In 1990s, there were many economies that moved over from state run economies to private sector driven economies. These economies were called Transition economies.
I came across this interesting paper from Eric Berglof and Partick Bolton. It looks at financial development in these economies and whether it helped them move to a market driven system. They call the transition as the Great Divide and ask whether financial development helped?
Perhaps the main lesson of the past decade of financial transition is the importance of fiscal and monetary discipline at the critical point when the Great Divide opens up. It appears to have been a necessary condition for a successful financial transition. Without fiscal discipline, private investment is crowded out or discouraged by the looming threat of macroinstability. Lack of fiscal discipline has also been a symptom of other ills, like a lack of commitment to close down loss-making firms, poor enforcement of property rights and low tax compliance.
Countries on the wrong side of the divide have been caught in a vicious circle of macro instability and repeated relapses in financial development. Financial development in these countries at best has had little effect on economic growth, and may even have been counterproductive, by making it easier for firms to receive credit and thereby reducing their incentive to undertake needed restructuring.
In the countries that have crossed the Great Divide financial architecture appears to have converged to a bank-based system with substantial foreign ownership. On the positive side, the financial sector in these countries has contributed to the hardening of budget constraints. However, banks have not yet begun extending significant long-term finance nor have they actively promoted restructuring in the industrial sector.
So what is the way forward?
There is a basic complementarity between the macroeconomic notion of fiscal and monetary responsibility and the microeconomic foundations of sound financial institutions, protection of property rights and tax compliance. Writing new laws or transferring them more or less wholesale from abroad is a relatively easy task. Enforcement and the creation of functional institutions is much more difficult. Sound government finances create favorable conditions not only for financial development but also for proper enforcement of the law.
This transfer of foreign code for doing things right was quite fashonable that time. But it did not work. What is also interesting to see is that we need a full list of reforms and right real economy to get financial system working.
How about other recent papers? What do they say? I came across a recent IMF paper which says the story differently- financial development only helps those economies where there are proper institutions in place .
After conducting tests based on alternative empirical approaches and undertaking extensive robustness tests, we conclude that the beneficial effects of reforms on financial deepening have materialized only where the institutional environment was sufficiently favorable. More specifically, the key binding institutional dimension seems to have been the extent to which political institutions protect citizens from expropriation from the state or powerful elites. We do not find much evidence that other institutional dimensions, such as contractual rights, or features of the macroeconomic environment, such as fiscal prudence played such a pivotal role in shaping the impact of banking sector reforms.
Actually there is a lot of literature on the subject whether financial development leads to growth. One can check Ross Levine’s monumental paper on the same.