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Are Financial Development and Corruption Control Substitutes in Promoting Growth?

Author

Listed:
  • Christian Ahlin

    () (Department of Economics, Vanderbilt University)

  • Jiaren Pang

    () (Washington University)

Abstract

While financial development and corruption control have been studied extensively, their interaction has not. We develop a simple model in which low corruption and financial development both facilitate the undertaking of productive projects, but act as substitutes in doing so. The substitutability arises because corruption raises the need for liquidity and thus makes financial improvements more potent; conversely, financial underdevelopment makes increased corruption more onerous and thus raises the gains from reducing it. We test this substitutability by predicting growth, of countries and industries, using measures of financial development, lack of corruption, and a key interaction term. Both approaches point to positive effects from improving either factor, as well as to a substitutability between them. The growth gain associated with moving from the 25th to the 75th percentile in one factor is 0.63-1.68 percentage points higher if the second factor is at the 25th percentile rather than the 75th. The results show robustness to different measures of corruption and financial development and do not appear to be driven by outliers, omitted variables, or other theories of growth and convergence.

Suggested Citation

  • Christian Ahlin & Jiaren Pang, 2006. "Are Financial Development and Corruption Control Substitutes in Promoting Growth?," Vanderbilt University Department of Economics Working Papers 0709, Vanderbilt University Department of Economics.
  • Handle: RePEc:van:wpaper:0709
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    Keywords

    Financial development; growth; complementarity; corruption;

    JEL classification:

    • O16 - Economic Development, Innovation, Technological Change, and Growth - - Economic Development - - - Financial Markets; Saving and Capital Investment; Corporate Finance and Governance
    • O17 - Economic Development, Innovation, Technological Change, and Growth - - Economic Development - - - Formal and Informal Sectors; Shadow Economy; Institutional Arrangements
    • O40 - Economic Development, Innovation, Technological Change, and Growth - - Economic Growth and Aggregate Productivity - - - General
    • O43 - Economic Development, Innovation, Technological Change, and Growth - - Economic Growth and Aggregate Productivity - - - Institutions and Growth

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