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.

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.

From the early Eighties the change and amelioration were extended to the main functions and activities of the Italian financial industry.
There was improvement in the handling of payments and financial transactions. Better procedures, new technology, more effective risk control promoted less use of cash and deposits, lower costs in exchanges, extensive recourse to gross settlement and delivery-versus-payment.
There was improvement in the range of intermediaries (such as investment funds) and of financial forms (securitization, as well as a moderate use of derivatives, mainly for hedging).
There was improvement in the operating efficiency (lower costs) and in the allocative capacity of banks and market agents. Both exploited economies of scale and scope, through mergers and a wider spectrum of activities (despecialisation). A better balance between the two main channels of finance, credit intermediaries and markets, emerged.
There was improvement in the informational efficiency of securities markets. The Stock Exchange, in particular, increased its capacity to provide ‘price’ information from the so called Working-Roberts-Fama weak form (prices fully reflect historical prices) to the semi-strong form (prices fully reflect all publicly available information, including historical prices) and, in some of its activities at least, to the strong form (prices fully reflect all private as well as public information).
There was improvement, finally, in the incentives and disincentives for curbing moral hazard, mainly through a large scale privatization of both banks and financial markets.
The positive effects on the Italian economy of the transformation which took place in the financial industry were not negligible. According to my estimates, it added 0.3 percentage points to the annual increase of per capita Gdp from 1985 to 1998. The performance of total factor productivity deteriorated in those years, but for non-financial, “real” reasons.
In conclusion, theory and evidence teach policymakers a mixed lesson. Better finance is conducive to higher growth. But, at least in normal conditions, improving finance is a daunting and slow process. For both reasons it is a task never to be undervalued and postponed. Its  successful fulfilment postulates continuity.