On Finance and Growth
The specific role of the banks consists in the banker being called upon to make a simultaneous evaluation of the entrepreneur, the firm and the investment project, to be financed in a dynamic economy in which competition among producers is based on innovative capacity much more than on prices. Contrarywise, in a Walrasian static equilibrium entrepreneurs do not exist, projects are selected by the prevailing interest rate in the capital market and firms by the anonymous mechanism of price competition in the product market.
The essentially qualitative features of banking described by Schumpeter are very difficult to proxy using quantitative measures of banking activity, its composition, or even the efficiency with which it is performed. Yet a great amount of recent research on financial structures is inspired by a neo-Schumpeterian vision. It is an econometric literature, mainly cross sectional, but also based on panel data, time series and case studies at macroeconomic, industry and firm levels. The degree of financial development is normally measured by variables such as the ratio of liquid liabilities of the financial industry to Gdp; the ratio of bank credit to total credit in the economy; the ratio of transactions to capitalization in equity markets.
The results show a strong and positive ceteris paribus effect of the efficiency of the financial system –financial intermediaries and financial markets – on production and productivity. Econometrically, finance matters a lot for growth even when controlling for the potential bias due to simultaneity. An important line of causation runs from better finance to faster growth.
A few examples will give a quantitative idea of the relevant elasticities ( see Levine,R., Finance and Growth : Theory and Evidence, in Aghion,P.-Durlauf,S.N.,eds., Handbook of Economic Growth, Elsevier, New York, 2005).
An increase in the ratio of liquid liabilities of banks and of non-bank intermediaries to Gdp, from the mean of the slowest growing quartile of countries (0,2) to the mean of the fastest growing quartile (0,6), would raise the growth rate of per capita income in an economy by almost 1 per cent per year.
Similarly, annual growth in per capita Gdp would increase by 0,7 percentage points if the ratio of total bank credit to Gdp were 50 per cent higher than the present level. An acceleration in economic growth of the same order of magnitude would follow a rise from 0,16/0,19 to 0,25 in the ratio of credit to the private sector vis a vis Gdp.
As to financial markets, a 30 per cent increase in market liquidity (the transactions/capitalization ratio in the stock exchange) would add 0,8 percentage points to the per capita rate of growth of the economy.
These are relevant effects indeed. An additional result is that the composition of the financial industry does not help much in explaining cross-country differences in the relationship between finance and development. In other words, bank oriented and market oriented financial systems, as such, do not seem to have differential effects on the economy’s dynamics. Banks and financial markets are complementary. Ideally, the efficiency of both should improve.
However, even if the econometric evidence is taken for granted, these analytical experiments say nothing on how to improve the financial system, the time dimension of the improvement, and the difficulties in changing the system.
Financial structures can change radically, rapidly and easily when the change follows a deep economic and financial crisis, which forces the new system to emerge from the ruins of the old one. That was the case in Italy and in other countries in the 1930s. It had also been the case of Italy after the crisis which in 1889-1893 swept away the Péreire style financial intermediaries and one of the six banks of issue of the Kingdom, the Pope’s Banca Romana. Also the present, post-Lehman Brothers crisis calls for a change, which nonetheless is still lagging. It encounters impediments which go much beyond the suggestions and expectations of many.
Apart from crises and radical reforms prompted by them, in normal conditions the structural changes in finance result from the interplay of market forces, new institutions, and economic policies. Obstacles are always there, springing from vested interests and from the inertia which the role of reputation – built on past performance – injects into the activity of financial intermediaries. Consequently, the process of transforming and innovating financial structures is complex and time consuming. It can take years, if not decades, to be completed.
The last, wide range remodeling of the Italian financial system, for instance, was particularly cumbersome. It took twenty years, from the early 1980s to the late 1990s (Ciocca, P., The Italian Financial System Remodeled, Palgrave Macmillan, Lndon, 2005). In addition to endogenous market stimuli, at least four exogenous forces promoted the change: a new body of legislation; a new style in supervision; greater neutrality in taxation; intensified banking competition. It was not mere deregulation. It was an active and structural policy. The main lines of the reform – based on the analysis of the difficulties which the Italian economy met in the 1970s – were designed and enacted by the Bank of Italy. The Treasury and other supervisory agencies were very much involved as well.
