A Functional Approach to Studying Finance-Growth Nexus - Essay Example

? A Functional approach to studying finance-growth nexus Introduction Economists have expressed diametrically opposing views on the issue of importance of the financial systems of a country for its sustained economic growth. Joseph Schumpeter (1912) was one of the early economists to have established a direct link between the financial systems and economic growth, where he observed that financial intermediaries like banks that functional effectively, tend to induce innovative technological processes by distinguishing and processing funds for entrepreneurs that have the maximum potential for actualizing the various innovative production processes. John Hicks (1969) in his papers also emphasises on the importance of sound financial systems for a strong economic growth and observes that the financial systems played the primary role as an initiator in UK’s industrial revolution by expediting the movement of capital that was used starting and sustaining the entire process industrialisation. Joan Robinson however presents a complete perspective when he opines, “Where enterprise leads finance follows” (1952, 86), thus implicating that it is the nature of the country’s economic growth that creates demands for certain types of financial institutions, and the systems simply respond to these growing demands. Some economists also disregard the theory that places importance on the finance- growth. Robert Lucas in his papers contends that economists tend to “badly over-stress” the part played by the financial systems (1988, 6), while Chandavarkar (1992) in papers observes that development economists frequently overlook the role played by the financial systems in augmenting economic growth and simply ignore it (Meir and Seers, 1984). Keeping these conflicting perspectives in mind this paper analysis existing theories to organize a critical framework of the relationship between finance and economic growth, and then assess the relative importance of the financial systems within economic growth. Discussion What is functional development? The World Economic Forum has defined financial development “as the factors, policies, and institutions that lead to effective financial intermediation and markets, as well as deep and broad access to capital and financial services” (The Financial Development Report 2010, 2010, 4). Financial development is the route through which nations can aim towards furthering the competencies of their present economic systems (comprising of markets and resources), banking sectors, supervising investment projects, and overall strengthening the position of the financial systems within a country. Thus, one can view financial development as a major aspect in affecting a country’s economic growth and welfare (Huang, 2006). Strong empirical evidences reaffirm the theory that finance is at the base of a state’s economic developmental curve. Modern academic scholars are increasingly putting their faith on the efficient, smoothly running financial systems, opining that these systems are essential for processing funds for use in various financial activities, and in apportioning the risks management arena to those who can bear it, thus fostering economic development, enhancing infrastructural growth chances, balanced income distribution, and alleviating poverty (World Bank 2001). While measuring the functional objectives of the financial structures and analysing the process of financial development in a country, focus must be on the financial services, like institutions and markets; understanding the factors that are causing certain sections of the market to remain underdeveloped; and segregating the potential and perceivable barriers within the financial services (Rajan and Zingales, 1998). The dimensions along with the provisions made for the financial developments of a country are assessed are the efficiency, size, and reach of the institutions, services, and markets, along with the quality and cost of the financial services availed for the economic growth of that country (ibid). Thus, under idyllic conditions reflecting a strong financial developmental system in a country, there will be sound provisions for a safe and low cost transfer of money within the country, ready access to remote locations, and reach of the financial institutions to the socially and economically weak households. There will be facilities benefitting monetary deposit and other investment contingencies that will make provisions for good ‘risk-return’ trade-off values, and high liquidity gains. Various entrepreneurs will have a wide variety of funding sources for their effective functioning while affordable consumer finance and mortgaging facilities will accessible to all members of the society. A strong financial development will also reflect a system where “the credit renewal decisions of banks and the market signals coming from organized markets in traded securities will help ensure that good use continues to be made of investable funds”( World Bank and IMF, 2005, 70). In this context, we will study the functional approaches of a financial system in order to understand the financial-growth nexus. The Functional approach of the Financial Systems: The costs of making smooth financial transactions and gaining information tend to create a rationale for the evolution of financial institutions and markets. This is evident when we look at the Arrow-Debreu model framework where we find that with no transaction and information costs, financial systems lose their relevance, and are not required to monitor managers, design processes to minimise risk management, and distribute the resources for funding various research projects. Thus, we find that any of the economic theories that define the role of financial system within economic growth model, creates a sort of friction within the Arrow- Debreu model. The Financial institutions and markets created to alleviate the problems emerge from the transaction and information frictions. In attempting to facilitate information and transaction costs, the financial systems perform one important function; they help in the resource allocation processes, within uncertain environment (Merton and Bodie, 1995). Specifically, the financial systems within a country’s economic model perform certain basic functions. These are: produce information on appropriate allocation of resources and investments ; supervising managers and exercising effective corporate control; expediting in the processes of hedging, trading, diversifying, and risk pooling; actuating savings; and helping in the exchange of services and goods. Figure 1: A Theoretical Approach to Finance and Growth which shows how specific market frictions motivate the emergence of financial contracts, markets, and intermediaries and how these financial arrangements provide five financial functions that affect saving and allocations decisions in ways that influence economic growth (Source: Levine, 1997, 691). Within the financial framework of a country, the financial functions may influence the economic growth through two basic ways, and these are technological innovation and capital accumulation (fig 1). For capital accumulation, some of the growth models use either capital goods produce or capital externalities, using consistent returns to scale, but makes no use of the ‘non-reproducible’ elements to produce a consistent-state per capita growth (Rebelo, 1991). These models show that the functions of the financial systems influence a steady growth of a country by affecting the rate of capital accumulation. The financial system influences the capital savings either by changing the rate or by redistributing the savings amongst various technologies that generate capital. In case of technological innovation, a category of growth models highlights the invention of new production goods and processes (Aghion,  Howitt,  & Mayer-Foulkes,  2005). In all these growth models, the functions of the financial systems tend to influence the steady-state growth by modifying the degree of technological innovativeness. We will now examine the basic functions of the financial systems within a country’s economic model, to analyse the link between financial systems and economic growth. Produce information on appropriate allocation of resources and investments: It requires both time and money to analyse and evaluate managers, business firms, and market conditions (Carosso, 1970). It is not always possible for individual depositors to allocate time, and capacity, to gather and process the necessary information the present economic conditions. However, depositors will be seldom willing to invest in financial activities on which there is very little or no reliable information. Thus, we find that the high cost of information gathering may tend to restrain the capital from moving to its peak value-use point. Information collection costs create lucrative market niches for financial intermediaries to evolve (Boyd and Prescott, 1986). In case of a fixed cost to gather all relevant information on certain technology, of there are intermediaries, then each depositor must bear that cost. Financial intermediaries that work for many members at the same time help to economize on the cost for information gathering on various investments, thereby bettering the process of resource allocation. The ability to collect and analyse information generally tend to have important implications for the growth as many business firms and entrepreneurs will advocate the use of financial intermediaries, and markets which are adept at selecting the firms with the highest potential and managers will start a more effective system of capital allocation resulting in better and faster growth. Besides distinguishing the most effective production technologies, financial intermediaries also help in raising the growth of technological innovations by identifying the entrepreneurs that have maximum potential of successfully starting a new goods and production process (King and Levine, 1993). Stock markets also affect the collection and distribution of information about the business firms. As stock markets increase on size (Grossman and Stiglitz, 1980) and acquire more liquid value (Holmstrom and Tirole, 1993), market players acquire greater incentives to collect information about the various organisations. In larger markets with more liquid value, agents find it easier to use this collected information to make money, while improved information about business firms help to elevate the resource allocation significantly with positive implications for the economic growth (Merton, 1992). Supervising managers and exercising effective corporate control: Besides lowering the costs of information collection, the financial markets and intermediaries may also help in further lowering the costs related to information collection and the enforcement costs for supervising the managers, and exercising corporate control after financing certain activities. As for example, the business owners will adopt a financial arrangement that will force the firm managers to supervise the organisation in the best possible manner that would bring about the highest profits for the owners. The “external” creditors, like equity, banks, and bondholders that do not take care of corporate governance of the business firms on a daily basis will work towards processing financial arrangements that would force the ‘internal’ managers and owners to operate the firms suitable to the interests of the ‘external’ creditors. Lack of an effective financial arrangement that does not optimize effective corporate control may hamper the transfer of capitals from incompatible agents, thus keeping the capital from appropriate investments and earning profits (Shleifer, and Vishny, 1997). External investors taking part in a project may find it expensive to verify project returns, which may in turn create frictions and motivate financial development. Insiders generally have certain incentives to pass wrong information as regards the project returns the external investor, while the later may find it expensive and socially inefficient to verify and supervise consistently all the conditions. In such cases, there is the ‘optimal contract’ between ‘externals’ and ‘internals’ which is known as the debt contract (Gale and Hellwig, 1985), where there is an equilibrium interstate, that cites that when the returns are sufficiently high, the ‘internals’ pay r to the ‘externals’ while the latter refrains from monitoring. When returns are very low, then the borrower (or the ‘internal’) defaults, while the lender (external) pays the ‘monitoring’ charges in order to verify the true nature of the returns. Such verification costs constrain investment activities and lower the efficiency of a country’s economic system, also implying that ‘externals’ restrain the firms from borrowing in order to broaden the investment, “as higher leverage implies greater risk of default and higher verification expenditures by lenders. Thus, collateral and financial contracts that lower monitoring and enforcement costs, reduce impediments to efficient investment” (Levine, 1997, 696). Thus, one can derive that pertaining to sustaining and long-term growth, financial systems can work towards improving corporate governance and control, in order to promote rapid capital development and growth, by improving the allocation of capital resources (Bencivenga and Smith, 1995). Actuating or mobilizing savings: Actuating, or mobilizing or pooling, involves the accumulation of capital from diverse investors, for the purpose of investment. If there is a lack of multiple investors, many financial or technological production processes would be restricted owing to a lack of funding (Sirri and Tufano, 1995). Additionally the process of “mobilization involves the creation of small denomination instruments. These instruments provide opportunities for households to hold diversified portfolios, invest in efficient scale firms, and to increase asset liquidity. Without pooling, households would have to buy and sell entire firms”(Levine, 1997, 699). By augmenting liquidity, risk diversification, and size of firms, the process of pooling or mobilization serves to benefit resource allocation (Sirri and Tufano, 1995). Financial systems that can effectively manage pooling the savings of individual investors can positively influence the economic development. Furthermore, the direct results of improved savings pooling on capital accumulation, improved actualisation of savings can serve to advance the process of resource allocation and elevate the technological innovations. Here Bagehot gives an illuminating example of the situation that promote mobilisation of saving, “We have entirely lost the idea that any undertaking likely to pay, and seen to be likely, can perish for want of money; yet no idea was more familiar to our ancestors, or is more common in most countries. A citizen of Long in Queen Elizabeth’s time . . . would have thought that it was no use inventing railways...for you would have not been able to collect the capital with which to make them. At this moment, in colonies and all rude countries, there is no large sum of transferable money; there is not fund from which you can borrow, and out of which you can make immense works” (Bagehot, 1873, 3–4). Thus, by effectively pooling capital resources for projects and other activities, the financial systems play an important role in allowing the acceptance of improved technologies, thus, promoting economic growth. Easing the exchange of services and goods- Besides facilitating the process of mobilising savings and resources, and allowing the broadening of a “set production technologies available to an economy, financial arrangements that lower transaction costs can promote specialization, technological innovation, and growth” (Levine, 1997, 700). Smith (1776) had contended that the concept of division of labour, or specialization, is the main aspect that is behind all productivity improvements. Thus, workers with greater specialization will be more likely to create better technological machines, and improve the overall production processes. The primary issue here is that the financial systems can produce greater specialization, and in this context, Adam Smith (1776) opined that cheaper transaction costs allow greater specialization, as specialization needs flexibility and large number of transactions than an authoritarian financial environment. Information costs, however, also motivate the growth of money, thus one can say that transaction and information costs when they continue to decrease through a number of processes, the chances are that financial and institutional development will promote specialization and innovation, leading to an overall better growth. Modern theorists have illustrated in details the ties that exist between specialization, exchange, and innovation (Rajan, and Zingales, 2003). More specialization translates into greater number of transactions, and since each transaction is expensive, financial systems that decrease the cost of transactions will create greater specialization. Thus in one way, markets that advocate exchange, also supports gains from productivity. As Levine further adds, “There may also be feedback from these productivity gains to financial market development. If there are fixed costs associated with establishing markets, then higher income per capita implies that these fixed costs are less burdensome as a share of per capita income. Thus, economic development can spur the development of financial markets” (1997, 701). Facilitating the processes of hedging, trading, diversifying, and risk amelioration- In presence of particular information and high transaction costs, the financial institutions and markets may form a system to facilitate in hedging, trading, and risk pooling. Here generally two types of risks are considered: idiosyncratic risk and liquidity risks. Liquidity can be defined as the “ease and speed with which agents can convert assets into purchasing power at agreed prices. Thus, real estate is typically less liquid than equities, and equities in the United States are typically more liquid than those traded on the Nigerian Stock Ex- change” (Levine, 1997, 691). Liquidity risk emerges owing to the presence of uncertainty factors that are associated with asset transfer into an ‘exchange medium.’ Misinformation and high transaction costs may impede liquidity while raising the liquidity risks. These frictions in turn create a sort of catalyst for the growth and development of financial institutions and markets that in turn boost liquidity. Thus, “liquid capital markets...are markets where it is relatively inexpensive to trade financial instruments and where there is little uncertainty about the timing and settlement of those trades” (ibid, 692). There is a strong link between economic development and liquidity. This is owing to the presence of some high-return projects that require a long-term capital investment. However, depositors do not like the idea of leaving savings for a long-term period, thus, “if the financial system does not augment the liquidity of long-term investments, less investment is likely to occur in the high-return projects” (ibid). According to Sir John Hicks (1969) improvements in the capital markets that lowered the liquidity risks were the chief reason for the industrial revolution in England, and technological innovation he further contended that the products of the first few decades into industrial revolution were invented earlier, thus, proving that technological innovation did not ignite the sustained growth. once can say that the technological inventions alone could not bring about the economic growth that was noticed in 18th century UK, and a significant amount of financial investments also helped in the initiated the Industrial Revolution in UK and later in Europe (Hicks, [1969], 2001). In this context, Levine commented, “If the financial system does not augment the liquidity of long-term investments, less investment is likely to occur in the high return projects…. Because the industrial revolution required large commitments of capital for long periods, the industrial revolution may not have occurred without this liquidity transformation” (Levine, 1997, 692). Many of new and the existing inventions during the industrial revolution in UK required large monetary support and long-term capital commitments, it becomes clear that the main ingredient that sparked industrial growth in 18th century UK was the capital market liquidity. Under a system of liquid capital markets, depositors can have assets, like, bonds, equity, or demand deposits, which could be sold off easily and quickly if the depositor for some reason needs ready access to their savings. At the same time, the capital markets change these liquid financial measures into capital investments that are long term in nature through the illiquid production processes. Thus, in markets that have a liquid stock, the equity holders can easily sell off their shares, while the firms have an all time access to the capital deposited by the initial depositors. Thus, by easing trade, the stock markets also lower the liquidity risks, and “as stock market transaction costs fall, more investment occurs in the illiquid, high return project. If illiquid projects enjoy sufficiently large externalities, then greater stock market liquidity induces faster steady-state growth” (Levine, 1997, 694). Thus, information costs have always inspired the creation of stock markets, while trading costs also focus on the role of liquidity. Here, it must be noted that production technologies that are long term in nature makes it necessary that the ownership is transferred for the entire period of the production process, into secondary securities markets (Bencivenga, Smith, and Starr, 1995). If these exchanging ownership process turns out be costly, then the long-term production technologies will tend to appeal less to the investors. Thus, liquidity, as measured with the cost of the secondary market trading, influences production decisions, and higher liquidity will promote a move towards long-term and higher- yielding technologies. Besides decreasing risk of liquidity, financial systems also lessen the risks that may be linked with any individual project, business firms or industries, countries, etc. Securities markets, and mutual funds, and banks as financial institutions, all provide vehicles for pooling, trading, and risk diversification. Besides the link that exists between risk diversification and capital accumulation, risk diversification may also influence technological changes, and “agents are continuously trying to make technological advances to gain a profitable market niche” (Levine, 1997, 694). Besides producing profits for the innovator, a successful technological innovation also helps in accelerating changes. Though investing in innovation may prove to be risky, the capability to sustain various types of innovative projects decreases the inherent risk and advocates investments in growth stimulating innovative activities. Thus, financial systems that ease the process of trading, hedging, and risk diversification can also promote technological innovations and support economic growth. Conclusion From the time when Goldsmith in 1969 first recorded the evidences of a close link between financial and economic development more than 40 years back till date, this subject has made much progress in terms of collecting evidences. Much theoretical work and empirical evidences reveal the various intricate channels through which the financial systems and economic development mutually influence each other within a common framework. An increasing body of literature (both theoretical hypotheses and empirical analyses), which include industry-level studies, firm-level studies, broad cross country comparisons, and individual country-studies, show the presence of a strong relationship between the operations of the financial systems, and long-term economic growth of a country. Bibliography Aghion, P., Howitt, P., & Mayer-Foulkes, D., 2005. The effect of financial development on convergence: Theory and evidence. Quarterly Journal of Economics, 120(1), 173–222. Arrow, K., 1964. 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