## Section III and V — Finance, growth, innovation, and distribution ## Source details **Canonical URL:** [Section III and V — Finance, growth, innovation, and distribution](https://www.imf.org/-/media/files/publications/wp/2021/english/wpiea2021164-print-pdf.pdf) ## Other formats - [Markdown version](/-/media/files/publications/wp/2021/english/wpiea2021164-print-pdf.pdf.md) - [Structured JSON version](/-/media/files/publications/wp/2021/english/wpiea2021164-print-pdf.pdf.json) --- ### Critique of the empirical literature on finance and growth (Section III) - Empirical approaches surveyed: - broad cross-country growth regressions, time-series analyses, panel techniques, detailed country studies, industry- and firm-level examinations. - Main methodological shortcoming: - Measurement of “financial development” often misaligned with theory; researchers frequently use size proxies (e.g., size of banking system) that can misrepresent theorized functions (screening, governance, risk management, mobilization, exchange). - Conclusion: - The literature does not yet provide a definitive answer to: Does finance cause growth, and if it does, how? ### Tentative conclusions from existing research (Section III) - Three tentative findings emerge: - (1) Economies with better functioning banks and stock markets grow faster, and simultaneity bias does not seem to drive this conclusion. - (2) Better functioning financial systems foster growth by improving resource allocation and technological change, not by increasing savings rates. - (3) Better functioning financial systems - (a) ease the external financing constraints that impede firm and industrial expansion by improving screening and governance, and - (b) enhance the management of liquidity risks. - Suggested linkage: screening, governance, and liquidity creation are particularly important financial functions for growth. ### Financial innovation and long-run growth (Section V) - Definition: financial innovation = emergence of new and improvement of existing financial instruments, markets, and intermediaries. - Observations: - Much research focuses on level of financial development and largely ignores financial innovation. - Theory suggests innovation may be necessary to maintain sustained long-run growth as technological complexity and specialization increase. - Research agenda: - Explore connections among financial innovation, stability, long-run growth, and income distribution in greater depth. - Note: IMF / World Bank (2019) reports new financial technologies may foster inclusive growth that reduces inequality. ### Five critical financial services (theory overview, Section V) - Financial systems reduce information, enforcement, and transaction costs and provide five services: 1. Produce information about investments and allocate capital. 2. Monitor investments and exert corporate governance. 3. Provide mechanisms to trade, diversify, and manage risk. 4. Mobilize and pool savings. 5. Ease exchange of goods and services. - Improvements along any dimension can have different implications depending on other frictions. ### Roles of specific financial services (Section V) - Producing information and allocating capital: - Intermediaries lower information costs and fund more promising firms; financial development can relax financing constraints on human capital investment. - Monitoring and corporate governance: - Delegated monitoring by intermediaries can economize on aggregate monitoring costs and boost productivity, capital accumulation, and growth. - Stock market liquidity has ambiguous governance effects. - Risk trading and liquidity: - Cross-sectional diversification and liquidity provision lower barriers to funding long-term, high-return projects. - Banks and equity markets reduce liquidity risk and can spur growth via mechanisms like demand deposits and mixing liquid/illiquid assets. - Pooling of savings: - Mobilization enables investment in large, indivisible projects and reallocation toward higher-return activities. - Easing exchange: - Money and transaction-cost–reducing innovations facilitate specialization, raising productivity and innovation. ### Financial innovation, stability, and distribution (Section V) - Financial innovation can both create fragilities and promote inclusive growth; neglecting innovation understates its potential role in growth and distributional outcomes. --- ### Empirical evidence on finance and growth — cross-country, panel, industry, firm, and within-country ### Cross-country and panel findings - King and Levine (1993a) (KL): - Sample: 77 countries from 1960 through 1989. - Common proxy: Private Credit = credit to private firms divided by GDP. - KL find large, positive, and statistically significant relationships between financial development and: - (1) average rate of real per capita GDP growth, - (2) average rate of growth in the physical capital stock per person, - (3) average rate of productivity growth (growth of the "Solow residual"). - Example estimate: If Bolivia had the average value of financial development in 1960, holding other things constant, it would have grown about 0.4 percent faster per annum, so that by 1990 real per capita GDP would have been about 13 percent larger than it was. - Caveat: cross-country regressions do not formally address causality. - Levine and Zervos (1998) (LZ): - Sample: 42 countries, 1976-93. - Finding: initial stock market liquidity (turnover ratio) in 1976 and initial banking development in 1976 correlate positively and significantly with economic growth, capital accumulation, and productivity growth over the next 18 years; banks and markets provide distinct, complementary services. - Market size (market capitalization/GDP) is not robustly correlated with growth. - Instrumental-variable and panel GMM studies: - Legal origin indicators (LLSV) used as instruments confirm greater financial development associated with faster growth. - Levine et al. (2000) conceptual experiment: increasing Argentina’s Private Credit from (16) to the developing country sample mean (25) would have increased Argentina’s real per capita GDP growth by one percentage point; growth averaged 1.8 percent per year over this period. - Panel GMM studies on 77 countries over 1960–95 (data averaged over seven non-overlapping five-year periods) find exogenous components of financial development positively associated with growth. - Nonlinearities and thresholds: - Rioja and Valev (2004b); Arcand, Berkes, and Panizza (2015): finance-growth relationship may be nonlinear. - Arcand et al. find financial depth starts to slow growth when Private Credit reaches 100% of GDP. - Botev, Égert, and Jawadi (2019) challenge the threshold finding and reject a threshold where further financial development slows growth. ### Cross-industry and cross-firm evidence - Rajan and Zingales (1998) (RZ): - Sample: 36 industries and 42 countries. - Industries that are heavy users of external finance benefit disproportionately from financial development. - Example: Machinery external dependence 0.45 (75th percentile) vs Beverages 0.08 (25th percentile); country market capitalization example: Italy 0.98 (75th percentile) vs Philippines 0.46 (25th percentile). Estimates imply Machinery grows 1.3 percent faster than Beverages in Italy compared to the Philippines; actual difference is 3.4. - Firm-level studies: - Demirguc-Kunt and Maksimovic (1998); Beck et al. (2001): firms requiring external finance grow faster in economies with developed financial systems. - Firm-level surveys (Beck, Demirguc-Kunt, Maksimovic 2005): financing constraints exert first-order impact on firm growth, especially for smaller firms; financial development loosens effects of weak institutions and corruption. - Financing constraints reduce R&D and innovation (Brown, Fazzari, and Petersen 2009); stock market liquidity reforms may reduce innovation via takeover risk (Fang, Tian, and Tice 2014). - Bank liquidity creation found to exert a first-order impact on economic activity (Berger and Sedunov 2017). ### Within-country and historical studies - U.S. state-level evidence: - Jayaratne and Strahan (1996): state-level bank deregulation that intensified competition accelerated real Gross State Product (GSP) growth by improving credit allocation efficiency without markedly changing quantity of lending. - Deregulation spurred new business creation and increased innovation when quality of services to firms improved. - Venture capital supply shocks boost new business formations, employment, and growth (Samila and Sorenson 2011). - Regional/local and historical comparisons: - Local financial development increases business entry, competition, firm growth, and allocative efficiency. - Historical evidence (e.g., Brazil vs Mexico after 1889) links financial liberalization to lower industrial concentration and industrial expansion. --- ### Finance, poverty, and income distribution — theory and empirical evidence ### Conceptual framework (Demirguc-Kunt and Levine 2009) - Dynasty i’s total income in generation t: - y(i,t) = h(i,t)w(i,t) + a(i,t)r(i,t) - h(i,t) = level of human capital, - w(i,t) = wage rate per unit of human capital for dynasty i, - a(i,t) = dynastic wealth, - r(i,t) = return on assets for dynasty i. - Financial market imperfections shape intergenerational income differences via effects on human capital accumulation, wage rates for equivalent skills, and wealth accumulation. ### Finance and intergenerational persistence of human capital - Human capital production: - h(i,t) = h[e(i,t), s(i,t)] where e(i,t) ability endowment, s(i,t) schooling; complementarity ∂2h/∂e∂s > 0 implies efficient allocation gives more schooling to higher-ability children. - Financial development effects: - Well-functioning markets enable borrowing for education, tighten link between h(i,t) and e(i,t), reduce dependence of schooling on parental wealth, and reduce intergenerational persistence of inequality. - Poorly functioning systems make schooling a function of a(i,t-1), increasing persistence of inequality and producing inefficient allocations (rich low-ability parents investing more in schooling than high-ability poor children). - Consumption smoothing failures cause families to pull children out of school during shocks, hindering high-return human capital accumulation. ### Finance and wage inequalities - Wage dispersion arises beyond human capital due to employer discrimination. - Financial development reduces barriers to firm entry and increases competition, which can reduce discrimination (evidence emphasized on U.S. racial inequality; suggested research on gender and cross-country comparisons). - Ambiguity: improved allocation and lower cost of capital can either tighten income distribution (raise demand for low-skilled workers) or widen it (capital substituting for labor), with effects depending on general equilibrium responses. ### Finance and wealth inequalities - If high-return investments require large capital and suffer from information/transaction costs, wealthier families may disproportionately access them, amplifying dynastic disparities (∂r[(a(i,t),t)]/∂a(i,t) > 0). - Intermediary economies of scale (Greenwood & Jovanovic 1990; Townsend and Ueda 2006): - Low development: few join intermediaries, slow growth, equal incomes. - Transitional: some join, growth and inequality increase. - Advanced: many join, growth maximized, inequality reduced. - Entrepreneurship and credit constraints: - High fixed costs and borrowing constraints impede lower-income individuals from entrepreneurship, increasing intergenerational persistence and slowing aggregate growth; financial development can equalize opportunity. ### Three broad channels linking finance to inequality - Allocation of credit based on ability vs wealth/connections: better allocation broadens opportunities and boosts growth. - Labor demand and product-market competition: financial development can change relative demand for skilled vs unskilled labor and reduce discrimination by intensifying competition. - Investment nonconvexities: financial development that reduces nonconvex barriers can expand access to high-return investments and alter intergenerational dynamics. ### Country-level empirical evidence on inequality and poverty - Beck, Demirguc-Kunt, and Levine (2007): - Dependent variables: (a) Gini coefficient, (b) income growth of the lowest quintile relative to average growth, (c) poverty = fraction living on less than $2/day. - Data: Gini regressions 1960–2005 for 72 countries; poverty analyses 1980–2005 for developing countries. - Financial development measure: Private Credit (credit to privately-owned firms / GDP). - Findings: - Financial development reduces income inequality (Gini falls more rapidly with higher financial development). - Private Credit boosts income growth of the poorest quintile. - Financial development associated with reductions in fraction living on less than $2/day. - Supportive studies: Clarke, Xu, and Zhou (2006); Agnello and Sousa (2012); Hamori and Hashiguchi (2012); Meniago and Asongu (2018); Delis, Hasan, and Kazakis (2014); Cihak and Sahay (2020). - Contrasting findings and caveats: - Jeanneney and Kpodar (2011): access to savings and transaction services reduces poverty but financial development increases financial instability that can hurt the poor. - Kim and Lin (2011); Law, Tan, and Azman-Saini (2014): inequality reduction requires specific pre-existing conditions (sufficiently developed financial and governance institutions). - Bahmani-Oskooee and Zhang (2015): financial development reduced inequality in 10 of 17 countries studied; long-run effects persisted in only 3. - Jauch and Watzka (2016); De Haan and Sturm (2017): some panel studies find financial development associated with increases in income inequality. - Interpretation: - Heterogeneity in measures, methods, samples, and periods likely explains divergent empirical results; further research is needed to reconcile findings. ### Sub-national (U.S. state) evidence and mechanisms - U.S. intrastate branching deregulation (mid-1970s to mid-1990s): - States removed restrictions at different times, providing exogenous variation. - Deregulation intensified competition, improved banking services (lower loan rates, higher deposit rates, lower overhead, better screening), and reduced bad loans. - Effects on growth and distribution: - Jayaratne and Strahan (1996): deregulation increased states’ real per capita income growth through improved credit allocation efficiency. - Beck, Levine, and Levkov (2010): easing geographic restrictions reduced income inequality by increasing incomes at the lower end; Gini coefficient drops after deregulation. - Magnitude: Deregulation explains 60% of the variation of income inequality during the sample period relative to state and year averages. - Mechanism: deregulation disproportionately boosts incomes of the poor. - Labor markets and discrimination: - Levine, Levkov, and Rubinstein (2007): race gap falls by about 20% after intrastate branching removal. - Before deregulation: white man with identical observables earns 14% more than black man. - After deregulation: race gap falls to 11%. - Education, crime, entrepreneurship: - Financial reforms reducing costs to student loans lower high school drop rates and increase college enrollment among lower-income students. - Bank market competitiveness influences crime via effects on economic activity. - Financing constraints have first-order impacts on entrepreneurial entry by high-ability individuals. --- ### Research gaps and policy relevance - Major gaps: - Better measurement of financial development aligned with theoretical functions (screening, governance, liquidity, mobilization, exchange). - Deeper exploration of financial innovation's role in growth, stability, and distribution. - More work on links among financial sector functioning, distribution of economic opportunities, inequality, and poverty. - Policy relevance: - Financial sector policies may have potentially enormous impacts on distribution of economic opportunities, inequality, and poverty; economists may underappreciate these effects. *Source: wpiea2021164-print-pdf - Section III, Section V, and related sections of the IMF working paper content provided.* ### Section III critiques the burgeoning empirical literature on finance and growth. This ### wpiea2021164-print-pdf - Section III critiques the burgeoning empirical literature on finance and growth. This ### Critique of empirical literature on finance and growth - The empirical work includes: broad cross-country growth regressions, time-series analyses, the use of panel techniques, detailed country studies, and industry- and firm-level examinations of the mechanisms linking finance and growth. - A pervasive methodological shortcoming is measurement of “financial development.” Too often researchers do not accurately measure the concepts from theory, which emphasize services that financial systems provide: screening investments, exerting governance, easing risk management, mobilizing resources, and facilitating exchange. - Researchers frequently use measures of the size of one component of the financial system, such as the size of the banking system, which can misrepresent the theorized functions. - Conclusion from critique: the literature does not yet provide a definitive answer to the questions: Does finance cause growth, and if it does, how? ### Tentative conclusions from existing research - Despite weaknesses and lack of unanimity, three tentative conclusions emerge from the bulk of existing research: - (1) Economies with better functioning banks and stock markets grow faster, and simultaneity bias does not seem to drive this conclusion. - (2) Better functioning financial systems foster growth by improving resource allocation and technological change, not by increasing savings rates. - (3) Better functioning financial systems - (a) ease the external financing constraints that impede firm and industrial expansion by improving screening and governance, and - (b) enhance the management of liquidity risks. - These findings suggest a particular link between financial functions—screening, governance, liquidity creation—and economic growth. ### Finance, poverty alleviation, and income distribution - Financial development may affect whether an individual’s economic opportunities are determined by individual skill and initiative or by parental wealth, social status, and political connections. - The financial system influences: - who can start a business and who cannot, - who can pay for education and who cannot, - who can realize economic aspirations and who cannot. - Therefore, finance can shape the gap between the rich and the poor and the persistence of that gap across generations. - Finance affects capital allocation, which can alter both the economic growth rate and the demand for labor, with implications for poverty and income distribution. ### Theoretical ambiguity on finance-inequality nexus - Competing theoretical predictions: - Financial development might increase availability of financial services to individuals previously excluded, expanding opportunities of disadvantaged groups and reducing intergenerational persistence of relative incomes. - Alternatively, financial development could disproportionately help the rich (who already access the financial system), widening inequality and perpetuating cross-dynasty differences in economic opportunity. - Indirect mechanisms: changes in the financial system can influence aggregate production and allocation of credit, altering demand for low- and high-skilled workers and hence income distribution. - Example: improvements in finance that boost demand for low-skilled workers will tend to tighten income distribution, expanding and equalizing economic opportunities. ### Empirical evidence on finance, growth, and inequality - Emerging bulk of empirical research, subject to many caveats, tentatively indicates: - Improvements in financial contracts, markets, and intermediaries expand economic opportunities, reduce persistent inequality, and tighten income distribution. - Financial development fosters growth by expanding opportunities. - Specific documented mechanisms and outcomes: - Access to credit markets increases parental investment in the education of their children. - Credit access reduces the degree to which adverse shocks to family income induce families to pull children out of schooling and place them into labor market activities. - Better functioning financial systems stimulate the formation of new firms and the growth of small firms by expanding access to finance. - Financial development spurs dynamism of labor markets, creating environments where many firms compete for workers’ services. - Financial development can increase the relative demand for low-skilled workers, reducing income inequality and poverty. ### Research gaps and policy relevance - Much more work is needed on the links among financial sector functioning, distribution of economic opportunities, inequality, and poverty. - The author believes economists underappreciate the potentially enormous impact of the financial sector—and hence the potential impact of financial sector policies—on the distribution of economic opportunities, inequality, and poverty. *Source: wpiea2021164-print-pdf - Section III critiques the burgeoning empirical literature on finance and growth. This* ### Section V explores the connections between financial innovation and long-run ### Section V — Connections between financial innovation and long-run economic growth ### Financial innovation and its potential roles - Financial innovation defined as the emergence of new—and the improvement of existing—financial instruments, markets, and intermediaries. - Observations: - Much research examines the relationship between economic growth and the level of financial development (the extent to which financial systems ameliorate information and transactions costs and enhance screening, funding, governance, risk trading/management, savings mobilization, and exchange). - Research largely ignores financial innovation; excessive focus on fragilities created by some innovations risks understating the role of innovation in growth. - Theory suggests financial innovation may be necessary to maintain sustained long-run growth because economic growth increases technological complexity and specialization, making the “old” financial system less effective at screening, financing, governing, and providing risk-management instruments. - Research agenda: - Researchers need to explore connections among financial innovation, stability, long-run growth, and income distribution in greater depth. - The International Monetary Fund / World Bank (2019) reports that creation of new financial technologies may foster inclusive growth that reduces inequality. ### Theories of finance and growth — five critical financial services (overview) - Financial development occurs when instruments, markets, and intermediaries ameliorate information, enforcement, and transaction costs. - Financial systems provide five critical services to the economy: 1. Produce information about possible investments and allocate capital. 2. Monitor investments and exert corporate governance after providing capital. 3. Provide mechanisms to trade, diversify, and manage risk. 4. Mobilize and pool savings from disparate savers. 5. Ease the exchange of goods and services. - Improvements along any single dimension may have different implications depending on other frictions in the economy. ### A. Producing information and allocating capital - Role: - Financial intermediaries reduce costs of acquiring and processing information and improve resource allocation. - Better information production accelerates economic growth by funding more promising firms. - Theoretical and empirical links: - Cited works linking improved information to growth include Acemoglu et al., 2003; Buera, Kaboski, and Shin 2011; Greenwood and Jovanovic, 1990; King and Levine, 1993b; Galetovic, 1996; Townsend and Ueda 2006. - Financial development can relax financing constraints on human capital investment (Galor and Zeira, 1993). ### B. Monitoring firms and exerting corporate governance - Issues: - Effective monitoring influences savings mobilization and allocation; ineffective governance impedes these flows (Stiglitz and Weiss, 1983). - Small shareholders face information asymmetries, expertise gaps, free-rider problems, and weak legal protection (Shleifer and Vishny, 1997). - Concentrated ownership solves some monitoring problems but creates expropriation risks (Jensen and Meckling, 1976; La Porta et al., 1999; Morck et al., 2000). - Intermediaries as delegated monitors: - Financial intermediaries can economize on aggregate monitoring costs and eliminate free-rider problems (Diamond 1984; Boyd and Prescott 1986). - Models show governance-enhancing intermediaries boost productivity, capital accumulation, and growth (Bencivenga and Smith 1993; Sussman 1993; Harrison, Sussman, and Zeira 1999; De La Fuente and Marin 1996; Chakraborty and Ray 2004). - Stock market governance: - Diverse predictions: stock liquidity can incentivize information production (Grossman and Stiglitz 1980; Holmstrom and Tirole 1993) but may also reduce governance incentives (Shleifer and Summers 1988; Bhide 1993). - Market mechanisms (takeovers, compensation linked to stock prices) can discipline managers but have limitations due to informational asymmetries, free-rider issues, poison pills, and liquidity-driven exit incentives (Diamond and Verrecchia 1982; Jensen and Murphy 1990; Stiglitz 1985; DeAngelo and Rice 1983; Jensen 1993; Allen and Gale 2000). ### C. Providing mechanisms to trade, diversify, and manage risk - Cross-sectional risk diversification: - Financial systems that lower costs of holding diversified portfolios facilitate capital flows to higher-expected-return projects and accelerate technological change (Gurley and Shaw, 1955; Patrick, 1966; Greenwood and Jovanovic, 1990; King and Levine, 1993b; Saint-Paul 1992; Devereux and Smith, 1994; Obstfeld, 1994; Acemoglu and Zilibotti 1997). - Liquidity risk and long-term projects: - Liquidity lowers savers’ reluctance to fund long-term, high-return projects; lack of liquidity can hinder such investments (Hicks 1969). - Diamond and Dybvig (1983) framework: financial arrangements (banks, equity markets) emerge to insure saver liquidity needs while enabling illiquid, high-return investments. - Levine (1991): equity markets or banks reduce liquidity risk and spur growth. - Banks can offer demand deposits and mix liquid/illiquid investments to satisfy depositors and fund long-term projects (Bencivenga and Smith 1991). - Access to credit during production: - Holmstrom and Tirole (1998): lines of credit/options can provide intermediate-stage financing. - Aghion, Angeletos, Banerjee, and Manova (2004): ability to access credit during production affects innovation and growth, especially under macroeconomic volatility. ### D. Pooling of savings - Mobilization enables investment in large, indivisible projects and exploitation of economies of scale (Bagehot 1873). - Mobilizing savings shapes growth not by changing savings rates but by reallocating pooled savings toward productive ends. - Models show mobilization and diversified investment in risky projects facilitate reallocation toward higher-return activities (Acemoglu and Zilibotti 1997). ### E. Easing exchange - Reducing transaction costs facilitates specialization, which drives productivity and innovation (Smith 1776). - Money and other financial innovations lower transaction costs and encourage trade and specialization (Greenwood and Smith 1996). ### Empirical findings on finance and growth — cross-country, panel, industry, firm, and within-country evidence - Cross-country evidence (King and Levine 1993a, KL): - Sample: 77 countries from 1960 through 1989. - Common financial development proxy: Private Credit = credit to private firms divided by GDP. - Growth indicators: (1) average rate of real per capita GDP growth, (2) average rate of growth in the physical capital stock per person, (3) average rate of productivity growth (growth of the "Solow residual"). - KL find large, positive, and statistically significant relationships between financial development and all three growth indicators. - Example estimate: If Bolivia had the average value of financial development in 1960, holding other things constant, it would have grown about 0.4 percent faster per annum, so that by 1990 real per capita GDP would have been about 13 percent larger than it was. - Caveat: cross-country regressions do not formally address causality. - Banks versus stock markets (Levine and Zervos 1998, LZ): - Sample: 42 countries, 1976-93. - Stock market liquidity measure: turnover ratio (total value of shares traded divided by market capitalization). - Findings: initial stock market liquidity in 1976 and initial banking development in 1976 correlate positively and significantly with economic growth, capital accumulation, and productivity growth over the next 18 years. Both banks and markets provide distinct, complementary services. - Market size (market capitalization/GDP) is not robustly correlated with growth. - Instrumental variables, panel, and time-series studies: - Legal origin indicators used as instruments for financial development (La Porta et al. LLSV 1998); instrumental-variable results confirm cross-country findings: greater financial development associated with faster economic growth. - Levine et al. (2000) conceptual experiment: increasing Argentina’s Private Credit from (16) to the developing country sample mean (25) would have increased Argentina’s real per capita GDP growth by one percentage point; growth averaged 1.8 percent per year over this period. - Panel GMM studies (Levine et al., Beck et al.) on a panel of 77 countries over 1960–95 (data averaged over seven non-overlapping five-year periods) find exogenous components of financial development positively associated with growth. - Nonlinearities: Rioja and Valev (2004b) and Arcand, Berkes, and Panizza (2015) find the finance-growth relationship may be nonlinear; Arcand et al. find financial depth starts to slow growth when Private Credit reaches 100% of GDP. Botev, Égert, and Jawadi (2019) challenge the threshold finding and reject a threshold where further financial development slows growth. - Cross-country, cross-industry evidence (Rajan and Zingales 1998, RZ): - Sample: 36 industries and 42 countries. - Insight: industries naturally heavy users of external finance benefit disproportionately from financial development. - Example: external financial dependence percentiles—Machinery at 75th percentile (0.45) vs Beverages at 25th percentile (0.08). Country stock market capitalization example: Italy at 75th percentile (0.98) vs Philippines at 25th percentile (0.46). Estimates imply Machinery grows 1.3 percent faster than Beverages in Italy compared to the Philippines; actual difference is 3.4. - Extensions: bank competition fosters growth in externally dependent industries (Claessens and Laeven 2004); small-firm industries benefit disproportionately from financial development (Beck et al. 2004). - Cross-firm evidence: - Demirguc-Kunt and Maksimovic (1998); Beck et al. (2001): firms requiring external finance grow faster in economies with developed financial systems. - Firm-level surveys (Beck, Demirguc-Kunt, Maksimovic 2005): financing constraints exert first-order impact on firm growth, especially for smaller firms; financial development loosens growth-constraining effects of weak institutions and corruption. - Financing constraints reduce R&D and innovation (Brown, Fazzari, and Petersen 2009); stock market liquidity reforms may reduce innovation by increasing takeover risk and lowering monitoring incentives (Fang, Tian, and Tice 2014). - Bank liquidity creation by banks found to exert a first-order impact on economic activity (Berger and Sedunov 2017). - Within-country studies: - Jayaratne and Strahan (1996, JS): U.S. state-level bank deregulation that intensified competition accelerated real Gross State Product (GSP) growth by improving credit allocation efficiency without markedly changing quantity of lending. - Deregulation spurred new business creation (Black and Strahan 2002; Kerr and Nanda 2009) and, when improving quality of services to firms, increased innovation (Schneider and Zaldokas 2013; Cornaggia, Tian, and Wolfe 2012; Hombert and Matray 2016; Chava et al. 2013). - Venture capital supply shocks boost new business formations, employment, and economic growth (Samila and Sorenson 2011). - Regional/local studies (Guiso, Sapienza, and Zingales 2002; Bertrand, Schoar, and Thesmar 2004) show local financial development increases probability of starting a business, competition, firm growth, and allocative efficiency. - Historical comparisons (Haber 1991, 1997): liberalization of financial markets in Brazil after 1889 correlated with lower industrial concentration and industrial expansion relative to Mexico. ### Finance, poverty, and income distribution — conceptual framework - Income decomposition (Demirguc-Kunt and Levine 2009): - Dynasty i’s total income in generation t: y(i,t) = h(i,t)w(i,t) + a(i,t)r(i,t), where: - h(i,t) = level of human capital, - w(i,t) = wage rate per unit of human capital for dynasty i, - a(i,t) = dynastic wealth, - r(i,t) = return on assets for dynasty i. - Implications: - Financial market imperfections influence intergenerational income differences by shaping human capital accumulation, wage rates for equivalent skills, and wealth accumulation. - The literature seeks to determine who benefits from financial development—whether it disproportionately boosts earnings of the rich, the poor, or has little effect on income distribution. *Source: Section V and surrounding sections of the IMF working paper content provided.* ### 1. Finance and the intergenerational persistence in human capital ### 1. Finance and the intergenerational persistence in human capital ### Human capital production framework - Human capital: h(i,t) = h[e(i,t), s(i,t)], where e(i,t) is dynastic endowment of ability and s(i,t) is investment in human capital (schooling). - Complementarity assumption: ∂2h/∂e∂s > 0, implying socially efficient allocation gives more schooling to higher-ability children. - Ability dynamics: e(i,t) = ρ e(i,t-1) + ε(i,t), where 0 ≤ ρ < 1 and ε(i,t) is the random component; high-ability parents’ children tend to have greater abilities but differences shrink across generations. ### Financial development and human capital persistence - Better-developed financial markets: - Allow high-ability individuals to obtain schooling irrespective of parental wealth. - Tighten the link between h(i,t) and e(i,t), achieving socially efficient s(i,t). - Enable borrowing to finance education, reducing the persistence of dynastic wealth differences. - Result: greater social efficiency and less intergenerational persistence of inequality. - Poorly functioning financial systems: - Make schooling s(i,t) a function of a(i,t-1) so h(i,t) = h[e(i,t), a(i,t-1)], increasing persistence of income inequality. - Lead to inefficient allocations where rich parents with low ability invest more in schooling than high-ability children from low-income families. - When families cannot insure or borrow to smooth consumption, some low-income families withdraw children from school for low-wage labor, hindering high-return human capital accumulation (Jacoby and Skoufias 1997; Baland and Robinson 1998). - Net effects: increased cross-dynasty persistence of relative incomes, reduced opportunities for those born into poor dynasties, and lower socially efficient allocation of schooling. ### Footnote (as provided) - Financial market imperfections can influence persistence even when innate abilities are identical; Galor and Zeira (1993) show nonconvex human capital technology plus frictions makes self-financed investment feasible only for rich dynasties, disproportionately impeding poor dynasties’ accumulation. --- ### 2. Finance and wage inequalities ### Wage dispersion beyond human capital - Wage rates can differ for individuals with the same human capital due to employer discrimination by race, gender, religion, ethnicity, or other characteristics. - Example: employers preferring white workers may pay blacks with the same skills lower wages; competition tends to reduce such inefficiencies (Becker 1957). ### Financial development’s role in reducing discrimination - Better-functioning financial systems lower barriers to firm entry and spur competition, which can reduce discrimination (Levine, Levkov, and Rubinstein 2009). - Research to date has emphasized U.S. racial inequality; suggested avenues for future research include gender and cross-country comparisons (e.g., Black and Strahan, 2001). ### Capital intensity, cost of capital, and wage distribution - Financial development improves allocation efficiency and may increase capital accumulation, lowering the cost of capital to promising firms. - Ambiguous effects on wages and inequality: - If lower capital costs raise relative demand for lower-income workers, income distribution could tighten. - Alternatively, lower capital costs may lead firms to substitute capital for labor, potentially widening inequality. - Lower capital costs can also alter returns to capital vs. labor and barriers to entry, with complex distributional consequences. --- ### 3. Finance and wealth inequalities ### Access to higher-return investments - If high-expected-return investments require large capital injections and entail information/transaction costs, wealthier families may access higher expected-return opportunities, magnifying dynastic income and wealth disparities. - Model implication: ∂r[(a(i,t),t)]/∂a(i,t) > 0, so returns increase with dynasty assets a(i,t). ### Financial development and intermediary economies of scale - Greenwood & Jovanovic (1990): financial intermediaries enjoy scale economies in screening high-return projects; individuals pay a fee to join intermediaries; as more join, resource allocation efficiency and access to high-return investments expand. - Townsend and Ueda (2006) implication: - At low development: few join intermediaries, growth slow, income distribution equal. - Transitional phase: some join, growth and inequality increase. - Advanced stage: many join, growth maximized and inequality reduced. ### Entrepreneurship and credit constraints - High fixed costs to entrepreneurship combined with borrowing constraints impede lower-income individuals from becoming entrepreneurs (Mookherjee and Ray 2003; Jeong and Townsend 2007, 2008; Levine and Rubinstein 2020). - Consequences: - Financial frictions increase intergenerational persistence of income inequalities (low a(i,t) → low r(i,t)). - Credit constraints prevent talented low-income individuals from engaging in high-return activities, lowering overall economic efficiency (Piketty 2000, p. 455) and slowing aggregate growth. - Financial development can accelerate growth by equalizing opportunity. --- ### 4. Discussion of theories of finance and inequality ### Three broad channels identified - Allocation of credit based on ability vs. wealth/connections: - Better financial systems that allocate credit based on ideas and abilities boost growth by improving capital allocation efficiency and expanding opportunities beyond the wealthy and connected. - Labor demand and market competitiveness: - Financial development can change the relative demand for skilled vs. unskilled labor and influence product market contestability, affecting wages. - By intensifying product market competition, financial development raises the cost of discrimination based on non-productivity traits and can expand opportunities. - Investment opportunities and nonconvexities: - Nonconvexities in high-return investments can give wealthier families exclusive access to high returns, perpetuating inequalities. - Financial development that circumvents these nonconvexities and creates a more inclusive investment environment can alter intergenerational income dynamics. --- ### B. Finance, poverty, and income distribution: Empirical evidence ### 1. Country-level studies — main findings and methodologies - Beck, Demirguc-Kunt, and Levine (2007) study: - Dependent variables: (a) Gini coefficient of income inequality, (b) income growth of the lowest quintile relative to average growth, (c) poverty measured as fraction living on less than $2/day. - Data: Gini regressions use 1960–2005 for 72 countries; poverty analyses limited to developing countries 1980–2005. - Financial development measure: Private Credit (credit to privately-owned firms / GDP). - Methodology: cross-country regressions and panel regressions to assess whether finance disproportionately influences the poor, controlling for overall growth and other country characteristics. ### Empirical results reported - Beck, Demirguc-Kunt, and Levine (2007) find: - Financial development reduces income inequality (Gini falls more rapidly with higher financial development). - Private Credit boosts income growth of the poorest quintile. - Financial development is associated with reductions in the fraction living on less than $2/day. - Additional supportive studies: Clarke, Xu, and Zhou (2006); Agnello and Sousa (2012); Hamori and Hashiguchi (2012). - Other empirical findings and caveats: - Jeanneney and Kpodar (2011): improved access to savings and transaction services reduces poverty but financial development increases financial instability, which can hurt the poor. - Meniago and Asongu (2018): financial development reduces income inequality in a panel of 48 African countries. - Delis, Hasan, and Kazakis (2014): banking reforms improving banking operation decrease income inequality. - Contrasting results: - Kim and Lin (2011); Law, Tan, and Azman-Saini (2014): financial development reduces inequality only with specific pre-existing conditions (e.g., sufficiently developed financial and governance institutions). - Bahmani-Oskooee and Zhang (2015): financial development reduced inequality in 10 of 17 countries studied; long-run effects persisted in only 3 cases. - Jauch and Watzka (2016); Haan and Sturm (2017): some panel studies find financial development associated with increases in income inequality. - Cihak and Sahay (2020): financial reform policies targeting broader provision of financial services to individuals and firms can reduce inequality. ### Interpretation and research needs - Heterogeneous empirical findings may reflect: - Differences in measures of inequality and financial development. - Data frequency, econometric methodology, country samples, and sample periods. - Future research should reconcile divergent results and provide clearer answers on the impact of financial development on income inequality. *Source: wpiea2021164-print-pdf - 1. Finance and the intergenerational persistence in human capital* ### 2. Sub-national studies ### 2. Sub-national studies ### U.S. state banking deregulation: reform context and causal identification - From the mid-1970s to the mid-1990s, individual U.S. states removed regulatory restrictions on the opening of bank branches within their boundaries. - States changed their regulatory policies in different years, providing plausibly exogenous variation in the functioning of financial systems across states. - Deregulation intensified competition and triggered improvements in banking services: reducing interest rates on loans, raising them on deposits, lowering overhead costs, spurring development of better techniques for screening and monitoring firms, and reducing the proportion of bad loans. ### Effects on growth and income distribution - Jayaratne and Strahan (1996) find that removing geographic restrictions on banking increased states’ real per capita income growth. - Beck, Levine, and Levkov (2010) find that easing geographic restrictions on intrastate banking reduced income inequality by increasing incomes at the lower end of the income distribution. - After controlling for national trends in income inequality, the Gini coefficient of income inequality drops after bank branch deregulation. - The negative relationship between branch deregulation and inequality is robust to: different income distribution measures, examining different components of income, controlling for many time-varying state characteristics, and conditioning on state and year fixed effects. - Magnitude: Deregulation explains 60% of the variation of income inequality during the sample period relative to state and year averages. - Mechanism: Deregulation reduces income inequality by disproportionately boosting the incomes of the poor, not by hurting the rich. ### Labor markets and discrimination - Levine, Levkov, and Yona Rubinstein (2007) apply the Jayaratne-Strahan approach to study racial wage disparities across U.S. states using data from 1976 to 2005. - They compute the race gap as the difference between wage rates of white males and black males after controlling for a wide array of personal characteristics, and study how this race gap varies with deregulation, conditioning on individual characteristics and state- and year-fixed effects. - Finding: The race gap drops by about 20% after a state removes restrictions on intrastate branching. - Before deregulation: a white man with identical observable characteristics to a black man earns 14% more. - After deregulation: the race gap falls to 11%. - Interpretation: Improving the financial system reduces discrimination in labor markets, expanding opportunities for groups disproportionately stuck at the bottom of the income distribution. ### Education, crime, and socio-economic environment - Levine and Rubinstein (2013) find that financial reforms that improve the operation of financial systems tend to reduce high school drop rates and increase college enrollment rates among students from lower-income households. - Sun and Yannelis (2016) show that financial development lowered the costs to students of obtaining loans, boosting education. - Garmaise and Moskowitz (2006) find that the competitiveness of the banking market influences crime rates via effects on economic activity. ### Entrepreneurship and financing constraints - Levine and Rubinstein (2020) find that financing constraints exert a first-order impact on whether high-ability individuals become entrepreneurs. - Additional empirical work on financing constraints and entry into entrepreneurship includes Fairlie and Krashinsky (2012), Adelino, Schoar, and Severino (2015), Corradin and Popov (2015), Kerr, Kerr, and Nanda (2015), and Schmalz, Sraer, and Thesmar (2017). *Source: 2. 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