Financial Theory and Economic Growth: Empirical Evidence in a Cross-Section of Countries

Abstract

This paper investigates the empirical evidence of a theoretical mechanism through which financial development should affect economic growth. Theory tells us that financial markets and intermediaries reduce information problems such as adverse selection and moral hazard, and in doing so reduce the cost of external funding. I examine a large sample of countries over the course of three decades - the 1980s, 1990s, and the first decade of the 2000s - and test to see if industrial sectors which are more dependent on external financing grow faster in countries with higher levels of financial development. I find strong evidence in favor of this hypothesis, suggesting that financial development increases economic growth by increasing the efficiency with which economies allocate their resources. Traditional measures of financial development, such as credit depth, remain statistically significant throughout the sample period. However, the methodology employed in this study is motivated by financial theory and the potential efficiency improvements to asset allocation. As a result, I focus on proxies for financial development that 6 measure the efficiency of the financial system rather than its depth or level of access. I find that measures of intermediation efficiency, such as interest margin, credit to deposits, and overhead costs to total assets, are a larger and more significant determinant of economic growth than measures of depth or access. I conclude that financial development remains an important impetus to economic growth, and that while there a some indications that the magnitude of the relationship has declined over time, I do not find systematic evidence across a variety of financial development measures.