The legal environment, banks, and long-run economic growth.

This paper addresses two questions. First, do cross-country differences in the legal rights of creditors, the efficiency of contract enforcement, and the origin of the legal system explain cross-country differences in the level of banking development? Second, do better-developed banks cause faster economic development; that is, is the component of banking development defined by the legal environment positively associated with long-run rates of economic growth, capital accumulation, and productivity growth?

Examining the relationship between the legal system and banking development is valuable irrespective of issues associated with long-run growth. First, banks may influence the level of income per capita and the magnitude of cyclical fluctuations (Bemanke and Gertler 1989, 1990). Second, many economists stress that understanding the evolution of legal and financial systems is essential for understanding economic development (North 1981; Engerman and Sokoloff 1996). Consequently, quantitative information on the relationship between the legal environment and banks will improve our understanding of business cycles and the process of economic development.

Furthermore, examining the causal links between banks and economic growth has both conceptual and policy implications. On the conceptual front, a long literature debates the importance of banks in economic development. Starting as early as Bagehot (1873), economists have argued that better banks--banks that are better at identifying creditworthy firms, mobilizing savings, pooling risks, and facilitating transactions--accelerate economic growth. Others, however, question the importance of the financial system in the development process or disagree with the causal interpretation as discussed in Levine (1997a). Robinson (1952), for example, argues that economic development creates demands for financial services and the financial system responds to provide these services. Evidence on whether banks cause growth will help reconcile these conflicting views. There are also potential policy implications associated with clarifying the causal relationship between banks and growth. For example, if evidence suggests that greater banking development induces faster economic growth and we can identify the legal determinants of banking development, then this supports granting a higher priority to those reforms that improve the functioning of the banking sector. Alternatively, if the component of banking development associated with legal factors is unrelated to economic development, this lowers the priority given to these legal factors in any reform package.