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Randall Morck and Bernard Yeung

Japan, an isolated, backward country in the 1860s, industrialized rapidly to become a major industrial power by the 1930s. South Korea, among the world’s poorest countries in the 1960s, joined the ranks of First World economies in little over a single generation. China now seems poised to follow a similar trajectory. All three cases highlight the importance of marginalized traditional elites, intensive early investment in education, a degree of economic openness, free markets, equity financing, early-stage coordination of firms in diverse industries via arrangements such as business groups, and political institutions capable of curbing the power of families grown wealthy in early-stage rapid development to make way for prosperity sustained by efficient resource allocation to high-productivity firms.

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Thomas Lambert and Paolo Volpin

This chapter surveys the literature on the political economy of finance. This field offers three main insights. First, it highlights the importance of the role of political institutions in financial development. Second, it shows how the distribution of political power in society drives the prevailing set of contracting institutions and affects capital allocation and access to finance in developed and developing economies. Third, it argues that recognizing the endogenous nature of political institutions is crucial for our understanding of the evolution and functioning of financial systems.

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Alexander Popov

This chapter reviews and appraises the body of empirical research on the association between financial markets and economic growth that has accumulated over the past quarter-century. The bulk of the historical evidence suggests that financial development affects economic growth in a positive, monotonic way, yet recent research endeavors have provided useful and important qualifications of this conventional wisdom. Moreover, the proliferation of micro-level datasets has enabled researchers to study more precise links between theory and measurement. The chapter highlights the mechanisms through which financial markets benefit society, as well as the channels through which finance can slow down long-term growth.

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Hans-Joachim Voth

England's financial revolution in the eighteenth century has long been hailed as a key contributor to the world's first Industrial Revolution. Later, in the nineteenth century, roles change in standard narratives – finance turns from hero into villain, with Victorian economic “failure” a result of excessive financial development. This survey argues for the exact opposite. England's financial revolution was strictly limited to public finance, enabling an explosion of public borrowing that stifled economic activity in the century up to 1815. It was only afterwards that finance began to fulfill its promise, enabling the country's rise to become the undisputed workshop of the world by the 1850s. Finally, there is no evidence of Victorian failure through excessive capital exports. In sum, the English case eloquently demonstrates the risks of financial repression – and the vast benefits from repealing outdated rules and regulations.

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Allen N. Berger and Raluca A. Roman

Is finance an important driver for the development and growth of the real economy in the United States or is it rather a negative rent-seeking force that impedes growth and prosperity? Most academics believe that finance boosts the economy, while society often has a very different view. This chapter reviews the academic research on the issue, contributes to the debate, and demonstrates that for the most part, at the margin, finance has a positive effect on the US economy. In most but not all cases, exogenous or instrumentable events demonstrate that private debt, public debt, private equity, and public equity contribute favorably to real economic outcomes in the United States. The evidence also suggests some conclusions about regulation and provides some future research avenues.

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Levine Aghion, Peter Howitt and Ross Levine

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Norman Loayza, Amine Ouazad and Romain Rancière

This chapter reviews the evolving literature that links financial development, financial crises, and economic growth in the last 20 years. The initial disconnect – with one literature focusing on the effect of financial deepening on long-run growth and another studying its impact on volatility and crisis – has given way to a more nuanced approach that analyzes the two phenomena in an integrated framework. The main finding of this literature is that financial deepening leads to a trade-off between higher economic growth and higher crisis risk; and its main conclusion is that, for at least middle-income countries, the positive growth effects outweigh the negative crisis risk impact. This balanced view has been revisited recently for advanced economies, where an emerging and controversial literature supports the notion of “too much finance”, suggesting that there might be a threshold beyond which financial depth becomes detrimental for economic growth by crowding out other productive activities and misallocating resources. Nevertheless, the growth/crisis trade-off is alive and strong for a large share of the world economy. Recognizing the intrinsic trade-offs of financial development can provide a useful framework to design policies targeting financial deepening, diversity, and inclusion. In particular, it can highlight the need for complementary policies to mitigate their risks, from financial macroprudential policies to monetary policy frameworks that monitor the growth of credit and asset prices.