Eight Questions about the Relationship between Finance and Economic Development

Topic :

This paper is a useful literature review of the key material on financial systems analysis since the 1960s, pointing out the key debates and arguments, as well as gaps in the research. This is commendable given the sheer mass of empirical research on this subject in recent years. Meyer also, importantly, identifies the limitations and omissions in his work. The paper draws a few key conclusions based on the literature, and identifies several main policy implications.

These are eight questions that Richard Meyer asks, and reviews one by one:

  1. How have economists’ views evolved over time regarding the relationship between the financial system and growth?
  2. What does the empirical evidence reveal about the connection between financial development and growth?
  3. Does the structure of the financial market make a difference?
  4. How does the legal and regulatory environment affect the performance of the finance system and its impact on economic growth?
  5. Does the impact of finance vary by size or type of firm or industry?
  6. What is the paradigm shift that has occurred concerning the appropriate methods to increase the supply of financial services, especially credit, to small and medium enterprises (SMEs) and to agriculture?
  7. What is the objective of microfinance, and what are the differences between the successes of some microfinance development projects and the failures of most SME and agricultural credit programs?
  8. What has been the impact of providing the agricultural sector and microentrepreneurs with greater access to formal finance?

The most significant conclusion of this paper is that indeed ‘finance matters’ and financial intermediaries are important for economic growth. The reasons behind this are that they influence total factor productivity growth rather than increase savings or grow the level of the capital stock.

Other significant findings are that government ownership of banks can stifle the growth of the financial sector, and in turn the overall economy; outside investment can be beneficial; and adequate legal systems are needed, to protect the rights of outside investors, as this contributes to the development of the financial system and the wider economy.

This presents a clear policy signal that governments should move away from financial sector ownership to focus on creating a sound regulatory environment, and a strong financial infrastructure that supports an efficient financial system. In addition, governments need to place greater emphasis on financial institution building that serves agriculture and the poor, even though these can be slow and expensive processes.

Another key conclusion is that the directed credit paradigm when used in SME and agricultural credit projects, has been largely a categorical failure, compared to that of microfinance, despite its limitations and sustainability problems. While there may be cases where the expansion in credit supplies contributed to agricultural growth, this growth may instead be due to the improved access to finance rather than subsidized interest rates. Subsidies have simply created distortions, which have not aided the development of strong financial systems, particularly in agricultural areas.

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