Finance, Institutions and Economic Growth

Using data from 72 countries for the period 1978-2000, we find that financial development has larger effects on growth when the financial system is embedded within a sound institutional framework. This is particularly true for poor countries, where more finance without sound institutions is likely to fail in delivering more growth. For these countries, we find that improvements in institutions are likely to deliver much larger direct effects on growth than financial development itself. They are also likely to have positive indirect effects through the financial system, particularly when the latter is already providing large amounts of credit to the private sector. We also find that financial development is most potent in delivering extra growth in middle-income countries. Its effects are particularly large when institutional quality is high. Institutional improvements can also deliver more growth in these countries, especially when the financial system is well developed. Finally, we also find that while the effects of financial development in high-income countries are much smaller than in middle-income countries, even in these countries financial development has larger effects on growth when institutional quality is high.