addi- tutions-and the provision of financial
tional research, I organize the remainder services. Thus, this approach discourages
of this paper as follows. Section I1 ex- a narrow focus on one financial instru-
plains what the financial system does and ment, like money, or a particular institu-
how it affects-and is affected by-eco- tion, like banks. Instead, the functional
nomic growth. Theory suggests that fi- approach prompts a more comprehen-
nancial instruments, markets, and insti- sive-and more difficult-auestion: what
1
same direction: the functioning of finan- of the geographic source of those ser-
cial systems is vitally linked to economic vices. In measuring financial develop-
growth. Specifically, countries with ment, however, researchers often do not
larger banks and more active stock mar- account sufficiently for international
kets grow faster over subsequent de- trade in financial services. Second, the
cades even after controlling for many paper does not discuss policy. Given the
other factors underlying economic links between the functioning of the fi-
growth. Industries and firms that rely nancial system and economic growth, de-
heavily on external financing grow dis- signing optimal financial sector policies
proportionately faster in countries with is critically important. A rigorous discus-
well-developed banks and securities sion of these policies, however, would
markets than in countries with poorly require a long article or book by itself.5
developed financial systems. Moreover, Instead, this paper seeks to pull together
ample country studies suggest that dif- a diverse and active literature into a co-
ferences in financial development have, herent view of the financial system in
in some countries over extensive periods, economic growth.
critically influenced economic develop-
ment. Yet, these results do not imply 11. The Functions o f t h e Financial
that finance is everywhere and always ex- System
ogenous to economic growth. Economic
A. Functional Approach: Introduction
activity and technological innovation un-
doubtedly affect the structure and qual- The costs of acquiring information and
ity of financial systems. Innovations in making transactions create incentives
telecommunications and computing have for the emergence of financial markets
undeniably affected the financial ser- and institutions. Put differently, in a
vices industry. Moreover, "third factors," Kenneth Arrow (1964)-Gerard Debreu
such as a country's legal system and po- (1959) state-contingent claim framework
litical institutions certainly drive both fi- with no information or transaction costs,
nancial and economic development at there is no need for a financial system
critical junctures during the growth pro- that expends resources researching proj-
cess. Nevertheless, the weight of evi- ects, scrutinizing managers, or designing
dence suggests that financial systems are arrangements to ease risk management
a fundamental feature of the process of and facilitate transactions. Thus, any the-
economic development and that a satis- ory of the role of the financial system in
factory understanding of the factors un- economic growth (implicitly or explic-
derlying economic growth requires a itly) adds specific frictions to the Arrow-
greater understanding of the evolution Debreu model. Financial markets and
and structure of financial systems. institutions may arise to ameliorate the
As in any critique, I omit or treat cur- problems created by information and
sorily important issues. Here I highlight transactions frictions. Different types
First, I do not discuss the relation- and combinations of information and
ship between international finance and transaction costs motivate distinct finan-
growth. This paper narrows its concep- cial contracts, markets, and institutions.
tual focus by studying the financial ser-
vices available to an economy regardless " The financial policy literature is immense. See,
for example, Philip Brock (1992), Alberto Giovan-
4 Also, the theoretical review focuses on purely nini and Martha D e Melo (1993), Caprio, Isak Ati-
real economies and essentially ignores work on fi- yas, and James Hanson (1994), and Maxwell Fry
nance and growth in monetary economies. (1995).
In arising to ameliorate transaction
and information costs, financial systems
serve one primary function: they facili-
tate the allocation of resources, across
space and time, in an uncertain environ-
ment (Merton and Bodie 1995, p. 12).
To organize the vast literature on fi-
nance and economic activity, I break this
primary function into five basic func-
tions.
Specifically, financial systems
- facilitate the trading, hedging, diver-
sifying, and pooling of risk,
- allocate resources,
- monitor managers and exert corpo-
rate control,
- mobililize savings, and
- facilitate the exchange of goods and
services.
This section explains how particular
market frictions motivate the emergence
of financial markets and intermediaries
that provide these five functions, and ex-
plains how they affect economic growth.
I examine two channels through which
each financial function may affect eco-
.
Levine: Financial Development and Economic Growth
&
.
I
- information costs
- transaction costs
Financial markets
and intermediaries
Financial functzons
- mobilize savings
- allocate resources
- exert corporate control
- facilitate risk management
- ease trading of goods,
-
senices, contracts
Channels to growth
- capital acculnulation
technological innovation
Growth
nomic growth: capital accumulation and Aghion and Peter Howitt 1992). In these
technological innovation. On capital ac- models, the functions performed by the
cumulation, one class of growth models financial system affect steady-state
uses either capital externalities or capital growth by altering the rate of technologi-
goods produced using constant returns cal innovation. Thus, as sketched in Fig-
to scale but without the use of nonrepro- ure 1, the remainder of this section dis-
ducible factors to generate steady-state cusses how specific market frictions
per capita growth (Paul Romer 1986; motivate the emergence of financial con-
Lucas 1988; Sergio Rebelo 1991). In these tracts, markets, and intermediaries and
models, the functions performed by the how these financial arrangements pro-
financial system affect steady-state growth vide five financial functions that affect
by influencing the rate of capital forma- saving and allocations decisions in ways
tion. The financial system affects capital that influence economic growth.
accumulation either by altering the sav-
B. Facilitating Risk Amelioration
ings rate or by reallocating savings among
different capital producing technologies. In the presence of specific information
On technological innovation, a second and transaction costs, financial markets
class of growth models focuses on the in- and institutions may arise to ease the
vention of new production processes and trading, hedging, and pooling of risk.
goods (Romer 1990; Gene Grossman and This subsection considers two types of
Elhanan Helpman 1991; and Philippe risk: liquidity and idiosyncratic r i s k .
692 Journal of Economic Literatrare, Vol. XXXV (Tune 1997)
Liquidity is the ease and speed with market liquidity. With liquid capital mar-
which agents can convert assets into pur- kets, savers can hold assets-like equity,
chasing power at agreed prices. Thus, bonds, or demand deposits-that they
real estate is typically less liquid than can sell quickly and easily if they seek
equities, and equities in the United access to their savings. Simultaneously,
States are typically more liquid than capital markets transform these liquid fi-
those traded on the Nigerian Stock Ex- nancial instruments into long-term capi-
change. Liquidity risk arises due to the tal investments in illiquid production
uncertainties associated with converting processes. Because the industrial revolu-
assets into a medium of exchange. Infor- tion required large commitments of capi-
mational asymmetries and transaction tal for long periods, the industrial revo-
costs may inhibit liquidity and intensify lution may not have occurred without
liquidity risk. These frictions create in- this liquidity transformation. "The indus-
centives for the emergence of financial trial revolution therefore had to wait for
markets and institutions that augment li- the financial revolution" (Valerie Ben-
quidity. Liquid capital markets, there- civenga, Bruce Smith, and Ross Starr
fore, are markets where it is relatively 1966, p. 243).6
inexpensive to trade financial instru- Economists have recently modeled the
ments and where there is little uncer- emergence of financial markets in re-
tainty about the timing and settlement of sponse to liquidity risk and examined
those trades. how these financial markets affect eco-
Before delving into formal models of nomic growth. For example, in Douglas
liquidity and economic activity, some in- Diamond and Philip Dybvig's (1983)
tuition and history may help motivate seminal model of liquidity, a fraction of
the discussion. The link between liquid- savers receive shocks after choosing be-
ity and economic development arises be- tween two investments: an illiquid, high-
cause some high-return projects require return project and a liquid, low-return
a long-run commitment of capital, but project. Those receiving shocks want ac-
savers do not like to relinquish control of cess to their savings before the illiquid
their savings for long periods. Thus, if project produces. This risk creates in-
the financial system does not augment centives for investing in the liquid, low-
the liquidity of long-term investments, return projects. The model assumes that
less investment is likely to occur in the it is prohibitively costly to verify whether
high-return projects. Indeed, Sir John another individual has received a shock
Hicks (1969, pp. 143-45) argues that the or not. This information cost assumption
capital market improvements that miti- rules out state-contingent insurance con-
gated liquidity risk were primary causes tracts and creates an incentive for finan-
of the industrial revolution in England. cial markets-markets where individuals
According to Hicks, the products manu- issue and trade securities-to emerge. In
factured during the first decades of the Levine (1991), savers receiving shocks
industrial revolution had been invented
much earlier. Thus, technological inno-
vation did not, spark sustained growth. 6The financial revolution included the emer-
gence of joint-stock com anies with nonredeem-
Many of these existing inventions, how- able capital The DutcR East India Company
ever, required large injections and long- made capital ermanent in 1609, and Cromwell
run commitments of capital. The critical made the Eng8sh East India Company capital per-
manent in 1650. These financial innovations
new ingredient that ignited growth in formed the basis of liquid equity markets (Larry
eighteenth century England was capital Neal 1990).
Levine: Financial Development a n d Economic Growth 693
can sell their equity claims on the profits mediaries-coalitions of agents that com-
of the illiquid production technology to bine to provide financial services-may
others. Market participants do not verify also enhance liquidity and reduce liquid-
whether other agents received shocks or ity risk. As discussed above, Diamond
not; participants simply trade in imper- and Dybvig's (1983) model assumes it is
sonal stock exchanges. Thus, with liquid prohibitively costly to observe shocks to
stock markets, equity holders can readily individuals, so it is impossible to write
sell their shares, while firms have perma- incentive compatible state-contingent in-
nent access to the capital invested by the surance contracts. Under these condi-
initial shareholders. By facilitating trade, tions, banks can offer liquid deposits to
stock markets reduce liquidity risk.7 As savers and undertake a mixture of liquid,
stock market transaction costs fall, more low-return investments to satisfy de-
investment occurs in the illiquid, high- mands on deposits and illiquid, high-re-
return project. If illiquid projects enjoy turn investments. By providing demand
sufficiently large externalities, then deposits and choosing an appropriate mix-
greater stock market liquidity induces ture of liquid and illiquid investments,
faster steady-state growth. banks provide complete insurance to sav-
Thus far, information costs-the costs ers against liquidity risk while simulta-
of verifying whether savers have re- neously facilitating long-run investments
ceived a shock-have motivated the ex- in high-return projects. Banks replicate
istence of stock markets. Trading costs the equilibrium allocation of capital that
can also highlight the role of liquidity. exists with observable shocks. By elimi-
For example, different production tech- nating liquidity risk, banks can increase
nologies may have a wide array of gesta- investment in the high-return, illiquid
tion periods for converting current out- asset and accelerate growth (Bencivenga
put into future capital, where longer-run and B. Smith 1991). There is a problem,
technologies enjoy greater returns. In- however, with this description of the role
vestors, however, may be reluctant to re- of banks as reducing liquidity risk. The
linquish control of their savings for very banking equilibrium is not incentive
long periods. Thus, long-gestation pro- compatible if agents can trade in liquid
duction technologies require that owner- equity markets; if equity markets exist,
ship be transferred throughout the life all agents will use equities; none will use
of the production process in secondary banks (Charles Jacklin 1987). Thus, in
securities markets (Bencivenga, B. Smith, this context, banks will only emerge to
and Starr 1995). If exchanging owner- provide liquidity if there are sufficiently
ship claims is costly, then longer-run large impediments to trading in securi-
production technologies will be less at- ties markets (Gary Gorton and George
tractive. Thus, liquidity-as measured by Pennacchi 1990).8
secondary market trading costs-affects
production decisions. Greater liquidity 8Goldsmith (1969, p . 396) notes that "Claims
against financial institutions are generally easier to
will induce a shift to longer-gestation, liquidate (i.e., to turn into cash without or with
higher- return technologies. only insignificant delay, formality, and cost) than
Besides stock markets, financial inter- are primary debt securities. They have the addi-
Theory, however, suggests that en- turn projects. Thus, financial markets
hanced liquidity has an ambiguous affect that ease risk diversification tend to in-
on saving rates and economic growth.9 In duce a portfolio shift toward projects
most models, greater liquidity (a) with higher expected returns (Gilles
increases investment returns and (b) Saint-Paul 1992; Michael Devereux and
lowers uncertainty. Higher returns am- Gregor Smith 1994; and Maurice
biguously affect saving rates due to well- Obstfeld 1994). Greater risk sharing and
known income and substitution effects. more efficient capital allocation, how-
Further, lower uncertainty ambiguously ever, have theoretically ambiguous ef-
affects savings rates (David Levhari and fects on saving rates as noted above. The
T. N. Srinivasan 1969). Thus, saving savings rate could fall enough so that,
rates may rise or fall as liquidity rises. when coupled with an externality-based
Indeed, in a model with physical capital or linear growth model, overall economic
externalities, saving rates could fall growth falls. With externalities, growth
enough, so that growth actually deceler- could fall sufficiently so that overall wel-
ates with greater liquidity (Tullio Jap- fare falls with greater risk diversifica-
pelli and Marco Pagano 1994).10 tion.
Besides reducing liquidity risk, finan- Besides the link between risk diversifi-
cial systems may also mitigate the risks cation and capital accumulation, risk di-
associated with individual projects, versification can also affect technological
firms, industries, regions, countries, etc. change. Agents are continuously trying
Banks, mutual funds, and securities mar- to make technological advances to gain a
kets all provide vehicles for trading, profitable market niche. Besides yielding
pooling, and diversifying risk.11 The fi- profits to the innovator, successful inno-
nancial system's ability to provide risk di- vation accelerates technological change.
versification services can affect long-run Engaging in innovation is risky, however.
economic growth by altering resource al- The ability to hold a diversified portfolio
location and the saving rates. The basic of innovative projects reduces risk and
intuition is straightforward. While savers promotes investment in growth-enhanc-
generally do not like risk, high-return ing innovative activities (with sufficiently
projects tend to be riskier than low-re- risk averse agents). Thus, financial sys-
tems that ease risk diversification can ac-
9 T h e analyses described thus far focus on the celerate technological change and eco-
links between liquidity and ca ital accumulation. nomic growth (Robert King and Levine
Yet, liquidity may also affect 8 e rate of techno-
logical change if long-run commitments of re- 1993~).
sources to research and development promote
technolo ical innovation. C. Acquiring Information About
l o sim8arly, although greater liquidity unambi- Investments and Allocating
guously raises the real return on savings, more li- Resources
quidim ~ ay induce a reallocation of investment
out o initiating new capital investments and into I t is difficult and costly to evaluate
purchasing claims on ongoing projects. This ma
lower the rate of real investment enough to dece[ firms, managers, and market conditions
erate growth (Bencivenga, B. smith: and Starr as discussed by Vincent Carosso (1970).
1995). Individual savers may not have the time,
1lAlthough the recent uses of options and fu-
tures contracts to hedge risk have been well publi- capacity, or means to collect and process
cized, the development of these financial con- information on a wide array of enter-
tracts is by no means recent. Josef Penso de la prises, managers, and economic condi-
Vega published a treatise on options contracts, fu-
tures contracts, and securities market speculation, tions. Savers will be reluctant to invest in
Confusion de Confusiones, in 1688! activities about which there is little reli-
Levine: Financial Development and Economic Growth 695
able information. Consequently, high in- ventures than most countries in the mid-
formation costs may keep capital from 1800s, which helped it enjoy compara-
flowing to its highest value use. tively greater economic success.12
Information acquisition costs create Besides identifying the best produc-
incentives for financial intermediaries to tion technologies, financial intermediar-
emerge (Diamond 1984; and John Boyd ies may also boost the rate of technologi-
and Edward Prescott 1986). Assume, for cal innovation by identifying those
example, that there is a fixed cost to entrepreneurs with the best chances of
acquiring information about a product- successfully initiating new goods and
ion technology. Without intermediaries, production processes (King and Levine
each investor must pay the fixed cost. In 1 9 9 3 ~ )As
. eloquently stated by Schum-
response to this information cost struc- peter (1912, p. 74),
ture, however, groups of individuals may The banker, therefore, is not so much pri-
form (or join or use) financial intermedi- marily a middleman, . . . He authorises peo-
aries to economize on the costs of ac- ple, in the name of society as it were, . . . [to
quiring and processing information innovate].
about investments. Instead of each indi- Stock markets may also influence the
vidual acquiring evaluation skills and acquisition and dissemination of infor-
then conducting evaluations, an interme- mation about firms. As stock markets be-
diary can do it for all its members. come larger (Sanford Grossman and
Economizing on information acquisition Joseph Stiglitz 1980) and more liquid
costs facilitates the acquisition of infor- (Albert Kyle 1984; and Bengt Holm-
mation about investment opportunities strom and Jean Tirole 1993), market par-
and thereby improves resource alloca- ticipants may have greater incentives to
tion. acquire information about firms. Intui-
The ability to acquire and process in- tively, with larger more liquid markets, it
formation may have important growth is easier for an agent who has acquired
implications. Because many firms and information to disguise this private
entrepreneurs will solicit capital, finan- information and make money. Thus,
cial intermediaries, and markets that are large, liquid stock markets can stimulate
better at selecting the most promis- the acquisition of information. More-
ing firms and managers will induce a over, this improved information about
more efficient allocation of capital and firms should improve resource alloca-
faster growth (Jeremy Greenwood and tion substantially with corresponding
Boyan Jovanovic 1990). Bagehot (1873, implications for economic growth (Mer-
p. 53) expressed this view over 120 years ton 1987). However, existing theories
ago. have not yet assembled the links of the
[England's financial] organization is so useful chain from the functioning of stock mar-
because it is so easily adjusted. Political kets, to information acquisition, and fi-
economists say that capital sets towards the nally to aggregate long-run economic
most profitable trades, and that it rapidly growth.
leaves the less profitable non-paying trades.
But in ordinary countries this is a slow pro-
12 Indeed, England's advanced financial system
cess, . . . In England, however, . . . capital also did a good job at identifying profitable ven-
runs as surely and instantly where it is most tures in other countries, such as Canada, the
wanted, and where there is most to be made United States, and Australia during the 19th cen-
of it, as water runs to find its level. tury. England was able to "export" financial ser-
vices (as well as financial ca ital) to many econo-
England's financial system did a better mies with underdevelopeg financial systems
job at identifying and funding profitable (Lance Davis and Robert Huttenback 1986).
696 Journal of Economic Literature, Vol. XXXV (June 1997)
Debate still exists over the importance investments (Stiglitz and Andrew Weiss
of large, liquid, efficient stock markets in 1981, 1983). Because this vast literature
enhancing the creation and distribution has been carefully reviewed (Gertler
information about firms. Stock markets 1988; and Andrei Shleifer and Robert
aggregate and disseminate information Vishny, forthcoming), this subsection (1)
through published prices. Even agents notes a few ways in which financial con-
that do not undertake the costly pro- tracts, markets, and institutions improve
cesses of evaluating firms, managers, and monitoring and corporate control, and
market conditions can observe stock (2) reviews how these financial arrange-
prices that reflect the information ob- ments for monitoring influence capital
tained by others. This public goods as- accumulation, resource allocation, and
pect of acquiring information can cause long-run growth.
society to devote too few resources to in- Consider, for example, the simple as-
formation acquisition. The public goods sumption that it is costly for outsider
feature of the information thus disclosed investors in a project to verify project
may be sufficiently large, that informa- returns. This creates important frictions
tion gains from large, liquid stock mar- that can motivate financial development.
kets are small. Stiglitz (1985) argues that, Insiders have incentives to misrepresent
because stock markets quickly reveal in- project returns to outsiders. Given verifi-
formation through posted prices, there cation costs, however, it is socially ineffi-
will be few incentives for spending private cient for outsiders to monitor in all
resources to acquire information that is circumstances. With "costly state verifi-
almost immediately publicly available. cation" (and other assumptions including
risk-neutral borrowers and verification
D. Monitoring Managers and Exerting
costs that are independent of project
Corporate Control
quality), the optimal contract between
Besides reducing the costs of acquir- outsiders and insiders is a debt contract
ing information ex ante, financial con- (Robert Townsend 1979; and Douglas
tracts, markets, and intermediaries may Gale and Martin Hellwig 1985). Specifi-
arise to mitigate the information acquisi- cally, there is an equilibrium interest
tion and enforcement costs of monitor- rate, r, such that when the project return
ing firm managers and exerting corpo- is sufficiently high, insiders pay r to out-
rate control ex post, i.e., after financing siders and outsiders do not monitor.
the activity. For example, firm owners When project returns are insufficient,
will create financial arrangements that the borrower defaults and the lenders
compel firm managers to manage the pay the monitoring costs to verify the
firm in the best interests of the owners. project's return. These verification costs
Also, "outside" creditors-banks, equity, impede investment decisions and reduce
and bond holders-that do not manage economic efficiency. Verification costs
firms on a day-to-day basis will create fi- imply that outsiders constrain firms from
nancial arrangements to compel inside borrowing to expand investment because
owners and managers to run firms in ac- higher leverage implies greater risk of
cordance with the interests of outside default and higher verification expendi-
creditors. The absence of financial ar- tures by lenders. Thus, collateral and fi-
rangements that enhance corporate con- nancial contracts that lower monitoring
trol may impede the mobilization of sav- and enforcement costs reduce impedi-
ings from disparate agents and thereby ments to efficient investment (Stephen
keep capital from flowing to profitable Williamson 1987b; Ben Bernanke and
Levine: Financial Development and Economic Growth 697
ers (David Scharfstein 1988; and Jeremy the hopes of taking them over. Third,
Stein 1988). I am not aware of models current managers often can take strate-
that directly link the role of stock mar- gic actions to deter takeovers and main-
kets in improving corporate governance tain their positions. This argues against an
with long-run economic growth. important role for liquid stock markets in
There are disagreements, however, promoting sound corporate governance.
about the importance of stock markets in Moreover, liquid equity markets that
corporate control. Inside investors prob- facilitate takeovers may hurt resource al-
ably have better information about the location (Shleifer and Lawrence Sum-
corporation than outsiders. Thus, if well- mers 1988; and Randall Morck, Shleifer,
informed owners are willing to sell their and Vishny 1990). A takeover typically
company, less well informed outsiders involves a change in management. Exist-
may demand a premium to purchase the ing implicit contracts between former
firm due to the information asymmetry managers and workers, suppliers, and
(Stewart Myers and Nicholas Majluf other stakeholders in the firms do not
1984). Thus, asymmetric information bind new owners and managers to the
may reduce the efficacy of corporate same extent that they bound the original
takeovers as a mechanism for exerting managers. Thus, a takeover allows new
corporate control. Stiglitz (1985) makes owners and managers to break implicit
three additional arguments about take- agreements and transfer wealth from
overs. First, if an acquiring firm expends firm stakeholders to themselves. While
lots of resources obtaining information, new owners may profit, there may be a
the results of this research will be ob- deterioration in the efficiency of re-
served by other market participants source allocation. Overall welfare may
when the acquiring firm bids for shares. fall. To the extent that well-functioning
This will induce others to bid for shares, equity markets help takeovers, this may
so that the price rises. The firm that ex- allow hostile takeovers that lead to a fall
pended resources obtaining information in the efficiency of resource allocation.
must, therefore, pay a higher price than Furthermore, liquid stock markets may
it would have to pay if "free-riding" reduce incentives for owners to monitor
firms could not observe its bid. Thus, the managers (Amar Bhide 1993). By reduc-
rapid public dissemination of costly in- ing exit costs, stock market liquidity en-
formation will reduce incentives for ob- courages more diffuse ownership with
taining information and making effective fewer incentives and greater impedi-
takeover bids. Second, there is a public ments to actively overseeing managers
good nature to takeovers that may de- (Shleifer and Vishny 1986). Thus, the
crease the incentives for takeovers. If theoretical signs on the links in the chain
the takeover succeeds, and the share from improvements in stock markets to
price rises, then those original equity better corporate control to faster eco-
holders who did not sell make a big nomic growth are still ambiguous.16
profit without expending resources. This
E . Mobilizing Savings
creates an incentive for existing share-
holders to not sell if they think the value Mobilization-pooling-involves the
of the firm will rise following the take- agglomeration of capital from disparate
over. Thus, value-increasing takeovers
may fail because the acquiring firm will 16Some research also suggests that excessive
stock trading can induce "noise" into the market
have to pay a high price, which will re- and hinder efficient resource allocation (Bradford
duce incentives for researching firms in De Long e t al. 1989).
Levine: Financial Development and Economic Growth 699
savers for investment. Without access to ings to the intermediary (De Long 1991;
multiple investors, many production pro- and Naomi Lamoreaux 1994).
cesses would be constrained to economi- In light of the transaction and infor-
cally inefficient scales (Erik Sirri and mation costs associated with mobilizing
Peter Tufano 1995). Furthermore, mobi- savings from many agents, numerous fi-
lization involves the creation of small nancial arrangements may arise to miti-
denomination instruments. These instru- gate these frictions and facilitate pool-
ments provide opportunities for house- ing.17 Specifically, mobilization may
holds to hold diversified portfolios, in- involve multiple bilateral contracts be-
vest in efficient scale firms, and to tween productive units raising capital
increase asset liquidity. Without pooling, and agents with surplus resources. The
household's would have to buy and sell joint stock company in which many indi-
entire firms. By enhancing risk diversifi- viduals invest in a new legal entity, the
cation, liquidity, and the size of feasible firm, represents a prime example of mul-
firms, therefore, mobilization improves re- tiple bilateral mobilization. To econo-
source allocation (Sirri and Tufano 1995). mize on the transaction and information
Mobilizing the savings of many dispa- costs associated with multiple bilateral
rate savers is costly, however. It involves contracts, pooling may also occur
(a) overcoming the transaction costs as- through intermediaries as discussed
sociated with collecting savings from dif- above, where thousands of investors en-
ferent individuals and (b) overcoming trust their wealth to intermediaries that
the informational asymmetries associated invest in hundreds of firms (Sirri and
with making savers feel comfortable in Tufano 1995, p. 83).
relinquishing control of their savings. In- Financial systems that are more effec-
deed, much of Carosso's (1970) history tive at pooling the savings of individuals
of Investment Banking in America is a can profoundly affect economic develop-
description of the diverse and elaborate ment. Besides the direct effect of better
means employed by investment banks to savings mobilization on capital accumu-
raise capital. As early as the mid-1880s, lation, better savings mobilization can
some investment banks used their Euro- improve resource allocation and boost
pean connections to raise capital abroad technological innovation (Bagehot 1873,
for investment in the United States. pp. 3-4):
Other investment banks established close We have entirely lost the idea that any under-
connections with major banks and indus- taking likely to pay, and seen to be likely, can
trialists in the United States to mobilize perish for want of money; yet no idea was
capital. And, still others used newspaper more familiar to our ancestors, or is more
common in most countries. A citizen of Long
advertisements, pamphlets, and a vast in Queen Elizabeth's time . . . would have
sales force that traveled through every thought that it was no use inventing railways
state and territory selling securities to (if he could have understood what a railway
individual households. Thus, mobilizing meant), for you would have not been able to
resources involved a range of transaction collect the capital with which to make them.
At this moment, in colonies and all rude
costs. Moreover, "mobilizers" had to countries, there is no large sum of transfer-
convince savers of the soundness of the able money; there is not fund from which you
investments. Toward this end, interme- can borrow, and out of which you can make
diaries are generally concerned about es- immense works.
tablishing stellar reputations or govern-
ment backing, so that savers feel 17See Sections 1I.C and 1I.D for citations on
comfortabl; about entrusting their sav- the emergence of financial intermediaries.
700 Journal of Economic Literat~
ure, Vol. XXXV (June 1997)
Thus, by effectively mobilizing resources The critical issue for our purposes is
for projects, the financial system may that the financial system can promote
play a crucial role in permitting the specialization. Adam Smith argued that
adoption of better technologies and lower transaction costs would permit
thereby encouraging growth. This intu- greater specialization because specializa-
ition was clarified 100 years later by tion requires more transactions than an
McKinnon (1973, p. 13): autarkic environment. Smith phrased his
The farmer could provide his own savings to argument about the lowering of transac-
increase slightly the commercial fertilizer tion costs and technological innovation
that he is now using, and the return on this in terms of the advantages of money over
marginal new investment could be calculated. barter (pp. 26-27). Information costs,
The important point, however, is the virtual
impossibility of a poor farmer's financing
however, may also motivate the emer-
from his current savings the whole of the bal- gence of money. Because it is costly to
anced investment needed to adopt the new evaluate the attributes of goods, barter
technology. Access to external financial re- exchange is very costly. Thus, an easily
sources is likely to be necessary over the one recognizable medium of exchange may
or two years when the change takes place.
Without this access, the constraint of self-
arise to facilitate exchange (King and
finance sharply biases investment strategy to- Charles Plosser 1986; and Williamson
ward marginal variations within the tradi- and Randall Wright 1994).18
tional technology. The drop in transaction and informa-
tion costs is not necessarily a one-time
F. Facilitating Exchange fall when economies move to money,
Besides easing savings mobilization however. For example, in the 1800s, it "
and thereby expanding the of set pro- was primarily the development of insti-
duction technologies available to an tutions that facilitated the exchange of
economy, financial arrangements that technology in the market that enabled
lower transaction costs can promote spe- creative individuals to specialize in and
cialization, technological innovation, and become more productive at invention"
growth. The links between facilitating (Lamoreaux and Sokoloff 1996, p. 17).
transactions, specialization, innovation, Thus, transaction and information costs
and economic growth were core ele- may continue to fall through a variety of
ments of Adam Smith's (1776) Wealth of mechanisms, so that financial and insti-
Nations. Smith (1776, p. 7) argued that tutional development continually boost
division of labor-specialization-is specialization and innovation via the
the principal factor underlying produc- same channels illuminated over 200
tivity improvements. With greater spe- years ago by Adam Smith.19
cialization, workers are more likely to in- l*This focus on money as a medium of ex-
vent better machines or production change that lowers transaction and information
processes. costs by overcomin the "double coincidence of
wants problem" a n f by acting as an easily recog-
I shall only observe, therefore, that the in- nizable medium of exchange enjoys a long history
vention of all those machines by which labour in monetary theory, from Adam Smith (1776), to
is so much facilitated and abridged, seems to Stanley Jevons (1875), to Karl Brunner and Allan
have been originally owing to the division of Meltzer (1971), to more formal models as re-
labour. Men are much more likely to discover viewed by Joseph Ostroy and Starr (1990).
19 Financial systems can also promote the accu-
easier and readier methods of attaining any mulation of human capital by lowering the costs of
object, when the whole attention of their intertemporal trade, i.e., b facilitating borrowin
minds is directed towards that single object, for the accumulation of skihs (Thomas Cooley a n 3
than when it is dissipated among a great vari- B. Smith 1992; and Jose D e Gregorio 1996). If
ety of things. (Smith 1776, p. 3) human capital accumulation is not subject to di-
Leuine: Financial Development and Economic Growth 70 1
Modern theorists have attempted to il- poorly, and what are the implications for
luminate more precisely the ties be- economic activity of the emerging finan-
tween exchange, specialization, and in- cial arrangements?
novation (Greenwood and B. Smith
G. A Parable
1997). More specialization requires more
transactions. Because each transaction is Thus far, I have discussed each finan-
costly, financial arrangements that lower cial function in isolation. This, however,
transaction costs will facilitate greater may encourage an excessively narrow fo-
specialization. In this way, markets that cus on individual functions and impede
promote exchange encourage produc- the synthesis of these distinct functions
tivity gains. There may also be feedback into a coherent understanding of the
from these productivity gains to finan- financial system's role in economic de-
cial market development. If there are velopment. This is not a necessary impli-
fixed costs associated with establishing cation. In fact, by identifying the individ-
markets, then higher income per capita ual functions performed by the financial
implies that these fixed costs are less system, the functional approach can fos-
burdensome as a share of per capita in- ter a more complete understanding of fi-
come. Thus, economic development can nance and growth.
spur the development of financial mar- Earlier authors often provided illustra-
kets. tive stories of the ties between finance
This approach to linking financial mar- and development. For example Schum-
kets with specialization has not yet for- peter (1912, pp. 58-74) and McKinnon
mally completed Adam Smith's story of (1973, pp. 5-18) provide broad descrip-
innovation. That is, a better market-a tions-parables-of the roles of the fi-
market with lower transactions costs- nancial system in economic develop-
does not stimulate the invention of new ment. Just as Smith (1776) used the pin
and better production technologies in factory to illustrate the importance of
Greenwood and B. Smith's (1997) specialization, Schumpeter used the re-
model. Instead, lower transaction costs lationship between banker and industri-
expand the set of "on the shelf' produc- alist to illustrate the importance of the
tion processes that are economically at- financial system in choosing and adopt-
tractive. Also, the model defines better ing new technologies, and McKinnon
"market" as a system for supporting highlighted its importance in promoting
more specialized production processes. the use of better agricultural techniques.
This does not explain the emergence of However, even Schumpeter and McKin-
financial instruments or institutions that non did not amalgamate all of the finan-
lower transaction costs and thereby pro- cial functions into their stories of finance
duce an environment that naturally pro- and development. Consequently, this
motes specialized production technolo- subsection synthesizes the individual fi-
gies. This is important because we want nancial functions into a simple parable
to understand the two links of the chain: about how the financial system affects
what about the economic environment economic growth.
creates incentives for financial arrange- Consider Fred, who has just devel-
ments to arise and to function well or oped a design for a new truck that ex-
tracts rocks from a quarry better than ex-
isting trucks. His idea for manufacturing
minishing returns on a social level, financial ar-
rangements that ease human capital creation help
trucks requires an intricate assembly line
accelerate economic growth. with specialized labor and capital.
702 Journal of Economic Literature, Vol. XXXV (June 1997)
TABLE 1
FINANCIAL
DEVELOPMENT
AND REALPERCAPITA
GDP IN 1985
Correlation
with Real per
Capita GDP in
Indictors Very rich Rich Poor Very poor 1985 (P-value)
DEPTH 0.67 0.51 0.39 0.26 0.51 (0.OOOl)
BANK 0.91 0.73 0.57 0.52 0.58 (0.0001)
PRIVATE 0.71 0.58 0.47 0.37 0.51 (0,0001)
PRIVY 0.53 0.31 0.20 0.13 0.70 (0.0001)
RGDP85 13053 2376 754 241
Observations 29 29 29 29
GDP. The assumption underlying these as follows: (1) the average rate of real
measures is that financial systems that per capita GDP growth, (2) the average
allocate more credit to private firms are rate of growth in the capital stock per
more engaged in researching firms, ex- person, and (3) total productivity
erting corporate control, providing risk growth, which is a "Solow residual" de-
management services, mobilizing sav- fined as real per capita GDP growth mi-
ings, and facilitating transactions than fi- nus (0.3) times the growth rate of the
nancial systems that simply funnel credit capital stock per person. In other words,
to the government or state owned enter- if F ( i ) represents the value of the ith in-
prises. As depicted in Table 1, there is a dicator of financial development
positive, statistically significant correla- (DEPTH, BANK, P R I W , PRIVATE) av-
tion between real per capita GDP and eraged over the period 1960-1989, GO')
the extent to which loans are directed to represents the value of the jth growth in-
the private sector. dicator (per capita GDP growth, per cap-
King and Levine (199310, 1993c) then ita capital stock growth, or productivity
assess the strength of the empirical rela- growth) averaged over the period 1960-
tionship between each of these four indi- 1989, and X represents a matrix of condi-
cators of the level of financial develop- tioning information to control for other
ment averaged over the 1960-1989 factors associated with economic growth
period, F , and three growth indicators (e.g., income per capita, education, po-
also averaged over the 1960-1989 pe- litical stability, indicators of exchange
riod, G. The three growth indicators are rate, trade, fiscal, and monetary policy),
706 Journal of Economic Literature, Vol. XXXV (June1997)
TABLE 2
AND CONTEMPORANEOUS
GROWTH FINANCIAL
INDICATORS, 1960-1989
R2
" significant at the 0.10 level, "" significant at the 0.05 level, """ significant at the 0.01 level.
[p-values in brackets]
Observations = 77
BANK = Deposit bank domestic credit divided by deposit money bank + central bank domestic
credit
PRIVATE = Claims on the non-financial private sector to total claims
PRIVY = Gross claims on private sector to GDP
Productivity Growth = Real Per Capita GDP Growth - (0.3)"RealPer Capita Capital Stock Growth
Other explanato y variables included i n each of the 12 regressions: log of initial income, log of initial secondary
school enrollment rate, ratio of government consumption expenditures to GDP, inflation rate, and ratio of export
plus imports to GDP.
then the following 12 regressions are run quartile of countries (0.6) would have in-
on a cross-section of 77 countries: creased its per capita growth rate by al-
most one percent h e r rear. This is large.
G ( j )= a + PF(i) + yX + E.
The difference between the slowest
There is a strong positive relationship growing 25 percent of countries and the
between each of the four financial devel- fastest growing quartile of countries is
opment indicators, F(i), and the three about five percent per annum over this
growth indicators G(i),long-run real per 30 year period. Thus, the rise in DEPTH
capita growth rates, capital accumula- alone eliminates 20 percent of this
tion, and productivity growth. Table 2 growth difference.
summarizes the results on the 12 P's. Finally, to examine whether finance
Not only are all the financial develop- simply follows growth, King and Levine
ment coefficients statistically significant, (199313) study whether the value of fi-
the sizes of the coefficients imply an nancial depth in 1960 predicts the rate
economically important relationship. Ig- of economic growth, capital accumula-
noring causality, the coefficient of 0.024 tion, and productivity improvements
on DEPTH implies that a country that over the next 30 years. Table 3 summa-
increased DEPTH from the mean of the rizes some of the results. In the three
slowest growing quartile of countries regressions reported in Table 3, the de-
(0.2) to the mean of the fastest growing pendent variable is, respectively, real per
Levine: Financial Development and Economic Growth
TABLE 3
GROWTHAND INITIAL FINANCIAL
DEPTH,1960-1989
capita GDP growth, real per capita capi- more sophisticated time series studies,
tal stock growth, and productivity growth suggest that the initial level of financial
averaged over the period 1960-1989. development is a good predictor of sub-
The financial indicator in each of these sequent rates of economic growth, physi-
regressions is the value of DEPTH in cal c a ~ i t a laccumulation, and economic
I
1960. The regressions indicate that efficiency improvements over the next 30
financial depth in 1960 is significantly years even aftkr controlling for income, ed-
correlated with each of the growth indi- ucation, political stability, and measures
cators averaged over the period 1960- of monetary, trade, and fiscal policy.22
1989." These results, plus those from
controlling for many other factors associated with
21There is an insufficient number of observa- long-run growth.
tions on BANK, PRIVATE, and PRIVY in 1960 to ZZThese broad cross-country results hold even
extend the analysis in Table 3 to these variables. when using instrumental variables-primarily indi-
Thus, King and Levine (1993b) use pooled, cross cators of the legal treatment of creditors taken
section, time series data. For each country, data from LaPorta et al. 1996-to extract the exoge-
permitting, they use data averaged over the 1960s, nous component of financial development (Levine
1970s, and 1980s; thus, there are potentially three 1997). Furthermore, though disagreement exists
observations per count They then relate the (Woo Jun 1986 and Philip Arestis and Panicos
value of growth averager'over the 1960s with the Demetriafes 1995), many time-series investiga-
value of, for example, BANK in 1960 and so on for tions find that financial sector development
the other two decades. They restrict the coeffi- Granger-causes economic performance (Paul
cients to be the same across decades. They find Wachtel Rousseau 1995). These results are
that the initial level of financial develo ment is a ticularly strong when using measures of the va?",:
good redictor of subsequent rates oPeconomic added provided by the financial system instead of
capital accumulation, and economic effi- measures of the size of the financial system (Klaus
ciency improvements over the next ten years after Neusser and Maurice Kugler 1996).
708 Journal of Economic Literature, Vol. XXXV (June 1997)
The relationship between the initial sample of countries and test whether the
level of financial development and industries that are more dependent on
growth is large. For example, the esti- external finance (in the United States)
mated coefficients suggest that if in 1960 grow relatively faster in countries that
Bolivia had increased its financial depth begin the sample period with better de-
from 10 percent of GDP to the mean veloped financial systems. They find that
value for developing countries in 1960 industries that rely heavily on external
(23 percent), then Bolivia would have funding grow comparatively faster in
grown about 0.4 percent faster per an- countries with well-developed interme-
num, so that by 1990 real per capita diaries (as measured by PRIVY) and
GDP would have been about 13 percent stock markets (as measured by stock
larger than it was." Thus, finance does market capitalization) than they do in
not merely follow economic activity. The countries that start with relatively weak
strong link between the level of financial financial systems. Similarly, using firm-
development and the rate of long-run level data from 30 countries, Asli Demir-
economic growth does not simply reflect guq-Kunt and Vojislav Maksimovic
contemporaneous shocks that affect both (199613) argue that firms with access to
financial development and economic more developed stock markets grow at
performance. There is a statistically faster rates than they could have grown
significant and economically large em- without this access. Furthermore, when
pirical relationship between the initial individual states of the United States re-
level of financial development and fu- laxed intrastate branching restrictions,
ture rates of long-run growth, capital this boosted bank lending quality and ac-
accumulation, and productivity improve- celerated real per capita growth rates
ments. Furthermore, insufficient finan- even after controlling for other growth
cial development has sometimes created determinants (Jith Jayaratne and Philip
a "poverty trap" and thus become a se- Strahan 1996). Thus, using firm- and in-
vere obstacle to growth even when a dustrial-level data for a broad cross-
country has established other conditions section of countries and data on indi-
(macroeconomic stability, openness to vidual states of the United States,
trade, educational attainment, etc.) for recent research presents evidence con-
sustained economic development (Jean- sistent with the view that the level of fi-
Claude Berthelemy and Aristomene nancial development materially affects
Varoudakis 1996). the rate and structure of economic de-
Some recent work has extended our velopment.
knowledge about the causal relationships Not surprisingly, these empirical stud-
between financial development and eco- ies do not unambiguously resolve the is-
nomic growth. For example, Rajan and sue of causality. Financial development
Luigi Zingales (1996) assume that finan- may predict growth simply because fi-
cial markets in the United States are nancial systems develop in anticipation
relatively frictionless. This benchmark of future economic growth. Further-
country then defines each industry's effi- more, differences in political systems, le-
cient demand for external finance (in- gal traditions (LaPorta et al. 1996), or in-
vestment minus internal cash flow). They stitutions (Engerman and Sokoloff 1996;
then examine industries across a large Douglass North 1981) may be driving
both financial development and eco-
23 These examples do not consider causal issues nomic growth rates. Nevertheless, the
or how to increase financial development. body of evidence would tend to push
Lezjine: Financial Dezjelopment and Economic Growth 709
many skeptics toward the view that the case of Scotland between 1750 and 1845.
finance-growth link is a first-order rela- Scotland began the period with per cap-
tionship and that difference in financial ita income of less than one-half of En-
development can alter economic growth gland's. By 1845, however, per capita in-
rates over ample time horizons. come was about the same. While
recognizing that the "dominant political
C. Country-Case Studies
event affecting Scotland's potentialities
Country-case studies provide a rich for economic development was the
complement to cross-country compari- Union of 1707, which made Scotland an
sons. For example, Rondo Cameron et integral part of the United Kingdom,"
al. (1967) dissect the historical relation- Cameron (1967a, p. 60), argues that
ships between banking development and Scotland's superior banking system is
the early stages of industrialization for one of the few noteworthy features that
England (1750-1844), Scotland (1750- can help explain its comparatively rapid
1845), France (1800-1870), Belgium growth.24 Other analysts disagree with
(1800-1875), Germany (1815-1870), the "facts" underlying this conclusion.
Russia (1860-1914), and Japan (1868- Some researchers suggest that England
1914). These country-case studies do not did not suffer from a dearth of financial
use formal statistical analysis. Instead, services because nonfinancial enterprises
the researchers carefully examine the le- provided financial services in England
gal, economic, and financial linkages be- that Cameron's (1967a) measures of for-
tween banks and industry during the in- mal financial intermediation omit. Oth-
dustrialization of these seven countries. ers argue that Scotland had rich natural
Typically, the case studies start by de- resources, a well-educated work force,
scribing the political system, economic access to British colonial markets, and
conditions, and financial structure at the started from a much lower level of in-
start of the period of analysis. Then, they come per capita than England. Conse-
provide a detailed description of the evo- quently, it is not surprising that Scotland
lution of the financial system during a enjoyed a period of rapid convergence
period of rapid economic development. toward England's income per capita
Finally, they document critical inter- level. Finally, still other researchers dis-
actions among financial intermediaries, agree with the premise that Scotland had
financial markets, government policies, a well-functioning financial system and
and the financing of industrialization. emphasize the deficiencies in the Scot-
While providing an informative comple- tish system (Sidney Pollard and Dieter
ment to broad cross country compari- Ziegler 1992). Thus, although Andrew
sons, country-case studies rely heavily on Kerr first argued in 1884 that Scotland
subjective evaluations of banking system enjoyed a better banking system than
performance and fail to systematically England from 1750 until 1844, the de-
control for other elements determining bate about whether Scottish banking ex-
economic development. While emphasiz- plains its faster economic growth over
ing the analytical limitations of country- the period 1750-1845 continues today.
case studies, Cameron (1967b) con-
cludes that especially in Scotland and Ja- 24It is also worth noting that Scottish banking
pan, but also in Belgium, Germany, En- was comparatively stable over this period, suffer-
gland, and Russia, the banking system ing fewer and less severe panics than its southern
neighbor. For more on Scottish banking, see Syd-
played a positive, growth-inducing role. ne Checkland (1975) and Tyler Cowen and Ran-
Debate exists, however. Consider the d a i Kroszner (1989).
710 Journal of Economic Literature, Vol. XXXV (June 1997)
TABLE 4
STOCKMARKET
LIQUIDITY
MEASURES:
SELECTEDCOUNTRIES,
ANNUAL
AVERAGES
197&1993
and its price (e.g., Yakov Amihud and over ratios of almost 0.5, while for less
Haim Mendelson 1989; and Gregory liquid markets, such as Bangladesh,
Kadlec and John McConnell 1994). Put Chile, and Egypt they are 0.06 or less.27
differently, agents must be compensated The turnover ratio may differ from the
with a lower price for purchasing an as- value traded ratio because a small, liquid
set that is difficult to sell. These secu- market will have high turnover ratio but
rity-level studies of the relationship be- a small value traded ratio. For example,
tween the liquidity of individual India's average turnover ratio of 0.5 over
securities and their prices, however, do the 1976-1993 is greater than the
not link liquidity with national long run United States', but India's value traded
growth rates. ratio is about one-tenth the size of the
To evaluate the relationship between United States'. These measures seek to
stock market liquidity and national measure liquidity on a macroeconomic
growth rates, capital accumulation rates, scale: the objective is to measure the de-
and rates of technological change, gree to which agents can cheaply,
Levine and Sara Zervos (1996) build on quickly, and confidently trade ownership
Raymond Atje and Jovanovic's (1993) claims of a large percentage of the econ-
study and focus on two measures of liq- omy's productive technologies.28
uidity for a broad cross-section of 49 The researchers then assess the
countries over the period 1976-1993. strength of the empirical relationship
The first liquidity indicator, the value between each liquidity measure and the
traded ratio, equals the total value of three growth indicators: economic growth,
shares traded on a country's stock ex- capital accumulation, and productivity
changes divided by GDP. The value growth. They conduct a cross-country
traded ratio measures trading relative to analysis with one observation per coun-
the size of the economy. While not a di- try. Namely, six basic regressions are
rect measure of trading costs or the un- run: economic growth, capital accumula-
certainty associated with trading and set- tion, and productivity growth averaged
tling equity transactions, theoretical over the 1976-1993 period are regressed
models of liquidity and growth directly first on the value traded ratio in 1976
motivate the value traded ratio (Ben- and then on the turnover ratio in 1976
civenga, B. Smith, and Starr 1995). As while controlling for various factors asso-
shown in Table 4, the value traded ratio ciated with economic growth (initial in-
varies considerably across countries. For come per capita, education, political sta-
example, the United States had an aver- bility, indicators of exchange rate, trade,
age annual value traded ratio of 0.3 dur- fiscal, and monetary policy) to see
ing the 1976-1993 period, while for whether stock market liquidity predicts
Mexico and India it was about 0.04. The subsequent economic growth. Impor-
second indicator, the turnover ratio, tantly, the level of banking sector devel-
equals the total value of shares traded on opment (bank credit to private enter-
a country's stock exchanges divided by prises divided by GDP) measured in
stock market capitalization (the value of
listed shares on the country's ex- 27 Note, Germany's very large turnover ratio
(0.7) reflects the explosion in stock market trans-
changes). The turnover ratio measures actions during unification.
trading relative to the size of the market.
0
28Levine and Zervos 11996) also construct and
~t also exhibits substantial cross-country examine two measures of stock trading relative to
stock price movements: (1)the value traded ratio
active markets such as divided by stock return volatility, and (2) the turn-
Japan and the United States have turn- over ratio divided by stock return volatility.
Leuine: Financial Development and Economic Growth 713
TABLE 5
[p-values in brackets]
Observations = 42
Value Traded Ratio = Value of domestic equity transactions on domestic stock exchanges divided by GDP
Turnover Ratio = Value of domestic equity transactions on domestic stock exchanges divided by domestic market
capitalization.
1976 is included in the regressions to as- implies each Mexican would have en-
sess the independent link between stock joyed an almost 8 percent higher income
market liquidity and growth after con- in 1994. The results are consistent with
trolling for other aspects of financial de- the views that the liquidity services pro-
velopment. The results are summarized vided by stock markets are indepen-
in Table 5. The initial level of stock mar- dently important for long-run growth
ket liquidity-measured either by the and that stock markets provide different
turnover ratio or the value traded ratio- financial services from those provided by
is a statistically significant predictor of financial intermediaries (or else they
economic growth, capital accumulation, would not both enter the growth regres-
and productivity growth over the next 18 sions significantly).29
years. The sizes of the coefficients also Besides the difficulty of assigning a
suggest an economically meaningful rela- causal role to stock market liquidity,
tionship. For example, the results imply there are important limitations to mea-
that if Mexico had had the sample aver- suring it accurately (Sanford Grossman
age value traded ratio in 1976 (0.044) in- and Merton Miller 1988; and Stephen
stead of its realized 1976 value (0.004),
per capita GDP would have grown at a 29Stock market size, as measured by market
ca italization divided by GDP, is not robustly cor-
0.4 percent faster rate (0.04"0.098). Ac-
cumulating over the 18 year period, this
!'
re a ted with growth, capital accumulation, and
productivity improvements.
714 Journal of Economic Literature, Vol. XXXV (June 1997)
Wells 1994). Theory suggests that econo- nological, regulatory, and tax differences
mies will benefit from the ability to across countries may imply that different
trade ownership of an economy's pro- financial structures arise to provide liq-
ductive technologies easily. Stock mar- uidity and risk diversification vehicles.
kets, however, are only one mechanism For example, in one economy the costs
for providing liquidity. Banks and bond of establishing an intermediary may be
markets may also provide liquidity. Thus, high while the costs of conducting equity
measures of stock market liquidity might transactions are low. The reverse may
omit important financial arrangements hold in a second economy. The first
for providing liquidity. Moreover, the economy may provide liquidity and risk
liquidity indicators measure stock trans- diversification services primarily through
actions on a country's national stock ex- equity markets, while the second does it
changes. The physical location of the through financial intermediaries. The
stock market, however, should not neces- first economy has an active stock ex-
sarily matter. That is, Californian savers change, so that existing empirical studies
and firms would probably not have would classify it as providing substantial
greater access to liquidity if the New liquidity and risk diversification services.
York Stock Exchange were to move to In contrast, existing studies would class-
Los Angeles. Thus, measures of the trad- ify the second economy as financially un-
ing of equities on a country's exchanges derdeveloped. Thus, measuring the per-
may not gauge fully the degree of stock formance of one part of the financial
market liquidity available to the econ- system may generate a misleading indi-
omy. This measurement problem will cator of the functioning of the whole fi-
increase over time if economies be- nancial system.
come more financially integrated and
E . Financial Functions and Growth:
firms list and issue shares on foreign ex-
Information
changes.
Besides liquidity risk, the financial sys- Theory strongly suggests that financial
tem also provides mechanisms for hedg- intermediaries play an important role in
ing and trading the idiosyncratic risk as- researching productive technologies be-
sociated with individual projects, firms, fore investment and monitoring manag-
industries, sectors, and countries. While ers and projects after funneling capital
a vast literature examines the pricing of to those projects. Although it is very dif-
risk, there exists very little empirical evi- ficult to measure whether a country's fi-
dence that directly links risk diversifica- nancial system is comparatively adept at
tion services with long-run economic reducing information acquisition costs
growth. Moreover, the only study of the firm level studies provide insights into
relationship between economic growth the role played by financial intermediar-
and the ability of investors to diversify ies in easing information asymmetries
risk internationally through equity mar- (Schiantarelli 1995). Theory suggests
kets yields inconclusive results (Levine that as the costs to outsiders of acquiring
and Zervos 1996). information about a firm rise, a firm's in-
One common weakness in empirical vestment decisions become more tightly
work on liquidity, idiosyncratic risk, and constrained by retained earnings and
economic growth is that it focuses on eq- current cash flow. Thus, studies test
uity markets. Bond markets and financial whether the investment decisions of
intermediaries may also provide mecha- firms with particular traits that proxy for
nisms for diversifying risk. Indeed, tech- the costs to outsiders of acquiring infor-
Leuine: Financial Development and Economic Growth 715
mation are more sensitive to cash flow Scharfstein 1990), Italy (Schiantarelli
than firms without those traits. The sam- and Alessandro Sembenelli 1996), and
ple selection criterion varies across stud- the United States (Petersen and Rajan
ies. 1994). Furthermore, borrowers with
The empirical evidence suggests that longer banking relationships pay lower
the investment decisions of firms with interest rates and are less likely to
more severe asymmetric information pledge collateral than those with less
problems are more sensitive to cash flow mature banking relationships (Petersen
than those where it is less expensive for and Rajan 1994; and Allen Berger and
outsiders to monitor. This conclusion Gregory Udell 1995). Finally, stock price
holds when firms are classified according evidence also indicates that banks pro-
to whether they have received bond duce valuable, private information about
ratings (Toni Whited 1992; Charles borrowers. When banks sign loan agree-
Calomiris, Charles Himmelberg, and ments with borrowers, borrower-firm
Wachtel 1995), whether they are issuing stock prices respond positively (Christo-
large or small dividends (Steven Fazzari, pher James 1987; Scott Lummar and
Glen Hubbard, and Bruce Peterson McConnell 1989; and James and Peggy
1988; Hubbard, Anil Kashyap, and Weir 1990). The value of the information
Whited 1995), whether they are large or obtained by banks about firms can also
small (James Tybout 1983; Gertler and be exemplified by Continental Illinois'
Simon Gilchrist 1994), whether they troubles in the mid-1980s. Myron Slovin,
place a relatively high or low shadow Marie Sushka, and John Polonchek
value on internal funds based on their (1993) show that the banks' impending
response to taxes (Calomiris and Hub- insolvency negatively affected the stock
bard 1995), and whether regulations prices of its client firms and that the
restrict bank credit allocation (Fidel FDIC's rescue efforts positively affected
Jaramillo, Schiantarelli, Weiss 1996; the stock prices of those same clients.
John Harris, Schiantarelli, and Miranda These findings are consistent with the
Siregar 1994). In sum, when outsiders view that the durability of bank-bor-
find it expensive to evaluate and fund rower relationship is valuable. The evi-
particular firms, those firms find it dence directly indicates an important
relatively difficult to raise capital for in- role for financial intermediaries in re-
vestment and rely disproportionately on ducing informational asymmetries be-
internal sources of finance. Thus, finan- tween firm insiders and outside inves-
cial innovations or policies that lower tors. Indirectly, the evidence suggests
information asymmetries ease firm fi- that countries with financial institutions
nancing constraints on more efficient that are effective at relieving informa-
firms. tion barriers will promote faster eco-
More relevant for this section, a large nomic growth through more investment
body of work shows that when firms have than countries with financial systems
close ties to financial intermediaries, this that are less effective at obtaining and
reduces information costs and eases firm processing information.
financing constraints. Specifically, firms
F. Patterns of Financial Development
with close ties to banks tend to be less
constrained in their investment decisions I now turn to the question: Does fi-
than those with less intimate, less ma- nancial structure change as countries de-
ture banking relationships as shown for velop and does it differ across countries?
Japan (Takeo Hoshi, Kashyap, and Again, Goldsmith pioneered the cross-
716 Journal of Economic Literature, Vol. XXXV (June1997)
"
Financial Central Con~mercial Nonbank Stock Market Stock Market
Depth Bank Assets Bank Assets Assets Capitalization Trading
country work in this area. He traced the and economic development for approxi-
relationship between the mix of financial mately 50 countries over the period
intermediaries and economic develop- 1970-1993. This work finds that finan-
ment for 35 countries over the period cial structure differs considerably across
1860-1963. The World Bank (1989) and countries and changes as countries de-
Demirguq-Kunt and Levine (1996b) re- velop economically.
cently extended Goldsmith's work by Four basic findings emerge from
examining the association between the these studies, which are illustrated in
mix of financial intermediaries, markets, Figure 2. As countries get richer over
Levine: Financial Dezjelopment and Economic Growth 717
time or as one shifts from poor to richer financial structure and the level of GDP
countries, per capita, there are important excep-
(1) financial intermediaries get larger tions and differences within income
as measured by the total assets or groups. While one must be hesitant in
liabilities of financial intermediar- drawing conclusions about patterns of fi-
ies relative to GDP; nancial development, an even greater
(2) banks grow relative to the central degree of hesitancy is called for in link-
bank in allocating credit; ing financial structure to economic
growth.
(3) non-banks-such as insurance
companies, investment banks, fi- G. Financial Structure and Economic
nance companies, and private pen- Grou;th
sion funds-grow in importance; There exists considerable debate, with
and sparse evidence and insufficient theory,
(4) stock markets become larger, as about the relationship between financial
measured by market capitalization structure and economic growth. After
relative to GDP, and more liquid, briefly outlining the major examples
as measured by trading relative to used in discussions of financial structure,
GDP, market capitalization, and I describe the major analytical limita-
stock price variability. tions impeding research on financial
While these "patterns" pose a chal- structure and economic growth. The
lenge to financial theorists, they must be classic controversy involves the compari-
treated cautiously because the data suf- son between Germany and the United
fer from numerous problems. For exam- Kingdom. Starting early in this century,
ple, it is difficult to distinguish private economists argued that differences in
from public banks and development the financial structure of the two coun-
banks from commercial banks in many tries help explain Germany's more rapid
countries. Similarly, the definition of a economic growth rate during the latter
bank and of a non-bank are not always half of the 19th century and the first
consistent across countries. Further- decade of the 20th century (Alexander
more, there is nothing causal about these Gerschenkron 1962). The premise is as
relationships. These patterns alone do follows. Germany's bank-based financial
not suggest that poor countries can ac- system, where banks have close ties to
celerate their growth rates by changing industry, reduces the costs of acquiring
the structure of their financial systems. information about firms. This makes it
Finally, many differences exist across easier for the financial system to identify
countries at similar stages of economic good investments, exert corporate con-
development (World Bank 1989). For ex- trol, and mobilize savings for promising
ample, the assets of deposit banks com- investments than in England's more se-
posed 56 percent of financial system as- curities market oriented financial sys-
sets in France, while the comparable tem, where the ties between banks and
number in the United Kingdom was 35 industry are less intimate. Indeed, quite
percent. The assets of contractual sav- a bit of evidence suggests that German
ings institutions composed 26 percent bankers were more closely tied to indus-
of total financial system assets in the try than British bankers. Unlike En-
United Kingdom, while in France the gland, nearly all German bankers started
figure was only 7 percent in 1985. Thus, as merchants. The evolution from entre-
while there is a general trend involving preneur to banker may explain the com-
718 Journal of Economic Literature, Vol. XXXV (June 1997)
paratively close bonds between bankers and German bankers tend to be more in-
and industrialists. For example, German tricately involved in the management of
bankers frequently "mapped out a firm's industry than U.S. bankers (Randall
paths of growth, conceived farsighted Pozdena and Volbert Alexander 1992;
plans, decided on major technological in- Franklin Allen and Gale 1995; and
novations, and arranged for mergers and Demirguq-Kunt and Levine 1996a). Fur-
capital increases" (Gerschenkron 1968, thermore, historical evidence suggests
p. 137). Private German bankers also or- that German universal banks were more
ganized and promoted an impressive ar- efficient (lower cost of capital) than U.S.
ray of major manufacturing companies banks over the 1870-1914 period and
during the mid-19th century (Richard suffered less systemic problems than the
Tilly 1967, p. 179). Besides this en- U.S. banking system (Calomiris 1995). In
trepreneurial role, some evidence sug- contrast, the U.S. financial system is
gests that German bankers tended to be typically characterized as having a com-
more committed to the long-term fund- paratively larger, more active securities
ing of their clients than English bankers. markets with more equities held by
Short-term credits could be transformed households. These observations suggest
into longer-term securities more easily that the German bank-based system may
in Germany (Tilly 1967, pp. 178-81). reduce information asymmetries and
Thus, various pieces of evidence suggest thereby allow banks to allocate capital
a closer relationship between banker and more efficiently and to exert corporate
industrialist in Germany. While bank- control more effectively. In contrast, the
industry relationships may have been United States' securities market-based
closer in Germany, this does not imply financial system may offer advantages in
that the German financial system was terms of boosting risk sharing opportuni-
better at risk management, providing ties (Allen and Gale 1995). While this
liquidity, or facilitating exchange. functional approach highlights the rele-
Furthermore, economists disagree over vant issues, substantially more research
whether the growth differential between is needed before drawing conclusions
the two was really very large. Although about the dominance of one financial
German manufacturing production grew structure over another.30
noticeably faster than Britain's in the six Many of the arguments involving
decades before World War I, Germany's bank-based versus securities market-
overall per capita GNP growth rate was based financial systems have been used
1.55 while the U.K.'s was 1.35 over the to compare Japan and the United States.
period 1850 to 1913 (Goldsmith 1969, For example, research suggests that
pp. 406-07). Thus, aggregate growth dif- Japanese bankers are more closely tied
ferences are not very large, the signifi- to industrial clients than U.S. bankers.
cant differences that do exist are indus- This closer connection may mitigate in-
try specific, and other factors besides formation asymmetries (Hoshi, Kasyap,
differences in financial structure may ex- and Sharfstein 1990), which may foster
plain industry specific growth differen- better investment and faster growth.
tials over this period. Thus, the structure of the Japanese fi-
The debate concerning bank-based nancial system is sometimes viewed as
versus market-based systems eventually superior to the financial structure of the
expanded to include comparisons with
30 Park (1993) compares the structure and func-
the United States. German banks are tioning of the financial systems of Korea and Tai-
larger as a share of GDP than U.S. banks wan in relation to their industrial composition.
Levine: Financial Development and Economic Growth 719
United States and an important factor in Axis powers may simply have been con-
Japan's faster growth rate over the last verging to the income levels of the
four decades. Interestingly, however, the United States, such that observed
recent banking problems and slower growth rate differentials have little to do
growth in Japan have led some to argue with financial structure. Thus, before
that the absence of a credible takeover linking financial structure with economic
threat through efficient stock markets growth, researchers need to control for
has impeded proper corporate gover- other factors influencing long-run
nance and competitiveness. These con- growth.
flicting analyses highlight the need for A third factor that complicates the
better empirical measures of financial analysis of financial structure and eco-
structure and the functions provided by nomic growth is more fundamental. The
financial systems. current debate focuses on bank-based
There are severe analytical problems systems versus market-based systems.
with linking financial structure to eco- Some aggregate and firm level evidence,
nomic performance. First, existing re- however, suggest that this dichotomy is
search on financial structure does not inappropriate. The data indicate that
quantify the structure of financial sys- both stock market liquidity-as meas-
tems or how well different financial ured by stock trading relative to GDP
systems function overall. For example, and market capitalization-and the level
German bankers may have been more of banking development-as measured
closely connected to industrialists than by bank credits to private firms divided
their British counterparts, but less capa- by GDP predict economic growth over
ble at providing liquidity and facilitating subsequent decades (Levine and Zervos
transactions. Similarly, while Japanese 1996). Thus, it is not banks or stock mar-
Keiretsu may lower information acquisi- kets; bank and stock market develop-
tion costs between banks and firms, this ment indicators both predict economic
does not necessarily imply that the Japa- growth. Perhaps, the debate should not
nese financial system provides greater focus on bank-based versus market-
risk sharing mechanisms or more accu- based systems because these two compo-
rately spot promising new lines of busi- nents of the financial system enter the
ness. Furthermore, while Japan is some- growth regression significantly and pre-
times viewed as a bank-based system, it dict future economic growth. It may be
has one of the best developed stock mar- that stock markets provide a different
kets in the world (Demirguq-Kunt and bundle of financial functions from those
Levine 1996a). Thus, the lack of quanti- provided by financial intermediaries. For
tative measures of financial structure example, stock markets may primarily
and the functioning of financial systems offer vehicles for trading risk and boost-
make it difficult to compare financial ing liquidity. In contrast, banks may fo-
structures. cus on ameliorating information acquisi-
Second, given the array of factors in- tion costs and enhancing corporate
fluencing growth in Germany, Japan, the governance of major corporations. This
United Kingdom, and the United States, is merely a conjecture, however. There
it is analytically difficult-and perhaps are important overlaps between the ser-
reckless-to attribute differences in vices provided by banks and stock mar-
growth rates to differences in the finan- kets. As noted above, well-functioning
cial sector. Moreover, over the post stock markets may ameliorate informa-
World War I1 period, the devastated tion acquisition costs, and banks may
720 Journal of Economic Literature, Vol. XXXV (June1997)
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[Footnotes]
3
Financial Aspects of Economic Development
John G. Gurley; E. S. Shaw
The American Economic Review, Vol. 45, No. 4. (Sep., 1955), pp. 515-538.
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3
Money and Economic Growth
James Tobin
Econometrica, Vol. 33, No. 4. (Oct., 1965), pp. 671-684.
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Government Revenue from Financial Repression
Alberto Giovannini; Martha de Melo
The American Economic Review, Vol. 83, No. 4. (Sep., 1993), pp. 953-963.
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Agency Costs, Net Worth, and Business Fluctuations
Ben Bernanke; Mark Gertler
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14
How Good Are Standard Debt Contracts? Stochastic Versus Nonstochastic Monitoring in a
Costly State Verification Environment
John H. Boyd; Bruce D. Smith
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J. Bradford De Long; Andrei Shleifer; Lawrence H. Summers; Robert J. Waldmann
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Insiders and Outsiders: The Choice between Informed and Arm's-Length Debt
Raghuram G. Rajan
The Journal of Finance, Vol. 47, No. 4. (Sep., 1992), pp. 1367-1400.
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Debt, Liquidity Constraints, and Corporate Investment: Evidence from Panel Data
Toni M. Whited
The Journal of Finance, Vol. 47, No. 4. (Sep., 1992), pp. 1425-1460.
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