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The Disastrous Consequences of Weak Financial Sector Policies

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What is the role of the financial sector in development?  Does it really contribute, or does it merely respond to the demands of the real sector?  Are markets simply casinos for betting, or do they perform some productive role?  Shouldn’t the development community just focus its attention on more important issues, such as health, education, and the real sector?

I hear these questions all the time.  It is not surprising because prominent economists also hold conflicting views.  Many development economists do not even bother to discuss the role of the financial sector in development.  Joan Robinson famously stated “Where enterprise leads, finance follows,” and Robert Lucas has argued that the role of finance in the literature on growth has been “over-stressed.”

But at the other extreme, Joseph Schumpeter observed “The banker…authorizes people in the name of society…to innovate” and Merton Miller stated: “That financial markets contribute to economic growth is a proposition almost too obvious for serious discussion.”  This debate is crucial since it affects the decisions of policymakers to prioritize financial sector reforms, and the attention they pay to identifying and adopting appropriate financial sector policies.  Where do we come out?

Financial Development is Pro-Growth

While theory provides complex and conflicting predictions on the impact of financial development on long-run economic growth, a growing body of empirical research produces a remarkably consistent story.  Financial markets and institutions arise to mitigate the effects of information and transaction costs that prevent direct pooling and investment of society’s savings.  In doing so, they perform important functions: financial systems help mobilize and pool savings, provide payments services that facilitate the exchange of goods and services, produce and process information about investors and investment projects to enable efficient allocation of funds, monitor investments and exert corporate governance after these funds are allocated, and help diversify, transform and manage risk.

Empirically, the services provided by the financial system exert an important impact on long-term economic growth.  First, countries with better-developed financial systems tend to grow faster.  And a large body of evidence suggests that this effect is causal: hence financial development is not simply an outcome of economic growth; it contributes to this growth.  Second, we now also know more about the “how” of the impact of finance on growth – it promotes firm entry by easing the ability of financially constrained firms to access external capital, innovate, and expand; and by allowing firms to manage their risks better and to choose more efficient organizational forms such as incorporation.

Financial Development is Pro-Poor

Finance can also shape the gap between the rich and the poor and the degree to which that gap persists across generations.  Financial development may affect to what extent a person’s economic opportunities are determined by individual skill and initiative, or whether parental wealth, social status, and political connections largely shape economic horizons.  The financial system influences who can start a business and who cannot, who can pay for education and who cannot, who can attempt to realize his or her economic aspirations and who cannot.  Furthermore, by affecting the allocation of capital, finance can alter both the rate of economic growth and the demand for labor, with potentially profound implications for poverty and income distribution.

Theoretically, again, how financial development affects inequality is not clear.  However, an emerging bulk of empirical research points toward the conclusion that improvements in financial contracts, markets, and intermediaries expand economic opportunities, reduce persistent inequality, and tighten the distribution of income.  For example, access to credit markets increases parental investment in the education of their children and reduces the substitution of children out of schooling and into labor markets when adverse shocks reduce family income. Better functioning financial systems stimulate new firm formation and help small, promising firms expand as a wider array of firms gain access to the financial system.

Besides the direct benefits of enhanced access to financial services, research also indicates that finance reduces inequality particularly through indirect, labor market mechanisms. Specifically, accumulating evidence shows that financial development accelerates economic growth, intensifies competition, and boosts the demand for labor, disproportionately benefitting those at the lower end of the income distribution.  Hence, finance is not only pro-growth, but it is also pro-poor.

How to Avert Disaster?

As the 2007 financial crisis spread around the world, the potentially disastrous consequences of weak financial sector policies have moved to the forefront of policy debate once again.  At its best, finance works quietly in the background, contributing to growth and poverty reduction; but when things go wrong, financial sector failures are painfully visible.  Both success and failure have their origins largely in the policy environment; hence getting the important policy decisions right has always been and continues to be one of the central development challenges.

What can governments do to develop their financial systems?  Quite a bit.  For their financial systems to thrive, governments need to ensure a stable political system, fiscal discipline and sound macroeconomic policies. Institutional development – such as protection of property rights, effective enforcement of contracts and information infrastructures – are critical elements in financial system development.  Regulation and supervision of financial systems and ensuring a contestable system are crucial for stability and efficiency.  Governments also have an important role in building inclusive financial systems by expanding access.

This is a complex and challenging agenda that requires much work. Combining research analysis with practitioner experience can help temper and tailor reform to individual country circumstances.  Given all the evidence, policymakers should prioritize financial sector policies and devote attention to policy determinants of financial development as a mechanism for promoting economic development.

Further Reading:

Demirguc-Kunt, Asli, and Ross Levine. 2008.  “Finance, Financial Sector Policies, and Long Run Growth,” M. Spence Growth Commission Background Paper, No 11, World Bank.

Demirguc-Kunt, Asli, and Ross Levine. 2009.  "Finance and Inequality: Theory and Evidence." Annual Review of Financial Economics 1: 287-318. (NBER Working Paper version available here)

Demirguc-Kunt, Asli. 2010.  "Finance and Economic Development: The Role of Government." In The Oxford Handbook of Banking, ed. Allen Berger, Phillip Molyneux, John Wilson. Oxford, UK: Oxford University Press. 729-55. (PDF version available here)


Asli Demirgüç-Kunt

Former Chief Economist, Europe and Central Asia Region

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