Financial Development And Economic Growth Assignment Economics Essay

A well-developed financial system should help allocate financial resources to the most productive and efficient use. Hence services of the financial intermediaries would be important for promoting productivity and innovation in an economy.

The main purpose of this paper is to review the empirical evidence on the impact of financial development on economic growth relating to Latin America. The analysis then shed some lights on the possible mechanisms behind the correlation of financial development and economic growth as theorize by the various growth models.

In the following section, I present a brief economic background of Latin America, which is my region of interest followed by a review of the growth theory and some neoclassical growth models. This is followed by a review of the general empirical work on the link between financial development and economic growth in Section 5. A survey of empirical evidence from Latin America follows in section 6 and section 7 concludes.

ABOUT REGION OF INTEREST

Latin America is an economic region found in the south of United States of America. It comprises nineteen independent states and Brazil is the leading economy in the bloc. However there are other countries like Argentina, Mexico, Chile, Ecuador, Colombia and Venezuela that cannot be ignored. Latin America is more urbanised than the EU (World Bank, 2011). Approximately 79 per cent of the population lives in urban areas. One of the drawbacks of rapid urbanisation is its adverse impact on the environment such as greater pollution, health hazard and reduction in productivity. This study is more concerned with the impact on productivity since fundamentally all growth models centres on factor productivity (productivity of capital, labour and technology).

According to latest World Bank published statistics [1] , on average most countries in the Latin American region experienced positive GDP growth over the past 5 years. Argentina grew by 8.9 % in 2011 (9.2 % in 2010); Brazil grew by 2.7% (7.5% in 2010); Mexico 3.9% while Peru’s GDP rose by 6.9% (8.8% in 2010). Colombia’s GDP grew by 5.9% in 2011 while Chile had a GDP growth of 6.0% (6.1% in 2010).

THEORETICAL BACKGROUND OF GROWTH MODELS AND PROPOSITIONS

Growth models are basically economic models that try to explain how economies grow over time. Accredited to Solow, Harrod and Domar, growth models fittingly fall in two categories namely exogenous and endogenous growth models. Exogenous growth models stipulate that growth is exogenous and that long-term growth is determined by factors external to an economy. In contrast endogenous growth models advocates that long-term growth is determined by factors within the economy or system eg productivity of capital. The Harrod-Domar model is an example of an exogenous model that examines the consequences of fixing capital and labor ratios and savings. Essentially the model highlights the problems of rigidities in the capital-labor ratio and savings rate.

In contrast, Solow models maintain that growth in GDP is explained by productivity increases, technological progress and increased investment. Most economies do not operate at their full potential. Usually there is a gap between the amount of GDP actually produced and the potential GDP that the economy could produce with full employment and full resource utilization. Because of differences in factor productivity, countries achieve multiple equilibriums.

Neoclassical Growth Theory (Solow model)

This is a theory that underscores that in an economy technological changes have a major influence on economic growth. The theory argues that in an economy, economic growth will not continue unless there are continuous technological advances. Technological progress and other external factors are the main sources of economic growth. The model predicts that economies with the same preference and technology to converge to the same level of growth and hence achieve same growth rate. Endogenous growth theory hypothesize that growth is a matter of choice (by households and governments). The huge differences that exist in growth rates between countries and within a country are down to choices within these countries. The endogenous theory argues that economic growth is generated from within an economy as a direct result of internal processes. Essentially an enhancement of a country’s human capital will lead to economic growth by means of the development of new forms of technology and efficient ways or methods of production. As per the endogenous growth model, Lucas (1988) in a study of US and German, notes that growth increases with effectiveness of investment in human capital and declines with an increase in discount rate.

On the other hand Levacic and Rebmann (1982), points out that in the long run, steady state growth rate in an economy is determined by the growth of labour force and technological change. The rate of investment does not determine growth rate in an economy. An increase in the rate of investment will only lead to short-term temporary increase in the rate of growth, with the economy reverting to the natural rate of growth when it returns to the steady state. An increase in investment can lead to an increase in the natural rate of growth only when it results in an increase in the underlying technological know-how.

In contrast, exogenous growth theory which assumes that economic growth is primarily determined by external rather than internal factors. The size of the labour force and the progress of technology are given by forces beyond the control of households and governments. According to this belief, given a fixed amount of labour and technology, economic growth will cease at some point, as current production reaches a state of equilibrium based on internal demand factors.

RELATIONSHIP BETWEEN FINANCIAL DEVELOPMENT AND ECONOMIC GROWTH

Schumpeter (1912) is accredited to be the first empirical work attempting to explain the link between financial development and economic growth. Subsequent to the pioneering work of Schumpeter, a large amount of theoretical and empirical work has emerged on the role or importance of the financial system [2] in the productivity and growth process (see Goldsmith, 1969; McKinnon, 1973; Shaw, 1973; Galbis, 1977; Greenwood and Jovanovic, 1990; Bencivenga and Smith, 1991; De Gregorio and Guidotti, 1995; King and Levine, 1992; Pagano, 1993). Schumpeter and his colleagues advocate development of financial sector in order to achieve economic growth. Restrictions on financial intermediation through such measures as interest rate caps, high reserve requirements and directed credit lending programs tend to impede financial development and hence reduce economic growth.

Differences in a country’s financial structure and level of development influences the direction of its economic development and affects the speed of its economic growth (Goldsmith 1969), a view also shared by many endogenous growth theory advocates. The development of a country’s financial system mirrors the economic growth of the country. Goldsmith in his earlier empirical work involving the USA, Canada and Europe found that differences in the financial structure had a significant contributing factor in determining rate of growth of real GDP for these countries. The financial structure affected the level of the savings and the distribution of savings in a country at a given period. He noted that because of the prevailing connection between the level and distribution of capital formation and; the availability of funding to finance the process or productivity, the financial system influences economic growth through the amount of savings (or credit creation) that is made available to prospective entrepreneurs and the supply channels that funding can take.

Other subsequent studies also point in the same direction that financial development and economic growth are obviously related (McKinnon (1973) and; Shaw (1973)) although the channels and even the direction of causality remain empirically and theoretically unclear. Financial deepening is found to encourage savings and reduces constraints on capital accumulation. Financial intermediation improves the economy’s allocative efficiency of investment by transferring capital from less productive to more productive sectors (McKinnon, 1973). As a result efficiency and level of investment rises with the financial development.

More recent compelling evidence is also provided by a cross-country study by King and Levine (1993) and; Levine et al. (2000). Evidence from their cross-country studies of 80 countries support the existence of a linkage between the financial system, economic growth and productivity improvements. The results suggest that the level of financial development seem to be a good predictor of future economic growth and productivity. The link of financial development and growth operates through the effects of investment on growth. The productive capacity of the economy is determined by the quality as well as by the quantity of investment and capacity utilisation. The financial system plays an important role of efficiently identifying and funding potential productive or viable investment projects in an economy. The easing of credit restrictions on working capital in an economy is expected to improve the efficiency of resource allocation and in so doing reduce the gap between actual and potential output. Thus financial intermediation influences innovative choices of entrepreneurs or simply innovation in an economy which in turn impacts economic growth. The extent of innovation undertaken by entrepreneurs in an economy determines the rate of economic growth. Financial repression on the other hand impedes innovative activity and slows economic growth. Even Levine (2000) concedes that financial development impacts on growth through total factor productivity rather than through capital accumulation or savings rates and concludes that ‘maybe Schumpeter was right’.

Financial development as measured by depth or development of financial intermediation is also essential in information and liquidity provision although it can also be detrimental due to its vulnerability to systemic financial crises which are of late common to market economies. Levine (1996) contends that stock markets affect growth through liquidity, which makes investment less risky. Because of the existence of financial markets, firms enjoy perpetual access to capital through liquid equity issues. The conclusion drawn was that stock market development explains future economic growth.

On the whole, financial intermediaries promote technological innovation and economic growth by providing basic services such as mobilization of savings, evaluating and monitoring investment projects, managing and pooling risks, and facilitating transactions. Essentially, the financial system serves the functions of: provision of information about possible investments; mobilisation and pooling savings and allocation of capital; monitoring investments and assists in embracement of corporate governance principles by investors; facilitates diversification and management of risk and; ease the exchange of goods and services. Weaker corporate governance in the financial system as well impedes effective resource allocation and slows productivity growth.

The financial system through securities markets facilitates rapid advancements and adoption of technological choices and diversification of risk Saint Paul (1992). Accordingly in the absence of technological diversification which is made possible through capital markets there would be no growth convergence a cross similar countries. Consistent with the prediction of endogenous growth model, multiple equilibriums will be experienced. Countries with underdeveloped markets experiencing low equilibrium while developed countries experience high equilibrium. Paul attributes the above scenario to the growth disparities among countries which is linked to the marginal productivity of factors and the level of financial development and ultimately equilibrium output (steady state). His empirical finds hugely contributes supporting evidence relating to the enablement of diversification and management of risk.

Size of Financial System and Economic Development

There is a link between level or size of financial intermediation and economic development. A larger financial system allows the exploitation of economies of scale, and hence leading to better production of information and cost reduction which have a positive impact on economic growth (Greenwood and Jovanovic, 1990: Bencivenga and Smith, 1991). Such a large or well developed financial system eases credit constraints in an economy. With the easing of credit restrictions, borrowing becomes easier for firms hence it is more likely that profitable investment prospects will not be circumvented because of credit rationing. In addition, a large financial system is more effective at allocating capital and monitoring the use of funds because of significant economies of scale which are associated with this function. Greater exposure to means finance also helps to strengthen the resilience of the economy to external shocks, and smooth out consumption and investment patterns.

FINANCIAL DEVELOPMENT AND ECONOMIC GROWTH: EVIDENCE FROM LATIN AMERICA

There are a number of empirical cross-country studies on the relationship between indicators of financial development and observed rates of growth relating to Latin America. Although generalisation of the results to the whole Latin American bloc is not clear-cut, however taken together or collectively these different pieces of evidence (cross country studies) supports the view that the financial development is important for productivity growth and economic development. What is also evident from these studies is that the validity of the endogeneity and exogeneity of growth is dependent on the stage of the country’s development and is country specific.

Evidence from King and Levine (1993) confirm positive correlations between financial development indicators and economic growth indicators. Cross-country studies in Chile and Argentina found a close association between financial sector reforms and financial development in the 70s and 80s in these countries, King and Levine (1993:p.535). Financial sector reforms significantly correlated with the increase in financial development. Prior to reforms there were so many restrictions to financial development in the respective financial systems hence suppression of economic growth. The liberalisation of the financial sectors or reforms in these countries were found to highly correlate with aggregate measures of financial development (financial depth, levels of private credit) and consequently economic growth. Based on the empirical results, they concluded that financial development is related to economic growth.

Similarly evidence is found for Honduras and Venezuela by Demetriades and Hussein (1996), linking financial deepening and economic growth. The causality tests involving a sample of sixteen developing countries which included five Latin American countries (Honduras, Venezuela, Costa Rica, Guatemala and El Salvador) found bi-directional link between financial development and economic growth. The causality was however found to vary across the countries.

Other empirical findings are equally worth highlighting. Contrary to the findings of other researchers, empirical evidence from the eighties found negative correlation between financial development and economic growth in Latin America (Roubini and Sala-i-Martin, 1992). The negative effect is linked to financial repression which is found to be responsible for low economic growth in most of the countries. Similar evidence is gathered in De Gregorio and Guidotti (1995) who found slightly divergent results. For a large cross-country study for most of the countries they actually find that indicators of financial development are positively correlated with economic growth, suggesting that financial development stimulate growth. But, when the analysis is focused or narrowed down to Latin American alone, they found that indicators of financial development are in fact negatively correlated with economic growth. The conflicting results are attributed to the negative effects of financial liberalization that was done in an environment that had a poor financial regulation, widespread bank failures and collapsing economies. Interestingly for Latin America, low economic growth was experienced in countries that liberalized quicker, and had rapid growth of credit from the banking system to the private sector. The prevalence of moral hazard perpetrated by the likelihood of state bailout in the event of failure and poor financial regulatory environment lead to poor credit allocation and excessive risk taking.

CONCLUSION

This paper surveyed empirical evidence linking financial development and the growth theories. There is significant empirical evidence linking financial sector development and levels of growth in Latin American and even in other countries. The study finds sufficient evidence supporting the view that financial development impacts on the productivity and growth of an economy. Essentially, financial development is positively related to economic growth however the impact varies across countries (De Gregorio and Guidotti, 1992). Besides the efficiency as opposed to volume of investment is a key factor in the achievement of growth through financial development. In the long-run only total factor productivity growth is what determinations growth. The faster the productivity growth, faster growth.

The conclusion drawn is partly consistent with both the endogenous and exogenous growth models.

Consistent with neoclassical growth models, long-term economic growth depends on the ability to raise the rates of accumulation of physical and human capital, to use the resulting productive assets more efficiently, and to ensure the access of the whole population to these assets.

Financial intermediation supports the investment process by mobilising household and foreign savings for investment by firms; ensuring that these funds are allocated to the most productive use; and spreading risk and providing liquidity so that firms can operate the new capacity efficiently.