When does financial development fail?

Economic growth
Financial institutions
Financial Economics
Macroeconomics - Economic growth - Monetary Policy

Underdeveloped financial sectors and lack of education of the workforce are among the main causes behind why some countries remain poorer than others. Well-functioning financial and credit markets allow for the most talented entrepreneurs to obtain the necessary investment for new machines and equipment or for repairing old ones, enabling firms to become more productive and to grow to their optimal size. They also help to disentangle the choice to become an entrepreneur from individuals’ inherited wealth. The functioning of financial and credit markets hence has important effects for entrepreneurship and firm-level outcomes such as size and productivity of firms. And countries with larger and more productive firms tend to have higher aggregate total factor productivity, output, and growth. These benefits of a well-functioning financial sector are often summarized by a positive relationship between domestic credit as a measure of financial market development and countries' per capita Gross Domestic Product (GDP), as depicted in the left-hand graph of Figure 1.

On the other hand, educational attainment is important for economic development because an educated workforce is a crucial input to research and development which spurs technological growth. Furthermore, educated workers are needed to apply technological advances and to operate machines with newly embodied technologies. Educated workers are also more efficient at problem solving and can better deal with new environments. The importance of education for economic growth is usually illustrated with a positive correlation between countries' GDP per capita and educational attainment as shown in the right-hand graph of Figure 1.

Hence, not surprisingly, many of the efforts by international organizations to foster economic growth consist in promoting education and improving the efficiency, depth and access of financial and credit markets. However, when designing blueprints for financial development, policymakers typically ignore the role that education might play, and vice-versa. Likewise, academic economists tend to analyze the impacts of financial development on countries' economic performance separately from the impact of countries’ educational attainments.

Based on our own research (Allub, Gomes, and Kuehn, 2019) we find that both sources of economic development have to be analyzed jointly. In particular, we argue that financial development fails in countries where educational attainment is very low. Our argument is grounded on the widely accepted view amongst economists that capital and skilled labor are more complementary in production than capital and unskilled labor; i.e. one needs qualified workers to operate complex machinery.

Developing financial markets is crucial for allowing firms that do not have their own funds to borrow when they want to expand their capacity, by building factories and acquiring machines. However, when certain skill levels are required to operate machines and equipment, firms will only want to invest if they are able to find workers qualified enough to operate those machines. But not only that; to expand, firms need engineers to set up the latest machines, architects to design new projects, human resource experts to hire additional workers, and accountants for a different type of engineering. Finding all this expertise in countries with very poor education systems where most people are unqualified is hard. In these countries, educated workers are scarce and their wages comparably high. Even if firms could obtain credit relatively easily, it might be cheaper to hire unskilled labor and to operate more labor-intensive technologies than to expand activity by investing in machines that are oftentimes substitutes for unskilled labor. Hence, when financial markets start to develop in such an environment and entrepreneurs see their access to finance improve, they may not change their investment decisions much, because there are simply not enough qualified individuals to assist with a business expansion. As a consequence, financial development in a context of low educational attainment will have very little effect on average firm size, productivity, and output.

Technologies characterized by capital-skill complementarity thus imply that financial development which makes credit available to more firms will have different effects depending on the skill level of a country’s workforce. In particular, financial development will be more successful in countries with higher educational attainments. This observation might explain why some episodes of financial deepening were more successful (e.g. East Asian countries) than others (e.g. Latin American countries). The observation is also useful for policy makers to be able to evaluate under which circumstances financial market or educational reforms have a better chance of being successful. In our study we consider the example of three countries: the Philippines, Mexico, and Malawi, where 21, 11, and less than 1 percent of the population hold a college degree. Model-based calculations suggest that, if financial markets in these countries were as developed as in the US, output would increase by 24 percent in the Philippines, 21 percent in Mexico but by only 9.5 percent in Malawi. In countries with a negligible share of tertiary educated workers, financial development hence has much smaller effects on aggregate output.

The reverse side of this argument is that education reforms aimed at increasing the educational attainment of a country’s workforce, will lead to more growth only if financial markets are well developed. Promoting education when access to credit is restricted and most firms do not have the means to acquire expensive machinery will simply depress wages of skilled workers, potentially leading to a large share of them migrating (brain drain).

The interaction at the firm level between a country’s level of financial market development and its educational attainment is a novel mechanism that differs from the more widely held view that low financial development limits the accumulation of human capital because individuals cannot obtain loans to finance their education. We find empirical evidence for our mechanism at the firm level looking at microdata from the World Bank Enterprise survey, a leading survey of firms in developing countries. Controlling for several other characteristics, firms with more assets, indicative of facing fewer financial constraints, employ a larger fraction of educated workers. Recent research by Fonseca and Van Doornik [2019] provides even stronger empirical evidence supporting this mechanism. The authors consider a bankruptcy reform in Brazil that led to an expansion of credit, finding that firms that were constrained before the reform, increased employment, particularly of more qualified workers, relative to previously unconstrained firms.

Our mechanism has two important implications for policymakers. First, when designing financial market reforms or educational reforms, the interaction between both should be taken into account. Ambitious financial development programs will not be very successful when educational attainment is low. A better approach would be to design more gradual financial market deepening together with efforts to improve education. The second implication is that policymakers should be aware that financial market development increases wage inequality because it leads to firms hiring more skilled than unskilled labor and hence raises wages of skilled workers more than wages of unskilled workers. A more conceptual implication is that one-size fits-all policies are ineffective, because they abstract from country-specific characteristics. To design better policies, economists and policymakers should continue to investigate the right settings that make particular reforms, in our case financial development reforms, more likely to be successful.


Allub, Lian; Gomes; Pedro and Zoe Kuehn (2019): “Human capital and financial development: Firm-level interactions and macroeconomic implications,” CAF Working Paper #2019/06.

Barro, Robert J. and Jong-Wha Lee (2013): “A New Data Set of Educational Attainment in the World”, 1950-2010,'' Journal of Development Economics, 104, pp. 184-198.

Fonseca, Julia and Bernardus Van Doornik (2019): Financial Development, Labor Markets, and Aggregate Productivity: Evidence from Brazil," mimeo.

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