Fin Inst and Long run growth

THE ROLE OF FINANCIAL INSTITUTIONS IN LONG RUN ECONOMIC GROWTH By Michael W. Brandl The University of Texas at Austin McCombs School of Business Department of Finance

The recent economic difficulties in Southeast Asian economies are often linked to the financial sector in these countries. The business and popular press around the world are replete with stories connecting the economic crisis with difficulties in the financial sectors in these economies. The connection between the troubled banking sector and the economic slowdown is especially stressed. Asian economies that have been less impacted by the economic crisis, for example Taiwan, are often characterized as having more stable financial institutions then their neighbors. Yet this is not the first time “financial difficulties” have been linked with poor macroeconomic performance. Many today believe the Great Depression of the 1930s was made much more sever by problems in the banking sector specifically and financial markets inefficiencies in general. More recently the dramatic economic slowdown in the 1980s in the state of Texas in the United States are often linked to the banking and savings and loan crisis that gripped the state at the same time. This raises the question, what is the link between financial institutions and the macroeconomic performance of an economy? Economists hold dramatically different views regarding this question. From a much earlier time, Bagehot (1873), and Schumpeter (1911) argued that an efficient financial system greatly helped a nation’s economy to grow. As Ross Levine has pointed out it was Schumpeter’s contention that well-functioning banks spurred technological innovation by offering funding to entrepreneurs that have the best chances of successfully implementing innovative products and production processes. More recent economists have more skeptical about the role of the financial sector in economic growth. Joan Robinson (1952) asserted that economic growth creates (emphasis

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added) demand for financial instruments and that where enterprise leads finance follows. Robert Lucas (1988) has also dismissed the finance-economic growth relationship stating that economists “badly over-stress” the role financial factors play in economic growth. However in recent years thanks to the work of Ross Levine (1997, 1998), Robert King (King and Levine 1993a, 1993b, 1993c) and others (Pagano 1993), economists are again reexamining the role financial markets play in economic growth. On the theoretical side complex models have been developed to illustrate the many channels through which the development of financial markets affect and are affected by economic growth. These channels include the facilitation of trading hedging, diversifying, and pooling of risk; the efficient allocation of resources; the monitoring of managers and exerting corporate control; the mobilization of savings; and the facilitation of the exchange of goods and services. On the empirical side a growing body of studies at the firm-level, industry-level, countrylevel and cross-country comparisons have demonstrated the strong link between the financial sector and economic growth. King and Levine’s (1993a, 1993b, and 1993c) research has shown that level of financial depth (defined as the ratio of liquid assets to GDP) does in fact help to predict economic growth. Other work by Levine (1997, 1998) has shown that financial intermediary development does positively influence economic growth, these results are shown to be robust, that is the relationships still hold when other factors that are know to influence economic growth are held constant. In many ways the current research has opened as many new questions as it has attempted to answer. On the theoretical side, questions still exist on how and why do financial markets and institutions evolve? Why are financial markets at different levels of development in different markets? This research has also raised a number of very interesting public policy questions. Such as: under what legal environment do financial institutions development more rapidly? Financial regulation -- how are countries’ financial systems regulated and supervised, how

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can these be quantified, and to what extent do the differences matter. What is role of regulation in encouraging financial market development? What impacts both positive and negative will the recent bailout of financial institutions and financial markets have on the long run development of financial markets? I would like to turn our attention to one of these issues that I find most intriguing: why do financial markets develop at different rates in different economies?

That is, why do

financial institutions tend to cluster in high-income areas or economies and low-income areas seem to suffer from a lack of financial institutions? A related question is; do financial markets drive economic growth or does economic growth drive the creation of financial market and institutions? Why do financial markets develop at different rates? My idea centers on the concept of a poverty trap in the provision of financial instruments and in the development of financial institutions. One illustration of a poverty trap is the trap an economy can find itself in terms of human capital development, if learning has positive spillovers. Let us look at an example of how a poverty trap in human capital works. We will start with a counter example. That is, first let us look at how human capital has a positive spillover effect. Let us suppose that knowledge and learning have positive spillover effects in casual conversations. That is, if members of our society invest in human capital attainment by reading, learning, studying, etc., then there will be a sharing of this knowledge in casual conversation. Thus, I will learn from you and you will learn from me in our casual conversations. Therefore there will be a positive incentive for me to invest in human capital attainment since that will allow me to gain more from (and contribute more to) our conversations.

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Likewise, you will have an incentive to invest in your level of human capital as well. Thus, throughout the entire economy there will be incentives for people to invest in their human capital attainment, and thus the societal level of human capital will increase.

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result is that we have: HIGH LEVELS OF HUMAN CAPITAL ⇒ INCENTIVE TO INVEST IN MORE HUMAN CAPITAL DUE TO POSITIVE SPILLOVERS ⇒ HIGH LEVELS OF HUMAN CAPITAL INVESTMENT ⇒ HIGH LEVELS OF HUMAN CAPITAL. This positive re-enforcement mechanism can, however work in reverse, thus creating a trap. If a society has low levels of human capital attainment, the positive spillovers will be negligible; thus the incentives for further human capital attainment will be low. Due to a lack of incentives human capital investment will be low resulting in a continued low level of human capital for the society. However since human capital is an important determinant of economic growth, this society with low levels of human capital will also suffer slow or no economic growth thus being trapped in a cycle of poverty. My contention is that, perhaps, financial sector development functions much the same way that human capital attainment functions. A lack of financial institutions in an economy will make it very difficult for people to save. One argument that is often heard when one discusses the lack of financial institutions in economically repressed areas is that, people in low-income areas simply do not save. This it is argued is why there is a lack of financial institutions. I argue that the causation runs the other way. People in poorer areas do not save at high levels due to a lack of financial institutions. In fact it can be argued that people in economically disadvantaged areas do save. They simply do not save via financial institutions. It is well known among social workers in the United States for example, that low income families do save portions of their public assistance funds, even though for many years it has been illegal for them to do so. This savings usually takes the form of literally saving money in a cookie jar or under a mattress. This preponderance to hold cash may also explain the high incidence of home break-ins in economically disadvantaged area. The implications, however, are clear; the poor do save but not in financial institutions. 4

These low savings in turn makes it difficult for entrepreneurs in the economy to borrow funds in economically disadvantaged areas. Due to this difficulty in borrowing experienced by entrepreneurs the economy will experience a low level of investment. Thus, even though savings is taking place in the economy, the savings is not being used efficiently since it is not making its way into the hands of deficit units. If the savings could make their way to the entrepreneur the resulting investment would have positive spillover effects for the entire economy. The positive spillover effects from investment to economic growth are well known. If investment in physical capital creates new knowledge, then as Romer (1986, 1987) has shown there will be a spillover from each person’s investments to knowledge that is useful for all the other agents in the economy. Economies that already have high capital will have the highest returns for new investment. Higher levels of investment led to positive spillovers increasing the returns to and incentives for higher levels of investment. However, in economically disadvantaged areas with a lack of financial institutions a low level of investment results due to the lack of incentive for investment. This low level of investment results in slower or no economic growth thus retarding the growth of financial institutions in the economy. This relationship can be shown using Figure 1 below. An economy that begins with a lack of financial institutions will thus suffer from a low savings rate. This low savings rate will lead to a low level of investment. Finally, this low level investment will result in slow or no economic growth, further retarding the growth of financial institutions. Then the pattern repeats its self.

Lack of Financial Institutions

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Low Savings

Slow or No Growth

Low Business Investment Figure 1

There also may be other poverty traps stemming for the lack of financial institutions. Consider the role of information costs. With a lack of financial institutions, the information costs for savers and borrows are extremely high. Thus, these high information costs may also be reducing the level of business investment and furthering slowing economic growth. Figure 2 shows this compounding effect from suffering from a lack of financial institutions. The lack of financial institutions result in a low savings rate, but also in increased information costs. Both the low savings and high information costs reduce overall levels of business investment. This lower level of investment slows any economic growth that the economically disadvantaged economy may be experiencing. As in figure 1 the slower economic growth retards expansion of financial institutions and thus the cycle starts over.

Lack of Financial Institutions

Higher information costs

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Low Savings

Slow or No Growth

Low Business Investment Figure 2

Under this scenario the lack of financial institutions in an economy creates a poverty trap. In this model the deficit of financial institutions leads to the low official savings rates, which in turn lead to low levels of investment, further slowing the economy and resulting in a low level of financial institutions. This negative impact is compounded by the fact that the lack of financial institutions increases information costs further slowing business investment. The compounded impact is to further slow economic growth and still further slow the advancement of financial institutions into the market. This method of modeling financial institution impact on the macroeconomy offers an insight into the financial institutions-economic growth relationship. Do financial institutions drive economic growth or does economic growth drive the creation and expansion of financial institutions? The answer is yes to both. The next step in this line of research will be to develop this model formally, perhaps with in an endogenous growth model framework. The model also suggests the need for further

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study into the savings levels of economic agents in economically disadvantaged areas. Due to illegality of their savings official savings data will not provide effective insight. Conclusion To review, we have looked at the relationship between institutions and long run economic growth. This growing field of research may offer us a new insight into the dynamics of economic growth within and among various economies. In my presentation here today I have tried to motivate a new approach to modeling the role of financial institutions in long run economic growth by suggesting a poverty trap may exist in economies with low levels of financial institutions.

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BIBLIOGRAPHY Bagehot, Walter (1873), Lombard Street. Homewood, IL: Richard D. Irwin, 1962 edition. King, Robert E. and Levine, Ross (1993a), “Financial Intermediation and Economic Development.” in Financial Intermediation in the Construction of Europe. Editors: Colin Mayer and Xavier Vives. London: Centre for Economic Policy and Research, pp. 156-89. King, Robert E. and Levine, Ross (1993b), “Finance and Growth: Schumpeter Might Be Right,” Quarterly Journal of Economics, 108(3), pp. 717-37. King, Robert E. and Levine, Ross (1993c), “Finance, Entrepreneurship, and Growth: Theory and Evidence.” Journal of Monetary Economics, December, 32(3), pp. 513-42. Levine, Ross (1997), “Financial Development and Economic Growth.” Journal of Economic Literature, 35(2), pp. 688-726. Levine, Ross (1998), “The Legal Environment, Banks, and Long-Run Economic Growth.” University of Virginia, January, mimeo. Lucas, Robert E. Jr. (1988), "On the Mechanics of Economic Development," Journal of Monetary Economics, 22(1), pp. 3-42. Pagano, Marco (1993), “Financial Markets and Growth: An Overview.” European Economic Review, 37, pp. 613-22. Robinson, Joan (1952), “The Generalization of the General Theory,” in The Rate of Interest, and Other Essays. London: Macmillan, pp. 67-142. Schumpeter, Joseph A. (1912), Theorie der Wirtshaftlichen Entwicklung (The Theory of Economic Development). Leipzig: Ducker and Humblot. Translated by Redvers Opie. Cambridge, MA: Harvard University Press, 1934.

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