This paper reviews, appraises, and critiques theoretical and empirical research on the connections between the operation of the financial system and economic growth. While subject to ample qualifications and countervailing views, the preponderance of evidence suggests that both financial intermediaries and markets matter for growth and that reverse causality alone is not driving this relationship. Furthermore, theory and evidence imply that better developed financial systems ease external financing constraints facing firms, which illuminates one mechanism through which financial development influences economic growth. The paper highlights many areas needing additional research.

I discuss the concept and empirical importance of intemational technology diffusion from the point of view of recent work on endogenous technological change. In this literature, technologyis viewed as technological knowledge. I first review the maj or concepts, and how intemational technology diffusion relates to other factors affecting economic growth in open economies. The following main section of the paper provides a review of recent empirical results on (i) basic results in intemational technology diffusion; (ii) the importance of specific channels of diffusion, in particular trade and foreign direct investment; (iii) the spatial distribution of technological knowledge, and (iv) other issues.

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We introduce imperfect creditor protection in a multi-country version of Schumpeterian growth theory with technology transfer. The theory predicts that the growth rate of 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. The theory also predicts that in a country that converges to the frontier growth rate, financial development has a positive but eventually vanishing effect on steady-state per-capita GDP relative to the frontier. We present cross-country evidence supporting these two implications. In particular, we find a significant and sizeable effect of an interaction term between initial per-capita GDP (relative to the United States) and a financial intermediation measure in an otherwise standard growth regression, implying that the likelihood of converging to the U.S. growth rate increases with financial development. We also find that, as predicted by the theory, the direct effect of financial intermediation in this regression is not significantly different from zero. These findings are robust to alternative conditioning sets, estimation procedures and measures of financial development.

I document in this paper a puzzle that has not received previous attention in the literature. In 1980-98, median per capita income growth in developing countries was 0.0 percent, as compared to 2.5 percent in 1960-79. Yet I document in this paper that variables that are standard in growth regressions -- policies like financial depth and real overvaluation, and initial conditions like health, education, fertility, and infrastructure generally improved from 1960-79 to 1980-98. Developing country growth should have increased instead of decreased according to the standard growth regression determinants of growth. The stagnation seems to represent a disappointing outcome to the movement towards the "Washington Consensus" by developing countries. I speculate that worldwide factors like the increase in world interest rates, the increased debt burden of developing countries, the growth slowdown in the industrial world, and skill-biased technical change may have contributed to the developing countries' stagnation, although I am not able to establish decisive evidence for these hypotheses. I also document that many growth regressions are mis-specified in a way similar to the Jones (1995) critique that a stationary variable (growth) is being regressed on non-stationary variables like policies and initial conditions. It may be that the 1960-79 period was the unusual period for LDC growth, and the 1980-98 stagnation of poor countries represents a return to the historical pattern of divergence between rich and poor countries.

Much foreign direct investment (FDI) takes the form of mergers and acquisitions (M&A). It is commonplace in finance to view acquisitions as manifestations of the market for corporate control. Following on that insight we propose a model of FDI in which headquarters bid to control overseas assets. We derive an equation for bilateral FDI stocks that resembles the recently developed fixed effects approach to modelling bilateral trade flows. We estimate the model and use its parameters to construct benchmarks for evaluating multilateral inward and outward FDI. JEL classification: F21, F22, G34

In the problem of economic development, a phrase that crops up frequently is ‘the vicious circle of poverty.’ It is generally treated as something obvious, too obvious to be worth examining. I hope I may be forgiven if I begin by taking a look at this obvious concept. (R. Nurkse, 1953)

Standard theoretical arguments tell us that countries with relatively little capital benefit from financial integration as foreign capital flows in and speeds up the process of convergence. We show in a calibrated neoclassical model that conventionally measured welfare gains from this type of convergence appear relatively limited for the typical emerging market country. The welfare gain from switching from financial autarky to perfect capital mobility is roughly equivalent to a 1 % permanent increase in domestic consumption for the typical non-OECD country. This is negligible relative to the welfare gain from a take-off in domestic productivity of the magnitude observed in some of these countries.

This paper proposes a functional approach to designing and managing the financial systems of countries, regions, firms, households, and other entities. It is a synthesis of the neoclassical, neo-institutional, and behavioral perspectives. Neoclassical theory is an ideal driver to link science and global practice in finance because its prescriptions are robust across time and geopolitical borders. By itself, however, neoclassical theory provides little prescription or prediction of the institutional structure of financial systems — that is, the specific kinds of financial intermediaries, markets, and regulatory bodies that will or should evolve in response to underlying changes in technology, politics, demographics, and cultural norms. The neoclassical model therefore offers important, but incomplete, guidance to decision makers seeking to understand and manage the process of institutional change. In accomplishing this task, the neo-institutional and behavioral perspectives can be very useful. In this proposed synthesis of the three approaches, functional and structural finance (FSF), institutional structure is endogenous. When particular transaction costs or behavioral patterns produce large departures from the predictions of the ideal frictionless neoclassical equilibrium for a given institutional structure, new institutions tend to develop that partially

Abstract: The authors examine the relative importance of the growth of physical and human capital and the growth of total factor productivity (TFP) using newly organized data on 145 countries that span more than one hundred years for twenty-four of these countries. For all countries, only 3 percent of average output growth per worker is associated with TFP growth. This world average masks interesting variations across countries and regions. Of the nine regions, TFP growth accounts for about twenty percent of average output growth in three regions and between ten and zero percent in the other three regions. In three regions, TFP growth is negative on average. The authors use priors from theories to construct estimates of the relative importance of the variances of aggregate input growth and TFP growth for the variance of output growth across countries. Across all countries, variation in aggregate input growth per worker could account for as much as 35 percent of the variance of the growth of output per worker across countries, and variation in TFP growth could account for as much as 87 percent of that variance. Much of the importance of the variance of TFP growth appears to be associated with negative TFP growth.