Finance and Economic Development: The Role of Government Aslı Demirgüç-Kunt * December 2, 2008 Abstract: The empirical literature on finance and development suggests that countries with better developed financial systems experience faster economic growth and enjoy lower levels of poverty and income inequality. If finance is important for development, why do some countries have growth-promoting financial systems while others do not? This paper argues that the governments play an important role in building effective and inclusive financial systems and discusses policies to make finance work for development. JEL Classification Codes: O16, G2 Keywords: Financial development, economic development, financial sector policy * Senior Research Manager in Finance and Private Sector, Development Research Department, World Bank. The author is grateful to Meghana Ayyagari, Thorsten Beck, Bob Cull, Patrick Honohan, Vojislav Maksimovic and Sole Martinez for helpful comments and Edward Al-Hussainy for excellent research assistance. This paper’s findings, interpretations, and conclusions are entirely those of the author and do not necessarily represent the views of the World Bank, its Executive Directors, or the countries they represent.
2 What is the role of the financial sector in economic development? Economists hold very different views. On the one hand, prominent researchers believe that the operation of the financial sector merely responds to economic development, adjusting to changing demands from the real sector and is therefore overemphasized (Robinson, 1952; Lucas, 1988). On the other hand, equally prominent researchers believe that financial systems play a crucial role in alleviating market frictions and hence influencing savings rates, investment decisions, technological innovation and therefore long-run growth rates. (Schumpeter, 1912; Gurley and Shaw, 1955; Goldsmith, 1969; McKinnon, 1973; Miller 1998). 1 As the financial crisis that started in the summer of 2007 continues to grow and spread all around the world, the potentially disastrous consequences of weak financial sector policies have moved to the forefront of policy debate once again. At its best, finance works quietly in the background, contributing to growth and poverty reduction; but when things go wrong, financial sector failures are painfully visible. Both success and failure have their origins largely in the policy environment; hence getting the important policy decisions right has always been and continue to be one of the central development challenges. Despite their inherent fragility, financial institutions underpin economic prosperity. Financial markets and institutions arise to mitigate the effects of information and transaction costs that prevent direct pooling and investment of society’s savings. While some theoretical models stress the importance of different institutional forms financial systems can take, more important are the underlying functions that they perform (Levine, 1997 and 2000; Merton and Bodie, 2004). Financial systems help mobilize and pool