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Historical, Theoretical, and Empirical Background of Financial Liberalization

We concentrate in this section on the theoretical and empirical aspects of financial liberalization. We begin, nonetheless, with a short historical background to financial liberalization.

Historical Background

We may begin with what we might label as the most important intellectual development in terms of the finance-growth nexus, which came from Bagehot (1873) , in his classic Lombard Street. In that contribution, Bagehot (op. cit.) highlighted the crucial importance of the banking system in promoting economic growth. Indeed, Bagehot (op. cit.) highlighted the circumstances when banks actively spur innovation and future growth by identifying and funding productive investments. The work of Schumpeter (1911), is also important in that financial services are paramount in promoting economic growth, since production requires credit to materialise. Indeed, one “can only become an entrepreneur by previously becoming a debtor. ... What [the entrepreneur] first wants is credit. Before he requires any goods whatever, he requires purchasing power. He is the typical debtor in capitalist society” (p. 102). In this process, the banker is the key agent.

Keynes’s (1930) A Treatise on Money also highlighted the importance of the banking sector in economic growth. He suggested that bank credit “is the pavement along which production travels, and the bankers if they knew their duty, would provide the transport facilities to just the extent that is required in order that the productive powers of the community can be employed at their full capacity” (vol. II, p. 220). Robinson (1952) clarified by suggesting that financial development follows growth. However, Robinson (op. cit.) does not preclude the possibility that the causation may be bidirectional, in that growth may be constrained by credit creation in less developed financial systems. In more sophisticated systems, however, finance is viewed as endogenous responding to demand requirements. It therefore follows that the more developed a financial system the higher the likelihood of growth causing finance. Furthermore, Robinson (1952) argues that finance responds positively to technological innovation and development. All in all, Robinson’s (op. cit.) argument is that “where enterprise leads finance follows” (p. 86).[1]

More recently, however, McKinnon (1973) and Shaw (1973) put forward the ‘financial liberalization’ thesis. Their argument is that government restrictions on the banking system restrain the quantity and quality of investment. Even more recently, and with the development of the endogenous growth literature, the suggestion has emerged that financial intermediation has a positive effect on steady-state growth (see Pagano 1993, for a survey); and of equal importance from this argument’s point of view, government intervention in the financial system has a negative effect on the equilibrium growth rate (King and Levine 1993b). There is also the view that finance and growth are unrelated. Lucas (1988) is probably the most frequently cited contribution on this score, who argues that economists ‘badly over-stress’ the role of the financial system. The difficulty of establishing the link between financial development and economic growth was also identified by Patrick (1966), and further developed by McKinnon (1988) who argued that: “although a higher rate of financial growth is positively correlated with successful real growth, Patrick’s (1966) problem remains unresolved: what is the cause and what is the effect? Is finance a leading sector in economic development, or does it simply follow growth in real output which is generated elsewhere?” (p. 390).

The relationship between financial development and economic growth is, therefore, a controversial issue, with causality being an important aspect of the controversy. Attempts have been undertaken to resolve the issue of causality; not an easy exercise as the evidence shows. As noted above, the difficulty of establishing the direction of causality between financial development and economic growth was identified by a number of contributors, who actually questioned the direction of causation. An early attempt to tackle the issue of the strength and causation of the relationship between finance and economic development was undertaken by King and Levine (1993a). They provided empirical results, and argued that Schumpeter (1911) may very well have been ‘right’ with the suggestion that financial intermediaries promote economic development. The controversial issue of causality between financial development and economic growth could thereby be resolved potentially by resorting to empirical evidence. Arestis and Demetriades (1996) demonstrate that the empirical results of King and Levine (1993a) , which were obtained from cross-section country studies, were not able to address the issue of causality satisfactorily, and proceeded to produce two types of evidence in this context. The first is to show that King and Levine’s (op. cit.) causal interpretation is based on a fragile statistical basis. Specifically, it is shown that once the contemporaneous correlation between the main financial indicator and economic growth has been accounted for, there is no longer any evidence to suggest that financial development helps predict future growth. The second type of evidence demonstrates that cross section data sets cannot address the question of causality in a satisfactory way. To perform such a task, time- series data and a time-series approach are required. Adopting the latter approach and using cointegration techniques, as well as time-series data for 12 representative countries, it is shown that there are systematic differences in causality patterns across countries. It thus emerges that, and as shown in another study by Arestis and Demetriades (1997), the proposition that causality from financial development to economic growth is not a straightforward answer; it is clear then that Arestis and Demetriades (1996) were initially correct in at least voicing concerns over causality.

A more recent, and extensive review of the empirical literature by Levine (2005), concludes that “A growing body of empirical analyses, including firm-level studies, industry-level studies, individual country- studies, time-series studies, panel-investigations, and broad cross-country comparisons, demonstrate a strong positive link between the functioning of the financial system and long-run economic growth. While subject to ample qualifications and countervailing views noted throughout this article, the preponderance of evidence suggests that both financial intermediaries and markets matter for growth even when controlling for potential simultaneity bias. Furthermore, microeconomic-based evidence is consistent with the view that better developed financial systems ease external financing constraints facing firms, which illuminates one mechanism through which financial development influences economic growth. 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” (p. 921). However, there are relevant studies that reveal significant empirical problems. Favara (2003) fails to establish significant coefficients on financial variables in instrumented growth regressions. Another study, by Rousseau and Wachtel (2001), reports that in high inflation countries the possible effects of finance on growth weaken substantially.

A further aspect of financial liberalization relies on the elasticity of the savings relationship, which is, of course, at the heart of the thesis. The elasticity of the savings relationship is either insignificant or, when significant, it is rather small. Fry (1995), after a comprehensive review of the literature, suggests that “the real interest rate has virtually no direct effect on the level of saving, but may exert an indirect effect by increasing the rate of economic growth” (p. 188). Warman and Thirlwall (1994) also question that part of the theoretical framework of financial liberalization that suggests that rising real interest rates induce more saving and investment and therefore act as a positive stimulus to economic growth. Warman and Thirlwall (op. cit.) provide empirical evidence to support this hypothesis in the case of Mexico over the period 1960—90. In this contribution the important distinction between financial savings (defined as the amount of total savings that is channelled via financial assets) and total savings is made. It is further shown that although financial savings are positively related to real interest rate, total savings are completely invariant to real interest rate; total savings are related to the level of income. Investment is positively related to the supply of bank credit and negatively related to real interest rate. It is also demonstrated that interest rates have no positive effect on growth. Overall financial liberalization and higher real interest rates could only have a positive impact on growth through raising the productivity of investment.

The contributions we have referred to in this section add to the controversial and indeed unconvincing empirical support of the financial liberalization thesis. However, with so much emphasis on the financial liberalization thesis in the context of the growth-finance nexus, a more focused review of its theoretical premise and its policy implications is required. This is undertaken in the section that follows.

  • [1] Other contributors have argued that financial development and financial structure cause technological innovation and development. Yartley (2006), for example, presents panel regression resultsfor a group of developed and developing countries to explain cross-country diffusion of ‘innovationand communication technologies’ to make the point.
 
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