How Finance,Trade, and Growth are Connected

As trade barriers are lifted and economies opened, financial sectors surge to fund the wave of new economic activity.

Both financial liberalization and trade may affect economic growth. Expanding trade may have a direct effect on growth, as well as an indirect effect through the financial sector. These effects also may vary with the stages of a country's development.

In Historical Evidence on the Finance-Trade-Growth Nexus (NBER Working Paper No. 17024), co-authors Michael Bordo and Peter Rousseau study the linkages between financial development, international trade, and long-run growth with a particular interest in the evolving role of trade in growth as financial systems emerge and mature. Using data from seventeen "Atlantic" economies between 1880 and 2004, they find that financial development is strongly linked to growth throughout the period, but that the link between trade and growth emerges primarily in the period after 1945.

Their findings do not imply that trade had no positive impact on growth before 1945. In fact, trade and openness had indirect effects on growth, operating through finance: trade was dynamically linked to financial development, which itself was dynamically linked to growth. Although finance and trade seemed to reinforce each other before 1930, that dynamic did not persist after the Second World War.

To explain this phenomenon, the authors look at what they call "deeper" fundamentals, which encompass both the legal framework of a country and its political environment. The authors argue that a country's opening to trade spurs financial development, international integration, and growth by weakening the power of economic and political incumbencies that may block financial liberalization. Their results suggest that the component of financial development directly related to legal origin and the political environment is strongly correlated with growth throughout the 125-year sample, while the similar component of trade does not share such a persistent linkage. Therefore, financial development may be "primal" to growth.

Indeed, as trade barriers are lifted and economies opened, financial sectors surge to fund the wave of new economic activity as economies transition from a state of lower growth to a new higher-growth environment. Once the transition is complete, however, the relationship between trade and finance increasingly comes through other factors that affect them both, rather than by mutually reinforcing effects. That might explain the weakening of the linkage between trade and finance after 1945.

In studying the rising impact of trade on growth in the post-World War II period, the authors posit the importance of such factors as the signing of the General Agreement on Tariffs and Trade -- which led to the re-establishment and liberalization of trade channels severed during the World Wars -- and to enhanced integration in Europe through the common market, as well as the gradual elimination of capital controls after 1973.

--Claire Brunel