The Effect of Financial Development on Convergence: Theory and Evidence

ArticleDOI: 10.1162/qjec.2005.120.1.173

GAICIL Insights

Of all the things that could decide whether a poor country catches up, the one that survives every control is the humblest: whether lenders get repaid. The Effect of Financial Development on Convergence: Theory and Evidence, by Philippe Aghion, Peter Howitt and David Mayer-Foulkes, introduces imperfect creditor protection into a multicountry growth model and identifies financial development as a key determinant of convergence.¹

For donors and development banks launching AI-for-development programs, the sting is this: the binding constraint may be the credit system. Fund the creditor protection reforms first, and the AI adoption may finance itself.

The theory predicts that any country above a critical level of financial development converges to the growth rate of the world technology frontier, while all others have a strictly lower long-run growth rate. Above the threshold, financial development has a positive but eventually vanishing effect on steady-state GDP. The model fits the broad facts of convergence and divergence since the nineteenth century. The world splits into a club that keeps pace and a group that cannot.

The evidence supports it. A cross-country growth regression shows a significant and sizable negative coefficient on initial per-capita GDP relative to the United States interacted with financial intermediation. As predicted, the interaction coefficient is negative and highly significant, and financial intermediation's direct effect is not significantly different from zero. Finance matters through catching up, with little effect of its own.

The robustness is remarkable. Variables representing schooling, geography, health, policy, politics and institutions do not affect the significance of the interaction and show no independent effect on convergence. Findings survive removal of outliers and alternative conditioning sets, estimation procedures and measures of financial development. Many celebrated explanations of development fall silent once finance is in the regression.

The mechanism is intuitive. Catching up requires investment in innovation and technology adoption. Where creditor protection is weak, firms struggle to finance that investment. Financial development relaxes the constraints, letting countries adopt frontier technologies and converge. Below the threshold, financial constraints block convergence.

AI is pushing the frontier forward, and countries' ability to keep pace depends on their capacity to finance AI adoption and development. Financial development may decide whether countries converge toward AI leaders or fall further behind. The global AI divide may run along the fault lines of creditor protection.

The threshold is the critical feature. Countries above it may adopt AI and keep growing at the frontier rate. Countries below it may see persistently lower growth. Strengthening creditor protection and financial institutions could help them cross. A threshold means reform can produce a discontinuous payoff.

Finance's centrality stands out. Education, institutions and policy matter in many ways, yet the paper suggests financial development plays a distinctive role in convergence. For developing countries seeking AI's benefits, financial reform deserves priority. A credible bankruptcy code may be among the strongest supports for AI adoption.

International policy has a role. Supporting financial development in lower-income countries through institutional reform and capacity building could help them join AI-driven global growth. Without it, frontier progress could widen gaps between countries. Development aid for AI might best be spent on courts and credit registries.

History adds weight. Consistency with convergence and divergence patterns since the nineteenth century suggests the finance-convergence link is a durable feature of development. Each wave of technological progress, AI included, interacts with financial development to shape who catches up.

Translated into policy, financial development, especially creditor protection, lets countries finance the investments needed to converge toward the frontier. As AI accelerates frontier progress, financial reform becomes essential to ensuring more countries share the gains.

At bottom, financial development determines whether countries converge to the frontier growth rate. Above a critical threshold they converge; below it they grow more slowly. As AI pushes the frontier forward, the ability to finance adoption and innovation will shape which countries keep pace, making financial development a foundation of inclusive global growth.

Introduction

We introduce imperfect creditor protection in a multicountry Schumpeterian growth model. The theory predicts that any country with more than some critical level of financial development will converge to the growth rate of the world technology frontier, and that all other countries will have a strictly lower long-run growth rate. We present evidence supporting these and other implications, in the form of a cross-country growth regression with a significant and sizable negative coefficient on initial per-capita GDP (relative to the United States) interacted with financial intermediation. In addition, we find that other variables representing schooling, geography, health, policy, politics, and institutions do not affect the significance of the interaction between financial intermediation and initial per capita GDP, and do not show any independent effect on convergence in the regressions. Our findings are robust to removal of outliers and to alternative conditioning sets, estimation procedures, and measures of financial development.

Takeaway

The paper has developed and tested a Schumpeterian model of cross country convergence with financial constraints. The model is consistent with the broad facts of convergence and divergence since the 19th Century. It implies that all countries above some critical level of financial development should converge in growth rates, and that in such countries financial development has a positive but eventually vanishing effect on steady-state GDP. These implications were tested by estimating a cross-country growth regression with an interaction term between financial intermediation and the country’s initial relative output. As predicted, the coefficient of this term is negative and highly significant, and the direct effect of financial intermediation is not significantly different from zero.¹

When we re-estimated the coefficients in Tables 8 and 9 using the GMM procedure indicated in footnote 26 above the direct effect of finance became statistically significant in 5 of the regressions with institutional variables, and the interaction terms with three alternative institutional variables became statistically significant at the 10 percent level, but never at the 1 percent level. However, the main implication of the theory continued to be supported by the results: specifically, the crucial interaction coefficient β f y remained negative at the 1 percent significance level in all cases except again that of settler mortality.

Why some countries fail to converge in growth rates despite the possibility of technology transfer has been a puzzle. In combination with the theoretical results of Howitt (2000), Acemoglu, Aghion and Zilibotti (2002) and Howitt and Mayer-Foulkes (2002) our theoretical results show that Schumpeterian growth theory provides a framework for analyzing a variety of forces that contribute to nonconvergence.²^,³ Our empirical results suggest that financial development is among the most powerful of these forces, especially considering that educational attainment, initial relative output and a large number of other candidate variables do not have an analogous effect when included in the same regression with financial intermediation. A further test of the theory would be to examine the sectoral composition of innovation across countries with different levels of financial development. Financial development should be especially favorable to innovation in R&D-intensive sectors, where technology transfer requires much external finance. In future work we plan to test for industry-specific effects of financial development much the same way that Rajan and Zingales (1998) did, except using R&D intensity rather than their more general measure of dependency on external finance.⁴

Our results suggest that a country might escape divergence by using FDI as a substitute for lending to local entrepreneurs. However, the results of Alfaro et al. (2003) suggest that FDI and local finance are complements.⁵ Specifically, they find that FDI has a significant effect on growth only when interacted with finance. This is consistent with the view that FDI results in technology transfer only when complemented by the local entrepreneurial investments at the heart of our theory, which investments are impeded by lack of financial development.

Article

Notes

Philippe Aghion, Peter Howitt & David Mayer-Foulkes, The Effect of Financial Development on Convergence: Theory and Evidence, 120 Q.J. Econ. 173 (2005), https://doi.org/10.1162/qjec.2005.120.1.173. Takeaway source: Conclusion, reproduced from a free author or repository copy (working-paper version). ↩
Howitt, Peter. “Endogenous Growth and Cross-Country Income Differences.” American Economic Review 90 (September 2000): 829-46.. ↩
Howitt, Peter, and David Mayer-Foulkes. “R&D, Implementation and Stagnation: A Schumpeterian Theory of Convergence Clubs.” NBER Working Paper 9104, August 2002.. ↩
Rajan, Raghuram G., and Luigi Zingales. “Financial Dependence and Growth.” American Economic Review 88 (June 1998): 559-86.. ↩
Alfaro, Laura, Areendam Chanda, Sebnem Kalemli-Ozcan, and Selin Sayek. "FDI and Economic Growth: The Role of Local Financial Markets.” Journal of International Economics (forthcoming 2003).. ↩

Cite as: Philippe Aghion, Peter Howitt & David Mayer-Foulkes, The Effect of Financial Development on Convergence: Theory and Evidence, 120 Q.J. Econ. 173 (2005), https://doi.org/10.1162/qjec.2005.120.1.173

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