Financial Development and Economic Growth: Is Schumpeter Right?

Abstract

IAim: The aim of the study is to test the validity of Schumpeter’s prediction that finance promotes growth using annual time series data from South Africa. Study Design: Case Study Place and Duration of Study: South Africa. Time series data ranging from 1965 to 2010. Methodology: The study employs unit root testing, co-integration analysis, Fully Modified Ordinary Least Squares (FMOLS) regression, Two-Stage Least Squares (2SLS) regression, Error Correction Model and Pairwise Granger Causality test technique to analyze annual time series data from South Africa. Two measures of financial development are used: domestic credit as a share of GDP measuring the degree of financial intermediary services; and broad money supply as a share of GDP measuring the overall size of the financial intermediary sector. Control variables included in the model are inflation, size of government, openness of the South African economy, and a dummy variable accounting for financial reforms that began in South Africa in the 1980s. Results: Contrary to the prediction of Schumpeter that finance promotes growth, the empirical results suggest that financial development does not promote economic growth both in the short run and in the long run. The Pairwise Granger Causality test result supports the assertion that there is a unidirectional causality from financial development to economic growth in South Africa. Conclusion: The paper concludes that Schumpeter may not be right in theorizing that finance