Introduction

Development economists have long argued that the evolution of financial markets is an important dimension of growth. A corollary view is that financial repression in many less developed countries (LDCs) is a serious obstacle to progress. But, unfortunately, many countries have had disappointing experiences with liberalization. Freeing up financial markets at times has appeared to produce chaos rather than growth, forcing many countries to retreat from deregulation. With economic stagnation seeming to persist in many developing and transitional economies, policymakers face a dilemma: Should they cling to repressed financial markets or, instead, should they try the road to reform – in some cases, once again?

In this paper we reconsider the relation between finance and growth, and the appropriate role of government policy. We update earlier treatments of the subject by applying insights from recent theoretical literature that draws out the connection between the efficiency of financial markets and macroeconomic performance. We try to sketch informally a paradigm meant to be useful for thinking about the special problems that plague financial systems of developing countries. The overriding objective is to provide a basis for thinking about the process of financial reform. In addition, we present some macroeconomic evidence bearing on the relation between finance and growth.

Section 2.2 develops a benchmark for analysis by characterizing the role of financial markets in a setting of perfect markets. Section 2.3 provides a brief overview of the stylized facts on the relation between finance and growth.