to produce the correct incentives to reconcile choices from anonymous investors and savers, as well as from different firms operating on the two sides of the capital good market.

Thus: _In a market economy with limited information and incomplete trust, an efficient and stablefinancial system fundamentally complements the price mechanism in providing signals to reconcile the opening and closure phases of the circuit process, ensure the smooth sequence of circuit rounds, and allow the circuit process to grow steadily. With finance increasingly decentralized andfinancial decisions reflecting the objective and reaction functions of small, risk-averse, and interacting individuals, the overall stability and efficiency of the circuit process can best be achieved through incentives aimed to induce profit-seeking agents to internalize prudence and honesty within their decision plans._ Finance is therefore crucial for developing economies that have embraced, or seek to embrace, the market. Part II will argue that financial sector reforms based on incentives and incentive-compatible institutions can help achieve the maximum developmental potential of finance.

Recent research following the seminal work of King and Levine (1993) confirms that strong links exist between growth and finance and that a better developed financial sector precedes faster growth.'<sup>6</sup> Analyses show statistically significant links between both the extent to which commercial banks allocate credit and the tendency of financial systems to lend to private firms, on the one hand, and productivity growth on the other.

More credit extended to private firms likely coincides with banks performing more effectively their credit assessment, monitoring, and corporate governance functions, as well as doing a better job of providing efficient payments systems, than would be the case if governments and government-owned enterprises were the banks' main clients. Although it is possible that more developed economies lead to better financial systems, recent evidence finds that economies with deeper financial systems in 1960 saw faster growth in the following 30 years. This suggests that the effect of financial sector development on economic growth is significantY' Capital markets, too, have a positive effect on growth. Of 38 countries with the requisite stock market data, those with highly liquid equity markets in 1976 saw more rapid growth between then and 1990. And those with more liquid stock markets and more developed banking systems experienced the most rapid growth rates. This complementarity of banking and stock markets, which appears throughout most stages of development, likely arises because both debt and equity finance induce better accounting, auditing, and formation of a cadre of trained finance professionals. More important, as suggested by CTF, complementarity arises because efficient equity markets need to rely on efficient banking for the provision of liquidity, payment, and securities management services (OECD, 1993). It is only as countries reach the per capita income levels of OECD countries that further stock market development seems to induce a decline in firms' debt-equity ratios, as many of those services are progressively produced by non-bank financial institutions.

Convincing evidence of the relationship between finance and development also emerges from a look at how financial resources are allocated among firms before and after financial reforms. Schiantarelli _et. al._ (1994) found that, following financial reforms in Ecuador and Indonesia in the 1980s, there was an increased tendency for finance to be allocated to more efficient firms than before the reforms: with less intervention in credit allocation and pricing, intermediaries were more likely to allocate capital where it would be best used, thereby raising economic growth.1<sup>8</sup> 18