Global financial crisis: Lessons for developing economies

Part  IVThe positive association between financial development and economic development is undeniable given the results of the endogenous growth literature, as well as the empirical support from various cross-country studies cited above.

Part  IV
The positive association between financial development and economic development is undeniable given the results of the endogenous growth literature, as well as the empirical support from various cross-country studies cited above.

However, given the methodological flaws attendant in those studies, they deserve qualification.

The cross-section techniques employed in the above studies are limited by many factors; especially the nature of data used and the form in which it is used (see Barro, 1991).

A number of unrealistic assumptions, including one that stipulates that each economy in the sample has a stable path (see Quah, 1993), also limits such studies.

In addition, there are the effects of omitted variable bias, sample selection bias, and above all inappropriate weighting of countries in the sample.

Moreover, the cross-section nature of the techniques used cannot allow different countries to exhibit different causality patterns.

It is most likely that in some countries in the sample finance is a leading sector and could indeed facilitate economic development; while in others the financial sector could be so under-developed that it lags other sectors of real economy, in which case it would be irrelevant to the development of such economies or, at best, follow the growth of other sectors.

This implies that the causality results cited in these studies can only be valid on average.

As a result, the results contained in the studies cited above can at best be used to infer a contemporaneous correlation between financial development and economic development. 

Nevertheless, positive cross-sectional correlations are also consistent with the alternative view of the above relationship.

According to this ++view, financial development follows economic growth, in the sense that growth increases the demand for financial services, which will necessitate the creation of financial intermediaries in the economy to provide such services.

Robinson originally advanced this view (1952:86), who argued that, “Where enterprise leads finance follows.” Friedman and Schwartz (1963) who observed that the conventional ratio of broad money to stock of nominal GDP, which has been a standard measure of financial development in most existing literature, is also the inverse of the velocity of circulation of broad money stock supported Robinson’s hypothesis.

They further observed that the positive relationship between financial development and economic development might simply reflect an income elasticity of demand for money with respect to income, which is greater than unity.

Accordingly, the direction of causation would run from real GDP to financial development, through the demand for money.

Patrick (1966), who argued that, by themselves, positive associations between financial development and economic growth are insufficient in establishing the direction of causality, also supports this view.

A study by Kane (1975) revisited the earlier hypothesis postulated by Patrick (1966) (supply-leading finance) and argues that the development of financial systems and institutions in such countries as Britain, Germany, France and Russia was in response to the needs and the demand for such services by the productive sectors of these economies, rather than a consequence.

That is, innovations and entrepreneurial skills evolved in the financial sector were a consequence of the demand by non-financial sectors but not a cause.

This dissertation questions the validity of Patrick’s (1966) supply-leading finance as well as Gerschenkron’s (1966) bank-led economic development hypotheses; and it further complicates the causality relationship between financial developments, advocated by the Schumpeterian school of thought.

Kane (1975) suggests that as an economy develops, it will create various needs for various financial services to oil such growth and to sustain it in a circle that can answer the description of economic development.

Whereas empirical evidence seems to support the hypothesis (causation relation) that financial development enhances economic development at the earlier stages of development, this may be less than helpful in the real world.

Supply-led financial development would presuppose the existence of a financial superstructure put in place and equipped with substantial resources on standby to finance all viable ventures in the economy as and when they arise.

Nonetheless, this would depend on existence of prime factors. One such factor is a legal framework. Laporta et al., (1997, 1998) observe that legal and regulatory systems fundamentally influence the development of financial systems. On the same note, the study by Levine et al. 2000) found out that countries with strong legal and regulatory systems have better developed financial systems than their counterparts with weak systems. They thus argue that
 “… Contract enforcement seems to matter even more than legal and regulatory codes.

Countries that efficiently impose compliance with laws tend to have better developed financial intermediaries than countries where enforcement is more lax.” ibid 2000:36.

The above argument further questions the extent to which financial intermediaries in countries like Kenya, Congo and Nigeria (known to have some of the weakest legal systems in SSA see East African, January 22-28, 2001, and Daily Nation, Thursday, June 28th 2001) can be expected to develop, given their weak legal and regulatory systems, and later be expected to have contributed to their growth. Elsewhere, Lucas (1988:6) asserts that, “economists badly over-stress the role of financial factors in economic growth.”

The author is a Senior Presidential Advisor on Economic Affairs and can be reached at mnshuti@yahoo.co.uk.

Have Your SayLeave a comment