Economic Paper 158 Finance and economic growth A review

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European Communities 2001,Finance and economic growth. a review of theory and the available evidence,Michael Thiel. The EU s structural reform agenda attaches a considerable weight to the establishment. of efficiently working and integrated EU financial markets While there is a firm. consensus that a well functioning financial sector is a precondition for the efficient. allocation of resources and the exploitation of an economy s growth potential the. economic literature is less consensual on how and to what extent finance affects. economic growth This paper reviews the economic theory and available evidence. with particular focus on three questions 1 How does financial development affect. economic growth 2 what are the features of a growth supportive financial structure. and 3 how are financial structures related to structural change and technical. progress It emerges that financial development is related to economic growth even in. industrial countries But it is also shown that empirical analysis at the aggregate level. is unlikely to capture the complexity of the financial structures in industrial countries. and of the growth process, Views expressed in the paper are exclusively those of the author and do not necessarily correspond. to those of the European Commission for whose Directorate General for Economic and Financial. Affairs the author is working I would like to thank Servaas Deroose Harry Huizinga Briain. Kavanagh Rolf Kjaergaard and Sven Langedijk for comments on earlier versions of the draft. Shortcomings and errors are only the responsibility of the author. Table of Contents,1 Introduction 6, 2 Some stylised facts on financial developments in the EU 7. 3 How does financial development affect economic growth 14. 3 1 The economic function of finances the micro view 14. 3 2 The Finance growth nexus in theory 16,3 3 A review of the empirical evidence 20.
4 What are the features of a growth supportive financial structure 27. 4 1 Definition of the financial structure 27, 4 2 Theoretical considerations on the superiority of financial structures 28. 4 3 Empirical evidence 30, 4 4 Completeness and adaptability of financial structure 36. 5 How are financial structures related to structural change and technical. progress 38, 5 1 Structural change in the EU financial system 38. 5 2 The impact of technological progress on the production process of the. financial sector 40, 5 3 Changes in the demand for financial services 42. 6 Conclusions 45,References 46, Figure 1 Investment savings pattern in EU Member States and the USA.
average 1991 2000 in percent of GDP 8, Figure 2 The financial structure in the euro area and Member States some. snapshots of recent pattern 11, Figure 3 The financial structure of EU Member States changes over time 13. Figure 4 Level and growth effects 16, Figure 5 Legal aspects and financial structure EU Member States 32. Figure 6 Financial sophistication domestic interbank claims relative to claims. from banks on domestic non financial corporations 40. Figure 7 Composition of financing of small US business classified by age 43. Figure 8 Venture financing and growth in the high tech sector EU Member States 44. Table 1 Financial investment and financing of non financial sector in the. euro area at mid 200 10, Table 2 Recent empirical studies on the finance growth linkage at the. aggregate level 22, Table 3 Significance of financial variables in cross country regressions 25.
Table 4 Forms of financial claims 27, Table 5 Significance of financial structure in cross country regressions 33. Table 6 Recent empirical studies on the finance growth linkage at the industry and. firm level 35,1 Introduction, Although conclusions must be stated hesitantly and with ample qualifications the. preponderance of theoretical reasoning and empirical evidence suggests a positive. first order relationship between financial development and economic growth. There is even evidence that the level of financial development is a good predictor of. future rates of economic growth capital accumulation and technological change. Moreover cross country case study industry and firm level analyses document. extensive periods when financial development or the lack thereof crucially affects. the speed and pattern of economic development R Levine 1997. Since the survey by Ross Levine of what may be called the first wave of evidence on. the finance growth nexus research in this area has intensified Interest was stimulated. by at least three factors 1 the regained popularity of growth theory in general 2. the availability of huge cross country data sets and not least in the EU 3 a policy. interest in stimulating growth on the one hand and in creating a single financial. market on the other, The controversy between apologists of the neo classical approach and endogenous. growth models has certainly contributed to the revitalisation of economic growth. theory From the neo classical point of view economic growth is entirely driven by. the accumulation of input factors and technical progress with the potential role of. finance restricted to assistance in the accumulation of capital Endogenous growth. approaches stress the role of entrepreneurship and innovation which allows some. leeway for finance to direct incentives to research and innovation or rent seeking. While no economist affiliated to one or other camp would doubt that a developed. financial system is beneficial for growth the importance attached to finance differs. with respect to two key questions Firstly is financial development a pre condition for. economic development or does the financial sector develop in parallel with overall. economic development Secondly do differences in financial development only. account for differences in early stages of economic development or do they also. matter for mature industrial economies, The compilation of cross country data banks covering a wide range of economic. variables has given considerable impetus to empirical research Cross country. regressions have become a common tool for attributing variation in growth. performance to differences in economic social and political factors The empirical. literature on finance and growth has flourished with the availability of new data sets. However while a plethora of financial data exists the availability of data on financial. prices on a daily basis or even a greater frequency being particularly notable it must. be stressed from the onset that the availability of structural data of high quality for. financial markets and an insufficient degree of comparability across countries still. remains a fundamental problem for studying the finance growth linkage. The interest of economic policy makers in growth related questions is apparently. motivated by the appearance of high rates of growth in the country that is considered. to have the most advanced financial system the USA In comparison the growth. performance of the EU falls short and it has been repeatedly argued that the large and. advanced US financial system has decisively contributed to accomplishing dynamic. growth and that the lack thereof has curtailed growth in the EU In particular the. emergence of new economy growth patterns appeared to have benefited from a. circulus virtuosus characterised by technical progress in the ICT sector an. increasing valuation of ICT firms on stock markets and easy financial conditions for. innovation in the ICT sector However financial markets in the EU have featured. considerable changes and remedying national fragmentation is high on the policy. agenda with the momentum increased since the introduction of the euro. Earlier work by the Commission has dealt with the welfare gains expected from. financial integration 1 Meanwhile academic research has progressed in analysing the. dynamic effects of finance on economic growth which were only sketched in the so. called Ceccini report The present paper reviews the underlying transmission channels. between financial developments and economic growth and attempts to apply the. principles identified in the academic literature to the situation in the EU It discusses. recent theories and reviews the available empirical evidence with focus on three. 1 How does financial development effect economic growth. 2 What are the features of a growth supportive financial structure. 3 How are financial structures related to structural change and technical progress. 2 Some stylised facts on financial developments in the EU. Providing a comprehensive view on financial developments in the EU is complicated. by three facts Financial structures are complex they differ between Member States. and they change over time Despite the efforts from international organisations such. as for instance Eurostat the ECB the World Bank and the OECD data on financial. structure is neither sufficiently detailed and harmonised nor does it simultaneously. cover many Member States and longer time periods Thus this section cannot refrain. from applying a patchwork approach presenting data from different sources that do. not necessarily fit together, With the guiding concentration of this paper being on a phenomenon at the aggregate.
level it appears natural to follow a top down strategy The essential role of finance is. to channel savings to investment Financial prices such as interest rates exchange. rates or stock prices serve to adjust the individual plans of economic agents to be. consistent with equilibrium for the aggregate Figure 1 reveals the national. investment saving pattern as a snapshot for the 1990s For a closed economy the. balance of payments is zero by definition and consequently investment and savings. are equal Thus displaying investment and saving relations at the national level serves. to assess the impact of international flows on domestic finance 2 The chart reveals that. the larger EU Member States are closer to the 45 degree line I S than the small. open economies According to this measure the European Union and the euro area. The Ceccini report estimated the realisation of the single market for financial services to yield a. consumer surplus of around 26 billion euro This was derived from the convergence of prices for. financial services which at the end of the 1980s still differed considerably in EU See European. Commission 1988, This measure was first used by Feldstein Horioka 1980 to demonstrate the low degree of. international financial integration, display closed economy features 3 The finding that the Member States observations. are more distant from the 45 degree line than the European aggregates suggests that. intra European capital flows exert some influence on national savings and. investments within Member States Indeed the co existence of closed economy. features for the EU aggregates with some considerable deviation from the 45 degree. line for a number of Member States could be indicative of a well integrated intra. regional financial market with limited exposure to forces outside this area The. implication would be that the analysis of finance growth linkages via the observation. of investment and saving patterns ought to be carried out within a European rather. than a national framework Bearing this in mind it nevertheless appears appropriate to. analyse the finance growth nexus from the domestic point of view and neglect. international influences in the remainder of this paper. Figure 1 Investment savings pattern in EU Member States and the USA average. 1991 2000 in percent of GDP,Closed economy line,Investment equals Savings. Gross national savings,15 17 19 21 23 25 27, Source Commission services Gross capital formation total economy. The instruments used by non financial entities to save or to finance investment may. be evident from financial accounting systems which in the case of European. aggregates are still under construction The ECB has assembled data for the euro area. which while not yet as detailed as those by national central banks allows for a. cautious first impression to be derived see Table 1 4 The data is derived from. financial quarterly accounts covering data from ten euro area Member States data is. missing only for Ireland and Luxembourg The table shows that the three non. financial sectors government households and non financial corporations use different. forms of financing with the government dominating the security market and. households relying on long term loans Non financial corporates are mainly financed. through quoted shares and bank loans with two thirds of the latter two thirds being of. long term maturity As regards flows in contrast to stocks the relative importance of. The excess of investment over savings in the US in the chart reflects the US current account deficit. See Banque de France 2000 for France for Germany see Deutsche Bundesbank 2001. loans over stocks is even more pronounced for non financial enterprises 5 An. important item missing is the internal financing of enterprises For instance in. Germany more than 50 per cent of the investment of non financial corporations is. usually self financed through cash flows generated from profits and depreciation. Also lacking are unquoted shares and equity in any form other than shares. As regards assets only about a third of the non financial sector s financial wealth is. stored in securities quoted shares and debt instruments . future rates of economic growth capital accumulation and technological change Moreover cross country case study industry and firm level analyses document extensive periods when financial development or the lack thereof crucially affects the speed and pattern of economic development R Levine 1997

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