Finance and economic growth: what we know and what we need to know
Money, finance and growth
Professor Panicos Demetriades, Professor of Financial Economics, Department of Economics
Date of delivery: 09/09/03
The paper reviews the literature on the relationship between finance and growth, focusing on policy issues such as financial liberalisation and government ownership of banks. It argues that 'better', if not 'more', finance is likely to result in more growth. It also discusses a number of likely obstacles to financial development, including (i) financial repression and liberalisation (ii) government ownership of banks (iii) institutional weaknesses
(iV) political economy factors.
It argues that the case for financial liberalisation promoting financial development is far from proven. More often than not financial liberalisation has been associated with financial and economic instability. This association has not been coincidental: it is well documented in the empirical literature and there are good theoretical reasons to expect it, emanating from financial market imperfections. These imperfections can, nevertheless, be contained by a sound institutional infrastructure, including an effective system of financial regulation and supervision and a well-functioning legal system that protects investors' property rights.
The paper also takes issue with some recent empirical findings which suggest that privatisation of government-owned banks will lead to substantially increased growth rates. It argues that in many cases government ownership of banks is a symptom rather than a cause of wider problems, and it is particularly prevalent when institutions such as financial regulation and the rule of law are weak. It therefore suggests that it is much better to build institutions that foster the development of private banks and to remove any subsidies from these banks than to privatise government-owned banks. If done prematurely, the latter could, in fact result in a collapse of banking altogether.
The paper reviews recent literature that suggests that legal origins have important effects on financial development and growth. This literature argues that legal systems based on common law are superior to civic law systems in terms of the protection of investors' propert rights. Finally, the paper also reviews recent literature that examines the role of political economy factors in financial development and growth and highlights areas for further research.
The paper concludes that institutions have a first-order effect on financial development and growth and that their effectiveness determines the success or failure of policies like financial liberalisation and bank privatisation. Economists can therefore no longer afford to treat institutions as exogenous in their models.
2. What is the key finding of the work/research described in your presentation?
The case for financial liberalisation is far from proven.
Institutions have a first-order effect on financial development and growth and their effectiveness may determine the
success or failure of policies like financial liberalisation and bank
3. What is new and interesting about this work?
The emphasis on financial market imperfections and the healthy degree of scepticism it shows about (frequently driven
by ideological biases) policies like financial liberalisation and bank privatisation.
4. What is the relevance to a general audience?
When the financial system works well, economies grow fast and there is economic prosperity. When it doesn't, financial
crises erupt and their repurcussions are felt throughout the world (e.g. East Asia during 1997-98). The cause of such
crises are frequently to be found in poorly thought out financial liberalisation and bank privatisation programmes.
5. What is the next step for your work?
A better understanding of the institutions that promote financial development and their relationship to political economy
6. Others working in this specific field:
Svetlana Andrianova and Anja Shortland, both lecturers in Economics at the University of Leicester.
7. Details of relevant publications
S. Andrianova, P. Demetriades and A. Shortland "State Banks, Institutions and Financial Development", University of
Leicester Discussion Paper in Economics, 02/13, 2002.
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