Finance as the Binding Constraint to Growth

Timothy Cheston (), Brad Cunningham, Ricardo Hausmann and Jorge Tapia
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Timothy Cheston: Center for International Development at Harvard University
Brad Cunningham: Center for International Development at Harvard University
Jorge Tapia: Center for International Development at Harvard University

No 249, Growth Lab Working Papers from Harvard's Growth Lab

Abstract: Finance forms a necessary input for production, one so central that it was placed atop the decision tree in the original Growth Diagnostics framework. As we argue, one of the thorniest findings from more than a decade of practice in conducting Growth Diagnostics has been that it is often more difficult to disprove a finance constraint than it is to prove one. Finance has often earned more attention than deserved when considering the many complementary inputs that must be present for production to take place and investments to be profitable. The challenge is in getting the diagnostic right, starting with the use of sound evidence to test for signals. This paper revisits the starting question of the Growth Diagnostic framework: what does it mean for finance to be a constraint to economic growth? We provide an updated, detailed decision tree for finance, including a rethink of other sources of finance constraints, such as insufficient equity, that were not fully considered in the original decision tree. Our starting point to test for the presence of a finance constraint is to recognize that every financial system suffers from asymmetric information. While information is important for almost all assets in economic transactions, in financial markets, information is the asset. The inherent nature of information asymmetries to financial markets is, in part, what makes finance a focal point for constraint analysis, as greater size and sophistication of financial systems do not make a country immune to finance constraints. We present three reasons that finance may be constrained: a) insufficient aggregate savings, due to a both inadequate domestic savings and restricted access to foreign borrowing, resulting in not enough loanable funds to finance good projects; b) inadequate institutions and tools for assessing and mitigating risk, that are unable to resolve information asymmetries, preventing markets’ access to savings; and c) problems in financial intermediation, where intermediation itself may be high-risk, monopolistic, or otherwise inefficient to result in insufficient bank lending, or may face borrowers who lack sufficient equity. The paper aims to share lessons learned in testing whether finance is constrained – or not, as well as the policy space to address a finance constraint. The policy discussion emphasizes the risk of misclassifying finance as a constraint when it is not binding on production, as the alternate response of overregulating financial markets can create new intermediation failures to the trust between savers and borrowers. Ultimately, we conclude that policy responses to a finance constraint must be as context-specific as the syndrome presented by the diagnosis, where creating functional financial markets lies in preserving the delicate balance of trust between savers and borrowers.

Keywords: Growth; Diagnostics (search for similar items in EconPapers)
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