3  The link between financial systems and economic growth

There are two main channels through which financial systems can have an effect on economic growth: capital accumulation (both physical and human); and technological innovation. Both channels are discussed in this section.

3.1  Capital accumulation

Financial systems affect capital accumulation in three ways. First, financial systems lower the cost of channelling funds between borrowers and lenders, by reducing information and transaction costs. A decline in the cost of accessing finance frees up resources for other uses, including consumption, investment and capital accumulation.

Second, they can alter individuals’ and households’ saving decisions by making longer-term investments more attractive. If financial intermediaries and markets are unable to convince savers of the soundness of the investment projects that they are planning on funding, savers may choose to consume rather than save or place their savings in other less productive forms.

Third, financial intermediation affects capital accumulation by reallocating funds to their most productive uses, which raises the rate of return to saving. However, the effects of a change in the rate of return on saving are ambiguous. This is because higher rates of return increase the cost of consumption today or the cost of not saving, leading to more saving. But an increase in the rate of return to saving also means that individuals/households don’t need to save as much to achieve desired future levels of income. Empirically, the elasticity of saving with respect to rates of return is found to be small, suggesting that both effects are of approximately equal importance.

The effects of a change in saving and investment on economic growth can be illustrated with the neoclassical growth model of Solow (1956) and Swan (1956).[9] It shows that an increase in saving leads to a larger stock of capital, a higher level of output and temporarily faster per capita income growth while the economy moves to that higher level of output.[10]

Input accumulation, or capital more broadly defined, can lead to a permanent increase in the long-run rate of economic growth if it has spill-over effects to other factors of production and/or productivity. For example, in Lucas’ (1988) model an increase in the human capital of one worker also raises the productivity of other workers. Another example is Romer’s (1990) model where research and development (R&D) increases the available pool of knowledge that firms can draw on without cost, leading to a permanent increase in the long-run rate of economic growth, all else equal.[11]

3.2  Technological innovation

Financial systems may affect technological innovation. By allowing diversification, financial systems allow savers to obtain their desired level of exposure to high risk/reward firms, potentially increasing the level of finance directed at such activities. Financial intermediaries are well suited to provide external finance to new firms that require staged finance because they can credibly commit to additional funding based on key benchmarks. Specialised intermediaries can improve the willingness of savers to provide finance to firms with innovative or novel business plans through monitoring and oversight activities. Financial markets are effective at financing industries where relatively little information or few data are available or where a diversity of opinion is persistent. This is because markets allow investors with similar views to form coalitions to finance a particular investment project. New investment financed by financial intermediaries or markets is a channel for the diffusion of new technologies and productivity gains.