2.6. Financial
development
The costs of acquiring information, enforcing contracts, and
making transactions create incentives for the emergence of particular types of
financial contracts, markets and intermediaries. Different types and
combinations of information, enforcement, and transaction costs in conjunction
with different legal, regulatory, and tax systems have motivated distinct
financial contracts, markets, and intermediaries across countries and
throughout history. In arising to ameliorate market frictions, financial
systems naturally influence the allocation of resources across space and time.
(Merton and Bodie, 1995: 12)
To organize a discussion of how financial systems influence
savings and investment decisions and hence economic growth, Levine (1996) focus
on five functions provided by the financial system. In easing information,
enforcement, and transaction costs, financial systems provide five broad
categories of services to the economy. While there are other ways to classify
the functions of the financial system, we believe that the following five
categories are helpful in organizing a review of the theoretical literature and
tying this literature to the history of economic thought on finance and growth.
In particular, financial systems:
- Produce information ex ante about possible investments and
allocate capital;
-Monitor investments and exert corporate governance after
providing finance;
-Facilitate the trading, diversification and management of
risk;
-Mobilize and pull savings;
-Ease the exchange of goods and services.
While all financial systems provide these financial functions,
there are large differences in how well financial systems provide these
functions. Financial development occurs when financial instruments, markets,
and intermediaries ameliorate- though do not necessarily eliminate-the effects
of information, enforcement, and transactions costs. Thus, the financial
development involves improvements in the above-mentioned functions.
2.7. Financial development
and Economic growth
Nobel Prize Laureates and other influential economists
disagree sharply about the role of the financial sector in economic growth.
Finance is not even discussed in a collection of essays by the «pioneers
of development economics», which includes three winners of the Nobel Prize
(Meier and Seers, 1984). Nobel Laureate Robert Lucas (1988) dismisses finance
as a major determinant of economic growth calling its role
«over-stressed».
Joan Ribinson (1952, p. 86) famously argued that» where
enterprise leads finance follows«. From this perspective, finance does not
cause growth; finance responds automatically to changing demands from the
«real sector».
At the other extreme, Nobel Laureate Merton Miller (1988: 14)
argues that, the idea that financial markets contribute to economic growth, is
a proposition too obvious for serious discussion. Similarly, Schumpeter (1912),
Gurley and Shaw (1955) and McKinnon (1973) have all rejected the idea that the
finance-growth nexus can be safely ignored without substantially impending our
understanding of economic growth.
Resolving the debate and advancing our understanding about
the role of financial sectors in economic growth has helped to distinguish
among competing theories of the process of economic growth.
Furthermore, information on the importance of finance in the
growth process has affected the intensity with which researchers study the
determinants, consequences and evolution of financial systems. Finally, a
better understanding of the finance-growth nexus may influence public policy
choices since legal, regulatory, tax and macroeconomic policies all shape the
operation of financial systems.
| 
