Over the recent century, a long debate has emerged whether financial organizations, such as banks, have an impact on economic activity or economic growth. Firstly, I review some meta-analyses before entering into the empirical results in upcoming blog posts. Later, I will dedicate a series of essays on this topic by reviewing the discussions in the literature. In the following, I express my theoretical stance on the role of finance in economic growth, which resonates with the long-term personal research I have been doing over the recent months.

To start the analysis, I will focus on the emergence of functional properties of financial institutions to shed some light on the micro-macro interlinkages that may determine through which channels banks can impact economic growth trajectory in a region.

Economic growth is a long-term process entailing a multitude of business cycles, swings, and uncertainties. Yet, this long-term process is composed of various short- and medium-run events that are staggered to make up long-term growth. If we agree that growth emerges from economic coordination and industrial production of services and goods, then firms (or industrial organizations) play a crucial role in economic growth through innovating and expanding production capacities. Nevertheless, industrial production (such as major equipment, machinery, including high-skill services) takes time to be fulfilled. For instance, a machinery manufacturing firm may receive an order backlog in 2020 with only 25% of pre-payment for a product that takes over six months to assemble a complete form. We may call this an order-fulfillment cycle.

The financialization during this time-span becomes a problem for firms with limited financial resources owned. Depending on industries, the order-fulfillment cycle might be between 2 weeks and 6 years or even more. The lead time is especially high for products that are not in the assembly line already (non-existing products), such as products from the research and development (R&D) that need first the product prototypes successfully initiated, pre-tested, and then adjusted for economies of scale. This time-gap both for the pre-existing and non-existing (potential future products from the R&D process) production requires necessary financing of costs that a firm incurs. According to statistical analysis, roughly 66 percent of an average firm's activities are facilitated through funds that do not belong to that firm at the beginning of industrial processes. Therefore, one could assume that a random sample of firms borrows some portion of the financial resources necessary for implementing production.

Access to finance matters most for the entry of small firms and in sectors that are more dependent upon external finance, such as advanced technological producers. (Aghion 2007) Considering that 93% of all non-financial companies in Europe are small firms, it becomes important to study the financing patterns of firms, especially micro firms. (Masiak et al, 2007) One crucial issue is that the financing patterns of firms are heterogeneous with respect to the size of a firm, which varies between developing and developed market economies. (Beck et al., 2008; Ayyagari et al., 2012; Hanedar et al., 2014)

This random sample of firms from the distribution of total firms tries to access either a trade credit (such as through venture financing, entrepreneurial-investors, crowdfunding, personal savings, etc.) or bank credit. Banks as an easy access point facilitate at least half of the total credit demand of firms. As a response to this demand, banks or financial intermediaries lend credit money to firms. Credit becomes a liability for the borrower, but an asset for the bank, which is an illiquid and risky asset. Banks through similar lending activities get involved in risk-taking which may backfire anytime because industrial production is a long-term and usually uncertain process, i.e. default risk. This risky lending activity of banks requires a multi-level netting of hierarchical financial market structure to run risk-taking behavior in the short-run. For instance, banks using derivatives transactions (such as credit derivatives) can make it safer by creating a commitment device into a future period. To keep the discussion a little bit simpler, I assume the intricacies between a bank and financial markets away and only focus on the interactions between a firm and a bank.

In this bank-firm avenue, a firm is an agent while the bank is the principal, thus, turning this matter into a principal-agent problem with respect to contracting. Now there is a multitude of questions arising on the micro-foundational analysis of the macroeconomy, which I will address in the following blog posts.

In summary, we can assume that the financial sector makes risky long-term loans to firms, funded by deposits from savers (households, to make the analysis easier at this stage).

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For the upcoming two-three blog posts, I will do the following: (1) review some major publications in literature until the end of the 20th century, such as King and Levine (1993) or Levine (1997), (2) review a few empirical results that contradict or challenge previous findings, such as Rousseau and Wachtel (2011); (3) work on potential problems in identifying interlinkages of finance-growth nexus.

Notes: This article entails a lot of arguments that are not fully cited, please feel free to ask in case you identify something completely unrealistic in my arguments.

References: (non-exhaustive)

Aghion, P., T. Fally, and S. Scarpetta (2007). Credit constraints as a barrier to the entry and post-entry growth of firms. Economic policy 22(52), 732-779.

Ayyagari, M., A. Demirgüc-Kunt, and V. Maksimovic (2012). Financing of firms in developing countries: lessons from research. World Bank Policy Research Working Paper (6036).

Beck, T., A. Demirgüc-Kunt, and V. Maksimovic (2008). Financing patterns around the world: Are small firms different? Journal of financial economics 89(3), 467-487.

Hanedar, E. Y., E. Broccardo, and F. Bazzana (2014). Collateral requirements of SMEs: The evidence from less-developed countries. Journal of banking & finance 38, 106-121.

King, R. G. and R. Levine (1993). Finance and growth: Schumpeter might be right. The quarterly journal of economics108(3), 717-737.

Levine, R. (1997). Financial development and economic growth: views and agenda. Journal of economic literature 35(2), 688-726.

Rousseau, P. L. and P. Wachtel (2011). What is happening to the impact of financial deepening on economic growth? Economic Inquiry 49(1), 276-288