Finance & Development, June 2003

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Kumar As inflation rates decline worldwide, concerns about deflation are rising. Although the risks of generalized global deflation remain small, it is important to implement preemptive policies to prevent deflation setting in. The Realities of Modern Hyperinflation Despite falling inflation rates worldwide, hyperinflation could happen again Carmen M. Reinhart and Miguel A.

Savastano The authors recall seven lessons from modern hyperinflations. Institutions in Development Root Causes A historical approach to assessing the role of institutions in economic development Daron Acemoglu A look at the impact the different types of institutions established by Europeans in their colonies had on subsequent economic development, and the implications for development today.

Training Capabilities

The Primacy of Institutions and what this does and does not mean Dani Rodrik and Arvind Subramanian The authors come up with some striking results about the importance of institutions that have broad implications for development and lending conditionality. Testing the Links How strong are the links between institutional quality and economic performance? Hali Edison A study of the links between institutional quality and economic performance analyzes the degree to which sound institutions affect development, growth, and the volatility of growth.

Institutions Needed for More than Growth By facilitating the management of environmental and social assets, institutions underpin sustainable development Christian Eigen-Zucchi, Gunnar S. Eskeland, and Zmarak Shalizi. Also in This Issue Dancing in Unison? In Brief News from international agencies News from international agencies, including growing acceptance of collective action clauses in sovereign bond issues, and the IMF's recent move to step up technical assistance to Africa.


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Meltzer on why the international financial system remains accident prone, how the IMF has changed, and how he became an icon of American economics. Back to Basics The move to inflation targeting Why targeting a specified inflation rate has become increasingly popular with central banks.

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Growing water shortages and water pollution in developing and developed countries alike have plunged the world into a freshwater crisis. I begin with a review of studies indicating that financial sector development does improve growth. Then I address two fundamental questions.


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  6. First, does financial sector development help growth through faster capital accumulation, or does it also improve sustained productivity growth? Second, what is the impact of financial regulation on the relationship between financial sector development and growth? These empirical studies consider a range of data, including aggregated, national level data e.

    Aggregate data are more useful in studying the overall impact of financial sector development on growth across countries, while the added detail of disaggregated data is useful in identifying the particular channels by which financial development affects growth and in studying the importance of financial regulation. The prevailing view in economics is that financial development contributes to growth in various ways.

    Finance & Development, June - Contents

    For example, financial institutions are better suited than individuals to identify potentially successful projects because these institutions are big enough to pay large fixed costs of collecting information about individual projects and to analyze this information more efficiently. Financial markets also can enhance growth. First, they help collect resources from many savers necessary to invest in large projects.

    Second, they facilitate the pooling and hedging of risk inherent in individual projects and industries. Thus, well-developed financial markets and institutions can generate growth by increasing the pool of funds and by reducing the risk and enhancing the productivity of fund transfers from savers to investment projects. Economists have found empirical evidence that countries with developed financial systems tend to grow faster. King and Levine find that growth is positively related to the level of financial development.

    Finance and Growth

    Looking at the evidence from 80 countries from to , they show that the relative size of the financial sector in is positively correlated with economic growth over the period. However, positive correlation may simply reflect the fact that faster growing countries have larger financial sectors because of the increase in the number of financial transactions conducted.

    By measuring financial sector development at the beginning of the period, in , King and Levine try to mitigate concerns about possible reverse causation between financial development and economic growth. However, this evidence does not necessarily prove that financial development causes growth. The size of the financial sector in may depend on the expectation of future economic growth.

    Subsequent work using statistical techniques to control for the endogenous effect of economic growth on financial development as well as for country-specific factors that are not explicitly considered, and using both time series and cross-sectional data to extract more information from the data, has shown that the effect of financial development is robust For example, Levine, Loayza, and Beck , Benhabib and Spiegel The economics profession has evolved in its views of the primary factors driving economic growth.

    Macroeconomic Policy and Financing for Development Division

    Traditionally, economic growth theory focused on labor usage and capital accumulation as the main engines of long-run growth. This approach, however, has been unable to explain sustained growth without also assuming ongoing productivity growth, because the impact of capital accumulation is limited by diminishing returns for a given labor force; each unit of capital added in the economy will have a smaller marginal improvement on output.

    Beyond some point, the marginal return on adding new capital will be smaller than the marginal cost of adding new capital. Therefore, growth would stop at this point without increases in productivity. In principle, technological development could lead to sustained long-term growth because the increases in productivity would be enough to offset the decreases in productivity from diminishing returns to capital accumulation.

    Thus, it can generate growth as a result of the economic structure. The question then becomes whether financial sector development affects growth through the channel of capital accumulation, as in the old growth theory, or through the channel of productivity increases engendered by knowledge creation, as in the endogenous growth theory.

    Capital Idea

    The second channel is potentially more important because it implies that growth may be sustainable for long periods. Benhabib and Spiegel find that both channels are present: financial development improves capital accumulation as well as productivity growth. In a study using firm-level data, Rajan and Zingales find that younger firms in higher productivity sectors tend to depend more on external finance and therefore benefit more from the lower cost of financing in a developed financial system than do more established firms.

    This finding suggests that if these younger firms represent the units of production where new and more efficient technologies are created, then financial development may improve productivity growth, thus potentially sustaining long-run growth.


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    Some economists have focused on events that have led to large changes in the size and development of the financial sector in a short period of time to isolate the impact of financial development on growth within a country over time. Of course, because financial liberalizations usually are not implemented in isolation, it is important to control for other changes in the economic and legal environment that also may affect growth.

    The authors find an increase in the efficiency with which investment funds are allocated following reform. This effect holds for most countries in the study and persists after controlling for other possible sources of improvements of resource allocation, such as trade reform or other macroeconomic structural reforms.