Financial Development and Economic Growth bear a strong relationship with each other. “Theory and evidence imply that better developed financial systems ease external financing constraints facing firms, which illuminates one mechanism through which financial development influences economic growth” (Levine, 2005). Studies suggest that an economy’s financial system cuts transaction and information costs which in turn results into mobilizing savings, better investments and proper resource allocation. These in turn bring about innovation in technology, accumulation of capital and economic growth.
Levine (2005) suggests that when financial intermediaries are present in the market, investors gain access to high quality and reliable information about the market conditions and their investments. This leads to suitable allocation of scarce resources and accumulation of capital thereby affecting the entire market. When the public’s investments yield positive results and there is equity in their income distribution, goods and services are traded more easily. When trade channels begin to function smoothly, an economy’s Gross Domestic Product gets affected positively which in turn causes long-term economic growth.
When the financial markets of an economy are booming or receding, it directly affects the economy of a nation. For instance, The Great Recession of 2008 was caused when asset-backed securities and derivatives lost their value which directly impacted the GDP of USA and the other countries. Empirical research like time and panel studies also suggest that components of financial markets cause a deep impact on several economic factors such as poverty, income distribution, trade credit and GNP.
Additionally, corporate governance is another financial factor that has a major role to play in influencing economic growth. Economy is directly affected when shareholders of a company employ skilled managerial personnel who are in turn allowed to take informed decisions about crucial financial issues on their behalf. Financial issues such as mergers, acquisitions, financial restructuring, raising equity finance and liquidation have a direct impact on the economy. Levine (2005) is of the opinion that investors are more open to finance companies when their shareholders and creditors are in charge of effectively monitoring the firm’s managerial functions and encouraging managers to add and maximize the firm’s value. Subsequently, this enhances the firm’s efficiency to allocate resources which in turn causes mobilization of blocked funds in the market, facilitates trade and affects the growth rates.
Several other financial factors such as management of risk, income distribution, pooling of savings and controlling transaction costs also cause economic growth rates to increase. Levine (2005) illuminates that the occurrence of each of these events play a pivotal role in affecting economic growth. He argues that since money is the key indicator of both financial development and economic growth, it causes a chain reaction between these two elements.
Another school of thought argues that the banking system of an economy is more influential on the economy than the financial markets. Levine (2005) writes that banks can exercise immense control over firms and their corporate governance system since they can control borrowing and lending rates, voting power of shareholders and creditors. Banks may cause the economic growth rates to rise and the financial market to fall at the same time. Contenders who believe that financial development has a direct influence on economic growth, strongly argue that “by spurring competition for corporate control and by offering alternative means of financing investment, securities markets may reduce the potentially harmful effects of excessive bank power” (Levine, 2005) .
Levine concludes that although financial system has a direct impact on the growth of an economy, empirical evidence is insufficient to prove that.” Theory and empirical evidence make it difficult to conclude that the financial system merely --and automatically -- responds to economic activity, or that financial development is an inconsequential addendum to the process of economic growth.” (Levine, 2005). According to him, research shows ambiguous results since the banking system, stock market, politico-legal factors, global factors and socio-economic factors also have simultaneous impact on the growth rates. All these elements affect the growth rate of an economy alike and financial development of a country can thus be considered as one of the factors affecting economic growth.
Bibliography
Levine, R. (2005). Handbook of Economic Growth. In: P. Aghion and S. Durlauf, ed., Handbook of Economic Growth, 1st ed. [online] The National Bureau of Economic Research, pp.2-88. Available at: http://www.nber.org/papers/w10766 [Accessed 12 May 2016].
