## Finance and Economic Growth, Remarks by First Deputy Managing Director John Lipsky

_IMF News, October 19, 2009_

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## Bibliographic details
- Published: October 19, 2009

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### Context and Purpose
- Remarks delivered at the Bank of Mexico Conference, "Challenges and Strategies for Promoting Economic Growth", Mexico City, Mexico, October 19, 2009.
- Focus: longer-term issues for sustaining growth; the role of finance in economic growth and implications for financial regulation.
- IMF role highlighted: provide analytical support for the G20 mutual assessment process endorsed at the Pittsburgh Leaders’ Summit and the IMFC.

### The Role of Finance in Growth: Intellectual Debate
- Historical shift in views:
  - Early consensus treated finance as a second-order consideration; Solow’s 1956 growth model omitted financial variables.
  - Gurley and Shaw’s work (1955 article; Money in a Theory of Finance) argued finance was essential to growth.
  - McKinnon and Shaw (1973) emphasized financial system importance in promoting growth; Shaw authored Financial Deepening in Economic Development (1973).
- Key conceptual points:
  - Focusing on savings-investment flows alone misses:
    - Poorly designed incentives for financial institutions (including state ownership) can create inappropriate capital-output ratios and mute growth.
    - Failure to develop effective securities markets leads to excessive reliance on traditional banking, systemic inefficiencies, and instability.
- Measurement and consensus limits:
  - No clear consensus on precise measurement of financial development’s impact on growth.
  - Broad agreement exists on the direction of regulatory reform, but uncertainty remains on the extent reforms will reduce systemic instability.

### The 1990s, Financial Innovation, and the Backlash
- By the early 1990s, consensus moved toward seeing modern finance as growth-supportive; empirical research linked financial development (credit, broad money relative to GDP) to growth.
- Research strands noted:
  - Rajan and Zingales on availability of "outside" finance influencing industrial development.
  - Research on legal origins affecting financial development.
- Financial innovation trends:
  - Growth of finance’s share in the US economy and acceleration of securitization and derivatives.
  - Arguments for hedging strategies reducing capital cushions (Robert Merton).
- Crisis history and reassessment:
  - Warning signs from Mexican crisis (1994-95), 1997-98 Asian crisis, and Long-Term Capital Management were not fully heeded.
  - Post-2008-09 crisis: intellectual backlash but reaffirmation that markets are not perfectly self-regulating and require regulation.

### Historical Evidence: The American Experience
- Reassessment finds a well-functioning financial sector crucial to early US development (Sylla; Rousseau).
- Key historical facts and figures preserved from the record:
  - "Next year will mark the fiftieth anniversary of the publication of Jack Gurley and Ed Shaw’s path breaking monograph, Money in a Theory of Finance."
  - US financial system evolution:
    - "The US had only 3 state-chartered banks in 1789, but more than one hundred were chartered over the next two decades."
    - Banking numbers: "more than 800 by 1840 and to1600 by 1860."
    - By 1825, US banks had "nearly 2.5 times the amount of bank capital as their UK counterparts."
  - Early openness and diversification: by 1803, more than half of all US securities were held by European investors; by 1825 the number of listed securities in several US cities was approaching that of England.
- Crises and regulatory evolution:
  - Financial crises in the 19th and early 20th centuries led to improved regulations and market structures but progress was not steady.
- Theoretical advances grounded in history:
  - Diamond and Dybvig (1983) on deposit insurance; Bernanke and Gertler (1989) on accelerators; Bernanke (1983) on non-monetary effects of financial crisis.

### General Lessons from the Historical Record
- Three main lessons drawn:
  - Financial development is critical for both growth and development; transitions from agrarian economies to sustained diversified growth typically require well-functioning financial intermediation.
  - The presence of financial crises, even recurring ones, has not reversed the positive relationship between financial development and economic growth.
  - Completely suppressing financial crises requires severe financial sector repression and autarkic policies, which carry clear costs to growth and development.
- Conclusion: core insights from Gurley, Shaw, and McKinnon remain valid fifty years on, though the scale of recent output losses raises questions about policy choices.

### Implications for Emerging Markets
- Three reasons leading emerging markets remained confident in growth via open policies plus financial development:
  - Structural improvements and better fiscal and monetary management bolstered resilience to external shocks.
  - Many large emerging markets have not fully liberalized financial markets; lesson from late-1990s crises: strengthen domestic systems before full exposure to international markets. FSAPs aided this strengthening.
  - Recognition of the costs of repressed financial systems based on historical experience.
- Expected trajectory:
  - Emerging market authorities likely to adopt a cautious approach to further financial development, but not to return to financial repression.
  - A more developed financial system—more complete markets plus strengthened regulation and supervision—is both likely and appropriate.
  - The enhanced role of the G20 and the creation of the Financial Stability Board have brought major emerging market authorities into global regulatory and supervisory reform discussions.

### Reassessing Mature Financial Systems and Regulatory Reform
- Crisis diagnosis:
  - Not all large institutions pursued the risky strategies that fueled the crisis; failures were concentrated in those with flawed strategies and inadequate risk management.
  - Poor regulation and/or inadequate supervision were inadequate to prevent some firms from endangering systemic stability.
- Two principal aspects of systemic reform:
  - Normal market processes should allow better-managed firms to expand and displace weaker ones.
  - Strengthen regulatory and supervisory standards and their application.
- Broad consensus on three key regulatory reform aspects:
  - The perimeter of regulation must be redrawn to include all systemically important institutions.
  - Regulation must include macroprudential aspects to reduce procyclicality.
  - An agreed resolution mechanism is required for institutions with systemic importance and/or operating in multiple jurisdictions.
- On "too big to fail" and limiting institution size:
  - Size alone does not determine systemic risk; relatively small but highly interconnected firms can cause major problems.
  - No clear guide exists to the optimal size of banks and nonbank intermediaries; the IMF and FSB have begun developing a framework for analysis, but no precise determination is yet possible.
  - Caution advised: precipitous action could invite unintended consequences.
- IMF and complementary initiatives:
  - Early Warning Exercise (Fund and FSB) to alert authorities to potential risks and encourage contingency planning for tail risk scenarios.
  - Review of IMF support facilities: Flexible Credit Line (FCL) and High Access Precautionary Arrangements (HAPA) as new tools for crisis prevention; analysis underway on additional insurance-like facilities.
  - IMF asked to study whether financial sector taxation can be improved so that costs of risk mitigation are borne more directly by the sector (analogous to deposit insurance funding).

### Concluding Remarks and Research Priorities
- A new global economic and financial system is evolving rapidly; issues addressed at the Pittsburgh Leaders Summit and IMF/World Bank Annual Meetings in Istanbul.
- Restatement: Gurley, Shaw, and McKinnon’s basic conclusion—that financial systems play a key role in economic development and growth—remains broadly accepted.
- Remaining intellectual challenges:
  - Need renewed efforts to better understand the relation of financial sector development to strong, sustained and balanced growth.
  - IMF Macro/Financial Studies Group in the Research Department is collaborating with the Monetary and Capital Markets Department and external partners; the conference is expected to spur further work.

*Remarks by IMF First Deputy Managing Director John Lipsky, October 19, 2009.*

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## References

- [United Kingdom and the IMF](http://www.imf.org/external/country/GBR/index.htm)
- [Mexico and the IMF](http://www.imf.org/external/country/MEX/index.htm)
- [United States and the IMF](http://www.imf.org/external/country/USA/index.htm)
- [Speeches](https://www.imf.org/en/news/searchnews)
- [John Lipsky](https://www.imf.org/external/np/omd/bios/jl.htm)
- [PRESS CENTER](http://presscenter.imf.org/)
- [https://www.imf.org/en/home](https://www.imf.org/en/home)

_Source: https://www.imf.org/en/news/articles/2015/09/28/04/53/sp101909_