See Levine (1997) for a review of how finance affects growth.
We define here perfect capital markets to be markets with no transaction costs, nocontracting costs, no taxes, no information asymmetries, and no restrictions to trades in financialassets.1
This paper examines how the organization of financial activities within a country affectseconomic growth through its impact on how corporations raise and manage funds. In principle, howwell a financial system performs any of its functions can affect economic growth.
For instance, theorganization of a country’s payment system affects growth by making it easier for economic agents totrade. Often, policymakers and academics take it as given that savings will be invested efficiently, sothat firms do not matter. This view rests on traditional neoclassical principles. In a simple world of perfect capital markets and risk-neutral agents, the interest rate determines which investmentopportunities are valuable and all investment opportunities that are valuable are exploited.
This isnot the world we live in. Even though a country has savings, its growth can be stunted because itsfinancial system fails to direct these savings where they can be invested most efficiently. In this paper,we therefore examine how the organization of financial activities affects the efficiency with whichcorporations invest savings and take advantage of valuable investment opportunities.The fact that savings can be invested inefficiently because of how financial activities areorganized has been at the core of the intense debate on the comparative benefits and costs of the“Anglo-saxon” model and the “bank-centered” model. When the U.S. economy’s performance seemedpoor in contrast to the performance of the Japanese economy in the 1980s, the “bank-centered” modelwas viewed as a key determinant of why the performance of the two economies differed. A typicalview of that period is represented by Thurow’s argument that “the United States has organized a