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Rajan and Zingales_Fiancial Systems

OXFORD REVIEW OF ECONOMIC POLICY, VOL. 17, NO. 4

each kind of system responds to macroeconomic volatility and systemic risk. We conclude with some policy conjectures.

II.FINANCIAL DEVELOPMENT AND GROWTH

There is a long literature debating the impact of finance on growth—dating at least as far back as Schumpeter (1911)—that emphasizes the positive influence of the development of a country’s finan-cial sector on the level and the rate of growth of its per-capita income. The argument essentially is that the services the financial sector provides—allocat-ing capital and risk appropriately in the economy—are an important catalyst of economic growth. Early empirical work seemed consistent with this argu-ment. For example, on the basis of data from 35 countries between 1860 and 1963, Goldsmith (1969, p. 48) concludes that ‘a rough parallelism can be observed between economic and financial develop-ment if periods of several decades are considered’and ‘there are even indications in the few countries for which data are available that periods of more rapid economic growth have been accompanied, though not without exception, by an above-average rate of financial development.’Nevertheless, studies such as these simply suggest correlation. As Goldsmith (1969) puts it,

There is no possibility, however, of establishing with confidence the direction of the causal mechanism, i.e., of deciding whether financial factors were responsible for the acceleration of economic development or whether financial development reflected economic growth whose mainsprings must be sought elsewhere.

While Goldsmith (1969) was somewhat pessimistic about the possibility of establishing causation, other economists have expressed downright scepticism that financial development is anything but a side-show to economic development. Robinson (1952, p.

86) is representative of a school which seems to believe that institutions follow the inverse of Say’s law, that demand creates its own supply, when she claims, ‘Where enterprise leads, finance follows.’Others, such as Lucas (1988), argue that the impor-tance of financial development has been overem-phasized.The importance of the role financial markets and institutions play in an economy is undisputed and fairly well documented elsewhere (see Levine (1997), for example). What is disputed is whether financial markets and institutions appear on de-mand. If they do not, then the underdevelopment of financial markets and institutions would prevent an immediate response to industrial needs, and would retard the growth of a country. Recent evidence suggests this may be the case.

(i) Evidence on Financial Development and Growth

The rekindling of interest in the empirical connection between financial development and growth owes much to King and Levine (1993). They study 80 countries over the period 1960–89 to see whether the pre-determined component of financial develop-ment predicts long-run economic growth. They find that beginning-of-decade measures of a country’s financial development—such as the ratio of liquid liabilities of the financial system to gross domestic product (GDP), the share of domestic credit allo-cated by banks, or the ratio of domestic credit to private enterprises to GDP—are strongly related to the country’s economic growth, capital accumula-tion, and productivity growth over the subsequent decade. The economic size of the effects is also large. If, in 1970, Zaire had increased the share of domestic credit allocated by banks as opposed to the central bank from 26 per cent to the mean for developing countries (about 57 per cent), Zaire would have grown about 0.9 per cent faster each year in the 1970s, and by 1980 per-capita GDP would have been 9 per cent above its actual level (King and Levine, 1993, p. 734).

While the evidence in their paper sheds additional light, it does not lay to rest all doubts about causality. The sceptic could still offer a number of counter-arguments.

First, both financial development and growth could be driven by a common omitted variable, such as the propensity of households in the economy to save. Since endogenous savings (in certain macro-economic models) affect the long-run growth rate of the economy, it may not be surprising that growth and initial financial development are

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