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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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sum, the English case eloquently demonstrates the risks of financial repression – and the vast benefits from repealing outdated rules and regulations.
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.
Levine Aghion, Peter Howitt and Ross Levine
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.
Facundo Abraham and Sergio L. Schmukler
Since the 1970s, the world has embarked on a new financial globalization era. Cross-country capital flows have significantly increased in developed and developing countries. However, the characteristics of financial globalization differ from what was originally expected. Various examples illustrate this point. Although the literature predicted large gains from financial globalization (such as additional funding, broad diversification, and deeper financial systems), the positive effects have been more limited. In developed and developing countries, financial globalization has manifested in increasing gross capital flows (inflows and outflows) rather than larger net flows. Capital markets are segmented and only a few large firms access international markets. International institutional investors do not seem to have played a stabilizing role, helping to exacerbate and transmit crises across countries. Although financial globalization has brought several beneficial changes, its net effects and spillovers to the overall economies participating in it have yet to be understood.
Franklin Allen, Xian Gu and Oskar Kowalewski
Financial intermediaries and markets can alleviate market frictions through producing information and risk sharing in different ways. In practice, the structure of financial systems can be bank-based or market-based, varying across countries. The influence of financial structure on economic growth is dependent on the overall development of the real economy and institutions. The association is also different during crisis periods and non-crisis periods. Market-based systems tend to have an advantage for financially dependent industries in good times but are a disadvantage in bad times. The recent rapid growth of shadow banking benefits economic growth but also poses additional risks to the financial system and real economy.
Carsten Burhop, Timothy W. Guinnane and Richard Tilly
Germany’s industrialization started long after Britain’s, and Alexander Gerschenkron famously attributed to Germany’s banks a causal role in the rapid growth that followed. The German financial system was also more heavily bank based than the US or UK systems. For these and other reasons, the German financial system has long played a central role in discussions of finance and economic growth. This chapter traces the development of that system from the early nineteenth century to World War I. Germany’s political fragmentation, along with competition among the several pre-1871 states, helped shaped policy toward note-issuing banks in ways unlike the Anglo-Saxon countries. Several different types of banking institutions emerged, each with distinctive balance sheets, products, and clienteles. In additional to several different types of commercial banks, Germany also saw the development of savings banks as well as credit cooperatives aimed at small farmers and urban artisans. The famous, large universal banks that emerged in the later nineteenth century, indeed played a role in underwriting securities, but their role in corporate governance is less clear. German financial development suggests the drawbacks to classifying financial systems as either bank based or market based; the universal banks could only underwrite securities because Germany had developed active markets for corporate issue.
Meghana Ayyagari, Asli Demirgüç-Kunt and Vojislav Maksimovic
This chapter takes stock of the empirical evidence on the financing challenges faced by small and medium-sized enterprises (SMEs) especially in developing countries. We first discuss the institutional constraints that impede access to finance, including the lack of reliable credit information, lack of suitable collateral, and weak legal institutions. We next highlight firm heterogeneity amongst SMEs in accessing finance. We focus on the different policies and reforms that have been shown to be effective in improving access to credit for SMEs and conclude by highlighting areas where new research could be more effective.