The role of financial development in economic growth

In our previous progress report (Bloch and Tang, 2001), we review the literature relating to the role of technical change and productivity growth in East Asian economic growth. The topic of economic growth is central to development economics. Growth is one of the (if not the) major engine of improvements in living standards in the developing countries. Much recent work has addressed the potential links between financial development and economic growth. It is this literature which our current report addresses, both in the context of East Asia and more widely. Despite the rapidly growing literature, the debate concerning the role played by the development of financial intermediaries in economic growth is far from settled. The debate focuses on the possible causality running from financial development to economic growth on the one hand and the channels by which financial development contributes to enhancing economic growth on the other. In addition to outlining the main issues in the continuing debate and reviewing the existing literature, this paper also re-examines the data and conducts new tests on the topic. There are two alternative views about the links between financial intermediary development and economic growth. Joseph Schumpeter (1934) in 1911 was among the first to point out that banks facilitate technological innovation in their role of financial intermediaries. By assembling savings, evaluating investment projects, monitoring managers and facilitating transactions, banks are able to acquire detailed information about firms at a lower cost. They thus become the authorized agents of the society to allocate savings to entrepreneurs and to innovating and competitive firms. The Schumpeterian view is that the development of financial intermediaries has a direct impact on the pace of technical change and productivity growth, which feeds through Progress in Development Studies 3,3 (2003) pp. 243–251