Financial Development and Economic Growth - The Role of Stock Markets

Financial Development and Economic Growth: The Role of Stock Markets
Author(s): Philip Arestis, Panicos O. Demetriades and Kul B. Luintel

Source: Journal of Money, Credit and Banking , Feb., 2001, Vol. 33, No. 1 (Feb., 2001),
pp. 16-41
Published by: Ohio State University Press
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PHILIP ARESTIS
PANICOS O. DEMETRIADES
KUL B. LUINTEL
Financial Development and Economic Growth:
The Role of Stock Markets
Utilizing time series methods and data from five developed

economies, we examine the relationship between stock market de-
velopment and economic growth, controlling for the effects of the
banking system and stock market volatility. Our results support the
view that, although both banks and stock markets may be able to
promote economic growth, the effects of the former are more pow-
erful. They also suggest that the contribution of stock markets on
economic growth may have been exaggerated by studies that utilize
cross-country growth regressions.
THE GROWING IMPORTANCE of stock markets arourld the

world has recently opened a new avenue of research into the relationship between fi-
nancial development and economic growth, which focuses on the effects of stock
market developmerlt.l In this context, various stock market development irldicators
have been found to explain part of the variation of growth rates across countries, in
some cases over arld above the effects of the banking system (Atje and Jovanovic
1993; Levine and Zervos 1998). Since these results have been obtained from cross-
country growth regressions, tlley can at best provide only a broad-brush picture of
the relationship between stock markets and growth, the details of which may reason-
ably be expected to vary considerably across countries, depending on institutional
characteristics and circumstances. Furthermore, given the widespread skepticism
concerning the robustness of econometric results derived from cross-country growth
regressions, these results must be viewed with some caution (Levine and Renelt
The authors are grateful to two anonymous referees for constructive comments. They also thank the
participants of the 1997 Development Economics Study Group annual conference (University of Birm-
ingham) and the 1999 Royal Economic Society (RES) annual conference (University of Nottingham) for
useful comments. They acknowledge financial support from the ESRC (Grant No. R000236463).
1. World stock market capitalization grew from $2 trillion in 1982 to $4.7 trillion in 1986, $10 trillion
in 1993 and $15.2 trillion in 1996, implying an average annual growth rate of 15 percent; emerging mar-
ket capitalization grew from less than 4 to 13 percent of total world capitalization (Demirgu-Kunt and
Levine 1996; Singh 1997).
PHILIP ARESTIS is a professor of economics at South Bank University, London. E-mail:

p.arestis@sbu.ac.uk PANICOS 0. DEMETRIADES is a professor of economics at Leicester Uni-
versity. KUL B. LUINTEL is a reader in economics at Brunel University.
Journal of Money, Credit, and Banking, Vol. 33, No. 1 (February 2001)
Copyright 2001 by The Ohio State University

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PHILIP ARESTIS, PANICOS O. DEMETRIADES, AND KUL B. LUINTEL : 17
1992; Arestis and Demetriades 1997; Luintel and Khan 1999).2 In the specific con-
text of the cross-country relationship between stock market development arld
growth, for example, the presence of endogeneity has been shown to considerably
weaken the estimated effect of stock market indicators (Harris 1997). There are,
therefore, important econometric advantages in examining the role of stock markets
irl the relationship between financial developmerlt and growth using time series
methods. Besides being better able to address issues of causality and endogeneity,
they are also less likely to suffer from other limitations of cross-country growth re-
gressiorls.3 Even setting aside econometric issues, time series methods can provide
useful insights irlto differences of this relationship across countries arld may illumi-
nate important details that are hidden in averaged-out results.
This paper utilizes time series methods to reexamine the relationship between eco-
nomic growth and stock market development, while controlling for the effects of the
commercial banking sector and stock market volatility. Inevitably, a time series
analysis has its own limitations. Specifically, the need to obtain a long time series of
stock market development indicators narrows down the focus of the empirical analy-
sis to five developed economies, namely, Germany, the United States, Japan, the
United Kingdom, and France. While the absence of less-developed economies from
our sample means that no direct inferences can be made about the contribution of
stock markets at early stages of economic development, our findings nevertheless
have implications for the debate on bank-based versus capital-market-based finan-
cial systems (see, for example, Rajan and Zingales 1995 and 1996; Horiuchi and
Okazaki 1994; Edwards and Fischer 1994; Corbett and Jenkinson 1994). Thus, our
results could be indirectly valuable for less-developed economies, in that they may
irlform policy decisions relating to the adoption or otherwise of specific types of fi-
nancial system.
The rest of the paper is structured as follows. In sectiorl 1 we provide a discussion
of the role of stock markets and banks in the process of economic growth and sum-
marise the existing empirical literature. In section 2 we outline our data and econo-
metric methodology. In section 3 we present our findings and discuss their
implications for the debate on financial systems. Finally in section 4 we provide a
summary and some concluding remarks.
1. STOCK MARKETS, BANKS, AND ECONOMIC GROWTH
Positive EMfects of Stock Markets
Recent theoretical contributions suggest that stock markets may promote long-run
growth. Stock markets encourage specialization as well as acquisition and dissemi-
2. Quah (1993) emphasizes the nonexistence of balanced growth paths, Caselli, Esquivel, and Lefort
(1996) and Levine and Renelt (1992) focus on omitted variable bias or misspecification, Evans (1995) and
Pesaran and Smith (1995) dwell on the heterogeneity of slope coefficients across countries, while prob-
lems of causality and endogeneity are explored by Demetriades and Hussein (1996) and Harris (1997).
3. The view that time series studies of economic growth offer important advantages over cross-coun-
try growth regressions is gaining acceptance. See, for example, Jones (1995), Evans (1997), Kocherlakota
andYi (1997), and Klenow and Rodriguez-Clare (1997).

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18 : MONEY, CREDIT, AND BANKING
nation of information (Diamond 1984; Greenwood and Jovanovic 1990; Williamson

1986) and may reduce the cost of mobilizing savings, thereby facilitating investment
(Greenwood and Smith 1997). Well-developed stock markets may enhance corporate
control by mitigating the principal-agent problem through aligning the interests of
managers and owners, in which case managers would strive to maximize firm value
(Diamond and Verrecchia 1982; Jensen and Murphy 1990).
Stock Market Liquidity
Levine (1991) and Bencivenga, Smith, and Starr (1996) suggest that stock markets
make financial assets traded in them less risky because they allow savers to buy and
sell quickly and cheaply when they wish to alter their portfolios. Companies at the
same time enjoy easy access to capital through equity issues. Less-risky assets and
easy access to capital markets improve the allocation of capital, an important chan-
nel of economic growth. More savings and investment thereby may also ensue, fur-
ther enhancing long-term economic growth. It is conceded, though, that increased
liquidity can also influence growth negatively (see, for example, Levine 1997). There
are three channels through which this may take place (Demirguoc-Kunt and Levine
1996). The first is that greater stock market liquidity, by increasing the returns to in-
vestment, may reduce savings rates. The second is that, given the ambiguous effect
of uncertainty on savings, greater stock market liquidity might in fact reduce savings
rates through its negative impact on uncertainty since less uncertainty may decrease
the demand for precautionary savings. The third channel operates through the eu-
phoria and myopia that may be encouraged by highly liquid stock markets. Dissatis-
fied participants find it easy to sell quickly which can lead to disincentives to exert
corporate control, thus affecting adversely corporate governance and hurting eco-
nomic growth in the process (see, however, Jensen and Murphy 1990).
The Role of Volatility
Another important characteristic of stock markets is that of price volatility, as this

may undermine the ability of stock markets to promote an efficient allocation of in-
vestment. The undesirable side effects of volatility were recognized early on in the
literature, notably by Keynes (1936), who was particularly sharp-tongued:
As the organisation of investment markets improves, the risk of the predominance of

speculation does . . . increase . . . Speculators may do no harm as bubbles on a steady
stream of enterprise . . . a serious situation can develop . . . when enterprise becomes the
bubble on a whirlpool of speculation. When the capital development of a country be-
comes a by-product of the activities of a casino, the job is likely to be ill-done.... It is
usually agreed that casinos should, in the public interest, be inaccessible and expensive.
And perhaps the same is true of Stock Exchanges. (pp. 158-59)
More recent literature is less conclusive on this issue. While a certain degree of price
volatility in the stock market is clearly desirable, since it may reflect the effects of
new information flows in an efficient stock market, some evidence suggests that the
observed levels of volatility may be "excessive." This may reflect independence of
stock-market-asset values from underlying fundamentals (Shiller 1981 and 1989),

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even though the debate on the presence of excess volatility in stock returns is far
from settled. If present, excessive volatility is likely to result in an inefficient alloca-
tion of resources, upward pressures on interest rates in view of the higher uncer-
tainty, hampering both the volume and the productivity of investment and, therefore,
reducing growth (Federer 1993; DeLong et al. 1989). Furthermore, excessive stock
trading may very well induce "noise" into the market to the detriment of efficient re-
source allocation (DeLong et al. 1989).
BANKS
The relationship between stock markets and growth may also be influenced by the
link between stock markets and financial intermediaries, which is not unambiguous.
Stock markets and banks are clearly substitute sources for corporate finance since
when a firm issues new equity its borrowing needs from the banking system decline.
Assuming that banks and financial intermediaries are in a better position than stock
markets to address agency problems (for example, Diamond 1984; Stiglitz 1985), it
is then possible that stock market development may hamper economic growth if it
happens at the expense of banking system development.
Similar views are expressed by the literature on capital-market-based financial
systems that predicts a very weak relationship between stock markets and growth
since corporate investment is not financed through issues of equity (Mayer 1988;
see, also, Fry 1997). Corbett and Jenkinson (1994) when discussing the contribution
of stock market to corporate investment financing, suggest that it was negative in the
United Kingdom and only small positive overall in the United States during the
1970s and 1980s. Akyuz (1993) and Singh (1997) argue that unfavorable economic
shocks produce macroeconomic instability through the interactions between stock
markets and foreign exchange markets, which affect economic growth adversely.
On the other hand, at the aggregate level increased stock market capitalization
may be accompanied by an increase in the volume of bank business, if not an in-
crease in new lending, as financial intermediaries may provide complementary ser-
vices to issuers of new equity such as underwriting. Thus, it is likely that at the
aggregate level the development of the stock market goes hand in hand with the de-
velopment of the banking system.
Empirical Evidence
Existing evidence points to stock market development taking place in tandem with
other aspects of financial development. Using data for forty-four industrial and de-
veloping countries for the period 1986-1993, Demirguoc-Kunt and Levine (1996)
conclude that countries with well-developed stock markets also have well-developed
banks and nonbank financial intermediaries, while countries with weak stock mar-
kets tend to have weak banks and financial intermediaries. Demirguoc-Kunt and Mak-
simovic (1996), in their investigation of the effect of stock market development on
firms' financing choices in thirty industrial and developing economies from 1980 to

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1991, find that initial improvements in the functioning of a developin

produce higher debt/equity ratios for large firms, with small firms n
cantly affected. In already developed stock markets, further development leads to
substitution of equity for debt financing, especially for long-term debt. Boyd and
Smith (1996) argue that as an economy develops the ratio of debt to equity tends to
increase, with the two sources of finance being complementary.
Levine and Zervos (1998), utilizing cross-country regressions for a number of
countries covering the period 1976-1993, demonstrate that various measures of eq-
uity market activity are positively correlated with measures of real activity and that
the association is particularly strong for developing countries. Conditioning on a
number of variables, including indicators of banking development, they conclude
that stock markets provide different financial services from banks. They argue that
stock markets may enhance growth through liquidity, which makes investment less
risky, thereby enabling companies to enjoy permanent access to capital through liq-
uid equity issues. Atje and Jovanovic (1993), using a similar approach, also find a
significant correlation between economic growth and the value of stock market trad-
ing relative to GDP for forty countries over the period 1980-88. However, Harris
(1997) shows that this relationship is at best weak. Reestimating the same model for
forty-nine countries over the period 1980-91, but using current investment rather
than lagged, and utilizing two-stage least squares, he demonstrates that in the case of
the full sample (which includes both developed and developing countries), and of the
subsample of developing countries, the stock market variable does not offer much in-
cremental explanatory power. In the subsample of developed countries, although the
level of stock market activity has some explanatory power, its statistical significance
is weak.
The volatility characteristic of stock markets has been investigated from the point
of view of its relationship to the size of stock markets and capital control liberaliza-
tion. Demirguoc-Kunt and Levine (1996) find that in a sample of forty-four developed
and emerging markets from 1986 to 1993, large markets tend to be less volatile.
Also, that internationally integrated markets tend to be less volatile. Levine and Zer-
vos (1995) explore the effect of liberalizing capital controls in sixteen countries
which reduced substantially barriers to international capital and dividend flows in
the 1980s. They conclude that stock market volatility increases significantly imme-
diately following capital control liberalization in approximately half of the countries
considered and does not decrease significantly in any of them. This result may be
combined with that of Demirguoc-Kunt and Levine (1996) to suggest that, in the long
run, stock return volatility is lower in countries with more open capital markets.
However, more recently Levine and Zervos (1998) have examined volatility in a re-
lationship that concentrates on stock market liquidity and economic performance.
They conclude that in a cross-section approach, this link is not statistically robust
(and it is unexpectedly positive in most cases). We investigate this link further in this
paper and are able to improve substantially on this result and show that the link be-
tween volatility and growth is significantly strong and negative in our time series
analysis as shown below.

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2. DATA AND ECONOMETRIC METHODOLOGY
We are motivated by two primary objectives: First, to explore the long-run rela-
tionship between stock market volatility, stock market development, banking system
development and the level of output. In so doing, the magnitude of the estimated
long-run output elasticities with respect to the measures of banking system develop-
ment and the stock market development is likely to shed light on the relative impor-
tance of the two components of the financial system for output growth. Second, to
investigate the causal flows in this relationship, that is, between output and banking
system development on one hand and output and stock market development on the
other.
Data and Measurement
We employ quarterly data on output and indicators of banking system develop-

ment, stock market development and stock market volatility for Germany during
1973:1-1997:4, the United States for 1972:2-1998:1, Japan for 1974:2-1998:1, the
United Kingdom for 1968:2-1997:4, and France for 1974:1-1998:1.40ur variables
are measured as follows. Output is measured by the logarithm of real GDP (LY);
stock market development by the logarithm of the stock market capitalization ratio
(LMC), defined as the ratio of stock market value to GDP; banking system develop-
ment by the logarithm of the ratio of domestic bank credit to nominal GDP (LBY);
stock market volatility (SMV) is measured by an eight-quarter moving standard de-
viation of the end-of-quarter change of stock market prices.5
There are, of course, other possible indicators of financial development. As far as
banking sector development is concerned a deposit-based measure could also be
used. Earlier work by Arestis and Demetriades (1996), however, suggests that in the
case of developed economies credit-based indicators are more likely to exhibit a sta-
ble long-run relationship with output than deposit-based ones. As far as stock market
development is concerned, cross-section studies have found liquidity-based mea-
sures, such as the ratio of the value of traded shares to GDP, to be more closely
linked with economic growth than market capitalization indicators. Nevertheless, in
a time series context the capitalization indicator has a number of advantages over
transaction-based measures. Firstly, it is a stock variable rather than a flow variable
that makes comparison with the bank development-based indicator, which is also a
stock, more meaningful. Secondly, primarily for the same reason it is more likely to
have time series properties that make it suitable for cointegration analysis. Further-
more, the discussion of section 1 suggests that there are also conceptual reasons as to
why stock market capitalization may be more closely linked to economic growth
than transactions-based measures. Despite this we test the sensitivity of our results
4. All data series were extracted from the online information service Datastream International. Stock
market variables are end-of-quarter price indices and market values.
5. We first calculated the logarithmic first differences of the end-of-quarter stock market price index.
We then computed a moving eight-quarter standard deviation as a measure of stock market volatility.

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using alternative measures of stock market development; however, this is only possi-
ble for the United Kingdom and the United States since data on these variables are
not available for the other countries in our sample for a sufficiently long period.
Methods
We carry out our empirical investigation in a vector autoregression (VAR) frame-

work. Recent literature (for example, Gonzalo 1994; Hargreaves 1994; Haug 1996)
suggests that for sample sizes of around one hundred data points, the maximum like-
lihood approach of Johansen (1988) performs in general better than a range of other
estimators of long-run relationships (cointegrating vectors). Further, Toda and
Phillips (1993), Hall and Wickens (1993), and Hall and Milne (1994) show it to be
an efficient method of testing causality. We therefore follow this method to identify
the number of cointegrating vectors amongst the variables specified in the VAR and
then examine the direction of causality.
The Johansen (1988) method is based on a vector error correction (VECM) repre-
sentation of a VAR(p) model which can be written as
aXt = rlaxt l + r2aXt 2 + .............. + rp laXt p+l + rIXt-p + vDt + Ut (1)
where x is an nxl vector of the first order integrated [that is, I(1)] variables,
rl,r2,...,rp are nxn matrices of unknown parameters, D is a set of I(0) determimistic
variables such as constant, trend, and dummies, and u is a vector of normally and in-
dependently distributed errors with zero mean and constant variance. The steady-
state (equilibrium) properties of equation (1) are characterized by the rank of [I, a
square matrix of size n. In our case n = 4. The existence of a cointegrating vector im-
plies that [I is rank deficient. Johansen (1988) derives the maximal eigenvalue and
trace statistic for testing the rank of [I. Appropriate critical values are tabulated in
Osterwald-Lenum (1992). If [I is of rank r (0<r<n) then it can be decomposed into
two matrices ot (nxr) and ,3 (nxr)such that
[I = ot,X' . (2)
The rows of ,3 are interpreted as the distinct cointegrating vectors whereby ,A'x form
stationary processes. The ots are the error correction coefficients that indicate the
speeds of adjustment toward equilibrium. Substituting (2) into (1) we get
AXt = rlAxt_l + r2AXt_2 + .- - - + rp_lAxt_p+l + ot(l3'Xt-p) + VDt + Ut (3)
This is a basic specification for the test of long-run causality. A test of zero restric-
tions on the ots is a test of weak exogeneity when the parameters of interest are long
run (Johansen and Juselius 1992). Hall and Wickens (1993) and Hall and Milne
(1994) interpret weak exogeneity in a cointegrated system as a notion of long-run
causality. We employ weak exogeneity tests to examine the issue of long-run causal-

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ity between the variables in the system. The null of ot=O can be tested by the stan-
dard likelihood ratio test.
A number of issues are important in the estimation and interpretation of cointe-
grating vectors. First, in view of the various (financial) policy changes that have
taken place during the sample period, it is plausible to allow for the possibility of
structural break in the cointegrating relationships. We address this issue directly by
testing the null of parameter and rank constancy in the cointegrating relationships
following Quintos (1995) and Hansen and Johansen (1993, 1998). The hypothesis of
interest here is that [I and the rank of [I, p(TI), or the number of cointegrating rela-
tionships remains stable overtime. The null of parameter and rank constancy can be
stated as
Ho p(H) = r, or p(H) = p(H) for all t . (4)
The alternative hypothesis that allows for both the parameters and number of cointe-
grating ranks to change is
Ha: p(TI) + p(TI), for all or some of the t . (5)
Quintos (1995, p. 412) provides a likelihood ratio (LR) statistic which tests the null
of no structural break under a single break date. Implementation of Quintos's test re-
quires splitting the sample at the break date; estimating separate models for the pre-
and postbreak dates; and testing whether subsample eigenvalues are sigrlificantly
different from those of the full sample. In view of the fairly small sample we have we
do not follow this approach. Instead, we implement the rank stability tests in a recur-
sive framework as suggested by Hansen and Johansen (1993, 1998).6 The relevant
LR test can be shown as
q q,
LR=TE ln(1-Xi)-TjE (1-Xli)

i=l i=l
where X and Bl are the full and resursive sample estimates of the eigenvalues of ma-
trix 1I; subscript j indicates the starting date of recursion such that Tj = T1 + 1,
Tl + 2,...,T. Thus, our approach essentially involves estimating the cointegrating
vector(s) using full sample and then testing whether the full sample results (that is,
cointegrating parameters and ranks) remain stable when the model is estimated over
the recursive subsample. The recursive LR test is X2(2) distributed.
Second, it is shown that cointegrating relationships are sensitive to the treatment
of deterministic terms in the cointegrating space (Baillie and Bollerslev 1994;
Diebold, Gardeazabal, and Yilmaz 1994). To resolve this, Johansen (1992) suggests
6. It should be noted that Quintos's test is based on Hansen and Johansen (1993). One of the advan-
tages of recursive tests of structural break is that we do not require to identify break date endogenously
which is important in view of our sample size.

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identifying appropriate deterministic terms in the cointegrating space through rank

tests following the so-called Pantula principle. Crowder and Hoffman (1996) and
Luintel and Paudyal (1998), among others, implement cointegration tests along these
lines and we follow this approach. Third, it is well known that the results are sensi-
tive to lag length selection in the VAR. Generally lag lengths are specified following
some information criteria (for example, Akaike 1973; Schwarz 1978). However, Hall
(1989) and Johansen (1992) suggest that the lag length should be specified such that
the VAR residuals are empirically Gaussian. Cheung and Lai (1993) show that the
lag length selection based on information criteria may not be adequate when errors
contain moving average terms. We specify lag lengths as the minimum length for
which there is no significant autocorrelation in the estimated VAR residuals.
Finally, the identification and interpretation of the cointegrating vectors, ,X, as
long-run economic relationships is another pertinent issue. Given r cointegrating
vectors, Johansen (1991) suggests identification through the test of r2just-identiJ9ing
restrictions. Pesaran and Shin (1994), however, show that Johansen's identification
scheme is deficient in that the maximized log-likelihood values associated with any
set of just-identifying restrictions would be identical, which makes it impossible to
distinguish between the competing set of restrictions. Instead, they suggest identifi-
cation of long-run economic relationship through the tests of over-identifying re-
strictions. This requires testing for r2+k (where k ' 1) restrictions in a cointegrating
space spanned by r stationary relationships which gives k over-identifying restric-
tions. It should be noted that when a unique cointegrating vector is found then the
problem of interpretation does not arise, and one may simply test for just identifying
restrictions in the form of a normalization restriction.
3. EMPIRICAL RESULTS AND ANALYSIS
We begin by carrying out unit root tests which suggest that the all variables are
I(1).7We then perform cointegration analysis for each of the five countries, the re-
sults of which are reported in Tables 1-5. In order to allow for any deterministic sea-
sonality, centered quarterly dummies are included in unrestricted form throughout
the estimation. Part (a) of each table contains the results from recursive estimation.
In view of the sample size, the starting year for the recursive estimation is chosen as
1990(4) for all countries except for the United Kingdom, in which case because of
the longer sample we begin recursive estimation at 1987(4). The last column of each
table reports the LR tests under the null that the full sample cointegrating rank is sta-
ble over the recursive subsample. The rejection of the null indicates structural breaks
in the cointegrating rank that forms the basis for the introduction of appropriate shift
dummies.
Once the structural break is identified, we then reestimate the cointegration rank
7. Unit root tests for all variables (which are not reported here) can be obtained from the authors upon
request.

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for the full sample by allowing for structural shifts through shift dummies.8 Since
trace statistics and maximal eigenvalue statistics provide qualitatively similar results,
only the former are reported for the sake of brevity. In the event of multiple cointe-
grating vectors, identification of each vector to an economically interpretable rela-
tionship is achieved through tests of over-identifying restrictions (see Pesaran and
Shin 1994). Each vector is normalized on the variable for which we could find evi-
dence of error correction (that is, negative and significant loading factors, ot). These
results are reported in part (b) of each table. Finally in part (c) we report the results
of weak exogeneity tests, which are expected to shed light on the patterns of long-
run causality in each system.
The results on Germany, reported in Table 1, show evidence of a break in the coin-
tegrating rank during 1991-92, which coincides with the period of the German re-
unification. Once this structural break is taken into account through the introduction
of an intercept dummy for the period of 1991(1)-1992(4) in the cointegrating space,
we continue to find evidence of a single cointegrating vector. Tests of normality and
serial correlation suggest that the VAR residuals are empirically Gaussian.9
The cointegrating vector is normalized on output, given the correctly signed and
strongly significant error correction term (ot). The cointegrating vector for this coun-
try shows a positive relationship between the level of real GDP and banking system
development, as well as a positive stock market capitalization effect. It also shows
that stock market volatility, a variable treated weakly exogenous to the system, has a
positive but insignificant effect.l° Banking system development is endogeneous to
the output vector whereas stock market capitalization is not. Hence, in Germany,
there is bidirectional causality between banking system development and the level of
output while stock market capitalization is weakly exogeneous to the output vector
in the long run. Stock market capitalization, however, affects GDP through the posi-
tive and significant cointegrating parameter. The coefficients on LBY and LMC are
significant at the 1 percent level, with the former being more than three times larger
than the latter. These results are clearly not surprising given the close relationship of
the banking system with industry in Germany and the relatively minor role played by
the stock market there (see, for example, Arestis and Demetriades 1996).
In the case of the United States (see Table 2) the picture is rather different in view
of the endogeneity of stock market capitalization and the weak exogeneity of real
GDP, once the structural shift in 1990:1-1994:4 is accounted for. This period coin-
cides with a downturn in the U.S. economy, a substantial fall in bond market yields
and a serious number of defaults of "junk" bonds. There is only one cointegrating
vector for this country, which is normalized on LMC. According to this vector, LMC
8. We tested for both slope and intercept dummies but the former were insignificant in all cases.
9. In all cases recursive estimation is conducted without the introduction of any dummy variable.
However, few dummies were introduced in the other estimations to capture blips in the data. Exclusion of
these dummies does not change the results qualitatively, except for failure of the normality test. These are
not reported but can be obtained from the authors.
10. The likelihood ratio tests could not reject the weak exogeneity of SMV. The test statistic is distrib-
uted as chi-square(1) which gives ap-value of 0.136. In Tables 1-7, the coefficients for SMV, unlike the
other coefficients, are not elasticities.

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TABLE 1
FINANCIAL DEVELOPMENT AND ECONOMIC GROWTH IN GERMANY
1A: RECURS1VE ESTIMAT10N OF CO1NTEGRATING VECTORS (LAG=5)
Trace Statistic Ho rank=p Eigenvalues

Sample:
1973(1)- p=O p' 1 p'2 k1 k2 4 Rank stability test
1990(4) 48.18*** 17.31 2.71 0.369 0.196 0.039 0.54

1991(4) 52.89*** 16.10 3.05 0.404 0.168 0.042 6.54**
1992(4) 49.16''''''? 15.06 2.24 0.365 0.157 0.029 5.98''''''
1993(4) 45.19*** 14.68 1.92 0.320 0.149 0.024 0.81
1994(4) 46.46*** 15.79 2.07 0.309 0.152 0.025 0.34
1995(4) 46.80'''5'''' 16.22 1.92 0.296 0.152 0.022 0.26
1996(4) 46.03*** 17.12 1.64 0.272 0.156 0.018 1.42
1997(4) 47.90 17.58 1.71 0.273 0.154 0.018 Full sample
1B: ESTIMATED COINTEGRATING VECTOR AFTER ALLOWING FOR STRUCTURAL BREAK (LAG=5)
Trace Statistic Ho rank=p

p=0 p' 1 p'2
53.67*** 18.03 2.59
Normalized on LY Constant Dummy: 1991(1)-1992(4) LMC LBY SMVi
Coefficient 5.893 0.0633 0.1316 0.4405 1.239

p-value 0.0002 0.0623 0.0079 0.0000 0.1243
NorEs: 1. Treated as weakly exogenous.

p-values are that of the likelihood ratio tests under the null that the parameter is zero
Vector autocorrelation tests: F(45, 158) = 1.1959 [0.2110]
Vector normality test: chi-square (6): 4.082 [0.6652]
c: WEAK EXOGENEITY TESTS
LY LMC LBY
Loading (0C) -0.1450 0.2550 0.2148

p-value 0.000 0.3678 0.000
NorEs: p-values are that of the likelihood ratio tests under the null that the loading factor is zero.
***, ** and * indicate statistical significance at 1 percent, 5 percent, and 10 percent, respectively.

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oos . . .
TABLE 2
FINANCIAL DEVELOPMENT AND ECONOMIC GROWTH IN THE UNITED STATES
2A: RECURSIVE ESTIMATION OF COINTEGRATING VECTORS (LAG=4)
Sample: Trace StatisticH0: rank=p Eigenvalues

1972(2)- p=O P' I p'2 X, L k Rank stability test
990(4) 78.0*** 43.23*'** 19.14,,, 0.400 0.298 0.176 6.9**,,,

991(4) 71.29 43.28' 20.08' 0.317 0.282 0.162 12.01'
992(4) 67.04*** 42.28*** 19.70 0.278 0.257 0.137 4.61
993(4) 67.14**t 41.21i*' 19.00 0.277 0.242 0.135 3.82
994(4) 69.004'*$ 42.89*** 19.42 0.267 0.249 0.132 2.39
995 (4) 69.23 42.73 19.41 0.260 0.233 0.131 2.31
996(4) 70.39*** 43.76*** 19.9l 0.251 0.228 0.130 1.48
998(1) 71.58 42.24 19.62 0.261 0.208 0.131 Full-sample
2B: ESTIMATED COINTEGRATING VECTOR AFTER ALLOWING FOR STRUCTURAL BREAK (LAG=4)

p=0 p' 1 p'2
35.07*** 10.32 2.5
Normalized on LMC Constant Dummy: 1990(1)-1991(4) LY LBY SMVI
Coefficient N/a -0.1939 3.208 0.447 -6.331

p-value 0.465 0.000 0.779 0.181

p-values are that of the likelihood ratio tests under the null that the parameter is zero.
Vector autocolTelation tests: F(45,170) = 1.219 [0.184]
2C: WEAK EXOGENEITY TESTS
LY LMC LBY
Loading (0C) -0.0013 -0.109 0.003

p-value 0.617 0.0001 0.269

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is positively related to real GDP and to banking sector development (L

atively related to stock market volatility. However, only the GDP coeff
nificant in this vector. The weak exogeneity of real GDP and banking system
development suggests that capital market development, which in the long run is in-
fluenced by these two weakly exogenous variables, has no long-run causal influence
on either of these variables. This result shows that there is clear evidence to suggest
that in the U.S. financial development does not cause real GDP in the long run. Con-
sequently, these results are in sharp contrast to the ones obtained for Germany and
may, to some extent, reflect the international character and the nature of the banking
system in the United States which is a capital market-based system (as opposed to
the bank-based system in Germany).
The results for Japan are reported in Table 3. The recursive estimates show two
cointegrating vectors throughout 1990-1995 and one cointegrating vector after
1996. Such a shift in the number of significant eigenvalues is indicative of a struc-
tural break in the long-run relationship. We therefore treat the data points up to
1995:4 as the full sample and compute LR tests of rank stability for the other years
reported in the table. Tests reveal that in Japan structural breaks in the cointegrating
ranks appear during 1991-1992 and 1996-1998. The former period coincides with a
steep decline in bank profits, reflecting worsening in the scale of nonperforming
loans, due to a sharp fall in asset values, especially in the property market, and a tight
monetary policy. The structural break during the period 1996:1-1998:1 is clearly not
surprising given that this period coincides with one of the worst economic crises in
Japan's postwar history. Importantly, the Japanese financial system has been at the
center of these problems, with many financial institutions becoming insolvent. Once
this break is taken into account through the introduction of intercept dummies for
1996:1-1998:1 two cointegrating vectors emerge. These vectors are respectively
normalized on real GDP and banking system development, which show clear evi-
dence of error correction. The over-identifying restrictions that are accepted by the
data include two normalization restrictions, linear homogeneity of LBY and a posi-
tive coefficient on LMC in the first vector and exclusion of LY from the second vec-
tor. The first vector shows that both the stock market and the banking system
development indicators influence output positively; however, the influence of the
former is about one-sixth of the latter. Stock market volatility, on the other hand, ex-
erts a negative and significant influence on the development of the real economy. The
second vector is essentially a positive and significant relationship between the bank-
ing system development and stock market capitalization. Once again, stock market
volatility enters with a negative and significant coefficient, suggesting that increased
stock market volatility a weakly exogenous variable to the systeml l impacts neg-
atively on the development of the banking system. The estimated banking develop-
ment vector displays a downward shift during 1996: 1-1998:4, reflecting a significant
autonomous shift of 1.13 percent. This effect is not significant in the output vector.
11. Weak exogeneity test of SMV from the system assumes a p-value of 0.972 which is chi-square(2)
distributed.

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4.s . . s
TABLE 3
FINANCIAL DEVELOPMENT AND ECONOMIC GROWTH IN JAPAN
Sample: Trace Statistic Ho rank=p Eigenvalues

1973(1)- p=0 pSl ps2 Xl 2 4 Rank stability test
990(4) 68.46*** 41.27*** 18.91 0.333 0.284 0.167 3.1 1

991(4) 69.468*t 41.54**t 16.56 0.325 0.297 0.135 6.47**
992(4) 68.56*** 35.53** 15.35 0.356 0.236 0.160 6.77**
993(4) 65.73*** 35.12** 14.58 0.321 0.229 0.132 4.72
994(4) 61.42*** 33.97* 12.38 0.282 0.229 0.112 2.61
995(4) 59.83-' 36.09v' 13.39 0.239 0.230 0.119 #
996(4) 51.80* 27.99 13.71 0.230 0.145 0.114 22.63t**
1998(1) 53.40** 28.32 14.71 0.230 0.132 0.118 21.37***
# 1973(1)-1995(4) treated as full sample (see text for details).
3B: ESTIMATED COINTEGRATING VECTORS AFTER ALLOWING FOR STRUCTURAL BREAK (LAG=5)

p=0 ps 1 ps2
80.91*** 23.01*** 7.78
Vector 1
Normalized on LY Constant Dummy: 1996(1)-1998(4) LBY LMC SMV
Coefficient 12.92 -0.0111 1.000 0.130 -1.336

p-value 0.000 0.3866 0.000 0.008 0.000
Vector 2
Normalized on LBY Constant Dummy: 1996(1)-1998(4) LMC SMVl
Coefficient 0.5939 -0. 1130 0.304 -1 .755

p-value 0.0002 0.0381 0.000 0.000

p-values are that of the likelihood ratio tests under the null that the parameter is zero.
Test of over-identifying restrictions: chi-square(1) = 1.8842 [0.1699]
Vectorautocorrelationtests:F(45,161)=1.1371[0.2782]
LY LMC LBY
Loading (0C) of vector 1 -0. 1471 0. 1661 -0.901 1

p-value 0.0000 0.0119 0.0000
Loading (0C) of vector 2 0.0763 -0.1410 0.9005

p-value 0.0000 0.011 1 0.0002

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Finally, the weak exogeneity tests suggest a feedback relationship between real GDP
and both parts of the financial system since all three variables are endogenous to the
system. With perhaps the exception of the negative and significant influence of stock
market volatility, these results should not be surprising in view of the relative impor-
tance of the banking sector in Japan (Corbett and Jenkinson 1994; Arestis and Deme-
triades 1996).l2
The results pertaining to the United Kingdom, presented in Table 4, display sig-
nificant differences with those of the other countries, reflecting perhaps the unique-
ness of its financial system. To start with, we find evidence of a structural shift in the
estimated relationships during 1987:1-1991:4. As 1987 was the year of one of the
most important deregulations of the U.K. financial system in recent history the Big
Bang this is once again not a surprising result. There were also statistical redefini-
tions in the mid-1980s, pertaining to the inclusion of Building Societies in the bank-
ing system statistics. Once these structural shifts are taken into account, we find
evidence of two cointegrating vectors. They are normalized on stock market capital-
ization and banking development. The data-identifying restrictions are the following
five: exclusion of real GDP from the first cointegrating vector, exclusion of LMC and
linear homogeneity between LBY and LY in the second vector, and two normaliza-
tion restrictions. The first vector is a simple and straightforward positive relationship
between stock market capitalization and banking sector development: the two parts
of the financial system exhibit a stable long-run positive association subject to a
shift in the 1987-91 period. It also shows that stock market volatility impacts nega-
tively on stock market capitalization. The second vector suggests that banking sector
development is explained by real GDP growth, while stock market volatility exerts a
significant negative influence. The weak exogeneity tests show that real GDP is
weakly exogeneous with respect to the LBY vector, and marginally so in the case of
the LMC. Thus, the LMC vector appears to cause LY, although marginally, in the
long run. The long-run banking development vector has no relationship with the
level of output and stock market development. In the long run, causality runs from
LBY to LMC and from LMC to GDP. There is no direct long-run causal relationship
between banking system development and real GDP for this country.
In conclusion, the evidence on the United Kingdom suggests that in the long run
causality flows from banking system development to stock market development. It is
also evident, however, that the flow of causality from financial system development
to real GDP is, at best, weak. On the other hand, banking system development and
stock market development are both negatively affected by stock market volatility.
This evidence could also be interpreted as suggesting that the U.K. financial system
is not a strong promoter of domestic economic growth, which to some extent reflects
its weak links with industry, in that it is a typical capital market-based system, and its
international character.
Turning finally to France, we find evidence of instability in the cointegrating rank
12. Results including shift dummies for the period 1991(1)-1992(4) are qualitatively similar. Hence
they are not reported for the sake of brevity but are available on request.

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TABLE 4
FINANCIAL DEVELOPMENT AND ECONOMIC GROWTH IN THE UNITED KINGDOM
4A: RECU,;tSIVE ESTIMATION OF COINTEGRATING VECTOI;LS (LAG=5)
Sample Trace Statistic Ho rank=p Eigenvalues

1976(1)- p=0 pcl p'2 , 4 4 Rank stability test
987(4) 67.40*** 35.85*** 14.78 0.329 0.234 0.148 20.171***

988(4) 59.47*** 36.67*** 15.94 0.240 0.221 0.153 11.099**@
989(4) 49.66* 25.44 10.44 0.243 0.158 0.090 8.532**
990(4) 51.45* 26.11 10.62 0.243 0.156 0.086 7.062**
991(4) 51.85* 25.62 9.68 0.241 0.154 0.071 6.174**
992(4) 53.32** 25.93 9.52 0.242 0.153 0.065 4.017
993(4) 54.65** 26.39 10.54 0.240 0.143 0.067 4.429
994(4) 53.89*** 24.79 10.96 0.238 0.121 0.069 2.610
995(4) 55.52** 25.13 11.46 0.240 0.116 0.069 2.019
996(4) 56.60** 25.16 12.01 0.240 0.108 0.068 0.969
1997(4) 56.75 24.34 12.59 0.240 0.094 0.067 Full-sample
4B: ESTIMATED COINTEGRATING VECTORS AFTER ALLOWING FOR STRUCTURAL BREAK (LAG=5)

p=o pc 1 pc2
105.50** 47.72** 15.63

Vector 1
Normalized onLMC Constant Dummy: 1986(1)-1991(4) LBY SMV
Coefficient 0.791 0.490 0.499 -33.57

p-value 0.0004 0.026 0.0527 0.000
Vector 2
Normalized on LBY Constant Dummy: 1986(1)-1991(4) LY SMV
Coefficient -5.355 0.8173 1.000 -31.080

p-value 0.0011 0.0000 0.000 0.000
NarEs: p-values are that of the likelihood ratio tests under the null that the parameter is zero.
Test of over-identifying restrictions: chi-square(l) = 1.0176 [0.3131]
Vector autocorrelation tests: F(80,262) = 1.001 [0.485]
LMC LBY LY SMV
Loading (0C) of vector 1 -0.0210 0.081 0.0130 -0.014

p-value 0.0303 0.000 0.0531 0.000
Loading (0C) of vector 2 -0.0012 -0.082 -0.006 0.003
p-value 0.601 1 0.0001 0.3247 0.000
***, ** and * indicate statistical significance at l percent,5 percent, and l0 percent, respectively

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during 1990:1-1993:4. This period follows the completion of financial reforms,

which commenced in 1984 with the comprehensive reform of French banking legis-
lation, the official policy of deregulation and the harmonization of institutional
arrangements within the European Union. By 1992 capital account liberalization had
been completed. Also, 1992-93 saw the ERM turmoil with the French franc coming
under strong speculative attack. Furthermore, given the important deregulation of the
French financial system that took place during the mid-1980s, we allowed for addi-
tional structural shifts by incorporating an intercept dummy for the period of
1985:1-1985:4 in our estimation.l3 Thus, for France, we allow for two sets of shift
dummies, for 1985:1-1985:4 and 1990:1-1993:4.
Cointegration results for France, which take into account the above structural
shifts, are reported in Table Sb. The trace statistic shows evidence of two cointegrat-
ing vectors. On the basis of the sign and significance of the associated loading fac-
tors we normalize them on real GDP and stock market capitalization respectively.
The identifying restrictions that are data acceptable comprise exclusions of LMC
and the 1985 dummy from the first vector, exclusion of LY from the second vector,
and the two normalization restrictions. The first vector shows a positive impact of
banking system development and capital market on real GDP and a negative and sig-
nificant effect of stock market volatility. The second vector, portrays a positive rela-
tionship between the banking system and stock market capitalization while stock
market volatility is found to have a negative influence on LMC. This vector appears
to have been affected by the financial reforms of the mid-1980s, which seem to have
boosted stock market capitalization. In this sense this provides support to the argu-
ment put forward by Arestis and Demetriades (1996) that the French financial sys-
tem shifted toward becoming a capital-market-based one, following those reforms
(see, also, Bertero 1994). Although both the stock market capitalization and banking
system development appear with positive and significant cointegrating parameters in
the output vector, it is important to note that the magnitude of the latter's coefficient
is almost seven times that of the former. Thus, the effect of banking development on
real GDP appears to be much stronger than that of the stock market. The weak exo-
geneity tests reveal that no variable is weakly exogenous with respect to any of the
vectors, suggesting an abundance of feedback relationships between the variables in
the system. In the long run there is feedback between LY and LMC as all loadings
are significant. Both real output and stock market development vectors enter into the
banking system development suggesting that in the long run both LY and LMC
cause LBY.
In conclusion, the results on France suggest that while the French financial system
has directly contributed to long-term output growth, the role of the banking system
has been much more substantial than that of the stock market; this was in spite of the
growing importance of the latter as a result of the financial reforms of the 1980s.
Furthermore, even though the long-run development of the stock market has gone
13. In view of the sample size we did not compute recursive tests of stability for 1985:1-1985:4

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TABLE 5
F1NANCIAL DEVELOPMENT AND ECONOMIC GROWTH IN FRANCE
Trace Statistic HO: rank=p Eigenvalues

Sample:
1973(1)- p=0 pc 1 ps2 kl 2 4 Rank stability test
990(4) 52.22** 24.72 9.23 0.333 0.204 0.127 5.40*

991(4) 53.40** 25.40 10.20 0.322 0.190 0.131 4.90*
992(4) 55.11*** 26.25 11.18 0.316 0.180 0.133 4.97*
993(4) 55.198** 27.26 1 1.58 0.295 0.178 0.132 4.98*
994(4) 56.22*** 25.41 10.26 0.307 0.165 0.115 2.08
995(4) 58.42*** 27.31 1 1.28 0.298 0.167 0.118 1.79
996(4) 60.21*** 26.89 11.53 0.304 0.154 0.117 0.42
1998(1) 60.43 27.53 11.89 0.288 0.149 0.115 Full-sample
5B: ESTIMATED COINTEGRATING VECTORS AP liER ALLOWING FOR STRUCTURAL BREAK (LAG=4)
Trace Statistic H rank=p

p=0 p' 1 ° p52
1 16.4*** 41.48*** 10.69

Vector 1
Normalized on LY LMC Dummy 1990(1)-1993(4) LBY SMV
Coefficient 0.0561 -0.0383 0.3730 -3.358

p-value 0.0017 0.0003 0.0023 0.0023
Vector 2
Normalized on LMC Dummy: 1985(1)-1986(4) LBY SMV
Coefficient 0.738 5.164 -56.060

p-value 0.0076 0.000 0.0036
NarEs: I7-values are that of the likelih

Test of over-identifying restrictions: chi-square(1) = 0.0068 [0.9342]
LY LMC LBY SMV
Loading (0C) of vector 1 -0.0160 1.0730 0.0790 -0.1040

p-value 0.0059 0.0031 0.0003 0.0000
Loading (0C) of vector 2 -0.002 -0.057 0.0060 -0.0006
p-value 0.005 0.0025 0.0039 0.0068
NOTES: p-values are that of the likelih

***, ** and * indicate statistical significance at 1 percent, 5 percent, and l0 percent, respectively.

202.41.10.120 on Tue, 09 Mar 2021 04:12:34 UTC
hand in hand with the development of the banking system, the former appears to
have been much more of a follower in the process of economic development, re-
sponding positively to both output growth and banking system development. On the
other hand, stock market volatility seems to have been detrimental to both long-term
output growth and stock market development.
Alternative Measures of Stock Market Development: Sensitivity Checks

In order to check the sensitivity of our results vis-a-vis the alternative measures of
stock market development, we repeated the empirical analysis using two further
measures, namely, the logarithms of the ratio of total stock market transactions to
GDP (TRY) and the ratio of total stock market transactions to market valuation
(TRMV) for the United States and the United Kingdom. The stock market transac-
tion data for the United Kingdom are available for a period of 1976:1-1998:1 and for
the US 1973:1-1998:1. In view of the shorter samples for the United Kingdom, this
sensitivity analysis should be taken as indicative only. For other sample countries
lack of data on stock market transactions, or the insufficient length of this time se-
ries, prevented us from carrying out sensitivity analysis.
The results,obtained from alternative measures of financial development are re-
ported in Tables 6 and 7. They are, in qualitative terms, broadly similar to those ob-
tained using the stock market capitalization variable. Therefore, in the interests of
brevity we report only a summary of these findings. Specifically, for the United
States we continue to find one cointegrating vector, whichever of the above measures
is used. In either case the cointegrating vector is normalized on the stock market
variable in view of the correct sign and significance of the corresponding loading
factor. The normalized vector depicts a positive association between stock market
development, banking system development, and real GDP. Real GDP and banking
system development appear weakly exogenous when using the first variable but be-
come endogenous when using the second. Stock market volatility has negative ef-
fects in both vectors, albeit significant only in the TRMV vector. Further, weak
exogeneity tests reveal qualitatively similar causal patterns to those reported in Table
2c with respect to TRY vector whereas LY and LBY become endogenous with re-
spect to TRMV vector.
In the case of the United Kingdom, the results reported in Table 7 still show two
cointegrating vectors with the first alternative measure of stock market development,
TRY. The first cointegrating vector, normalized on TRY, is very similar to the one
normalized on LMC (see Table 4b) and shows a positive association between stock
market development and banking sector development; stock market volatility exerts
a significant negative effect on TRY. The second vector, normalized on LBY, now
shows an insignificant real output effect but the volatility effect is negative and much
stronger. Weak exogeneity tests suggest that there exists a feedback effect between
stock market development and banking system development; however, the causal
flows from financial variables to output are more significant now. With the second al-
ternative measure (TRMV), we find only one cointegrating vector, which is normal-
ized on LBY and shows a positive and significant relationshin between LBY and

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TABLE 6
FINANCIAL DEVELOPMENT AND ECONOMIC GROWTH IN THE UNITED STATES
TRANSACTIONS-BASED MEASURES OF STOCK MARKET DEVELOPMENT SAMPLE: 1973: 1-1998: 1
A. RATIO OF STOCK MARKET TRANSACTIONS TO GDP RATIO (TRY)
ESTIMATED COINTEGRATING VECTOR AFTER ALLOWING FOR STRUCTURAL BREAK

p=0 p' 1 p'2
31.32*** 12.52 2.99

Coilltegratillg Vector
NormalizedonTRY Constant Dtlmmy: 1987(1)-1991(4) LBY LY SMV
Coefficient N/a -0.128 1.464 5.299 -1.775

p-value 0.532 0.235 0.003 0.641

WEAK EXOGENEITY TESTS
LY TRY LBY
Loading (0C) 0.0024 -0.2528 -0.005

p-value 0.5881 0.0181 0.3026
B. RATIO OF STOCK MARKET TRANSACTIONS TO STOCK MARKET VALUATION (TRMV)
ESTIMATED COINTEGRATING VECTOR AFTER ALLOWING FOR STRUCTURAL BREAK; SAMPLE: 1973: 1-1998: 1

p=0 ps 1 ps2
36.80*** 12.28 2.477

Coilltegratillg Vector
Normalized onTRMV Constant Dummy: 1987(1)-1991(4) LBY LY SMV
Coefficient N/a 0.181 3.372 2.527 -7.144

p-value 0.426 0.044 0.009 0.054

LY TRMV LBY
Loading (0C) 0.0068 -0.0815 -0.0063

p-value 0.0440 0.078 0.0642
* k*, ** and * indicate statistical significance at 1 percent, 5 percent, and 10 percent, respectively.

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TABLE 7
FINANCIAL DEVELOPMENT AND ECONOMIC GROWTH IN THE UNITED KINGDOM
TRANSACTIONS-BASED MEASURES OF STOCK MARKET DEVELOPMENT
A. RATIO OF STOCK MARKET TRANSACTIONS TO GDP RATIO (TRY); SAMPLE: 1976: 1-1997:2
ESTIMATED COINTEGRATING VECTOR AFTER ALLOWING FOR STRUCTURAL BREAK

p=0 ps 1 ps2
84.51 35.24 18.75

Vector 1
NormalizedonTRY Constant Dummy: 1987(1)-1991(4) LBY SMV
Coefficient -0.932 0.553 0.630 -34.74

p-value 0.762 0.020 0.000 0.006
Vector 2
Normalized on LBY Constant Dummy: 1987(1)-1991(4) LY SMV
Coefficient -0.697 2.122 - 8.506 - 131.40

p-value 0.006 0.003 0.120 0.0054
NorEs: p-values are that of the likelihood ratio tests under the null that the parameter is zero.
Vector autocorrelation tests: F(80, 1 16) = 1.023 [0.452]
LY TRY LBY SMV
Loading (0C) of vector 1 0.0069 -0.154 0.1096 0.1340

p-value 0.0045 0 0004 °°°° 0-0004
Loading (0C) of vector 2 -0.002 0.030 -0.0363 -0.0065
p-value 0.005 0.0002 0.000 0.0006
B. RATIO OF STOCK MARKET TRANSACTIONS TO STOCK MARKET VALUATION (TRMV)
ESTIMATED COINTEGRATING VECTOR AFTER ALLOWING FOR STRUCTURAL BREAK; SAMPLE: 1976: 1-1992:2

p=0 ps 1 ps2
76.57*** 33.720 15.19

CoilltegratiTlg Vector
Normalized on LBY Constant Dummy: 1987(1)-1991(4) TRMV LY SMV
Coefficient -8.607 0.452 0.612 1.598 - 15.85

p-value 0.001 0.003 0.0004 0.258 0.000

LY TRMV LBY SMV
Loading (0C) 0.009 -0.006 -0.072 -0.012

p-value 0.038 0.939 0.001 0.0004

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TRMV. The real GDP effect is insignificant and stock market volatility is signifi-
cantly negative. Weak exogeneity tests indicate causality from LBY to LY and no as-
sociation between LBY and TRMV.
Implications for the Debclte on Financiczl Systems
Even though our results vary across countries, they accord reasonably well with
widely accepted views regarding the comparative ability of various types of financial
system to stimulate investment and growth. Specifically, our findings are broadly
consistent with the view that bank-based financial systems are more capable of pro-
moting long-run growth than Anglo-Saxon type systems because they are better able
to address agency problems and short-termism (for example, Stiglitz 1985; see also
Singh 1997). Specifically, both (i) the positive influence of the banking system on
real GDP in Germany, Japan, and France and (ii) the absence or weakness of a posi-
tive causal link from financial development to real GDP in the United Kingdom and
the United States, accord well with this view. What is also interesting in the cases of
Germany and Japan is that both banking system and stock market development seem
to have played a positive role in promoting long-run growth, even though in quanti-
tative terms the contribution of the stock market was substantially smaller.
4. SUMMARY AND CONCLUSIONS
Our empirical analysis shows that while stock markets may be able to contribute
to long-term output growth, their influence is, at best, a small fraction of that of the
banking system. Specifically, both stock markets and banks seem to have made im-
portant contributions to output growth in France, Germany and Japan, even though
the latter's contribution has ranged from about one-seventh to around one-third of
the latter. Finally, the link between financial development and growth in the United
Kingdom and the United States was found to be statistically weak and, if anything,
to run from growth to financial development. Thus, our findings are consistent with
the view that bank-based financial systems may be more able to promote long-term
growth than capital-market-based ones.
Our findings also suggest that stock market volatility had negative real effects in
Japan and France. In the case of the United Kingdom stockmarket volatility seems
to have exerted negative effects both on financial development and output. Finally,
the effects of stock market volatility in Germany were found to be insignificant.
While in principle the presence of volatility in stock prices may reflect efficient func-
tioning of stock markets, our findings do not support this hypothesis. Furthermore,
they are consistent with the findings of Aizenman and Marion (1996), who found
that other measures of volatility fiscal, monetary and external also have negative
real effects. This, of course, may suggest that volatility of any kind reflects general
economic uncertainty and is, therefore, negatively correlated to real economic activ-
ity. Clearly further research is needed before more definitive conclusions can be
drawn on this issue, especially on the channels through which stock market volatility
may affect economic activity.

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The rich diversity in our results complements the findings obtained f1 om cross-
country growth regressions concerning the relationship between stock markets and
growth. It also confirms the view that cross-country growth regressions at best only
provide a broad- brush picture of the relationship between financial development and
growth, which misses out many important details. There are good theoretical reasons
why the relationship between the financial system and growth may vary substantially
across countries. This paper's findings suggest that these reasons are empirically
sound. Thus, the broad-brush conclusion that stocl market development helps pro-
mote economic growth must now be viewed with some caution. 14
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