Conclusions
This paper reviewed theoretical and empirical work on the relationship between financial development and economic growth. Theory illuminates many of the channels through which the emergence of financial instruments, markets and institutions affect - and are affected by - economic development.
A growing body of empirical analyses, including firm-level studies, industry-level studies, individual country-studies, time-series studies, panel-investigations, and broad cross-country comparisons, demonstrate a strong positive link between the functioning of the financial system and long- run economic growth. While subject to ample qualifications and countervailing views noted throughout this article, the preponderance of evidence suggests that both financial intermediaries and markets matter for growth even when controlling for potential simultaneity bias. Furthermore, microeconomic-based evidence is consistent with the view that better developed financial systems ease external financing constraints facing firms, which illuminates one mechanism through which financial development influences economic growth. Theory and empirical evidence make it difficult to conclude that the financial system merely - and automatically - responds to economic activity, or that financial development is an inconsequential addendum to the process of economic growth.In the remainder of this section, I discuss broad areas needing additional research. In terms of theory, Section 2 raised several issues associated with modeling finance and growth. Here I simply make one broad observation. Our understanding of finance and growth will be substantively advanced by the further modeling of the dynamic interactions between the evolution of the financial system and economic growth [Smith (2002)]. Existing work suggests that it is not just finance following industry.
But, neither is there any reason to believe that it is just industry following finance. Thus, we need additional thought on the co-evolution of finance and growth. Technology innovation, for instance, may only foster growth in the presence of a financial system that can evolve effectively to help the economy exploit these new technologies. Furthermore, technological innovation itself may substantively affect the operation of financial systems by, for example, transforming the acquisition, processing, and dissemination of information. Moreover, the financial system may provide different services at different stages of economic development, so that the financial system needs to evolve if growth is to continue. These are mere conjectures and ruminations that I hope foster more careful thinking.In terms of empirical work, this paper continuously emphasized that all methods have their problems but that one problem plaguing the entire study of finance and growth pertains to the proxies for financial development. Theory suggests that financial systems influence growth by easing information and transactions costs and thereby improving the acquisition of information about firms, corporate governance, risk management, resource mobilization, and financial exchanges. Too frequently empirical measures of financial development do not directly measure these financial functions. While a growing number of country-specific studies develop financial development indicators more closely tied to theory, more work is needed on improving cross-country indicators of financial development.
Much more research needs to be conducted on the determinants of financial development. To the extent that financial systems exert a first-order impact on economic growth, we need a fuller understanding of what determines financial development. There are at least two levels of analysis. There is a growing body of research that examines the direct laws, regulations, and macroeconomic policies shaping financial sector operations.
There is a second research agenda that studies the political, cultural, and even geographic context shaping financial development.Some research examines how legal systems, regulations, and macroeconomic policies influence finance. LLSV (1997, 1998) show that laws and enforcement mechanisms that protect the rights of outside investors tend to foster financial development. Beck, DemirguQ-Kunt and Levine (2003b, 2005a) show that legal system adaptability is crucial. The financial needs of the economy are continuously changing, so that more flexible legal systems do a better job at promoting financial development than more rigid systems. Barth, Caprio and Levine (2001a, 2001b, 2004, 2005) and La Porta, Lopez-de- Silanes and Shleifer (2005) show that regulations and supervisory practices that force accurate information disclosure and promote private sector monitoring, but do not grant regulators excessive power, boost the overall level of banking sector and stock market development.[549] Monetary and fiscal policies may also affect the taxation of financial intermediaries and the provision of financial services [Bencivenga and Smith (1992), Huybens and Smith (1999), Roubini and Sala-i-Martin (1992, 1995)]. Indeed, Boyd, Levine and Smith (2001) show that inflation has a large - albeit non-linear - impact on both stock market and bank development.
At a more primitive level, some research studies the forces shaping the laws, regulations, and institutions underlying financial development. LLSV (1998) stress that historically-determined differences in legal tradition shape the laws governing financial transactions. Haber (2004), Haber, Maurer and Razo (2003), Pagano and Volpin (2001), Roe (1994), and Rajan and Zingales (2003) focus on how political economy forces shape national policies toward financial development. Guiso, Sapienza and Zin- gales (2004) examine the role of social capital in shaping financial systems, while Stulz and Williamson (2003) stress the role of religion in influencing national approaches to financial development.
Finally, some scholars emphasize the impact of geographical endowments on the formation of long-lasting institutions that form the foundations of financial systems [Engerman and Sokoloff (1997, 2002), Acemoglu, Johnson and Robinson (2001), Beck, DemirguQ-Kunt and Levine (2003a), Easterly and Levine (2003)]. This broad spectrum of work suggests that political, legal, cultural, and even geographical factors influence the financial system and that much more work is required to better understand the role of financial factors in the process of economic growth.Acknowledgements
Philippe Aghion, Thorsten Beck, John Boyd, Maria Carkovic, Asli Demirguc-Kunt, Steven Durlauf, John Kareken, Luc Laeven, Raghu Rajan, Bruce Smith, and Luigi Zin- gales provided helpful comments.
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