Finance is powerful. The financial system can be an engine of economic prosperity – or a destructive cause of economic decline and misery. The impact of the financial system on the rest of the economy depends on how it mobilises savings, allocates those savings, monitors the use of those funds by firms and individuals, pools and diversifies risk, including liquidity risk, and eases the exchange of goods and services.
When financial systems perform well, they tend to promote growth and expand economic opportunities. For example, when banks screen borrowers effectively and identify firms with the most promising prospects, this is a first step in boosting productivity growth. When financial markets and institutions mobilise savings from disparate households to invest in these promising projects, this represents a second crucial step in fostering growth. When financial institutions monitor the use of investments and scrutinise their managerial performance, this is another essential ingredient in boosting the operational efficiency of corporations, reducing waste and fraud, and spurring economic growth. When securities markets ease the diversification of risk, this encourages investment in higher-return projects that might be shunned without effective risk management vehicles. And when financial systems lower transaction costs, this facilitates trade and specialisation, which are fundamental inputs into technological innovation and economic growth.
But when financial systems perform poorly, they tend to hinder economic growth and curtail economic opportunities. For example, if financial systems simply collect funds with one hand and pass them along to cronies, the wealthy, and the politically connected with the other hand, this produces a less efficient allocation of resources, implying slower economic growth. If financial institutions fail to exert sound corporate governance, this makes it easier for managers to pursue projects that benefit themselves rather than the firm and the overall economy. Similarly, well-functioning financial systems allocate capital based on a person’s ideas and abilities, not on family wealth and political connections. But, poorly functioning financial systems become an effective tool for restricting credit – and hence opportunity – to the already rich and powerful.
As stressed by King and Levine (1993), Levine (2005), and Levine and Zervos (1998), the financial system exerts this powerful influence over the economy primarily by affecting the quality of capital allocation, not the quantity of investment. Thus, finance should not be viewed as a plumbing system, where pouring more credit in one end yields more growth at the other. Rather, finance functions as an economy’s central nervous system, choosing where to allocate resources. It is the incentives shaping these choices that influence economic growth.
A growing and diverse body of empirical research produces a remarkably consistent, though by no means unanimous, narrative. The services provided by banks exert a first-order impact on (1) the rate of long-run economic growth, primarily by affecting the allocation of capital, and (2) the distribution of income, primarily by affecting the earnings of lower-income individuals. This message emerges from cross-country analyses, panel techniques that exploit both cross-country differences and changes in national performance over time, microeconomic studies that examine the underlying mechanisms through which finance may influence economic growth, and individual country cases.
For example, measures of the level of bank development in 1960 predict the growth rate of real per capita GDP over the next forty years even after controlling for cross-country differences in initial income and education, national differences in measures of the openness to international trade, inflation, fiscal deficits, and after conditioning on indicators of political stability, as shown by King and Levine (1993). Furthermore, the close association between bank development and long-run growth runs primarily through the allocation of credit, not through the overall rate of investment.
Research also shows that bank development disproportionately helps the poor (Beck et al 2011). Improvements in the functioning of banks reduce income inequality. Moreover, this tightening in the distribution of income does not happen by making the rich poorer, but rather primarily by boosting the incomes of the poor.
Securities markets matter too. As shown by Levine and Zervos (1998), better-functioning equity markets improve the efficiency of capital allocation, boosting growth. Thus, securities markets are not simply casinos where the rich come to place their bets. They too can affect both the allocation of capital and the availability of economic opportunities.
How does financial innovation fit into the process of economic growth? Given the roles of credit default swaps, collateralized debt obligations, and other new financial instruments in the recent financial crisis, financial innovation has developed a bad reputation. From this perspective financial innovations are mechanisms for fooling investors, circumventing regulatory intent, and boosting the bonuses of financiers without enhancing the quality of the services provided by the financial services industry. This is part of the story. Financial innovation can be a powerful source of economic instability, stagnation, and misery. But this is only an incomplete part of the story.
A longer-run consideration of financial development suggests that financial innovation is essential for growth. Adam Smith argued that economic growth is a process in which production become increasingly specialized and technologies more complex. As firms become more complex, however, the old financial system becomes less effective at screening and monitoring firms. Therefore, without corresponding innovations in finance that match the increases in complexity associated with economic growth, the quality of financial services diminishes, slowing future growth.
Several examples from history illustrate the crucial role of financial innovation in sustaining economic growth as noted by Laeven et al (2011). Consider first the financial impediments to railroad expansion in the 19th century. The novelty and complexity of railroads made pre-existing financial systems ineffective at screening and monitoring them. Although prominent local investors with close ties to those operating the railroad were the primary sources of capital for railroads during the early decades of this new technology, this reliance on local finance restricted growth.
So financiers innovated. Specialized financiers and investment banks emerged to mobilise capital from individuals, to screen and invest in railroads, and to monitor the use of those investments, often by serving on the boards of directors of railroad corporations. Based on their expertise and reputation, these investment banks mobilized funds from wealthy investors, evaluated proposals from railroads, allocated capital, and governed the operations of railroad companies for investors. And since the geographical size and complexity of railroads made it difficult for investors to collect, organise, and assess price, usage, breakdown, and repair information, financiers developed new accounting and financial reporting methods.
Next, consider the information technology revolution of the 20th century, which could not have been financed with the financial system that fuelled the railroad revolution of the 19th century. Indeed, as nascent high-tech information and communication firms struggled to emerge in the 1970s and 1980s, traditional commercial banks were reluctant to finance them because these new firms did not yet generate sufficient cash flows to cover loan payments and the firms were run by scientists with little experience in operating profitable companies. Conventional debt and equity markets were also wary because the technologies were too complex for investors to evaluate.
Again, financiers innovated. Venture capital firms arose to screen entrepreneurs and provide technical, managerial, and financial advice to new high-technology firms. In many cases, venture capitalists had become wealthy through their own successful high-tech innovations, which provided a basis of expertise for evaluating and guiding new entrepreneurs. In terms of funding, venture capitalists typically took large, private equity stakes that established a long-term commitment to the enterprise, and they generally became active investors, taking seats on the board of directors and helping to solve managerial and financial problems.
Finally, consider the biotechnology revolution of the 21st century, for which the venture capital modality did not work well. Venture capitalists could not effectively screen biotech firms because of the scientific breadth of biotechnologies, which frequently require inputs from biologists, chemists, geneticists, engineers, bioroboticists, as well as experts on the myriad of laws, regulations, and commercial barriers associated with successfully bringing new medical products to market. It was unfeasible to house all of this expertise in banks or venture capital firms. Again, a new technology promised growth, but the existing financial system could not fuel it.
Yet again, financiers innovated. They formed new financial partnerships with the one kind of organisation with the breadth of skills to screen biotech firms – large pharmaceutical companies. Pharmaceutical companies employ, or are in regular contact with, a large assortment of scientists and engineers, have close connections with those delivering medical products to customers, and employ lawyers well-versed in drug regulations. Furthermore, when an expert pharmaceutical company invests in a biotech firm this encourages others to invest in the firm as well. Without financial innovation, improvements in diagnostic and surgical procedures, prosthetic devices, parasite-resistant crops, and other innovations linked to biotechnology would almost certainly be occurring at a far slower pace.
The operation of the financial system exerts a powerful influence on economic growth and the opportunities available to individuals. Well-functioning financial systems allocate resources to those with the best ideas and entrepreneurial skills, enhancing efficiency and expanding economic horizons. Poorly functioning financial systems funnel credit to those with strong political and social connections, with harmful ramifications on economic welfare.
Author’s Note: This paper draws liberally from “Regulating Finance and Regulators to Promote Growth,” which was presented at the Federal Reserve Bank of Kansas City’s Symposium, Achieving Maximum Long-Run Growth, which was held in Jackson Hole, Wyoming on August 25-27, 2011 and will be published in the proceedings of that symposium.
Beck, Thorsten, Ross Levine, and Alexey Levkov (2010) “Big Bad Banks? The Winners and Losers from US Branch Deregulation.” Journal of Finance 65: 1637-1667.
King, Robert G, and Ross Levine (1993) “Finance and Growth: Schumpeter Might Be Right.” Quarterly Journal of Economics 108: 717-38.
Laeven, Luc, Ross Levine, and Stelios Michalopoulos (2011) “Financial and Innovation and Endogenous Growth.” Brown University, mimeo.
Levine, Ross (2005) “Finance and Growth: Theory and Evidence.” in Handbook of Economic Growth, Eds., Aghion, P. and S. Durlauf, 1A, pp. 865-934, North-Holland Elsevier, Amsterdam.
Levine, Ross, and Sara Zervos (1998) "Stock Markets, Banks, and Economic Growth." American Economic Review 88: 537-558.