Sustained Economic Growth
and the Financial System
Franklin Allen and Hiroko Oura

Traditional growth theory does not include financing and suggests thatgrowth will be continuous. In fact, however, growth is often discontinuous.
In some periods, there are booms with rapid growth that end in financial
crises with low growth for sustained periods. This paper argues that thefinancial system plays a crucial role in understanding these variations
in growth. High growth may require that firms and entrepreneurs takenon-diversifiable risks to obtain high returns. This risk taking may leadto high growth but also to frequent crises. Although growth followed bycrisis can be beneficial, this is not always the case. When a crisis follows
the bursting of a bubble in asset prices, it can have very negative impacts
on growth, as in the U.S. Great Depression or in Japan in the 1990s. For
sustained growth, policy should be devoted to avoiding bubbles, contagion,and financial fragility.
Keywords: Growth; Crises; Bubbles; Contagion; Financial fragility
JEL Classification: D9, E3, E5Franklin Allen: Department of Finance, Wharton School, University of Pennsylvania (E-mail:allenf@wharton.upenn.edu)
Hiroko Oura: Department of Economics, School of Arts and Sciences, University of Pennsylvania(E-mail: oura@ssc.upenn.edu)
We thank our discussants, Palle Andersen and Richard W. Peach, and participants at the conference
for their comments.
MONETARY AND ECONOMIC STUDIES (SPECIAL EDITION)/DECEMBER 2004
DO NOT REPRINT OR REPRODUCE WITHOUT PERMISSION.

95

I. Classical Views
What is the relationship between growth and the financial system? This is an oldquestion that has received many different answers over the years.1 Authors including
Bagehot (1873) and Hicks (1969) emphasize that financial systems played a criticalrole in igniting industrialization in England by facilitating the mobilization ofcapital. Schumpeter (1912) argues that well-functioning banks encourage technological innovation by identifying and funding entrepreneurs with the best chancesof successful innovation. On the other hand, many authors, such as Robinson(1952) and Lucas (1988), argue that financial systems do not matter for growthand financial development simply follows or reflects anticipation of economic
development. In addition, the role of finance is often simply ignored in development
economics. For example, Stern’s (1989) review of development economics does notdiscuss the financial system, even in a section that lists omitted topics.
A reading of the traditional neoclassical literature on growth would suggestthat financing is not important. In this literature, there are two main sources ofgrowth. The first is growth within the technological frontier caused by factor
accumulation. The second is innovation that causes the technological frontier tomove outward. Innovation is necessary for an economy to experience sustained
growth for a long period of time. However, factor accumulation can still be a large
component of growth, particularly for emerging economies that are a long way fromthe technological frontier.
Early models focus on factor accumulation as the engine of growth. In these models,
reproducible inputs, such as physical and human capital, ultimately show diminishingreturns. This feature leads the models to predict the convergence of economies towarda steady state. Growth based on factor accumulation stops eventually. Long-run growth
takes place as a result of exogenous technological progress.2
The next step is to try and model how innovation occurs rather than assumingthat it is exogenous. Endogenous growth models usually contain an innovation“production” process. Innovation is the crucial source for long-run growth. Innovative
activity requires the use of scarce resources, and the incentives for innovation areprovided by monopoly profits. Because of this imperfectly competitive market
structure, the market solution is not usually Pareto-optimal.3
These traditional approaches to growth do not consider the role of financial
systems in the growth process. However, they suggest that if the financial system is toplay a role, it can be through its effect on factor accumulation or on innovation.

II. The Role of Financial Systems
Financial systems channel household savings to the corporate sector and allocate
investment funds among firms. They allow intertemporal smoothing of consumption
1. Levine (1997, 2003) provides excellent surveys of the literature on economic growth and financial development.
2. See, e.g., Solow (1956), Swan (1956), Cass (1965), and Koopmans (1965).
3. See, e.g., Romer (1987, 1990), Aghion and Howitt (1992), and Grossman and Helpman (1991).

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Sustained Economic Growth and the Financial System

by households and expenditures by firms. They allow both firms and households toshare risks. These channels are the sources connecting financial development andfinancial structure to economic growth.
In this section, we give an overview of the literature discussing financial systems
and economic growth. The discussion is organized according to the particular role ofthe financial system analyzed in each study, including information acquisition andrisk sharing. In doing so, we pay special attention to the relation between financial
structure and the difference in outcomes. Whether the difference in financial
structure results in different long-run economic growth or not is an importanteconomic policy concern.
A. Producing Information and Allocating Capital
The information production role of financial systems is explored by Ramakrishnan
and Thakor (1984), Bhattacharya and Pfleiderer (1985), Boyd and Prescott (1986),
and Allen (1990). They develop models in which financial intermediaries arise to
produce information and sell this information to savers. Financial intermediaries
can improve the ex ante assessment of investment opportunities with positive ramifications on resource allocation by economizing on information acquisition costs.
As Schumpeter (1912) argued, financial systems can enhance growth by spurring
technological innovation, by identifying and funding entrepreneurs with the best
chance of successfully implementing innovative procedures. For sustained growth at
the frontier of technology, acquiring information and strengthening incentives for
obtaining information to improve resource allocation become key issues.
Some studies have explicitly incorporated these channels in a growth model.
Greenwood and Jovanovic (1990) construct a model in which financial intermediaries produce better information, improve resource allocation (by financing the firms
with the best technologies), and foster growth. Growth means that more individuals
can afford to join financial intermediaries, which improves the ability of the financial
intermediaries to produce better information. King and Levine (1993a) show that
financial intermediaries may boost the rate of technological innovation by identifying
those entrepreneurs with the best chances of successfully initiating new goods andproduction processes.
These models focus on financial systems based on intermediaries. As for the roleof markets, what is often indicated is the inherent free-riding problem when it comesto incentives for information acquisition. However, there is one important area inwhich markets potentially perform better than intermediaries. It is where people havediversity of opinion and there is genuine disagreement about the optimal decision.
This idea is explored by Allen and Gale (1999). They ask whether financial markets
or banks are better at providing finance for projects that involve the development of
new technologies. They argue that with new technologies investors are likely to havediversity of opinion which arises from differences in prior beliefs, rather than differences in information. The advantage of financial markets is that they allow people withsimilar views to join together to finance projects. This will be optimal provided that thecosts necessary for each investor to form an opinion before investment decisions are
made are sufficiently low. Finance can be provided by the market even when there is97

great diversity of opinion among investors. Intermediated finance involves delegating
the financing decision to a manager who expends the cost necessary to form an
opinion. There is an agency problem in that the manager may not have the same prioras the investor. This type of delegation turns out to be optimal when the costs offorming an opinion are high and there is likely to be considerable agreement in any
case. The analysis suggests that market-based systems will lead to more innovation
than bank-based systems. Hence, the role of the market might be more importantin the phase of economic growth at the technological frontier.
B. Risk Sharing
One of the most important functions of a financial system is to achieve an optimal
allocation of risk. Many studies directly analyze the interaction of the risk-sharingrole of financial systems and economic growth. These theoretical analyses clarify theconditions under which financial development that facilitates risk sharing promotes
economic growth and welfare. Quite often in these studies, however, authors focus
on either markets or intermediaries, or a comparison of the two extreme cases where
every financing is conducted by either markets or intermediaries. The intermediatecase in which markets and institutions coexist is rarely analyzed in the context ofgrowth models, because the addition of markets can destroy the risk-sharing opportunities provided by intermediaries. In addition, studies focus on the role of financial
systems that face diversifiable risks. The implications for financial development andfinancial structure on economic growth are potentially quite different when markets
cannot diversify away all of the risks inherent in the economic environment.
One importance of risk sharing on economic growth comes from the fact thatwhile savers generally do not like risk, high-return projects tend to be riskier than
low-return projects. Thus, financial markets that ease risk diversification tend to
induce a portfolio shift toward projects with higher expected returns as pointed out
by Greenwood and Jovanovic (1990), Saint-Paul (1992), Devereux and Smith(1994), and Obstfeld (1994). King and Levine (1993a) show that cross-sectionalrisk diversification can stimulate risky innovative activity for sufficiently risk-averse
agents. The ability to hold a diversified portfolio of innovative projects reduces risk
and promotes investment in growth-enhancing innovative activities.
In addition, better risk diversification in international financial markets may
enhance economic growth by exploiting the benefit from trade in goods acrosseconomies. Standard models in international trade predict that each country specializes in producing a smaller number of final goods to maximize the gains from trade.
However, as Helpman and Razin (1978) show, if uncertainty is introduced, therisk-averse nature of consumers results in imperfect specialization that reduces the gains
from trade. In such circumstances, financial development that allows the tradingof contingent claims provides better risk-sharing opportunities without changing
production possibilities. Therefore, financial development in an international context
will enhance growth by allowing each economy to specialize in producing a small
subset of goods, but at the same time will allow the diversification of the increased
income risk from specialization.

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Sustained Economic Growth and the Financial System

Risk sharing plays a key role in promoting growth when agents face liquidity risk
as well. The standard link between liquidity and economic development arises
because some high-return projects require a long-run commitment of capital, but
savers do not like to relinquish control of their savings for long periods. Hicks (1969)
argues that products manufactured during the first decades of the Industrial
Revolution had been invented much earlier. Rather, the critical innovation that
ignited growth in 18th-century England was capital market liquidity.
Levine (1991) takes the Diamond and Dybvig (1983) setup for liquidity demand,models the endogenous formation of equity markets, and links this to a growth model.
As stock market transaction costs fall, more investment occurs in the illiquid,
high-return project. If illiquid projects enjoy sufficiently large externalities, thengreater stock market liquidity induces faster steady-state growth. Bencivenga, Smith,and Starr (1995) construct a model in which high-return, long-gestation production
technologies require that ownership be transferred throughout the life of the
production process in secondary securities markets. Smaller transaction costs enhanceliquidity and induce a shift to longer-gestation, higher-return technologies. Bencivenga
and Smith (1991) show that, by eliminating liquidity risk, banks can increase
investment in the high-return, illiquid asset and accelerate growth. They presume
preexisting impediments to liquid equity markets. DeGregorio (1996) constructs amodel in which financial systems can promote growth with accumulating humancapital by easing liquidity constraints.
The above studies focus on the role of either markets or intermediaries, and thebenefit of financial development is emphasized by comparing the situation in which
each individual must bear the idiosyncratic risks and that in which such risk canbe traded in the financial system. Analysis in which markets and intermediaries
coexist is rare, because of the disintermediation effects of having markets. The basic
reason for the existence of banks in the Diamond and Dybvig (1983) model is toprovide liquidity insurance that smooths consumption across states. In markets,
investors constantly rebalance their portfolios to earn the highest rate of return.
Liquidity insurance requires that investors accept lower returns than the market offers
in some events to get higher returns in others. A financial institution that mustcompete with financial markets will face disintermediation when the market returnis higher than the bank’s smoothed return, even though the insurance provided
by financial institutions would make everyone better off than they would be
without it.
Fecht, Huang, and Martin (2004) consider the case where banks and markets
coexist by adopting a different approach. They consider a model with a Diamondand Dybvig (1983) setup but in which there is the possibility for individual agents totrade in markets only when they incur costs. Better risk sharing of liquidity shocks byintermediaries can be preserved as long as the cost to participate in markets is
relatively high and the portion of individual market participants is not too large.
They point out the possible trade-offs between better risk sharing and a higher
growth rate (as a result of more risk taking in investment with a higher return), andshow some cases in which more bank-based financial systems experience better
liquidity insurance at the cost of a lower growth rate.

99

Acemoglu and Zilibotti (1997) consider an environment in which markets are notcomplete and it is costly to produce assets that increase diversification opportunities.
In the model, they endogenize the degree of market incompleteness and examine
the impact of diversification choices on economic development led by capital
accumulation. Key properties of their model include (1) high-return, risky projects
that are indivisible and require a large initial investment, (2) people’s dislike ofrisk, (3) lower-return, safe projects, and (4) scarcity of capital. The desire to avoid
highly risky investments slows capital accumulation, and the inability to diversify risk
introduces a large amount of uncertainty in the growth process. They point out that
decentralized equilibrium is inefficient and takes a much longer time to emerge fromthe “primitive accumulation” stage with highly variable output, because individuals
do not take into account their impact on others’ diversification opportunities.
These studies shed some light on the relationship between the risk-sharing role ofthe financial system and growth. However, one limitation of the literature is that it
does not consider the effect of non-diversifiable risk. As we will see below, this is an
important omission, as there can be important interactions between non-diversifiablerisk and growth.
C. Empirical Evidence
Our review of the theory has indicated that the degree of sophistication of a country’s
financial system and the type of financial system may have an important impact on
growth. This naturally raises the question of what is the empirical evidence on therelationship between growth and the financial system. We start by considering
the relationship between the development of financial systems and then consider
bank-based versus market-based systems.
1. Does financial development matter for growth?
Although the seminal work of Goldsmith (1969) that studies the finance-growthnexus was inconclusive, the majority of empirical evidence now available seems toshow a positive relationship between the measures of financial development andeconomic growth. Hence, the task for researchers is to provide evidence on thecausality from finance to growth, as well as confirming the robustness of effects.
Numerous researchers have applied different econometric methods to pick up thecorrelation between financial development and growth. The pioneering works,
including that by Goldsmith (1969), adopt cross-country growth regression analysis.
As for recent research, King and Levine (1993b) conduct a study with 77 countries forthe time period of 1960–89. They add financial development indicators to a growth
regression and find a strong positive relationship between financial development
and growth.
One of the key issues in the field is which indicators for financial development
should be used. Depending on the choice of indicators, there can be differences inresults, and different interpretations of results concerning potential routes connecting
the financial aspect of economies and the real side of economies. King and Levine(1993b) used measures such as (1) liquid liabilities of banks and nonbank financial
intermediaries (currency plus demand and interest-bearing liabilities) over GDP,(2) bank credit over the sum of bank credit and central bank domestic assets, and

100 MONETARY AND ECONOMIC STUDIES (SPECIAL EDITION)/DECEMBER 2004

Sustained Economic Growth and the Financial System(3) credit to private enterprises over GDP. These measures were shown to havepositive correlation with economic growth, and became standard variables for later
studies. La Porta, Lopez-de-Silanes, and Shleifer (2002) suggest an alternative financial development indicator capturing government involvement with the financial
sector. They used the degree of public ownership of banks, and find that higher
degrees of public ownership are associated with (1) lower levels of bank developmentand (2) slower economic growth.
Also, there are studies, such as Atje and Jovanovic (1993) and Levine and Zervos(1998), that measure financial development using stock market-related variables.
Levine and Zervos (1998), which builds on Atje and Jovanovic (1993), try several
stock market development indicators including turnover ratio (the total value ofshares traded on a country’s exchanges over stock market capitalization). They findthat both the initial level of turnover ratio and banking development (bank credit)
enter the growth regression significantly. Therefore, they conclude that banks
and stock markets provide different financial functions. They also emphasize thatthe mere size of the stock market is not significant, and what matters is a variable
capturing how active the market is.
Benhabib and Spiegel (2000) obtain results in line with Levine and Zervos (1998)
suggesting different functions from different financial services. In their study, financial
development is positively related to total factor productivity growth, as well as theaccumulation of physical and human capital. Moreover, different indicators offinancial development are linked with different components of growth.
In confirming the direction of causality, King and Levine (1993b) made use of thelong length of the data they have. They consider the predictability of 1960 financial
development for the next 30 years of growth. Since it is unlikely that financial development at a point in time reflects growth far in the future, their finding that the degreeof financial development at 1960 is positively correlated with the next 30 years ofgrowth indicates that finance leads growth.
Furthermore, some studies test this direction of causality by using instrumental
variables that are correlated with financial development but not with growth beyond
their link to financial development. Levine (1998, 1999) and Levine, Loayza, and Beck
(2000) use La Porta et al.’ s (1998) measures of legal origin as instrumental variables.
Economies can be put into four types of groups depending on whether theircommercial/company laws derive from English, French, German, or Scandinavian
law. Since the choice of legal system is mostly realized through colonization, it isplausible to take it as exogenous. Also, it is correlated with the degree of financial
development. Their results show a strong positive connection between instrumental
variables and growth.
Other researchers have tried to see the direction of causality with time-series
analysis such as Granger-type causality tests and vector autoregressive procedures. Also,
some studies focus on a limited number of countries so that they can make use of much
longer time series of data, as well as taking more detailed country-specific measures offinancial development into account. Some studies have mixed results over causality;
however, the majority of research seems to suggest that financial development or
certain changes in financial aspects of an economy lead to stronger growth.

101With this time-series methodology, pioneering work by Jung (1986) and
Demetriades and Hussein (1996) finds that causality frequently runs both ways,
especially for developing economies. However, more recent work by Xu (2000),
which extends Jung (1986) with vector autoregression analysis, rejects the hypothesisthat finance simply follows growth. In addition, Christopoulos and Tsionas (2004)
show that causality runs from finance to growth in the long run with panel unit tests
and panel cointegration analysis.
For some industrial economies, longer time-series data are available. Rousseau and
Wachtel (1998) studied five industrial economies over a century. They documentthat the dominant direction of causality runs from finance to economic growth.
Sometimes, a study covers only one country. Rousseau and Sylla (1999) examine thehistorical role of finance in the United States from 1790–1850. They find strong
support for finance-led growth. Rousseau (1999) investigates the Meiji Period ofJapan (1868–84) and shows that the financial sector was instrumental in boosting
Japan’s explosive growth prior to World War I.
Some time-series analysis follows the effects on economic variables from a change
in the financial system. Bekaert, Harvey, and Lundblad (2001a, b) examine the effects
of opening equity markets to foreign participation. Financial liberalization boosts
economic growth by improving the allocation of resources and the investment rate.4
Regional analysis within a country is also helpful, although not perfect, to deal
with the issue of causality and concern over the possibility that aggregate financial
development variables simply reflect other country-specific omitted characteristics.
Studies of this kind also confirm the positive relation between finance and growth.
Jayaratne and Strahan (1996) study U.S. liberalization over the restrictions on interstate branching in some states. They show that branch reform boosted bank lending
quality and accelerated real per capita growth rates. Guiso, Sapienza, and Zingales(2004) examine individual regions of Italy. They find that local financial development (1) enhances the probability that an individual starts a business, (2) increases
industrial competition, and (3) promotes the growth of firms.
Confirming the relationship between finance and growth at a microeconomic
level seems to be a recent trend as well. Industry-level analysis is pioneered by
Rajan and Zingales (1998), in which they study 36 industries in 42 countries. They
test whether industrial sectors that are relatively more in need of external financedevelop disproportionately faster in countries with more developed financial markets
or not. They find that this is the case. Their unique methodology involves using the
U.S. market to identify external dependence. Their financial development measures
are stock market capitalization plus domestic credit over GDP and accounting
standards. Beck and Levine (2002) confirm the Rajan and Zingales (1998) findings
with different financial development measures. Wurgler (2000) documents thatcountries with a higher level of financial development both increase investment morein growing industries and decrease investment more in declining industries thanfinancially underdeveloped economies.
4. Although the endogeneity of liberalization choice casts a potential problem on causality, the worldwide trend
toward financial globalization in the past two decades adds some exogenous force toward liberalization.

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Sustained Economic Growth and the Financial System

Firm-level analysis tends to focus on identifying some particular channels fromfinance to growth, and/or some intermediate phenomenon likely to be related tofirm/economic growth. Demirgüç-Kunt and Maksimovic (1998) test whether thegreater financial development removes impediments to the exploitation of profitable
growth opportunities or not. High turnover and high bank assets over GDP are positively related with the excess growth of firms compared to the growth rate achievable
only with retained earnings and short-term borrowing. As is the case in Levine andZervos (1998), stock market size does not matter. Love (2003) examines whether
financial development eases financial constraints (but not growth, however).
Sensitivity of investment to internal funds is greater in countries with less developed
financial systems. Claessens and Laeven (2003) examine the effect of financial development on the availability of external funds, and the impact of legal systems on
financial development. They find that countries with legal systems that do not dowell at supporting financial development tend to (1) have less external financing offirms, and (2) allocate external financing toward fixed assets.
To summarize, the currently available empirical studies show that (1) there is astrong positive effect from finance to growth, and (2) the result seems to be able tosurvive the issue of causality and robustness of results against inclusion of omitted
variables that capture the economies’ characteristics.
2. Bank-based or market-based?
The empirical literature discussed so far has focused on confirming the financegrowth nexus. For that purpose, several financial development measures are proposed
and used. Some of them capture financial development in the banking sector,
whereas others capture financial development in the stock market. Some earlier
studies, such as Levine and Zervos (1998) referred to in the previous subsection,
seem to suggest a potential difference in channels connecting the structure offinancial systems and economic performance. As we saw earlier in the theory section(Section II.A and B), there are a number of important differences between banks andmarkets. Are different financial systems performing different functions, or do they
constitute different ways of doing the same thing? Can we say that one system is“better” than another? Numerous subsequent studies pursue these questions. As wewill see, the evidence is mixed.
Initially, analysis comparing financial systems focused on a small set of developed
countries. For example, Allen and Gale (2000a) discuss financial systems in fiveindustrial countries. Depending on the relative importance of banks compared tofinancial markets (i.e., organized markets for securities such as stocks, bonds, andderivatives) on allocating resources in the corporate sector, Germany, Japan, andFrance are considered to have bank-based systems, and the United States and United
Kingdom have market-based systems. However, all of these countries show similar
long-run growth rates compared to developing countries. Hence, the marginal effectof having different financial systems on growth is not strong within this group.
To make progress on this issue, the debate must be broadened to include a wider
range of national experiences. For this sake, Beck, Demirgüç-Kunt, and Levine(2000) construct a large cross-country, time-series database on financial structure forup to 150 countries from 1960–95. Demirgüç-Kunt and Levine (2001) classify

103

countries into bank- and market-based financial systems by using data from Beck,
Demirgüç-Kunt, and Levine (2000). Also, they document the tendency for national
financial systems to become more market-based as they become richer.
Several studies conclude that financial structure does not matter in accounting
for growth based on the expanded data set on financial structure. Beck et al. (2001)
document that countries do not grow faster with either market-based or bank-based
financial systems. They emphasize that what matters more is the overall level offinancial development and the efficiency of the legal system in protecting outside
investors’ rights in terms of inducing a higher economic growth rate. Levine (2002)
allows for the possibility of a different effect of bank-based systems for poorer
countries, or countries with weaker legal systems or otherwise weaker institutions.
Still, he does not find any difference.
The irrelevance of financial structure is also documented at the industry as well as
the firm level. For example, Beck and Levine (2002) provide evidence that financiallydependent industries do not expand at higher rates in bank-based or market-based
financial systems. They use Rajan and Zingales’ (1998) method and confirm that
greater financial development accelerates the growth of financially dependent industries, but financial structure does not matter. Also, according to Demirgüç-Kunt and
Maksimovic (2002), firms’ access to external finance is not easier, and firms do not
grow faster in either market-based or bank-based financial systems.
However, these results are not fully conclusive. Tadesse (2002) finds that while
market-based systems outperform bank-based systems among countries with developed
financial sectors, bank-based systems fare better among countries with underdeveloped
financial sectors. Also, countries dominated by small firms grow faster in bank-based
systems and those dominated by larger firms do so in market-based systems. This
research suggests that economies might need more nuanced financial development
policies depending on the current state of their financial and economic level.
Furthermore, even if the aggregate cross-country level classification of financial
structure does not matter much for overall economic growth, financial structure may
still affect types of activities at the microeconomic level. Carlin and Mayer (2003)
find a positive association between information disclosure (the effectiveness of theaccounting system), the fragmentation of the banking system (low bank concentration), and the growth of equity finance and skill-intensive industries. Their result is
consistent with the view, as suggested by Allen and Gale (1999), that having financial
systems that allow diverse views matters for financing high-technology firms.

III. Growth, Crises, and Bubbles
Although the traditional growth literature did not consider the role of the financial
system, the more recent empirical and theoretical literature suggests that the financial
system does play a significant role in the growth process. However, the factors focusedon in the literature discussed in the previous section do not explain one important
aspect of growth in many countries. This is that growth is often discontinuous. In someperiods, there are booms with rapid growth that end in financial crises with low or

104 MONETARY AND ECONOMIC STUDIES (SPECIAL EDITION)/DECEMBER 2004

Sustained Economic Growth and the Financial System

negative growth for sustained periods. How can this variation in growth be understood?
We will argue that the financial system plays a crucial role in understanding thesevariations in growth.
There is also the issue of whether such variation is good or bad. We will argue
that sometimes it can be good. The models of risk sharing discussed above focus ondiversifiable risk. High growth may well require that firms and entrepreneurs takesignificant non-diversifiable risks to obtain high returns. This risk taking may lead
not only to high growth but also to frequent crises. For instance, the U.S. financial
system experienced frequent financial crises during the latter part of the 19th century
and the early part of the 20th century. During this time, the average growth rate
was high, however. There is also some recent empirical evidence that countries withhigher growth rates have a higher frequency of crises.
However, in some cases the negative effects of boom-bust cycles are so extremethat the variation in growth is bad. This appears to be the case when bubbles in asset
prices lead to severe corrections that are followed by a prolonged reduction in growth
rates. The classic examples of this kind of event are the “Roaring Twenties,” the Great
Crash of 1929, and the Great Depression in the United States and the 1980s bubble
and the subsequent lost decade of the 1990s in Japan. Table 1 and Figure 1 provide a
Table 1 A Comparison of the United States (1920–43) and Japan (1980–2003)
United States
1920
1921
1922
1923
1924
1925
1926
1927
1928
1929
1930
1931
1932
1933
1934
1935
1936
1937
1938
1939
1940
1941
1942
1943

Real GDP growth rate
(percent)
–1.9
–3.4
6.9
13.9
2.8
2.2
6.1
0.6
1.8
6.5
–8.6
–6.4
–13.0
–1.3
10.8
8.9
13.0
5.1
–3.4
8.1
8.8
17.1
18.5
16.4

Japan
1980
1981
1982
1983
1984
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003

Real GDP growth rate
(percent)
3.6
3.0
2.8
1.6
3.1
5.1
3.0
3.7
6.8
5.3
5.3
3.3
1.0
0.2
1.1
1.9
3.6
1.8
–1.2
0.2
2.8
0.4
–0.3
2.7

105

Figure 1 A Comparison of the U.S. Great Depression and Japan’s Lost Decade

15

Real GDP growth rate, percent

12
9
6
3
0
–3
–6
–9
United States, 1930 = year 0
Japan, 1990 = year 0

–12
–15
–10

–8

–6

–4

–2

0

2

4

6

8

10

comparison of these two episodes in terms of the growth rate of real GDP. In the
United States, relatively high growth rates in the 1920s were followed by a very severe
contraction from 1930–33. After that, except for 1938, output grew at high rates,
especially after the outbreak of World War II. In Japan, the relatively high growth
rates of the 1980s continued for approximately two years after the 1990 collapse instock market prices. The decline in growth coincided with the start of the fall in realestate prices. Although the collapse in growth was not nearly as severe as in the
United States during the Great Depression, it has been much longer lasting.
The negative experience of the Great Depression was so severe for the UnitedStates and many other countries that extensive financial regulation and other measures
were put in place to make sure that nothing like it ever happened again. These
measures, particularly those established in much of Europe and Asia, effectively
restricted risk taking to a great degree. They were effective in preventing banking crises,
however. From 1945–71, there was only one banking crisis in the world, in Brazil in
1962. Apart from that, there were none. As Bordo and Eichengreen (2000) document,
this is very different from previous and subsequent periods. The prevention of crises
was achieved at a high cost, however. The measures to prevent crises were so severethat they effectively prevented the financial system from allocating resources. Startingin the 1970s and accelerating in the 1980s, financial systems were deregulated. With
the ability to take more risks, banking crises returned. In some cases this financial
liberalization has been beneficial, but in others it has led to bubbles and significant
reductions in growth.
This view of the relationship between growth and financial systems suggeststhat finance is of first-order importance. It is quite a different perspective than the

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Sustained Economic Growth and the Financial System

traditional neoclassical view of growth as a result of factor accumulation andinnovation. We start by considering the literature on growth and crises and then go on
to consider bubbles and crises, contagion and financial fragility, financial liberalization,and banks versus markets.
A. Growth and Crises
The research that tries to formally analyze the overall cost of financial crises in termsof economic growth and welfare is relatively new. The main result is to show that it ispossible both empirically and theoretically for economies to grow faster and havehigher welfare with crises than without them.
Ranciere, Tornell, and Westermann (2003) start by reporting an empirical observation that countries which have experienced occasional crises have grown on average
faster than countries without crises. They take an endogenous growth model inwhich the production technology for nontradable goods, which are used as inputs for
tradable consumption goods, is linear in reproducible capital consisting of nontradable
goods. Firms can issue default-free bonds either in domestic or foreign currency tofinance their investments, but the nontradable sector faces contract enforceability
problems that might constrain their borrowing to a function of their net worth,which inefficiently depresses investments. The government provides systemic bailout
guarantees only when a certain ratio of firms becomes insolvent. The only source of
uncertainty in this model is self-fulfilling real exchange rate depreciation that depends
upon the realization of a sunspot which occurs with a certain (exogenous) probability.
The authors show that an economy may be able to attain higher growth by taking
more credit risk in the form of currency mismatch, even though it may experience
occasional crises. This is because taking more credit risk that comes along with agovernment guarantee eases the borrowing constraint for the sector whose investment
is the source of endogenous growth.
Gaytan and Ranciere (2002) study the effect of the liquidity function of banks on
investment and growth for different stages of economic development. They take aneoclassical growth model together with Diamond-Dybvig type banks that provide
insurance against idiosyncratic liquidity shocks. The economy has a short-term liquid
production technology as well as a long-term illiquid technology. As the economy
grows, the return from the illiquid technology diminishes. If a bank chooses “exposedbanking,” it promises a larger payment to early consumers than the amount it can
pay by liquidating the long-term asset, and faces the risk of a self-fulfilling bank run.
In this case, a bank run arises depending upon the realization of a sunspot with some(exogenous) probability. Instead, a bank can choose “covered banking,” in which it
constrains its portfolio in such a way that it can always respond to early withdrawals
from patient depositors. Banks’ maximization involves the optimal choice between
exposed and covered banking. The authors show that middle-income countries may
find it optimal to be exposed to liquidity crises, while poor and rich economies havemore incentives to develop a fully covered banking system.
The empirical research on crises and growth is sparse. An exception is Ranciere,
Tornell, and Westermann (2003), who study both industrial and developing
economies for the time period between 1980 and 1999. They capture crises as the107negative skewness,5 i.e., bumpiness, of credit growth, and document that there is apositive link between this crisis measure and growth. That is, countries that haveexperienced occasional crises have growth on average faster than countries withsmooth credit conditions.
Another exception is Loayza and Ranciere (2002). They first note that the growth
literature (e.g., King and Levine [1993b] and Levine, Loayza, and Beck [2000]) finds
a positive relationship between financial development measures, such as private
domestic credit and liquid liabilities, and economic growth, whereas the literature
on currency and banking crises (e.g., Kaminsky and Reinhart [1999]) often finds
such variables useful in predicting crises. In their empirical analysis, they tried todifferentiate the short-run and long-run effect of these financial development
variables on growth. They found that a positive long-run relationship between
financial development and output growth coexists with a mostly negative short-run
relationship. In addition, the long-run positive relation still holds even for the
economies in Latin America where many of the crisis episodes occur.
In summary, crises are not necessarily bad for growth and for welfare. Why thenare crises so often regarded as awful events to be avoided at any cost? As we will see
next, when crises follow a bubble in asset prices they can be very damaging.
B. Bubbles and Crises
Financial crises often follow what appear to be bubbles in asset prices as in the Great
Crash of 1929 in the United States. A more recent example is the dramatic rise in realestate and stock prices that occurred in Japan in the late 1980s and their subsequentcollapse in the early 1990s. Norway, Finland, and Sweden had similar experiences in
the 1980s and early 1990s. In emerging economies, financial crises of this type havebeen particularly prevalent since 1980. Examples include Argentina, Chile, Indonesia,
Mexico, and most recently the Asian economies of Malaysia, Indonesia, Thailand,
and South Korea.
These bubbles in asset prices typically have three distinct phases. The first phasestarts with financial liberalization or a conscious decision by the central bank toincrease lending or some other similar event. The resulting expansion in credit isaccompanied by an increase in the prices for assets such as real estate and stocks. This
rise in prices continues for some time, possibly several years, as the bubble inflates.
During the second phase, the bubble bursts and asset prices collapse, often in a shortperiod of time such as a few days or months, but sometimes over a longer period.
The third phase is characterized by the default of many firms and other agents thathave borrowed to buy assets at inflated prices. Banking and/or foreign exchange crises
may follow this wave of defaults. The difficulties associated with the defaults andbanking and foreign exchange crises often cause problems in the real sector of theeconomy that can last for a number of years. There is a significant interaction
between the financial system and growth.
5. As we will mention later, financial fragility is sometimes measured with variance in economic variables in theliterature on crises and/or economic liberalization. The authors emphasize that extreme events such as crises
cannot be captured well by variance.

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Sustained Economic Growth and the Financial System

The Japanese bubble in the real estate and stock markets that occurred in the
1980s and 1990s provides a good example of the phenomenon. Financial liberalization throughout the 1980s and the desire to support the U.S. dollar in the latter partof the decade led to an expansion in credit. During most of the 1980s, asset pricesrose steadily, eventually reaching very high levels. For example, the Nikkei 225 Stock
Average was around 10,000 in 1985. On December 29, 1989, it reached a peak of
38,916. The then governor of the Bank of Japan, less concerned with supporting thedollar and more concerned with fighting inflation, tightened monetary policy andthis led to a sharp increase in interest rates in early 1990 (see Frankel [1993] andTschoegl [1993]). The bubble burst. The Nikkei 225 Stock Average fell sharply
during the first part of the year and by October 1, 1990 had sunk to 20,222. Realestate prices followed a similar pattern, although the decline did not start to occur
until the early 1990s. The next few years were marked by defaults and retrenchment
in the financial system. The real economy was adversely affected by the aftermathof the bubble, and growth rates during the 1990s were mostly slightly positive or
negative, in contrast to most of the postwar period when they were much higher.
Many other similar sequences of events can be recounted. As mentioned above,
Norway, Finland, and Sweden also experienced this type of bubble. Heiskanen (1993)
recounts that in Norway lending increased by 40 percent in 1985 and 1986. Assetprices soared, while investment and consumption also increased significantly. The
collapse in oil prices helped burst the bubble and caused the most severe banking
crisis and recession since World War II. In Finland, an expansionary budget in 1987
resulted in massive credit expansion. Housing prices rose by a total of 68 percent in1987 and 1988. In 1989, the central bank increased interest rates and imposed reserve
requirements to moderate credit expansion. In 1990 and 1991, the economic situation
was exacerbated by a fall in trade with the Soviet Union. Asset prices collapsed, banks
had to be supported by the government, and GDP shrank by 7 percent. In Sweden, asteady credit expansion through the late 1980s led to a property boom. In the fall of
1990, credit was tightened and interest rates rose. In 1991, a number of banks had
severe difficulties because of lending based on inflated asset values. The government
had to intervene, and a severe recession followed.
Mexico provides a dramatic illustration of an emerging economy affected by thistype of problem. In the early 1990s, the banks were privatized and financial liberalization occurred. Perhaps most significantly, reserve requirements were eliminated.
Mishkin (1997) documents how bank credit to private nonfinancial enterprises wentfrom a level of around 10 percent of GDP in the late 1980s to 40 percent of GDP in
1994. The stock market rose significantly during the early 1990s. In 1994, theColosio assassination and an uprising in Chiapas triggered the collapse of the bubble.
The prices of stocks and other assets fell, and banking and foreign exchange crises
occurred. These were followed by a severe recession.
Kaminsky and Reinhart (1996, 1999) study a wide range of crises in 20 countries
including five industrial and 15 emerging ones. A common precursor to most of thecrises considered was financial liberalization and significant credit expansion. These
were followed by an average rise in the price of stocks of about 40 percent per year
above that occurring in normal times. The prices of real estate and other assets also

109

increased significantly. At some point, the bubble burst and the stock and real estatemarkets collapsed. In many cases, banks and other intermediaries were overexposedto the equity and real estate markets and about a year later on average a banking crisis
ensued. This was often accompanied by an exchange rate crisis as governments chose
between lowering interest rates to ease the banking crisis or raising interest rates todefend the currency. Finally, a significant fall in output occurred and the recession
lasted for an average of about a year and a half.
How can events such as these be understood? Allen and Gale (2000b, 2003)
provide a theory of bubbles and ensuing crises based on the existence of an agency
problem. Standard theories of asset pricing assume that investors purchase assets with
their own wealth. In most financial systems, this is not the whole story. Intermediation
is important. Many of the agents buying real estate, stocks, and other assets do sowith other people’s money. The purchase of real estate is usually debt financed. If theinvestment is successful, the borrower repays the loan and retains the difference
between the value of the asset and the principal and interest. If the investment is
unsuccessful, the borrower has limited liability and the lender bears the shortfall.
Similarly, a large proportion of stocks are held by mutual funds, pension funds,
and insurance companies. Money managers also have incentives to take risk. If theirinvestment strategy is successful, they may be rewarded by a share of the returns, but
most importantly they will attract new investors in the future. Because they receive
management fees in proportion to the assets under their control, they will be significantly better off as a result of their good performance. If the investment strategy is unsuccessful, there is a limit to the downside risk that the manager bears. In the worst case heor she will be fired, but in any case the liability is limited. Thus, when intermediaries makeinvestment decisions, the incentive scheme they face has convex payoffs.
The agency problem of excessive risk taking associated with limited liability is
crucial for the analysis. If the penalties for default on debt or the reputational loss
from being fired from an intermediary are sufficiently high, then there will not be an
incentive to take risks. Hence, the theory can be thought of as applying to cases
where these factors are insufficient to prevent risk taking.
If there is an agency problem of the type described, the people making the investment decisions will have an incentive to take on risky projects. The fact that lenders areunable to observe the characteristics of a project means the borrowers can shift risk to
the lenders and increase the payoff to themselves. This causes investors to bid up theprices of risky assets above their fundamental values, giving rise to a bubble. The morerisky the asset, the greater the amount that can be shifted and the larger the bubble.
Such risk can come from two sources: (1) asset return risk and (2) financial risk, therisk associated with future financial conditions such as the amount of credit that will
be available.
C. Contagion, Financial Fragility, and Growth
We have argued that the bursting of bubbles in asset prices can have very negative
impacts on growth with the U.S. Great Depression and Japan’s lost decade being theprime illustrations. Although similar in some respects, these two episodes also display
important differences. In the U.S. Great Depression, the stock market collapse in 1929

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Sustained Economic Growth and the Financial System

was followed by a dramatic fall in GDP and banking crises as shown in Table 1 andFigure 1. Growth resumed, albeit from a low level in 1934 and with the exception of1938 was quite robust. In Japan, the sequence of events was rather different. Growthcontinued after the collapse of the stock market in 1990 until 1991, when real estate
prices started to fall. Growth did fall, but there was not the massive contraction in
GDP that the United States suffered, and there was no widespread banking crisis on
the scale of the banking crises in the United States. However, the lower growth rates
continued until at least 2003. Why were these experiences so different?
One answer is that the United States experienced problems of contagion andfinancial fragility while Japan did not. However, by avoiding these problems Japan
prolonged its period of low growth. We will consider both these aspects in turn.
Contagion and financial fragility are associated with discontinuities arising fromthe operation of the financial system. Allen and Gale (2000c) focus on a channel ofcontagion that arises from the overlapping claims that different regions or sectors of
the banking system have on one another through interbank markets. When one region
suffers a banking crisis, the other regions suffer a loss because their claims on thetroubled region fall in value. If this spillover effect is strong enough, it can cause acrisis in the adjacent regions. In extreme cases, the crisis passes from region to region
and becomes a contagion. Aghion, Bolton, and Dewatripont (1999) also consider amodel of contagion through interbank markets. In their model, there are multiple
equilibria. In one equilibrium there are self-confirming beliefs that a bank failure is an
idiosyncratic event, and in the other there are self-fulfilling beliefs that a bank failure
signals a global shortage of liquidity. Lagunoff and Schreft (2001) study the spread ofcrises in a probabilistic model. Financial linkages are modeled by assuming that eachproject requires two participants and each participant requires two projects. Whenthe probability that one’s partner will withdraw becomes too large, all participants
simultaneously withdraw and this is interpreted as a financial crisis. Van Rijckeghem
and Weber (2000) document linkages through banking centers empirically.
The notion of financial fragility is closely related to that of contagion. When afinancial system is fragile, a small shock can have a big effect. Allen and Gale (2004)
show how an arbitrarily small shock can lead to a collapse in asset prices. There iseffectively contagion through market prices. The reason that a small shock can have a
big effect is that the supply of liquidity is endogenous. Liquidity will only be supplied if
price variations make it profitable to hold liquid resources with a low return.
The banking crises and dramatic collapse in asset prices in the United States inthe early 1930s are perhaps consistent with these kinds of models of contagion andfinancial fragility. They arise because of hard constraints where bankruptcy is
imposed and assets are liquidated quickly.
In contrast, in Japan contagion and fragility appear to have been avoided byhaving soft constraints with regard to bankruptcy and liquidation. Hoshi and Kasyap(2004) persuasively argue that the length of Japan’s period of low growth can be
explained by the willingness of banks to keep lending at a subsidized rate to firms
with little prospect of ultimate recovery. This practice is known as “evergreening.” Thefirms that are supported in this way in turn compete with other firms and ensure low
profitability in many sectors. While undesirable from the perspective of prolonging

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the low-growth period, this type of soft application of bankruptcy constraints does
ensure that contagion and financial fragility are avoided. An important issue for future
research is to find some balance between preventing contagion and financial fragility
while at the same time avoiding prolonged periods of low growth.
D. Financial Liberalization, Crises, and Growth
As the above discussion indicates, financial-sector regulation can play a significant
role in taming crises. Both domestic regulation controlling the activities of financial
institutions and restrictions on international capital flows seem to be important. In
particular, the policy trilemma of combining financial opening with exchange ratestabilization policy and maintaining economic stability by way of autonomous monetary policy is well known. We have also discussed whether the economic variability
arising from crises is good or bad for growth. Sometimes, the cost of occasional crises
seems to be relatively small compared to the growth-enhancing effect of financial
liberalization, but not all the time. Especially, crises following bubbles in investment
and asset prices seem to impose extremely costly recessions on an economy.
These observations lead us to a cost-benefit analysis of financial deregulation andliberalization. Occasional, costly crises seem to be inevitable in a deregulated environment. At the same time, deregulation and globalization allow more risk taking andhigher expected returns as well as a better allocation of capital. Which economies are
better off with financial liberalization together with the associated risk of financial
crisis? Were the recent episodes of financial globalization, which often ended with acrisis, growth-enhancing overall?
Tornell, Westermann, and Martinez (2004) studied 52 economies from 1980–99
to answer these questions. They point out that in developing countries, (1) financial
liberalization indeed leads to financial fragility and incidents of crises, but (2) financial
liberalization also has led to higher GDP growth. In fact, faster-growing countries
are typically those that have experienced boom-bust cycles. Their conclusion is thatoccasional crises are the byproduct of financial liberalizations that eventually enhance
economic growth.
This conclusion is in line with the majority of the empirical finance-growth literaturedescribed above that confirms a positive relationship between financial development
and economic growth. However, such direct research on liberalization, financial
fragility, and economic growth is still sparse. A more nuanced conclusion is warranted
when we look at each of the three related literatures and try to synthesize results.
There are numerous studies on the effect of financial liberalization on economic
growth and/or welfare, which do not necessarily consider the issue of financial crises.
Prasad et al. (2003) and Obstfeld and Taylor (2004) provide excellent reviews. Afteran extensive survey of the empirical literature relating liberalization and growth,
Prasad et al. (2003) point out the following. First, they note that it is difficult toestablish a robust causal relationship between the degree of financial integration andoutput growth performance.6 Second, they indicate that there is little evidence that
6. For example, Quinn (1997) showed a positive relation between capital account liberalization and economic
growth, and Bekaert, Harvey, and Lundblad (2001a) found that stock market liberalization led to a 1 percent
increase in per capita GDP growth over a five-year period. Henry (2003) finds that stock market liberalization in

112 MONETARY AND ECONOMIC STUDIES (SPECIAL EDITION)/DECEMBER 2004

Sustained Economic Growth and the Financial Systemfinancial integration has helped developing countries to better stabilize fluctuations
in consumption, which is a better measure of well-being than output. In the end,
they conclude that while there is no proof in the data that financial globalization has
benefited growth, there is evidence that some countries may have experienced greater
consumption volatility as a result.
What leads to this conclusion? We have already seen how costly crises can be.
Therefore, the question is why the potential and/or attained growth-enhancing
benefit from liberalization is not necessarily enough to compensate for the risk of acrisis. The growth-enhancing benefits of internationalization come from (1) capital
accumulation, as emphasized in neoclassical growth models, and (2) better international risk sharing that allows agents to specialize in high-risk and high-returnprojects. Recent empirical and quantitative evidence on the size of these benefits is
discouraging. As for the benefit from capital accumulation, Gourinchas and Jeanne(2003) conducted a simulation based on a Ramsey growth model and concluded
that the benefit from this channel was quite small for developing economies. The
result comes from the fact that productivity in developing countries is much lower
than in developed economies, and developing economies have in fact the level ofcapital near the steady state determined by their lower technology level. Merefinancial opening does not enhance growth significantly. Rather, it is productivityincreasing economic reforms that increase the benefit of liberalization by shifting up
the steady state level of capital.
Based on this study, Obstfeld and Taylor (2004) emphasize the role of good
institutions in increasing the effective productivity in an economy and hence increasing the benefit from financial opening. The benefit from risk sharing can be detectedby examining volatility in consumption. Internationalization may not necessarily
reduce output volatility, as emphasized in Helpman and Razin (1978) and Obstfeld(1994), due to more specialization in high-risk and high-return projects. However,the better risk-sharing opportunities allow trading of output variability to attainconsumption smoothing. The empirical evidence seems to be quite discouraging fordeveloping economies in this respect. Bekaert, Harvey, and Lundblad (2002) showthat equity market liberalization significantly decreases the volatility in output
and consumption growth for the time period excluding 1997–2000. With the data
for the Asian crisis years, 1997–2000, the negative effect on consumption growthvariability is weakened for emerging markets. Capital account openness reduces
the volatility of output and consumption, but not as much as the effect from equity
market liberalization. In addition, capital account openness increases the volatility ofoutput and consumption in emerging markets. Overall, the potential benefit from
capital accumulation without other economic reforms seems to be low, and theachieved benefit so far from international risk sharing also seems to be low comparedemerging markets decreases the aggregate dividend yield (the cost of capital), and increases the growth rate ofcapital by 1.1 percent and per worker output by 2.3 percent per year. At the firm level, Chari and Henry (2002)
find that stock market liberalization increases the growth rate of firms’ capital stock. In contrast, Rodrik (1998)
and Kaay (1998) find no significant relationship. Also, a number of papers find a positive effect of capital accountliberalization on growth, conditioning on the level of industrialization (Klein and Olivei [2000]), the level ofdevelopment of an economy (Edwards [2001] and Arteta, Eichengreen, and Wyplosz [2001]), and the institutionaland sociological characteristics of an economy (Bailliu [2000] and Chanda [2001]).

113

to the first-best benchmark models. So once we take the cost of crisis into account,the net benefit of financial opening for developing economies will be small or could
be negative.
Our take on this empirical result, as discussed at length in previous subsections, isthat the benefit of financial opening may be much smaller in an economy facing
agency problems and other market failures compared to first-best outcomes. In asecond-best world with agency problems, excessive risk taking may result in bubbles ininvestment and asset prices that tend to arise at the time of increased uncertainty from
deregulation and structural change. This eventually increases the cost of subsequent
financial crises. Let us note that our view shares some common elements with Obstfeld
and Taylor’s (2004) view that emphasizes the role of better institutions and higher
effective productivity in increasing the benefit from financial opening. The agency
problem we emphasize is one of the underlining distortions that gives importanceto institutional aspects, such as contract enforceability, shareholder rights protection,and the rule of law. Once again, it seems that more research, both theoretical andempirical, is needed in this area to identify the precise nature of second-best outcomesto help reach definitive conclusions.
E. Banks, Markets, and Crises
The debate on bank-based versus market-based systems discussed in the previous
section has an additional dimension of complexity when we consider the relation
between financial architecture and economic stability. Economic instability, suchas that triggered by a financial crisis, is often regarded to be growth impeding as
discussed above. The difference in financial architecture may matter for growth, since
one system may be better at maintaining financial/economic stability. For example,
one popular policy discussion triggered by the Asian crisis seems to favor markets
over banks for enhancing economic resilience against a bad shock. That is, with moredeveloped bond markets, the Asian crisis would have been much milder. Is this true?
Can the mere replacing of bank loans by bonds increase the stability?
The answer does not seem to be that simple. To begin with, judging whether
an economy is truly bank-based or market-based is a complex task. For example,
according to the criteria proposed in Demirgüç-Kunt and Levine (2001), South Korea
is classified as market-based and yet has experienced a crisis with a subsequentrecession as serious as, for example, Thailand, which is classified as bank-based.
Demirgüç-Kunt and Levine (2001) classified South Korea as market-based because of
its relatively large equity market. The country has a relatively well-developed corporatebond market as well. The deep crisis there seems to suggest that the mere existence oflarge bond markets does not enhance resilience very much. In fact, a large portion of
corporate bonds is held by financial institutions that implicitly promise fixed payments
to households. This type of securitization may not enhance risk diversification inbond markets and hence makes an economy less market-based than suggested by mere
observation of market size.

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Sustained Economic Growth and the Financial System

IV. Concluding Remarks
The traditional growth literature emphasizes factor accumulation and innovation as
the engines of growth. The role of the financial sector is not considered. Morerecently, a large literature has documented theoretical reasons for the importanceof the financial system in determining growth. A large empirical literature has
confirmed that in practice financial systems are important for growth.
We have argued that the view the conventional literature espouses is one ofcontinuous growth. However, the process of actual growth is often discontinuous withbooms followed by crises. The experience of the “Roaring Twenties” and the Great
Depression in the United States was an extreme example. In many countries, it led tosignificant regulation and other measures to ensure that banking crises, contagion, andfinancial fragility would be eliminated. The measures severely limited the amount ofrisk that could be taken. They were successful in that from 1945–71 banking crises were
eliminated. However, the allocational role of the financial system was impaired.
With financial liberalization, which relaxed the restrictions on risk taking, crises
returned. There is some evidence that higher risk taking and accompanying crises canbe beneficial in terms of long-run growth and economic welfare. However, if asset
price bubbles occur, then subsequent crises can be very damaging. Japan’s 1980s
bubble and its subsequent lost decade provides an example of this. However, it might
have been even worse had contagion and financial fragility not been avoided. In the
Great Depression, these appear to have been quite detrimental. Our conclusion is that,for sustained growth, policy should be devoted more to avoiding bubbles, contagion,and financial fragility. Crises can be beneficial for growth, but not if the crises follow
large asset price bubbles or involve contagion and financial fragility.

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Comment
PALLE ANDERSEN
Bank for International Settlements
My comments are not very substantial and should only be seen as marginal notes toan extremely well-structured and well-written paper.

I. Role of Financial Systems and the Empirical Evidence
for Growth
On the role of financial systems and the empirical evidence with respect to growth,I fully agree with the conclusion that there is a positive and statistically significant
effect from finance to growth that survives robustness and causality tests. I only have
two minor additions:• Nearly a century ago, Schumpeter (1912) argued that financial systems enhance
growth by identifying and funding entrepreneurs that would implement technological innovation. Yet it took 75–80 years to construct growth models and test
the empirical evidence for this channel. Now, however, the number of studies using
industry and firm data to test Schumpeter’s hypothesis is rising at an exponential
rate and just summarizing this literature would require an entire paper.

119• On the question of markets versus banks, I have the impression that the authors
are “leaning toward” markets as being the more growth enhancing. However,there are still some unsettled issues. As the authors note, one is that we do nothave models which incorporate both banks and markets. Another is that the“test sample” is not very large, as the United States and the United Kingdom areprobably the only countries where there is a clear shift from bank to capital
market financing. In the United States, this shift has been accompanied by amarked rise in productivity growth, consistent with Schumpeter’s hypothesisthat good financial systems help fund innovative entrepreneurs. But in the
United Kingdom, productivity growth has stagnated at a low level. One issue
that the authors might have addressed is that of bond markets in Asia. Several
analysts have noted that if the bond markets had been more developed, theAsian crisis would have been much milder. Others, however, argue that South
Korea (with a relatively well-developed bond market) suffered as much as
Thailand (where the bond market was relatively underdeveloped). And how
about Japan? Did the existence of a large bond market attenuate the effects onbanks of the bursting of the bubble? Or did it worsen the banking crisis because
the best borrowers went to the bond market to cover their financing needs?

II. Growth, Crisis, and Bubbles
The authors should be complimented for their section on growth, crisis, andbubbles and for the way in which they attempt to combine the literature on financial
liberalization and growth with the crisis literature and the literature on volatility
and financial liberalization. You rarely see that in surveys of economic growthand financial systems, and the paper adds an important dimension to the literature.
I have one minor and one more substantial comment:• In discussing the crisis literature, the authors quote the findings by Ranciere,
Tornell, and Westermann (2003) and Tornell, Westermann, and Martinez(2004) that for developing countries there is a positive link between thebumpiness of credit and economic growth. Or to put it more simply, countries
that have experienced a financial crisis also tend to have high growth. I find thatvery hard to believe. It is true that Finland, Norway, and Sweden (which
all went through a financial crisis in the late 1980s) have a better growth performance than Denmark (which did not have a crisis) (Table 1). However, theLatin American countries with very bumpy credit growth certainly did not
expand faster than emerging Asia. In general, I would view unstable and unevencredit growth as a symptom of bad policies and not as an indicator of risk taking.
• On the question of globalization/financial integration and economic growthin developing countries, the paper might perhaps have gone a little bit further
in surveying the literature. More specifically, I would like to have seen morediscussion of the three principal findings in Prasad et al. (2003):7
7. See also Edison et al. (2002).

120 MONETARY AND ECONOMIC STUDIES (SPECIAL EDITION)/DECEMBER 2004

Comment

Table 1 Real GDP, Credit to Private Sector, and FDI
Real GDP
Mean

China
South Korea
Singapore
Taiwan
Malaysia
Thailand

9.5
7.2
6.5
6.3
6.0
5.9

India
Indonesia
Hong Kong
Philippines
TurkeyChile
MexicoBrazilPeru
Argentina
Uruguay
NorwayFinlandSwedenDenmark
United States
Japan
Euro area

5.7
5.2
5.1
2.5
4.0
4.6
2.4
1.9
1.9
1.1
0.9
2.8
2.3
2.0
1.8
3.5
2.7
2.3

St. dev.

Private credit/GDP
Mean/St. dev.

Max./Min.

Percentage changes, 1980–2003
3.2
5.3/6.6
15.6/–11.1
4.3
5.3/5.9
17.9/–3.9
4.2
2.2/7.0
19.8/–11.2
2.9
4.3/8.9
32.6/–8.9
4.7
5.8/9.0
24.2/–13.0
5.7
5.0/10.5
27.9/–14.6
1.9
4.5
4.2
3.0
4.7
5.2
3.5
3.3
6.1
6.3
4.7
1.8
2.9
1.8
1.7
1.9
1.9
1.4

1.7/6.0
6.8/22.1
2.4/6.8
1.9/19.0
0.1/25.1
4.6/18.6–2.2/28.1
26.7/559.7
28.5/149.4
50.1/648.6
0.7/26.0
1.9/6.4–6.4/7.2
1.8/9.7
0.7/8.7–1.2/5.6
0.9/2.9
1.3/2.1

FDI
Inflow/grossInwardfixed investment stock/GDP
Percent, average of 2000–02
10.4
33.9
3.9
8.9
14.51
60.01
5.8
10.8
9.5
59.5
10.2
23.2

13.3/–8.9
48.2/–69.3
16.5/–14.3
37.0/–37.6
45.7/–44.5
67.9/–17.0
65.7/–52.4
1,364/–1,536
667/–2212,829/–1,288
85.8/–44.4
10.4/–10.9
7.8/–15.5
22.6/–19.4
17.5/–19.0
8.1/–12.4
7.1/–3.8
5.0/–2.0

2.8
–12.6
7.81
8.8
7.3
21.9
14.9
23.6
10.9
14.0
12.2
9.2
28.1
37.3
49.1
9.7
0.6
29.72

4.6
37.4
41.01
14.0
10.6
65.7
21.1
42.8
20.6
42.9
12.1
18.4
22.9
43.0
41.7
12.8
1.3
30.12

Notes: 1. Net flows and stocks.
2. Averages for European Union countries rather than the euro area.
Sources: United Nations Conference on Trade and Development, World Investment Report, 2003;
national data.

(1) A systematic examination of the evidence suggests that it is difficult to establish
a robust causal relationship between the degree of financial integration andoutput growth performance.
(2) There is little evidence that financial integration has helped developing
countries to better stabilize fluctuations in consumption growth,
notwithstanding the theoretically large benefits that could accrue.
(3) In fact, new evidence presented in the paper suggests that low to moderatelevels of financial integration have made some countries subject to evengreater volatility of consumption relative to that of output.
These are sobering and discouraging conclusions. And they raise the question ofwhether something has gone wrong or whether our expectations were based on thewrong model. Let me conclude with some tentative answers:121• According to Stiglitz (2004), the neoclassical model underlying the study by
Prasad et al. (2003) (and indeed, many policy recommendations to liberalize
capital accounts) is inappropriate, since it does not recognize capital market
imperfections, agency problems, and asymmetric information. Moreover, since
short-term capital flows are pro-cyclical they tend to exacerbate rather thandampen fluctuations in consumption. The conclusion according to Stiglitz:
instead of liberalizing capital accounts, countries should try to make capital flows
counter-cyclical and devise ways by which interest rate and exchange market risks
are shifted toward the creditors. Nobody could disagree with this conclusion.
However, most would probably also argue that implementing these ideas is morethan problematic.
• Among the many interesting results in Obstfeld and Taylor (2004), I would
highlight two:
(1) Because of underdeveloped institutions, most developing countries are
actually not very far from their steady state. Consequently, unless institutions
are improved, we should not expect financial integration to have much effecton economic growth. A similar conclusion is “hinted at” in Prasad et al.
(2003) and in several other studies.
(2) Underlying much of the discussion of financial market developments andstructures in Obstfeld and Taylor (2004) is the “impossible trinity”: i.e.,that countries cannot simultaneously have free capital flows, a stableexchange rate, and an independent monetary policy. As Taylor (2004)
writes: “The unravelling of Argentina in 2001 offers a classic example ofcreeping monetary policy autonomy . . . leading to the collapse of a peg underopen capital markets.” In my view, failure to recognize the impossible
trinity provides a better explanation of the relationship between financial
liberalization, crisis, and growth than does the aforementioned theory basedon liberalization and bumpy credit cycles.
• A number of studies find a significant relationship between financial liberalizationand variables that normally appear with a positive coefficient in cross-country
growth equations. For instance, there seems to be a positive relationship between
financial liberalization and financial deepening as well as with stock market capitalization and turnover. The puzzle is that once you leave out the intermediate link
and estimate a reduced-form equation, financial integration has little or no effect.
• Better measurement of financial integration might lead to more positive results.
Much of the current work is based on the International Monetary Fund (IMF)
classification of capital and exchange controls or on measures of total capital
flows. However, we know that the individual components of capital flows(foreign direct investment [FDI], portfolio flows, bank loans, and other credits)behave very differently with respect to stability and cyclicality. From this pointof view, it might be helpful to focus on FDI flows, which some studies havefound to enhance growth. For those who wish to pursue this line of causation,
the last two columns of the table present evidence on inflows and inward stocks
across the countries.

122 MONETARY AND ECONOMIC STUDIES (SPECIAL EDITION)/DECEMBER 2004

Comment
References

Edison, H. J., R. Levine, L. Ricci, and T. Sløk, “International Financial Integration and Economic
Growth,” Journal of International Money and Finance, 21 (6), 2002, pp. 749–776.
Obstfeld, M., and A. M. Taylor, Global Capital Markets: Integration, Crisis, and Growth, Cambridge,
England: Cambridge University Press, 2004.
Prasad, E., K. Rogoff, S.-J. Wei, and M. A. Kose, “Effects of Financial Globalization on Developing
Countries: Some Empirical Evidence,” IMF Occasional Paper No. 220, International Monetary
Fund, 2003.
Ranciere, R., A. Tornell, and F. Westermann, “Crises and Growth: A Re-Evaluation,” NBER Working
Paper No. 10073, National Bureau of Economic Research, 2003.
Schumpeter, J., “Theorie der Wirtschaftlichen Entwicklung (The Theory of Economic Development),”
Leipzig: Dunker and Humblot, 1912 (translated by Redvers Opie, Cambridge, Massachusetts:
Harvard University Press, 1934).
Stiglitz, J., “Capital-Market Liberalization, Globalization and the IMF,” Oxford Review of Economic
Policy, 20 (1), 2004, pp. 57–71.
Taylor, A. M., “Global Finance: Past and Present,” Finance and Development, International Monetary
Fund, March, 2004, pp. 28–31.
Tornell, A., F. Westermann, and L. Martinez, “The Positive Link between Financial Liberalization,
Growth and Crises,” NBER Working Paper No. 10293, National Bureau of Economic
Research, 2004.

Comment
RICHARD W. PEACH
Federal Reserve Bank of New YorkThis paper provides a thorough overview of the state of theory and empirical researchon the fascinating issue of the relationship between an economy’s rate of growth andthe structure of its financial system. As someone who is not a specialist in this topic,
I found the paper to be well organized and very readable. I did find that the use ofsome jargon, such as diversifiable versus non-diversifiable risks, was not sufficiently
defined or explained. Some additional elaboration on such topics would give readers
greater insight into the issues covered.
The authors’ main conclusions are as follows. First, financial systems perform
important functions that contribute to innovation and capital accumulation. Second,heavily regulated financial systems greatly reduce the likelihood of financial crises
but at the cost of less risk taking. Third, financial system liberalization appears tospur growth but often leads to crises and, in some cases, asset bubbles. And finally,
country-specific practices regarding bankruptcy and loss recognition appear to play arole in both the degree of contagion and the rate of recovery from crises. I found thethird conclusion particularly interesting. The remainder of my comments will pertain
to this issue, with particular reference to a well-known case of financial liberalizationin the United States.
As someone with a great deal of respect for the power of unregulated markets
to efficiently allocate resources, I am troubled by the conclusion that financial
liberalization often leads to financial crisis. Is this a case of inherent market failure,123where the agency problem is so severe that it makes deregulated systems inherently
prone to bubbles? Or rather, is it the initial conditions at the time of liberalizationthat lead to crises, such that, with time, the liberalized system would work quite well?
In this context, I would like to make some observations regarding the U.S. thrift
industry crisis of the 1970s and 1980s as an example of liberalization leading tocrisis. The thrift industry was established after the Great Depression with the purposeof financing residential investment, mainly home ownership. The thrift industry washeavily regulated, including restrictions on both liabilities and assets. Regulation Q
established ceilings on the interest rate paid on deposits by both commercial banks
and thrifts, with the ceiling for thrifts being somewhat higher than that for commercial banks. This system provided a relatively stable and adequate flow of credit
to the housing market until the late 1960s and early 1970s. However, as inflation
began to increase thrifts had to pay higher interest rates on deposits, while the yieldon their portfolio of mortgages was slow to adjust upward. This maturity mismatch
sharply depressed thrift earnings and began to erode their capital base. In addition,
there were periodic episodes in which short-term interest rates exceeded the deposit
rate ceilings, with the resulting disintermediation causing sharp declines in housing
market activity.
In an effort to strengthen thrift earnings and balance sheets, the industry was
substantially deregulated over the late 1970s and early 1980s. Thrifts were grantedvery broad asset and liability powers, and began to enter markets in which they had
little previous experience. This contributed to what is now generally regarded as a
bubble in commercial real estate in the 1980s. Numerous thrifts failed, prompting
the establishment of the Resolution Trust Corporation to liquidate these institutions.
As indicated in Franklin Allen and Hiroko Oura’s paper, this is a clear example ofliberalization leading to a crisis. However, the preconditions and the motivation forliberalization played an important role in the ultimate crisis. By the time of liberalization, thrifts had been substantially weakened, and liberalization was an attempt toredefine and salvage these financial institutions. With the granting of expanded asset
and liability powers and the large increase in the maximum amount of deposits covered
by deposit insurance, the agency problem was clearly made much more intense. Withhindsight, it is also clear that an adequate supervisory system was not in place at thetime that these additional powers were granted. Finally, the tax code was intimately
linked with the ensuing bubble in commercial and rental real estate (in terms ofaccelerated depreciation, relatively high marginal tax rates, and limited partnerships).
This example suggests that additional study and documentation is needed with regard
to the conclusion that financial liberalization often leads to financial crisis.
Finally, I would like to add a comment on another topic of the paper: the issue ofbank versus market financing. While I have not seen it documented, it is generally
believed that the marginal equity and debt investors in commercial real estate in
the United States are now real estate investment trusts (REITs). It appears that thishas resulted in a more disciplined investment cycle, with less overbuilding even in theboom of the late 1990s. With further study, this development may provide insight into
the issue of bank versus market financing.

124 MONETARY AND ECONOMIC STUDIES (SPECIAL EDITION)/DECEMBER 2004

General Discussion

General Discussion
Franklin Allen responded to the discussants’ comments as follows. Regarding
Palle Andersen’s suggestion on the role of the bond markets, he agreed that a closer
look would further enrich discussions of the paper. However, he added that betterdeveloped bond markets, albeit important, would not necessarily mitigate financial
crises. He also agreed with the importance of considering models with various kindsof market imperfections. Regarding Richard W. Peach’s comment on the relationshipbetween liberalization and crisis, he noted that it was difficult to reach a general
conclusion, because there were always many other factors behind these events. In
addition, he mentioned that case studies were very useful, as suggested by the U.S.
thrift industry example. He also acknowledged that a good link between theory andpractice was necessary in this area.
With respect to policy responses to bubbles, Philip W. Lowe (Reserve Bank ofAustralia) agreed that policy should be devoted to avoiding asset price bubbles,
contagion, and financial fragility, but also stressed that it is extremely difficult to takeappropriate actions in practice. Eiji Hirano (Bank of Japan) concurred with Lowe’sview. Shigenori Shiratsuka (Bank of Japan) added that the Japanese bubble taught thedifficulty of identifying the nature of the shocks and responding to them properly ona real-time basis.
In response, Allen commented that he thought central banks were too fixated on
consumer price inflation. He stressed that asset price bubbles could be extremely
damaging and therefore a central bank should raise interest rates in a more preemptive
manner to stem asset price increases. In the meantime, Bennett T. McCallum(Carnegie Mellon University) stressed the importance of clearly defining a bubble toenhance the discussion.
In regard to asset price bubbles and crises, Hirano asked whether Japan’s lost decade
could be attributed mainly or solely to the bursting of the bubble. He suggested that
other factors such as a dramatic downward revision in growth expectations on thepart of firms and households could be important. Masaaki Shirakawa (Bank of Japan)
added that one reason for the persistent stagnation in Japan was inefficient credit
allocation due to malfunctioning financial markets. In this sense, he stated that morediscussion should be devoted to the question of how the infrastructure of the financial
system should be enhanced.
Referring to Japan’s experience, Allen stated that the lost decade of the 1990s
could have been mitigated if the Bank of Japan had pricked the bubble in 1986 or
1987. He also suggested that policy measures should be enacted before a financial
system’s meltdown, citing the example of the Federal Reserve Bank of New York’s
excellent response to the failure of Long-Term Capital Management. In discussing
the 1997 South Korean crisis, Jeong-Ho Hahm (The Bank of Korea) maintained that
there was no asset price bubble at that time, and emphasized that South Korea’s main
problem was a mismatch between short-term borrowing from foreign countries andlong-term lending to local businesses.
Jean-Philippe Cotis (Organisation for Economic Co-operation and Development)suggested that although there may be a negative correlation between financial stability

125

and financial market liberalization, deregulation would have the positive effect of effectively transmitting the monetary policy changes. Consequently, financial stability could
be achieved. Stefan Gerlach (Hong Kong Monetary Authority) argued that liberalization
itself did not necessarily lead to a crisis. However, liberalization together with poor
regulatory policy could lead to one, with the Swedish banking crisis as an example.
In response to Cotis’s argument, Allen stressed that financial market liberalization
would enhance market efficiency, so that crises caused by such liberalization were
not bad as long as they were not extreme. Allen also agreed with Gerlach that liberalization might not be the only cause of a crisis. Nevertheless, he stated that withliberalization many uncertainties would increase, making an economy particularly
prone to crisis. He added that we should consider how policies could be devoted to
avoiding the problems of market failures which could lead to bubbles, extreme crisis,
and financial contagion.
As for the conclusion that an economy with crises experiences faster growth,
Hiroshi Fujiki (Bank of Japan) stated that he was interested in the conclusion, andasked whether it was considered better to have a crisis earlier or later to facilitatemaximum growth. Vincent R. Reinhart (Board of Governors of the Federal Reserve
System), however, inferred that such results arose because GDP statistics did not fullyreflect economic welfare. Assaf Razin (Tel Aviv University and Cornell University)
acknowledged that a high probability of crisis led by liberalization was negatively
related to growth, by citing global game equilibrium literature and his own empirical
work with Yona Rubinstein.8 Using an example of capital account liberalization, hestated that there was not only a direct effect to enhance growth through the positiveeffect of a fixed exchange rate on the trade sector, but also an indirect effect to reduce
growth by increasing the probability of a currency/debt crisis.
Allen addressed the comments regarding the relationship between crisis and growthby contending that it was generally better for a crisis to occur earlier rather than later,
given the possibility for negative effects to be greater during the later stages. He agreed
with Reinhart’s comment that GDP was not fully linked to welfare, but stressed thatthe paper was more concerned with a longer-term relationship between crisis andgrowth. Allen also responded to Razin’s comment that he was mainly focusing on thebanking crisis, and this was a somewhat different phenomenon from other crises, suchas currency crises or twin crises, which were probably the case in Razin’s comment.
To conclude, Allen stressed that more in-depth debate was needed on the issues ofcrises, contagion, and financial fragility, as well as proper monetary policy reactions toasset prices. He also suggested that integrating macroeconomics, monetary economics,
and finance was necessary to answer these questions.

8. See Assaf Razin and Yona Rubinstein, “Growth Effects of the Exchange-Rate Regime and the Capital-AccountOpenness in a Crisis-Prone World Market: A Nuanced View,” NBER Working Paper No. 10555, National
Bureau of Economic Research, 2004.

126 MONETARY AND ECONOMIC STUDIES (SPECIAL EDITION)/DECEMBER 2004