Quantifying the Impact of Financial Development on Economic Development

I came across this paper by Richmond Fed economists – Jeremy Greenwood, Juan M. Sanchez and Cheng Wang. The title looked interesting but the paper was just too technical.

Anyways the abstract says:

How important is financial development for economic development? A costly state verification model of financial intermediation is presented to address this question. The model is calibrated to match facts about the U.S. economy, such as intermediation spreads and the firm-size distribution for the years 1974 and 2004. It is then used to study the international data, using cross-country interest-rate spreads and per-capita GDP. The analysis suggests a country like Uganda could increase its output by 140 to 180 percent if it could adopt the world’s best practice in the financial sector. Still, this amounts to only 34 to 40 percent of the gap between Uganda’s potential and actual output.

And what accounts for remaining gap between potential and actual output? The paper says difference s in productivity of the non-financial sector.

On reading the paper I think it is making tall claims. Uganda (or any other developing economy) just cannot adopt US financial sector right away. What the paper does is build a model on US financial sector seeing its efficiency over a period of time. It then applies this model on the other economies to see the improvement in other economies. The model centres on reduction of interest rate spread over the years 1974-2004. I am not able to extract the content of the paper so cannot bring out more insights.

The paper is appealing in terms of the benefit financial sector could provide. But found it too simplistic. It goes too far. There are just too many factors and policies which lead to financial sector developments and lowering of interest rate spreads. The reforms don’t just extend to financial sector but all kinds of other areas as well – legal, administrative, labour and host of real sector ones as well. So there is a lot of background work to be done. And unless these are done, no matter how sophisticated your financial system is, outcomes are only going to be a nightmare. There are umpteen examples of such a scenario. It is like one of those papers you read before the crisis. You would read these papers with caution now. However, some economists still believe strongly in power of finance.

Another point is to understand all these technicalities with financial sector development. It is quite difficult to model it. Krugman pointed that (via this paper) before the crisis it was believed and shown in research that US is more productive than US. But 50% of productivity difference was attributed to financial services sector. And then came the crisis…..

Again, I am not against financial sector reforms. But we need to think it as an enabler and not as a doer. Without reforms in real sector, financial sector reforms are not going to help much. I think this is a fundamental lesson from the crisis. Countries like UK, Iceland etc that build their economies around finance and thought it as a doer got a huge shock. What better way but to learn all this from Lord Turner of FSA, UK.

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2 Responses to “Quantifying the Impact of Financial Development on Economic Development”

  1. select your broker Says:

    On reading the paper I think it is making tall claims. Uganda (or any other developing economy) just cannot adopt US financial sector right away. What the paper does is build a model on US financial sector seeing its efficiency over a period of time. It then applies this model on the other economies to see the improvement in other economies. The model centres on reduction of interest rate spread over the years 1974-2004. I am not able to extract the content of the paper so cannot bring out more insights.

  2. unicon india Says:

    And what accounts for remaining gap between potential and actual output? The paper says difference s in productivity of the non-financial sector.

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