Financial Institutions and The Wealth of Nations: Tales of Development

Abstract

Interactions between economic development and financial development are studied by looking at the roles of financial institutions in selecting R&D projects (including for both imitation and innovation). Financial development is regarded as the evolution of the financing regimes. The e?ectiveness of R&D selection mechanisms depends on the institutions and the development stages of an economy. At higher development stages a financing regime with ex post selection capacity is more e?ective for innovation. However, this regime requires more decentralized decision-making, which in turn depend on contract enforcement. A financing regime with more centralized decision-making is less a?ected by contract enforcement but has no ex post selection capacity. Depending on the legal institutions, economies in equilibrium chose regimes that lead to di?erent steady-state development levels. The financing regime of an economy also a?ects development dynamics through a ‘convergence e?ect’ and a ‘growth inertia e?ect.’ A backward economy with a financing regime with centralized decision-making may catch up rapidly when the convergence e?ect and the growth inertia e?ect are in the same direction. However, this regime leads to large development cycles at later development stages. Empirical implications are discussed.