Financial Markets, Specialization, and Learning by Doing

The research was supported in partby NSFGrantSES-892I346. Thefirst authoralso acknowledges support from the JohnM. Olin Foundation. Wehavealso benefitted from helpfuldiscussionswith Julie Anderson Schaffnerand Gary Fields. ABSTRACf This paper considers three questions: (1) what is the role of financial markets in development, (2) why do some economies have such poorly developed financial markets, and (3) can government policy be used to promote financial market development? With respect to the first question. we formalize the widely-held notion that financial markets promote entrepreneurship, specialization. and leaming-by-doing. However, if economic incentives for specialization are absent. financial markets may fail to form. This occurs when real interest rates are too low. We also discuss policies that can be used to promote financial market development. When these policies are successful, they will be growth promoting. Finally, we examine policies intended to manipulate returns on savings, which are often important components of "financial liberalizations. " We describe conditions under which such policies will be conducive to growth. This paper is concerned with three general questions. First, what role do financial markets play in the process of economic development? Second, assuming that they do play an important role, why is the state of financial market development so rudimentary in so many