Financial Development, Investment, Productivity and Economic Growth in the U.S.

This paper uses time-series methods and a new Granger causality procedure to examine how financial development affects long-term economic growth in the U.S. It also examines whether there is a feedback or reverse causal effect from the growth processes to financial development. The results show that financial development affects growth by increasing the level of investment and its productivity. On the other hand, no evidence of reverse causality from economic growth to financial development is found. The findings are consistent with the view that financial development has a significant and independent positive effect on long-term economic growth. INTRODUCTION In recent years there has emerged a substantial body of theoretical models that established a positive link between financial development and economic growth. These models have also provided important insights into how financial development affects economic growth and vice versa. They show that financial development positively affects economic growth in two ways: One, by increasing the saving rate, thereby raising the level of investment and capital accumulation; and two, by enhancing the efficient allocation of investment, thereby increasing the productivity of investment (see, Pagano, 1993; Levine, 1997 for a comprehensive survey of the literature). While the effectiveness of a financial system can be determined by how well it performs these two functions, economists, however, emphasize that the efficiency enhancing role of the financial system is more important because of its long-run growth effect (see, Levine, 1993; Watchel, 2001). Consequently, how the financial structure (that is, the way the financial system is organized) impacts the efficiency (productivity) enhancing role of the financial system has become an important policy issue. This issue is at the core of the ongoing theoretical debate on the comparative advantages and disadvantages of different financial structures; in particular, between the Anglo-American market-based and German or Japanese bankbased financial systems. If one form of financial structure is more conducive to economic growth than another then economic policy must take this into account. The aim of this paper is to empirically examine how financial development affects economic growth in the U.S. More specifically, it attempts to determine whether financial development affects growth by increasing the level of investment, its productivity, or both. Although the study is limited to only the U.S., the findings will, however, have direct implications on the role of market-based financial system Southwestern Economic Review 24 on economic growth and development because the U.S. financial system is considered as the leading example of the market-based financial system. Working with large cross-section of countries (developed and developing) and using the method of pure cross-country regression, or dynamic panel data methods such as the generalized methods of moments (GMM), several studies have examined the channels through which financial development affects economic growth (see, De Gregorio & Guidotti, 1995; Levine & Zarvos, 1998; Beck et al., 2000, and Benhabib and Spiegel, 2000, among others). However, many criticisms have been expressed against these studies with respect to the data and estimation methods they used. Predominant among which is that, cross-country/multi-country panel regression estimates “mask important cross country differences” (Levine and Zarvos, 1996; Darlauf, 2001). That is, the slope coefficient is taken to be identical across the countries included in the panel, which implies that financial development generates equivalent investment and productivity increases across countries. However, heterogeneity across countries in terms of their institutional and financial structures which plays a crucial role in determining the finance-growth relationship has been documented in the literature (Stigletz, 1985; Edwards and Fisher, 1994; La Porta et al., 1997; Shleifer & Vishny, 1998; Stulz, 2001). For example, as alluded to earlier, there is a rich diversity of opinion in the existing literature on the relationship between the financial structure (that is, the degree to which the financial system is bank or market-based) and long-term economic growth (see, Allen & Gale 1999; Levine, 2002 for a comprehensive review of this Literature). All of these raise the possibility that the relationship between financial development and economic growth is country-specific, hence, the crosscountry/multi-country panel estimates may not correspond to country specific estimates. Consequently, generalization based on cross-country or multi-country panels may provide incorrect inference for several countries included in the panel; thereby, seriously impairing their policy significance. The shortcomings of the cross-country/panel estimators have prompted a number of researchers to rely on time-series method to examine the finance-growth nexus based on the data of individual countries (Neusser & Kuglar 1998; Rousseau & Watchtel 1998; Arestis & Luintel, 2001). As argued by Arestis & Luintel (2001, pp 17), ‘time series methods can provide useful insights into differences of this [financial development and economic growth] relationship across countries and may illuminate important details that are hidden in averaged-out results’. However, no attempt has been made to use the same technique to investigate the channels through which financial development affects economic growth in the U.S. This paper attempts to fill in this gap. Using long-term time-series data and the VAR method of analysis, this study attempts to empirically examine the channels through which financial development affects long-term economic growth in the U.S. In addition to the stated objective, it builds on the existing literature in two important ways. First, financial sector GDP (value added) is used as a measure of financial development. This is a major departure from the commonly used bank related measures such as: monetary aggregates like M2, liquid liabilities of the financial system, or bank credit to the private sector. As is explained below, compared to these measures, financial sector GDP is by far a better measure of financial development in a number of ways; one of which is that, it represents a broader measure of financial development. Consequently, unlike the other measures, it does not underestimate the level of financial development in industrialized countries like the United States, where a significant Financial Development, Investment, Productivity and Economic Growth in the US 25 portion of financial development or innovation occurs outside the banking system. Second, it uses a new Granger non-causality testing procedure developed by Toda & Yamamoto (1995) to conduct causality analysis. The use of this method enables to avoid the potential of pre-testing biases resulting from testing non-stationarity and cointegration of the data series. The rest of the paper is organized as follows. First, in order to put the empirical analysis in proper perspective, a selective review of both the theoretical and empirical literature is provided. Next, an outlines of the methodology and model used in the empirical study is presented, followed by discussion of the data and measurement issues. The last two sections provide, respectively, the empirical results and the conclusion. LINKAGES BETWEEN FINANCIAL DEVELOPMENT AND ECONOMIC GROWTH Analytical Framework The theoretical framework adapted here draws essentially on the recent literature on endogenous growth theory, which shows that growth rate can be related to institutional arrangements (Romer 1986, Lucas 1988, Barro 1991, Grossman and Helpman 1991, among others). In this section, a simple endogenous growth model, the “AK model”, where aggregate real output is a function of the aggregate capital stock is used to illustrate the potential impacts of financial development on economic growth.