Referee report 1 NAKE Martijn Boermans, January 5, 2010
Dear editor, Hereby I send you my recommendation for the paper “Financial Markets and Growth” received on September 21, 2010. The author(s) can bring some “Minor Revisions” mainly related to the focus of the paper. I will clarify my opinion hereafter. --The research tries to set out how financial development may foster economic growth using an endogenous growth model in a very concise manner. The presumption that financial development causes growth is addressed by reviewing some analytical foundations highlighted in a straightforward AK-model. As the study explains (p.613) “this provides the theoretical underpinnings that early contributors lacked: financial intermediation can be shown to have not only level effects, but also growth effects.” The study seems to hold a broad view of financial development and implicitly applies a definition of financial markets that includes both the financial structure as well as the financial intermediaries. This point may be noted in the paper. This distinction between financial structure (role of banks, market power?) and financial intermediation (which affects the flow of savings?) is not always clear, see the conclusion (“too generic a term”, p.621). In order to abstract for this issue the general impact that financial markets have on growth is modelled as follows. It is assumed that a proportion (1- φ) of the flow of savings is lost in the process of financial intermediation [e.g. costs of acquiring information, contract enforcement, see 2.1] which in this endogenous setting (where savings equal investment) immediately affects the growth rate:
g As However, financial development does not only foster growth by raising φ. The author(s) argue that is may also increase A, the social marginal productivity of capital, and it can influence s, the private saving rate. The former aspects refers to the improved allocation of capital under financial development (p.615). The latter aspect, namely the saving rate and therefore growth is ambiguously afflicted by financial development. It is mentioned (pp.616-617) that as capital markets develop, households gain risk haring facilities, credit becomes more readily available and interest rates margins decline. However, overall it seems the study argues that the effect is negative instead of ambiguous. The authors(s) argue that (p.617) “a well-known result is that consumers will save less if their utility function has a positive third derivative” such that insurance reduces precautionary saving and lowers the growth rate. They do refer to studies where it is assumed that the risk aversion is not in that area, hence, the reverse may happen. Yet the author(s) seem to favour a negative effect. This section of the paper may be clarified in more detail and may include how heterogeneity in risk preferences may affect the findings.
Next, household borrowing may increase because liquidity constraints become less severe, and hence, saving, and the growth rate, again decrease. Finally, the author(s) may clarify in more detail the interest rate effects. Better financial markets “should raise saving and growth” but is not explained to what mechanism is referred. Related to this point, the study does not explain the effect of financial market deepening on the proportion of saving in a developing country context. Arguably, in these regions people who save rely on informal savings, which is inefficient, and hence, they are likely to save a higher proportion of income as a result of financial market development. Savers cannot store money at the bank, and as banking facilities develop, they will be more inclined to save. It is suggested that the study explore the relationship of the propensity to save not only with the interest rate, but the author(s) may want to address a context specific effect of financial development on the savings rate, where one could argue that in the early stages of development the effect on the proportion of saving, and hence, the growth rate, is positive, while it later may become negative (as already postulated), depending on risk aversion assumptions. A more serious issue is the lack of discussion about investment. There have been many studies focusing on the role of financial market development on the propensity to invest. The author(s) assume that saving equals investment (e.g. equation 3) and hence it is remarkable that investment are not covered elsewhere. It may be the case that financial development will increase investment, and therefore the savings channel must also have a growth rate enhancing effect, thus making the prior analysis less relevant. There are some other issues not addressed in the paper. First, there can be spillovers of financial development on other key growth enhancement variables such as political stability and rule of law (institutions). As such, the study shows a downward bias on the true impact of financial market deepening. Related to this point, with financial market development firms may be able to acquire more capital and increase their productivity. In abstract form, these factors are included in A, the marginal productivity of capital, and if so, then a more detailed discussion of what the author(s) note as “improved allocation of capital under financial development” (p.615) requires some extension. Most of the effects discussed occurs not instantaneously, but because the focus is on steady-state growth rates time indices are dropped. However, from a policy perspective the time dynamics are highly relevant. As such, the author(s) may want to add how quickly financial development affects the various proposed saving channels. Also, in an international context a certain threshold of financial development may exist to facility savings and investment from abroad. As such, financial development may spur the growth rate beyond what is suggested by the model. Related to the investment point, foreign direct investment may raise the growth rate further, and as such this part can easily be covered in the proposed model, showing the effect on A and s. A more fundamental point that haunts all studies in this area is reversed causality. Joan Robinson said that “where enterprises lead, finance follows” suggesting endogeneity concerns. If growth causes financial development, the proposed changes in A and s may have already occurred before financial markets developed. They do mention Greenwood and Jovanovic (1990) and Saint-Paul (1992) as those who “are among the few models in which growth and financial development are jointly determined.” (p.619), but they do not discuss the consequences of this on the prior model. One may suggest to shorten section three on “what determines financial development” as the research question and the model only focus on the consequences of financial market development. This part distracts from the core model and hence may be shortened and be located in the concluding remarks.
Finally, the author(s) build on King and Levine (1992) who show - as is pointed out on p.621 - that the empirical work “neglects one of the lessons of the theoretical literature, namely that the effect of financial development can vary depending on the specific market where it occurs.� What the study is referring to is unclear, so an explanation of this part is suggested. Also, the paper provides a brief discussion of various empirical work. This is very informative and explains how the model relates to the empirics. On the one hand, one may suggest to shorten this part to highlight the theoretical nature of the paper, or, at the other extreme, ask the author(s) to empirically test the channels of the model themselves. In conclusion, the paper aims to model how financial development affects the growth rate. This is a useful project because there are various channels at play that before were not included in a single model. The author(s) generally succeed in presenting an original and concise theoretical foundations for how growth rates change as the saving rate, fraction of saving channelled to investment and the marginal productivity of investment are altered. It is well-written and most of analysis is supplemented with good argumentation As argued above, there are some shortcomings and some clarifications of certain statements can be provided, which overall result in some minor revisions of the paper.