On Finance and Growth
During the last two centuries world Gdp has risen more than 60 times in real PPP terms. It has increased 10 times per capita: a spectacular multiplication – never experienced before in human history – to the benefit of a population exploded from one to nearly seven billion people.
The highest growth rate in output per person (8 per cent per annum) was achieved by Japan in 1950-70 and more recently by China. At the other extreme, economic progress has been very slow in several areas of the world, such as in Africa. The intercountry variance in growth performance explains 60 per cent of the extremely high overall inequality (measured by a 0,7 Gini index) in the worldwide distribution of personal income (the remaining 40 per cent being due to disparities among the citizens of each nation).
According to growth accounting and econometrics, as well as to economic history, three factors, or macro variables, underlie the mystery of economic development: accumulation of physical and human capital; greater efficiency in the use of resources; innovation, or technical progress. Since Adam Smith’s 1776 Inquiry into the Wealth of Nations growth theory – Marx, Schumpeter, Harrod, Kaldor, Solow, Pasinetti, up to the recent endogenous models – has been based on this triad, albeit in a variety of analytical paradigms. The main empirical result of a huge body of research is that quality in the application of resources to productive uses (improved efficiency and technical progress) is even more important than the total volume of resources. The basic sense of the following statement by Simon Kuznets – a pioneer in the statistical analysis of growth – can be shared by the large majority of economists today: “The direct contribution of man-hours and capital accumulation would hardly account for more than a tenth of the rate of growth in per capita product (…) The large remainder must be assigned to an increase in efficiency in the productive resources – a rise in output per unit of input, due either to the improved quality of the resources, or to the effects of changing arrangements, or to the impact of technological change, or to all three”. More particularly, technical progress, alone, seems to explain nearly two thirds of the progress in income per capita.
The identification of the triad – Resources, Efficiency, Innovation –and the quantification of the relative importance of each of the three elements in it represent a fundamental achievement in the inquiry into the wealth of nations.
Nonetheless, we would like to go further. What determines the elements of the triad? Why more resources? Why greater efficiency? And, especially, why innovation and technical advancement?
Explorations in this deeper layer, or stratum of dynamic forces have brought to light a second, possibly more relevant albeit rather slippery, triad: Institutions, Politics, Culture. In this vein, much emphasis has been put on Finance, as one of the main determinants of economic growth strictly linked to the components of the second triad.
Financial Structure and Development: this was the title of a path- breaking book by Raymond Goldsmith, published in 1969. Goldsmith built and systematically collected data on saving, wealth and in particular on the financial system of 35 countries. He assumed that the relative size of the financial sector in economy – the ratio (FIR) of gross financial assets to real national wealth – is a good proxy of the quantity and quality of services provided by financial intermediaries and markets. He succeeded in showing that financial deepening is positively correlated with the economy’s development. Nonetheless, he was very cautious in drawing inferences on the causal links going from finance to growth, or in the opposite direction. In theory, causation can be both ways, with feedbacks as well. Goldsmith – a pioneer in his field, no less than Kuznets in growth accounting- finally never took a firm stand on whether financial structure is a decisive, autonomous factor in economic development, not even in his latest writings.
Building on Goldsmith’s seminal work, a more recent and quite impressive body of empirical and historical research has reached several solidly grounded conclusions. Finance exerts a significant influence on the levels of output, in absolute terms and per capita. It does so, both directly and through macro variables such as the capital/labour ratio and total factor productivity. Even more importantly, improvements in the way the financial system fulfills its functions ceteris paribus, raise the rate of growth of the economy in the long run. Those functions include the easing of transactions, the mobilization and pooling of saving, the selection of firms and investment projects, the monitoring of producers, the diversification and management of risk, the treatment and diffusion of information through interest rates and asset prices.
In one respect, finance in general and banks in particular are crucial for the dynamics of a capitalist economy. The allocation of financial and consequently of real resources to innovative firms was rightly stressed by Schumpeter, in his 1911 Theory of Economic Development, as the engine of technical progress and productivity growth. For Schumpeter, through credit the banker “makes possible the carrying out of new combinations”. In order to perform this basic function efficiently, banks should be “independent of the entrepreneurs whose plans they are to sanction or to refuse”. A fundamental principle is the separation between banking and commerce, between financial and non-financial agents. Banks should not own non-financial firms, and vice versa.
