Rich Country, Poor Country: Economists say Financial Sector Key Driver of Economic Growth

Economists have long suspected that one reason developing countries struggle to emerge from poverty is that they lack robust financial sectors, especially when compared to wealthier nations.

Although it may seem obvious that a weak financial sector would stifle growth within a developing country, few economists until now have tried to determine just how this phenomenon occurs. This has made it difficult for policymakers and investors to understand how financial markets may be failing and to create effective solutions to correct them.

Economists Francisco J. Buera of UCLA and the Federal Reserve Bank of Minneapolis, Joseph Kaboski of the University of Notre Dame, and Yongseok Shin of Washington University in St. Louis present important insights into this phenomenon in a paper recently published in the journal American Economic Review.

The authors used a computer-based economic model and data from 79 countries to quantify key aspects of the relationship between development and finance. Their work suggests that poor financing environments in developing countries inhibit talented individuals from gaining the most from their abilities and result in lopsided economic landscapes. This ultimately slows economic growth.

The researchers examined two features of developing economies in particular: (1) technologies that cause differences in the scale of production across sectors and (2) the ability of entrepreneurs to overcome financial constraints by self-financing through savings.

They showed that the lack of financing affects productivity in both large- and small-scale industries, but it impacts large-scale industry disproportionately. In large-scale industries, such as manufacturing, poor financing opportunities make it harder to start businesses, which leads to too few entrepreneurs and too-large establishments in the marketplace.

Conversely, in smaller service industries, where it is easier for entrepreneurs such as retail shop owners to self-finance, the challenges to starting a business are actually reduced as the opportunity cost of doing so — earning a market wage and saving at the market interest rate — decreases. This results in too many entrepreneurs and too-small establishments in traditional service industries.

“An important lesson from our analysis is that the lack of good credit markets also reduces the return to savers in an economy,” Buera said. “This makes it more costly for poor individuals to build up a buffer and protect themselves from the various risks they face. The use of economic models is important for uncovering these indirect, systemic effects of financial intermediation.”

The authors’ findings confirm that weak financial development — such as the lack of financial services — accounts for a substantial part of the difference between poor and rich nations’ development; it accounts for poor countries’ low per-capita income, their large differences across industrial sectors in prices and productivity, and their low aggregate total factor productivity (TFP), which is an indicator of how effectively an economy produces, relative to the resources it uses.

“We think these findings are significant because we can characterize how much poor countries are being held back by the lack of financial development,” Buera said. “The next step is to understand what might be done about it. Why aren’t the credit markets more developed? How might enhancing credit markets increase returns on savings? What policies might we implement to solve this?”

The authors’ paper, “Finance and Development: A Tale of Two Sectors,” was published in the August issue of American Economic Review.

Francisco J. Buera is an assistant professor of economics at UCLA and a senior economist at the Federal Reserve Bank of Minneapolis. Joseph Kaboski is the David F. and Erin M. Seng Foundation Associate Professor of Economics at the University of Notre Dame. Yongseok Shin is an assistant professor of economics at Washington University in St. Louis.

Buera and Kaboski are also affiliated researchers with the Consortium on Financial Systems and Poverty, which supported this research, in part.

The Consortium on Financial Systems and Poverty (CFSP) is a private research organization comprised of leading and emerging economists whose goal is to improve the lives of the world’s poor and to reduce poverty through helping to identify, design and implement more efficient financial systems. Robert M. Townsend of the Massachusetts Institute of Technology serves as the consortium’s principal investigator.

The full study is available at https://bit.ly/mV50BN.

Written by: Jennifer Roche

*Source: University of California (UCLA)

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